Oct. 25 (Bloomberg) -- Record overseas purchases that have stoked a ``bubble'' in Indian stocks may slow under new rules planned by regulators, investors and analysts say.

Foreign investors sold a net $1.3 billion worth of Indian shares since capital markets regulator M. Damodaran proposed curbs on Oct. 16, the biggest five-day selloff in two months. Damodaran, chairman of the Securities & Exchange Board of India, will today hold a board meeting to approve new rules aimed at forcing overseas investors to register before buying stocks.

Finance Minister P. Chidambaram yesterday said inflows have caused a ``bubble'' in the stock market and stoked the rupee to a 9 1/2-year high. More than half of client assets held by Citigroup Inc., JPMorgan Chase & Co. and other foreign brokerages are in offshore derivatives linked to Indian stocks.

``In the long run, rerouting equity flows probably would have only a very limited effect, but in the short run, it can have a significant impact on sentiment and flows,'' UBS AG's Hong Kong-based economist Philip Wyatt said. ``It takes time to do the legal paperwork and register as an onshore Foreign Institutional Investor, so there is a liquidity impact.''

U.S. Treasury Secretary Henry Paulson yesterday urged India to avoid placing controls on international investment, two days before leaving for his first visit to the country since taking office.

Offshore derivatives, known as participatory notes, rose 11- fold to 3.54 trillion rupees ($89 billion) in 3 1/2 years, the regulator said on Oct. 16. These accounted for 52 percent of foreign brokers' assets under custody, the regulator said.

The watchdog will hold a press conference at 5 p.m. in Mumbai to give details on the outcome of today's board meeting.

Share Rally

Foreign funds and institutions have bought $16.7 billion of shares this year, with 43 percent invested since the U.S. Federal Reserve cut rates on Sept. 18. That's driven the benchmark Bombay Stock Exchange Sensitive Index, or Sensex, past 19,000 for the first time, making it the third-best performer among global indexes since the Fed cut.

The regulator on Oct. 16 suggested foreign institutional investors shouldn't be allowed to issue or renew offshore derivative instruments linked to futures and options. The proposals triggered a slump in markets that halted trading for an hour the next day and ended eight straight weeks of gains on the Sensex.

Liquidity Impact

``In the short term, liquidity will come down,'' said Chakri Lokapriya, who manages $850 million of stocks in India, Brazil, Russia and China at BNP Paribas Asset Management U.K. Ltd.

Damodaran eased concerns on the rule changes in a conference call with brokers including JPMorgan and Goldman Sachs Group Inc. on Oct. 22.

He dropped a proposed ban on overseas brokerages using offshore derivatives for their own trading.

Foreign investors registered in India will be allowed to apply for a license for accounts based outside the South Asian nation, he said. There won't be a limit on the number of accounts each brokerage can convert.

There are 1,119 registered Foreign Institutional Investors and 3,447 registered sub-accounts as of Oct. 23, according to the regulator's Web site.

One-Year Rule

Damodaran said rules requiring investors to have been in operation for at least a year may be dropped to allow more funds to set up in India.

Chidambaram said on Oct. 18 the proposed curbs are aimed at reducing inflows that had stoked the rupee's almost 11 percent advance this year, the top performer of Asia's 10 most actively traded currencies.

Overseas investors have poured funds into India, lured by the world's second-fastest pace of economic growth. Chidambaram yesterday said he ``can't see the flows slowing down.''

``The rush of foreign investment is building bubbles in the stock-market and real-estate market,'' the finance minister said in the Norwegian capital Oslo.

Overseas investors using derivatives to invest in futures and options will have to unwind in 18 months under the proposed rules. These account for about 30 percent of all their offshore investments in Indian stock and bond markets, or about 1.17 trillion rupees.

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.

Regulators will decide at the board meeting today which category of funds can apply to register as a so-called Foreign Institutional Investor, or FII, Damodaran said.

``We expect the market to remain sluggish and witness a fall in volumes until the activity from new Foreign Institutional Investors has gathered critical mass,'' said N. Krishnan of CLSA Ltd.

To contact the reporter on this story: Pooja Thakur in Mumbai at pthakur@bloomberg.net.

Last Updated: October 25, 2007 00:15 EDT