* Treasurer Hockey rejects offer on national interest grounds
* Grain growers worried about foreign ownership of key east coast handler
* GrainCorp shares fall by a quarter to below pre-bid levels
By Lincoln Feast and Colin Packham
SYDNEY, Nov 29 (Reuters) - Australia rejected a A$2.8 billion ($2.6 billion) takeover of GrainCorp by U.S. agribusiness giant Archer Daniels Midland (ADM) on Friday, bowing to pressure from grain growers in a rare and surprising decision.
GrainCorp shares plunged, losing a quarter of their value, as the rejection by Treasurer Joe Hockey effectively ring-fenced Australia's last major independent grains handler from any takeover.
The deal had been seen as the first test of the conservative government's vow that Australia was "open for business" after the victory of Prime Minister Tony Abbott in September elections.
"It would have been great consolidation for ADM and beneficial for Australian farmers and the grains industry. It's a pity it did not get through," said Vijay Iyengar, managing director of Singapore-based trading company Agrocorp International. "The food sector is always very sensitive."
Hockey said he was rejecting the proposal on national interest grounds after Australia's Foreign Investment Review Board (FIRB) failed to reach a consensus recommendation.
"Many industry participants, particularly growers in eastern Australia, have expressed concern that the proposed acquisition could reduce competition and impede growers' ability to access the grain storage, logistics and distribution network," Hockey told reporters in Sydney.
The rejection is a blow to ADM, which is more U.S.-focused than rivals Cargill, Bunge and Louis Dreyfus and had wanted to improve its access to fast-growing Asian markets.
Both ADM and GrainCorp expressed disappointment at the decision, which would deny the country's agricultural industry significant capital investment, said GrainCorp Chairman Don Taylor.
Shares of Decatur, Illinois-based ADM were down 2.4 percent at $40.49 by 10:50 a.m. CDT (1650 GMT) on Friday.
GrainCorp shares slumped to a low of A$8.25, below its pre-bid level. The company has been diversifying its business, but earnings are under pressure from lower grains harvests. The stock closed down 22 percent at $8.72.
"The recent numbers from GrainCorp look pretty scary. So my feeling is the downside on GrainCorp is a lot lower than what it was trading at before this was announced, so really bad news for shareholders," said Shannon Rivkin, a director at Rivkin Securities.
Australia is the world's second-largest wheat exporter and GrainCorp is the largest listed grains company, handling about a third of the country's wheat production.
It dominates the country's east coast storage, distribution and marketing of grains, handling 85 percent of eastern Australia's exports.
The deal had previously been approved by Australia's competition regulator and analysts had expected it to proceed.
But it was unpopular with farmers and many voters and had stoked divisions between the Liberal Party and its junior partner, the rural-based National Party.
"Political expediency has overruled rational thought, in our view, with the treasurer succumbing to political pressure from the National Party, rural members of the Liberal Party and grower groups," JP Morgan analyst Stuart Jackson said.
ADM could use partnerships with GrainCorp to build relationships with Australian farmers and "go some way to meeting its objectives in securing a competitive position in accumulating east coast grain," Jackson said.
Farmers were sceptical of another foreign deal in the grains industry after Canadian agribusiness Viterra in 2009 purchased ABB Grain, then Australia's largest agribusiness. Many South Australian farmers have complained about higher prices and long waiting times to deliver grain.
Glencore Xstrata Plc, which purchased Viterra in 2012, was not immediately available for comment.
"All the way along we wanted ADM to show us how growers would benefit and no one could," said Dan Cooper, a farmer in New South Wales and committee chair at the NSW Farmers Federation.
Only a handful of foreign investment deals are rejected by Australian authorities each year and ADM's tilt at GrainCorp is far from the first foreign deal in the agriculture sector.
Hockey said the deal was the only one of 131 significant foreign investment applications that had been rejected since he took office. The last major foreign investment blocked was Singapore Exchange Ltd's $8 billion bid for ASX Ltd in 2011.
"People will interpret this as maybe Australia is not so 'open for business'," said Shane Oliver, head of investment strategy, AMP Capital Investors. "But I think it's a one-off and will not set a precedent."
Hockey said he was open to ADM - one of the four "ABCD" firms that have dominated the global agricultural business for decades - increasing its stake in GrainCorp to nearly 25 percent. ADM said it would consider an increase.
The GrainCorp takeover was still awaiting approval from China, which this year imposed stiff conditions on Japanese trading house Marubeni Corp's $5.6 billion purchase of U.S. grain merchant Gavilon amid anxiety over food security.
ADM's bid is part of a wave of international interest in Australia's agricultural industry. Most recently Australia's Warrnambool Cheese and Butter Factory Company Holdings Ltd has sparked a bidding war involving Canada's Saputo Inc , which has already won FIRB approval.
U.S. wheat has lost about a quarter of its value since ADM first expressed interest in GrainCorp in October last year. A rebound in global production is weighing on prices.
ADM was advised by Citi and Barclays, while Credit Suisse and Greenhill advised GrainCorp