The Deficit Conundrum Beyond the Fiscal Cliff: Exploring The Impact on Economic Growth in South Asia

Abstract

This study investigates the relationship between budget deficits and economic growth in South Asia focusing on Pakistan, India, Bangladesh, and Sri Lanka from 2002 to 2021. Persistent fiscal deficits, fueled by rising government expenditures and weak revenue mobilization, pose significant macroeconomic challenges, including increased borrowing, debt servicing pressures, inflation, and exchange rate instability. These factors erode public investment, crowd out private sector activity, and hinder long-term growth.

Using advanced panel data econometrics, including unit root tests, the Auto-Regressive Distributed Lag (ARDL) model, Error Correction Model (ECM), and Johansen co-integration analysis, the study explores short- and long-run dynamics. The empirical framework incorporates GDP growth, budget deficits, exchange rates, inflation, investment, and interest rates. Findings reveal that while exchange rate depreciation and investment positively influence growth, high interest rates and inflation have adverse effects. Although sustainable deficits can boost short-term demand, chronic excessive deficits undermine long-run growth and macroeconomic stability.

The study concludes with actionable policy recommendations, emphasizing fiscal discipline, tax reforms, strategic expenditure management, monetary-fiscal policy coordination, and prudent external debt practices. Despite limitations in sample size and cross-country variability, the research provides critical insights for policymakers aiming to reconcile fiscal sustainability with economic development in South Asia.