* 1.35 tln rupees of bonds, 760 bln rupees from market, budget
* Recapitalisation plan over two years
* Jaitley says banking reforms to follow
* Analyst says plan might impact fiscal deficit (Adds top bank SBI comment, context)
By Devidutta Tripathy
NEW DELHI, Oct 24 (Reuters) - India's cabinet approved a $32.43 billion plan on Tuesday to recapitalise its state banks over the next two years, in a bid by Prime Minister Narendra Modi to tackle a major drag on the economy that has frustrated his attempts to boost growth.
Once the world's fastest-growing major economy, India has seen its growth rate plummet to the lowest in three years, far below levels needed to create enough jobs to absorb the million Indians joining the work force every month.
Modi's government has tried to respond by stepping up public spending, but the slowdown has stressed its finances, making it imperative that private investment picks up the slack.
Officials privately admit they have struggled to revive private investment because state-owned banks, which provide much of the credit in the economy, are saddled with a mountain of bad debt that has crimped their ability to extend new credit.
The huge capital injection into the banks is meant to clear that bottleneck, Finance Minister Arun Jaitley said at a press conference in New Delhi.
"The decision to recapitalise public sector banks with 2.11 trillion rupees will address the bank balance sheet problem and push growth forward," Jaitley said.
By some estimates, banks need as much as $65 billion in additional capital by March 2019 to fill the hole left by soured loans and to meet new regulatory requirements.
The official announcement, which was followed by a series of tweets from government ministers holding it up as "unprecedented", comes after a flurry of activity in the government over the past few weeks, driven by the prime minister's office.
Modi, who swept to power in a landslide victory for his Bharatiya Janata Party (BJP) in 2014 promising a reform agenda to revive economic growth, faces state elections later this year and a re-election bid by 2019.
He has faced criticisms after a surprise scrapping of high-value bank notes last November and a new goods and services tax effected earlier this year disrupted businesses across the country.
People close to Modi have previously told Reuters he wants to control the political damage and ensure the economic slowdown remains temporary.
Mohan Guruswamy, an economist in New Delhi, said the government should have taken action three years ago to revive the banking sector.
"Now it's more expensive, and we will not see results soon," Guruswamy said.
Finance ministry officials said the bank recapitalisation would be followed by a series of reforms in the sector. They said the details would come later.
Of the planned 2.11 trillion rupees sum, recapitalisation bonds will account for 1.35 trillion rupees, while about 580 billion rupees is estimated to come from share sales by banks, the ministry said. The government will also use 180 billion rupees left from its previously budgeted recapitalisation fund.
It was not immediately clear what the impact will be on the country's fiscal deficit, which Jaitley aims to keep at 3.2 percent of GDP for the current fiscal year to March and at 3 percent in the next financial year.
"India's banking was the weakest link in the revival of the economy," said N.R. Bhanumurthy, an economist at the National Institute of Public Finance and Policy, a Delhi-based think-tank partly funded by the finance ministry. "The government should complete the process as early as possible."
Bhanumurthy added that the move might have an impact on the government's fiscal deficit target this year.
Major rating agencies welcomed the move, as did the chairman of top lender State Bank of India, Rajnish Kumar, who called it "bold and courageous".
Twenty one state-run banks account for more than two-thirds of India's banking assets. But they also account for a bulk of the record 9.5 trillion rupees ($145 billion) of soured loans.
In addition to repairing their balance sheets, the banks need billions of dollars in new capital to meet global Basel III banking rules, due to fully kick in by March 2019.
Fitch Ratings estimates Indian banks will need $65 billion of additional capital by March 2019 to meet Basel III global banking rules. Moody's expects the top 11 state lenders alone will need nearly $15 billion.
In its previous recapitalisation plan, the government had budgeted to inject a total 700 billion rupees over four years through March 2019.
Officials added the recapitalisation needs would be assessed on factors such as size and performance of a bank, while Jaitley said he expected the capital injection to make bank stocks attractive, helping sales of shares to external investors.
Bank stocks rallied ahead of the news conference on expectations of a recapitalisation plan. The state bank index closed 3.8 percent higher. ($1 = 65.0550 Indian rupees) (Reporting by Devidutta Tripathy, Nidhi Verma, Nigam Prusty, Manoj Kumar, Rupam Jain, Neha Dasgupta and Abhirup Roy; Editing by Alex Richardson)