Evaluating Sri Lanka's Debt Sustainability through Fiscal Reaction Function: A Structural Vector Autoregression Approach

Abstract

This research significantly advances the understanding of fiscal policy and debt sustainability by combining the Fiscal Reaction Function and Structural Vector Autoregression techniques. Traditionally, these methods have been explored independently, but their combination addresses a crucial gap in the literature. The study focuses on Sri Lanka and provides nuanced insights into its fiscal behavior and prospects for debt stabilization. The developed framework offers a robust analytical tool for policymakers to evaluate and adjust fiscal policies effectively. The analysis covers historical data from fiscal years 1960 to 2021, providing a comprehensive understanding of fiscal policy dynamics over an extended period. By examining how fiscal policy reacts to various economic conditions and impacts macroeconomic variables, the research offers strategic recommendations for enhancing fiscal discipline and debt management. The results show that a one-unit increase in debt significantly increases the GDP growth rate due to government spending financed through borrowing stimulating economic activity. The higher GDP growth rate boosts tax revenues and improves the primary balance relative to the size of the economy over time. This Impulse Response Function analysis underscores the need for continuous and disciplined fiscal monitoring to ensure that debt remains manageable. These findings are vital for developing fiscal policies prioritizing immediate economic needs while providing long-term fiscal responsibility, thus supporting sustainable economic growth and stability in Sri Lanka.