"After years of reliance on short-term financing from international markets to cover its fiscal deficit, Sri Lanka experienced a sudden stop of international capital flows as the global crisis hit," the IMF said.
"The central bank’s initial efforts to keep the exchange rate from depreciating led to a significant loss of reserves."
The program aims to maintain economic growth at least at 3.0 percent of gross domestic product and build up the country's depleted foreign reserves to 2.49 billion US dollars, with a flexible exchange rate.
"The program aims to rebuild reserves to prudent levels while allowing the flexibility in the exchange rate necessary to boost the competitiveness of Sri Lanka’s exports," deputy managing director Takashita Kato said in a statement.
"At the same time, the central bank’s policies will aim to control inflation while ensuring adequate credit to the private sector."
Following a float of the rupee the central bank has collected about 500 million US dollars by July pushing up gross reserves to 1.7 billion US dollars.
The disbursement of two tranches would see Sri Lanka meeting the target, with only a little more to be collected.
The program gives considerable leeway for the Central Bank to lose its grip on inflation allowing prices to go up to 8.0 percent by end-2009 and 10.7 percent by 2010.
Though there is heavy pressure on the central bank from the public not to print money for the government and make people poor, it has already shown signs of acting like a giant discount window for the government on at least one occasion this month.
The practice of silently printing and advancing money for the Treasury, then withdrawing allows some transactions that would not have taken place in a real world without the existence of a money printing central bank to cleared, generating inflation.
Critics say such practices show how the central bank has consistently generated inflation high above the anchor US dollar currency over the last 50 years while other dollar pegged countries like Malaysia, Singapore, Hong Kong and now even China, have kept inflation low, allowing people to escape poverty.
However central bank governor Nivard Cabraal had said he would maintain monetary independence and inflation would only be allowed to go up just over 5.0 percent by the end of the year.
Cabraal had built up considerable inflation credibility over the past year. Inflation fell to 0.9 percent in June.
IMF said the government was now trying to fix the budget, keeping the deficit at an ambitious 7.0 percent, allowing central bank room to conduct proper monetary policy.
But losses at state-run Ceylon Petroleum Corporation and Ceylon Electricity Board would make the public sector deficit 7.7 percent of GDP.
CPC has massive losses on petroleum derivatives it could be forced to pay in full or in part based on the outcome of an ongoing arbitration.
Expenditure is expected to be contained at 21.9 percent of GDP from an original budget of 22.8 percent.
Sri Lanka ended a 30-year conflict with Tamil Tiger separatists in May and is looking for money to rebuild the country.
IMF said the government's plan was "ambitious," but it would helped by lower military spending and higher taxes would help keep the budgets from deteriorating.
"The government’s ambitious program, supported by the IMF, intends to restore fiscal and external viability and address the significant reconstruction needs of the conflict-affected areas, thereby laying the basis for future higher economic growth," Kato said.
"Reducing the central government fiscal deficit, while preserving spending on health and education and protecting the most vulnerable in society from the economic downturn, is a central goal of the government’s program.
"This, together with savings on military spending and possible concessional donor financing, should help finance the considerable reconstruction spending needs."
The IMF program expects national debt to spike to 83.7 percent of GDP in 2009 and 84.4 percent in 2010 before beginning to fall.
Such a spike is a natural outcome of lower inflation which reduces nominal economic growth, until real fiscal discipline and real economic growth comes back to the economy.
In the recent past national debt has been reduced by a rapidly inflating economy that grew faster than the outstanding debt stock by paying local lenders to government such as a private sector employee's provident fund, less interest than inflation.
Ordinary Sri Lankans were put in a high interest rate, high inflation straight jacket from the early 1980s when budgets started to deteriorate with high government spending and politicians and state workers being freed from income tax.
Except for a brief period following fiscal tightening in 2002, housing loans have cost around 20 percent or more, while state workers got subsidized lands, houses and low interest loans, and while the government borrowed excessively.
Most of the high quality infrastructure spending in Sri Lanka's budgets are financed by foreign borrowing. Large sections of money raised from the people through taxes and borrowing, are spent on indiscriminate subsidies - sometimes though state enterprises.
Make-work programs to give jobs to sections of society that are politically vocal - such as unemployed graduates - became a hall mark of national economic policy in 2004 and has since led to an unsustainable expansion of the public sector.
The IMF program aims to reduce state domestic borrowing - including state enterprise deficits - from 7.1 percent of GDP in 2008, to 6.8 percent of GDP in 2009 and hopefully 4.5 percent in 2010.
This may allow ordinary Sri Lankans to get long term housing loans at under 10 percent if inflation is kept below 5.0 percent by the central bank by the time the 20-month program ends if deficit targets are met and CEB and CPC do not run losses.
By 2010 the overall deficit is expected to come down to 6.0 percent of GDP in 2010 and 5.0 percent in 2010.
In the past however runaway budgets and political opposition have de-stabilized IMF programs and the country had returned to a high inflation, high interest rates spiral leading to the program being abandoned halfway.
In the first half of this year interest rates fell, as private sector credit contracted despite government borrowings rocketing up.
The program aims to boost private sector credit to generate 3.0 percent economic expansion in 2009 and 5.0 percent by 2010.
The IMF praised central bank intervention in the banking sector and its efforts to fix Seylan Bank, a large private sector bank that faced a run.
Analysts have said that Cabraal's tight monetary policy helped prevent a property bubble from spreading to banks, but it was too late to help the so-called finance company sector that operated in Sri Lanka's sub-prime market.
Critics say Central Bank rate hikes were also not transmitted into the rural sector because state banks in particular kept saving rates far below inflation, driving people into the hands of questionable deposit taking institutions.