In the first quarter economic growth was at 6.1 percent, though lower than the same period last year, analysts say it is a reasonable rate for a country mired in a crippling internal conflict.

"The achievement of reserve money targets clearly suggests that inflation will be brought under control as already predicted by the Central Bank, without causing any harmful effect on the growth momentum of the economy," the Central Bank said in a statement Tuesday.

"After a period of 6 months, the Central Bank is pleased to announce that the actual reserve money level has so far been below the targeted limits throughout the first half of the year and the targeted limit as at the end of June 2007 was also comfortably achieved."

The bank says it would increase reserve money by 28 billion or 11.6 percent by end – 2007 to 267 billion rupees according the monetary policy roadmap released in January.

Targets Achieved

The March target was 254.6 billion while the actual reserve money volume achieved was 252.9 billion. The June target was 250.4 billion while the actual achieved was 247.8 billion.

However some economic analysts have warned that a jump in reserve money in April to over 277 billion rupees which is higher than the year-end target has negative consequences for the economy, and it is a structural problem that the bank should pay more attention to.

In May and June Colombo's consumer prices have spiked up by about 3 percent reversing an earlier trend of stable prices.

Stability

The bank says it is conducting monetary policy to achieve economic and price stability.

"Price stability is achieved by influencing changes in the broad money supply which is linked to the reserve money of the Central Bank," the bank said.

"An increase in reserve money is the fresh money released to the economy by the Central Bank."

Reserve money is injected into the economy by the increase of net foreign assets (NFA) and net domestic assets (NDA) of the Central Bank.

When the Central Bank purchases the inflows of foreign currency into the country’s banking system, it increases net foreign assets of the Central Bank, and thereby raises the reserve money stock.

The bank can also increase net domestic assets by purchasing Treasury bills at the primary or secondary market and by giving provisional advances to the government.

The bank says the level of reserve money is estimated based on the expected economic growth and inflation of the year.

The central bank says in the recent past an annual increase of 15 percent in reserve money was estimated, but by end December reserve money expanded by 21 percent to 239 billion rupees as against an original target of 12 billion rupees.

However critics of the central bank have said that reserve money went up last year because the bank was not willing to raise rates sufficiently to avoid buying treasury bills and also because it also engaged in heavy sterilized interventions in the foreign exchange markets.

The bank says net foreign assets increased by around 33 billion rupees in 2006 from purchases of foreign currency off the loans taken by the government.

Bill Factor

Though the Treasury bill holdings of the Central Bank increased by around 30 billion during the year 2006, the bank says the net increase in net domestic assets was only about 9 billion rupees.

"Hence, reserve money had not increased by an amount commensurate with the gross increase in Treasury bill holdings of the Central Bank," the bank said.

"It should also be noted that since the increase in Treasury bill holdings is only one component of the change in reserve money, such increase cannot be interpreted as the excess money printed by the Central Bank."

The bank said the monetary program for 2006 was designed more stringently allowing for only a growth of 11.6 percent in reserve money for the year.

"It was estimated that such limit would be sufficient to offset the excess of the previous year while accommodating the smooth functioning of the economy as well," the bank said.

"The Central Bank is carefully monitoring the developments within the economy as well as managing liquidity at desirable levels to promote economic activities while aiming to achieve single digit inflation on a year-on-year basis by end 2007."

Central Bank says it will employ appropriate monetary policy instruments to achieve the reserve money targets set for September and December 2007.

Fiscal Pressure

Though the Central Bank has been following prudent monetary policy so far this year, analysts say government finances needs to improve so that the central bank can maintain economic stability.

With many companies seeing their profits fall with higher interest costs and a slowdown in economic activity due a rising conflict the government also cannot rely on income tax increases.

As result the government needs to cut expenses and increase value added tax and raise the prices of government services.

Economists have warned that unless the government improves the fiscal side and cuts expenses, central bank efforts at stabilizing the economy may not bring the desired results.

"In the end, no matter how successfully the central bank tries to maintain financial and monetary stability, if governments keep spending more than they collect in taxes, eventually you have a time bomb," Peter Sinclair, Professor of Economics at the Birmingham University said in Colombo recently.

"Sooner or later it is going to blow up."

The interbank market has become after several weeks of excess liquidity which is believed to be caused by a decline in net foreign assets related to fiscal activity.