By Neha Dasgupta and Suvashree Choudhury
NEW DELHI/MUMBAI (Reuters) - Rupee fell to a near one-month low and bonds weakened on Monday after central bank governor Raghuram Rajan's surprise announcement he would quit when his term ends in September, though a more crucial test for markets could be seen when his successor is named.
While the currency partially recovered losses, investors warn Rajan's replacement, who is yet to be named, will need to be seen as credible and somebody who can defend the central bank's autonomy at a critical juncture in its history.
India's central bank was seen selling dollars via state-owned lenders to curb the fall in the local currency soon after the open of trading, three traders said.
The rupee was down 0.4 percent at 67.36 to the dollar at 0503 GMT, having hit 67.70 to the dollar earlier in the session, its weakest level since May 24.
"Markets generally have come become more resilient to outflows to negative news given the improvement in fundamentals," said Mitul Kotecha, head of FX and rates strategy for Barclays in Singapore.
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"A lot depends on who Rajan's successor is, and on prospects of policy continuity. We will wait to see these factors."
Graphic: Indian Economy https://bsmedia.business-standard.comreut.rs/1UFu5SB
The negative market response to the news was also mitigated somewhat by a wider Asian rally as fears that Britain would leave the European Union abated on Monday. India's NSE share index even gained 0.2 percent.
Analysts say the new governor would need to be a deft manager of currency markets, as India is bracing for about $20 billion in outflows starting in September as dollar-term deposits raised from citizens abroad during a currency crisis in 2013 mature.
"If you were to see someone come in who has very different set of policies, then the market will question if something has changed," said Josh Crabb, head of Asian equities at Old Mutual Global Investors in Hong Kong with $37.3 billion under management.
"That would not be my base case. If that were to happen, that would make me reassess how we thought about India. If the system shows a willingness, a continuation of those (Rajan) policies, irrespective of the individual involved, that's quite a large vote of confidence."
The benchmark 10-year bond yield was up 3 basis points to 7.53 percent, after earlier touching as much as 7.55 percent, its highest since mid-March.
INDIA'S FUNDAMENTALS
Though analysts had speculated Rajan might not pursue a second term, few had foreseen an announcement would come in the form of a letter to staff.
Rajan, a former International Monetary Fund chief economist, has been popular with foreign investors due to his efforts to tackle inflation and rescue India from its worst financial crisis in more than two decades when he took the role in 2013.
He also helped build foreign exchange reserves to a record high and implemented major market reforms including re-launching bond futures.
Beyond his departure, India still retains significant appeal for investors.
India's strong economic performance means it is seen as one of the better-positioned emerging markets to ride out volatility should Britain vote to leave the European Union later this week.
Meanwhile, investors are also hopeful Prime Minister Narendra Modi's government can deliver promised reforms such as a nationwide goods and services tax.
Foreign investors have been net buyers of Indian shares since the start of March and have bought a net $2.8 billion so far this year, but sold a net $1.4 billion in debt.
Analysts said the new governor would need to continue the fight to tame inflation and resist government pressure to boost growth through rate cuts.
(Additional reporting by Swati Bhat in MUMBAI and Nichola Saminather and Jeong-woo Cheon in SINGAPORE and Umesh Desai in HONG KONG; Writing by Rafael Nam; Editing by Shri Navaratnam and Sam Holmes)