By Neha Dasgupta and Manoj Rawal
MUMBAI (Reuters) - Indian stocks and the rupee rose on Tuesday after the government stuck to its fiscal deficit target in the Union Budget for the year starting April 1, raising hopes the pledge would spark a move by the Reserve Bank of India to cut key policy rates.
A commitment by Finance Minister Arun Jaitley on Monday to meet the fiscal deficit target of 3.5 percent of the gross domestic product is also raising hopes it would raise confidence among foreign investors after heavy selling this year.
The broader Nifty and the benchmark Sensex gained more than 2 percent each, recovering from falls of around 0.6 percent on Monday when a sharp drop in energy stocks offset the broader optimism sparked by the budget.
The rupee was trading at 68.2700/2750 to the dollar, after strengthening to as much as 68.2475 earlier, the highest since Feb. 16. The currency had closed at 68.4250/68.4350 on Monday.
Gains also came after advances in Asian markets following China's monetary easing and downbeat manufacturing and service surveys that raised hopes of additional stimulus measures.
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India's benchmark 10-year bond yield however was up 1 basis point at 7.63 percent on mild profit-taking after posting the sharpest single-day fall on Monday since June 2015.
"Markets are rallying because the budget was good - fiscal deficit commitments were adhered to and there was no tinkering on the capital gains tax structure," said Varun Khandelwal, a director at advisory services provider Bullero Capital.
"Additionally, pressures in global markets have alleviated on the back of PBoC (People's Bank of China) liquidity injections and in anticipation of dovish stances by the Fed, and the ECB."
Traders expressed hope the RBI may step in to cut the repo rate even before its next scheduled policy review on April 5 given the central bank had pinned any further easing on the government's fiscal stance at its policy review last month.
A combination of a rate cut intended to support economic growth along with the government's pledge for fiscal discipline is also raising market hopes of a reversal in some of the strong foreign outflows this year.
Foreign investors sold a net $2.2 billion from stocks and debt in February, the highest monthly outflows since October.
"The momentum we've seen in rupee is because of the fiscal deficit and a possible rate cut but then at 68 (rupees to the dollar) RBI might start picking up dollars as it is a psychological support," said Paresh Nayar, FX and fixed-income head, First Rand Bank in Mumbai.
(Editing by Biju Dwarakanath)