Runway state expenses from the second half of 2011 - mostly off-budget debt taken to fund state enterprise losses - as well as central bank money printing to keep interest rates down, forced Sri Lanka's rupee to weaken and inflation to go up in 2012.
The rupee fell from 110 to 132 rupees and inflation has hit almost 10 percent, ending more than three years of economic stability, which helped improve people's living standards.
In April, large volumes of money was printed to meet salaries of state workers, despite the rupee peg being under pressure, weakening the currency further and pushing inflation higher.
But from May Sri Lanka's fiscal picture has started to improve.
Analysts say recent economic instability shows once again that annual deficit targets are not of much use when severe fiscal overruns over short term puts pressure on the monetary system, weakening exchange rates and pushing inflation up.
In 2011, though the central government kept to a planned 7.2 percent deficit target on paper, off-budget spending though energy enterprises of over 1.5 percent of de-stabilized the economy. Energy prices were partially fixed in February 2012.
In the six months to June the state collected 488.5 billion rupees in taxes up 14.8 percent from a year earlier, while current spending rose 17.4 percent to 563.8 billion rupees above annual 10 percent increase projected in the budget for 2012.The deficit in the current account is 1.0 percent of projected GDP for 2012, far higher than the roughly balanced current budget promised for the full year.
The state also pushed up capital spending 40.9 percent to 235.8 billion rupees in the first half of the year from a year earlier or to 3.1 percent of GDP, fiscal data released by the Central Bank shows.
In recent years, the finance ministry has directed significant volumes of money to build infrastructure.
The entirety of Sri Lanka's capital spending is financed out of debt as the state, as Sri Lanka's high spending state has not left any tax revenues paid by the citizens to invest in their future since 1987.
Foreign financed capital spending does not put pressure on the exchange rate, but analysts say there has a been a recent tendency to finance capital spending through domestic commercial bank credit, which may have contributed to earlier economic instability.
The overall budget deficit (after reducing grant funding) rose 39.8 percent to 302.8 billion rupees up to June 2012, from a year earlier. The gap, at 4.0 percent of GDP is about two thirds of the full year target of 6.2 percent.
If citizens do not pay more taxes, Sri Lanka is on track to run a deficit of over 8.0 percent of GDP in 2012.
While the budget deficit measured through conventional methods is only 302 billion rupees (or 311.1 billion rupees with grant funding until the method was changed recently), the implied deficit shown by the net increase in debt state was 818.3 billion rupees.
This was partly due to rupee depreciation, which expands the nominal value of foreign debt.
Though the budget deficit is higher than in 2011, Sri Lanka's interest rates are now also much higher than in 2011, indicating that private sector investment and consumption can be cut to compensate for the extra state deficit spending.
The higher rates will allow the economy to stabilize, helping the poorest sections of citizens most, who are most hurt by higher inflation and exchange rate depreciation, though 'growth' measured by conventional methods, will slow.
Authorities are expecting the economy to expand between 6.7 to 7.2 percent in 2012, despite a global economic slowdown.