Crowding-out Effect of Public Borrowing in Sri Lanka

The government of Sri Lanka has been disproportionately borrowing from the domestic banking and non-banking sectors to finance its budget deficit. These sectors also serve as funding sources for the country's private investors. The government's expansionary fiscal policy has increased its total income, but it may also raise interest rates and reduce private investment. This study estimates the crowding-out effect of public borrowing from domestic sources on private investment in Sri Lanka. Using time-series data from 1960-2014 sourced from the Central Bank of Sri Lanka and World Development Indicators, we develop an investment function with three independent variables, public borrowing, interest rate, and gross domestic product. Unit root tests and the autoregressive distributed lag and vector error correction models are also utilized. To test the long-run relationships among the variables, we conduct a bound test of co-integration, and the results show that there is long-run co-integration between the variables. Vector autoregressive models, variance decomposition analysis, the Granger causality test, and impulse response functions are used to analyse the results. The study provides evidence for the absence of a crowding-out effect in Sri Lanka as a result of public borrowing from domestic sources. This evidence has important implications of fiscal management in Sri Lanka. To avoid external indebtedness and unnecessary inflation due to debt financing, the government can rely on domestic sources without hurting private investment in the country.