The country suffers from a self-inflicted affliction: twin deficits (see graph: Twin Deficit). As our columnist Bellwether is wont to argue, fiscal deficits tend to lead to balance of payments deficits given the way our Central Bank operates (printing money and advancing funds to the state to meet estimated expenditures of the state).

Economists have long touted Sri Lanka as a classic example of a twin deficit economy. Such economies are prone to high levels of debt, a heavy reliance on foreign capital inflows, a steady depreciation of its currency, and high rates of interest noted, Dushni Weerakoon, Utsav Kumar, and Roselle Dime in an ADB South Asia Working Paper Series titled Sri Lanka’s Macroeconomic Challenges: A Tale of Two Deficits. As a result, the recurring balance of payments crises has resulted in 16 IMF bailouts and debts rising to unsustainable levels (see inset Mounting Debt).

Twin Deficit
Sustained and worsening fiscal and balance of payments
deficits make stability untenable

There never was an urgency to deal with Sri Lanka’s twin deficit problem. Even after the Aragalaya ousted the Rajapaksas, the scale and scope of the fundamental economic problem have not sunk in. Even in the best of times. Despite the euphoria of the 30-year civil war ending in 2009, the Central Bank issued a sobering reminder in its annual report of that fateful year, with Sri Lanka poised for another watershed moment in the scale of independence, or JR’s nominal economic liberalization.

In 2010, releasing its annual report for the previous year, the year Sri Lanka emerged out of bloody conflict, the Central Bank demonstrated an ability to be foreboding despite the prevailing euphoric mood.

Mounting Debt 
The twin deficits have rocketed and driven debt to unsustainable
levels in the last decade as fiscal indiscipline worsened

“The fiscal consolidation process needs further strengthening to facilitate demand management policies and to enhance public investment to support higher and sustainable economic growth,” the Central Bank said, albeit a thinly veiled warning, hinting at the precarious fiscal position.

However, it does not mince its words further on. It said the relatively lower level of government revenue underscores the need to strengthen the tax system. Simplifying the tax system, appropriate rates, broadening the tax base, reducing tax concessions and exemptions, simplifying the import duty structure (to abandon protectionism, perhaps), and improving tax administration with technology “will be helpful”, the Central Bank said.

An efficient tax regime would also encourage private-sector economic activity and capital formation. But what about curtailing government expenditure?

The Central Bank duly noted that it would be impossible to rationalize state spending overnight. Any gains from expenditure rationalization would accrue in the medium term because of the limited room to reduce recurrent expenditure immediately. In other words, voters, including the mass of public sector trade unions and crony capitalists (or mercantilists) will not forgive such indiscretions as spending cuts. However, the Central Bank holds its argument: “As the continued high growth of recurrent expenditure is unsustainable, effective measures (are needed) to rationalize transfers, subsidies, pensions, and interest payments by addressing the root causes of such expenditure sources. At the same time, vulnerable sections of society have to be protected by appropriate safety nets”. That was what the Central Bank said in 2009. And it could not be truer today, 24 years later.