Deficits, Debt and Interest Rates in Sri Lanka: Does the Spillover of Foreign Interest Rates Matter?

Fiscal policy’s impact on the interest rate has a controversial background. To reconcile theoretical uncertainties, researchers and policymakers often relied on empirical exploration. This article appraises the impact of external debt, domestic debt, the budget deficit, and foreign interest rates on interest rate variations in Sri Lanka, for the period when interest rates were deregulated. It applies the bounds testing procedure to the cointegration and error correction models within an autoregressive distributive lag framework. A set of relevant variables like the exchange rate, trade openness and money supply is controlled to corroborate whether such impacts are robust. It is found that the budget deficit elevates interest rates both in the long and short runs; external debt raises interest rates only in the long run; and domestic debt lowers interest rates both in the long and short runs. The spillover of foreign interest rates has a positive impact on Sri Lanka’s interest rate. As interest rates respond to domestic fiscal policy, they can induce fiscal discipline by affecting the cost of borrowing. On the other hand, the significant impact of foreign interest rates on Sri Lanka’s interest rate is a critical issue, as domestic macroeconomic policy has to face challenges to achieve its goal.