Twin Deficits in Sri Lanka: An Econometric Analysis

Abstract

This paper examines empirically the relationship between current account and budget deficits in the developing small open economy of Sri Lanka using time series econometric tests. Economic theory suggests that there is a link between the twin deficits in open economies. Increased budget deficits lead to an increase in the interest rate. An increase in the interest rate appreciates the exchange rate. In turn, exports become relatively expensive and imports cheaper, thus generating a trade deficit. Hence, empirical evidence of a relationship between the two would be very important to enable economists and policymakers to better understand whether there is a causal relationship or merely a correlation between these two variables. The empirical results of this study support the existence of a long-run relationship between the budget and current account deficits in Sri Lanka. To avoid a future depreciation of the exchange rate and perhaps a fiscal and currency crisis, the Sri Lankan government will have to timely introduce fiscal adjustment measures to control the negative implications of its rising budget deficits and public debt.