Loans to private borrowers from banks rose 34 percent from a year earlier to 2,179.8 million rupees but the monthly volume collapsed to just 18.7 billion rupees, a level not seen since June 2010 when private borrowings were 19 billion rupees.

In April, while private sector credit fell to a near two year low, credit to the central government rose 32 billion rupees to 1,028 billion rupees, up 47.4 percent from a year earlier.

Loans to state enterprises rose another 10.1 billion rupees to 257.2 billion rupees, up 105.8 percent from a year earlier.

Sri Lanka has tried to curb private sector credit after a balance of payments crisis was triggered during the second half of 2011 by heavy state borrowings energy utilities to finance tariff manipulations.

Energy prices were raised in February, but credit to state enterprises have continued to grow. Energy price deceptions remain probably the biggest threat to Sri Lanka's economic stability now that a 30-year war is over.

The central bank worsened the problem by keeping interest rates down with sterilized sales of foreign currency.

Sterilizing foreign exchange sales (printing fresh money to keep interest rated down when the monetary system tightens following a foreign exchange sales to defend a peg) is however a 'stimulus' which further boosts credit.

Sterilizing foreign exchange sales with fresh money, injects reserves (deposits) from thin air into the banking system, generating fresh loans. When demand from the loans spill over to the balance of payments, the exchange rate comes under pressure.

A rise in interest rates on the other hand increases deposits raised by banks, reduces consumption and can also reduce loan demand, keeping the economy in balance and the exchange rate stable.

The rupee has fallen from 110 to 130 to the US dollars in the past year.

Total loans to private borrowers which was around 30 to 40 billion rupees accelerated to around 50 to 60 billion rupees after sterilized foreign exchange sales began.

Total loans to both the state and private sectors topped 100 billion rupees from December. In February total loans from commercial banks to the state and private sector was 115.1 billion rupees and in March 110.7 billion rupees.

But in April total loans collapsed to 60.8 billion rupees.

Though the rupee was nominally made flexible in February the Central Bank has made unsterilized purchase in the forex markets including through swaps, and made sterilized sales for oil purchases, both activities put pressure on the peg.

Analysts have urged the Central Bank to avoid making unsterilized purchases through swaps when banks borrow abroad.

They have also urged the Central Bank to avoid making sterilized foreign exchange sales for oil purchases but to give dollars against Treasury instruments to the state petroleum utility, which will avoid a 'reserve pass through' the domestic monetary base.

Foreign reserve losses that that by-pass the domestic rupee monetary base, such as repayment of state debt for Treasuries or repayments to the International Monetary Fund, are neither expansionary nor contractionary.

Such activities result in further currency weaknesses unless the monetary authority is prepared to follow up with unsterilized sales when demand is generated later through the loans generated from the proceeds of central bank swaps.

Analysts who have studied credit conditions during the past two months have also said that if any foreign exchange purchases by the Central Bank are aggressively sterilized (mopped up by outright sales of its Treasuries stock) the rupee can be rapidly strengthened.

Update II