The government did not disclose the size of the three-year issue placed with two state-run banks but market sources pegged it at two to three billion rupees (20 to 30 million dollars).

"This issue is quite good in the sense it commits the treasury to keeping inflation down," said Ajith Fernando, chief executive of Capital Alliance Holdings in Colombo. "It's like putting the government on a treadmill."

The bond carries an 11 percent coupon rate in the first year. The coupon rate is pegged at one percentage point above the country's annual inflation rate for the remaining two years.

Sri Lanka's official inflation rate stood at 12.1 percent in November after ballooning to 18 percent last January. Sri Lanka's central bank has forecast year-end inflation of around 10.0 percent, up from an annual average of 7.6 percent in 2004.

Inflation in the tropical island torn by ethnic conflict and with coastlines devastated by last December's tsunami has been fuelled by rising food and fuel costs.

The bond issue was made Wednesday, officials at the central bank and the two state banks told AFP on condition of anonymity. Finance officials of the government, which never immediately announces bonds placed with state banks, declined comment.

The inflation-linked bond came almost a week after Sri Lanka got its maiden sovereign rating, a first step in tapping international bond market for funds.

Two international rating agencies - Fitch Ratings and Standard and Poor's -- assigned speculative ratings to the country. Fitch gave the nation a BB- rating while Standard and Poor's awarded it an even lower B+ sovereign rating.

Despite the "junk" grades, President Mahinda Rajapakse, elected last month, said the ratings marked a "respectable beginning with the universe of rated sovereigns."

The island is anxious for cash to meet growing oil and tsunami-related reconstruction costs that have strained the nation's finances.

Sri Lanka hopes to borrow 122.9 billion rupees (1.22 billion dollars) from the domestic market and 66.4 billion rupees (660 million dollars) from foreign sources next year, the government said in its annual budget for 2006.

Hasitha Premarathne, head of research at HNB Stock Brokers, said the inflation-linked bonds tied to inflation should encourage the government to control inflation, but added it would be a tough challenge.

"The principle is good but if they can do it in practice is the problem," he said, citing the new Marxist-backed government's subsidy-laden budget presented in early December.

"Given the welfare measures in the budget and a lack of revenue to meet those expenses, I don't think the government will be able to do much to keep inflation down next year," Premarathne said.

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