July 6 (Bloomberg) -- Indian stocks fell the most in six months, led by banks, after the government forecast the widest budget deficit in 16 years, increasing the risk of a cut in sovereign ratings. The rupee and bonds sank.

ICICI Bank Ltd. and State Bank of India Ltd. led Indian lenders lower as the government budget omitted measures to open the industry and on concern that the borrowing plan will reduce the value of bond holdings. Larsen & Toubro Ltd., India’s largest engineering company, lost 8.9 percent and Reliance Infrastructure Ltd., the second-biggest utility, sank 12 percent even as Finance Minister Pranab Mukherjee pledged increased spending on roads and power.

“Only some tinkering has been done, no big-bang reforms have been announced,” said A.N. Sridhar, a fund manager at Sahara Asset Management Co. in Mumbai. “It appears the finance ministry got little time to decide on so many things which the market expected today, which did not come.”

The Bombay Stock Exchange’s Sensitive Index, or Sensex, slumped 869.65, or 5.8 percent, to 14,043.4, the most since Jan. 7. The S&P CNX Nifty Index on the National Stock Exchange to slumped 5.8 percent to 4,165.7. The BSE 200 Index lost 5.7 percent to 1,715.51.

The rupee weakened 1.2 percent, the most in almost six weeks, to 48.485 against the dollar. The yield on the most- traded 6.07 percent note due May 2014 surged 27 basis points, the most since March 17, to 6.50 percent, according to the central bank’s trading system.

ITC Gains

ITC Ltd., India’s biggest cigarette company, gained 3.1 percent to 197.7 rupees after the budget left tobacco taxes unchanged. “No news is good news,” said Manoj Menon, an analyst with Kotak Securities Ltd. ITC is one of two stocks that gained on the Sensex today.

ICICI Bank, the second-biggest lender, lost 10 percent to 679.7 rupee. State Bank of India Ltd., India’s biggest lender, declined 8.6 percent to 1,653.5 rupees. HDFC Bank Ltd., the No. 3, dropped 6.1 percent to 1,423.95 rupees

The government had been expected to raise foreign direct investment limits in banks and insurers, Care Ratings said, while Axis Bank Ltd. expected the foreign ownership cap to rise to 40 percent from 26 percent.

Indian lenders also retreated on concern the government’s proposed increase in debt will reduce funds available for lending to companies and individuals, said Amisha Vora, joint managing director at Prabhudas Lilladher Pvt.

Fiscal Deficit

The fiscal deficit may rise to 6.8 percent of gross domestic product in the year ending March 31, the most since 1994, Mukherjee told parliament today.

“The banking sector will be affected by the huge fiscal deficit,” Sahara Asset’s Sridhar said. “Also, the finance minister said there will be no divestment of state-run banks; the market was expecting this.”

Mukherjee increased spending on roads, power and aid to the poor, setting the agenda for a government that in May won its biggest election victory in two decades. Indirect taxes will be streamlined through a goods and services tax, he said in his speech in New Delhi today.

Prime Minister Manmohan Singh’s government is spending more to speed up economic growth and reduce poverty in a nation where malnutrition is worse than Sub-Saharan Africa. Stocks and the currency weakened on investor concerns that a ballooning budget deficit may lead to a downgrade in India’s credit rating.

“The fiscal deficit is at 6.8 percent, the market clearly did not like this figure,” said Vaibhav Sanghavi, a director at Ambit Capital Ltd. in Mumbai, who manages funds for wealthy individuals. “The market has built in too many expectations from the budget.”

Larsen & Toubro fell 8.9 percent to 1,464.15 rupees. Jaiprakash Associates Ltd., the biggest maker of dams, dropped 10 percent to 193.2 rupees. Reliance Infrastructure lost 12 percent to 1,130.75 rupees.

Reliance Industries Ltd., India’s most valuable company, slipped 6.6 percent to 1,893.15 rupees. Bharat Heavy Electricals Ltd., whose turbines and generators light up three of every four homes in India, retreated 3.9 percent to 2,100.50 rupees.

To contact the reporters on this story: Rajhkumar K Shaaw in Mumbai at rshaaw@bloomberg.net

Last Updated: July 6, 2009 07:32 EDT