Sri Lanka anti-inflation fight mired in excess liquidity

May 8, 2007 (LBO) Sri Lanka’s fight against inflation has received a set-back with monetary authorities unable to sterilize excess liquidity in the banking system which is now reaching towards one percent of gross domestic product. Excess liquidity in the banking system reached 22 billion rupees, reminiscent of the ‘bad old days’ of 2004 and 2006 when the authorities fuelled very high inflation and a balance of payments crisis.

However, analysts say this time the liquidity seems to be coming from the external sector.

The Central Bank cancelled a short term auction yesterday, days after it only accepted 100 million rupees at another auction.

Both auctions would have have sterilized several billion rupees had they been completed.

Since the bank halted money printing to finance the budget deficit in December and tightened monetary policy inflation has come down sharply.

Until this week most traders were expecting the bank to keep on a tight path and were expecting lower inflation towards the end of the year.

However, fears are now rising that the bank may be more concerned about interest rates than inflation and expectations of inflation are rising again.

“We think the bank wants to keep interest