Banks lead India stocks fall on budget, ITC gains

* Higher govt borrowing sends bond yields up, spooks banks

* Spending plans fail to cheer, construction firms fall

* State-run firms drop as divestment plan disappoints

* ITC bucks trend after duty on cigarettes unchanged

By Janaki Krishnan & Narayanan Somasundaram

MUMBAI, July 6 (Reuters) - Shares in banks led a slide in Indian stocks on Monday after the annual budget set a higher government borrowing plan, triggering a spike in bond yields that could dent treasury income for lenders.

Commercial banks in India are required to hold at least 24 percent of their deposits in government securities and profits from trading in bonds form a substantial part of their revenue.

A sharp drop in bond prices, which move inversely to yields, would lower the value of bond holdings for banks.

Bond yields spiked as much as 18 basis points after Finance Minister Pranab Mukherjee said the fiscal deficit for 2009/10 was expected to rise to 6.8 percent of gross domestic product from 6.2 percent in the last fiscal year. [ID:nCOL101034]

"The expectations of more market borrowing has led bank stocks down," said Sandip Sabharwal, chief executive of Portfolio Management Services at Prabhudas Lilladher.

The budget fell short of investor expectations on infrastructure spending, ignored financial sector reform and gave a poor stake sale target unnerving investors, traders said.

Top lender State Bank of India (SBI.BO) dropped 9.5 percent to 1,638 rupees, No. 2 ICICI Bank (ICBK.BO) fell 10.2 percent to 677 rupees and top mortgage firm Housing Development Finance Co (HDFC.BO) shed 9.4 percent to 2,342.50 rupees.

At 2:56 p.m. (0926 GMT), the 30-share BSE Index .BSESN was down 6.3 percent at 13,979.38 points with all but one component losing. The index had risen as much as 1.2 percent in early trade.

The run-up to the annual budget announcement, always subject to fierce jockeying by ministries, industries and other interest groups, was especially frenzied this year after the ruling coalition won elections in May for a second five-year term.

Anticipation the government would unleash sweeping market-oriented reforms and infrastructure spending had sent the benchmark index up as much as 94 percent between mid-March and mid-June.

The budget increased allocation for highways by 23 percent and said state-owned India Infrastructure Finance Co would refinance loans of commercial banks but remained mum on equity capital requirements.