The Twin Deficits Problem in Sri Lanka

Many economists have argued that prolonged fiscal expansions contribute to current account imbalances. The purpose of this paper is to explore this phenomenon in the case of Sri Lanka during the period 1970 to 2003. In this study, the autoregressive distributed lag (ARDL) model and the bounds test for cointegration (Pesaran et al. 2001) were used to assess the long-run dynamics between the twin deficits in Sri Lanka. The empirical analysis in this paper supports the Keynesian view that there is a long-run relationship between current account imbalances and budget deficit. The empirical results also show that the direction of causality runs from the budget deficit to the current account deficit. Thus, any policy measures to reduce the budget deficit in Sri Lanka could well assist in reducing the current account imbalances. Strategies and policies to manage the twin-deficits are discussed in this paper.