Fitch Ratings predicts profitability at Indian banks will worsen from a five-year low as a cash crunch forces them to pay more to attract deposits even as loans grow at the slowest pace since 2009.

HDFC Bank Ltd., the nation's largest lender by market value, raised interest rates on savings maturing up to one year by as much as one percentage point from July 27, while Axis Bank Ltd. increased them by 4 percentage points effective July 31, according to their websites. Yes Bank Ltd. said it added as much as 50 basis points, or 0.5 percentage point, from Aug. 1.

Lenders in Asia's No. 3 economy are battling for deposits as a record jump in money-market rates erases gains from three reductions in benchmark borrowing costs in the first half, eroding earnings and boosting bad debts. Three-month interbank rates jumped an unprecedented 223 basis points in July to 10.75 percent as the Reserve Bank of India tightened cash supply to shore up the rupee. A similar gauge is at 4.65 percent in China.

“While some of the larger banks may be able to pass on the increased cost of funds to borrowers, many medium-sized ones will see lending margins narrowing further,” Saswata Guha, a Mumbai-based director at Fitch's India unit, said by telephone yesterday. “This will be a further drag on profitability.”

Neeraj Jha, Mumbai-based spokesman for HDFC Bank, declined to comment on the reasons for the deposit-rate increase. Axis Bank raised the deposit rates to align it with prevailing market rates “after taking into account current money-market conditions,” a spokesman for the lender said in a e-mailed statement yesterday.

David Fuller's view With year on year combined CPI inflation of over 9% and economic growth slowing to approximately 5%, it is little wonder that the RBI is attempting to wring speculative excess from the banking sector and moderate price pressures. So far it has had mixed success but as the RBI remarked last week, its efforts are short-term in nature. I thought it might be instructive to review some of India's more important financial ratios.

The difference between 10-year and 2-year yields, often referred to as the yield curve spread, dropped below zero in May and has extended the decline to the current -83 basis points. The last time the spread moved into negative territory was in 2008.

The downward spike in the spread between 3-month interbank rates and 3-month government yields (TED spread) highlights the fact that the tightening of credit currently affecting the banking sector is state sponsored rather than an issue with the interbank market.

Although the RBI's stated aim is to bolster the currency, the Rupee dropped to a new low today. The Trade Weighted Indian Rupee Index has accelerated lower since April and a break in the progression of lower rally highs, currently near 79.4, will be required to suggest a return to demand dominance.

The Bombay Banks Index./ BSE 500 ratio has experienced its largest decline since 2008 and while the banking sector is becoming increasingly oversold, a clear upward dynamic will be required to check momentum and suggest a return to outperformance. In absolute terms the Bombay Banks Index broke its more than 18-month progression of higher major reaction lows less than a month ago extended its decline today. Last Thursday's bounce has not held and a clear upward dynamic will be required to check momentum.

The banking sector has been a leader in both rising and falling markets since 2008 and therefore its weakness cannot be ignored. The Nifty Index which has been led higher by consumer oriented shares such as ITC has now also experienced downward pressure and dropped below the June lows today. While oversold in the short-term, evidence of short covering will be required to bolster confidence.

The appointment of Raghuram Rajan as the new governor of the RBI may be seen as a positive by investors fretting over the size of the current account deficit, currency weakness and persistently high inflation. However, the question remains as to what additional measures will be taken to shore up the currency. Until we have some visibility on this issue the stock market is likely to remain under pressure.