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Indian banks have increased their fundraising activity through the issuance of certificates of deposits, as funding in the banking system continues to contract, analysts said.

"Banks are not raising deposit rates, as they are able to get funds easily from money market by issuing CDs, and that too cheaply, and they may continue to opt for this route of fundraising for next few weeks," said Raju Sharma, head of fixed income at IDBI Mutual Fund.

Indian private and state-run banks have raised around 300 billion rupees ($3.76 billion) through two-month to one-year CDs in the two weeks to Aug. 19, sharply higher than the roughly 50 billion rupees in the previous two weeks, data compiled by Reuters showed.

Larger lenders, such as Punjab National Bank and Bank of Baroda, have also jumped the bandwagon and are actively borrowing funds through three-month and one-year notes. These lenders are paying around 6.60%-6.74% for one-year funds, and keen to tie up funds for a year in anticipation of policy tightening in the near future.

The Reserve Bank of India's repo rate stands at 5.40%.

India’s banking system liquidity surplus has dropped below one trillion rupees, and has averaged around 1.40 trillion rupees in August, falling further from 1.90 trillion rupees in July and 2.92 trillion rupees in June.

"With liquidity getting drained out of the banking system, we expect banks to continue to raise funds through CDs as well as bonds," said Venkatakrishnan Srinivasan, founder and managing partner at debt advisory firm Rockfort Fincap.

Market participants also said that a pick up in credit growth as the economy revives will create need for a steady flow of funds at banks. At the same time, mutual funds have been happy to park funds in CDs, thus making it a win-win for issuers as well as investors.

"Debt funds that are mandated to invest in shorter duration are always on the lookout for investment opportunities, and that is the major reason, banks are able to get large quantums without any major difference on rates," IDBI Mutual Fund's Sharma said.

"We expect the liquidity tightness to lead to an effective policy rate hike of 60-75 bps," Upasna Bhardwaj, chief economist at Kotak Mahindra Bank said.

($1 = 79.8875 Indian rupees)