India's key share index slipped to a one-month closing low on Thursday on worries that hedge funds and small foreign funds may face new regulatory restrictions, though analysts remained confident the downtrend was temporary.
The 30-issue Mumbai index slid 2.86 percent to 5,593.74 points, taking losses in the past three days to 7.8 percent. Losing issues outnumbered gainers by about four to one.
A report in The Economic Times daily sparked concerns that the market regulator is likely to bar hedge funds from using participatory notes (PNs) to route their investments to shares.
The notes are contracts issued to unregistered foreign funds who want to take exposure to Indian shares without going through the regulatory hassles. "It appears to be liquidation from PNs which is pressuring markets," said Falguni Nayar, a director with Kotak Securities.
"The extreme volatility has forced retail investors to reduce their leveraged positions," she added.
G.N. Bajpai, chairman of the Securities and Exchange Board of India, when reached by Reuters, did not offer any immediate comment, while government officials also declined to comment.
Overseas funds injected a net $6.7 billion into Indian shares last year and analysts estimate about $100 million of that came from hedge funds. The record purchases by foreign funds in 2003 were a key driver of the index's 73 percent climb last year.
Analysts said besides hedge funds, other smaller overseas funds had also been using the participatory notes route.
"About seven to eight percent of all flows are estimated to come from unregulated funds through the notes and if they are banned, they will obviously liquidate positions," said Srividhya Rajesh, fund manager at Madras-based Sundaram Mutual Fund.
The blue-chips which led last year's rally tumbled the most.
Tata Iron and Steel Co, the No 2 steel maker, dropped 5.6 percent to 394 rupees and top Indian motorcycle maker Hero Honda Motors dived 5.4 percent to 426.60 rupees. Ranbaxy Laboratories, the top drug-maker by sales, shed 3.5 percent to 1,011.20 rupees.
India's largest truck maker, Tata Motors, slumped 9.1 percent to 416.80 rupees, despite trebling its earnings.
But analysts were optimistic on the market's medium-term outlook given that foreign funds were still net buyers of shares.
Data from the market regulator showed foreign funds have so far invested a net of nearly $500 million so far in January.
"Our view is that once the present volatile phase passes, we should see a resumption of buying, though it will be more selective in nature," Sundaram's Srividhya said. "The valuations for a number of blue-chip and mid-cap stocks are attractive."