UPDATE 5-Satyam chief quits, fraud scandal slams shares

* Chairman quits, says profits inflated

* Shares dive 78 pct in Mumbai

* Banker Merrill Lynch terminates Satyam ties

* NYSE halts trade in Satyam's shares (Adds company comment, NYSE halt, background)

By Sumeet Chatterjee

BANGALORE, Jan 7 (Reuters) - The head of Indian outsourcing company Satyam Computer Services (SATY.BO) (SAY.N) resigned on Wednesday, disclosing that profits had been falsely inflated for years and sending its shares plunging nearly 80 percent.

India's biggest corporate scandal in memory threatens future foreign investment flows into Asia's third-largest economy and casts a cloud over growth in its once-booming outsourcing sector.

The news sent Indian equity markets into a tailspin, with Bombay's main benchmark index .BSESN tumbling 7.3 percent and the Indian rupee fell.

The New York Stock Exchange halted trading in Satyam's shares indefinitely, saying it wanted to review the news.

Ramalinga Raju, founder and chairman of India's fourth-largest software services exporter, said in a statement that Satyam's profits had been massively inflated over recent years. He added that no other board member was aware of the financial irregularities at the Satyam, which in Sanskrit means "truth."

"If a company's chairman himself says they built fictitious assets, who do you believe here? This has put a question mark on the entire corporate governance system in India," said R.K. Gupta, managing director at Taurus Asset Management in New Delhi.

Raju, who founded Satyam as a family business with his brother and brother-in-law more than two decades ago, said about $1 billion or 94 percent of the cash on the company's books was fictitious.

The startling admission comes as investors across the globe pay more attention to oversight following last month's arrest of Bernard Madoff over charges he swindled clients out of billions of dollars.

"In a bull market, people forgot about it (corporate governance)," said Singapore-based Ashish Goyal, chief investment officer at Prudential Asset Management. "In a bear market chickens are coming home to roost, so it gets highlighted at a time like this."

"RIDING A TIGER"

Satyam's auditor PricewaterhouseCoopers declined comment, saying it was investigating the matter. U.S. Securities and Exchange Commission spokesman John Nester had no comment on the matter.