Oct. 30 (Bloomberg) -- India's central bank unexpectedly ordered lenders to set aside more reserves for a fourth time this year to prevent ``unacceptably high'' inflows of foreign cash from reigniting inflation.

The Reserve Bank of India raised the ratio of deposits lenders must put aside by half a point to 7.5 percent, up from 5.25 percent at the start of the year. Interest rates were kept unchanged, the central bank said in a statement in Mumbai today.

The increase follows steps last week by India's stock market regulator to check foreign investment that drove the share index to a record and pushed the rupee to a 9 1/2 year high. Governor Yaga Venugopal Reddy said inflows rose after the U.S. Federal Reserve cut rates to stem subprime mortgage defaults, increasing the risk of ``financial contagion.''

``Further monetary action cannot be ruled out,'' said Shuchita Mehta, senior economist at Standard Chartered Bank in Mumbai. ``Foreign fund flows will remain strong because India is an attractive market.''

Overseas investors have bought $18.97 billion of stocks and bonds this year, double the record $9.46 billion in 2005. That's sent India's benchmark Sensitive index higher by 43 percent this year and the rupee by 12.3 percent.

Foreign funds are lapping up Indian stocks to gain from an economic expansion that's averaged 8.6 percent each year since 2003, the most since the country's independence in 1947.

Bonds Fall

Bonds and shares fell. The yield on the benchmark 7.99 percent bond due July 2017 rose 4.5 basis points to 7.86 percent at close of trading in Mumbai, the highest since Oct. 22.

The Bombay Stock Exchange's Sensex dropped 1 percent to 19,783.51. The index yesterday crossed 20,000 for the first time, after doubling in less than two years. The rupee traded at 39.39 against the dollar versus 39.405 before the announcement.

India and China are restricting bank lending to prevent asset bubbles from spurring inflation in the world's two fastest growing economies. The stock markets of the two Asian nations have added a combined $3 trillion this year, more than doubling their market capitalization.

``The biggest challenge is the management of capital flows,'' India's central bank said in its quarterly monetary policy statement, while keeping an inflation target of 5 percent. Inflation was at 3.07 percent in the second week of October.

To check the flood of capital, the Securities and Exchange Board of India, the stock market regulator, on Oct. 25 barred issuance of offshore instruments tied to derivatives.

Foreign Investment

These offshore derivatives, known as participatory notes, rose 11-fold to 3.54 trillion rupees in 3 1/2 years, the regulator said Oct. 16. They accounted for 52 percent of foreign brokers' assets under custody, the regulator said.

``I doubt if the new rules in the stock market will seriously dent inflows,'' said Navneet Munot, who helps manage about $8 billion at Birla Sun Life Asset Management Co. in Mumbai.

The central bank today left its key overnight borrowing rate unchanged at 6 percent and the overnight lending rate was maintained at 7.75 percent. The benchmark has been increased nine times since October 2004.

`If there are signs of any pressure from outside, nothing to do with our fundamentals, we have to protect our system,'' Reddy told reporters in Mumbai today. ``Whatever options are required will be taken by us.''

Rising rates have widened the spread between two-year Indian government bonds and similar maturity U.S. Treasury notes to 3.82 percent from as low as 1.84 percent in June, Bloomberg data shows.

`Discourage Arbitrage'

``If they want to slow foreign capital flows, interest rates need to be cut,'' said Paresh Nayar, chief foreign exchange dealer at the Development Credit Bank Ltd. in Mumbai. ``That will discourage arbitrage.''

Rising policy rates in India have also nudged commercial banks to raise their lending rates to the highest in almost a decade, hurting sale of cars, homes and other products.

Growth in car sales in the five months to August slowed to 13.6 percent from 20.6 percent in the same period last year. Sales of scooters and motorcycles declined 5 percent, according to the Society of Indian Automobile Manufacturers.

``Interest rates will start to level off now,'' said Karl Slym, managing director of the Indian unit of General Motors Corp., the world's biggest automaker. ``We will be able to see sales pick up.''

Oil Prices

The central bank said rising food and oil prices ``pose risks to the inflation outlook''. India has prevented its state- run refiners from raising local fuel prices even as crude oil prices have risen by 47 percent to a record this year, prompting the bank to describe current inflation levels as ``suppressed''.

``Elections are round the corner and the government is unlikely to raise fuel prices now,'' said D. H. Pai Panandiker, president of the RPG Foundation, an economic policy group based in New Delhi.

Analysts expect Prime Minister Manmohan Singh to call snap elections because of opposition from his communist allies on economic policy. The communists have resisted easing foreign investment rules and sale of state assets. And since August they have thwarted a civilian nuclear deal Singh was forging with the U.S. to secure the nation's energy supplies.

To contact the reporter on this story: Cherian Thomas in New Delhi at cthomas1@bloomberg.net.

Last Updated: October 30, 2007 09:52 EDT