ASMARA, Nov 3 (Reuters) - Eritrea's central bank said on Tuesday it has started selling treasury bonds to raise funds to stabilise an economy threatened by a stand-off with former key trading partner Ethiopia.

Officials at the central National Bank of Eritrea (NBE) said the bonds could be purchased directly from the NBE or Eritrean embassies abroad.

NBE officials are in Washington to ensure the sale in the United States takes off smoothly.

The first batch of bonds -- in $300, $500 and $1,000 denominations -- will mature in 2001 and pay zero interest.

They are targeted at patriotic Eritreans abroad who are prepared to loan money to the government at no cost. At present, remittances from the 500,000 Eritreans abroad contribute heavily to government foreign exchange earnings.

The government is also offering $410 and $820 bonds maturing in 2004, $360 and $720 bonds maturing in 2006 and $300 and $600 bonds maturing in 2008 with interest rates of between 4.0 percent and 4.8 percent, a senior NBE official told Reuters.

``The issuance of the bonds will help offset problems with the budget deficit,'' a senior central bank official said.

``It is expected that the bonds will firstly be bought by Eritreans abroad and then by other interested investors. We expect the issues to be a success,'' despite the lack of any financial incentive on the shorter-term bonds, the official added.

Eritrea's economy has been under severe stress since a row over disputed border territory escalated into conflict in May in which hundreds were killed.

There has been no fighting since mid-June but tension remains high and trade with neighbouring Ethiopia has collapsed.

The NBE estimated headline inflation to have risen to seven percent in October from five percent in June and said it could rise further if the price of essential foodstuffs increased.

Eritrea's nakfa has remained steady, however, easing to around 7.5 against the dollar in October from 7.3 in June.

The introduction of the nakfa to replace the birr -- which Eritrea shared with Ethiopia until November 1997 -- heightened tension between the two Horn of Africa countries.

Central bank adviser Girmai Abraha told Reuters the impact of the stand-off could be felt in transport, trade and tourism.

He also pointed to limited traffic at the Assab port, which was a conduit for Ethiopian imports and exports.

To cope with the growing economic crisis, the Eritrea government recently increased marginal rates of income tax -- in some cases by as much as 100 percent -- to replace a system under which citizens volunteered their salaries to the war cause.

The lowest rate of tax is three percent for those with earnings of around 200 nakfa ($27), while the top rate stands at 38 percent for those with income of around 8,000 nakfa.

``Our tax regime is relatively low so (the increase) is not such a big burden,'' said Goitom Woldemarian, head of Eritrea's department of income tax.

Revenue from the increased taxation will go into a special fund as part of government plans to streamline receipt of financial contributions from Eritreans at home and abroad.

Eritrea gained independence from Ethiopia in 1993 after fighters from both sides fought a protracted guerrilla war against the Marxist Ethiopian regime of Haile Mengistu Mariam.

($1 - 7.5 nakfa)
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