Sri Lankan Debt Crisis: The Role of Fiscal Deficit and Current Account Deficit

Abstract

This paper examines the relationship between the debt-GDP ratio and twin deficits during 1971-2021 in the context of the present economic crisis in Sri Lanka using the techniques of cointegration and error correction model. The results of the study indicate the existence of a long run relationship among these variables. A fiscal deficit tends to increase the debt-GDP ratio in the long run, whereas in the short run, there is no evidence of any impact of fiscal deficit on the debt-GDP ratio. A current account deficit is expected to raise the debt-GDP ratio in the short run; but in the long run, it seems to have a significant negative impact. Similar results are obtained when the relationship among debt-GDP ratio, fiscal deficit and trade deficit is investigated. Hence, the view that opines persistent high fiscal deficit as the main cause behind the crisis, is supported by the present study. The results advocate for utilizing a country’s own resource generating methods like taxation rather than using external debt as a source to finance deficits.