A senior official of the Ministry of Finance and Planning said the reduction of lending rates to between eight and 12 percent was only applicable to selected sectors of the economy.

"As I understand it, the Presidential directive to bring down rates to a maximum of 12 percent was only for priority sectors of the economy such agriculture, construction, tourism and SME sector, and is intended to lift up entrepreneurs," the official told the Island Financial Review.

Private commercial banks have began to respond to the lending rate cuts of the state banking sector and are reducing rates on new loans to selected sectors of the economy.

"We cannot match the rates state banks are lending at," a private sector banker said. "But we can reduce rates gradually on existing loans because our deposits are contracted at higher rates and we need time to adjust."

Private sector commercial banks are expected to offer lower rates for new fixed deposits thereby giving them space to offer lower lending rates on new loans.

An analyst said the move to reduce lending rates was a smart one although defying logic, and could benefit the economy despite being a political move in view of elections next year.

"You could say reducing lending rates while deposit rates are higher is a foolish thing to do because it obviously erodes profitability when net returns are less then net costs. But the President’s move is something else," an analyst said.

The domestic banking sector has been holding excess liquidity positions for quite a while as Central Bank purchased dollars to stabilise the exchange rate.

Commercial banks used these ‘excess’ rupees to invest in government securities or in the Central Bank repurchase window earning 8.5 percent in the process.

"It seems the President’s rational is based on what has been done with these excess rupees. Instead of investing in government securities or parking them overnight at the Central Bank, the government is trying to encourage banks to lend to selected sectors.

"So, it seems that the deposit/lending rate argument does not apply here," the analyst said.