Oct. 26 (Bloomberg) -- Indian stocks and the rupee currency may fall after regulators barred some funds from buying equities.

M. Damodaran, chairman of the Securities & Exchange Board of India, yesterday said all funds must be regulated in their home countries before they can apply to invest in Indian stocks. The regulator also scrapped offshore securities linked to derivatives and capped investments backed by equities, confirming proposals made on Oct. 16.

By barring unregulated funds, Damodaran is seeking to force more holders of the $89 billion of securities held offshore to come under India's rules or exit the market. Tighter regulations may spur hedge funds to shift to other markets that are relatively cheaper than India.

``India is now one of the most expensive markets in the world of emerging markets,'' said Allan Conway, head of emerging markets at Schroders Plc, which oversees $276 billion, in London. ``It's a market on a prospective price-to-earnings ratio of about 15 times for 2008. Brazil is on 9 times and Russia is on 10 times.''

India tightened the rules a day after U.S. Treasury Secretary Henry Paulson urged Asia's third-largest economy to avoid placing controls on international investment. Paulson will visit India for the first time this weekend.

Limit on Investment

Securities of Indian companies trading in New York were mixed. ICICI Bank Ltd., India's most valuable lender, fell 0.3 percent yesterday. HDFC Bank Ltd. dropped 2.8 percent, and Infosys Technologies Ltd. gained 0.3 percent.

Bombay's benchmark Sensitive Index yesterday rose 1.4 percent to 18,770.89. The Bombay and National Stock Exchanges suspended trading for an hour on Oct. 17 after the regulator's proposals triggered an almost 10 percent slump. The stock market lost $120 billion in value in a minute.

The rupee had it first weekly loss in two months last week because of the sell-off in equities. India's currency yesterday rose 0.1 percent to 39.535 at the 5 p.m. close of trading in Mumbai, according to data compiled by Bloomberg.

Under the new rules, foreign investors can only issue offshore derivatives linked to stocks up to a limit of 40 percent of their assets under custody as of Sept. 30.

The ``handful'' of funds over the threshold will have to freeze their holdings, Damodaran said yesterday. Brokers who have issued less than the limit may increase at an incremental rate of 5 percent of their assets under custody, he said.

The 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.

Unregistered Accounts

Foreign investors currently registered in India won't be allowed to issue new derivatives from their own accounts based in tax havens such as Mauritius, called sub accounts.

Brokers that have applied to register accounts set up for their own trading can continue while their application is being processed, he said. Applications will be processed in a week.

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

To ease the impact of the new curbs, Damodaran said pension funds, charitable institutions, foundations and university funds that aren't regulated overseas will be able to register in India.

Fund managers with a one-year track record will be allowed to register funds that have been in operation for less than a year, the regulator said.

`Building Bubbles'

Overseas investors have poured funds into India, lured by the world's second-fastest pace of economic growth. Finance Minister Palaniappan Chidambaram said on Oct. 18 the proposed curbs are aimed at reducing inflows that had stoked the rupee's 12 percent advance this year, the top performer of Asia's 10 most actively traded currencies.

``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 this week.

Foreign buying helped propel India to be the third emerging market to pass $1 trillion in value, joining China and Russia. The market has since added more than $100 billion a month to $1.47 trillion, according to data on the Bloomberg.

Under the Securities & Exchange Board of India's 2004 Act regulating investment, only registered institutions are allowed to buy shares in India.

Hedge funds that are regulated in their home country will be allowed to register as overseas investors in India, Damodaran said. The market for derivatives and offshore trading has boomed as hedge funds are barred from setting up in India to buy and sell equities.

India vs. Singapore

Singapore, 2 1/2 hours time difference from India's commercial capital Mumbai, is home to 190 hedge funds managing more than S$40 billion ($27 billion) of assets in 2006, up 150 percent from a year earlier.

Still, curbs on overseas buying of stocks aren't as prohibitive as investing in India's commodities markets.

Indian commodities exchanges are closed to overseas funds, although the South Asian country is the world's largest consumer of gold and the second-biggest producer of wheat, sugar and rice.

The Forward Markets Commission, which regulates India's commodity futures market, has recommended to the government that overseas funds be allowed to trade metals, bullion and oil.

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.

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

Last Updated: October 25, 2007 20:00 EDT