India should introduce a wholesale liberalization of rules restricting foreign investors from participating in domestic bond markets, according to a report produced by the country's main financial markets regulator.
Asia's third-largest economy currently restricts to $30 billion the amount foreign investors can hold in Indian government debt, and places further limits on the quantity of corporate debt held abroad.
But new research from a panel set up by the Securities and Exchange Board of India suggests that the country's restrictions "fail to meet the objectives of economic policy" set by the nation's government.
The SEBI research paper criticizes the existing restrictions as "complicated" and says that the limits have left India less open to foreign debt investment compared with other emerging market peers.
"Participation by foreign investors in the domestic bond-currency-derivatives nexus will fuel market development and help achieve a deep and liquid market. This furthers an essential objective of domestic financial development," the paper says.
Although the report's authors – members of the SEBI internal development research group – stress that their views are not the official policy of the regulator, they come at a time of renewed hope for liberalization among international investors. They also come as policy makers search for new ways to attract scarce foreign capital to the country after repeated debt market outflows in the aftermath of India's recent currency turbulence.
(Read more: Suddenly, things are looking up for India)
The report follows remarks from new Reserve Bank of India governor Raghuram Rajan saying said he will explore whether Indian debt could now be included in global bond market indices used by major international investors.
Such a step could bring much needed capital inflows into the country, helping to reduce its elevated current account deficit, but inclusion in the indices would almost certainly require the removal of existing investment caps as a prerequisite.
At a press conference last Friday Mr Rajan said: "There is some talk about bringing India into some of these bond indices. What needs to be done? We will have conversations with international index agencies and some of the investment banks that create these indices. Let us see what they require."
A report from Standard Chartered earlier this month said inclusion in the indices, which include JPMorgan's government bond emerging markets global diversified index, could be "a game-changer" for Indian financial flows, potentially attracting between $20 billion and $40 billion a year.
Bond market liberalization would increase India's overall external debt to GDP ratio, and also comes with risk that capital could move suddenly out of the country as the indices adjust, creating financial instability, analysts say.
(Read more: Mobius: The rupee rout will be over soon)
Tushar Poddar, chief India economist at Goldman Sachs, says: "The attraction of these global indexes is that you can get passive inflows from pension funds and insurance funds who just buy the benchmark, which is attractive given India needs capital.
"But to get included they would need to liberalize, meaning they would have to remove the overall limits on the total amount of foreign ownership of government debt, so that benefit requires a change in policy."