The Impact of Public Debt on Domestic Investment and Foreign Direct Investment in Sri Lanka

Abstract

Indebtedness has become one of the major development policy issues for the Sri Lankan economy. The excessive government borrowings over the capacity of the country cause adverse impacts on an economy, particularly its unfavourable effects on domestic and foreign investment inflows. Therefore, this study investigates the impact of the components of public debts (domestic and external debts) on the various forms of investment (domestic investment and foreign direct investment) in Sri Lanka for the period between 1980 and 2020. Thus, this study estimated two investment models where domestic investment and foreign direct investment were dependent variables. ARDL bounds testing approach was employed in this study which confirmed the existence of a long-run cointegration relationship among the variables.  Empirical findings of this study show the evidence for the presence of a crowding out effect of both domestic and external debt on domestic investment in Sri Lanka both in the short-run and long-run. It was also found that domestic debt crowds out FDI inflows in the long-run, but it crowds-in the flow of FDI in the short-run. Furthermore, external debt has a significant inverse relationship with FDI inflows in the short-run, as expected, but it does not influence FDI in the long-run. The findings also showed that higher lending interest rates reduce the volume of domestic investment, but it does not influence FDI in the long-run. However, in short-run, an increase in the rate of lending interest rate lowers the expectation of foreign investors and crowds out the flow of FDI in Sri Lanka, as expected. Furthermore, the depreciation of the exchange rate decreases both domestic and foreign investment in the short-run, but it encourages both types of investments in the long-run. The results further concluded that the impact of domestic debt on various forms of investment in Sri Lanka is greater than external debts. The study, therefore, recommends that the government should strive to reduce its higher debt profile by improving its revenue base and formulate better debt management strategies in order to increase the volume of investment in the country.

Keywords: Domestic Debt, External Debt, Domestic Investment, Foreign Direct Investment, Sri Lanka