Assessing the Impact of Key External Sector Indicators on Economic Growth of Sri Lanka

Abstract

This study investigates the impact of key external sector indicators on Sri Lanka’s economic growth over the period 1988–2023, focusing on trade openness, foreign direct investment (FDI), exchange rate fluctuations, and foreign exchange reserves. As a small, open economy, Sri Lanka’s growth trajectory is closely tied to external sector performance, with trade and capital flows significantly shaping its macroeconomic stability and development path. Using secondary time-series data from the Central Bank of Sri Lanka, World Bank, and other credible sources, the research applies the Autoregressive Distributed Lag (ARDL) bounds testing approach to capture both short-run dynamics and long-run equilibrium relationships among the selected variables. Inflation and military expenditure are included as control variables to account for domestic macroeconomic influences. The results indicate that trade openness and FDI inflows have a statistically significant and positive effect on GDP growth in the long run, supporting the notion that integration with global markets and foreign investment can enhance Sri Lanka’s economic performance. Exchange rate depreciation demonstrates mixed impacts, improving export competitiveness while simultaneously increasing import costs and inflationary pressures, affecting growth sustainability. Adequate foreign exchange reserves are found to contribute positively to economic stability, providing a buffer against external shocks and supporting investor confidence. Diagnostic tests confirm the reliability and stability of the ARDL model, reinforcing the robustness of the findings. Based on these insights, the study underscores the importance of coherent trade and investment policies, effective exchange rate management, and reserve accumulation strategies to foster sustainable and resilient economic growth in Sri Lanka. The findings provide valuable empirical evidence for policymakers, development practitioners, and researchers seeking to design informed strategies to enhance external sector management while supporting long-term economic development.