THE CAUSAL RELATIONSHIP BETWEEN

TOURISM AND ECONOMIC GROWTH IN

SRI LANKA: SOME EMPIRICAL EVIDENCE

GUNERATNE B WICKREMASINGHE
RANJITH IHALANAYAKE

WP2006.10
DECEMBER 2006
 THE CAUSAL RELATIONSHIP BETWEEN TOURISM AND
ECONOMIC GROWTH IN SRI LANKA: SOME EMPIRICAL EVIDENCE

Guneratne B. Wickremasinghe
School of Accounting and Finance, Victoria University
and
Ranjith Ihalanayake
School of Applied Economics, Victoria University

ABSTRACT

Although there are arguments that development in the tourism industry leads to economic development,
very few studies empirically addressed this issue. This paper investigates the issue from a developing
country perspective: Sri Lanka. We use annual data from 1960 to 2000 to model the causal relationship
between tourism and economic growth using multivariate cointegration, error-correction modelling and
variance decomposition analysis. The results of the study suggest that there is a significant causal
relationship from tourism receipts to the Gross Domestic Product (GDP) of Sri Lanka. It can be argued
that economic policies should be directed to improving the tourism industry to produce a higher
economic growth rate.

KEYWORDS

Tourism, economic development, cointegration, Sri Lanka, error-correction model, variance

decomposition.

Acknowledgement: The first author wishes to record his sincere thanks to Professor Maxwell Leslie King
of Monash University for providing the financial support under a research fellowship.

Address for Correspondence:

Ranjith Ihalanayake
School of Applied Economics
Victoria University
PO Box 14428, Melbourne City
MC Vic 8001, Australia
Email: Ranjith.Ihalanayake@vu.edu.au

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INTRODUCTION

Sri Lanka entered the international tourism market in the 1960s. Since then, government involvement
has been a key factor in tourism development in Sri Lanka. The Ceylon Tourist Board was established
in 1966 in order to provide direction and leadership to this promising sector of the developing economy.
The tourism sector has been instrumental in generating foreign exchange, employment opportunities
and household income for Sri Lankans, as it has in many other developing economies. Therefore, the
development of the tourism sector appears to have been as important as the development of other
sectors of the economy of Sri Lanka.

There were several set-backs during last few decades in the tourism development process.1 However,
the Sri Lankan tourism sector has been growing significantly, contributing remarkably to GDP. For
example, international tourist arrivals to Sri Lanka increased from 18,969 in 1966 to 400,414 in 2000
(see Appendix). International tourism receipts also increased from US$ 1.3 million to US$ 252.8 million
during the same period. Further, this sector’s contribution to the direct and indirect employment
opportunities increased from 12,078 in 1970 to 91,063 in 2000 (Sri Lanka Tourist Board, 2000).
Although tourism plays a key role in the Sri Lankan economy, a little attention has been paid to this
sector in the empirical research. There have been a few attempts in the past to address some of the
issues relevant to the economic impact of tourism in Sri Lanka (see, Gamage (1978), King and Gamage
(1994), and Ihalanayake (1996)). In addition to these, Garcia (1988), Crick (1989; 1992) and Richter
(1989) have examined the social and cultural aspects, particularly the negative impacts. More recently,
Gamage et al. (1997/98) and Gamage and King (1999) addressed issues such as the impact of political
upheaval on tourism. However, to the knowledge of the authors, no study has examined the causal
nexus between tourism growth and economic growth in Sri Lanka.

The objective of this paper is to investigate whether tourism leads to economic growth or vice versa.
The results will provide some evidence as to whether economic growth can be achieved by facilitating
the growth of the tourism industry.

The remainder of this paper is organized as follows. In the next section, the existing literature on tourism
and economic growth is reviewed. Then we discuss the methodology and data used in the study

1During late 1980s and early1990s, the tourism sector was severely affected by the political upheavals in Sri Lanka. For
example, during this period, tourism arrivals dropped by almost half causing reductions in tourism receipts and job
opportunities (for more details Gamage et al. (1997/98).

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followed by a discussion of empirical results. The last section draws some conclusions from the
analysis.

TOURISM AND ECONOMIC DEVELOPMENT

Tourism’s contribution to economic development has been well documented in the literature. For many
developing countries, which were traditionally dependent upon primary products in export earnings,
tourism has become a major source of foreign exchange earnings. This has been vital for such
countries given their prevailing economic conditions. Many developing countries have experienced
severe deficits, particularly in the current account of the balance of payments during past few decades.
Furthermore, they have experienced an increasing burden of foreign debt. A relatively high percentage
of GDP and of the budget is allocated for foreign loan settlement. With ongoing civil unrests in some of
these countries, the situation results in high defence budgets. In view of this volatile economic
background, foreign exchange earnings from tourism have been important contributions to economic
development.

However, whether tourism actually contributes to the economic development depends, to a large extent,
on how efficient these countries are in allocating earnings from tourism. Balaguer and Cantavella-Jorda
(2002) argued that, in a more traditional sense, foreign exchange brought by international tourism could
well be used to import capital goods in order to produce other goods and services, leading in turn to
economic growth. This means that international tourists to a particular destination might contribute
significantly to finance the country’s imports. Further, they argued that, “if those imports are capital
goods or basic inputs for producing goods in any area of the economy, then, it can be said that earnings
from tourism are playing a fundamental role in economic development” (p. 878).

Available evidence suggests that many developing countries are able to raise a significant proportion of
government revenue from international tourism. For instance, the World Trade Organisation (1998)
claimed that these countries (most of them are highly specialised tropical, tourist countries) raise 10 to
25 per cent of government revenue from the tourism sector. In some cases, more than 50 per cent of
government revenue has been generated by the tourism sector. The contribution of tourism to
government revenue, for example, accounted for over 50 per cent in the Bahamas (Bird, 1991) and over
40 per cent in Maldives (Sathiendrakama and Tisdell, 1987).

Although the contribution of tourism to the economy has been quantitatively measured in different
countries, little attention has been paid to study the causal relationship between tourism growth and

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economic growth. Most of the available research tends to emphasise the so-called economic
contribution. To a larger extent, they ignore the high import leakage involved with tourism. Therefore, no
matter how significant the economic contribution of tourism to the economy, the actual contribution of
tourism in the economic growth might be insignificant. One way of addressing this dilemma is exploring
the cointegration and causality between tourism and economic growth.

There have been several recent empirical studies which explored the relationship between tourism and
economic growth. Hazari and Sgro (1995) developed a growth model in which they model tourism as an
added component to the domestic aggregate demand. Furthermore, they model the foreign supply of
capital and the growth in export as dependent on tourism growth. They concluded that tourism has a
positive impact on the long-run growth of the economy. This is generated by tourism acting as a
timesaving device, which allows the domestic population to consume now rather than later. They found
that growth in tourism facilitates foreign capital inflow, thereby reducing the need for high domestic rates
of saving and capital accumulation.

Durbarry (2004) investigated cointegration and causality between tourism and economic growth in
Mauritius and found that tourism has contributed to economic growth. Furthermore, he claimed that
tourism has a significant positive impact on Mauritian economic development. Dritsakis (2004)
examined the impact of tourism on the long-run economic growth of Greece. He analysed the causality
of GDP, exchange rate and international tourism receipts and concluded that there is a strong Ganger-
causality relationship between international tourism receipts and economic growth, a strong causal
relationship between exchange rate and economic growth, and moderate causal relationships between
economic growth and international tourism receipts and between exchange rate and international
tourism receipts.

METHODOLOGY AND DATA

This paper uses the multiple cointegration test of Johansen (1991, 1995). The procedure is carried out
in two steps. The first step is to test for order of integration of the variables. The order of integration is
the number of times a variable has to be differenced before it becomes stationary. A condition for the
tests is that the variables entering the cointegrating equation should be integrated of the same order. To
test the degree of integration of the variables, two well-known tests are used. The first test is the
Augmented Dickey-Fuller (1979, 1981) (ADF) test and the second test is the Phillip-Perron test (1988).

5
According to Engle and Granger (1987), if two variables are cointegrated, there exists a long-run
comovement or a cointegrating relationship between the two variables, say x and y. Johansen’s
multiple cointegration test is based on the following vector autoregression equation.

y t = A1y t −1 + ... + Ap y t − p + Bx t + ε t (1)

where yt is a k-vector of non-stationary I(1) variables, xt is a vector of deterministic variables and εt is a

vector of innovations. The above vector auto-regression can be rewritten as follows;
p −1
Δy t = Πy t −1 + ∑ Γt Δy t −1 + Bx t + ε t (2)
i =1
p p
where Π = ∑ Ai − I and Γt = − ∑ A j
i =1 j = i +1

According to Granger, if the coefficient matrix ∏ has reduced rank r < k, then there exists k × r
matrices α and β each having rank r such that ∏ = αβ ′ and β y t is stationary. Each column of β

and the elements of α are respectively known as the cointegrating vector and adjustment coefficients
of the vector error- correction model. The cointegrating rank or the number of cointegrating relations is
denoted by r. In implementing the Johansen cointegration test, the ∏ matrix has to be estimated in
unrestricted form and then the restrictions implied by the reduced rank of ∏ are tested to examine
whether they can be rejected.

In making inferences about the number of cointegrating relations, two statistics known as trace statistic
and maximal eigenvalue statistic are used. The trace statistic is determined using the following formula.
n
λtrace = −T ∑ log(1 − λˆi ) r = 0, 1, 2,…, n-1
i =r +1

where T is the number of observations, λˆi is the ith eigenvalue and n is the number of endogenous
variables.

The maximum eigenvalue statistic is determined using the following formula.

λmax = −T log(1 − λˆr +1 ) r = 0, 1, 2,…,n-1

The MacKinnon, Haug, Michelis (1999) method is used to compute probability values of the trace and
maximum eigenvalue statistics. These probability values are used to make inferences regarding the
number of cointegrating relationships among the variables.

6
Engle and Granger (1987) prove that if two variables are cointegrated, there exists an error-correction
model of the following form.
m n
Δ x t = a1 + b1 ect t −1 + ∑ c1 Δ x t − i + ∑ d 1 Δ y t − i + e1t (3)
i =1 i =1

m n
Δ y t = a 2 + b2 ect t −1 + ∑ c 2 Δ x t − i + ∑ d 2 Δ y t − i + e 2t (4)
i =1 i =1

where x t and y t are the variables which are cointegrated, Δ is the difference operator, m and n are

the lag lengths of the variables2, ect1t and ect 2t 3 are the residuals from the cointegrating equation4 and

e1t and e 2t are the white-noise residuals.

The error-correction model opens another channel of causality through the error-correction term which
is ignored in standard Granger-causality tests. Therefore, causality can also be tested by examining (i)
the statistical significance of the error-correction term by a separate t-test, (ii) by testing the joint

significance of the lags of each explanatory variable by an F- or Wald χ 2 test, or (iii) by a test of the
error-correction terms and lagged terms of each explanatory variable simultaneously by a joint F- or

Wald χ 2 test.

Granger-causality test can be interpreted as a within-sample causality test. Therefore, to make

inferences on causality beyond the sample period, variance decomposition analysis is used. In this, the
variance of the forecast error of a particular variable is partitioned into proportions attributable to
innovations (or shocks) in each variable in the system, including its own. If a variable can be optimally
forecast from its own lags, then it will have all its forecast variance accounted for by its own
disturbances (Sims, 1982).

2 There are several criteria used to select the optimal number of lags to be included in the regression equations, such as AIC,
BIC, FPE, HQC, and likelihood ratio tests. Of these, the likelihood ratio test is used to select the optimal number of lags of
the variables in the error-correction model.
3 As Engle and Granger (1987) and Miller and Russek (1990) point out, more than one lag of the error-correction term is

unnecessary. The effects of additional lagged error-correction terms are already captured in the distributed lags of xt and yt.
4 There is no unanimity as to residuals from which cointegrating equation should be included in the error-correction model.

Therefore, the residuals from any of the cointegrating equations can be included as the error-correction term. However, this
issue does not arise in the context of Johansen cointegration test. In the Johansen cointegration test, all cointegration
relationships are imbedded in the error-correction models.

7
Data used in the study consisted of two variables: tourism receipts and GDP of Sri Lanka in millions of
Sri Lankan rupees. They were obtained on an annual basis from two sources for the period 1966 to
2000. Tourism receipts were obtained from the annual statistical report of the Sri Lanka Tourist Board
for the year 2000. The data on the GDP of Sri Lanka were obtained from the International Financial
Statistics CD-ROM, December, 2004.

Figure 1: Tourism Receipts and Gross National Product, Sri Lanka

16

14

12

10

0
1970 1975 1980 1985 1990 1995 2000

EMPIRICAL RESULTS

Figure 1 shows the time series plots of the natural logarithm of tourism receipts and the GDP of Sri
Lanka over the period 1966 to 2000. Both series show upward trends. Salient features of these two
series are the smooth upward pattern of the GDP series and a more volatile behaviour of tourism
receipts. However, in the long-run, the two series seem to follow each other.

A close perusal of the graph for tourism receipts suggests that the civil commotions in Sri Lanka in 1983
negatively affected the tourism industry. However, this impact prevailed only from 1983 to 1986. During
this period, Sri Lanka has lost Rs.750.3 million in tourism receipts. After 1986, tourism receipts have
sustained a positive growth until 2000, excepting 1996.

8
In addition to the preliminary overview of the tourism-economic growth nexus presented above, a more
formal analysis was undertaken using cointegration, error-correction modelling and variance
decomposition analysis. First, the time series properties of the two variables were examined. It is a
necessary condition that the variables entering a cointegration equation be integrated of the same
order.

Table 1 presents the results of the unit root tests. Panel A of the table shows the results for the two unit
root tests when only a constant is included in the test equation. For tourism receipts, we can reject the
null hypothesis of a unit root at the ten per cent level of significance. However, the GDP does not reject
the null hypothesis of a unit root. Panel B of the table shows the unit root test results for the two
variables when both a constant and a linear time trend are included in the test equation. In this case, the
null hypothesis of a unit root is not rejected for both the variables. In view of these results, we conclude
that the tourism receipts series has a unit root.

Table 1: Unit Root Test Results for the Levels of Variables

Variable ADF test PP test
Test statistic p-value Test statistic p-value
Panel A: With a constant in the test equation
Tourism receipts -2.899 (1) 0.056c -2.373 (2) 0.157
Gross domestic product -0.131 (0) 0.938 -0.143 (2) 0.936
Panel B: With a constant and a time trend in the test equation
Tourism receipts -1.467 (2) 0.820 -1.033 (2) 0.926
Gross domestic product -1.604 (0) 0.770 -1.904 (2) 0.631
Notes:
c implies statistical significance at the ten per cent level.
Numbers within brackets after the unit root test statistics indicate the number of lags of the dependent
variable used to produce white-noise residuals.
Lags of the dependent variable in the ADF test equation were selected using AIC.
The numbers within brackets followed by PP statistics represent the bandwidth selected based on
Newey-West method using Bartlett Kernel.

Unit root test results for the first differences of GDP and tourism receipts are reported in Table 2.
According to the results, for both variables we can reject the null hypothesis of a unit root at the one per
cent level of significance. Results of the ADF and PP tests when both a constant and a linear time trend
are included are shown in Panel B of the table. Since both variables become stationary when their first
differences are used, we can conclude that they have unit roots. In other words, we can conclude that
both these variables are integrated of order one. The results of cointegration tests are discussed in the
following paragraphs.

9
Table 2: Unit Root Test Results for the First Differences of Variables
Variable ADF test PP test
Test statistic p-value Test statistic p-value
Panel A: With a constant in the test equation
Tourism receipts -3.909 (0) 0.005a -3.972 (2) 0.004a
Gross domestic product -4.548 (0) 0.001 a -4.548 (0) 0.001a
Panel B: With a constant and a time trend in the test equation
Tourism receipts -4.787 (0) 0.003a -4.787 (0) 0.003a
Gross domestic product -4.481 (0) 0.006 a -4.481 (0) 0.006a
Notes:
a implies statistical significance at the one per cent level.
See notes for Table 1 for details of lag selection in ADF and PP tests.

Table 3 presents the results of Johansen’s Maximum Likelihood test. Panel A of the table reports results
for the Trace test and the Maximum Eigenvalue test for cointegration. The results show that both tests
reject the null hypothesis of no cointegration at the one per cent level of significance. Further, the null
hypothesis of at most one cointegration relationship between GDP and tourism receipts exists is also
rejected at the five per cent level. Therefore, we can conclude that GDP and tourism receipts are
cointegrated or they co-move in the long-run. Panel B of the table shows the estimated cointegration
equation normalised on the natural log values of tourism receipts/GDP. According to the results, there is
a statistically significant positive relationship between the GDP and tourism receipts of Sri Lanka. The
estimation results indicate that when the GDP increases by Rs. 1 million, tourism receipts increase by
Rs. 1.538 million. However, when tourism expenditure rises by Rs. 1 million, the GDP rises only by Rs.
0.65 million.

As explained earlier, if two variables are cointegrated, there exists an error-correction model as shown
by equations (3) and (4). The results for the estimated the error-correction models are discussed in the
succeeding paragraphs.

The estimation results and diagnostic results for the error-correction model are presented in Table 4.
The estimation results for the error-correction models are shown in Panel A of the table. The error-
correction models were estimated without any lags of the dependent variables as the lag length
selection criteria for the vector autoregression for the cointegration test indicated that we can include
only one lag in levels of the variables. This means that as we use the first differences of the variables in
the error-correction models, no lags of the variables should be included. In such a case, the Granger-
causality test is performed by examining whether the error-correction terms are statistically significant.
The estimated error-correction models show that both the error-correction terms are significant at the

10
one per cent level. These results suggest a long-run feedback relationship between the GDP and
tourism receipts in Sri Lanka.

Table 3: Results of Johansen Cointegration Test

Panel A: Trace and Maximum eigenvalue test results
No. of cointegration relations Trace statistic (p-value) Maximum eigenvalue statistic (p-value)
None 91.897 (0.000) a 82.458 (0.000)a
At most one 9.439 (0.044)b 9.439 (0.044)b
Panel B: Estimated cointegration equation Normalised on tourism receipts/GDP

Tourism receipts = -12.390 + 1.538 GDP

(9.929)a (12.276)a

GDP = 9.357 + 0.650 Tourism receipts

(25.902)a (12.909)a
Notes:
One lag was included in the vector autoregression (VAR) based on AIC.
a and b imply statistical significance at the one and five per cent levels respectively.
P-values for Trace and Maximum eigenvalue statistics were calculated using MacKinnon-Huag-Michelis
(1999) method.
Trend assumption for the cointegration equation was selected based on Johansen’s Pantula principle.
The assumption used in the cointegration test was: No deterministic trend (restricted constant).
VAR stability condition was examined based on the roots of characteristic polynomial which indicated
that no root lies outside the unit circle.

Panel B of Table 4 reports diagnostic results for the residuals of the estimated error-correction models.
According to the results of the Ljung-Box Q-statistic test, the residuals of the estimated error-correction
are not autocorrelated at any of the lags considered. Further, the residuals are normally distributed and
are homoscedastic.

Table 4: Estimation and Diagnostic Test Results for the Error-Correction Model
Panel A: Estimation results for the error-correction model
Independent variable Dependent variables
ΔTEXP (t-statistic) ΔGDP (t-statistic)
ECT 0.065 (4.951)a 0.042 (18.369)a
Panel B: Diagnostic test results for the residuals of error-correction model
Autocorrelation LBQ-statistic (lag) P-value
5.178 (1) 0.253
14.982 (4) 0.452
28.432 (8) 0.429
36.918 (12) 0.594
J-B test for normality of χ2 = 2.490 (p-value = 0.646)
White’s test for Heteroscedasticity χ2 = 2.262 (p-value = 0.894)
Notes:
a implies statistical significance at the one per cent level.

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 ΔTEXP, ΔGDP and ECT denote the first difference of tourism receipts, first difference of gross domestic
product and the one-period lagged residuals from the cointegration equation which is the error-correction
term.
LBQ-statistic is Ljung-Box Q-statistic.

The Granger-causality test is a within sample causality test. Therefore, to obtain an idea as to the out-
of-sample causal relationships, a variance decomposition analysis was performed. The results of the
variance decomposition analysis are presented in Table 5. Panel A of the table shows the variance
decomposition results for the tourism receipts. According to the results, most of the forecast error
variance of tourism receipts is explained by itself at all the times horizons considered. The forecast error
variance of the tourism explained by GDP is statistically insignificant at all time horizons considered.
Panel B of the table presents the variance decomposition analysis for GDP. According to the results, the
percentage forecast variance of GDP explained by the tourism is high at longer time horizons. For
example, the amount of forecast variance of the GDP explained by tourism receipts at time horizon 12 is
approximately 82 per cent. However, the percentage forecast variance of GDP that is explained by prior
values of itself goes down when time horizon increases. For example, GDP explains approximately 88
per cent of its variance at time horizon one whereas at time horizon twelve, it explains approximately 18
per cent of its forecast variance. These results suggest that GDP is caused by both prior values of GDP
itself and tourism receipts, whereas tourism receipts are caused only by prior values of themselves.

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Table 5: Results of Variance Decomposition Analysis
Panel A: Variance Decomposition of tourism receipts
Period S.E. LOG(EXP) LOG(GDP)
1 0.270 100.000 a 0.000
2 0.394 99.987a 0.013
3 0.496 99.960 a 0.040
4 0.590 99.921 a 0.079
5 0.678 99.871a 0.129
6 0.763 99.814 a 0.186
7 0.846 99.750 a 0.250
8 0.928 99.680a 0.320
9 1.010 99.607 a 0.393
10 1.092 99.530 a 0.470
Panel B: Variance Decomposition of gross domestic product
Period S.E. LOG(EXP) LOG(GDP)
1 0.048 12.419 a 87.581a
2 0.069 21.439 a 78.561a
3 0.088 31.608a 68.392a
4 0.106 41.872a 58.128a
5 0.126 51.457 a 48.543a
6 0.146 59.932a 40.068a
7 0.168 67.151a 32.849a
8 0.192 73.152 a 26.848a
9 0.217 78.062a 21.938a
10 0.244 82.044a 17.955a
Notes:
a implies statistical significance at the one per cent level.
Cholesky Ordering: LOG(EXP) LOG(GDP).
Standard errors were calculated using the Monte Carlo method with 100 repetitions.

CONCLUSION AND POLICY IMPLICATIONS

This paper examined the causal nexus between GDP and international tourism receipts in Sri Lanka.
Although tourism receipts have been volatile over the sample period, the results suggest that there is a
long-run co-movement between GDP and tourism receipts. While the relationship is positive, an
additional one percent increase in tourism receipts appears to result in a more than proportionate
increase in GDP. However, an additional one per cent increase in tourism receipts is associated with a
less than proportional increase in tourism receipts subsequently.

The results of the Granger-causality tests based on the error-correction model estimates suggest that
there is a feedback or two-way causal relationship between GDP and tourism receipts. As Granger-
causality tests only in-sample causal relationships, we used variance decomposition analysis which
reveals out-of-sample causal relationships between the variables. The results suggest that current GDP

13
is caused by past values of itself and those of tourism receipts, whereas tourism receipts are caused
only by their past values. Further, the forecast error variance of GDP that is explained by tourism
receipts increases with increases in time horizon.

Although the analysis reveals feedback relationships between GDP and tourism receipts, the influence
of tourism receipts on the GDP is more dominant than the influence of GDP on tourism. Therefore,
policies should be directed to attract more and more tourists so that the GDP can be increased resulting
in a higher growth in Sri Lanka.

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School.

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Journal of Social Economics 26, 312-324.

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Lanka’, Asia Pacific Journal of Tourism Research 2, 75-87.

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APPENDIX

Table A1: Tourism Statistics for Sri Lanka (1966-2000)

Year Tourist Arrivals Receipts (US$ million) Employment
1966 18,969 1.3 -
1970 46,247 3.6 12,078
1975 103,204 22.4 23,848
1980 321,780 110.7 47,900
1985 257,456 82.2 54,533
1990 297,888 132.0 59,914
1995 403,101 225.4 84,163
2000 400,414 252.8 91,063
Source: Sri Lanka Tourist Board, Annual Statistical Report, 2000.

17