A proposal by India's stock market regulator to restrict foreign funds' trading could deepen India's stock market slump, analysts said on Thursday.

The stock market has been on a downward spiral ever since the Securities and Exchange Board of India released on Monday a draft paper containing a proposal to disallow foreign funds from dealing in derivatives--with underlying domestic securities--that are issued outside India.

These instruments include "participatory notes"- contracts issued to overseas investors who want exposures to Indian stocks but don't want to go through the required cumbersome procedures.

"Any measure that curbs foreign fund participation is not healthy and would slowdown inflows," said Krishnamurthy Vijayan, the chief executive officer at JM Capital Management.

India's most widely tracked index, the 30-issue Bombay index, which closed 1.1 per cent lower on Thursday, has lost about three per cent since the regulator released the draft paper.

Foreign funds have about $15 billion invested in India, nearly a quarter of which analysts estimate is routed through instruments that the watchdog proposes to ban.

The proposals have staunched the flow of foreign portfolio investment, with offshore funds reducing their exposure to Indian equity by $5.2 million this week- after a net inflow of $84.6 million in February and $221.4 million in January.

"Implementation of such move is likely to irritate genuine players and to that extent business might suffer," said Shankar Char, senior manager institutional sales at Cholamandalam Securities.

The Bombay Stock Exchange has lost Rs 193 billion in market capitalisation since the beginning of 2003, with domestic investors pulling out money after foreign fund investment in the new year fell short of expectations, mainly due to uncertainty over Iraq.

Testing the Waters

Foreigners can now buy and sell domestic stocks and derivatives only if they are registered with the regulator. They are required also to appoint a tax consultant and custodian, who liases with the stock market regulator, the central bank and exchanges.

Overseas arms of foreign funds or brokers registered with the Indian regulator often issue participatory notes to entities that don't wish to register in India but nevertheless want exposure to some local stocks.

These notes then function in lieu of the underlying Indian shares.

For example, an unregistered foreigner can take an exposure to blue-chip software stock Infosys Technologies through these notes instead of directly buying the company's American Depositary Receipts listed on Nasdaq.

This would work out cheaper as the local stock now trades at a 40 per cent discount to the American Depository Receipts.

Overseas investors also use the facility to test the waters, said a director at a India-registered foreign brokerage dealing in participatory notes.

"If they are convinced that India is attractive for long-term investment, they then apply for registration," said the director, who declined to be identified.