The Twin Deficits Hypothesis in Sri Lanka: An Econometric Analysis

Abstract

Introduction :

The Twin Deficits Hypothesis (TDH) states that a government budget deficit (BD) leads to current account deficit (CAD) in an open economy (Salvatore, 2006). High BD, by leading to higher interest rates would in turn attract capital inflows and thereby cause an appreciation of the exchange rate. This will make exports more expensive and imports cheaper, thereby worsening the trade deficit, which is the major component in the CAD. In the economics literature, two prime approaches are used to explore the relationship between the CAD and BD of a country: the Keynesian proposition and the Ricardian Equivalence Hypothesis (REH). Based on the Mundell-Fleming framework, the Keynesian view asserts that BD has a statistically significant impact on CAD; there exists a unidirectional causality that runs from BD to CAD. By contrast, the REH posits that a cause and effect relationship does not exist between the two deficits. But, these are not the only posible outcomes between the two deficits. A bi-directional causality between the two deficits could also exist.

For a long period of time, Sri Lanka has experienced persistently high BD as well as CAD. The COVID-19 is likely to further exacerbate the highly vulnerable fiscal and external financial situation of Sri Lankan economy. The anti-COVID-19 measures have lowered economic activities and would further reduce fiscal revenues. The recently announced import restrictions will also reduce the import tax revenues. On the other hand, government expenditure will increase due to additional expenditure incurred on anti-COVID-19 efforts including cash payouts to the affected people. The Export Development Board has estimated that the export of goods and services will drop by $ 7 billion in 2020. The CAD of Sri Lanka’s balance of payments is likely to increase from $ 3 billion to $ 6 billion - $ 7 billion (www.ft.lk). These twin deficits cause macroeconomic imbalances and indebtedness. Hence, this study attempts to examine the relationship between CAD and BD. The findings of the study are expected to guide policymakers to formulate fiscal and monetary policies to avert further BD and CAD.

Saleh et al. (2005) and Sivarajasingham and Balamurali (2011) examined TDH for Sri Lanka only by focusing on the relationship between current account balance (CAB) and BD. Therefore, this study attempts to examine the TDH of Sri Lanka including important variables such as interest rate and exchange rate, which directly influence the twin deficits process.