By Neha Dasgupta and Suvashree Dey Choudhury

MUMBAI, June 2 (Reuters) - India's first term reverse repo auction to drain cash met with a poor response as expected on Monday as market participants believed liquidity was not as flush as the central bank was anticipating.

The Reserve Bank of India (RBI) allotted only 20.25 billion rupees ($342.70 million) at the 4-day term reverse repo auction, sharply below the minimumn notified amount of 150 billion rupees, and set a cut-off rate of 8 percent. ID:nI8N0MZ02J

The auction - under which banks would loan money to RBI in exchange for bonds - would have proven unprofitable for lenders, traders said, given the rate paid by the central bank was capped at 8 percent.

However, most banks are lending and borrowing from each other at rates of above 8 percent in the overnight cash window, without the need to pledge bonds.

The RBI's move was likely intended to address a potential surplus of cash from renewed government spending and its maturing forward dollar sales, which increase the amount of cash when they are converted back to rupees.

RBI Governor Raghuram Rajan is keen to ensure that the cash rate, which is banks' intraday borrowing and lending rate, stays closer to the repo rate of 8 percent.

The RBI kickstarted term repo auctions - meant to infuse liquidity - in October last year to deepen money markets and move away from its usual practice of buying bonds through the open market, which were helping the market to absorb the government's market borrowing.

In 2007, the RBI used the Market Stabilisation Scheme (MSS) to withdraw excess liquidity by selling bonds and in 2008 raised the banks' reserve requirements 1.50 percentage points to 9 percent.

At present, traders do not foresee cash conditions to loosen too much.

"We do not foresee a situation in the next four days when liquidity will improve sharply and we have to lend below the repo rate of 8 percent in the next four days," said a trader with a foreign bank, declining to be identified as he was not authorised to speak to the media.

The interbank call rate INR=OND , which helps determine the rates at which banks lend and borrow from each other through the overnight window, was trading at 8.15/8.20 percent, above its Friday's close of 7.30/7.40 percent.

Cash conditions had tightened on Monday following the sale of 160 billion rupees worth of debt on Friday. ($1 = 59.0900 Indian Rupees)

(Editing by Kim Coghill)

((neha.dasgupta@thomsonreuters.com)(+91-22-61807177)(Reuters Messaging: neha.dasgupta.thomsonreuters.com@reuters.net))

Keywords: INDIA CENBANK REVERSEREPO