But crowding out is needed to keep the economy stable and limit loans to deposits and credit repayments.
In January 2013 credit to the central government from dollar books of banks eased marginally to 131.6 billion rupees from 132.4 billion, which may be due to currency valuations. Credit to the state from rupee banking books was up 27.6 percent from a year earlier.
Credit to state enterprises also edged lower to 291.4 billion rupees in January from 292.5 billion rupees, with dollar loans falling to the equivalent of 197.7 billion rupees from 201.2 billion rupees.
But in December 2012 banks loaned state enterprises 31.4 billion rupees, and private sector credit contracted to 9.9 billion rupees from 24.8 billion rupees a month earlier.
Despite the central bank cutting policy rates in December, bank interest rates have been high, with heavy state borrowing crowding out private borrowers.
State banks have been borrowing at rates as high as 18 percent to lend to loss making state enterprises, according to industry sources, though the rates have since come down.
Treasury bill and bond rates have fallen as money was borrowed from banks rather than bond markets.
Fitch Ratings said up to 20 percent of state-run Bank of Ceylon's loans were to Ceylon Petroleum Corporation. Meanwhile private banks were also loaning money to the Road Development Authority.
But analysts say in the wake of a balance of payments crisis, it is normal for private credit to slow, as state revenues also take a beating and the deficit financing goes up.
After the 2009 balance of payments crisis, private credit turned negative as the budget deficit surged to 10 percent of gross domestic product and economic growth fell to 3.5 percent.
Unlike in Europe, where 'state austerity' is now practiced, the rulers do not halt spending in Sri Lanka and belt tightening is imposed mostly on ordinary citizens in the form of currency depreciation, inflation and higher taxes.
Authorities have recruited close to 50,000 graduates to an already bloated state sector amid the economic slowdown.
Treasury secretary P B Jayasundera, who analysts say has been walking a tight rope trying to improve fiscal disciple to some extent, came under a vicious attack from a member of the elected ruling class recently, which does not help the fiscal picture.
He came under heavy fire for trying to curtail allowances to graduate trainees.
Both Bank of Ceylon and National Savings Bank are to go to international markets this year.
Power prices are however expected to be raised this year, which may help reduce state pressure on the banking system and reduce the gap between policy rates and bank lending rates.
There can also be monthly variations in credit disbursements.
Commercial Banks loaned 9.7 billion rupees to private borrowers, the lowest since May 2010, when 7.2 billion rupees was loaned to business. In the year to January 2013, credit to private borrowers was up 15.5 percent to 2,368.1 billion rupees.
But credit to the state from domestic banking units rose by 55.4 billion rupees to 689.4 billion rupees, up 27.6 percent from a year earlier.
Total credit to the government from the banking system rose by a slower 42.1 billion rupees to 1,087.3 billion with central bank credit (stock of printed money outstanding) falling to 266.3 billion rupees in January from 634.0 billion rupees a month earlier.
Killing central bank credit reduces the outflow of dollars from the economy compared to the inflow, allowing foreign reserves to be built up and the economy kept stable, but it also has a 'crowding out' effect on domestic credit.
A second International Monetary Fund loan to the Central Bank in 2013 would have allowed a lower level of foreign reserves to be built up by killing domestic credit, allowing the Treasury to borrow more from the banking system without slowing growth.
LBO's economics columnist (Thrift Column) had earlier explained that authorities were mistaken in demanding Treasury funding from the IMF as the final effect on the economy was the same even if money was given to the Central Bank, based on the foreign reserve target for the year.
During a balance of payments crisis, when a central bank sterilizes foreign exchange sales with printed money, credit surges as nobody is 'crowded out' as banks get injected money in addition to deposits to make loans and drive imports to unsustainable levels.