Budget records a surplus: Will it prevail?

(Source: CBSL Weekly Economic Indicators 5 June, 2026) 

The Government Budget recorded an overall surplus in the first quarter of 2026. This is significant because it occurred after about seven decades. Sri Lanka has not recorded an overall Budget surplus since 1955. According to provisional data, the Government’s overall Budget surplus was Rs. 116.35 billion (see Table 1).

However, in the second quarter of 2026, the currency came under pressure to depreciate, experiencing significant exchange-rate volatility. If the currency depreciates, Budget surpluses may not be sustainable.

Good news and bad news have emerged together, with positive and negative developments occurring simultaneously. How do we understand this dilemma? Can we find remedial measures to sustain a strong fiscal position while bringing exchange-rate volatility under control?

If the Budget surplus is driven by increased tax revenues and other non-tax revenues such as service fees, licensing fees, rents, and SOE profit transfers, excluding import tariffs, then that is positive. However, if import tariffs contribute significantly to revenue growth, then the pressure on the currency becomes easier to understand. This means that certain revenue policies that solve the Budget deficit problem may have created another problem in the monetary sector, adversely affecting external accounts.

If pressure on the currency continues, the Budget surplus achieved may not be sustained. To understand this point, let us look at one of the major external accounts, namely the current account. Over the past few years, from 2023 onwards, the current account recorded a positive balance. From the first quarter of 2025, however, the current account surplus declined through to the end of the first quarter of 2026. We recorded only a small surplus in the first quarter of 2026. However, in the second quarter, the current account has begun to post a small deficit. If that deficit is offset by dollar inflows (foreign currency inflows) recorded in the capital and financial account, especially through non-credit-based sources, we can still target higher economic growth.

In theory, when surpluses in the capital and financial account exactly offset a current account deficit, the overall Balance of Payments (BoP) remains in equilibrium. In that situation, there is generally no immediate pressure on the domestic currency to depreciate because substantial foreign currency is flowing into the country to meet the excess demand for foreign exchange. If the currency is under pressure to depreciate and is in fact depreciating, that implies that the above-mentioned balancing mechanism is not taking place.

All this means that economic progress ultimately depends on external accounts and the BoP, not merely on Budget surpluses. The BoP records all transactions between a country and the rest of the world. It determines whether the country is earning or receiving enough foreign exchange to pay for essential imports, service external debt, and ensure the stability of the domestic currency.

Geopolitical developments can certainly affect exchange-rate volatility. However, it is not true that geopolitical developments alone contributed to the recent exchange-rate volatility. In Sri Lanka’s recent situation, the depreciation pressure on the rupee appears to be more closely linked to domestic factors, particularly a rapid increase in private credit growth associated with the surge in vehicle imports.

In a cause-and-effect framework, the transmission mechanism is straightforward. Private credit expands rapidly as financial institutions finance vehicle purchases, leading to a significant increase in vehicle imports. Importers require more foreign exchange to pay overseas suppliers. As a result, demand for foreign currency rises relative to supply. 

The outcome is that the rupee comes under depreciation pressure. This occurred previously when Ravi Karunanayake was Minister of Finance. As Sri Lanka has been recovering from a major external debt crisis, the monetary authorities and the Government should have exercised greater caution. Unwarranted private credit expansion should have been avoided.

In a small open economy such as Sri Lanka, large import-driven credit expansions can quickly affect the BoP and the foreign exchange market, especially when the imports have a high foreign-exchange content and are unable to add value and, in turn, generate foreign currency inflows, as is the case with motor vehicles.

Economic growth requires foreign exchange to import fuel, raw materials, machinery, and technology, as well as to repay external debt, while ensuring a stable exchange rate that encourages both domestic and foreign investment.

If the BoP is weak, growth becomes difficult regardless of the Government’s fiscal position.