Courtesy The Daily Mirror

Sri Lanka’s Extended Fund Facility (EFF) programme with the IMF focuses heavily on external debt restructuring to restore debt sustainability. However, external debt restructuring alone is insufficient because a large portion of debt service obligations arise from currency depreciation of external debt thereby inflating domestic debt, including treasury bills and bonds.

Currency depreciation, while theoretically boosting export competitiveness, increases the rupee cost of essential imported inputs, further squeezing margins. Local clients paying in rupees face higher costs, dampening demand for digital services.

Sri Lanka’s economic future is being quietly reshaped beneath the surface of fiscal targets and IMF scorecards. As an 18% VAT on digital services takes effect and currency depreciation alters domestic cost structures, a deeper economic realignment is underway. While headline reforms focus on debt restructuring and public finance, the true fault lines lie in managing domestic and external balance sheets separately. Without addressing this dual challenge, the country risks building an economy that appears balanced on paper but remains vulnerable in substance, undermining innovation, trade competitiveness, and long-term resilience.

Sri Lanka’s engagement with the IMF and the implementation of an 18% VAT on digital services mark a pivotal moment in the country’s economic trajectory. While the VAT aims to broaden the tax base and protect local industries from untaxed imports and dumping, it also raises operational costs for key export sectors, especially digital services.   

This article argues that the core economic challenge lies in managing two distinct balance sheets -domestic and external-and their cash flows separately.   

Properly addressing these twin accounts is essential for sustainable debt restructuring, fiscal stability, and industrial competitiveness. Without this dual approach, reforms risk creating a hollow economy, balanced on paper but fragile in substance.   

A quiet but profound economic shift 

Two years into Sri Lanka’s IMF-supported reform programme, a transformation is unfolding quietly but with lasting implications. Public attention has focused on headline reforms such as fiscal consolidation, interest rate liberalisation, and state-owned enterprise restructuring.   

Yet, beneath these surface changes, deeper shifts in cost structures, industrial competitiveness, and economic autonomy are taking place. Central to this is the introduction of an 18% VAT on digital services effective October 2025, alongside currency depreciation and structural policy shifts.   

While these measures aim to stabilise public finances, they risk throttling Sri Lanka’s vibrant digital economy and export and industrial sectors, raising broader questions about the country’s market share for its industrial future and economic resilience.   

VAT on Digital Services: A Double-Edged Sword 

On paper, extending VAT to digital services aligns Sri Lanka with global tax norms and broadens the government’s revenue base.   

However, in practice, the 18% VAT imposes a structural cost burden on digital firms, many of which rely on US dollar-priced software, cloud platforms, and cybersecurity tools. This tax raises operational costs for startups and MSMEs, causes significant vulnerabilities and eroding their global competitiveness.   

Meanwhile, currency depreciation, while theoretically boosting export competitiveness, increases the rupee cost of essential imported inputs, further squeezing margins. Local clients paying in rupees face higher costs, dampening demand for digital services.   

This combination of VAT and currency effects threatens to weaken one of Sri Lanka’s most promising export sectors, undermining innovation, employment, and foreign exchange earnings.   

VAT’s Positive Role: Protecting Local Industries from Dumping 

Despite these challenges, VAT plays a vital protective role against untaxed imports that can create a dumping” scenario. Dumping of goods and services occurs when foreign goods and services enter the market at artificially low prices, often because they avoid taxes or regulatory costs, thereby undercutting local producers. By imposing VAT on imports, Sri Lanka ensures that foreign goods do not enjoy an unfair price advantage over domestically produced items.   

This levels the playing field for local manufacturers and service providers, helping to preserve jobs and industrial capacity.   

This function of VAT is especially critical given Sri Lanka’s relatively nascent industrial base, which remains vulnerable to global competition without adequate safeguards. However, in a country where technological goods are a prerequisite for value creation, security, innovation and manufacturing designing, printing and packaging this has a negative impact.   

Parallels with Free Trade Agreements (FTAs) 

The VAT’s role in protecting local industries from dumping parallels the challenges posed by Free Trade Agreements (FTAs). FTAs open domestic markets to foreign competition, which can be beneficial for consumers but detrimental to local industries lacking global competitiveness.   

Without protective measures, FTAs risk accelerating deindustrialisation and economic dependency. Similarly, VAT ensures that imports and local products are taxed comparably, preventing market distortions and unfair competition. This safeguard is essential for countries like Sri Lanka that are still building their industrial foundations.   

 The Core Issue: Managing domestic and external balance sheets separately 

A fundamental but often overlooked challenge in Sri Lanka’s economic reforms is the need to keep domestic and external balance sheets and their cash flows separate and managed distinctly.   

Sri Lanka’s public debt is roughly split between domestic and foreign obligations, each with unique characteristics, risks, and implications for fiscal sustainability. Domestic debt accounts for a significant share of interest payments and refinancing needs, while external debt carries foreign exchange risks and influences the country’s balance of payments. 

Why Separate Balance Sheets Matter 

•  Domestic Balance Sheet: 

Comprises treasury bills, bonds, and domestic currency debt held largely by local banks, the central bank, and pension funds. Its volatility in service affects domestic liquidity, interest rates, and therefore national production output.   

Restructuring domestic debt is complex because it risks destabilising the local financial system if not carefully managed.   

•  External Balance Sheet: 

Includes foreign currency assets and liabilities such as commercial bonds, bilateral loans, and multilateral debt. Its debt service depends on foreign exchange earnings from goods and services and retained earnings i.e. reserves. Therefore, it is far more significant that we pay attention to external debt restructuring as it is critical for restoring debt sustainability and regaining access to international capital markets.   

•  Separate Cash Flows:

The cash flows servicing these two debt types differ fundamentally. Domestic debt service affects local currency liquidity and interest rates, while external debt service impacts foreign currency reserves and the balance of payments. Managing these balance sheets as one undifferentiated entity obscures the distinct challenges and policy tools required for each. For example, a successful external debt restructuring that reduces foreign currency obligations does not automatically ease domestic debt pressures, which will continue to strain from incorrect fiscal space that hinders balance sheet capacity and restrains market share and in turn creates monetary instability.   

Sri Lanka’s Experience with Debt Restructuring 

Sri Lanka’s Extended Fund Facility (EFF) programme with the IMF focuses heavily on external debt restructuring to restore debt sustainability. However, external debt restructuring alone is insufficient because a large portion of debt service obligations arise from currency depreciation of external debt thereby inflating domestic debt, including treasury bills and bonds.   

The government’s total Debt obligation as at end 2024, stands at 103 billion US Dollars (or 115pct of real GDP), of which 38 billion Dollars is external debt, while 66 billion Dollars is domestic. Domestic Debt Optimisation (DDO) plan, initiated in mid-2023, aimed to restructure key domestic and external debt categories but covers only about 60% of each in total, leaving significant liabilities unaddressed.   

This partial coverage limits the overall impact on fiscal sustainability and gross financing needs. Without a comprehensive approach that addresses both domestic and external debt separately but cohesively, Sri Lanka risks fiscal and monetary instability despite meeting headline IMF targets.

The Cash flow challenge: Core of Sri Lanka’s economic vulnerability 

The twin balance sheets issue is fundamentally about cash flow management. Sri Lanka’s ability to service debt depends not only on the size of external liabilities but on the timing and currency composition of debt service payments relative to government revenues and foreign exchange earnings.   

• External cash flows are constrained by foreign exchange earnings from exports, remittances, and foreign investment. A shortfall leads to reserve depletion and currency depreciation.   
• Domestic cash flows depend on tax revenues, monetary policy, and the health of the local financial system. High domestic debt service crowds out productive investment spending by both public and private sectors and tightens liquidity with currency volatility.   

The mismatch and mismanagement of these two cash flows and balance sheets create vulnerabilities that can trigger deeper crises, as seen in Sri Lanka’s recent economic turmoil.   

Broader implications 

The combined effect of ad hoc fiscal measures such as VAT, rupee currency depreciation/volatility, exacerbate external debt servicing pressures thus shifts away from self-sustaining industrial development approach toward a more external debt dependent and fragile economy.   

External revenue from goods and services are a core part of this nuanced approach.   

Sectors that are end users of digital services covered under the new VAT legislation, must be shielded from rising VAT costs, or these companies will now face rising cybersecurity costs and threats, data cost, and digital marketing costs and thus could erode market share due to inability to add value to products and retain competitiveness.   

It is also possible that entrepreneurs may retreat to protected or rent-seeking sectors rather than tradable industries.   

Sluggish industrial profitability due to the IMF pre-conditions, of ad-hoc VAT adjustments and other increases in taxes in general, together with high domestic borrowing costs due to currency depreciation would deter investment in new high technological factories, R&D, and IT sector and also be restrictive to adding new physical infrastructure.   

This unhealthy combination makes the domestic economy vulnerable to external shocks, interest rate cycles and thus would have to revert back to external borrowing to meet the growing tradable account deficit.  

These dynamic risks create an extractive economic model focused on fiscal extraction rather than value creation, production, market share and industrial solution innovation i.e. automation, and data driven decisions.   

Achievements and Hidden Costs 

Sri Lanka has made progress in meeting IMF programme targets: achieving primary budget surpluses, stabilising foreign reserves, and addressing SOE losses. However, these successes mask underlying weaknesses:   

• GDP growth remains sluggish (well below 2018).   
• Private sector credit is subdued.   
• Employment in tradable sectors is weakening.   
• Inflation moderation has come at the cost of suppressed balance sheet growth and hence sluggish demand and investor confidence. It is therefore evident that the economy is being balanced through contraction and compliance rather than expansion and innovation, risking long-term structural fragility and loss of market share.   

Industrialisation 6.0- Vision Grounded in Reality

Asian economies are already carving markets based on Industrialization 6.0, as this marks a revolutionary leap in global manufacturing, heralding an era where fully autonomous systems powered by advanced AI, robotics, and cyber-physical technologies, manage production of goods and logistics with minimal human involvement.   

This new industrial epoch transcends previous revolutions by shifting from mere automation to complete autonomy, enabling factories to self-optimise, self-adapt, and deliver hyper-personalised products at scale. Sri Lanka cannot leapfrog directly into advanced industrial stages like autonomous manufacturing or AI-powered ports due to infrastructural and capital constraints.   

Instead, it should focus on realistic, incremental adoption of Industry 4.0 and 5.0 technologies that enhance existing sectors such as apparel sector that caters to multiple markets, processed agri-manufacturing, electronics assembly, software development, KPO/BPO, and logistics. In order to get these off the ground it’s essential that fiscal policy signals align with national balance sheet priorities.  

Finally- Balancing reform with resilience 

Sri Lanka’s economic reforms highlight the complexity of balancing fiscal discipline with industrial competitiveness and economic autonomy.   

The 18% VAT on digital services is a litmus test of whether reforms can be tailored to national realities rather than boilerplate prescriptions.   

Critically, managing domestic and external balance sheets separately, with a focus on their distinct cash flows, is essential for sustainable debt restructuring and economic stability. VAT plays a dual role raising revenue and protecting local industries from dumping yet must be balanced with targeted support to avoid undermining growth sectors.   

Without this nuanced approach, Sri Lanka risks building a fiscally balanced but industrially hollow economy, vulnerable to future shocks and lacking the dynamism needed for long-term prosperity.   

The quiet unravelling began not with protests, but with escalation in price lists, contraction in balance sheets, and missed market share opportunities. Sadly the real economic cost will be visible only in hindsight.