Analysing Determinants of the Public Debt Dynamics in Sri Lanka: An Auto-Regressive Distributed Lag Bound Testing Approach

Abstract

While certain theoretical backgrounds allow for a positive impact of reasonable public debt levels, most of the current literature concludes that high public debt levels impact economic growth negatively. Rapid government debt build-ups are more likely to lead to a financial crisis resulting in more significant output losses. Recently, the public debt ratios in Sri Lanka have risen, and due to recent tax cuts and pandemic related complications, many expect the situation to take a turn for the worse. Given the negative outlook on Sri Lanka's debt trajectory, this study attempts to identify the determinants of public debt dynamics in Sri Lanka. A linear Auto-Regressive Distributed Lag (ARDL) model is used to assess the impact of economic growth, fiscal deficits, exchange rates, domestic and international interest rates on the debt-to-GDP (Gross Domestic Product) ratio in Sri Lanka using annual data from 1990 to 2019. The study shows that achieving high economic growth is the key to lowering debt ratios in the long run. At the same time, fiscal deficits would continue to deteriorate the debt dynamics in the short run. This presents a unique case where a trade-off decision has to be made on whether to follow a fiscal consolidation approach or achieve sustained economic growth through expansionary fiscal measures which would weaken debt fundamentals in the short run but allow for a more sustained debt outlook in the long term. Given the crises such as the COVID-19 pandemic, public expenditure plays a crucial role in revitalising the consumption and investment expenditures in an economy. Attempting fiscal consolidation at such a crucial juncture is likely to damage a struggling economy further. Given this context, for Sri Lanka, fiscally stimulating consumption and investment expenditures as well as achieving sustainable debt dynamics in the long run through enhanced economic growth is an acceptable alternative.

Keywords: Public Debt, Debt Management, Fiscal Policy