Debt and Fiscal Sustainability in Sri Lanka

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1 Inernaional Journal of Scienific and Research Publicaions, Volume 2, Issue 3, March Deb and Fiscal Susainabiliy in Sri Lanka N. P. Ravindra Deyshappriya Uva Wellassa Universiy SRI LANKA Absrac- Fiscal policy plays a cenral role in he economy in order o achieve is economic and social objecives hrough macroeconomic sabiliy. Especially, developing counries are suffering from higher rae of deb and budge defici. Consequenly, he fiscal policies of hese counries are no in a susainable posiion. Therefore, i is imely imporan o examine he susainabiliy of he fiscal policy in erm of Sri Lanka. Hence in his sudy, I aemp o examine he deb and fiscal susainabiliy of Sri Lanka by using Iner-emporal Budge Consrain Approach. In his regards, Dickey Fuller, Augmened Dickey Fuller and Phillip Paron ess have been employed. Furher, he sudy applied Ordinary Leas Squares mehod o analyze he deerminans of facors ha affec o increase he ne oal deb in Sri Lanka. Time series daa se from 199 o 29 has been used on his regard. The resuls reveal he sance of he fiscal policy is unsusainable during he considered ime duraion. Moreover, he resuls poined ou ha growh rae of GDP, budge defici, poliical insabiliy and ime rend posiively affec o increase he ne oal deb. Thus, i is necessary o expand governmen revenue while reducing he expendiure in order o achieve he deb and fiscal susainabiliy. Furher, he sudy srongly recommends improving he ax adminisraion, inroducing broad based new axes, minimizing welfare expendiure, defense expendiure and reducion of ransfers o corporaions in order o reach he menioned achievemens. Index Terms- iner-emporal budge consrain, fiscal susainabiliy, budge defici, ordinary leas squares B I. INTRODUCTION ackground of he Sudy In recen years, several developing counries have been facing dramaically high fiscal deficis. The governmen s abiliy o cope wih he fiscal defici has been receiving he increasing aenion from economiss. A high and acceleraed level of economic growh is a mus o achieve fiscal susainabiliy. Hence, he effec should be made o follow he Golden Rule of public finance, which emphasizes ha public secor borrowings should be underaken exclusively for he purpose o financing growh enhancing invesmen aciviies. I should be also ensure ha economic growh and fiscal consolidaion effors should no be in conflic wih each ohers, consequenly ha boh objecives are achieved. The noion of fiscal susainabiliy has been defined in several ways. As Blanchard e al (199) susainabiliy is essenially an analysis of wheher (based on curren policy sance) a governmen is headed owards excessive deb accumulaion. Therefore, fiscal policy has o mainain level of defici and ha a counry can afford wihou excessive increase. Wilcox (1989) noes ha a susainable fiscal policy is one ha would be expeced o generae a sequence of deb and deficis such ha he presen value condiion would hold. If his condiion is violaed, perpeual defici will be impossible and changes in fiscal policy will be ineviable. Sri Lanka and oher developing counries, endured persisen budge defici for several decades. Especially, afer 1977 here was a rapid increase budge defici and deb level. This siuaion is more developed wih poliical insabiliy of Sri Lanka afer The coninued deficis increased borrowings resuling in accumulaion of he couny s deb sock. All in all, a pruden fiscal policy is needed wihou furher delay and/or reveals in order o urn around he increasing deb/gdp raio of he counry and ensure fiscal susainabiliy in he medium erm. According o he background fiscal policy sysem is more imporan in Sri Lanka s developmen process. Therefore, his sudy analyses he long run fiscal susainabiliy concerning he join behavior of deb and budge defici using Iner-Temporal Budge Consrain (IBC) approach. Furhermore, his sudy aemps o deermine facors ha affec o increase ne oal deb in Sri Lanka using ime series daa for 52 years. The paper has been organized as follows. This secion describes he overall fiscal policy and accumulaion of deb and budge defici in Sri Lanka. Furher, his secion provides he deails abou objecives of he research. In he nex secion, he concepual framework of fiscal susainabiliy can be seen followed by he heoreical background of he sudy. Afer ha, IBC approach and derived he IBC approach o Sri Lanka has been included. Furher, he model for deermining he facors ha are affecing o ne oal deb in Sri Lanka also enclosed. Aferward, I have indicaed he resuls of he sudy and ulimaely conclusion and policy implicaion as well. B. Budge Defici and accumulaion of deb in Sri Lanka Afer gaining he independence in 1948, Sri Lanka has come almos full circle wih respec o economic policy regimes. In he early 195s, he counry followed by pro-enerprise liberal economic policies wih lile direc governmen involvemen in economic aciviy and wih minimum inervenion in foreign rade and exchange conrols. However, direc governmen inervenion and conrol over economic aciviies commenced in he lae 195s and increased in 196s, ransforming Sri Lanka basically in o semi-planned mixed economy. By he early 197s, he economy had become highly regulaed and conrolled. In 1977, a complee urnaround in he co unry s economic policy was iniiaed wih he inroducion of marke-oriened policy package feauring he deregulaion of marke aciviies and he reducion of direc governmen paricipaion in he economy. The liberalizaion programme was coninued in he 198s, making he economy he mos liberalized in he Souh Asian region. The balance of paymen defici afer he lae 195s led o a large foreign deb and he mos of ha was accumulaed afer 1978.

2 Inernaional Journal of Scienific and Research Publicaions, Volume 2, Issue 3, March The rapid increase in exernal deb, by comparison wih he domesic deb, presened a double burden. The following graph illusraes he changes of he budge defici and deb as a percenage of GDP from 195 o 21. Fig. 1 Budge Defici and Deb as a Percenage of GDP from 195 o 21. Source: Cenral Bank Annual Repor 21 According o he graph, Sri Lanka generally has a considerable budge defici and higher rae of deb. There were only wo years specifically; in 1954 and 1955 Sri Lanka had very lile budge surpluses. During he period of , budge defici was around 8% and afer 1977, increases in expendiures were no recovered by corresponding increase in revenue, and he resuls was rapid increase in he public deb. The average budge defici was 15% as percenage of GDP from 1978 o The highes budge defici recorded in 198 which was 23% of GDP. As a remedy for dramaic budge defici, governmen had addressed he balance of paymens defici in he 196s by imposing direc conrols ha resriced impors. However, hey were unable o avoid increase in he foreign deb, which rose from around 62 US$ millions in 196 o 231 US$ millions in 1969 and 38 US$ millions in Afer liberalizaion of he economy in 1977, impor resricions were loosened and foreign credi became much more readily available. The accumulaed foreign deb ended o increase annually in rupee erms in he 198s because of he seady depreciaion of he rupee in relaion o he currencies of he lending naions. The oal exernal deb, including shor-erm loans and credis, was esimaed o be approximaely 4 US$ billions a he end of Considering he overall siuaion, he shock of ousanding public deb increased progressively from Rs. 24,752 million in 1977 o Rs. 97,426 million in 1998 showing an annual average growh rae of 11%. The public deb/gdp raio was 69% in 1977 and i had increased o 89% by The sharp growh of governmen deb can be aribued o he budge defici which increased sharply in relaion o GDP requiring more and more borrowings. The average budge defici as a raio of GDP is 9.1% from 1996 o 22 due o rapid increase in governmen deb. In 22 i recorded he highes oal deb Rs 1,669,282 millions. During his period, he naional deb as a raio of GDP was 15.3%; which consiss 59.8% domesic deb and 45.5% foreign deb. The achievemen of fiscal susainabiliy of Sri Lanka has also been linked o he recenly inroduce Fiscal Managemen Responsibiliy Ac (FMRA). FMRA requires he governmen deb o be a level of 5% and 85% of GDP respecively by 26. I also requires ha he ousanding governmen deb o be reduced 6% of GDP by 213. C. Saemen of problem The issue of deb susainabiliy is ofen discussed in he conex of fiscal susainabiliy as he governmen deb is he final oucome of a fiscal policy of a counry. The issue of fiscal susainabiliy generally revolves around he quesion of wheher he presen and prospecive fiscal sance is heading owards an excessive and persisen accumulaion of deb levels. Hence, in order o mainain fiscal susainabiliy, fiscal policy should be planed o sabilize he deb/gdp raio wihin a feasible range raher han he allowing i o increase o an unsusainable level. A higher and increasing level of deb has several implicaions. The governmen will have o pay a significan amoun of is revenue receips as ineres paymens on ousanding deb which will increase pressure on he governmen s abiliy o mee is oher commimens, leaving lile room for oher essenial and developmen oriened expendiure. I also ends o reduce resources availabiliy o he privae secor. Apar from ha i also resuls o increase he ineres raes in domesic marke. This will increase he cos of borrowing by he privae secor occurring crowding ou effec heavily ha adversely affecs o he economic growh of counry. High governmen deb also increases he need for frequen rollover of exising deb making fiscal managemen more difficul. Furhermore, i limis he maneuvering abiliy of fiscal policy emphasizing he need for bringing down he level of governmen deb o more desirable levels in he medium o long run, here by resoring fiscal susainabiliy. The persisenly high fiscal deficis and associaed high level of ousanding governmen deb sock have raised he quesions regarding deb susainabiliy in Sri Lanka. As a percenage of GDP, he overall budge defici and he ousanding governmen deb sock have averaged around 1% and 97% respecively during he period of Ineres paymens on ousanding deb have also averaged o 6.3% of GDP during he same period. In paricular, here has been a significan increase of ousanding deb from 1997 a year in which he lowes deb/gdp raio (85.8%) was recorded in he recen pas, o 22 where he deb/gdp raio rose o 15.3%. The high level of deficis and deb are he combined oucome of various facors. The slowdown of he governmen revenue collecion and relaively high governmen expendiure are he major facors ha affeced he increase in he overall defici. In addiion, he slippage in fiscal consolidaion effors in recen years, he reducion of financial repression wih increased liberalizaion of financial markes and he resuling increase in he average ineres rae on governmen borrowings and he gradual decline in exreme concessional loans, which had helped o keep he average cos of foreign borrowing a a relaively high level, also conribued he worsening of he fiscal posiion. The gradual shif in defici financing process owards more domesic borrowings and he consequen srucural change in he ousanding deb sock (owards more domesic deb) and increased deb service paymens have furher aggravaed and

3 Inernaional Journal of Scienific and Research Publicaions, Volume 2, Issue 3, March siuaion. The ineres rae on foreign loans has been 9% of oal ineres paymens alhough foreign loans amoun o abou 45% of oal governmen deb. The main reason is abou 97% of foreign loans have been obained a highly concessional ineres raes. However, he coninuous depreciaion of Sri Lanka rupee, paricularly agains currencies in which a large porion of he ousanding foreign deb sock is dominaed, such as he Japanese yen and Special Drawing Righs (SDR), has resuled in a significan expansion in he ousanding value of exernal deb, alhough ne new foreign financing in he budge is very small. The average economic growh rae has also remained below he poenial level is recen pas. These developmens indicae ha deb dynamics are likely o worsen in he fuure in he absence of comprehensive and prolonged fiscal consolidaion process and economic growh acceleraing effors. Therefore, his fiscal policy background has provided more aenion o analyze fiscal susainabiliy and facors affecing o he naional deb in Sri Lanka. D. Objecives of he Sudy There are wo objecives involve wih his sudy. 1. Analyze he fiscal policy susainabiliy concerning he join behavior of deb and budge defici. 2. Deermine he facors affecing o he naional deb in Sri Lanka II. CONCEPTUAL FRAME WORK A. Governmen Budge Consrain Any discussion of fiscal susainabiliy sars wih he dynamic governmen budge consrain. The change in nominal value of he deb is given by; db G H T ib ds (1) B Nominal deb i Nominal ineres rae on deb G Nominal governmen spending on goods and services H Transfers T - Taxes The value of spending plus ransfer, minus axes is referred as he primary defici. I will play an imporan role below, and i is denoed by D. The righ side of he equaion (1) corresponds o usual definiion of he defici. As economies are growing over he ime, i is more useful o rewrie he budge consrain in erm of raio o GNP. Then equaion (1) can be wrien as; db g h ( r ) b d ( r b ds ) (2) b Raio of real deb o real GNP g, h, Raio of he primary defici o GNP θ Real rae of growh r ex-pos real rae of ineres (I-JI, where JI is he rae of inflaion) Equaion (2) is cenral o any discussion of susainabiliy. I says ha he evoluion of he raio of deb o GNP depends on wo ses of facors. The firs, which reflecs curren spending, ransfer and ax rules, is he primary defici. The second reflecs he inheriance from he pas, is produc of he raio of he accumulaed deb o GNP imes he difference beween he real ineres rae and he growh rae. If his difference is posiive, a primary surplus is needed o mainain a consan raio of deb o GNP. B. Defining Susainabiliy A formal definiion can now be given o he noion of susainabiliy of fiscal policy. Fiscal policy can be hough of as a se of rules, as well as inheried level of deb and susainable fiscal policy can be defined as a policy such ha he raio of GNP evenually converges back o is iniial level, b. Obviously, i would make lile sense o classify as unsusainable which implies a emporary bulge in he raio. The jusificaion for requiring he raio evenually reurn o is iniial level, as opposed o say o zero, or o a higher bu sable level, is, however, much less eviden. As noed laer, his condiion can be subsanially relaxed wih no change in resuls; he discussion will be easier once he basic equaions have been laid ou. Wha resricion does susainabiliy hen impose on fiscal policy? To answer he quesion, he firs equaion is o use he equaion (2) o characerize he evoluion of b. Suppose one sars a ime zero wih a raio of deb o GNP equal o b and ha fiscal policy as currenly defici o GNP (ds). I is assumed ha he difference beween r and θ is a consan and posiive. Alhough, consancy is only for noaional simpliciy, he assumpion ha (1- θ) is posiive is an imporan one abou which more is said below. The deb o GNP raio a any ime n is hen given by; n bn b exp( r )n d s exp( r )( n s) ds (3) The raio of deb o GNP a ime n is equal o he value of he iniial raio a ime zero, accumulaed a a rae equal o he difference beween he ineres rae and he growh rae, pulse he accumulaed value, a he same rae, of he primary deficis along he way. Two sample manipulaions of equaion (3) are needed. Firs, boh sides of equaion (3) are pre-muliplied by exp (1- θ) (Which in economics erm is equivalen o discouning boh sides o ime zero), yielding; n d s exp ( r ) sds b bn exp ( r ) n Secondly, aking he limi of equaion (4) as n goes o infiniy yields he proposed definiion of susainabiliy. The requiremen ha he raio of deb o GNP, b n ends evenually back o b as n ends o idenify implies ha he discouned value of deb goes o zero; lim n x b n exp ( r ) n (5) Combining equaion (4) and (5) yields a second imporan relaion; x d s exp ( r ) sds b (6) Equaion (6) says ha he fiscal policy is susainable if he presen discouned value of he primary defici o GNP under he laer policy is equal o he negaive of he curren level of deb o GNP. Furhermore, puing anoher and simple way, for a fiscal policy o be susainable, a governmen which has deb ousanding mus anicipae sooner or laer o run primary budge (4)

4 Inernaional Journal of Scienific and Research Publicaions, Volume 2, Issue 3, March surpluses. Those surpluses have o be large enough o saisfy equaion (6). C. Fiscal policy and economic growh Fiscal policy is generally believed o be associaed wih growh. More precisely, i is held ha appreciae fiscal measures in paricular circumsances can be used o simulae economic growh or developemen. (Barro, 199; Barro and Sala i- Marin, 1992). There is considerable debae over he effec on governmen fiscal policy on economic growh, especially in developing counries. The impac on fiscal policy on economic growh is a conroversial and long-sanding opic in economic heory, empirical research and economic policy making. Tanzi and Zee (1997) have discussed ha here are hree candidae indicaors of fiscal policy-governmen expendiure, axes and deficis. The lieraure does no sysemaically favor one indicaor of fiscal policy over he ohers. In recen years, a vas lieraure has emerged on he relaionship beween fiscal policy and long-run economic growh. Generally, he empirical lieraures have found an inverse relaionship beween governmen spending and growh (Engen and Skinner, 1992; Levine and Renel, 1992), bu here seems o be a posiive relaionship beween he increase in expendiure and he economic growh rae (Easerly and Rebelo, 1993). In general, governmen impac can have a posiive impac on growh hrough wo main channels: hrough increasing he qualiy of facors of producion and hus causing increase in oupu growh, and indirecly hrough increasing marginal produciviy of privaely supplied facors of producion (Barro and Sala-i-Marin, 1992). Much of heoreical debae ceners on he effec of fiscal expansions on growh where he classical Keynesian heory expecs his effec o be posiive, and vice versa, fiscal conracions are in his radiion associaed wih lower growh and recessions. III. METHODOLOGY A. Daa Descripion The ime series daa during he period of were used in his sudy. Daa is obained from various issues of he Cenral Bank repors published by Cenral Bank of Sri Lanka. Daa was analyzed using E-views saisical sofware. B. Model 1- Deermine he Fiscal Susainabiliy using Iner-Temporal Budge Consrain Approach a. Theoreical Derivaion of IBC Approach In his presen heoreical derivaion of he IBC ha saisfied he fiscal susainabiliy. Fiscal process is susainable if he expeced discouned value of he deb convergence o zero. Consider he governmen budge ideniy; B B r B d (1) Where; B Real sock of ousanding deb a he end of year r Real rae of ineres during he period d A period ne-of-ineres defici Equaion (1) describes he evaluaion over he ime of sock variable B. Le I -1 denoe he informaion se of privae agens a he beginning of period. Assume ha r is sochasic wih E(r +1 /I -1 )=r, for all i. R will be used o denoe he realized gross rae of reurn 1+r, and is expeced value will be denoed by R. Furher, assume ha while B -1 is in I -1, neiher r nor d are in I -1. Taking expecaion of equaion (1), condiional on he informaion se I -1 and recursively eliminaing fuure value of he sock deb yields he IBC. B ( j1) ( j1) R ( d / I 1 ) lim R E( B j / I 1) 1 j (2) Under he hypohesis of presen value budge value balance, he las erm in equaion (2) mus be equal o zero. lim ( j1) R E( B / ) j 1 I 1 (3) If he condiion (3) is saisfied, he discouned value of he expeced fuure sock of deb convergence o zero as he ime horizon goes o infiniy. Then he equaion (2) implies ha he curren ousanding real sock of deb B -1, mus be equal o he presen discouned value of curren and expeced fuure ne-of- ( j1) R ( d / I 1 ) ineres surpluses, -. (Trehan, B and Walash, C.W, 1991). b. Theoreical Derivaion of Iner-Temporal Budge Consrain Model for Sri Lanka The derivaion of IBC in his secion is mainly drawn from he work by Grasen and Nellor (1997). The relaionship beween he governmen deb and fiscal defici is described by he following equaion. B B 1 r 1B 1 S (4) Where; B Toal deb r Ineres rae S Primary defici S G R G Expendiure ne of ineres rae R Revenue This can be wrien as; B ( 1 r ) 1 B 1 S (5) This equaion describes he dynamics of accumulaion of deb a ime, can be given as a funcion of previous deb, amoun of ineres rae for previous deb and primary surplus a ime. The governmen budge ideniy for Sri Lanka is as follows (Siriwardena M, 1998) D X D (1 r 1 ) D 1 (1 r 1 ) X D S (6) D Domesic currency denominaed ne oal deb D Foreign currency denominaed ne oal deb in foreign currency X Curren period exchange rae r -1 Ineres rae on domesic currency denominaed deb r -1 Ineres rae on foreign currency denominaed deb S Primary surplus of governmen σ - Increase of he nominal sock of reserve money (or base money) Hence, B D X D (7) B Ne oal deb measured in domesic currency

5 Inernaional Journal of Scienific and Research Publicaions, Volume 2, Issue 3, March Define δ as he proporional depreciaion rae of he exchange rae. X / X as B In period. Then equaion (6) can be wrien ( 1 r 1 ) B 1 s X D 1 {(1 r 1 ) (1 r 1 )(1 )} (8) Defining he augmened primary surplus, in order o accoun for changes in deb due o variaions from uncouned ineres pariy and he increase in he reserve money as S ' S X D )(1 )} 1{( 1 r 1 ) (1 r 1 Then, he equaion (8) can be wrien as B ( 1 ) ' r 1 B 1 S (1) As suggesed by Wilcox (1989), he following discouned facor is applied o discoun he variables from period back o period. Q j 1 1 ; Q 1 1 r j This allows sochasic ineres raes in he process, as agains he assumpion of fixed ineres rae made by Hamilon and Flavin (1986). The realizaion of Q will be known as ime. Applying his discouned facor in o equaion (1) he discouned variables can be obained in he following form. Q B Q (9) ' 1B 1 Q S (11) Leing b and S as he discouned value of he deb and augmened primary surplus respecively, equaion (1) can be wrien as follows. b b 1 S Rearranging he above equaion b b b 1 S (12 ) This implies ha he changes in he discouned value of he deb a period equals o he discouned primary surplus a period. As Hamilon and Flavin (1986) poined ou, forward recursive subsiuion of equaion (12) yields he following equaion. b b N N S j j1 (13) If he firs erm of he righ hand side of he equaion (13) goes o zero or is non-posiive in he final period, he sock of deb will be zero or non-posiive in a finie horizon economy. In an infinie horizon economy if he ransversaliy condiion holds; N Lim E b N (14) Then, he ousanding deb of ime equals o he presen discouned value of fuure augmened primary surpluses. The, erm E is equaion (14) ac as he expecaion operaor based on he informaion a ime. This saed ha he expecaion a ime of he presen value of fuure governmen deb go o zero in he limi. Then, he supply his condiion o equaion (13) he governmen IBC can be obained as follows. b S j 1 j (15) When b is he curren sock of deb and S is he expeced fuure augmened non ineres (primary) surplus. If he deb sock is posiive, governmen will have o make negaive primary surpluses in he fuure o compensae curren posiive primary surpluses. The susainabiliy of fiscal policy can be deermined by obaining he forecas rajecory of sochasic process of he b and esing wheher N lim b N. If forecased rajecory of he discouned deb convergence o zero, fiscal policy can be considered as susainable (Wilcox, 1989). In order o conduc economeric analysis i is assumed ha b (discouned deb) follows Mulivariae Auo Regressive Inegraed Moving Averaged (ARIMA) process as suggesed by Wilcox (1989). In his analysis b should display wo properies. Firs, i has o be saionary and secondly, b mus have is uncondiional means equals o zero. If non-saionary is found, hen i would imply ha he policies pursued during he sample period would be unsusainable and if hey were adhered in o he indefinie fuure, imply ulimae insolvency of he governmen. The following model is used o ascerain he saionary of discouned ne oal deb. b b 1 u Where, b Discouned ne oal deb a ime α Drif erm β Auo regressive parameer U Random error erm e E( Y 2... Y ) Y (16) 1 (17) The error erm is assumed o be independen and idenically disribued. The equaion (16) is used a convenional model developed by Dicky and Fuller (1979) for uni roo ess. β is he parameer concern in his analysis. The discouned ne deb will be saionary if β is less han one. If b follows a equaion (16) i has uni roo if and only if β=1. If α= and β=1, b follows a random walk wihou drif (wih he innovaions e saisfying (17)). If and β = 1, b is a random walk wih drif, which means ha E(b ) is a linear funcion of. A uni roo process drif behaves very differenly from wihou drif. Neverheless, i is common o leave α unspecified under null hypohesis and his approach applied for his sudy. Therefore, he null hypohesis has uni roo. H : β = 1 In almos all cases i is ineresed in one side alernaives. H 1 : β < 1 (In pracice his means < β<1 as β< for series ha we suspec i has uni roo would very rare) Alernaive H 1 : β > 1 is no usually considered, since i implies ha b is explosive. In fac, if α >, b has an exponenial rend in is mean when β > 1. 1 When, b is sable AR(1) process which means i is weakly dependen and asympoically uncorrelaed. A convenien es for carrying ou he uni roo es is o subsrc b-1 from boh sides of he equaion (16) and defines θ = β 1. Then equaion (16) become;

6 Inernaional Journal of Scienific and Research Publicaions, Volume 2, Issue 3, March b b e 1 (18) E saisfied condiion of equaion (17). This is dynamically compleed model and hence i seems o be sraigh forward o es. H : θ = H 1 : θ < Furher, his sudy analyzes he uni roo is more compleed dynamic process adding more lags for equaion (18). Then i becomes; b b b... b e 1 1 p p (19) Then, -es is carried ou on θ, he coefficien on b -1 as before. This exended version on Dicky Fuller is known as Augmened Dicky Fuller Tes (ADF Tes). Then, his can be modified using ime rend as follows. b b b... b e 1 1 p p (2) Pillips and Perron (1988) have inroduced anoher more useful es for uni roos where he residuals are no necessarily whie noise in his es. In order o make he resuls more robus, he economeric analysis of his sudy based on hese hree arges. In addiion o discouned ne oal deb, he oal deb as a percenage of GNP or deb/gnp raios will be analyzed using he same models. Moreover, he definiion for he variable areas follows. The ne oal deb cosses of ne oal domesic deb and be foreign deb. The ne oal domesic deb calculaed by adjusing governmen domesic deb o reasury bills held by Cenral Bank of Sri Lanka. The ne oal foreign deb consis of public and publicly guaraneed long erm and shor erm foreign deb and use of IMF credi for Sri Lanka. Foreign asses are subraced his figure. In order o discoun he variables, governmen rupee loan ineres rae and Treasury bill yields rae used. I is difficul o find one discoun rae which represens he rue marginal cos of public deb. This is he main limiaion of his sudy. Therefore, in order o obain more accurae findings, wo differen discoun raes are used in his sudy. C. Model 2 - Deermining he Facors Affecing he Naional Toal Deb in Sri Lanka In order o achieve his objecive, regression analysis has been applied according o he Ordinary Leas Squares (OLS) mehod. Furher, following model is used o deermine he facors affecing o he naional oal deb in Sri Lanka. Y 1X1 2 X 2 3X 3 4 X 4 5 X 5 U (2) Y Toal naional deb X 1 GDP X 2 Budge defici X 3 - Economic policy Dummy variable X 3 = 1 : Open economic policy X 3 = : Oherwise X 4 Time rend X 5 Ehnic problem Dummy variables X 5 = 1 : War period X 5 = : Oherwise IV. RESULTS AND DISCUSSION A. Resuls of IBC Approach This secion presens he resuls of model 1 and model 2 ha menion in he previous secion. Table 1 illusraes he resuls of equaion (18). Table 1: DF Tes Resuls for Discouned Ne Toal Deb Tes Variables α θ b (674.39) (.16).159 (.6) (2.47) b (81.33) (.27).12 (.5) (2.36) b (2.2) (1.93) -.33 (.2) (-1.177) Criical Value 1% % % Noe: Sandard errors are in he firs parenheses and es saisics are in he second parenheses. b 1 Discouned ne deb by governmen rupee loan ineres rae b 2 Discouned ne deb by Treasury bill yield rae b 3 Ne oal deb as a percenage of GNP - Significan a 1% - Significan a 5% - Significan a 1% According o DF es resuls illusraed in above able, he parameer θ is no significan a any significance level. Therefore, he resuls are in uni roo process. This siuaion reflecs unsusainabiliy of Sri Lanka s fiscal policy sysem. Table 2: ADF Uni Roo Tes Resuls for Discouned Ne Toal Deb and Ne Toal Deb-GNP Raio wih Drif Number of Lags Criical Value % % % Wih Drif Only b 1.24 (.11) (2.14) b (.15) (1.46) b (.2) (-1.31).246 (.43) (1.72).41 (.18) (2.26) -.34 (.3) (-1.8).44 (.18) (2.32).24 (.8) (2.97) -.3 (.3) (-.96) Above able illusraes he resuls of ADF es for discouned ne oal deb and ne oal deb o GDP raio wih drif and hree lags. According o his resul, ne oal deb discouned by Treasury bill yield rae wih only hird lags case is significanly shown saionary process a 1% significance level. Remaining cases reflec ha fiscal policy is un-susainable. The following able presens he resuls of ADF es for discouned ne oal deb and ne oal deb o GDP raio wih drif and rend variable. This resul also poins ou excep deb discouned by Treasury bill yield rae wih wo lags. Therefore, in all oher cases null

7 Inernaional Journal of Scienific and Research Publicaions, Volume 2, Issue 3, March hypohesis canno be rejeced. Hence, fiscal policy sysem is in non saionary process. Thus, his resul also evidence for unsusainabiliy of fiscal policy of Sri Lanka. Table 3: ADF Uni Roo Tes Resuls for Discouned Ne Toal Deb and Ne Toal Deb-GNP Raio wih Drif and Trend Number of Lags Criical Value % % % Wih Drif and Trend b 1.41 (.13) (2.93).2229 (.8) (2.67).42 (.23) (1.79) b 2.22 (.88) (2.48).37 (.11) (3.26).2 (.88) (2.27) b (.94) (- (.1) (- (.1) (- 2.76) 2.69) 2.21) The following illusraes Phillips-Parron Tes resuls for wo discouned deb series and deb o GDP raio wih drif. Table 4: Phillips-Parron Uni Roo Tes Resuls for Discouned Ne Toal Deb and Ne Toal Deb-GNP Raio wih Drif Number of Truncaion Parameers Criical Value % % % Wih Drif b b b The following resuls also show Sri Lanka s fiscal policy is in un-susainable way since hey are in non-saionary process reflecing uni roo process. Moreover, he following able summarizes Phillips-Parron es resuls for wo discouned deb series and deb o GDP raio wih drif and rend. Table 5: Phillips-Parron Uni Roo Tes Resuls for Discouned Ne Toal Deb and Ne Toal Deb-GNP Raio wih Drif and Trend Number of Truncaion Parameers Criical Value % % % Wih Drif and Trend b b b Afer including he rend erm also, he resuls indicae ha unsusainabiliy of Sir Lanka s fiscal policy under he Phillips- Parron es. Considering all resuls of DF, ADF and PP ess, Sri Lanka s fiscal policy sysem is un-susainable for discouned wo deb series and deb GDP raio. In very few cases, i reflecs Sri Lanka s fiscal policy sysem is susainable. Someimes, high ineres rae may cause hese differen resuls. I is difficul o find appropriae discoun rae which represened rue marginal cos of public deb for developing counries like Sri Lanka. Moreover, he second model was used o quanify he facors ha influence o increase he oal deb in Sri Lanka. B. Resuls of he OLS Regression The following able indicaes he resuls of OLS regression ha was employed o idenify he facors ha affec o naional oal deb in Sri Lanka. Table 6: Resuls of he OLS Regression R- square.98 Adjused R-.98 square Variables Coefficiens Sandard - Prob. Error Values Inercep GDP Budge defici Economic policy Time Trend Ehnic problem - Significan a 1% level According o he resuls overall resuls is good in fi since here is a higher R-square and adjused R square values. Almos same R- square and adjused R square values also sugges ha sufficien variables have been included in he model. The variables GDP, budge defici, ime rend and ehnic problem are highly significan and show posiive relaionship wih oal deb. The relaionship furher emphasizes he above DF, ADF and PP uni roo es resuls of un-susainable way of Sri Lanka s fiscal siuaion. The mos obvious reason ha affecs o increase deb is higher growh of GDP. Wih a liberalized policy, Sri Lanka s GDP growh rae is increased because of invesmen on indusrial and services secors. Mos of his invesmen is supplied by foreign and domesic deb and his siuaion badly affec he fiscal sysem. Budge defici also highly affecs o increase he ne oal deb in Sri Lanka. Especially, excep wo years; Sri Lanka recorded higher rae of budge defici and i resuled o increase he deb. According o he figure -1 in he inroducion par showed he gap beween deb and budge defici. Economic policy i.e. open economic policy compared o he closed economic siuaion does no significanly affec he deb level. However, wih he ime rend here is a posiive and significan relaionship wih he deb level. The main reason for his siuaion is also high growh rae of GDP and poliical insabiliy wih war in 198s decade. Wih he coninuing war siuaion in Sri Lanka, especially afer 198; defense expendiure is highly increased. Therefore, Sri Lanka had o depend on more foreign and domesic deb. This siuaion also increases he deb level in Sri Lanka. Hence, he overall resuls sugges ha Sri Lanka s fiscal policy is in a un-susainable posiion and GDP, budge defici, ehnic

8 Inernaional Journal of Scienific and Research Publicaions, Volume 2, Issue 3, March problem and ime rend are posiively affec o he naional deb level. V. CONCLUSION AND POLICY IMPLICATION A. Conclusion The budge defici consiues a major fiscal indicaor as i has imporan ramificaions on a counry s macroeconomic posiion. Wihou fiscal susainabiliy, no economic developmen sraegy ge succeed. Unforunaely, in many emerging markes and developing counries, weak poliical insiuions, incompeen and corrup public adminisraions impose very sric limis on he amoun of public deb, inernal and exernal, ha can be carried. In principle, igh consrains on governmen borrowings and deb capaciy does no preven from reaping he benefis of consumpion smoohing. In developing counries paricularly, governmens are likely spend more on various obligaions incurring high expendiure coss hough revenue sources are limied. This leads o incur budge defici. According o Keynesian Theory, budge defici hrough expansionary spending and increased borrowing have desirable couner cyclical and growh effecs. The higher defici has resuled in accumulaion of deb over he years and his is more common in developing counries. Sri Lanka also faces budge defici and a higher rae of accumulaion of deb. This siuaion causes he un-susainabiliy of fiscal policy. Hence, in his sudy analyzed he fiscal susainabiliy of Sri Lanka using IBC approach and deermine he facors ha affec o he ne oal deb in Sri Lanka using OLS regression model. Time series daa from 195 o 21 were used for he analysis. Furher, DF, ADF and PP uni roo es resuls reflec Sri Lanka s fiscal policy is un-susainable in almos all cases and OLS regression model emphasizes ha GDP, budge defici, ime rend and ehnic problem in Sri Lanka posiively relaed wih naional deb level. B. Policy Implicaion This analysis suggesed he need for fiscal consolidaion measures o address he problem of susainabiliy. In his regards, he reducion of budge he defici would consiue an imporan fiscal adjusmen measures owards a more susainable deficis. The adjusmen would be made in mainly wo ways i.e. rough increased ax revenues and decreased governmen expendiure. However, increase in ax revenue would be a difficul ask because of he inelasic naure of he ax base in Sri Lanka. However, his achievemen can be reached by improving ax adminisraion, inroducing new ax and inroduce broad base ax sysem. Alhough he revenue could be increased hrough he axes, here will be a limied opporuniy because higher axes may reduce privae secor paricipaion in he producion aciviies. Therefore, reducion in expendiure would be oher alernaive way. The minimizaion of he welfare expendiure, beer argeing of welfare programmes, reducion of ransfers o corporaion and specially reduce he defense expendiure can be inroduced as imporan policy implicaions. As an imporan way of obaining primary surpluses (or a leas o reduce he budge defici o considerable level), reducion of ineres burden is imporan. This will have favorable effec on he deb procedure since ineres paymens have significanly increased recen years. REFERENCES [1] Barro, R.J and Sala-i-Marin, X. (1999), Economic Growh. Massachuses: MIT Press. [2] Barro, R.J and Sala-i-Marin, X. (1992b), Regional Growh and Migraion: AJapan-Unied Saes Comparison, Journal of he Japanese and Inernaional Economies, 6, [3] Blanchard O. Jean Claude Chouraqui Rober P. Hagemann and Nicola Saror 199, The Susainable of Fiscal Policy, New Answer o an Old Quesion, OECD Deparmen of Economics and Saisics Working Paper No.15 (Auumn), pp7-36 [4] Cenral Bank of Sri Lanka, Annual Repor (Various Issues) [5] Dicky, David A. and Wayne A. Fuller (1979), Disribuion of Esimaor for Auoregressive Time Series wih a Uni Roo, Journal of he American Saisical Associaion, Vol.74 (July), pp [6] Dicky, David A. and Wayne A. Fuller (1981), Likelihood Raio Saisics for Auoregressive Time Series wih a Uni Roo, Economerica, Vol.49 (July), pp [7] Easerly, W and Rebelo, S. (1993). Fiscal Policy and Economic Growh; An Empirical Invesigaion, Journal of Moneary Economics, 32 (December) [8] Engen, E and Jonahan, S. (1992). Fiscal Policy and Economic Growh, Bureau of Economic Research Working Paper, # 4223 [9] Gerson, P. and David, N. (1997), Philippine Fiscal Susainabiliy, Growh and Savings in Maroeconoic Issues Facing ASEAN COunries" [1] Hamilon, J.D. and Flavin, M. (1986), On he Limiaion on Governmen Borrowing: A Frame Work for Empirical Tesing, American Economic Review, Vol 76 (Sepember), pp [11] Levine, R. and David, R. (1992), A Sensiiviy Analysis of Cross-Counry Regressions, American Economic Review, 82 (Sepember), pp [12] Phillips, P.C.B. and Pierre, P. (1988), Tesing for Uni Roo in Time Series Regression, Biomerica, Vol. 75, pp [13] Siriwardeana, K.M.M, (1998), An Analysis of Fiscal Susainabiliy in Sri Lanka, Saff Sudies, Cenral Bank of Sri Lanka. [14] Tanzi, V. and Howell H. Z. (1997), Fiscal Policy and Long-Run Growh, Inernaional Moneary Fund Saff Papers, 44 (June):n [15] Trehan, B. and Walsh, C.E. (1991), Tesing Iner-Temporal Budge Consrain: Theory and Applicaion o US Federal Budge and Curren Accoun Deficis, Journal of Money Credi and Banking, Vol.23, No. 2, pp [16] Wilcox, D.W., (1989), The Susainabily of Governmen Deficis: Implicaions of he Presen Value Borrowing Consrain, Journal of Money, Vol 21, (Augus), pp AUTHORS Firs Auhor N.P.Ravindra Deyshappriya, Uva Wellassa Universiy, SRI LANKA id -

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