External Debt Sustainability and Economic Growth in Sri Lanka

Researchers have shown an increased interest in the nexus between economic growth and foreign borrowing. This study explores the effect of external debt sustainability on Sri Lanka’s economic growth by applying a non-linear auto regressive distributed lag (NARDL) model, which allows us to decompose the effect of the debt variables into positive and negative effects, based on the annual data covering the period 1980 – 2021. The estimated NARDL model shows that external debt stock and foreign debt service payments had a robust short term and long-term effect on economic growth in Sri Lanka. The asymmetric cointegration results provide strong evidence for a long-run integration that exists between economic growth and external debt sustainability. The study discovered a strong and negative relationship between the decline in the external debt stock and economic growth, suggesting that lowering the stock of debt may boost economic growth. The study further discovered an asymmetric relationship between economic growth and debt service payments. Accordingly, an increase in debt service payments would lead to a decrease in growth, while a downward change in that would lead to an increase in growth. Concerning control variables, trade openness has a negative relationship with growth, whilst the real exchange rate indicates a positive nexus. The study also found that short-run findings are almost likely to be those in the long-run. In light of these findings, the low level of economic wellbeing in Sri Lanka can be attributed to debt overhang and the crowding out effect which discourages investment. As per the results, the real exchange rate is positive and not a significant determinant of trade balance in the short run, indicating the J-curve effect as not being valid for the case of Sri Lanka. In this context, a proper debt management mechanism should be implemented to maintain a sustainable external debt level in Sri Lanka.