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UPDATE 4-Indian inflation spike hits bonds, spurs rate policy and fiscal worries

worries@

* Inflation surprise puts bond yields at highest since July 2016

* Jump in inflation threatens economy, challenge to policymakers

* Rate hike not easy call as worries about economy persist

* Focus also on government's finances, electoral prospects (Updates with late gains in bond prices)

MUMBAI/NEW DELHI, Dec 13 (Reuters) - India's benchmark 10-year bond hit its lowest in more than 16 months on Wednesday, as investors saw surging inflation as a potential threat to a still-struggling economy and a daunting challenge to policymakers.

The 10-year bond yield rose as much as 6 basis points to 7.26 percent, the highest since July 2016, after data late on Tuesday showed annual inflation spiking to a 15-month high of 4.88 percent in November, way above expectations.

Bonds rebounded late in the day, however, on suspected central bank intervention and after the government announced a debt buyback, with the 10-year yield ending down 2 basis points.

Nonetheless traders said inflation concerns would remain, since the rate was sharply above the Reserve Bank of India's 4 percent medium-term inflation target, and was driven higher by a sharp rise in food prices.

The elevated inflation rate creates a dilemma for the Reserve Bank of India, raising the prospect it could respond with a rate hike even as the economy is growing at far below the 8 percent pace needed to create jobs for millions of young people joining the workforce every year.

Furthermore, the 75 basis point rise in bond yields since the end of June could bring higher borrowing costs and steep mark-to-market losses at the country's lenders, India's biggest bond investors. That, in turn, would hurt their ability to extend the loans needed for an economic revival.

For now, analysts said they still expect the RBI to hold its repo rate at a more than 7-year low of 6.00 percent after last cutting it in August, but warned that the odds of a hike had risen.

The RBI's monetary policy committee (MPC) next meets in early February.

"We now see 30 percent chance of a precautionary rate hike in the February policy (meeting) itself, with the MPC facing an acute trade-off between sluggish growth and rising inflation for the first time in its short existence," Citigroup wrote to clients on Wednesday.

NOT AN EASY CALL

The surge in food prices is unlikely to cool, say farmers who saw unseasonal rains in October and early December cut production of vegetables such as onions and tomatoes.

Also, the government has set higher support prices for wheat and pulses to help a rural sector hit hard in recent years by low food prices.

Raising interest rates won't be an easy call for the RBI, which took advantage of an extraordinary period of low inflation to cut them by 200 basis points from January 2015 until August, the longest easing cycle since the 2008 global financial crisis.

Government officials are bound to disagree with any rate hikes, given their concerns about the economy.

Data on Tuesday also showed annual industrial output grew a lower-than-expected 2.2 percent in October, indicating an economy still on the mend, even as growth recovered to 6.3 percent in July-September, halting a five-quarter slide.

LATEST BAD NEWS

For bond investors, the inflation data is the latest bad news in a year in which prices are on track to fall after three years of gains.

The surge in bond yields threatens to dent credit growth at a time when Prime Minister Narendra Modi's government badly needs banks to lend more, leading policymakers to unveil a $33-billion recapitalisation plan for the sector.

"If the borrowing cost overall goes up in the economy, then the effectiveness of the government's recapitalisation plan intended at boosting credit might get hit," said Soumya Kanti Ghosh, chief economist at State Bank of India.

Bond investors already have been worried the government will have to widen its 3.2 percent fiscal deficit target for the year ending in March, leading to increased borrowing.

Investors also worry the government might try to prepare for the 2019 election by announcing a slew of populist measures next year.

These expectations could rise if the ruling Bharatiya Janata Party emerges with a sharply reduced majority from elections now being held in Gujarat, indicating discontent in the western state once led by Modi, analysts said. ($1=64.4300 Indian rupees) (Reporting by Suvashree Dey Choudhury, Rajendra Jadhav and Manoj Kumar; Additional reporting by Swati Bhat; Writing by Rafael Nam; Editing by Eric Meijer and Clarence Fernandez)