Twin deficits in Sri Lanka in the presence of trade liberalisation

This paper examines the long run and short run relationships between the current account deficit, budget deficit, saving and investment gap and trade openness in Sri Lanka using the Autoregressive Distributive Lagged (ARDL) approach. Time series properties of the variables, in the presence of endogenous structural break, have been analysed by using Additive Outlier (AO) and Innovational Outlier (IO) models of Perron (1997). The empirical analysis supports the Keynesian view that there is a linkage between the current account, budget deficit and saving and investment gap. Trade openness was found to have a positive effect on the current account deficit but was statistically insignificant. Strategies to stabilise the budget deficit and current account deficits are provided in this paper.