India's plans to allow domestic firms to raise rupee-denominated debt abroad for the first time are being eclipsed by the rising cost of funds in international markets, making it harder for cash-starved businesses to take advantage of the relaxed rules.

A weakening rupee and foreign investors' cooling appetite for Asia's third-largest economy have added to the cost of accessing funds overseas in recent months.

In early April, the Reserve Bank of India said it will allow Indian companies to raise rupee-denominated debt offshore - known as "masala bonds" - but it has yet to issue the final guidelines.

While the move is being viewed as a step towards full currency convertibility, and potentially even lowering the cost of capital that is among Asia's highest, bankers say that firms may be discouraged by the high premium sought by foreigners.

"We have to see the appetite and time the issue accordingly," said Managing Director Rajiv Dutt at IRFC.

"Pricing is an important factor."

According to some bankers interviewed by Reuters, a top-rated Indian corporate would in current conditions have to fork out around 9 percent on a 10-year offshore rupee bond when forex swap and withholding tax are taken into account.

This is around 60-65 basis points higher than borrowing from the domestic rupee market, up from a premium of 35-40 basis points some three months earlier, according to several bankers who spoke on condition of anonymity.

The final cost will also depend upon the extent to which an investor wants to hedge the rupee, depending on the currency outlook.

WEAK RUPEE, SLOW REFORMS

The prospect of further currency weakness and disappointment over the slow pace of reforms could drive up funding costs even higher - meaning issuers could be put off for now.

The backdrop of weak corporate earnings and falling export receipts have sent the Indian rupee INR=D2 down as much as 1.5 percent in the last month and foreign investors have sold $2.03 billion in stocks and bonds.

"Allowing INR-denominated bonds for investment by foreign investors is a welcome move and is seen as a small step towards internationalization of the currency, but it is unlikely to be a big hit until growth picks up and the view on the currency improves," said Manoj Rane, managing director and head of global markets at BNP Paribas India.

So far, only the Asian Development Bank and the International Finance Corporation, an arm of the World Bank, have issued masala debt, allowing investors' to access rupee debt outside India last year.

Indian Railway Finance Corp, the finance arm of state-run Indian Railways is one of at least 10 companies that have confirmed plans to tap this offshore local currency bond market, and is likely to be first off the block.

"Demand from investors will be more driven by the macro view on India," said Rakesh Garg, managing director, global finance, Barclays India, adding India's current high-profile tax dispute with foreign investors would also weigh.

"Tax is a big issue in the minds of investors. They want certainty on tax rates at least during the tenor of the instrument."