Public Debt and Economic Growth in Sri Lanka: Is There Any Threshold Level for Pubic Debt?

The nexus between public debt and economic growth is multifaceted. Sri Lanka is not unique to this phenomenon, as there is growing concern about the implications of public debt on economic growth. By the end of 2012, public debt stood at Rs.6 trillion (79.14 percent of GDP). The shares of domestic and external debt to total debt stock were 42.6 and 36.5 per cent of GDP, respectively. In 2012, the total interest paid on public debt was Rs.408.5 billion, which was equal to 5.39 per cent of GDP and 41.35 per cent of the government's total revenue. In addition to large interest payments, there are growing concerns about the huge public debt accumulation and its impact on the economy in the long run. The debt increases economic growth through investment, and it also involves costs because of interest payments. The government aims to reduce the current debt-to-GDP ratio of 79.14 per cent down to 60 per cent by 2016. One can also argue that if the borrowings help increase the growth through high returns, debt accumulation may not be a burden to the economy. The relationship between debt and economic growth in Sri Lanka is inconclusive and has been based on ideological predilections and circumstantial evidence. Although there seems to be an obvious positive linear relationship between debt and growth in Sri Lanka, it is difficult to establish a clear long-run link between the two without a thorough investigation. This study aims to investigate several issues: What is the exact relationship (either positive or negative) between debt and economic growth? If the relationship is nonlinear, what is the optimum or threshold rate of debt that would minimise the economic cost of debt in terms of economic growth? That is, what is the sustainable level of debt for Sri Lanka? Is the Central Bank debt reduction target of 60 per cent by 2016 desirable? The paper develops an econometric model to address these issues based on a conditional convergence using time series data for the period 1960-2010. The study uses two-year non-overlapping averages to capture short-run fluctuations and instrumental variables to address the endogeneity problem. The study finds that there is a nonlinear relationship between the public debt and GDP per capita growth in Sri Lanka. The threshold level for public debt is 59.42 per cent of GDP. Above this level, public debt makes a negative impact on GDP per capita growth. Our finding of a threshold level strongly justify and support the debt reduction target of the government, which aims to reduce the current debt ratio of 79.14 per cent down to 60 per cent by 2016.