81730 South Asia Economic Focus Fall 2013 A Wake-Up Call © 2013 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Some rights reserved 1 2 3 4 16 15 14 13 This work is a product of the staff of The World Bank with external contributions. Note that The World Bank does not necessarily own each com- ponent of the content included in the work. The World Bank therefore does not warrant that the use of the content contained in the work will not infringe on the rights of third parties. The risk of claims resulting from such infringement rests solely with you. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. 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License: Creative Commons Attribution CC BY 3.0 Translations—If you create a translation of this work, please add the following disclaimer along with the attribution: This translation was not created by The World Bank and should not be considered an official World Bank translation. The World Bank shall not be liable for any content or error in this translation. All queries on rights and licenses should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights@worldbank.org. ISBN (electronic): 978-1-4648-0118-1 DOI: 10.1596/978-1-4648-0118-1 Cover photo: Dominic Sansoni / World Bank; Cover design: Alejandro Espinosa/Sonideas South Asia Economic Focus Fall 2013 A Wake-Up Call s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 a wake-up call 5 This report is a product of the Office of the Chief Economist for the South Asia Region. Its preparation was led by Markus Kitzmuller, with substantive contributions from David Gould, under the oversight of Martin Rama (Chief Economist, South Asia Region). The report benefit- ted from inputs by country teams in the Poverty Reduction and Economic Management unit (SASEP) as well as Sanket Mohapatra and colleagues in the Development Economics Prospects Group (DECPG) under the supervision of Andrew Burns (Manager, DECPG). Economists providing information for country briefs include Deepak Bhattasali, Daminda Fonseka, Camilo Gomez Osorio, Zahid Hussain, Omar Joya, Faruk Khan, Aurelien Kruse, Chandana Kularatne, Denis Medvedev, Jose Lopez Calix, Kirthisri Rajatha Wijeweera, Saadia Refaqat, Nadeem Rizwan, Smriti Seth, Thirumalai G. Srinivasan, Muhammad Wahid, and Salman Zaidi, under the guidance of Vinaya Swaroop (Sector Manager, Poverty Reduction and Economic Management, South Asia Region) and Ernesto May (Sector Director, Poverty Reduction and Economic management, South Asia Region). Valuable research assistance was provided by Bilge- han Gokcen and Ayesha Raheem, as well as Amir Sadegh Sadeghi, who significantly contributed to the analytical work done for the focus section. Gabriela Aguilar signed responsible for the layout, design and typesetting, and Neelam Chowdhry provided administrative support. South Asia as used in this report includes Afghanistan, Bangladesh, Bhutan, India, Mal- dives, Nepal, Pakistan and Sri Lanka. 6 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 Table of Contents Recent economic developments············································································································································································································9 Advanced economies  are picking up, while emerging markets are slowing down········································································ 9 Growth across South Asia  is slowing down, beyond India···································································································································12 Inflation remains high across most South Asian countries···································································································································14 Fiscal policy spacestays constrained·························································································································································································15 The largest current account deficits are not always the most difficult to finance. ·······································································17 Risks are on the risebut the policy response has been encouraging········································································································21 Outlook and policy·······························································································································································································································································23 The overall outlook for South Asiaremains cautiously optimistic················································································································23 However, significant downside risks need to be closely monitored············································································································24 Focus: Business cycle transmission to and within South Asia···············································································27 The nature of co-movements  in economic activity affecting South Asia changed with the global crisis ··········28 Global cyclical movementsdo get transmitted to India and the rest of South Asia····································································31 the rest of South Asia, albeit modestly, but not the other way around····························35 Fluctuations in India affect  South Asia Country Briefs···································································································································································································································37 Afghanistan·······················································································································································································································································································38 Recent Economic Developments···································································································································································································38 Outlookand Policy·······································································································································································································································39 Bangladesh·························································································································································································································································································40 Recent Economic Developments···································································································································································································40 and Policy·······································································································································································································································41 Outlook  a wake-up call 7 Bhutan··········································································································································································································································································································42 Recent Economic Developments···································································································································································································42 and Policy·······································································································································································································································42 Outlook  India··················································································································································································································································································································43 Recent Economic Developments···································································································································································································43 and Policy·······································································································································································································································46 Outlook  Maldives····································································································································································································································································································48 Recent Economic Developments···································································································································································································48 and Policy·······································································································································································································································48 Outlook  Nepal···············································································································································································································································································································49 Recent Economic Developments···································································································································································································49 and Policy·······································································································································································································································50 Outlook  Pakistan·····································································································································································································································································································51 Recent Economic Developments···································································································································································································51 and Policy·······································································································································································································································52 Outlook  Sri Lanka···································································································································································································································································································54 Recent EconomicDevelopments···································································································································································································54 and Policy·······································································································································································································································55 Outlook  South Asia at a Glance··················································································································································································································································56 Notes·························································································································································································································································································································60 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 a wake-up call 9 Recent economic developments G lobal capital rebalancing has highlighted , and provides the incentive to re-engage re- structural weakness and vulnerability in forms to create a favorable investment climate. South Asia, acting as a wake-up call for policy makers. While recent economic developments in advanced countries are encouraging, large parts of the South Asian region con- Advanced economies a  re tinue to slow. Portfolio capital outflows, triggered by picking up, while emerging the prospect of unwinding Quantitative Easing (QE) markets are slowing down in the US, have made current account deficits more difficult to finance across emerging countries. Meanwhile, supply-side constraints and macroeco- As advanced countries show tentative signs of re- nomic imbalances remain to be tackled in most South covery, developing and emerging market economies Asian countries. But the depreciation of regional cur- continue to exhibit slow and flat growth, particularly rencies offers the opportunity to accelerate exports in South Asia. Many large developed countries have FIGURE 1: Real GDP growth suggests a tentative recovery of advanced economies Percent change, q/q saar 1.5 1.0 0.5 0 -0.5 -1.0 2012Q2 2012Q3 2012Q4 2013Q1 2013Q2 Developing Countries Eurozone Japan United States Source: World Bank DECPG 10 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 FIGURE 2: South Asia is not among the fastest-growing developing regions anymore Percent change, q/q saar 2.5 2.0 1.5 1.0 0.5 0 2012Q1 2012Q2 2012Q3 2012Q4 2013Q1 2013Q2 -0.5 East Asia & Paci c Europe & Central Asia Latin America & Caribbean Middle East & N. Africa Sub-Saharan Africa South Asia Source: World Bank DECPG seen economic activity strengthen somewhat in re- developing countries now have to compete more fierce- cent months. Europe is beginning to show signs of a ly to attract once plentiful capital inflows. The recent tentative recovery and the US economy is exhibiting and ongoing international capital portfolio rebalancing modest but stable growth, while Japan’s exceptionally has led to depreciating currencies, particularly in those expansionary monetary policy may finally be moving emerging market economies characterized by structural its economy out of its long deflationary stagnation. weakness. Capital outflows have also fueled concerns Despite recent concerns over the budget impasse in the about the sustainability of external financing across de- US, across developed countries, measures of financial veloping countries. The postponement of Quantitative market risk have shown a downward trend and asset Easing (QE) tapering in the US has helped to calm prices have been increasing. the environment. This offers a window of opportunity to reduce vulnerabilities rooted in over-stretched fiscal Global portfolio rebalancing has put pressure on balances and structural bottlenecks from inadequate emerging markets, particularly those with external regulation and poor infrastructure. and structural weaknesses. With the prospect of interest rates increasing again in advanced economies, FIGURE 3: Concerns about Quantitative Easing tapering induced capital to leave developing countries US$ millions 70000 6000 60000 5000 50000 4000 40000 3000 30000 2000 20000 10000 1000 0 0 2013M01 2013M02 2013M04 2013M05 2013M05 2013M06 2013M07 2013M08 EQUITY ISSUE BOND ISSUE BANK LOANS Flows to South Asia (right axis) Source: World Bank and Dealogic a wake-up call 11 FIGURE 4: Currencies adjusted more sharply in countries with larger macroeconomic imbalances Currency depreciation since May 2013 25 India 20 Indonesia 15 Brazil Turkey 10 South Africa Mexico Russia 5 Pakistan 0 China -8 -6 -4 -2 0 2 4 Current account as % of GDP -5 Source: World Bank FIGURE 5: India’s growth has been declining for several quarters GDP growth, percent change, q-on-q, saar 2.5 2.0 1.5 1.0 0.5 0 2012Q1 2012Q2 2012Q3 2012Q4 2013Q1 2013Q2 -0.5 -1.0 Brazil Russia India China Turkey Sources: World Bank DECPG, IMF International Financial Statistics, JP Morgan Among emerging economies, India has felt the im- mediate effects from the QE tapering announcement in May the most. Weak growth and exchange rate depreciation have characterized India for some time; nonetheless, several factors have led to a relative risk re-assessment by investors. A wide current account deficit, at 4.8 percent of GDP for 2012/13 (FY13), that has been financed most recently by volatile portfolio capital flows, has been perceived as a weakness of the economy. Retail price inflation, at 9.6 percent (y-o-y, April-July, 2013), though driven by food and oil price developments, is still unusually high. A relatively large fiscal deficit, at 7 percent of GDP for FY13, continues to constrain fiscal space and leads to greater reliance on monetary policy. 12 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 FIGURE 6: India’s real exchange rate has been depreciating for several years REER index, Jan 2000 = 100 130.0 125.0 120.0 115.0 110.0 105.0 100.0 95.0 90.0 85.0 80.0 2005M02 2005M05 2005M08 2005M11 2006M02 2006M05 2006M08 2006M11 2007M02 2007M05 2007M08 2007M11 2008M02 2008M05 2008M08 2008M11 2009M02 2009M05 2009M08 2009M11 2010M02 2010M05 2010M08 2010M11 2011M02 2011M05 2011M08 2011M11 2012M02 2012M05 2012M08 2012M11 2013M02 2013M05 2013M08 Developing countries Developing countries excl. China India Sources: World Bank DECPG, IMF International Financial Statistics, JP Morgan s Growth across South Asia i in the aftermath of the financial crisis of 2008. This slowing down, beyond India spillover effect adds to the direct effect that other devel- oping countries, the US and other advanced economies have on the region. While India is the country most India’s slowdown has significant spillover effects to directly affected by portfolio outflows, the impact is felt the rest of South Asia, and even more so after the fi- across all South Asian economies. And this is so even if nancial crisis of 2008. As shown in this edition’s Focus each country faces specific idiosyncratic challenges and section, there is a clear transmission of the global busi- shocks to economic performance. ness cycle to South Asia, but also a significant effect from India on South Asian economies’ GDP growth Overall, growth in South Asia is expected to rates. Not only do Indian business cycle movements moderate in 2013 compared to prior projections. spill over to other economies in the region: the nature Regional growth has deteriorated in the second and and speed of the pass through has significantly changed third quarters of 2013, mainly due to supply-side FIGURE 7: Real GDP growth remains respectable, but it is on a declining path % change 9 14 8 12 7 10 6 8 5 6 4 4 3 2 2011 2012 2013 Bangladesh Bhutan India Maldives Nepal Afghanistan (RHS) Pakistan Sri Lanka Source: World Bank and National Authorities a wake-up call 13 constraints and weak domestic demand. India, the 2013. Around May, India saw IP growth turn nega- region’s largest economy, slowed down significantly to tive, and its recent decline in manufacturing Purchas- an estimated 3.2 percent real GDP growth at market ing Managers’ Index is unique among BRICS and prices in FY13 from 6.3 percent in the previous fiscal advanced economies. Sri Lanka and Bangladesh faced year. Afghanistan sticks out in terms of the size of its steep declines as well. slowdown, expecting a 2013 growth rate of just 3.1 percent down from an exceptional 14.4 percent in While fundamentals in South Asia have not changed 2012, mainly driven by increased uncertainty stem- significantly over the last 12 months, exuberance ming from the political and security transition. Ban- has given way to pessimism, particularly in the case gladesh’s estimated growth for 2013, at 6 percent, is a of India. Like other developing regions, South Asia is 0.2 percentage point decrease vis-à-vis 2012, reflect- facing greater turbulence as markets reassess sources of ing political uncertainties, supply side constraints and global growth and risks. As capital may become scarcer lower private investment. Similarly, real GDP growth for developing and emerging markets, those with more is set to fall in Bhutan, to 6.9 percent in 2012/13 pronounced structural weaknesses and higher external down from 8.1 percent, in Nepal, to 3.6 percent in exposure will remain more vulnerable. However, short- 2013 from 4.9 percent in 2012, as well as in Pakistan, term capital market turbulence is manageable and the where a marginal 0.1 percentage point decrease to 3.5 return to sustainable growth in the developed world is percent for 2013 is estimated. Only Maldives and Sri a positive development for South Asia. Greater export Lanka are expected to see a slight increase in their demand accompanied by relative price advantages offer growth rates. support to growth over the medium-term. While South Asian countries differ in terms of political, economic, Industrial Production continues to be lackluster and financing challenges, ensuring macroeconomic across South Asia. With the exception of Pakistan, stability and removing supply-side constraints remain all major South Asian economies have seen industrial the best response to ride the turbulent waves of global production (IP) plummet during the second quarter of capital flows. FIGURE 8: Industrial production remains subdued relative to other regions 15 % change, 25 y-o-y saar 20 10 15 5 10 5 0 0 -5 -5 -10 2012M01 2012M02 2012M03 2012M04 2012M05 2012M06 2012M07 2012M08 2012M09 2012M10 2012M11 2012M12 2013M01 2013M02 2013M03 2013M04 2013M05 2013M06 2013M07 2013M08 2012M01 2012M02 2012M03 2012M04 2012M05 2012M06 2012M07 2012M08 2012M09 2012M10 2012M11 2012M12 2013M01 2013M02 2013M03 2013M04 2013M05 2013M06 -10 Latin America & Caribbean Sub-Saharan Africa Bangladesh India Middle East & N. Africa East Asia & Paci c Sri Lanka Pakistan South Asia Europe & Central Asia Source: World Bank DECPG 14 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 FIGURE 9: In times of increasing confidence around the globe, India’s Purchasing Managers’ Index is trending down August 2013 57 UK 55 US 53 Japan Germany Euro zone 51 China Italy Russia France 49 Brazil India July 2013 47 47 49 51 53 55 57 Source: World Bank FIGURE 10: Declining exports and investment are at the core of moderating growth GDP at market prices, annual percentage changes 15.0 10.0 5.0 0.0 2010 2011 2012 2013 -5.0 Private Consumption Goverment Consumption Gross Fixed Investment Exports, GNFS Imports, GNFS GDP growth (Fall 2013 est.) Current account balance (% of GDP) GDP growth (Spring 2013 est.) Source: World Bank DECPG  cross Inflation remains high a pushed consumer prices to 9.5 percent. Afghanistan’s most South Asian countries inflation rate reached 7.7 percent in June 2013. Nepal stood just under 10 percent in FY13, while Bangladesh reached 7.4 percent, up from 5 percent the previous South Asian inflation remains the highest among year. Even in countries where inflation declined, it developing regions and this continues to constrain remained at levels which are high by international monetary policy. Core inflation in some countries standards. Bhutan’s price increase registered 5.5 percent actually declined and remains within the confidence (y-o-y) during the second quarter of 2013, compared bands of central banks. But food and commodity price to 8.4 percent in the previous quarter. Pakistan saw its increases drive retail prices, which are signing responsible headline inflation decrease to an average 7.4 percent in for continuously high headline inflation levels. In India, 2012/13, down from 11 percent in 2011/12. Sri Lanka wholesale core inflation decelerated to 2.4 percent y-o-y experienced a decrease to 6.3 percent from 9.8 percent (April –August 2013) and overall wholesale price infla- between January and August 2013. Only Maldives tion came down to 5.3 percent y-o-y. However, over the maintained moderate average inflation in 2013 at 4.5 same period double-digit food and fuel price inflation percent. a wake-up call 15 FIGURE 11: South Asia maintains its top spot for inflation among regions Percent change, y-o-y 11 9 7 5 3 1 2010M01 2010M02 2010M03 2010M04 2010M05 2010M06 2010M07 2010M08 2010M09 2010M10 2010M11 2010M12 2011M01 2011M02 2011M03 2011M04 2011M05 2011M06 2011M07 2011M08 2011M09 2011M10 2011M11 2011M12 2012M01 2012M02 2012M03 2012M04 2012M05 2012M06 2012M07 2012M08 2012M09 2012M10 2012M11 2012M12 2013M01 2013M02 2013M03 2013M04 2013M05 2013M06 2013M07 2013M08 East Asia & Paci c Europe & Central Asia Latin America & Caribbean Middle East & N. Africa South Asia Sub-Saharan Africa Source: World Bank FIGURE 12: Consumer price inflation remains high in almost all South Asian countries % change, y-o-y, seasonally adjusted 11 10 9 8 7 6 5 4 3 2 2012M10 2012M11 2012M12 2013M01 2012M02 2013M03 2013M04 2013M05 2013M06 2013M07 Afghanistan Bangladesh India Sri Lanka Nepal Pakistan Maldives Source: World Bank Fiscal policy space a large share of that debt is domestic, which reduces stays constrained the vulnerability of South Asian economies to real exchange rate depreciation. Fiscal deficits and public debt in the region remain Across the region, several countries struggle to large, thereby constraining space for stimulus. The bring fiscal deficits down. India’s general government average fiscal deficit across South Asian countries deficit in 2012/13 is expected to have come down to 7 was estimated to be 7.1 percent of GDP in 2013, percent of GDP from 8.1 the previous fiscal year, while up from 7 percent. This puts South Asia in the top the central government deficit stands at 5.1 percent, spot across all regions. The international compari- below the March estimate of 5.4 percent. However, son is slightly more favorable in the case of public from April to August 2013, this downward trend has indebtedness. Still, general government gross debt come under pressure as the central government deficit reached an average of 66.3 percent of GDP in 2013, has already reached 62.8 percent of the annual ceiling, up from 62.3 percent in 2012. On the positive side, compared to 51.5 percent in the previous fiscal year. 16 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 Similarly, with a fiscal deficit (excluding grants) of 4.3 FIGURE 13: South Asia has the largest fiscal deficit of percent in 2012/13, Bangladesh has done better than all regions in the previous year. However, revenue collection fell short of its target by 0.5 percent of GDP, while the 70 10 spending pressure from subsidies continues to rise. 65 9 Revenue shortfalls also caused a deterioration of fiscal 60 balances in other countries. Afghanistan’s saw its fiscal 55 8 revenue decline by 11 percent between the first half of 50 % of GDP 2012 and the first half of 2013. Pakistan experienced 45 7 a fiscal deficit of 8 percent in 2012/13, compared to a 40 6 target of 4.8 percent, partly due to revenues coming 35 in below target. While Sri Lanka reduced its fiscal 30 5 deficit to 6.4 percent in 2012, revenue mobilization 25 20 4 decreased by 4 percent, at a time when a 27 percent 2012 2013 increase was expected. South Asia Public External Debt (left Axis) South Asia Public Domestic Debt (left axis) Public debt has similarly resisted reduction. Across South Asia Fiscal De cit (right axis) countries in the region, public debt remains elevated; Source: World Bank Sta Calculations in Bhutan and Maldives it is actually increasing. With debt at 86.2 percent of GDP, and little room left for further borrowing, Maldives is at risk of debt distress. The largest reduction was in Sri Lanka, where public In India, the central government’s debt marginally debt declined from 86 percent of GDP in 2009 to 79 increased in 2012/13 to 53 percent of GDP, up from percent in 2012. 52.9 in 2011/12, thereby reversing a previous down- ward trend. This was mainly due to slower growth and lower revenues. Pakistan on the other hand saw its public debt decline to 62.9 percent as of end-June 2013, down from 63.7 percent one year before. But its interest payments continue to be large, at 4 percent of GDP. Bangladesh and Nepal feature the lowest total public debt. In Bangladesh, public debt stands at 41.2 of GDP (down from 42.8 in 2011/12) and in Nepal it is a healthy 30.8 percent (down from 33.6 in 2011/12). FIGURE 14: Fiscal deficits are sizeable in most South Asian countries % of GDP 1 0 -1 -2 -3 -4 -5 -6 -7 -8 2011 2012 2013 East Asia & Paci c Europe & Central Asia Latin America & Caribbean Middle East & N. Africa South Asia Sub-Saharan Africa Source: World Banks Global Economic Prospects June 2013 a wake-up call 17 FIGURE 15: The lion’s share of the region’s public debt is domestic Percent 100 90 80 70 60 50 40 30 20 2011 2012 2013 Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka Source: World Bank FIGURE 16: Public debt stays stubbornly high in most countries in the region Percent 110 100 90 80 70 60 50 40 30 20 2011 2012 2013 Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka Source: World Bank The largest current account deficit may not seem a matter of concern, as the coun-  deficits are not always the try has a rather small and slightly improving current most difficult to finance. account deficit of 1 percent of GDP in 2012/13, down from 2.1 percent in 2011/12, but the lack of f oreign investment remains an issue. The most positive notes Current account deficits are large in most of the come from Bangladesh and Nepal. Bangladesh’s cur- region, and some of them are extraordinarily high by rent account balance managed a solid rebound from a international standards. India’s current account deficit 0.4 percent of GDP deficit in fiscal year 2012 to a posi- peaked at 5.2 percent of GDP in the first three quarters tive 1.9 percent in fiscal 2013, mainly fueled by export of 2012/13, and gave way to a more modest 3.6 percent growth, flattening of imports and strong remittance in the fourth quarter. But the deficit for the fiscal year inflows. Nepal remained in surplus in fiscal year 2013, as a whole was 4.8 percent of GDP, up from 4.2 per- at 3.3 percent of GDP, mainly thanks to remittances cent in 2011/12. Sri Lanka’s current account deficit is from its large number of migrant workers. On the other projected at 4 percent of GDP for 2013, up from 6.6 hand, Bhutan, Maldives and Afghanistan experience percent in 2012, although the country is grappling with extraordinarily large current account deficits, with the weaker trade performance. On the surface, Pakistan’s latter two reaching a staggering 28 and 41.5 percent of GDP respectively. 18 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 However, the magnitude of current account deficits increase foreign exchange reserves. But FDI only is not a direct measure of the financing difficulties financed 22.5 percent of the current account deficit faced by individual countries. While Afghanistan’s in 2012/13, down from 28 percent in 2011/12. In deficit is projected at 41.5 percent of GDP for 2013, Pakistan FDI slightly increased, from US$ 0.7 billion driven by a widening trade deficit, the country is highly in 2011/12 to US$ 1.2 billion in 2012/13. But total dependent on aid. Factoring in grants puts the balance capital inflows deteriorated to US$ 0.5 billion, down at a positive 2.5 percent, down from 3.9 percent in from 1.5 billion the previous year. On the other hand, 2012. The same applies to Bhutan, which maintained Bangladesh withstood pressures on its external position a high and growing current account deficit between through managing constant increases in FDI, this past 2012 and 2013, but has large reserves and finances its fiscal year 2013 amounting to growth of 9.2 percent. deficit mainly through grants and loans for hydropower development. In Maldives, debt financing continues to The reversal of capital flows has accelerated a longer- put pressure on the country’s very low reserves and on term trend towards real exchange rate depreciation, its currency, the rufiyaa. which in the near term is making the region more competitive. Not all countries in the region were Capital has been leaving South Asia in the months directly affected by the announced QE tapering as since May 2013. The rebalancing of global portfolios India was, but Nepal and Bhutan have their currencies was triggered by global investors reassessing risk and pegged to the rupee so that the consequences were the return in emerging markets relative to advanced econo- same. And with business cycle fluctuations in India af- mies. Overall, regional gross capital inflows declined by fecting economic activity in the region, the impact also 70 percent between May and August, 2013, with bank extended to countries whose currencies are independent loans, as well as equity and bond issues all dipping. from the rupee. Partly due to the substantial currency depreciation, In India exports began to strongly recover, Financing current account deficits has become more with merchandise exports experiencing double-digit difficult across South Asia and above all in India, growth rates for the last three months. Afghanistan’s where greater reliance on portfolio inflows increased exports, though growing more slowly than imports, are exposure to sudden changes in investor sentiment. up by 76 percent in the first half of 2013, compared to 3 While FDI represented 91 percent of total capital percent in 2012. Bangladesh registered a solid increase inflows to the region in 2008, by 2012 the share had in export growth, from 5.9 percent in fiscal year 2012 declined to 31.9 percent, the rest corresponding to to 11.2 percent in fiscal year 2013. Nepal, and especially more volatile portfolio investments. In India, overall Sri Lanka, are the exceptions to this general trend. Sri inflows have remained sufficient and actually could Lanka has continued loosing competitiveness relative FIGURE 17: Large current account deficits are the norm in South Asia Percent of GDP 10 5 0 -5 -10 -15 -20 -25 -30 2012 2013 2014 2015 Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka Source: World Bank and IMF a wake-up call 19 FIGURE 18: There has been a decline in capital inflows to South Asia in recent months US $ Million 8000 7000 6000 5000 4000 3000 2000 1000 0 2010M01 2010M02 2010M03 2010M04 2010M05 2010M06 2010M07 2010M08 2010M09 2010M10 2010M11 2010M12 2011M01 2011M02 2011M03 2011M04 2011M05 2011M06 2011M07 2011M08 2011M09 2011M10 2011M11 2011M12 2012M01 2012M02 2012M03 2012M04 2012M05 2012M06 2012M07 2012M08 2012M09 2012M10 2012M11 2012M12 2013M01 2013M02 2013M03 2013M04 2013M05 2013M06 2013M07 2013M08 GROSS CAP FLOWS EQUITY ISSUE (3m crawl) BANK LOANS (3m crawl) BOND ISSUE (3m crawl) Source: World Bank DECPG FIGURE 19: FDI now finances a much smaller share of the current account deficit 100 80 60 40 20 0 -20 2008 2009 2010 2011 2012 -40 Net Portfolio In ows Net FDI In ows Net Equity In ows FIGURE 20: South Asia’s real effective exchange rate (REER) has been depreciating for a while REER Index 170 160 150 140 130 120 110 100 90 80 2011M02 2011M05 2011M08 2011M011 2012M02 2012M05 2012M08 2012M011 2013M02 2013M05 2013M08 East Asia & Paci c Latin America & Caribbean South Asia Europe & Central Asia Middle East & N. Africa Sub-Saharan Africa Source: World Bank DECPG and ECB 20 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 FIGURE 21: Export growth is on its way up across most of South Asia 45 35 25 15 5 -5 -15 2011 2012 2013 Afghanistan Bangladesh Bhutan India Pakistan Sri Lanka Nepal Source: World Bank and National Authorities to its peers in the region as its currency, the Lankan increase reserves in the recent past. India chose to let rupee, appreciated right until May 2013. As a result, the rupee float, not risking to drive down its foreign ex- exports declined to 13.9 percent of GDP in the first change reserves, which were at a comfortable US$245 half of 2013, down from 16.4 percent in 2012. In this billion by end September 2013. Afghanistan’s reserves sense, Sri Lanka has not yet started to benefit from plateaued in the first half of 2013 at around US$ 6.9 the depreciation of its currency by 4.2 percent since billion. May 2013. Similarly, Nepal experienced a significant slowdown in export growth to 3.6 percent for 2012/13, compared to 15.4 percent in the previous year. With the exception of Pakistan and Maldives, South Asian countries maintain solid reserve levels. Some of them, notably Bangladesh and Nepal, could even FIGURE 22: Foreign exchange reserves are broadly holding ground or even expanding Months of Import Coverage 14 12 10 8 6 4 2 0 2008 2009 2010 2011 2012 2013 Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka Source: World Bank, IMF and National Aukthorities a wake-up call 21 FIGURE 23: Non-performing assets of the banking system remain high in India and Pakistan 20 10 15 8 10 6 5 4 2 0 MAR-12 APR-12 MAY-12 JUN-12 JUL-12 AUG-12 SEP-12 OCT-12 NOV-12 DEC-12 JAN-13 FEB-13 MAR-13 APR-13 MAY-13 JUN-13 IND Gross NPAS and Restructures Assets of Commercial banks to Advances IND NPLs to Total Loans PAK Gross NPL to Loans PAK Net NPLs to Loans Source: Reserve Bank of India and Quarterly Compendium of the Banking Sector, 2013 (Pakistan) Risks are on the risebut the policy supply of coal to newly built power plants. As a result response has been encouraging of these announcements, the peak rupee depreciation of around 20 percent since May 2013 has partly been reversed. Also, markets may by now have factored in Financial and private sector debt constitutes an actual QE tapering – likely to unwind in 2014 – and increasing risk factor in some countries, particularly therefore real effects could be more modest down after the currency depreciation put stress on balance the road. However, the policy agenda is broad: short- sheets. In India, corporate debt levels increased with term imbalances, inadequate regulation and structural the investment boom of recent years. Meanwhile for- bottlenecks remain to be tackled. eign debt exposure, steadily growing over the past five years, strongly picked up more recently due to cheap interest rates on foreign exchange borrowing. Non- government foreign debt accounted for a substantial 16 percent of GDP and 80 percent of total external debt by end March 2013, with around a third due in less than one year. The recent rupee movements particularly affect large corporations, for which 40 to 70 percent of debt is denominated in foreign currency and may not be completely hedged. Bad debt, in turn, creates risks for the banking sector. Warning signs of stress include an increase in non-performing assets (NPAs) and gross non-performing loans (NPLs), from 3.4 percent in March 2013 to 4.4 percent in March 2014. In Paki- stan, weak credit quality has translated into risk-averse banking, with NPLs remaining steady at 14.8 percent of total loan portfolio at end of June 2013. Recent developments have refocused policy mak- ers’ attention on the need to continue the long-term reform agenda—and the market has responded positively to announcements. Measures have been adopted in India to speed up the implementation of major investment projects and to ensure a longer-term s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 a wake-up call 23 Outlook and policy W hile the overall outlook for the re- uptick are exports and investment. Most recent devel- gion remains positive, serious down- opments point to the direction of increased exports for side risks continue to exist and any South Asia, while both domestic and foreign investors positive development in growth will continue to cautiously believe in the region’s growth depend on progress in ensuring mac- potential. However, International capital markets have roeconomic stability, strengthening the investment delivered a loud and clear wake-up call to regional climate, and removing infrastructure bottlenecks. policy makers. A recovery in exports seems possible in light of depreciated currencies and the strengthening of global demand. Furthermore, the expected acceleration of large investment projects , resulting from measures The overall outlook for South Asia taken in the past few months, is expected to contribute remains cautiously optimistic to further growth. In Pakistan, reforms initiated by the new government with the support of a program agreed with the IMF may rekindle investor sentiment. The Despite the near-term challenges and significant challenge for South Asian policy makers is to keep a downside risks, South Asia’s outlook remains cau- steady hand on the tiller and not get sidelined away tiously positive. The main drivers of this expected from long-term reforms. FIGURE 24: South Asia’s growth may look up 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 2012 2013e 2014f South Asia Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka Source: World Bank DECPG (Fall 2013 estimates) 24 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 TABLE 1: South Asia’s growth forecasts do not match its recent performance but they are encouraging Forecasts 2010 2011 2012 2013e 2014f GDP growth 10.0 7.3 4.0 4.4 5.7 Private Consumption 7.3 7.3 4.2 4.5 5.5 Government Consumption 9.1 7.6 4.3 4.9 5.8 Gross Fixed Investment 16.7 6.0 2.6 4.1 5.5 Exports, GNFS 14.5 16.5 8.3 6.3 8.1 Imports, GNFS 16.0 17.5 11.0 6.3 6.8 Statistical Discrepancy (% of GDP) 0.7 2.5 3.3 3.8 3.9 Current account balance (% of GDP) -2.6 -3.1 -4.5 -3.4 -3.0 Source: World Bank Development Prospects Group Note: Forecasts are subject to change. FIGURE 25: The positive outlook in growth will depend on contributions by exports and investment 8.0 6.0 4.0 2.0 0 2013e 2014f -2.0 -4.0 Private Consumption Gross Fixed Investment Imports, GNFS Government Consumption Exports, GNFS Current account balance (% of GDP) Source: World Bank DECPG (Fall 2013 estimates) However, significant downside South Asian economies raise less tax revenue, relative risks need to be closely monitored  to GDP, than would be expected given their level of economic development. This is the result of frequent tax exemptions, widespread tax avoidance, and rampant Financial sector vulnerabilities and continued weak- tax evasion. ness in revenue collection will need to be tackled in order to mobilize resources for investment. Particu- Across the region, a vibrant democratic process can larly some of India’s biggest infrastructure companies be celebrated, but political transitions have created have a debt coverage of less than one, meaning that their uncertainty on the policy response to changing global operating profits only cover interest payments. If large economic conditions. Recent democratic elections in investment projects remain stalled, the overleveraged Pakistan have improved the investment climate in the domestic infrastructure sector could face difficulties in country, but many other countries in the region still face the short and middle run. Furthermore, most South elections over the next 12 months. Heightened uncer- Asian countries are operating under tight fiscal condi- tainty over their outcome continues to underlie a wait- tions, which constraints the mobilization of resources and-see attitude that restrains investment. Bangladesh towards much needed infrastructure. Recently, revenue remains in a state of political flux and uncertainty, due generation has been less than satisfactory in coun- to protests and conflict between the two major parties. tries such as Pakistan or Afghanistan. More broadly, Across the region, the lack of consensus over key policy a wake-up call 25 FIGURE 26: Tax revenue in South Asia is low when compared to international peers Tax Revenue (% of GDP) 25 20 15 NPL LKA IND 10 BGD AFG PAK 5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5 GDP per capita (in log, ppp, constant, 2011) Govt Tax Revenue (% of GDP) 2011 Fitted Values Source: WDI orientations has become more apparent in the run-up in this respect. But even with greater inclusion, meeting to elections. global poverty reduction goals will be unlikely if South Asia’s economic growth slows down substantially rela- Yet macroeconomic stability and rapid economic tive to recent years. Three complementary policy areas growth remain top priorities for South Asia to suc- are central to regaining the growth momentum. South cessfully tackle its poverty challenge. While the pov- Asian countries need to continue the gradual tighten- erty rate is higher in Sub-Saharan Africa, South Asia is ing of their fiscal and monetary policies, to reduce the region with the largest number of poor people. And volatility. They also need to improve the quality of their this is despite the fact that it is becoming a middle- regulations and strengthen governance, to boost invest- income region. Policies that foster inclusion are neces- ment –domestic and foreign- and support job creation. sary to maximize the poverty reduction associated with Last but not least, policy makers in the region must every percentage point of GDP growth. A focus on focus on removing infrastructure bottlenecks, especially lagging regions and on disadvantaged groups is the key in relation to energy.. FIGURE 27: South Asia remains at the center of the global poverty reduction challenge 600 60 500 50 400 40 300 30 200 20 100 10 0 0 South Asia Sub-Saharan East Asia and Latin America Middle East and Europe and Africa Paci c and the Caribbean North Africa Central Asia Number of poor (in millions) Poverty rate at $1.25 PPP (%) - right axis Source: World Bank (2010 data or most recent available( s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 a wake-up call 27 Focus: Business cycle transmission to and within South Asia T he recent upswing in actual and expected advanced economies typically associated with lower growth in advanced economies has been growth in South Asia and then a rebound? Do global associated with an unexpected softening in shocks get transmitted to South Asia through India, several emerging market economies, par- or are all South Asian countries impacted jointly? ticularly in the economies of Brazil, India, Answering these questions may shed some light on and Indonesia. Capital flows to these large developing how a global economic recovery may eventually be countries have reversed course and currencies have transmitted to South Asia. Of course, idiosyncratic depreciated significantly over the last five months. This events in each country are also important, so knowing might seem contrary to conventional wisdom, given the typical proportion of cyclical movements of GDP that improving economic conditions in the US, Europe, that can be explained by other countries is of interest. and other advanced countries should be associated with While business cycle transmissions between countries better prospects for growth in developing countries if may be important, they may only represent a small economic linkages are strong. part of what determines real GDP movements in any one country. This may not be such a paradox when considering that higher expected growth in advanced economies To address these questions, this focus section will ex- will be associated with higher interest rates—as ac- amine the relationship between the transmission of commodative monetary policy is unwound— and economic shocks from India to the rest of South Asia, this in turn changes the payoffs to investing in some as well as from the world to South Asia. The intention markets compared to others. Changes in investor is not to delve into the precise mechanisms by which sentiment appear to be playing out in recent months economic shocks are transmitted between countries; as some emerging economies with relatively weaker for example, whether it is through trade, financial flows, fundamentals and greater external financing needs remittances, or other factors. The goal is to examine the have been hit harder than countries with better fun- patterns and timing of the transmission of economic damentals. South Asia is arguably more vulnerable shocks to and within South Asia, and to get a sense of than other regions as its financing needs are relatively how lasting these connections are.1 Doing so should large, budgets are strained, and its investment climate help understand better the implications of the accelera- has faced significant hurdles. These weaknesses became tion of advanced country growth on India and the rest more evident after the recent talk about QE tapering of South Asia, and also the role of India’s slowdown on in the US. the rest of South Asia. But what has been, and what will likely be, the impact of the uptick in the global business cycle on South 1 For a discussion of possible transmission mechanisms, see Ejaz Ghani and Rahul Anand, “How Will Changes In Globalization Impact Growth In South Asia?” World Bank Working Asia? Is acceleration in growth in the US and other Paper #5079, 2009. 28 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 The analysis finds that: and then peaked in late 2007, before the onset of the global crisis. Not surprisingly, all areas experienced a ·· Controlling for movements in cyclical sharp downturn in growth between the fourth quarter components of real GDP outside the region, of 2008 and the second quarter of 2009, reflecting the India’s cyclical patterns are correlated to, onset of the global crisis. The general pattern of growth and precede, cyclical growth patterns in the is roughly similar between advanced economies (US, rest of South Asia (Bangladesh, Pakistan, Sri OECD-US) and developing countries (SAR-I, India, Lanka) and not vice versa. This suggests that, BRCS). While they move at different rates it is difficult independent of global business cycle move- to determine, by just eyeballing these trends, whether ments, India likely plays an important role in there is a high co-movement in growth or whether one influencing growth across the region. This ef- unit tends to proceed or follow the others, which may fect has increased since the 2008 global crisis. provide an indication of the direction from which one region’s general shocks are transmitted to other regions. ·· The US played a larger role in influencing global cyclical real GDP movements before To better understand how movements in real GDP the global crisis, but since then its indepen- across areas are related, and to extract important dent influence has diminished as all regions quarterly movements in each region’s real GDP are moving together in greater frequency. time-series, a first step is to de-trend the data.3 De- trending not only allows the data’s turning points and ·· While relationships between cyclical move- variation to become more apparent, but also reduces ments in real GDP in South Asia and the the likelihood of observing spurious high correlations rest of the world are evident, the proportion between the data due to similar trend components. As of cyclical movements within the region that is well documented in the statistical literature, time- is explained by other regions is quite small, series data that have similar trends will show high particularly for South Asia excluding India. correlations even when cyclical movements may differ This suggests that much of the cyclical real substantially. This is why the analysis needs to focus GDP variation in the region is idiosyncratic. on percentage deviations in the real GDP growth of each unit relative to its trend. The availability of data for South Asian countries limits our sample to the period from the first quarter of 2002 to the first quarter of 2013. The nature of co-movements i n economic activity affecting South Two features of the cyclical components of real GDP Asia changed with the global crisis are striking. First is the dramatic decline in all series in the third quarter of 2008, corresponding to the global economic crisis which hit the world after the collapse Consider the following major economic areas: India, of Lehman Brothers. Second, there is the downturn in South Asia less India SAR-I (which for the purposes India’s GDP in the third quarter of 2002, due to the of this analysis includes Bangladesh, Pakistan, and poor monsoon season, and the rebound the following Sri Lanka), the US, advanced economies less the US year. (OECD-US) and the BRICS countries less India (BRCS, which includes Brazil, Russia, China, and While examining the cyclical components of real South Africa).2 Consider also the period starting in GDP is informative, it still is difficult to observe the first quarter of 2002, indexing the log of quarterly visually any clear pro-cyclical or counter-cyclical GDP in real terms to 1 in the first quarter of 2005. co-movements in real GDP between countries, For all major economic units, and particularly for excluding the dramatic downturn at the end of 2008. developing countries, growth was initially quite strong Digging deeper into the possible relationships requires looking at the simple pair-wise correlations in the 2 Because only annual data for Pakistan and Bangladesh real GDP are available, quarterly series are generated by using the quarterly variation in industrial production, which is then mapped into a quarterly real GDP series using the Denton Method. Due to data 3 This is done using the Hodrick-Prescott (HP) filter with λ=16. This produces a stationary availability in Sri Lanka, the analysis begins in 2002Q1 to 2013Q1. series, as validated by the Augmented Dickey-Fuller test. a wake-up call 29 FIGURE F1: The bird’s eye view cannot reveal co-movements 2.0 log real GDP, 2005Q1=1 1.8 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0 2002q1 2002q3 2003q1 2003q3 2004q1 2004q3 2005q1 2005q3 2006q1 2006q3 2007q1 2007q3 2008q1 2008q3 2009q1 2009q3 2010q1 2010q3 2011q1 2011q3 2012q1 2012q3 2013q1 SAR-1 India BRCs OECD-US United States FIGURE F2A: Emerging markets and South Asia were hit hard when the global financial crisis started 0.03 log real GDP, percentage deviation from trend 0.02 0.01 0 -0.01 -0.02 -0.03 2002q1 2002q3 2003q1 2003q3 2004q1 2004q3 2005q1 2005q3 2006q1 2006q3 2007q1 2007q3 2008q1 2008q3 2009q1 2009q3 2010q1 2010q3 2011q1 2011q3 2012q1 2012q3 2013q1 SAR-1 India BRCS Crisis period FIGURE F2B: Advanced economies also saw the cyclical component of their real GDP collapse in 2008 0.015 log real GDP, percentage deviation from trend 0.01 0.005 0 -0.005 -0.01 -0.015 -0.02 -0.025 2002q1 2002q3 2003q1 2003q3 2004q1 2004q3 2005q1 2005q3 2006q1 2006q3 2007q1 2007q3 2008q1 2008q3 2009q1 2009q3 2010q1 2010q3 2011q1 2011q3 2012q1 2012q3 2013q1 OECD-US United States Crisis period 30 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 TABLE F1: Cyclical co-movements were strong during the crisis, but not so afterwards Pre crisis (2002Q1-2008Q1) Post crisis (2009Q4-2013Q1) (#obs 25) (#obs 14) SAR-I India BRCS OECD-US USA SAR-I India BRCS OECD-US USA SAR-I 1 SAR-I 1 India 0.0676 1 India 0.399 1 BRCS 0.322 0.0466 1 BRCS 0.173 0.203 1 OECD-US 0.268 0.275 0.733*** 1 OECD-US -0.368 0.400 0.0859 1 USA 0.0187 0.566*** 0.243 0.436** 1 USA -0.137 0.197 -0.0412 0.561** 1 Full sample (2002Q1-2013Q1) Crisis (2008Q2-2009Q3) (#obs 45) (#obs 6) SAR-I India BRCS OECD USA SAR-I India BRCS OECD-US USA SAR-I 1 SAR-I 1 India 0.320** 1 India 0.767* 1 BRCS 0.438*** 0.430*** 1 BRCS 0.801* 0.761* 1 OECD-US 0.250* 0.460*** 0.850*** 1 OECD-US 0.598 0.65 0.955*** 1 USA 0.226 0.506*** 0.699*** 0.799*** 1 USA 0.638 0.558 0.954*** 0.980*** 1 Note: -South Asia region does not include India. -OECD does not include United States. -*** p<0.01, ** p<0.05, * p<0.1 cyclical component of the de-trended data. To do this, the US (2 percent). In contrast, India has a relatively it is convenient to break the data up into four time peri- low correlation with the other BRICS (5 percent) and ods, 1) the full sample (from the first quarter of 2002 to a higher correlation with other advanced economies the first quarter of 2013), 2) the pre-crisis period (until (OECD-US, 28 percent) and especially with the US the first quarter of 2008), 3) the crisis period (from the (56 percent). The low correlation India has with the rest second quarter of 2008 to the third quarter of 2009), of South Asia seems consistent with the low economic and the post crisis period (from the fourth quarter of linkages between countries in the region. Paradoxically, 2009 onwards).4 India’s economy appears to be more closely linked to that of the US than to the rest of South Asia. Examining the simple pair-wise correlations be- tween cyclical components of GDP growth provides Not surprisingly, during the crisis period, all areas some initial insights into the relationship between show a significant jump in correlations. When the business cycles in South Asia, India, and the rest global economy turned downward there was a sharp of the world. In the pre-crisis period, fluctuations in synchronicity of movements in real GDP. Interest- South Asia excluding India (SAR-I) display relatively ingly, India and the rest of South Asia became much low and insignificant correlations with those of other more correlated with each other, and they both became regions. But India has relatively higher correlations— more correlated with the BRCS. particularly with the US and other advanced countries (OECD-US). At only 7 percent, the correlation is low- The post-crisis period, 2008-2013, may have stronger est between SAR-I and India. SAR-I has higher cor- relevance for how the recent acceleration in advanced relations with the BRICS excluding India (BRCS, 32 economies may be transmitted to India and the rest percent) and with other advanced economies (OECD- of South Asia. During this period the correlation be- US, 27 percent), and a relatively small correlation with tween movements in real GDP across major areas falls substantially. This may suggest that the co-movements between economies are being driven by more idio- 4 The start and end of the crisis period were determined using the Clemente, Montañés syncratic factors and less by global events. In other and Reyes test (Clemente, J., Montañés, A., and Reyes, M. (1998), “Testing for a unit root in variables with a double change in the mean”, Economics Letters, Vol. 59, pp.175-182), words, the typical transmission mechanisms between which examines the data to identify structural breaks in the time-series. countries may have broken down to some degree, at a wake-up call 31 least in recent years. There is still a relatively high and What stands out the most from these analyses is the statistically significant correlation between the US and different pattern that a positive change in the cyclical other advanced economies (OECD-US, 56 percent) component of real GDP in advanced economies has and also, quite interestingly, between India and the rest on India and the rest of South Asia, compared to a of South Asia (SAR-I, 40 percent). However, the latter positive change in the cyclical components of real is not statistically significant at the 10 percent level. GDP in BRCS countries. A cyclical growth impulse from the US or other advanced economies tends to be associated with a one- to two- quarter initial increase in cyclical real GDP in India and the rest of South Asia. Global cyclical movements This positive response is followed by a decline and a do get transmitted to India reversion to the steady state trend. Reversion to the and the rest of South Asia steady state is a much slower process in the pre-crisis period than in the full-sample. In contrast, an impulse from the BRCS countries tends to be associated with Two key questions are how do cyclical movements in an initial decline and then an increase, as real GDP global real GDP get transmitted to India and the rest reverts to its steady state trend. This process also ap- of South Asia, and how do cyclical movements get pears to have accelerated in more recent years. One transmitted within South Asia itself. While simple possible explanation for this behavior is that BRCS correlations are indicative, they do not give a clear sense may act more like competitors with South Asia than of the impact over time, nor do they account for the the advanced countries, so cyclical growth acceleration indirect impact of cyclical movements through third in these countries may be associated with a decline in countries. For example, a high correlation in business South Asia as economic activity initially shifts away fluctuations between India and the rest of South Asia from the region. Overall, however, the statistical sig- could be jointly driven by the US and other advanced nificance of these patterns is quite low, particularly for economies, and not independently by co-movements South Asia excluding India, as indicated by the wide with each other. Moreover, correlations do not make confidence intervals. it possible to determine the direction of the impact; for instance, whether changes in real GDP in the US The relationship between India and the rest of South precede changes in India’s GDP, or vice versa. Asia is quite interesting. The response of South Asia excluding India to a positive cyclical change coming As a means to answer these questions, a vector au- from India is similar to its response to a change com- toregressive (VAR) analysis is conducted. A VAR ing from the BRCS. There is an initial downturn and analysis helps to determine the impact of changes of the then upturn as the cyclical component returns to the cyclical component of one area ’s real GDP on another steady-state trend. This indicates a possible substitution area, taking into account the dynamic interdependen- effect—a positive growth shock to India may initially cies among multiple units over time.5 The results can be take away growth from the rest of South Asia. In con- summarized by showing the impact of a one standard trast, a positive cyclical change coming from the rest deviation change in the cyclical component of log real of South Asia has an initial positive impact on India, GDP on various units in the pre-crisis and full sample indicating that the rest of South Asia may complement periods, over eight quarters. In the terminology of VAR India’s growth prospects, as least in the near term. analysis, this is called an impulse response. Confidence intervals of two standard deviations around the path of the estimated impact are also shown. The post-crisis period is not shown due to the lack of sufficient data to estimate the model. 5 All variables in a VAR are treated symmetrically in a structural sense, even if the esti- mated quantitative response coefficients will not in general be the same. Each variable (the cyclical log of real GDP in one unit) has an equation explaining its evolution based on its own lags and the lags of the other units’ cyclical log of real GDP. The VAR used in this analysis incorporates two own lags and two lags of the other units’ real GDP. Only two lags were chosen due to the relatively short time series, especially in the pre- and post-crisis time periods. 32 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 FIGURE F3: Pre-crisis: India and rest of South Asia initially respond positively to positive shocks in advanced economies Response to one standard deviation changes in the cyclical component South Asia less India response to: India’s response to: OECD OECD 2.0 4 Standard Deviation Change Standard Deviation Change 1.5 2 1.0 0.5 0 0 -2 -0.5 -4 -1.0 -1.5 -6 0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7 1.0 United States 4 United States Standard Deviation Change Standard Deviation Change 3 0.5 2 1 0 0 -0.5 -1 -2 -1.0 -3 0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7 BRCS BRCS 1.0 3 Standard Deviation Change Standard Deviation Change 0.5 2 1 0 0 -0.5 -1 -1.0 -2 -1.5 -3 0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7 India South Asia 0.4 4 Standard Deviation Change Standard Deviation Change 3 0.2 2 1 0 0 -1 -0.2 -2 -3 -0.4 -4 0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7 a wake-up call 33 FIGURE F4: Full Sample: In recent years, India’s cyclical upturns have become more of a benefit to the rest of South Asia Response to one standard deviation changes in the cyclical component South Asia less India response to: India’s response to: 1.5 OECD 3 OECD Standard Deviation Change Standard Deviation Change 1.0 2 0.5 1 0 0 -0.5 -1 -1.0 -2 0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7 United States United States 0.6 2 Standard Deviation Change Standard Deviation Change 0.4 1.5 1.0 0.2 0.5 0 0 -0.2 -0.5 -0.4 -1.0 -0.6 -1.5 0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7 BRCS BRCS 1.0 2 Standard Deviation Change Standard Deviation Change 1 0.5 0 0 -1 -0.5 -2 -1.0 -3 0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7 0.3 India 1.5 South Asia Standard Deviation Change Standard Deviation Change 0.2 1.0 0.1 0.5 0 0 -0.1 -0.5 -0.2 -1.0 -0.3 -1.5 0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7 34 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 TABLE F2: India stays important for the rest of South Asia (Temporal Precedence in Cyclical Real GDP) Pre crisis period (2002Q1-2008Q1) Post crisis (2009Q4-2013Q1 0.253405 0.493468 è è South Asia India South Asia India -0.30726** 3.636643** ç ç 0.048731 -0.21615** è è South Asia BRCS South Asia BRCS -0.14376 0.353468** ç ç 0.28173* -0.66713** è è South Asia OECD South Asia OECD 0.680422* -2.06934** ç ç 0.083588 -1.37113** è è South Asia United States South Asia United States 0.354911* 1.851602** ç ç -0.29054* 0.472048** è India BRCS è -2.47017** India BRCS -0.31093* ç ç -0.01563 -0.54645** è è India OECD India OECD 1.954893 0.479699** ç ç 0.163867 -0.8482** è è India United States India United States 0.63499** 0.391596** ç ç 2.768388** -0.30804 è è BRCS OECD BRCS OECD 0.050662 1.432267** ç ç 0.040999 2.662996** è è BRCS United States BRCS United States 0.036295 0.442245** ç ç 0.189488 0.70047** è è OECD United States OECD United States 0.107577** 0.121819 ç ç a wake-up call 35  he Fluctuations in India affect t One important question is how much overall varia- rest of South Asia, albeit modestly, tion in cyclical movements in each economic area is but not the other way around explained by other countries and regions, and is not idiosyncratic. An answer to this question is provided by the proportion of variation in each area ’s cyclical While it is not possible to determine definitive cau- real GDP that is explained by two lags of all the other sality in the relationship between economic shocks regions for the full sample (the so-called adjusted R- flowing from one economic unit to another, it is squared)7. For South Asia excluding India, the total possible to observe whether cyclical shocks from one variation explained by other major economic areas country or region tend to precede or follow shocks is only 7.9 percent. For the US it is 30.4 percent, for from another country or region. Showing temporal India it is 39.2 percent, for the BRCS 52.3 percent, precedence can be indicative of causality, even if it does and for other advanced economies 57.3 percent. The not confirm it. In statistical analysis, so-called Granger comparison suggests that in South Asia’s case, most of Causality is a means to provide some suggestive evi- the variation in cyclical real GDP is idiosyncratic and dence how economic shocks transfer from one major not related to other major economic units. economic unit to another. The direction of these pair- wise relationships in cyclical components can be sum- marized by an arrow reporting the sum of the estimated FIGURE F5: India, the rest of South Asia, and the US are coefficients on the lagged variables.6 Relationships that largely subject to idiosyncratic shocks are significant in one direction and not the other are considered to indicate clear temporal precedence and Proportion of Variation in the Cyclical Component are highlighted in blue. of Real GDP that is explained by other Regions 1.0 This analysis shows that India has clear directional impact on the rest of South Asia, but not vice versa. 0.8 In the pre-crisis period, the relationship was nega- tive, indicating possible competition with the rest of 0.6 the region, while in more recent post-crisis years the relationship became much stronger and positive. This may indicate growing complementary economic rela- 0.4 tionships in the region, although they remain relatively modest compared to other regions. 0.2 In the pre-crisis period, the US has had a clear posi- 0 tive directional impact on India and the rest of South South Asia India BRCS OECD United Asia; however, in the post-crisis period the direction States of the relationship is not clear and goes in both direc- Adj. R2 tions. In the pre-crisis period the US also had a posi- tive directional impact on other advanced economies and the BRCS. However, in the post-crisis period the direction of impact reversed vis-à-vis advanced econo- mies and became ambiguous vis-à-vis the BRCS. In general, in the post-crisis period the direction of impact is less clear and there appears to be more bi-directional co-movements between countries and regions. The ex- ceptions are co-movements between India and the rest of South Asia, and between the US and other advanced countries. 7 The Adjusted R-squared is estimated applying Ordinary Least Squares to an equation with the cyclical fluctuation of the major unit of interest as the independent variable and 6 Two lags of the independent variables are used due to the small sample size in the two lags of all the business cycle fluctuations of all other major units as the explanatory post-crisis period. variables. s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 a wake-up call 37 South Asia Country Briefs In alphabetical order: AFGHANISTAN BANGLADESH BHUTAN INDIA MALDIVES NEPAL PAKISTAN SRI LANKA 38 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 Afghanistan months of 2013, down 11 percent in nominal terms from Afs 54 billion in the first six months of 2012. The decline in revenue collection was due to leak- ages and weakness in administration, particularly in customs, and the economic slowdown. As the politi- cal uncertainty invites greater rent-seeking behavior and undermines enforcement, revenues are expected  evelopments Recent Economic D to remain low, at about 10-10.5 percent of GDP during 2013-14. To preserve fiscal sustainability, Economic growth slowed considerably in 2013 from a concerted effort will be required on the part of a strong showing in 2012, amid uncertainty over the authorities to improve revenue mobilization by the political and security transition in Afghanistan. strengthening tax and customs administration and GDP growth is projected to reach 3.1 percent this year expediting the introduction and implementation of and 3.5 percent in 2014, from an outstanding 14.4 per- the planned value-added tax. Afghanistan faces con- cent in 2012 that was driven by a bumper harvest and siderable expenditure needs in the areas of security, pre-transition surge in services. Agriculture this year is infrastructure development, service delivery, and expected to contribute flat or slightly negative growth, operations and maintenance. Meeting these needs while investment has slowed as well. Overall growth will also require significant donor assistance for the is slated to pick up again in 2015, assuming a smooth foreseeable future. political and security transition. In the midst of these transition-related uncer- Presidential elections are scheduled for April tainties and underperformance, Afghanistan’s 2014, which seems likely to complicate uncer- leaders will need to stay focused on the country’s tainty over whether the new government will be medium-term structural reform goals. These in- sufficiently cohesive to make coherent policy clude: (i) safeguarding sustainability by mobilizing decisions. revenue and securing grant assistance; (ii) support- ing inclusive and job-creating post-transition growth Fiscal performance of the current government, by unlocking the potential of the agriculture and meanwhile, has weakened, leading to declining natural resource sectors and by tapping the potential revenues that could potentially derail Afghani- of regional integration; (iii) raising the low levels stan’s smooth passage toward self-reliance. Rev- of human capital and skills; and (iv) continuing to enues amounted to Afs 48 billion in the first six strengthen institutions and governance. Services remain a large component of GDP Growth 25.0 20.0 15.0 10.0 5.0 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Services Electricity, gas, water Construction Mining and quarrying Manufacturing Agriculture a wake-up call 39 Outlookand Policy percent of GDP by 2016 will require a concerted effort on the part of the Afghan authorities to (i) reduce leak- Political stability, security, and certainty, or their ages and strengthen customs administration; and (ii) absence, are the primary factors that will determine expedite the introduction and implementation of the the economic performance of Afghanistan in the planned value-added tax (VAT). medium term. Continued violence, economic crime, and systemic corruption also have undermined progress Budget expenditures are expected to continue to rise in Afghanistan’s governance and state-building agenda. from about 24 percent of GDP in 2012 to about 30 Much will depend, therefore, on Afghanistan’s success percent of GDP by 2016. The increase in budget ex- in achieving peace, stability and reconciliation penditures is largely a result of more spending moving on budget from previously being undertaken directly In the medium term, post-transition growth is pro- by donors. Afghanistan has considerable public expen- jected at about 5 percent per year during 201516. This diture needs in the areas of security, service delivery, is less than the average annual growth of 9.4 percent building essential infrastructure, and operations and during 2003-12 that was fueled by the surge in inter- maintenance. These needs are likely to remain substan- national aid and security spending. tial for the foreseeable future. Agriculture and extractive industries are most likely to drive growth. Agriculture accounts for about a Cumulative Revenues, H1 2012 & 2013 quarter of GDP and is linked closely to other parts of the economy, such as food and beverages, which 60 account for almost all of manufacturing, and parts of transport and retail. Afghanistan has the potential to build on this foundation by reviving its historical 14.9 11.0 position as an important exporter of fruits, nuts, veg- 40 Billion Afghanis etables, and other higher value-added products. This will require investments in irrigation and extension 14.3 13.3 services to improve capacity, as well as efforts to build and improve downstream agro-processing activities. 20 The extractive industry, which currently accounts for a very small share of GDP, has significant potential 24.7 23.7 in light of Afghanistan’s deposits of copper, iron ore, and hydrocarbons. However, the timeline for natural - resources to contribute meaningfully to Afghanistan’s 2012 2013 prosperity has become less certain in light of recent Non-tax revenue Customs revenue Tax revenue developments in the sector. Unlocking this potential will require progress on the legislative framework as well as the ability to secure financing for the necessary infrastructure. Donors have committed to cover the budget financ- ing gap, but the funds are contingent upon the The current fiscal revenue outlook is subpar and Afghan government making sufficient progress likely to delay Afghanistan’s progress to self-reliance, under the Tokyo Mutual Accountability Framework so the authorities need to improve revenues. In light (TMAF) that calls for improved domestic revenues. of the recent weak revenue performance, domestic The framework commits the Afghan government to revenues are projected at 10.1 percent of GDP in 2013, increasing revenues to 15 percent of GDP by 2016 and rising to 12.6 percent by 2016. Weak revenue perfor- 19 percent of GDP by 2025. Given current projections, mance in 2013-14 is projected to result from a number it could achieve this only by developing the mining of factors including the slowdown in economic activ- sector, fostering private sector development, broaden- ity, changes in the structure of imports, but perhaps ing the tax base and reducing the leakages at customs. more importantly, from high leakages and weaknesses The current decline in revenue therefore poses risks not in administration, particularly in customs. In light of only to long-term fiscal sustainability but also to the recent developments, the increase in revenues to 12.6 achievement of TMAF targets. 40 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 Bangladesh mainly to an increase in export growth from FY12 and flat import payments. The surplus in current and finan- cial accounts also improved remarkably. As a result, for- eign exchange reserves continued to set historic records. The current reserve level, at 4.9 months of imports, is adequate but not excessive. Bangladesh Bank interven- tions helped keep the interbank average nominal ex-  evelopments Recent Economic D change rate stable, but the premium on the curb market rate has been increasing since April, 2013. This apparent GDP growth in FY13 decelerated for the second suc- divergence in the behavior of the formal and informal cessive year, to 6 percent. Disruptions caused by political market exchange rates is attributable to a rise in demand and labor strife, deepening tensions over the impending for informal market dollars, perhaps due to capital flight. political transition, and inadequate improvements in the provision of power, gas, and infrastructure were key fac- The banking system remains under stress and capital tors in the slowdown. These served to weaken investor market activities have been weak. Several financial scams and consumer confidence, prompting real private invest- and resultant loan defaults in the state-owned commercial ment to fall by 1.2 percent and private consumption to banks (SCBs) moved them into positions of insolvency, grow moderately at around 5 percent, well below the which requires, and has begun to receive, urgent atten- historic 9 percent average growth rate. Robust increases tion. Capital market activities remained generally weak in exports and remittance helped maintain GDP growth throughout FY13. Low investor confidence persisted, and above the average 5 percent growth for developing coun- securities traded narrowly in both volume and price. tries in 2013. Growth declined in both agriculture and services while industry rose slightly. Fiscal policy is on track, but a host of domestic chal- lenges remain. The conduct of fiscal policy in FY13 Annual average inflation declined to 6.8 percent in has been broadly in line with the original budget. The FY13, from 8.7 percent in FY12, due mainly to declines overall fiscal deficit (excluding grants), at 4.3 percent in both food and non-food prices internationally. of GDP, has been below the budget target of 5 percent. Increased production, declining demand from large im- The FY14 budget targets a modest deficit of 4.6 percent porters, and increasing food stocks in international mar- of GDP and a domestic financing target of 2.9 percent, kets exerted downward pressures on international prices. as the authorities face numerous domestic challenges. The conduct of monetary policy improved remarkably These range from increasing road traffic congestion, and in FY13, which helped reduce non-food price increases. shortages of power, water, and gas to the need for higher As year-on-year inflation was still high in August, at 7.4 welfare spending to protect the poor and vulnerable. percent, the Bangladesh Bank’s (BB) decision to stay the course on monetary discipline in FY14, despite the Structural reform has progressed slowly. The IMF’s forthcoming elections, was a bold and timely step. Extended Credit Facility (ECF) is on track, strength- ening macroeconomic conditions and structural The external trade deficit decreased significantly, due policies. The new VAT law is being implemented; the GDP Growth slows (percent) 7.0 6.6 6.7 6.4 6.5 6.3 6.2 6.1 6.0 6.2 6.0 6.0 5.5 5.7 5.0 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 Source: Bangladesh Bureau of Statistics a wake-up call 41 National Board of Revenue has introduced an online disruptions and wage-push factors, slowing of exports tax registration system; amendments to the Banking and remittances, fiscal expansion due to increased re- Companies Act have been passed, and progress is being current expenditures in response to political pressures, made in identifying critical weaknesses in the state- and failure of financial intermediation. Overall, the owned commercial banks in a step toward strengthen- Bangladesh economy is moving into a more volatile ing their governance and financial positions; the FY14 phase. The risks stemming from the impending political budget introduced revenue reforms such as increasing transition have grown significantly, while new risks and the corporate-profit tax rate on cigarette manufacturing challenges have gained prominence. Notable among the companies and reducing the nominal protection rate to latter is the damaged image of Bangladesh’s only manu- 28.1 percent in FY14 from 28.9 percent in FY13. facturing mega-success story – garment manufacture. A succession of devastating factory accidents in the Revamping the garment industry in the wake of the past 11 months, topped by the Rana Plaza building deadly factory accidents will be crucial to Bangla- collapse in April that killed more than 1,100 workers, desh’s future economic growth. The crisis within the have revived concerns over labor standards, wages, and garment industry has placed the country’s vital foreign compliance with safety regulations, and threaten the currency generator at a historic crossroads. The sector future growth of Bangladesh’s most important export could become a US$36-42 billion revenue-earner by industry, ready-made garments. The government has 2020 if it can prevent a recurrence of the horrors seen pledged to work with the International Labor Organiza- in the Tazreens Fashions and Rana Plaza disasters tion to improve worker safety in the country. At the same and improve workers’ employment conditions. But time, supply-side bottlenecks have to be addressed. On- continued neglect of workers’ rights and safety would going political uncertainty, frequent general strikes and prompt international buyers to cut their reliance on associated hostilities, have added to the existing negative Bangladesh, or even abandon the country altogether. pressure caused by longstanding energy and infrastructure The United States’ removal of Bangladesh products deficits that continue to dampen the investment climate. from its Generalized System of Preferences (GSP) might not hurt unduly, but if the EU were to suspend its GSP benefits, the country could lose 4.1 percent, or even as much as 8.1 percent of total exports.  nd Policy Outlook a The impact of the Indian rupee depreciation is uncer- Bangladesh’s near- and medium-term macroeconom- tain. The rupee had depreciated to about 62 per dollar ic outlook hinges on internal stability and structural in mid-September from 53.7 in early May. Similar large reforms. The outlook is subject to several vulnerabilities depreciations have occurred in Indonesian and Turkish – further growth slowdown due to internal strife, the currencies as well. Since these countries compete with prospect of resurgent inflation due to intensified supply Bangladesh in the export markets, such large deprecia- tions are likely to toughen competition for Bangladesh. The impact will depend on the permanence of the cur- Export Growth moderates (percent) rency depreciation, the impact of the policy response in 45 these countries, the feedback effects on their inflation 40 rates, and the impact on the cost of intermediate input and raw material imports to Bangladesh. But a weaker 35 Indian currency is not all bad news for Bangladesh; 30 since the country sources more than one-third of its 25 imported cotton and cotton fabrics in India, the weaker 20 rupee makes these imports far cheaper, which in turn reduces the production costs of Bangladesh’s garment 15 exports, thereby muting the loss of competitiveness. 10 5 Overall, the Bangladesh economy is moving into a 0 more uncertain phase. The risks stemming from the im- FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 pending political transition have enhanced significantly Source : Export Promotion Bureau while new risks and challenges have gained prominence. 42 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 Bhutan domestic revenue envelope (a constitutional require- ment), while capital spending increased commensu- rately with additional donor grant financing. Bhutan has relatively high debt, but the risks of debt distress are mitigated because public debt is  evelopments Recent Economic D concentrated in the commercially-viable hydropower projects, which are virtually guaranteed revenues Bhutan’s growth remains strong, averaging over from electricity exports to India. 8  percent annually, though it is estimated to have moderated to 6.9 percent in 2012/13 due to the ru- pee shortage and statutory measures that restricted  nd Policy Outlook a credit. Hydropower contributes about one-third of GDP and one-fifth of economic growth, including The economic outlook is favorable if risks are managed direct and spillover activities. well. In the medium term, GDP growth is expected to average 6.9 percent, driven by investment in hydropower The construction of ongoing and pipeline hydropower projects and expansion of the service sector. The fiscal projects will remain the major drivers of growth, with stimulus package could boost growth. India’s growth the industry sector projected to grow at 6.2 percent slowdown and the rupee depreciation have the potential through 2014. Growth in the service sector has come to adversely affect Bhutan’s growth through financing from an increase in domestic demand and tourism, uncertainties and by reducing Indian tourist arrivals. particularly new investments in hotels and restaurants, the finance sector, and transport and communications. Long-term development challenges remain. Economic volatility is a natural risk, with more than half of govern- The overheating episode which started in 2011 has ment revenues coming from grants and electricity sales ended, though its effects linger. Rapid private-sector to India. Revenues are subject, therefore, to the timing of credit growth has been severely dampened by a credit hydropower developments coming on-stream, seasonal- crunch caused by the government’s emergency halt to ity of power generation, and timely receipt of grants. The personal loans as a temporary measure to curb the de- absence of scale economies in most industries, limited mand for rupees. access to finance, skill mismatch of the labor force, and under-provision of infrastructure constrain the develop- The 2013/14 budget projects a higher budget deficit ment of a vibrant private sector. With its thinly-spread of 3.7 percent combined with an off-budget stimulus population and high transport costs, Bhutan would plan of around 4 percent of GDP executed through benefit from urban agglomeration with careful city man- the banking system. The deficit was ramped up by a agement. Located in a region subject to natural disasters, sharp drop in project-tied grants from India. Bhutan would also benefit from prioritizing the devel- opment of robust plans for proactive risk management. Inflation, which had fallen from last year, was up again, to 5.5 percent (y-o-y) in Q2 2013 from 8.4 per- GDP Growth by Sector cent in Q1, due mostly to pass-through from higher 10 fuel prices imported from India. 8 Bhutan remains dependent on donor funding to finance capital expenditures. The FY 2013 fiscal posi- 6 tion is expected to produce a moderate deficit of 0.9 percent of GDP, down from the previously estimated 4 1.6 percent. Tax collection slightly over-performed, 2 particularly corporate tax and excise duties -- though tax revenues overall were lower this year by India 0 refunding only one year of excise duty as opposed to 2008/09 2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 the customary two-year’s duty. Current expenditures Taxes net of subsidies Services Industry (other) remained below the fiscal anchor of staying within the Construction Electricity Agriculture a wake-up call 43 India FY2013. On a seasonally adjusted annual (saar) basis, GDP growth fell to a seventeen-quarter low of 4.2 per- cent, its worst performance since the onset of the global financial crisis in FY2009. Output in mining continued to contract, while growth in manufacturing – which had already shrunk by 0.1 percent saar in the previous quarter – fell sharply by -9.4 percent saar. On the other  evelopments Recent Economic D hand, growth in services strengthened somewhat to 8.0 percent saar (due largely to a larger contribution Recent market turmoil – while driven mainly by ex- from the public sector), and growth in agriculture more ternal factors – has magnified India’s macroeconomic than doubled to 3.7 percent saar due to a favorable vulnerabilities. India was just one of a large number of monsoon. Reflecting weakness in the manufacturing emerging market economies whose currency and capi- sector, investment contracted by 1.2 percent y-o-y in tal account were adversely affected by a large outflow of Q1 FY2014 after registering single-digit growth dur- portfolio investment this summer. While these port- ing the previous three quarters. Business confidence, as folio flows have been driven largely by investor fears captured by the HSBC Composite Purchasing Man- of a shift in the US monetary policy, countries with agers’ Index which surveys private manufacturing and greater macroeconomic vulnerabilities have come under service firms, has fallen to 46.1 in September, marking greater scrutiny. India’s below-potential GDP growth, the worst outturn in over four years and a third con- due to continued slowdown in investment, high current secutive month below the contraction threshold of 50. account deficit with growing structural vulnerabilities, Consumer confidence was also affected, with consump- rising food and fuel prices, and an improving but still tion growth falling to below 2.0 percent saar for the elevated fiscal deficit, have added to investor fears about first time since FY2004. the economy’s ability to cope well with external shocks. As global investors withdrew US$15 billion of port- Acceleration in food and fuel price growth offset the folio investment from Indian markets in June-August, decline in core inflation. Core inflation decelerated to the rupee fell by 18 percent vis-à-vis the US$ during 2.4 percent y-o-y for the fiscal year-to-date, marking this period before recovering more than a third of its a major deceleration from an average price growth of losses in September. 4.9 percent during FY2013 and placing core inflation well within the Reserve Bank of India (RBI) comfort Economic growth decelerated to 4.4 percent in the level of 4 percent. On other hand, food price growth first quarter of the current fiscal year. Growth in real ticked up in June to 10.3 percent y-o-y due to higher GDP at factor cost came in below 5 percent for the vegetable and cereals prices. Growth in fuel prices has third quarter in a row, slowing from 4.8 percent in Q4 also accelerated with gradual deregulation of diesel Indian rupee mirrored closely the movement of yields on 10Y US Treasury bonds 70 3.00 68 66 2.75 64 2.50 62 60 2.25 58 56 2.00 54 1.75 52 50 1.50 2-May-13 9-May-13 16-May-13 23-May-13 30-May-13 6-Jun-13 13-Jun-13 20-Jun-13 27-Jun-13 4-Jul-13 11-Jul-13 18-Jul-13 25-Jul-13 1-Aug-13 8-Aug-13 15-Aug-13 22-Aug-13 29-Aug-13 5-Sep-13 12-Sep-13 Rs./USD spot exchange rate 10-year US Treasury Bond yield (RHS) 44 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 Economic growth decelerated in Q1 FY2014 (percent y-o-y growth) 11 9 7 5 3 1 -1 Q1 2008-09 Q3 2008-09 Q1 2009-10 Q3 2009-10 Q1 2010-11 Q3 2010-11 Q1 2011-12 Q3 2011-12 Q1 2012-13 Q3 2012-13 Q1 2013-14 Agriculture Industry Services Source: Central Statistics O ce and World Bank Sta estimates Headline in ation remained subdued 20 16 (y-0-y percent growth) 12 8 4 0 -4 Aug-09 Dec-09 Apr-10 Aug-10 Dec-10 Apr-11 Aug-11 Dec-11 Apr-12 Aug-12 Dec-12 Apr-13 Aug-13 WPI CPI Food in ation Core in ation Source: Ministry of Commerce and Central Statistics O ce prices and mark-to-market petrol prices which have been affected by the depreciation in the rupee. As a Diesel under-recoveries result, growth in consumer prices – where food and rose sharply after May (INR/litre) fuel account for nearly 60 percent of the entire basket 15 – remained elevated at 9.5 percent in the current fiscal year (although down from an average of 10.2 percent 10 in FY2013). Vulnerabilities in the corporate sector are on the rise. 5 While corporate debt levels have risen, earnings and profitability remained under pressure, pushing up debt coverage ratios. These vulnerabilities were transmitted 0 to the banking sector, with a concomitant increase in 1-Apr-13 15-Apr-13 29-Apr-13 13-May-13 27-May-13 10-Jun-13 24-Jun-13 8-Jul-13 22-Jul-13 5-Aug-13 19-Aug-13 non-performing assets, particularly among public sec- tor banks. The banking system remains robust overall, although stress levels are elevated, meriting close Source: Ministry of petroleum and natural gas attention. a wake-up call 45 Current account de cit improved in Q4 FY2013 35 7 30 6 25 5 20 4 15 3 10 2 5 1 0 0 Q1 2009-10 Q2 2009-10 Q3 2009-10 Q4 2009-10 Q1 2010-11 Q2 2010-11 Q3 2010-11 Q4 2010-11 Q1 2011-12 Q2 2011-12 Q3 2011-12 Q4 2011-12 Q1 2012-13 Q2 2012-13 Q3 2012-13 Q4 2012-13 US$ billion % of GDP Source: Reserve Bank of India The central government’s FY2013 fiscal deficit came percent of GDP. As merchandise exports strengthened in better than expected, but fiscal pressures have in- in Q4 FY2013, the current account deficit improved to creased this year. Revised data show that the central 3.6 percent of GDP. Strong portfolio inflows – which government’s fiscal deficit in FY2013 reached 4.9 rose from 0.9 to 1.5 percent of GDP during the fiscal percent of GDP –well below last October’s target of year – played an increasingly important role in financ- 5.3 percent and better than the 5.2 percent estimate in ing the deficit while external commercial borrowing March – due to lower current expenditures and higher (ECB) remained stable at 0.5 percent of GDP. Even non-tax revenue. However, the central government with a 10 percent y-o-y decrease in FDI (in US$), total incurred a fiscal deficit of 3 percent of GDP during the capital inflows rose by nearly 32 percent, comfortably first four months of FY2014, equivalent to 62.8 per- financing the current account deficit and adding almost cent of its fiscal deficit target for the year. A significant US$4 billion to the stock of international reserves. portion of the shortfall can be attributed to lower tax collection due to a slower pace of economic activity: The growing trade deficit has been responsible for the the central government collected just 16.4 percent of majority of the widening in the current gap, but ex- its total budgeted tax revenue between April and July port performance improved recently. The merchandise 2013, compared with 18.5 percent of budget estimates trade deficit rose to 10.6 percent of GDP in FY2013 over the same period last year. In addition, rising under- from 10.2 percent in the previous year as merchandise recoveries on diesel – the difference between interna- exports (in US$) fell by 1.1 percent y-o-y while imports tional fuel prices and costs of production that arise due increased by 0.5 percent. The slowdown in mining – a to regulated domestic fuel prices – have erased the gains decline in iron ore exports and a concomitant increase achieved under the diesel price reform earlier this year in imports of coal over the past two years – exacerbated and threaten to push the central government’s subsidy the widening of the trade deficit while appetite for gold bill above last year’s outturn of 2.5 percent of GDP. remained high as declines in international prices have somewhat offset the impacts of the depreciating rupee After reaching a record high in Q3 FY2013, the cur- and higher import duties. More recently, however, the rent account deficit improved in the fourth quarter. rupee’s depreciation helped improve export competi- The current account balance has gone through a major tiveness and close the merchandise trade gap. Merchan- shift in the past decade, deteriorating from a surplus of dise exports (in US$) grew at an eighteen month high 0.2 percent of GDP in the five years before the global of 12.3 percent y-o-y in July and August while imports, crisis (FY2003-2007) to an average deficit of 2.6 per- which already fell by 0.4 percent in June, contracted cent of GDP during FY2008-2012, and reaching con- further by 3.6 percent y-o-y in July-August. Industrial secutive record highs of 4.2 and 4.8 percent of GDP output also rebounded strongly by 2.6 percent y-o-y in FY2012 and FY2013. Most of the deterioration in July (58.1 percent saar), led by a 3.0 percent y-o-y in FY2013, however, took place during the first three increase in manufacturing and particularly 15.6 percent quarters when the current account deficit rose to 5.2 y-o-y growth in the production of capital goods. 46 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 Export growth accelerated with rupee depreciation (y-o-y percent growth) 80 60 40 20 0 -20 -40 Dec-11 Aug-11 Apr-11 Dec-09 Dec-10 Dec-12 Aug-13 Aug-09 Aug-10 Aug-12 Apr-13 Apr-10 Apr-12 Exports Imports Source: Ministry of Commerce and Industry v The decline in poverty has accelerated, although  nd Policy Outlook a vulnerability remains high. Between 2005 and 2012, India lifted 137 million people out of poverty and The reform momentum has picked up in the last year reduced the poverty headcount (at the national pov- with authorities putting forth a number of important erty line) to 22 percent of the population. The pace of reform initiatives. These reforms include a major poverty reduction has been accelerating over the years, expansion of social protection coverage with the pas- and a much larger fraction of the decline is taking place sage of the National Food Security Act, a new Land in low-income states. On the other hand, inequality Acquisition Bill that replaced more than 100-year-old continues to rise – albeit at a decelerating rate – and legislation, a new Pension Bill that allows foreigners to more than half of India’s population remains vulner- invest in Indian pension fund companies, a Banking able, living close to the poverty line. Bill that allows for new banking licenses, a Companies Bill that replaces sixty-year old legislation and increases transparency and corporate accountability and FDI-fa- Poverty Decline Accelerated cilitating reforms in a number of sectors. Together with 1994 2005 2010 2012 new policy announcements by the new RBI Governor 0 50 and a 10-point action plan to accelerate growth by the Finance Minister, these developments send a strong 45 -1 40 signal about a recovery in reform momentum. 37 -2 30 The economy is expected to expand by 4.7 percent in 30 the current fiscal year. The pace of economic activity -3 22 20 in FY2014 will be restrained by a weak outturn dur- ing the first quarter; furthermore, two consecutive months ( July-August) of negative business sentiment -4 10 and higher interest rates indicate a modest recovery in Q2 FY2014 despite a strong rebound in manufacturing -5 0 output in July. However, as financial markets stabilize, Decline (ppt/year) Poverty Ratio exporters continue to take advantage of improvements in external competitiveness following the depreciation bout in the rupee, recovery in the manufacturing sector continues, and delayed investment projects begin to come on stream, activity is expected to pick up strongly in the last six months of the fiscal year, rising above 6.0 percent saar in Q4 FY2014. The recovery will also be supported by a pick-up in agricultural activity due to a wake-up call 47 heavy and early monsoon rains which – while damaging of being rolled over) and short-term trade credits some crops like coffee – have resulted in higher sum- (which are implicitly hedged, to an extent). Increases mer planting of rice, corn, barley, cotton, and soybeans. in inflation are likely to be limited by a small share of This is expected to result in a bumper summer crop as imported food in the overall consumption basket and well as improved agricultural output in winter due to the diesel pricing mechanism which limits increases to higher soil moisture levels. Rs.0.50 per liter per month. While rising prices will put some pressure on household budgets, real income The macroeconomic environment is expected to losses – particularly in the rural areas – could well be improve further and growth is expected to acceler- offset by a favorable monsoon. The greatest risks are in ate gradually in the medium term. The baseline the corporate and banking sector, where depreciation scenario is conditional on further improvements in the has exacerbated pressures from falling profitability and macroeconomic framework, benign global conditions, rising non-performing assets. Overall, however, the and continued efforts by the authorities to strengthen situation is likely to be manageable and instead offers the business environment and improve fiscal sustain- the authorities a window of opportunity for measures ability. Under these assumptions, the pace of economic to strengthen the business environment, attract more activity is expected to improve further to 6.2 percent FDI, and increase productivity. These measures could in FY2015. The acceleration in growth is unlikely to include steps to reinforce the financial sector via create inflationary pressures as several years of growth capitalization and broader banking/financial sector below potential have opened a positive output gap, reforms, simplify the regulatory environment for firms, and inflation is expected to decelerate to 5.3 percent and strengthen fiscal balances through continued fiscal and 5.2 percent in FY2014 and FY2015. The pick-up discipline and the adoption of GST. Further steps in in exports bodes well for closing of the current ac- the above directions by the authorities could bode well count gap, but the merchandise trade deficit is likely for stronger growth in the medium and long-term. to remain elevated in the short- and medium-term as fuel imports, which tend to be relatively less sensitive to price changes, account for more than one-third of the total import basket. In addition, the acceleration of growth in the second half of FY2014 and FY2015 is likely to require higher imports of capital goods. Under these assumptions, the current account deficit is expected to decline to 4.1 percent of GDP in FY2014 and 3.7 percent of GDP in FY2015. Financing of the gap is expected to come in roughly equal parts from FDI and institutional flows in FY2014, with a growing contribution from FDI in FY2015. The depreciation in the rupee is unlikely to have major adverse effects and provides an opportunity to accel- erate growth through further progress on the reform agenda. Adverse impacts of the depreciation on invest- ment growth are likely to be offset by gains in export performance due to improved external competitiveness. Even with new pressure on fiscal balances, external and domestic financing needs are likely to be financed without much difficulty as real interest rates are close to zero and government short-term debt is around 1 percent of GDP. Although external short-term debt at residual maturity is relatively high at 9 percent of GDP (44 percent of total external debt), short-term sovereign external debt is just 0.3 percent of GDP and the vast majority of the remainder is accounted for by deposits by Indians abroad (which have a reasonable likelihood 48 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 Maldives private sector, and high-net-worth individuals at high interest rates; increased monetization of the deficit; and growing payment arrears. Loose fiscal policy has led to a significant accu- mulation of debt and the country is under risk of debt distress. Arrears, at close to 6 percent of GDP,  evelopments Recent Economic D have become a significant fiscal burden. The balance of payments is under stress reflected by critically The economic position has become dependent on low external reserves. Reserves have unexpectedly resolution of its volatile and fluid political situation. held up, even after settlement of significant external The second round of the Presidential election has been debt commitments in early 2013. They will continue postponed after the first round has been disputed in to be under pressure from public spending, demand September. The majlis (parliamentary) election is for imports, other currency needs, and a risk that scheduled for the second quarter of 2014, and lack of settlement of the terminated airport concession and political consensus is expected to slow reforms. arbitration process could lead to a significant pay- ment requirement. After two years of 7 percent annual growth, real GDP growth slowed to 3.4 percent in 2012 and is expected to remain modest in 2013. Tourism demand is slowly picking up, and the growing Chinese tourist segment  nd Policy Outlook a will continue to compensate for lower arrivals from Europe – so long as it is not derailed by political unrest. Growth is expected to remain at or a little over 4 Strong tourism will also have a positive spill-over to the percent in 2013, contingent on tourism maintaining non-tourism sectors, such as construction, communica- its growth trend. tions, and fisheries, which will remain dynamic with a positive contribution to the economy. With a growing fiscal deficit financing will be chal- lenging during 2013. The government already has Maldives is spending beyond its means, and financ- encountered serious cash flow problems that are likely ing the large budget deficit risks harming the real to worsen in the fourth quarter. This would mean con- economy. Deficit financing will be challenging for tinued ad-hoc, expensive financing of the budget and the remainder of 2013. The government has opted for the accumulation of more arrears. Debt is expected to financing in ways that could pose macro risks: reliance continue to accumulate to over 91 percent of GDP by on short-term commercial borrowing from the banks, 2014. The new government will need to seek rapid measures to curtail expenditures and raise revenues. Better The economy depends on tourism growth % targeting of the main subsidy schemes – particularly 50 the electricity subsidy and the universal health insur- ance scheme – should be a priority, while postponing 40 capital expenditure beyond 2014 may also be viable. In 30 the medium term the government may look to address 20 structural pressures on public finances: the size of the 10 3.4 4.3 civil service and associated high costs of pay and allow- 0 ances. The recently-established pay commission needs to be supported with a targeted program to rationalize -10 the public sector and its payroll. Furthermore, limit- -20 ing the direct budget transfers to SOEs would require -30 containing operational loses and contingent liabilities. -40 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E Consolidation of tax measures – raising tax rates (particularly GST) and rationalizing the import-duty Real GDP Tourism Growth regime may help to close the gap. a wake-up call 49 Nepal uncertainty. Industrial growth in FY13 was a lackluster 1.6 percent, down sharply from 4.3 percent and 3.0 per- cent in FY11 and FY12. Manufacturing activity growth slowed to 1.8 percent (from 3.6 percent the previous year) as unresolved structural bottlenecks were compounded by political uncertainty. While construction activity picked up in FY13 (1.6 percent vs. 0.2 percent growth  evelopments Recent Economic D in FY12) after the real estate bubble burst, it remained constrained by delays in budget execution, low levels of Nepal’s economic development depends chiefly upon public spending on capital projects, restrictions on bank political developments. Political uncertainty continues lending to the real estate sector, and investor nervous- to hamper growth-oriented fiscal policies while the pri- ness over possible changes to administered prices. vate sector has adopted a wait-and-see position. Over the short term, the scheduled elections – if they are held and achieve a degree of consensus – will be a major test. Over Growth is expected to slow due to weak the medium term, increased political stability should be agriculture and industrial production followed by structural reforms to tackle enduring sources 10.0 of fragility, including financial sector consolidation, pub- lic financial management reform, governance improve- ments, and a strategy to address the gradual erosion of 5.0 Nepal’s external trade competitiveness. Political instability has clouded the outlook in FY13. 0 The delayed adoption of a full budget in FY13 has FY09 FY10 FY11 FY12R FY13P depressed growth, while agricultural activity has suf- fered from a weak monsoon. Overall economic growth is estimated to have dipped to 3.6 percent, with average -5.0 inflation just under the double-digit mark. Agriculture Industry Service Source: CBS However, Nepal’s underlying fundamentals remain healthy. Despite a large – and growing – trade imbal- ance, the current account remained in surplus, thanks The services sector, which accounts for an ever-grow- to the countervailing impact of remittances, which have ing share of total value added, was an outlier with a continued to grow robustly (albeit at a slower pace than healthy 6.0 percent increase over the 4.5 percent and in past years). On the fiscal side, the combined effect of 3.4 percent of the preceding years. Within the sector, low spending and continued revenue growth has allowed wholesale & retail trade (+9.5 percent), hotels & restau- the government to draw down its overall stock of debt. rants (+6.8 percent), transport, storage & communica- tions (+6.7 percent), and financial intermediation (+6.6 A critical source of weakness in past years, the finan- percent) saw considerable growth in FY13, whereas cial sector, has rebuilt strength. All key indicators of it was more muted in the remaining sub-sectors, real financial sector health – credit default rate, exposure estate and public/community services. Services growth to real estate, non-performing loans (NPLs) – have has been unaffected by the deceleration in remittance registered improvements, on the back of resolute policy growth in FY13, possibly because of lag effects. interventions by the Nepal Rastra Bank (NRB) and accommodative monetary policy. Further consolidation Inflation rose to 9.9 percent in FY13, reversing a is needed, however, with key policy actions still pending trend of steady decrease since FY09. The rise was well or in progress, and the possible need to adopt a tighter above the NRB’s initial target of 7.5 percent (and mid- monetary stance in coming months. term revised targets of 9.5 percent). It remained near or above 10 percent until mid-March this year and mod- Industrial output performed marginally better than erated only in the last four months of the fiscal year be- the last two years, as structural bottlenecks were cause of seasonal trends, similar movements in Indian compounded by weak public demand and political prices, and the ability of firms to mobilize inventories. 50 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 Trade de cit largely o set remittances 30.0 Remitances, Reserve, Current Account and Trade De cit (percent of GDP) 25.0 20.0 15.0 10.0 5.0 0 -5.0 -10.0 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 Trade de cit ind. service Reserves, net change Worker remitances Current account balance “Cost-push” factors kept prices high in FY13: a disap- to address major bottlenecks to public expenditures pointing harvest prompted a surge in imported food and private sector development. These include de (volumes of rice and vegetables from India grew by 98 facto streamlining of the budget preparation/adoption percent and 76 percent); food prices rose by 9.7 per- process, which could be further institutionalized, high cent, from 7.6 percent in FY12; and non-food prices profile anti-corruption initiatives (as part of a broader also increased to 10 percent from 9 percent the year effort to strengthen PFM), and the establishment of before. Structural factors – supply side rigidities – were the Investment Board Nepal, which appears poised to the main drivers: higher fuel and gas prices that raised approve transformational projects in coming months. transport costs, and the onset of the rupee’s deprecia- tion against major convertible currencies, that drove up For FY14, the baseline scenario is a gradual return costs of imported goods, and domestic production via to trend with higher growth and sustainable fiscal imported inputs and raw materials. expansion. If elections are held on time and the result achieves broad consensus, macroeconomic projections Nepal’s trade balance continued to deteriorate, to a point to a gradual return to trend with economic growth record 27.1 percent, in FY13, with adverse develop- returning to 4-4.5 percent and inflation remaining in ments in both exports and imports. Export growth single digits. The government of Nepal has ample scope decelerated to a mere 3.6 percent, from 15.4 percent to increase spending, while maintaining overall fiscal in FY12, while imports growth rose to 20.6 percent sustainability targets, an opportunity that ought to be compared to 16.5 percent the previous year. put to good use by boosting capital spending. While important psychologically, and for specific sectors of the economy, the Nepalese rupee’s deprecia-  nd Policy Outlook a tion is not expected to hold back growth or threaten macroeconomic stability. Nepal has important buffers Whether and how well Nepal manages the political against currency shocks, most notably strong remittance transition process will be a major determinant of eco- inflows. That said, specific sectors of the economy will be nomic progress going forward. There is considerable affected adversely. Of particular concern are (i) the finan- uncertainty still surrounding the elections scheduled for cial health of major SOEs, and (ii) possible inflationary November 19 – whether they will be delayed and how pressures, which will need to be managed proactively. consensual the outcome will be. If elections are held While a revision of the peg with India may eventually successfully, public and private investment are expected be warranted, Nepali policy makers that determined to pick up. that this is not the time – when markets are unstable – to move impulsively; instead, such a major policy shift Important initiatives to improve the governance should be based on clear policy objectives and in-depth environment have been taken, which could be analysis of likely economic outcomes, including the long broadened. In past months the government has tried term impact on Nepal’s trade competitiveness. a wake-up call 51 Pakistan On the supply side, growth continued to be domi- nated by the services sector, even as the sector decel- erated to 3.7 percent in 2012/13. Services accounted for 60 percent of economic growth, with agriculture and industries contributing 20 percent each. Weaken- ing profits in telecoms and transport and a slowdown in general government services overshadowed the im-  evelopments Recent Economic D proved performance of the wholesale & retail trade and finance & insurance sub-sectors. The latter reflected he Pakistan’s economy remains stuck in a low-invest- higher volume of commercial bank financing of the fis- ment, low-growth trap. Real GDP growth fell to a cal deficit and strong growth in State Bank of Pakistan modest 3.6 percent in 2012/13, from 4.4 percent the (SBP) profits. previous year, bringing the average for the last five years to 3 percent. The tepid performance has slowed Agricultural sector growth of 3.3 percent in 2012/13 poverty reduction and undermined progress in social was characterized by large differences between the services such as education. The 2012/13 slowdown was expected and actual outputs of various crops. Kharif due in part to a marked fall in private investment (to crops (particularly cotton and rice) were hit by heavy 10.3 percent of GDP), the lowest level in two decades. rains and localized flooding. Sugarcane production in Energy bottlenecks and security concerns are also Sindh rose because farmers had opted to sow a more major contributors to the slump. Inflation dropped resilient variety. Wheat, the staple crop of Pakistan, re- markedly to single digits (7.4 percent in 2012/13) due sponded quite well to better water availability, moder- to improved food supply, reduced demand, and lower ate temperatures, and a higher off-take of fertilizer. The inflationary expectations. However, pressure on prices sector was further supported by a steady performance from monetary expansion might push inflation back of the livestock sub-sector, and strong performance of into double digits. minor crops. Industrial sector growth was boosted to 3.5 percent Contributions to GDP Growth by the large-scale manufacturing (LSM), mining, and 8% quarrying sub-sectors. The LSM recovery was broad- 6% based as industries that account for about 80 percent 4% of manufacturing’s value added showed positive results. Negative results, however, continued to flow from the 2% consumer durables industries, especially automobiles 0% and electronics, reflecting bearish consumer sentiment. -2% -4% 2006/07 2007/08 2008/09 2009/10 2010/11 2011/12 2012/13 Private Sector Credit and Investment (% of GDP) 15.0 5.0 Consumption Total Investment Net External demand GDP Growth at FC 14.0 4.0 * Data on constant prices of 2005/06. 13.0 3.0 Source: Pakistan Economic Survey 12.0 2.0 11.0 1.0 10.0 Private-sector investment continued its long, slow decline of recent years, while consumption growth 9.0 0 was driven by strong workers’ remittance inflows 8.0 -1.0 and higher fiscal spending. The drop in private-sector FY07 FY08 FY09 FY10 FY11 FY12 FY13 investment stemmed largely from a shortage of bank credit to the private sector, which fell to -0.1 percent of Private Sector Credit Private Investment GDP in 2012/13. 52 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 Real Policy and Weighted Average Lending Rates 6.0 4.0 2.0 0.0 -2.0 -4.0 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Real WALR Real Policy Rate *Real rates calculated using YoY in ation Source: State Bank of Pakistan Data and WB Sta A large increase in the fiscal deficit was due in part debt categories, especially IMF financing. However, to a shortfall in budgeted revenue. Revenue collection, significant government borrowing increased domestic at Rs 1,936 billion, was Rs 445 billion (or 1.9 percent debt stock from 38 percent of GDP in 2011/12 to 41.5 of GDP) below the target set in the 2012 budget. The percent in 2012/13. shortfall was caused by sub-par collection of GST and direct taxes. And despite greater-than-budgeted Broad money creation was expansionary, growing disbursements from the Coalition Support Fund by 15.9 percent y-o-y in 2012/13. A large increase in (CSF) – i.e., reimbursements of the cost of the “war the financing requirements of the fiscal deficit raised on terror” by the US administration – non-tax revenue net domestic assets of the banking system by 21.1 fell short of the target by 0.8 percent of GDP, mainly percent (y-o-y) during 2012/13. Not only did the because revenue expected from the auction of 3-G government resort to inflationary borrowing from telecoms licenses failed to materialize for the third year the central bank (Rs 507 billion), it also borrowed in succession. Overall, consolidated revenue collection heavily from scheduled commercial banks (Rs 940 was 1.7 percent below the budget target, even counting billion), for net budgetary borrowing from the bank- revenue collected by the provinces. ing system of Rs 1,447 billion (38 percent growth y-o-y). The falloff in headline inflation, coupled with the low level of private investment, prompted the SBP to reduce the policy rate by a cumulative 300 bps during 2012/13. However, despite nominal easing, the  nd Policy Outlook a real policy rate remained positive. Nonetheless, as y-o- y inflation rose from 5.1 percent in May 2013 to 8.5 Pakistan is facing many crises at the same time: ter- percent in August 2013, the SBP raised the policy rate rorism, economic problems, and energy shortages. by 50 bps in September 2013. In this very difficult context, the country has elected a new government with a large majority. This has raised Public debt remained above the 60 percent threshold hopes that the new administration will be able to tackle set in the Fiscal Responsibility and Debt Limitation the implementation of a comprehensive reform agenda Act. Nevertheless, compared with last year’s level (63.8 necessary to help the country avoid a balance of pay- percent of GDP), the debt declined marginally to ments crisis and regain strong and sustained growth 62.9 percent of GDP. This resulted from the growth rates. in nominal GDP and the virtual absence of additional foreign debt creating inflows during the year. External The administration has moved swiftly to confront debt stood at US$59.6 billion at the end of 2012/13, the country’s economic woes, requesting a US$6.6 decreasing by a historic US$5.9 billion over the previ- billion loan under an Extended Fund Facility (EFF), ous year. Net flows were negative across most external which the IMF approved in early September. Within a wake-up call 53 the EFF, the government set out a bold program of State Bank of Pakistan rose, reducing the availability of stabilization and structural reforms for the next three private-sector credit. years aimed at reducing the risk of a crisis in the short term and regaining and sustaining high and inclusive Pakistan will not be able to recover without major growth in the medium term. As its initial steps, the structural reforms, especially in tax administration government pledges to focus on fiscal consolidation and the energy sector. The Federal Board of revenue, and strengthening the external situation. A well- responsible for collecting taxes, has tried to register implemented reform program will restore a framework tax evaders, remove zero ratings for domestic sales of for effective budget support from the World Bank and, selected export products, and raise excise duties on to- possibly, other donors which could address structural bacco, but with little success, as the tax ratio fell to 9.6 reforms in areas such as the power sector, business cli- percent of GDP. On the energy front, the government mate, SOEs, trade liberalization, and strengthening of balked again at increasing power tariffs and, as a result, the safety-net system. expenditures on the tariff differential subsidy reached Rs 349 billion – 1.5 percent of GDP. Meanwhile, the Pakistan’s weak external position remains the most financial losses of state-owned enterprises (SOEs) pressing short-term economic challenge. While the continue to bleed the budget. current account deficit remained small due to a mar- ginal improvement in export growth, deceleration in A cautious estimate would put GDP growth for imports associated with the economic slowdown and 2013/14 at the same level as last year. Fiscal adjustment inflows of workers’ remittance, falling financial inflows, might have a contractionary effect on the economy, and substantial debt amortization payments have re- as fiscal consolidation may fall disproportionately on sulted in a marked drawdown of foreign reserves. In public investment. However, all economic sectors have terms of import coverage, reserves declined from about shown significant resilience in the past year, agriculture 2.7 months by June 2012 to 1.5 months by June 2013 and large-scale manufacturing growth remains positive (1.2 months in September 2013). and should benefit from the government’s commitment to effectively address the energy bottlenecks and reduce Pakistan’s unsustainable fiscal imbalances compound security concerns, while reducing SOE losses and im- the current crisis and need urgent attention. The con- proving the services they deliver. Fiscal consolidation solidated fiscal deficit exceeded by a sizeable margin may also enhance general investor perceptions about the budgeted target, to return to 8 percent of GDP. the economy and government performance. Indeed, if Significant shortfalls in revenue and a sharp overrun reforms are adopted and implemented promptly, this in energy subsidies worsened the already-large fiscal would also contribute to keeping inflation low, thereby deficit. Moreover, restricted external financing, do- improving the investment climate. mestic bank borrowing, and direct financing from the Average Headline CPI In ation 20 16 12 8 4 0 2008/09 2009/10 2010/11 2011/12 2012/13 Actual Source: Federal Bureau of Statistics 54 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 Sri Lanka collection. The higher deficit is being financed through increased domestic bank borrowing. The country has been financing the current account deficit through external debt. From 2000-2012, short- and long-term external debt has been the main driver Recent EconomicDevelopments of capital inflows to Sri Lanka, accounting for an aver- age 70 percent of such funding. Of this, long-term debt Sri Lankan GDP grew by 6.8 percent in the second accounts for 80 percent of total sovereign external debt. quarter of 2013, on the back of expansion in both ser- High external debt could expose a country to numer- vices and industry despite slowing in agriculture. The ous risks, including exchange rate risk. Therefore there rate was broadly consistent with the average 6.4 percent is need to promote non-debt-creating capital inflows, annual growth rate of the past ten years, characterizing particularly FDI, to fund the current account deficit. a country that has weathered the uncertainties of the global economic environment. Growth also has been Portfolio debt ows increasing (% of GDP) inclusive, with poverty rates declining dramatically to 9 10 percent in 2010 from 22 percent in 2002. Sri Lanka growing relatively well 12 Regional Growth Comparison 10 5 QoQ annualized growth (%) 8 6 4 0 2 2000 2002 2004 2006 2008 2010 2012 Short Term Government Financing 0 Portfolio Investment Long Term Government Financing FDI -2 2012Q1 2012Q2 2012Q3 2012Q4 2013Q1 2013Q2 Remittances India Indonesia Malaysia Philippines Sri Lanka In the first half of 2013, the exports-to-GDP ratio continued its downward trend. Yet, owing to a steeper decline in the import bill, the trade deficit narrowed. Headline inflation continued to fall, along with food Buoyant worker remittance and tourism receipts fur- prices, while a tighter monetary policy environment ther reduced the pressure on the balance of payments. in 2012 was responsible for a drop in core inflation. However, the external sector remained vulnerable to sudden capital outflows. Monetary policy became expansionary in 2013 to stimulate growth by reducing policy rates and the FDI in Sri Lanka has increased but remains relatively statutory reserve ratio, and eliminating the credit low compared to other middle-income countries. In ceiling. Responding to these changes, private sector 2012, FDI in Sri Lanka reached 2 percent of GDP, credit is beginning to pick up. US$1.3 billion lower than the government’s target of US$2 billion for that year (although, 69 percent of total Although the management of fiscal spending has FDI (US$6.2 billion) over the past 35 years has accrued since been strengthened progressively over the past few 2006, indicating a clear upward trend). Much of the recent years, the fiscal balance deteriorated considerably foreign investment into Sri Lanka went into the manufac- in the first four months of 2013 due to low revenue turing sector (23 percent), telecoms (18 percent), and port a wake-up call 55 development (15 percent). In September, the Board of In- declining export-to-GDP ratio adversely affecting vestment began allowing would-be investors to make online the trade balance, and further nominal depreciation applications, thereby streamlining the application process. of the currency due to capital flight. The country hopes to attract US$2.1 billion in FDI this year. Rising losses by SOEs are adversely affecting private- sector credit growth and, therefore, investment and  nd Policy Outlook a GDP growth. The government may have to transfer additional resources to improve the balance sheets of GDP growth is expected to average 6.8 percent in these SOEs, which could also raise administered prices 2013, with acceleration through the second half of the to cover their costs. The latter could have an adverse in- year and into 2014, when the rate should normalize at flationary impact reducing overall consumption expen- about 7.4 percent. Growth will be led by strong per- diture and affecting export competitiveness negatively. formances of construction and services, with wholesale and retail trades benefiting from rising consumption Given that the growth in the two key export sectors, buoyed by the more accommodative monetary policy i.e., tea and apparel, remain stagnant, there is a risk stance and increasing remittance inflows. Positive ag- that there will be a continued decline in the exports- ricultural production growth may boost consumption to-GDP ratio. There needs to be a new thrust towards further. diversification of both product and export markets to ensure that the trade balance remains manageable. Three salient macroeconomic challenges face the Sri Lankan economy: Continued depreciation of the Indian rupee may have adverse effects on FDI inflows and tourist arrivals from 1. Raising the domestic savings rate to support India together with a decline in Sri Lanka’s exports to rising investment; that country, its biggest trading partner and source of tourism revenues. Further deprecation of the Indian 2. Increasing exports in order to generate jobs; and rupee would likely fuel imports from India which, ceteris paribus, could undermine Sri Lanka’s trade balance. 3. Improving FDI rather than external debt to cover the external payments deficit and add to reserves. External factors could be influential: the US Fed’s fu- ture decisions on tapering its stimulus program will Risks to the outlook include increased fiscal stress improve or limit Sri Lanka’s economic prospects, as due to anemic tax revenue growth, state-owned would growth levels in China and the euro zone, and enterprises incurring acute and persistent losses, a the performance of Japan’s fiscal stimulus. Growth expected to slightly moderate Raising Savings to support investment 10.0 25 9.0 20 8.0 15 7.0 % of GDP 10 6.0 5 5.0 0 4.0 2011Q1 2011Q2 2011Q3 2011Q4 2012Q1 2012Q2 2012Q3 2012Q4 2013Q1 2013Q2 2013Q3 2013Q4 2014Q1 2014Q2 2014Q3 2014Q4 -5 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 Private Savings Government Savings GDP growth q/q saar GDP growth y-o-y 56 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 South Asia at a Glance SAR     AFG (1) BGD (5) BTN (8) IND (10) MDV (15) NPL (18) PAK (22) LKA (28)   (32) 2010 8.4 6.1 10.0 10.5 (11) 7.1 4.8 3.7 8.0 10 2011 6.1 6.7 8.1 (prov) 6.3 7.0 3.4 4.4 8.2 7.2 2012 14.4 6.2 6.9 (e) 3.2 (e) 3.4 4.9 3.6 6.4 4.7 Real GDP Q4 .. .. .. 4.8 .. .. .. 6.3 4.8 Growth 2013 3.1 (p) 6.0 (e) 7.1 (p) 4(p) 4.3 (e) 3.6 (p) 3.5 (p) 6.8 (f ) 5.5 (f ) Q1 .. .. .. 4.4 .. .. .. 6.0 4.8 Q2 .. .. .. 4.4 .. .. .. 6.8 4.4 2010 7.7 6.8 5.7 10.4 6.2 9.5 13.7 6.2 10.0 2011 10.2 10.9 8.9 8.4 11.3 9.6 11.0 6.7 9.6 2012 6.4 8.7 9.1 10.4 10.9 8.3 7.4 7.5 9.4 Inflation 2013 7.1 (p) 6.8 (p) 7.6 7.74 (f ) 6 9.9 (e) 6.0 (p) 5.9 (f ) 6.04 (f ) (y-o-y) May 6.8 8.0 8.4 (Q1) 9.3 3.0 8.7 5.1 7.3 6.9 June 7.7 8.1 5.5 (Q2) 9.9 2.2 8.2 5.8 6.8 7.0 OUTPUT and PRICES July 9.1 7.8 .. 9.6 3.3 7.8 8.3 6.0 7.4   August   7.4         8.5     2010 9.8 (2) 4.8 .. 5.0 .. 5.8 9.3 7 (29) .. 2011 14.6 6.8 .. 7.3 .. 6.4 9.9 6.9 .. 2012 6.6 11.5 .. 5.4 .. 10.7 10.6 5.8 .. Core Inflation 2013 6.8 (p) 7.5 (6) .. 4.9 .. 9.9 (19) 9.8 (23) 4.3 (H1) .. May 6.2 .. .. 2.5 (12) .. .. .. .. .. June 6.9 .. .. 2.2 .. .. .. .. .. July 8.2 .. .. 2.3 .. .. .. .. .. 2010 -1.4 10.1 10 (Q4) 14.2 12.4 15.1 .. 6.9 11.4 2011 12.1 12.8 9 (Q4) 7.9 12.0 14.7 11 9.0 11.4 2012 4.6 7.5 12 (Q4) 8.1 -8.0 7.6 9 5.0 4.9 Food Inflation 2013 .. 7.8 .. 9.3 -2.0 9.7 8 12.0 .. May 5.2 8.1 .. 10.7 5.3 7.8 .. 3.5 6.8 June 7.0 8.3 .. 10.3 3.8 8.4 .. 3.3 7.1 July 9.7 8.1 .. 11.1 7.9 8.8 .. 2.7 8.1 a wake-up call 57 SAR     AFG (1) BGD (5) BTN (8) IND (10) MDV (15) NPL (18) PAK (22) LKA (28)   (32) -21.5 2010 2.8 (3) 3.7 -2.8 -9.2 -2.4 -2.2 -2.2 -2.6 (prov) Current 2011 3.1 0.8 -19.3 (p) -2.7 -21.4 -1.0 -2.1 -7.8 -3.1 Account (% 2012 3.9 -0.4 -19.4 (p) -4.18 (e) -27.1 4.8 -1.0 -6.5 -4.5 of GDP) Q4 .. .. .. 3.6 .. .. .. .. .. 2013 2.5 (p) 1.9 (p) -29.7 (p) -4.78 (p) -27.9 (e) 3.3 (e) -1.7 (e) -3.9 (p) -3.7 (f ) 2010 -45.9 -5.2 -7.9 -7.5 15.1 (e)(16) -26.2 -0.5 -9.7 -5 Trade Balance 2011 -42 -6.9 -31 -8.8 3 (e) -25.8 -8 -16.5 -6 (% of GDP) 2012 -41.9 -7.8 -32.3 -10.9 -3.1 (e) -24.3 -7.4 (p) -15.9 .. 2013 -41.6 (e) -5 (p) -28.3 .. -6 (p) -27.1 .. -13.3 (p) .. 2010 5.1 5.5 36.9 (e) 28.8 -6.5 10.2 4.7 34.5 16.0 2011 2.7 41.8 39.4 (e) 24.2 24.0 3.4 12.8 50.0 17.8 BALANCE of PAYMENTS 2012 11.2 9.9 -3.3 (e) 1.1 (e) 20.4 16.5 -1.6 -5.8 8.6 Import 2013 .. 0.8 2.4 (p) 7.8 (p) .. 20.6 6 (e) 11 (e) 5.8 (f ) Growth May .. .. .. 7.0 1.9 .. .. .. .. June .. .. .. -0.4 6.7 .. .. .. .. July .. 7.9 .. -6.2 8.3 .. .. .. .. 2010 4.7 4.1 7.1 (e) 37.5 -18.6 .. 7.0 17.1 14.0 2011 1.8 41.5 21.8 (e) 17.9 55.1 .. -2.6 22.4 16.7 2012 2.7 5.9 -1.6 (e) 0.3 (e) 22.6 15.4 0.2 -7.4 4.5 Export 2013 -2 (e) 11.2 4.2 (p) 15.7 (p) .. 3.6 (p) .. 7 (e) 5.9 (f ) Growth May .. .. .. -3.3 -7.9 .. .. .. .. June .. .. .. -4.6 -8.5 .. .. .. .. 23.9 14.6 July .. .. 11.6 -7.2 .. .. .. .. (Jul-Aug) 2010 .. 10.9 (7) -0.1 54 (13) -0.2 3.5 (20) 9.7 (24) 4.2 (30) 82 (33) Remittances 2011 .. 12.1 -0.1 63 -0.2 4.2 13.2 5.2 97 (US$ billion) 2012 .. 13.7 (e) .. 69.8 (e) .. 5.1 (e) 13.9 6.3 (e) 109 ( e )     AFG (1) BGD (5) BTN (8) IND (10) MDV (15) NPL (18) PAK (22) LKA (28) SAR (32)   58 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 SAR       AFG (1) BGD (5) BTN (8) IND (10) MDV (15) NPL (18) PAK (22) LKA (28) (32) 2010 0.9 (4) -3.7 1.6 -7.6 -15.7 -0.8 -5.9 (25) -8 -8.7 2011 -1.2 -4.0 -1.1 -8.1 -11.3 -1.0 -8.4 -6.9 -7.6 Fiscal Deficit 2012 -0.8 -4.1 -0.9 -7.0 (e) -13.4 1.9 -7.7 -6.4 -9 ( e ) (% of GDP) Q4 .. .. .. .. .. .. -8 .. .. 2013 -0.6 (p) -4.3 -3.7 (b) -7.3 (p) -11.0 (e) -0.8 -5.5 (p) -5.8 (p) -8.3 (f ) 2010 13.8 42.9 54 (e) 67.9 65.7 35.4 61.6 (26) 81.9 .. 2011 13.2 44.2 68.8 67.9 72.4 33.4 59.4 78.5 .. Public Debt 2012 11 (e) 42.8 94 (r) 68.7 (f ) 80.4 29.6 63.8 79.1 .. to GDP (%) GOVERNMENT FINANCES and MACRO POLICIES Q4 .. .. .. .. .. .. 62.9 .. .. 2013 .. 41.3 (p) 97.2 (b) 70.8 (p) 86.2 (f ) 27.8 (e) 62.9 75.0 (p) .. 2010 6.7 3.4 10.5 7.1 3.9 5.4 3.7 5.9 7 2011 6.9 3.9 25.4 (prov) 6.8 (14) 2.7 5.8 2.9 3.5 .. 2012 7.7 3.3 27.8 (p) 6.6 2.4 7.2 .. 4.3 .. Reserves H1 .. .. .. .. .. .. 2.7 (June) .. .. in Months of Import 2013 7.3 (p) 4.6 23 (p) .. 2.6 (e) 7.6 (e) .. 4.2 (p) .. 4.1 H1 .. 11 (June) 6.58 (Feb) 2.4 (Jan)   1.5 (June .. .. (December) H2 .. 3.7 (Jul-Aug) .. .. 2.6 (Jul) 10.1 (Jul) 1.2 (Sept) .. .. 2010 114.4 108.3 97.4 (9) 99.3 124.5 (17) 54.1 (21) 71.9 (27) 81.9 (31) 99.8 2011 126.2 108.9 98.6 (p) 96.8 135.0 46.0 66.8 57.34 97.9 REER 2012 127 105.2 .. 90.7 120.3 40.3 52.9 47.8 92.7 2013 .. 111.6 (p) .. 88.5 .. .. .. .. 90.6 Q1 127.3 .. .. .. 95.7 47.1 42.3 40.8 .. s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 a wake-up call 59 SAR       AFG (1) BGD (5) BTN (8) IND (10) MDV (15) NPL (18) PAK (22) LKA (28) (32) 2010 120 80 66.3 (e) 72.5 .. 88 90 66 .. 2011 120 81 64.1 (e) 72.8 .. 91 92 70 .. Consumption (% of GDP) 2012 .. 81 63.2 (e) 77 (p) .. 80 .. 69 (e) .. 2013 .. 81 60.7 (p) 75.5 (p) .. 88 .. .. .. 2010 27 24.4 51.6 (e) 31.7 .. 32.5 16 28 28 2011 25 25.2 59.4 (e) 30.6 .. 32.8 12.5 30 27 Investment (% of GDP) 2012 .. 26.5 61.8 (e) 30.5 (p) .. .. 11 28 (e) .. 2013 .. 26.8 65 (p) 31.3 (p) .. .. .. .. .. CONSUMPTION and INVESTMENT 2010 .. 0.9 0.1 9.4 0. 22 (e) 0.1 1.6 0.9 30.4 2011 .. 0.8 0.37 (prov) 22.1 0. 28 (e) 0.1 0.7 1.5 35.7 2012 .. 1.2 0.1 (p) 19.8 (e) 0.16 (e) 0.1 1.2 1.4 29.7 (e) FDI (US$ billion) Q4   .. .. 2.1 .. .. .. .. .. 2013 .. 1.3 0.01 (p) 20 (p) 0.22 (p) .. .. 2.1 (p) 36.9 (e) Q1 .. .. .. 5.7 .. .. ..   .. 2010 .. -0.12 .. 28.2 .. 0.0 0.3 -0.46 29.9 2011 .. -0.03 .. 16.6 .. 0.0 -0.14 -0.29 -4.8 Portfolio 2012 .. 0.24 .. 26.7 (e) .. 0.0 0.03 0.5 11.5 (e) Investment (US$ billion) Q4       9.8         2013 .. 0.29 .. 22 (p) .. .. .. .. 16.4 (f ) Q1       11.3           60 s o u t h a s i a e c o n o m i c f o c u s fa l l 2013 Notes b Budgeted e Estimate f Forecast p Projections prov Provisional r Revised Afghanistan 1 These numbers are for calendar year unless otherwise mentioned 2 Core inflation (exc. Fuel and cereal, %) 3 Including grants 4 Including grants Bangladesh 5 These numbers are for fiscal year unless otherwise mentioned. For example; for 2012 numbers, 2012-2013 values are used. 6 (Avg of Jan-Feb) 7 Remittances numbers are taken from GEP 2013 Jan report and they are calendar year numbers (US$ billions) Bhutan 8 These numbers are for fiscal year unless otherwise mentioned. For example; for 2010 numbers, 2010-2011 values are used. 9 WB Staff Calculations India 10 These numbers are for fiscal year unless otherwise mentioned. For example; for 2012 numbers, 2012-2013 values are used. 11 Real GDP Growth ( at market prices) 12 WPI Core Inflation 13 Remittances numbers are taken from GEP 2013 Jan report and they are calendar year numbers (US$ billions) 14 Calendar year for 2011 and 2012 Maldives 15 These numbers are for calendar year unless otherwise mentioned. 16 WB Staff Calculations 17 WB Staff Calculations a wake-up call 61 Nepal 18 These numbers are for fiscal year unless otherwise mentioned. For example; for 2012 numbers, 2012-2013 values are used. 19 (Avg of Jan-Feb) 20 Remittances numbers are taken from GEP 2013 Jan report and they are calendar year numbers (US$ billions) 21 WB Staff Calculations Pakistan 22 These numbers are for fiscal year unless otherwise mentioned. For example; for 2012 numbers, 2012-2013 values are used. 23 (Avg of Jan-Feb) 24 Remittances numbers are taken from GEP 2013 Jan report and they are calendar year numbers (US$ billions) 25 Including grants 26 Data is end of the year for 2010-2013 27 WB Staff Calculations Sri Lanka 28 These numbers are for calendar year unless otherwise mentioned. 29 (Avg of Jan-Feb for 2010-2012) Remittances numbers are taken from GEP 2013 Jan report and they are calendar 30 year values which is same as the fiscal year (US$ billions) 31 WB Staff Calculations SAR 32 These numbers are for calendar year unless otherwise mentioned. 33 Remittances numbers are taken from GEP 2013 Jan report and they are calendar year numbers (US$ billions) 1818 H Street, N.W. Washington, DC 20433