By Swati Bhat

MUMBAI (Reuters) - India's benchmark 10-year bond slumped to a nearly 18-month low on Thursday, sending its yield up as much as 17 basis points, after the government flagged additional borrowing for the year ending in March that far exceed market expectations.

It's no surprise there would be extra borrowing in the last three months of the fiscal year, as tax collection plunged after the launch of the national Goods and Services Tax (GST) in July.

But India's announcement it would borrow an additional 500 billion rupees ($7.79 billion) was well above the 250-300 billion rupees most traders expected.

The government now faces a steep challenge as it tries to offset the sharp shortfall in tax revenue at a time when it is seeking to bolster an economy that's only just started to recover after a five-quarter slide.

The government will need to determine how much to widen the deficit, currently set at 3.2 percent of gross domestic product, with traders having pencilled in 3.5 percent.

Anything wider than that could further spook investors as they worry the inflationary impulse from additional fiscal impulse could prompt the central bank to raise interest rates.

"The market is nervous. No one was expecting an additional 500 billion rupees worth of borrowing," said Harish Agarwal, a fixed income trader in Mumbai for First Rand Bank.

The benchmark 10-year bond yield was up 15 basis points at 7.37 percent by 0752 GMT, after rising to 7.39 percent, its highest level since early July 2016.

However, Indian shares and the rupee were broadly flat.

GROWTH VS INFLATION

Although India's GDP grew 6.3 percent in July-September, its fastest pace in three quarters, Prime Minister Narendra Modi's government is hoping for stronger growth as it vies for re-election in 2019, raising concerns of increased spending.

However, Modi's government also wants to maintain its standing with investors and burnish its fiscal credentials, having just a few weeks ago earned a sovereign ratings upgrade from Moody's Investors Service.

Policy makers would also be mindful of an acceleration in annual inflation, which spiked to a 15-month high of 4.88 percent in November, due to higher food and commodity prices.

The Reserve Bank of India took advantage of a period of extraordinary low inflation to cut rates by 200 bps between January 2015 and August 2017.

But the 10-year bond yield has risen more than 90 bps since that last cut in early August, as investors have started pricing in the prospect of rate hikes.

Early this month, the RBI kept its policy rate steady at 6.00 percent, and for now, analysts said they still expect the central bank to hold rates again at its next meeting in early February.

Much of what happens next will hinge on how the government manages its fiscal deficit, with a key test looming as it prepares to unveil the annual budget for the next year around the same time.

"Going ahead, we continue to believe that India rates look set to remain on the upside in fiscal year 2018/19. The floor will be set with the end of RBI's rate-cut cycle and expectations of a possible start to a rate-hike cycle," Kotak wrote in a note.

(Reporting by Swati Bhat; Editing by Rafael Nam & Shri Navaratnam)