By James Fontanella-Khan

Sri Lanka’s central bank cut key interest rates yesterday in spite of its economy showing signs of recovery since a 26-year civil war against separatist Tamil Tigers ended in May. It reduced the reverse repurchase rate 75 basis points to 9.75 percent and the repurchase rate 50bp to 7.5 percent, with bank officials saying they could manage rising inflation and excess liquidity in spite of a looser monetary policy. However, observers said the move by the central bank governor, who is appointed by the government, was driven by political, rather than economic, interests. Mahinda Rajapaksa, the president, is likely to face an election challenge from a former general credited with ending the war.

Inflation in the country has fallen from a six-year high of 28.2 percent in June 2008 to a record low of 0.7 percent in September and remained close to 1 percent in November. The central bank expects it to rise moderately next year but remain “relatively subdued”. Meanwhile, the Sri Lankan rupee has strengthened, foreign reserves have doubled to $5bn (€3.3bn, £3bn) and the Colombo Stock Exchange has more than doubled. The government expects economic growth of 3.5 percent this year.

A bitter political battle could harm the country’s economic recovery efforts as lower lending rates, added to rising commodity prices and excess liquidity, stoke fears of high inflation and a weak rupee.

Any rise in inflation could cause problems between Colombo and the International Monetary Fund, which has agreed to a $2.6bn loan on condition that the country’s budget deficit is kept under control.

Colombo has agreed to cut the deficit from 9 percent of gross domestic product to 7 percent. However, the rate cuts were broadly welcomed by the business community. Sri Lankan industry captains interviewed by the Financial Times leaders had told the Financial Times in interviews that cheaper loans were a priority to help boost investment.

Economists and market analysts said the cuts would help lift consumption and investment, but some saw the decision as politically motivated, with one saying it had an “election connotation”. “The timing and the size of the rate cut is clearly linked to the fact that we are about to enter an electoral campaign period,” said Murtaza Jafferjee, an analyst in Colombo. Sarath Fonseka, the army general credited with masterminding the successful end to the conflict with the Tamil Tigers, resigned his post this week amid speculation that he plans to run against Mahinda Rajapaksa.