Sept. 14 (Bloomberg) -- Sri Lanka's economy, constrained by the highest interest rates in Asia and renewed violence in the island's civil war, will post slower growth this year, central bank Governor Nivard Cabraal said.

The $26 billion economy will expand 7 percent in 2007, Cabraal said in Mumbai, half a percentage point lower than his forecast in July. Sri Lanka's economy grew 7.4 percent last year, buoyed by textile and clothing industries, the biggest export earners. Citigroup Inc. forecasts 6 percent growth this year.

Governor Cabraal has kept the central bank's benchmark interest rate at a five-year high of 10.5 percent for six straight meetings to curb runaway inflation. That's damping growth in an economy already suffering from escalating attacks by separatist rebels on industrial facilities in government- controlled areas.

``Any country which did not have any strife would have been happy with this growth,'' Cabraal said. ``We are resilient.''

Gross domestic product expanded 6.4 percent in the three months ended June 30 from a year earlier, accelerating from growth of 6.1 percent in the first quarter, the Department of Census & Statistics said yesterday. Analysts expected a 6.1 percent increase.

Unrest discourages private investment and hinders the flow of goods to and from the north and east of the island, where the fighting is taking place.

Borrowing Costs

Sri Lanka's peace process has been halted by almost daily violence since February last year and the nation is experiencing its worst fighting since Norway brokered a truce in 2002. The Liberation Tigers of Tamil Eelam bombed Royal Dutch Shell Plc and Indian Oil Corp. plants and an air force base in two raids since March 26.

The government says higher borrowing costs have helped to rein in inflation fanned by increased oil prices and higher import costs because of a depreciating currency.

Consumer prices in the capital Colombo rose 17.3 percent in August from a year ago, after increasing 17.6 percent in July. They soared 20.5 percent in January.

The central bank will keep its benchmark interest rate, currently the highest in Asia, until inflation is contained, Cabraal said. Prices are expected to rise 10 percent this year, he said. The next monetary policy review is due Sept. 25.

Currency Trading

The central bank will only intervene in the South Asian island's currency market to stem volatility in the rupee, Cabraal said.

The Sri Lankan rupee has fallen 5.2 percent this year, dropping to successive record lows, making it the worst performer among 11 Asian currencies tracked by Bloomberg.

The government is to continue with a planned $500 million bond sale, Cabraal said.

Sri Lanka hired Barclays Capital, HSBC Holdings Plc and JPMorgan Chase & Co. on Aug. 2 to help raise the money to upgrade the country's infrastructure. The debt sale will also serve as a benchmark for Sri Lankan companies raising money in international capital markets, the central bank said on July 13.

To contact the reporters on this story: Anusha Ondaatjie in Colombo, Sri Lanka at anushao@bloomberg.net; Sumit Sharma in Mumbai at sumitsharma@bloomberg.net.

Last Updated: September 14, 2007 09:43 EDT