The Maldives contracted in 2004 following the tsunami but the economy recovered to grow by 19 percent in 2006.
But the budget deficit which was just 1.9 percent of the economy in 2004 had expanded to 7.3 percent in 2006 and is set balloon to 23.9 percent in 2007.
The IMF warned the island nation should stop printing money to finance the expanding deficit and welcomed a recent law that gave the Monetary Authority of Maldives more independence.
Inflation which was at 3.7 percent in 2006 is now expected to nearly double to 7.0 percent this year.
IMF said it hoped that the recent launch of treasury bills "would help eliminate the practice of automatic central bank financing of fiscal deficits", and asked for further development of the markets.
The Fund said spending was rising too fast and projections of revenue were over-estimated.
Expenditure was expected to rocket up by 45 percent while domestic financing was expected to rise by 31 percent.
Compared with the economy expenditure would rise from 46 percent to 54 percent in 2007
"The 2007 budget carries risks of a significant deficit as the large spending program is based on optimistic revenue assumptions," the IMF said in a public information notice following its annual review of the islands known as Article IV consultations.
IMF said so far inflation had been low due to the openness of the economy, but the balance of payments was showing the strain of deficit spending.
"Higher fiscal deficits have, however, resulted in sizable external current account deficits," IMF noted.
"The current account deficit widened from 36 percent of GDP (Gross Domestic Product) in 2005 to 41 percent in 2006.
"External debt has risen from 43 percent of GDP in 2004 to about 65 percent in 2006, while the debt service ratio has increased from 5.1 percent to 8.8 percent."
IMF warned that the atoll's foreign reserves and the currency which had been pegged to the US dollar with good results up to now may be hit by the ballooning budget deficit.
Its Executive Directors who reviewed the staff report called on the Maldivian government to cut the deficit as expected revenue, based on an "overly ambitious resort development schedule", may not come.
"They stressed the need to keep expenditures in line with a realistic resource envelope, in order to contain inflation, strengthen private investment and growth, and safeguard the external position," the IMF statement said.
"They cautioned that in a small, open economy like that of Maldives, fiscal slippages tend to magnify external vulnerabilities and could cause the already low level of international reserves to fall rapidly."
IMF said there was not enough information to say whether the Maldivian Rufiya was technically overvalued against the US dollar, particularly as the Euro has been rising.
The Fund said the peg to the US dollar could be kept on as long as budget deficits were low.
"They were concerned, however, that with unchanged fiscal policies, the resulting sharp fall in reserves would undermine the dollar peg," the IMF statement said.
In the last ten years Maldives had doubled per capita income and now has the highest per capita income in South Asia.
Until 2004 when budget deficits started to rise the Maldives had low inflation and high economic growth and has been a net importer of labour from the South Asian region.Source: LBO