Dealers said the domestic money market running a high rupee liquidity position for the past eight months still remained at high levels and although it could help keep interest rates at low levels on the long run it could lead to inflationary pressure on the economy.

Dealers said the rupee was trading at 114.60/65 with importer demand picking up and high rupee liquidity levels remained as the domestic money market held a surplus of Rs. 21 billion overnight leading to Wednesday.

"Importer demand is strong and the dollar continues to be traded in the upper limit of the Central Bank band of Rs. 114.35 – Rs.114.65. The market was trading dollars at the Rs. 114.60/65 range," a dealer said speaking to the Island Financial Review last afternoon.

Meanwhile, rupee liquidity levels remained at high levels, at a Rs. 21 billion surplus when the money market closed trading on Tuesday.

"We have had high liquidity surplus positions for the past eight months or so. In the short term this surplus is going to ensure that interest rates remain low as banks look for ways to invest their surplus liquidity, but on the long run it is going to create inflation," a dealer said.

According to available data, by November 2009 credit to the government from the domestic banking system grew by 25 percent as against a 44 percent growth rate in November 2008. Private sector credit growth on the other hand fell by 6.1 percent in November 2009 after growing by 8 percent the previous year.

Dealers said borrowings have dried up and are expected to remain at low levels due to upcoming general elections. However, fiscal side concerns remain as dealers said expanding government spending could once again lead to inflation and high interest rates.

"There is so much uncertainty these days," a dealer said.

High rupee liquidity positions were created after the Central Bank purchased the bulk of dollar inflows after foreign interest in Sri Lanka soared after the war in a bid to keep the rupee stable as an appreciation against the dollars would have hit exporters.

For example, in November 2009, the Central Bank purchased US$ 286.9 million from the domestic market as against sales amounting to US$ 28 million. In November 2008, things were different as the Central Bank pursued a policy of selling dollars to prevent the rupee from depreciating. Dollars sold from reserves amounted to US$ 160.20 million in November 2008 as against purchases of US$ 34 million.

Dealers said since foreign investments in rupee denominated government securities had almost reached their limits equities were the other source of foreign investment inflows.

According to brokers, foreign buying at the Colombo Stock Exchange so far this year amounted to Rs. 8.2 billion with foreign selling amounting to Rs. 11.5 billion. In 2009, foreign buying amounted to Rs. 43.05 billion and sales Rs. 43.85 billion. This means there is a net outflow of foreign investments from the stock exchange in 2009 and so far this year as well.

"The Stock Exchange experienced some heavy interest from foreign investors during the latter half of 2009 but then a considerable outflow was experienced due to Raj Rajaratnam’s arrest for insider dealing in the US," a broker said.

But things are relatively quiet in the domestic money market.

"Things are relatively quiet these days and all we are seeing is some improvement in importer demand putting pressure on the rupee to appreciate. This is why the dollar is trading at the upper limits of the Central Bank exchange rate band," a dealer said.