By Hema Senanayake –

The government is expected to present its budget for the year 2027 in this month. This is going to be a totally different budget, even though the government is required to stick to certain IMF guidelines. The dynamics of the economy have changed in 2026. The treasury has excessive savings. On the contrary, the external sector will be experiencing a deficit in 2026 and in 2027, according to IMF forecasts.

Accordingly, I think this raises an important macroeconomic policy question: Should fiscal policy be determined primarily by the government’s revenue position, or should it also respond to the country’s external-sector capacity?

How much additional government expenditure can the economy accommodate without creating an unsustainable balance-of-payments problem?

The next budget should be able to answer the above macroeconomic questions. The answer would require developing a fiscal expenditure framework strengthening the external sector. Or this budget would present an External-Sector-Compatible Fiscal Expenditure Framework.

This does not mean that Sri Lanka can’t increase government expenditure even when the external sector is experiencing a deficit. It is also true that a government budget surplus is not a guarantee of a current account surplus, and a government budget deficit does not automatically produce a current account deficit.

My view is that these two phenomena should be examined separately.

Understanding Sri Lanka’s present position

According to the IMF’s May 2026 review (Country Report No. 26/111), actual economic performance is as follows.

Indicator	2025 actual
Primary surplus	5.4% of GDP
Overall budget deficit	2.3% of GDP
Government revenue	16.7% of GDP
Government expenditure	19.0% of GDP
Current account surplus	US$1.719 billion

Like a doctor checks all vitals of a patient, economists check the vitals of the economy. As per the above chart vitals for the year 2025 were good. But the IMF projects a current account deficit of US$534 million for 2026. If the deficit continues in 2027 the external position would come under pressure. One reason could be higher fuel import costs. But it is only one reason. Higher private credit growth than expected could also be another significant reason. Increasing government expenditure without targeting to strengthen the external sector can create heavy pressure on external accounts.   

Why increasing government expenditure can create external pressure

Consider the following transmission mechanism. The government increases expenditure. As a result, household disposable income and business revenue increase. And if there is no proper monetary policy or administrative control to contain private credit growth, the demand for imported goods increases, almost exponentially, creating pressure on the external sector.

Also, suppose the government increases expenditure while commercial banks simultaneously expand private-sector credit.

Both activities can increase aggregate domestic demand.

If the private credit expansion finances vehicle imports, consumer goods and other imports, the external-sector pressure could become substantial.

Therefore, fiscal expansion should be coordinated with monetary and credit policy.

The objective should not simply be to increase or decrease money supply. It should be to ensure that additional purchasing power is accompanied by an appropriate expansion of domestic productive capacity.

However, not all government expenditure produces the same external-sector consequences, if the government is careful as to what expenditure should increase.

What type of government expenditure should increase?

Basically, we can think of three strategic scenarios.

Scenario 1 – Immediate economic recovery

* Essential public services.

* Targeted household welfare.

* Rehabilitation of infrastructure.

Scenario 2 – Import reduction

* Agricultural productivity.

* Renewable energy.

* Domestic intermediate goods production.

* Industrial technology development.

Scenario 3 – Foreign exchange generation

* Export infrastructure.

* Tourism development.

* Technology exports, development of a futuristic industrial zone.

* Research and development.

* Logistics and port-related services.

The ultimate objective should be to transform Sri Lanka from an economy primarily dependent on importing industrial technology into an economy that participates in producing the technologies of the AI era, while addressing the challenges of immediate economic recovery. The above three scenarios are formulated for that purpose. For example, I am hopeful that if Sri Lanka thinks of developing solid-state battery production technology, not only will we be self-sufficient in energy production (stabilising the national grid), but also, we will export solid-state batteries to neighbouring countries. If the government takes the lead, there are capable Sri Lankan entrepreneurs who can venture into such futuristic technological areas.   

The government should evaluate each strategic expenditure scenario mentioned above and select major expenditure programmes according to its expected foreign exchange consequences.

A new approach

I would suggest introducing an expenditure policy based on increasing external-sector capacity.

The government should not unnecessarily suppress productive government expenditure merely to maintain an exceptionally high primary surplus when the external-sector constraints can be addressed through expenditure composition. The IMF itself recognised the need for fiscal easing in 2026 in response to economic shocks, while requiring a return to a 2.3% primary surplus from 2027 onwards.

However, there is one important qualification in following the said approach. The government must also consider interest payments, debt-service obligations and the availability of sustainable financing. The primary surplus alone does not measure the government’s complete fiscal capacity.

Such a framework could help Sri Lanka determine the appropriate level of government expenditure in its budget by examining its effects on domestic production, imports, exports, private credit and foreign exchange reserves.