The country’s GDP growth is driven by government spending, a top economist and former central banker Dr. Indrajith Coomaraswamy said, creating short term cycles of boom and busts.

During the conflict period GDP growth averaged around five percent per annum and every time the growth rate reached 6 percent, the economy showed signs of overheating.

"This is because the economy is largely driven by the budget deficit, and not by export growth as in most countries in the region. There is a strong correlation between GDP growth and the budget deficit and our economy is by and large influenced by public expenditure. This unsustainable model meant that no sooner the economy grew by 6 percent there was overheating and demand management, such as increasing interest rates and moving exchange rates up and down, was used to counter the problem. Now, can we hit a sustainable 8 percent growth rate without structural changes? This is the short term challenge facing the economy," Dr. Coomaraswamy said delivering a lecture on ‘Development Prospects for Middle Income Sri Lanka—Challenges and Prospects’ organised by the South Asia Policy and Research Institute at the BMICH last Wednesday (17).

"In 2010/11, after the decades-long conflict the government was under pressure to deliver the peace dividend, so they forgot economic fundamentals brought interest rates down and took various short cuts which led to the overheating of the economy, pressure mounted on the rupee and there was a drawdown of reserves. Of course, the government must be commended for adopting tough policy corrections in early 2012, but if you look at the past 35 years or so we see this repeating cycle and it seems we are unable to breakaway from this. The only solution we have is to adopt structural reforms, without which we cannot realise sustainable growth at 8 percent," Dr. Coomaraswamy, who is advising the government on the Commonwealth Heads of Government Meeting to be held here later this year, said.

He said Sri Lanka’s economy was driven by domestic trade and public spending and sustaining growth at 8 percent was not possible unless the export sector was the major driver of economic growth.

There are limitations to state-capitalism because of the high fiscal deficit and debt profile.

With the government concentrating on infrastructure development, provisions for healthcare and education in the budget are squeezed out. A bloated public service was not adding value to the economy either, Dr. Coomaraswamy said.

The country had done a lot during the past few years to bring down the budget deficit and make its debt profile more favourable, but it did not mean Sri Lanka was out of the woods yet.

"The government’s fiscal commitments are very encouraging but there is a lot that needs to be done," IMF Sri Lanka Resident Rep Dr. Koshy Mathai said at Sri Lanka Economic Forum earlier this month. He said fiscal discipline was critical for macroeconomic stability and Sri Lanka’s fiscal position was still weak and exacerbated economic volatility.

Dr. Mathai said the country continued to loosen its fiscal policy during boom periods and tighten its belt during downturn. He said while many poor and emerging economies moved away from this policy, Sri Lanka had yet to do so.

Comparing Sri Lanka’s performance with other economies, Dr. Mathai said Sri Lanka’s loose fiscal position led to higher inflation and higher interest rates. A high level of public debt had also stunted growth compared with many other economies, including Sri Lanka’s peers, and put pressure on the banks.

Financial market analysts said fiscal and monetary policy created short term cycles of boom and busts too often in this country, making difficult for business to plan effectively for the long term.

Despite bringing down policy rates twice since December, and reducing the statutory reserve ratio of the country’s banking sector with intention of boosting private sector credit growth in order to stimulate the economy, private sector credit growth is still sluggish with many businesses adopting a wait-and-see approach, analysts said.

The Fiscal deficit for the first four months of this year expanded by 20.3 percent to Rs. 343.5 billion from Rs. 285.5 billion a year ago, data released earlier this month by the Treasury showed. The deficit was 3.9 percent of GDP, marginally up from 3.8 percent last year. The deficit target for the full year is 5.8 percent of GDP.

Government revenue and grants fell 4.22 percent to Rs. 314.8 billion during the first four months of this year down from Rs. 328.7 billion a year earlier. As a percentage of GDP, revenue fell to 3.6 percent from 4.4 percent last year. Tax revenue fell 2.59 percent to Rs. 289.8 billion during the four month period, from Rs. 297.5 billion a year ago.

Recurrent expenditure of the government amounted to Rs. 471.4 billion during the first four months of this year, up 2.33 percent from a year ago with the salaries bill increasing 13.23 percent to Rs. 126.9 billion, interest payments increasing 1.4 percent to Rs. 176 billion. As a percentage of GDP, current expenditure declined to 5.4 percent from 6.1 percent a year ago.

The revenue deficit (revenue minus recurrent expenditure) increased by 17.47 percent to Rs. 157.4 billion up from Rs. 133.9 billion a year ago, unchanged at 1.8 percent of GDP for the first four months of 2012 and 2013.

Public investments or capital expenditure grew 21.98 percent to Rs. 196 billion up from Rs. 160.7 billion a year earlier, growing to 2.3 percent of GDP from 2.1 percent of GDP a year ago.

As a result, the overall budget deficit increased by 20.3 percent to Rs. 343.5 billion from Rs. 285.5 billion a year ago.