An Empirical Analysis of Current Account Determinants in Sri Lanka

Abstract

Introduction :

The current account balance of a country is considered as one of the primary determinants of the future development of the economy. The behaviour of the current account balance represents important information about economic performance. Increasing current account imbalances negatively influence economic performance and a current account surplus positively influences economic performance. The current account balance is influenced by various factors such as economic growth, budget deficit, exchange rate, foreign direct investment, trade openness, inflation rate etc. Sri Lanka’s current account has posted a continuous deficit over past periods. In 2018, it recorded a value of - 2,813 million US dollars. It has also fluctuated substantially in recent years. Sri Lanka got affected badly after the global financial crisis due to the widening trade deficit and sharp fall in remittances inflows.

In the literature, several studies give different predictions about the elements determining the current account balance and the sign and magnitude of the relationships between current account fluctuations and its determinants. The current account balance can be affected by the domestic output level. According to the elasticity approach, there is a positive association of domestic output with the capital account and a negative link with the current account. The absorption approach states that there is a positive link of domestic output with the current account. Net foreign assets can influence current account balance in two ways. From the saving-investment perspective, an increase in the foreign income flow has a positive effect on current account balance. In a flexible exchange rate regime, the sum of the current account and capital account must be equal to zero as an economy can afford a higher trade deficit up to an extended period with a high level of net foreign assets and remain solvent. This leads to a negative relationship between net foreign assets and the current account.

Trade openness is likely to be negatively related to the current account, because an economy open to more international trade with less trade restrictions, tends to attract more foreign capital. There are two ways in which the exchange rate can affect the current account. One is the saving-investment perspective that relates it negatively to the current account balance of an economy and other one is the consumption-smoothing hypothesis that relates positively to the current account balance. According to the study of Fayaz and Sandeep (2016), the application of the Johansen Cointegration test indicates the existence of a long-run equilibrium relationship between the current account and gross domestic product, net foreign assets, real effective exchange rate, trade openness and wholesale price index, implying that India’s current account is influenced by these factors. The study concluded that net foreign assets and wholesale price index have a positive significant relationship with the current account balance, while trade openness and real exchange rate have a negative relationship with the current account balance in the long run. The results of VECM indicate that only the real effective exchange rate and gross domestic product have a statistically significantly impact on current account balance. However, there is no study that examines the main determinants of Sri Lanka’s current account balance using recent data and advanced econometric techniques. Thus, this study tries to bridge this gap.