Financial liberalisation in Sri Lanka: an econometric analysis

This study examines the impact of financial liberalisation on macroeconomic issues such as saving, investment, financial performance, financial sector widening, gross domestic product, and the money demands of Sri Lanka over the time series annual data from 1963 to 2005. Financial liberalisation in Sri Lanka commenced in since 1977 with most of the effort being made up to 1995. This study is based on empirical analysis using the Ordinary Least Square (OLS) base Auto Regressive Distributed Lag (ARDL) approach of cointegration, and includes a causality test. This study contributes primarily where an evaluation of financial liberalisation impacts the financial liberalisation index as a proxy of financial liberalisation. The financial liberalisation index has been constructed with 13 policy instruments for its phase of implementation in the Sri Lankan economy. The unit root tests were conducted by applying the DF (Dickey-Fuller), ADF (Augmented Dickey-Fuller) and PP (Phillips-Perron) methods. The cointegration tests were conducted to find out the long-run relationship among the variables concerned, and the ECM (Error Correction Model) version of ARDL was applied to test the speed of adjustment to equilibrium. The empirical test results suggest that financial liberalisation in Sri Lanka has a mixed impact in the short term. The average population per bank branch, real interest rates, and real gross domestic product are key variables for widening the financial sector, while real gross domestic product was also a significant contributor towards widening the financial sector, which shows that economic growth fosters the country\u27s financial sectors. The results showed that financial liberalisation did not widen the financial sector in the long term although it did in the short term through income led interest rates, savings, and investments. The results also show that financial liberalisation did not improve the financial performance of the economy, as was expected. Our results reveal that financial liberalisation cannot by itself enhance economic growth in Sri Lanka unless followed by proper strategies with suitable sequential procedures. The relationship between real narrow money and real broad money demand is studied with the conclusion being that the real lending rate has a significantly positive association while financial liberalisation has a significantly negative association within the narrow money demand over the long term. With broad money, the real gross domestic product and real lending rate are the key variables that have a positive association with the demand for broad money. Financial liberalisation has a significantly negative impact which means that an expansion in the demand for money is possible if economic growth is enhanced, which in turn increases real income, not by financial liberalisation as it has occurred. This study found that in Sri Lanka the one-way causal relationship between economic growth and financial performance, based on the empirical results, showed that economic growth causes financial development and financial performance