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ISBN (electronic): 978-0-8213-9979-8 DOI: 10.1596/978-0-8213-9979-8 South Asia Economic Focus Spring 2013 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 benefitted from inputs by country teams in the Poverty Reduction and Economic Management unit (SASEP) as well as Sanket Mohapatra and colleagues, with guidance of Andrew Burns in the Development Economics Prospect Group (DECPG). Economists providing information for country briefs include Deepak Bhattasali, Zahid Hussain, Au- relien Kruse, Chandana Kularatne, Claudia Nassif, Denis Medvedev, Jose Lopez Calix, Kirthisri Rajatha Wijeweera, Susan R. Razzaz, Saadia Refaqat, Thirumalai G. Srinivasan 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 byBilgehan Gokcen , Ayesha Raheem and Amir Sadegh Sadeghi. 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. Design: Alejandro Espinosa/sonideas Photo: © World Bank /Scott Wallace 6 South Asia Economic Focus Table of Contents I. Recent Economic Developments····························································································································································································9 a. Growth shows signs of stabilization significantly below pre-crisis levels···························································································· 9 b. Core inflation has eased, but headline inflation remains high due to food prices··································································11 c. The policy stance remains accommodative, but some countries recover fiscal space························································12 d. Current account deficits have been widening, but remittance flows held up well································································14 e. Capital inflows are increasingly dependent on volatile portfolio investments···········································································17 II. Outlook and Policy················································································································································································································································21 a. The region remains vulnerable in light of continuing near-term uncertainty·············································································22 b. Uncertainty on policy orientations is bound to affect investment·········································································································23 III. Focus: The Investment Climate as the Key to Regain Momentum·············································27 a. Much of the economic slowdown can be traced back to slow investment····················································································27 b. FDI has expanded in most countries, but goes mainly into the services sector········································································28 c. FDI inflows bear the potential to boost overall investment and growth ·························································································30 IV. South Asia Country Briefs····················································································································································································································35 Afghanistan·······················································································································································································································································································36  ecent Economic Developments···································································································································································································36 R  Outlook and Policy·······································································································································································································································37 Bangladesh·························································································································································································································································································38  ecent Economic Developments···································································································································································································38 R Outlook and Policy·······································································································································································································································39  Spring 2013 7 Bhutan··········································································································································································································································································································41  ecent Economic Developments···································································································································································································41 R Outlook and Policy·······································································································································································································································41  India··················································································································································································································································································································42  ecent Economic Developments···································································································································································································42 R Outlook and Policy·······································································································································································································································43  Maldives····································································································································································································································································································46  ecent Economic Developments···································································································································································································46 R  Outlook and Policy·······································································································································································································································46 Nepal···············································································································································································································································································································48  ecent Economic Developments···································································································································································································48 R Outlook and Policy·······································································································································································································································49  Pakistan·····································································································································································································································································································50  ecent Economic Developments···································································································································································································50 R  Outlook and Policy·······································································································································································································································51 Sri Lanka···································································································································································································································································································53 Recent Economic Developments···································································································································································································53 Outlook and Policy·······································································································································································································································54  V. South Asia at a Glance···································································································································································································································57 Notes: (Table South Asia at a glance)·····················································································································································································59 South Asia Economic Focus Spring 2013 9 I Recent Economic Developments T o regain the strong growth it had before 1). Due to its size and regional importance, India’s the global crisis, South Asia will have economy continues to significantly affect other to manage a combination of persistent countries, particularly Nepal.1 India accounts for external economic headwinds and in- about 80 percent of South Asia’s GDP; its real GDP creasing regional macroeconomic and growth (at market prices) is projected at 4.7 percent structural vulnerabilities. Macroeconomic policies for FY2012/13, down from an actual 6.3 percent in to tackle the adverse effects of the global downturn FY2011/12. Most recently, during Q3 of FY 2012/13 have left the South Asian countries with weaker real GDP growth at factor cost slipped to a 15-quar- fiscal and monetary options to stimulate growth ter low of 4.5 percent (year-over-year), compared today. Against this background, countries will need to 5.3 percent in the previous quarter. Pakistan, the to confront the economic slowdown and a still- region’s second largest economy with about 8 percent tumultuous external environment with continuing of regional GDP, faces a stagnant environment where action to boost productivity and investment. The factor-cost GDP growth is estimated at 3.5 percent options are well known to the region’s policy-makers in FY2012/13, with a negative outlook, down from and progress has been made, but keeping ahead of an actual 3.7 percent in FY2011/12. the global curve will require a deepening of commit- ment to growth. With the exception of Afghanistan, economic growth across other South Asian countries— Bangladesh, Bhutan, Maldives, Nepal, and Sri Lanka—has been moderating or stagnating. In A. Growth shows signs of Bangladesh, with export and investment growth stabilization significantly slowing, GDP growth is likely to fall to around 6 below pre-crisis levels percent in FY2013/14, down from 6.3 percent in FY2012/13. Over the same period, Bhutan saw its growth rate decline from almost 9 percent to 7.6 South Asian economies managed the turbulence of percent. For Nepal, public spending dropped sharply, Photo: © World Bank/Simone D. McCourtie the financial and economic crisis reasonably well; however, post-crisis real GDP growth rates have moderated and remain well below pre-crisis rates. Partly, this reflects a return to more sustainable levels 1 Growth spillover effects may occur through such direct linkages as trade and financial flows as well as such indirect linkages as total factor productivity (TFP) or of growth, but current rates leave the region below its business confidence. “India’s Growth Spillovers to SA,” a recent IMF WP (12/56) by Ding and Masha, conducts panel regressions with country fixed effects and, controlling for potential. Overall, regional growth slowed from 7.2 standard drivers of growth, estimates that real GDP growth in India is significantly percent in calendar year (CY) 2011 to 4.7 percent in affecting SAR growth rates over the post-reform period of 1995-2007. A 1 percentage point increase in India’s growth rate implies a 0.37-0.77 percentage point increase in CY2012, mainly driven by India’s slowdown (Figure the regional growth rate. 10 South Asia Economic Focus GDP growth across the region has slowed down but appears to stabilize (percent, constant 2005 USD) FIGURE 1:  15 20.0 15.0 10 10.0 5.0 5 0.0 -5.0 0 -10.0 2005 2006 2007 2008 2009 2010 2011 2013f 2005 2006 2007 2008 2009 2010 2011 2013F Afghanistan Bangladesh SAR SAR minus INDIA Bhutan Maldives INDIA PAK Nepal Sri Lanka Source: World Bank, IMF and National Authorities FIGURE 2: Declining trade and investment have caused South Asian growth to slow (GDP at market prices; annual percentage change) % 00-09 2010 2011 2012 2013f 25 20 15 10 5 0 -5 -10 Private consumption Public consumption Fixed Investment Exports, GNFS Imports, GNFS SAR CA as a % of GDP Real GDP Growth Source: World Bank Sta Calculations agricultural performance was meager, and India’s A significant drop in the region’s exports and fixed economy slowed significantly. As a result, growth of investment are primarily responsible for South a subdued 3 percent is expected in FY2012/13, down Asia’s growth moderation. Private consumption from 4.6 percent in FY2011/12. The crisis depressed remained stable, helped by resilient remittance flows, Maldives’ tourism sector, contributing to a decline and is expected to only pick up slowly due to effects in real GDP growth from 7 percent in 2011 to 3.4 of persistent inflation, fiscal consolidation and slow percent in 2012. Sri Lanka, facing prudent macro- recovery in disposable income. Fiscal constraints have economic policies and dampened demand in main led to decreasing public consumption and investment. export markets, will see estimated growth of 6.4 Export growth has plummeted from 16.5 percent in percent in 2012, compared to 8.3 percent in 2011. In 2011 to 4.5 percent in 2012, and is forecast to stay Afghanistan, the regional outlier, real GDP growth weak due to slow and uncertain recoveries in Europe for 2012 is estimated at 11.8 percent, up from 7.3 and the US. Fixed investment growth has dropped to percent in 2011. a low of 2.6 percent in 2012, less than half of its 2011 rate and down from 12.3 percent in 2010 (Figure 2). Spring 2013 11 Industrial production across main South Asian economies remains sluggish (monthly; y-o-y; percent) FIGURE 3:  30 20 10 0 -10 -20 2006M12 2007M12 2008M12 2009M12 2010M12 2011M12 2012M12 India IndProduction Pakistan IndProduction Sri Lanka IndProduction Source: IMF IFS, Central Bank of Sri Lanka After recovering in CY2009-10, regional industrial headline inflation (year-over-year) was 9.8 percent in production has been trending downwards and re- February 2013, and Nepal’s was 9.5 percent. Bhutan’s mains sluggish, particularly in India, Pakistan, and inflation rose to 13.5 percent in the second quarter Sri Lanka. The slowdown has been caused by a mix of FY2012/13. of weak external demand and structural supply-side constraints in domestic economies (Figure 3). Most Core inflation fell across several countries, includ- recently, India saw its mining sector activity slow ing Bangladesh, India, and Pakistan, while food down and its IIP (Index of Industrial Production for and fuel price inflation continues as the main core sectors) registered a contraction of 2.5 percent impetus driving South Asian headline inflation for February 2013, down from 3.1 percent in January, (Figure 4). Recently, lower food prices—mostly with five of the eight sectors — coal, crude oil, natu- due to favorable weather and international market ral gas, fertilizers and electricity seeing declines in conditions—helped push down headline inflation output and none of the sectors expanding faster than in Pakistan (though equally driven by core nonfood a year ago. Overall IP expanded 0.6 percent y-o-y in prices), Maldives, and Afghanistan. In India, year- February, 2013, down from 2.4 percent in January. over-year core inflation was 3.8 percent in February 2013, but prices increased 10.7 percent for food and 10.5 percent for fuel. In January 2013, Sri Lanka’s year-over-year food inflation was 12.9 percent, well B. Core inflation has eased, above the nonfood inflation of 7.2 percent. Unfavor- but headline inflation remains able harvests and balance of payments developments high due to food prices in Bhutan pushed food-price inflation to 18.4 per- cent for the second quarter of FY2012/13, compared with nonfood inflation of 10.7 percent. Headline inflation has recently moderated across SAR countries; however, it remains at relatively Notable exceptions to this regional trend are Ban- high rates, with recent signs of an upswing mainly gladesh and Nepal, where non-food prices have due to food prices. Most recent data indicate a CPI recently driven headline inflation. In Bangladesh, increase in India from 8.8 percent (year-over-year) the rise in annual headline inflation from 8.8 percent in February 2012 to 10.9 percent in February 2013 in FY2011/12 to 10.6 percent in FY2012/13 was ac- with a slight decline to 10.4 percent in March 2013, tually driven by non-food price inflation, most likely however Wholesale Price Index (WPI) inflation through upward adjustments of administered energy surprised positively in March 2013 with 5.95 per- prices as well as expansionary macroeconomic policy. cent, down from February’s 6.8 percent. Sri Lanka’s However, lower food price inflation during 2012 12 South Asia Economic Focus South Asian core inflation trended downwards with food prices keeping headline inflation high FIGURE 4:  (percentage change, y-o-y) 20.00 15.00 10.00 5.0- 0.00 -5.00 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 SAR (Headline in ation) SAR (Food in ation) BRICS In ation India (Core in ation) Afghanistan (Core in ation) Sri Lanka (Core In ation) Source: CEIC and National Authorities South Asian real interest rates paint a mixed picture FIGURE 5:  12.000 9.000 6.000 3.000 0.000 -3.000 -6.000 -9.000 -12.000 9/2010 10/2010 11/2010 12/2010 1/2011 2/2011 3/2011 4/2011 5/2011 6/2011 7/2011 8/2011 9/2011 10/2011 11/2011 12/011 1/2012 2/2012 3/2012 4/2012 5/2012 6/2012 7/2012 8/2012 9/2012 10/2012 11/2012 12/2012 1/2013 2/2013 Bangladesh Nepal India Sri Lanka Pakistan Source: World Bank and CEIC has helped reduce overall inflation to 8.2 percent in C. The policy stance remains February 2013. In Nepal, higher headline inflation— accommodative, but some from 4.2 percent in May 2012 to 11.8 percent in countries recover fiscal space December to 9.6 percent in February 2013—comes from increasing commodity prices, the deprecia- tion of the Nepali rupee, and structural supply-side With the exceptions of Sri Lanka and India, real constraints. interest rates remain negative for major South Asian economies, suggesting that monetary policy’s overall stance has been broadly accom- modative (Figure 5). Negative real interest rates (RIR) signal an easy monetary policy stance for many South Asian countries, suggesting the need Spring 2013 13 FIGURE 6: South Asia Region’s (SAR) fiscal space Today, most countries in South Asia are con- remains limited (percent of GDP) strained in the fiscal policy space they have to 80 10 buffer potential external shocks, leaving them 9 much more vulnerable to adverse events. With 70 the exception of Bangladesh, space for fiscal and 8 monetary stimulus is more limited now than it was 7 in the aftermath of the global crisis (Figure 6). In 60 6 addition, those countries in difficult economic and political situations face severe difficulties in starting 5 50 to rebuild their buffers. Fiscal deficit constitutes a 4 major concern in Pakistan, where revenue shortfalls 40 3 coupled with an electricity subsidy overrun have lifted the projected consolidated FY2012/13 bud- 2 get deficit above 7 percent of GDP, well above the 30 1 targeted 4.7 percent (Figure 7). By contrast, India’s situation has shown some improvement. Using the 20 0 2008 2010 2012 World Bank definition, which discounts one-time SAR Public External Debt (left axis) divestments from revenues, the FY2012/13 central government deficit came in at 5.4 percent of GDP, SAR Public Domestic Debt (left axis) 0.6 percent of GDP lower than the previous year and SAR Fiscal De cit (right axis) significantly below the peak deficit of 6.8 percent in Source: World Bank Sta Calculations FY2009/10. Maldives had the region’s largest deficit in FY2011/12—and the largest projected deficit in FY2012/13. for central banks to tighten policy to restore posi- tive real interest rates return. India’s positive RIR Some countries have executed prudent fiscal man- and softening core inflation have led the Reserve agement to rebuild buffers. Bangladesh achieved Bank of India to recently ease monetary policy a budget deficit below the target of 5 percent of slightly by reducing its repo rate by 25 basis points GDP (excluding grants); to better its financing, the in January and March 2013, down to 7.5 percent. country is using more concessional resources and However, rates remain relatively high by historical less domestic bank financing. The external position standards. is stable, and international reserves reached a record FIGURE 7:Recent trends suggest many South Asian countries have started to rebuild buffers (fiscal deficit to GDP (percent)) Afghanistan Bangladesh Sri Lanka Maldives Pakistan Bhutan Nepal India 5 0 -5 -10 -15 -20 -25 2007 2008 2009 2010 2011 2012 2013 projection Source: World Bank and IMF 14 South Asia Economic Focus Public debt to GDP (percent) shows little movement and broadly remains at manageable levels. FIGURE 8:  100 90 80 70 60 50 40 30 20 10 0 2007 2008 2009 2010 2011 2012 Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka Source: CEIC, IMF WEO and World Bank sta calculations USD 13.6 billion in March 2013. Nepal’s fiscal posi- D. Current account deficits tion remains comfortable. As tax collections remain have been widening, but high, total revenues and grants are expected to exceed remittance flows held up well expenditure by 3.6 percentage points of GDP, with the Government a net lender. South Asian countries’ current account deficits, Debt-to-GDP ratios have remained fairly stable particularly the larger than expected increase in across the region (Figure 8). Slowing growth stalled India, imply the growing need for ongoing capital India’s debt ratio reductions, begun in FY2002/03. inflows (Figure 9). India’s current account deficit has In the current fiscal year, the country debt load is widened to 6.7 percent of GDP for Q3/FY2012/13, projected at 67.9 percent, remaining close to the up from 4.4 percent for Q3/FY2011/12, signaling FY2011/12 level of 67.6 percent. Standing at 58 weakening external demand as well as domestic percent of GDP at the end of December 2012, Paki- supply-side constraints. While India remains capable stan’s debt ratio maintains an upward trajectory, and of financing its current account deficit, Bangladesh, it is projected to reach 64.5 percent for FY2012/13. Maldives, and Pakistan may find themselves in While both Bhutan and Maldives may have higher more difficult situations, struggling to prevent their debt levels, Bhutan is capable of managing its debt economies from shrinking and managing a smooth and Maldives risks problems with debt sustainability adjustment of their currencies. in the medium term. Bhutan’s high debt is tied to commercially viable hydropower projects, and Indian South Asia’s trade balance remains negative, energy demand is set to remain high. Maldives exter- with both export and import growth significantly nal debt obligations, including the public and private slowing across countries. Recovery is expected to sectors, probably reached 86 percent of GDP in be slow due to continued demand weakness in the 2012, and they are projected to rise to 115 percent by Euro Area, the region’s most important export mar- 2015, a difficult development in light of the country’s ket. India’s record current account deficit widening increasing balance of payments pressures. was mainly fueled by its growing trade deficit, with merchandise trade deficit increasing from 10 percent to 11 percent of GDP. During January and February 2013, however, merchandise exports start- ed to pick up, reducing the year-over-year export decline from 7 percent in April through December to 5 percent April through February. Meanwhile, Spring 2013 15 FIGURE 9:Current account deficits (percent of GDP) will challenge some South Asian economies 00-09 (avg) 2010 2011 2012 2013 2014 3.00 -2.00 -7.00 -12.00 -17.00 -22.00 -27.00 -32.00 Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka Source: World Bank (Bangladesh, India, Nepal, Pakistan, Sri Lanka); IMF WEO (Afghanistan, Bhutan, Maldives) FIGURE 10: Export growth (above) and Import Growth (below) dropped, though export slowing outpaced declining import growth % 50 40 30 20 10 0 2008 2009 2010 2011 2012 -10 -20 -30 Afghanistan Bangladesh India Maldives Sri Lanka Pakistan Nepal Bhutan % 50 0 2008 2009 2010 2011 2012 -50 Afghanistan Bangladesh India Maldives Sri Lanka Nepal Bhutan Sources: World Bank Sta Calculations and IMF DOTS growth in merchandise imports slowed to 1 per- deficit improve only marginally, driven by import cent, down from 33 percent for the same period a contraction due to overall slowdown in productive year earlier (Figure 10). Overall import growth re- activity. In Maldives, import growth drove most of mains positive, but the boost received through gold the current account deficit widening during 2012, imports has weakened with gold imports growing while import slowdowns helped improve the trade by 5.6 percent between April and December 2012, balances in Sri Lanka and Bangladesh. Sri Lanka’s down by 9 percent (in USD terms) when compared share of exports to GDP continues to decline. Af- to the same period last year. Pakistan saw its trade ghanistan’s large trade deficit of 43 percent of GDP 16 South Asia Economic Focus FIGURE 11: Depreciating real effective exchange rates reflect weak fundamentals, 3-month crawling average (Index 2005=100) 80 200 70 60 150 50 40 100 30 20 50 10 0 0 Mar-11 May11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 BDG IND NPL PAK LKA AFG (right axis) MDV (right axis) Source: World Bank Sta Calculations FIGURE 12: Resilient migrant remittance flows (USD billions) partly offset trade deficits to balance current accounts. 120 30.0 100 20.0 80 10.0 60 0 40 -10.0 -20.0 20 -30.0 0 2005 2006 2007 2008 2009 2010 2011 2012e Bangladesh India Nepal Pakistan Sri Lanka Bangladesh India Nepal Sri Lanka Remittances Trade De cit Pakistan SAR Current Account Balance Source: World Bank Sources: World Bank, IMF WEO and CEIC remains a major issue as exports continue to decline The overall real effective exchange rate deprecia- in spite of currency depreciation, suggesting major tion across South Asia reflects weak economic fun- capacity constraints. Nepal’s trade deficit continues damentals. For Bangladesh and Sri Lanka, flexible to grow by 1 percentage point per year, with con- nominal exchange rates (depreciation/devaluation) strained export performance and growing imports clearly have been helping offset relatively high infla- six times the value of export earnings. Lastly, Bhu- tion rates vis-à-vis main trading partners, moderating tan’s export performance remains volatile due to the negative impact on competitiveness (Figure 11). weather induced weaker electricity exports in 2012. In India, the real effective exchange rate remained Overall, while the eurozone may remain subject to fairly constant, suggesting a fairly stable economy weak demand for time to come, the US recovery that remained sufficiently capitalized. In Pakistan, may help boost South Asian exports in the middle the central bank has kept nominal exchange rates term. fairly stable despite the country’s weak fundamentals, Spring 2013 17 FIGURE 13: South Asian capital flows (USD billion) become increasingly dependent on net portfolio flows 130 80 30 -20 2008 2009 2010 2011 2012e 2013f Net Portfolio In ows Net FDI In ows Net Equity In ows Source: World Bank accepting the costs of diminished international re- E. Capital inflows are serves and decreasing competitiveness in exchange increasingly dependent on for near term interest rate stability. Ultimately, the volatile portfolio investments Maldives’ announced depreciation of 2011 reflects the catching up of nominal exchange rates with fundamentals. South Asia’s fixed investment declined in 2012, while total private net inflows are estimated to Remittances have proven fairly resilient, helping remain at 2011 levels, driven by more volatile net to sustain consumption and mitigate trade balance portfolio flows. Overall, net FDI inflows totaled an effects (Figure 12). For 2012, South Asia’s remit- estimated USD 29.7 billion in CY2012, down from tances are estimated at USD 109 billion, up from USD 35.7 billion in 2011 and USD 50.8 billion in USD 97 billion in 2011. India experienced robust 2008 (Figure 13). The sharpest FDI decline was in inflows, increasing to 1.7 percent of GDP during Pakistan, which fell to one-third its FY2010/11 level. Q1-Q3 FY2012/13, up from 1.6 percent a year ago. The decline reflected market concerns about security, Pakistan benefitted from strong remittance growth structural energy constraints, and weak growth pros- of 10.4 percent between July 2012 and January 2013, pects and contributed to a significantly weakened helping the country avoid a complete balance of pay- external position. In India, FDI has been bouncing ments collapse—for now. In Nepal, estimated remit- back after a slump of USD 9.4 billion in FY 2009/10 tances reached 23 percent of GDP for FY2011/12, to a projected USD 20 billion for FY 2012/13, al- enough to cover the economy’s net deficit. However, though it declined 26 percent (year-over-year) dur- this may not be sustainable. Compared to the previ- ing Q1-Q3 of FY2012/13, a likely result of weaker ous fiscal year, Bangladesh had a solid 17.3 percent business sentiment and policy uncertainty. Regional growth in remittance inflows during the first eight net portfolio investment inflows have proven volatile months of FY2012/13. Sri Lanka relied on remit- in recent years, with a collapse of almost USD 5 bil- tances—up 16 percent to 10 percent of GDP—as a lion in 2011 followed by some returning momentum cushion for its widening current account deficit. at USD 11.5 billion in 2012. With FDI dropping and IMF debt repayments underway, subdued port- folio investment in Pakistan could not help alleviate the overall balance of payments stress. India, falling in line with other emerging market economies, could increase its net year-over-year portfolio investment inflows from USD 0.8 billion to USD 5.6 billion in the first half of FY2012/13. 18 South Asia Economic Focus FIGURE 14: International reserves in months of import coverage 14 12 10 8 6 4 2 0 2007 2008 2009 2010 2011 2012 Afghanistan Bangladesh Bhutan India Maldives! Nepal Sri Lanka Pakistan Source: CEIC, IMF WEO, IMF Article IV Consultations and World Bank Sta Calculations International gross reserves fell below levels of two months of import coverage in Pakistan as well as the Maldives, partly reflecting the two countries' difficult external situations. During the first eight months of FY2012/13, Pakistan’s net international reserves fell to 1.8 months, down from 2.6 months in the previous fiscal year (Figure 14). This reduction was mainly driven by a sudden stop in FDI inflows. Aggravated by high fiscal deficits and recent debt settlements, also the Maldives saw their gross official international reserves deteriorate below two months of import coverage in February 2013, exacerbating Maldives’ vulnerable situation in the face of weak tourism and potential commodity price hikes. South Asia Economic Focus Spring 2013 21 II Outlook and Policy O verall, South Asia is set to continue to global environment. On the other hand, with a view grow, although on a more modest pace toward achieving increased and sustainable medium- and with significant downside risk. Re- term growth rates, South Asian countries will have gional GDP growth is expected to pick to address structural and regulatory constraints that up to 5.5 percent in 2013 and eventually stand as impediments to an efficient and attractive 6.3percent in 2014. Ultimately, external and regional investment and business climate. How countries cope factors will determine the region’s growth trajectory with these issues will be critical not only for manag- and the extent the region takes full advantage of the ing near-term current account or fiscal deficits but demographic dividend.2 On the one hand, prudent also for tackling the region’s long-term challenges of near-term macroeconomic management will help infrastructure, energy pricing, poverty reduction, and to reduce countries’ vulnerabilities in an uncertain shared prosperity in South Asia and beyond. TABLE 1: Forecasts for South Asia show significant regional slowdown but suggest bottoming out (GDP at market prices; annual percentage change) 2010 2011 2012 2013 2014 2015 GDP 10.0 7.2 4.7 5.5 6.3 6.6 Private Consumption 7.4 7.1 5.9 5.5 6.1 6.5 Government Consumption 9.9 7.6 6.5 5.6 5.9 6.1 Gross Fixed Investment 16.7 6.2 2.6 4.7 6.8 7.4 Exports, GNFS 14.0 16.7 4.5 5.9 7.3 8.1 Imports, GNFS 16.0 17.8 8.6 5.8 6.6 7.6 Statistical Discrepancy (% of GDP) -2.6 -0.6 0.3 0.5 0.5 0.5 Change in inventories 0.9 -0.5 0.3 0.2 0.0 0.0 Photo: © World Bank/Simone D. McCourtie       Current account balance (% of GDP) -2.6 -3.1 -4.5 -3.7 -3.1 -2.7 Source: World Bank Staff Calculations; Note: Includes India, Pakistan Bangladesh, Sri Lanka and Nepal 2 Demographic dividend broadly refers to favorable demographic developments including high dependency ratios due to a relatively large young, working share of the population, and related favorable savings and investment rates as well as scale effects in educational attainment. 22 South Asia Economic Focus A. The region remains critical levels. While improving, fiscal deficits remain vulnerable in light of continuing a vulnerability in India, Pakistan, Sri Lanka, and near-term uncertainty above all Maldives, and relatively high debt levels will be costly to sustain for many countries, most notably Bhutan, India, Maldives, and Sri Lanka (Table 2). With ongoing uncertainty prevailing in the Euro Zone and the US economies, the probability of ex- Inefficient revenue collection and expenditures on ternal shocks continues to be a risk at a time when (energy) subsidies need to be addressed because South Asian economies have gradually become they remain important driving forces of fiscal defi- more exposed to the external environment. Despite cits across countries. In Pakistan, only 38 percent of some improvements in the global economic outlook budgeted revenue had been collected at the end of in recent months, many countries’ current account the first half of FY2012/13, suggesting an imminent balances have deteriorated and put pressure on the shortfall. Meanwhile, power sector subsidies have financing side of the balance of payments. Inflation reached 80 percent of their budgeted cap, making it remains high in all SAR countries, posing a severe almost certain they’ll exceed the budgeted 0.8 percent monetary policy constraint. All countries in South of GDP. Sri Lanka’s fiscal system exhibits significant Asia remain dependent on imports and thus vulner- structural weaknesses, with total revenues slipping able to international commodity price movements. to 13.5 percent of GDP and tax revenue down to Some countries have decreased their reserves sig- 11.5 percent of GDP—both the lowest levels ever nificantly—in the case of Pakistan and Maldives, to recorded. At the same time, expenditures rose by 10 TABLE 2: Most countries in South Asia are vulnerable to external shocks MONETARY AND ER EXTERNAL VULNERABILITY FISCAL VULNERABILITY Expenditure as a VULNERABILITY percent of Total Commodity IM/ Int. Reserves to Exchange Rate (months of IM) (share of GDP) Primary Fiscal to GDP Real Interest Fiscal Deficit Remittances Expenditure Mandatory EX to GDP Flexibility   Reserves Inflation Balance total IM to GDP Debt Rate GDP CAB             AFG                           BGD                           BTN                           IND                           MLD                           NPL                           PAK                           LKA                           Source: World Bank Staff Calculations Threshold descriptions of vulnerability by indicator in sequence (green=low/yellow=intermediate/red=high). Exports to GDP (<25%/25-50%/50%>); Commodity imports/total imports (<20%/20-30%/30%>); Current Account Balance to GDP (0); Remittances as a share of GDP (<2%/2-8%/8 %<); Reserve Coverage in months of imports (>1y/6m-1y/6m>); Primary Fiscal Balance (>1.5%/-1-1.5%/-1%>); Debt Burden (<25%/25-60%/60%<); Fiscal Deficit to GDP (<5%/5-12%/12%<); Mandatory Expenditure as a % of Total Expenditure (<50%/50-70%/70%<); Inflation (<3.5%/3.5-7%/7%<); RIR (>1.5%/0-1.5%/0%>); ER Flexibility (float/managed float/peg); Int. reserves to GDP (>15%/10-15%/10%>). Spring 2013 23 percent nominally and reached 20.3 percent of GDP, a stimulating investment climate will require mainly driven by debt service, subsidies, and transfer determined action by South Asia’s policy makers. payments. India faces lower than expected revenues Investors, both domestic and foreign, as well as sav- from corporate and excise taxes as well as customs du- ers (depositors) will look towards ongoing improve- ties (down 0.2 percent of GDP) and non-tax revenue ments regarding inflation, fiscal deficits and debt, (down 0.3 percent), leaving the overall shortfall at 0.5 consumption, export growth, as well as underlying percent of GDP. While expenditures remained below policies pertaining to interest and tax rates, regula- target, fiscal consolidation continues to lag recom- tion across real and financial sectors, and the broader mendations by India’s Finance Commission. In Ban- political economy with great and continued interest. gladesh, tax revenues failed to meet the July 2012 to January 2013 target, contributing to a shortfall in the Current and upcoming political transitions will overall revenue target for FY2002/13, the first since pose challenges to reform momentum in several FY2008/09. Expenditures remain broadly on track, South Asian countries. Afghanistan’s transition, and the Government’s moderate consolidation path presidential elections in April 2014, and security is within reach. Similarly, Maldives’ revenue collection concerns caused by the departure of NATO troops fell well below budget levels due to reduced customs will create challenges for the Government. In par- duties and shortfalls in nontax revenues, while expen- ticular, reduced international aid flows will increase ditures on subsidies and transfers to State Owned pressures to create a stable and vibrant domestic Enterprises also boosted the overall fiscal deficit. business environment. Maldives has effectively Also Afghanistan missed its 2012 revenue target by a entered a state of political flux, with presidential margin of 3.9%, mainly due lower customs revenues. elections scheduled for September 2013 and Majlis elections for the second quarter of 2014. Both elec- tions are expected to be keenly contested. Pakistan achieved a milestone in March 2013, when an elected B. Uncertainty on policy government completed its five-year term peacefully, orientations is bound paving the way for democratic transition through a to affect investment caretaker government currently preparing for general elections scheduled for May 11, 2013. However, se- curity concerns have been mounting and remain a To tackle the challenges of reestablishing resil- concern. In Bangladesh, increasingly fragile political ience against potential external shocks, sustaining conditions may affect the investment climate, while a stable macroeconomic environment and assuring Nepal shows signs of improvement. FIGURE 15: A market perspective on key South Asian economies 8.00 7.50 7.00 6.50 6.00 5.50 5.00 4.50 4.00 3.50 3.00 Dec 10, 2012 Oct 08, 2012 Feb 13, 2012 Aug 13, 2012 Feb 11, 2013 Jun 11, 2012 Sep 10, 2012 Nov 12, 2012 Jan 09, 2012 Jul 09, 2012 Jan 14, 2013 Apr 10, 2012 May 14, 2012 Mar 12, 2012 Mar 11, 2013 Bangladesh - 01. GDP (% change) - 2013 - Consensus Forecast India - 01. GDP (% change) - 2013 - Consensus Forecast Pakistan - 01. GDP (% change) - 2013 - Consensus Forecast Sri Lanka - 01. GDP (% change) - 2013 - Consensus Forecast Source: Consensus Economics Inc. 24 South Asia Economic Focus Market sentiment reflects perceptions of con- tinuing uncertainty and vulnerability. Consensus forecasts show that market expectations were deteriorating at the beginning of 2013, reflecting new information regarding India’s economic per- formance and a significantly more modest growth outlook than at the end of CY2012 (Figure 15). While these forecasts give insight into current market sentiments and perceptions, they may foreshadow future attractiveness for investment and broader business activity. Most of South Asia’s recent economic slowdown has been associated with significant decline in exports and a pronounced slowdown in the invest- ment rate, while near term growth is expected to be mainly investment driven. With trade and con- sumption expected to remain modest growth drivers in the short and middle run, investment activity will be key in allowing the region to regain momentum. Following India’s recent reforms and increasing openness to international investment, the region hopes to benefit from increasing fixed investment growth in the middle to long run, while continued fiscal consolidation and efforts to reduce subsidy burdens will help countries including Bangladesh, India and Sri Lanka to further rebuild fiscal buffers. With a view to the longer term, the region will have to continue its attempts to tackle structural supply side challenges, most notably relating to energy and infrastructure gaps. South Asia Economic Focus Spring 2013 27 III Focus: The Investment Climate as the Key to Regain Momentum A. Much of the economic FIGURE 16: SAR total fixed investment growth slowdown can be traced slowed down, in line with lower net private inflows back to slow investment 18 100 16 90 For South Asian countries, private investment 14 80 will increasingly become important for financing 70 current account deficits and fueling economic 12 growth. Over the next 20 years, more than 1 million 60 10 new workers will be entering the South Asian labor 50 8 market each month, offering an opportunity to reap 40 6 a substantial demographic dividend. To absorb these 30 workers into productive jobs and ultimately to reduce 4 20 poverty and boost shared prosperity, South Asia will 2 10 need to provide an investment climate conducive 0 0 to sustaining broad-based growth and job creation. 2010 2011 2012e With fiscal deficit and debt levels constraining pub- Gross xed investment (annual percentage change) lic budgets in the medium term, countries will need to stimulate and attract private investment to com- Net Private In ows (US$ billion, right axis) pensate for weaknesses in public-sector investment. Net Portfolio Flows (US$ billion, right axis) FDI In ows US$ billion, right axis) Total regional fixed investment growth has Source: World Bank dropped to 2.6 percent in 2012, down from a high of 16.7 percent in 2010 (Figure 16). Broadly, invest- ment rates have stagnated, for example in Bangla- desh at relatively low and in India at comparably GDP in FY 2012/13 as compared to 25.2 percent in higher levels, or significantly dropped such as in the the previous fiscal year, while Sri Lanka’s investment Photo: © World Bank/Graham Crouch case of Pakistan. In Pakistan, total investment during rate slightly increased to an estimated 30.6 percent FY 2011/12 reached a historic low of 12.5 percent of of GDP in 2012, up from 29.9 percent in 2011. GDP, y-o-y, mainly driven by a stark fall in FDI in- To regain momentum, however, a sufficiently high flows, while India is projected to register investment investment rate able to accelerate and sustain growth at 30.6 percent of GDP for FY 2012/13, only down will be important. Experience of successful develop- 0.1 percent of GDP from its FY 2011/12 rate. Ban- ing countries in Asia in recent decades reveals that gladesh’s investment rate stagnated at 25.4 percent of the historically high economic growth recorded by 28 South Asia Economic Focus these economies is essentially the result of increased played out in South Asia during the global financial levels of investment in relation to GDP. Capital crisis that began in 2008 (Figure 17). deepening and related efficiency gains, including labor productivity helps driving growth while lack India attracts 85 percent of total South Asian FDI of improvement in macroeconomic, political and inflows; however, the relative economic importance governance indicators has contributed to stagnation of FDI as a share of GDP and related pass through in private investment in relation to GDP. effects stemming from the global crisis appear as more evenly distributed across countries in the Increasing domestic private sector investment is region. In relative terms, the Maldives was the most important, but no country has moved into middle- affected by the global crisis because it relies heavily on or upper-income status without the benefit of tourist activity from the US and Europe. It saw a 64 substantial foreign-capital inflows (Frankel, 2010). percent drop in inward FDI as a share of GDP during Foreign-capital inflows—both direct and portfolio 2008-11 (Figure 17). Looking at absolute levels, both (i.e., equity and debt)—expand the potential sources India and Pakistan had significant FDI declines after of capital, raising productivity and boosting growth. the crisis. India experienced a 30 percent FDI slide However, studies find that foreign direct investment between 2008 and 2010. Annual FDI to the Pakistani (FDI) has a potentially larger role due to its greater economy fell by 60 percent during the same period stability (Levchenko and Mauro, 2007) and its larger and continued to fall in 2011. Foreign investors, par- impact on transfers of knowledge and technology.3 ticularly from Europe and the US, suffered losses at Domestic and foreign investors respond to the same home, leaving them less capital to invest abroad. The incentives and economic fundamentals that make an fall was compounded by Pakistan’s weakening macro- attractive investment climate. economic environment, security issues, and political uncertainty. Unlike Pakistan, India’s absolute inward FDI flows rebounded in 2011. The country’s FDI saw additional but more modest growth in 2012. B. FDI has expanded in most countries, but goes mainly Most recently, some countries including Bangla- into the services sector desh and Pakistan have experienced significant de- cline in FDI performance. Bangladesh’s rate of FDI inflows registers USD 995 million received during South Asia has experienced rising inflows of FDI FY 2012/13 down from USD 1.13 billion in 2011, and portfolio investment, falling in line with the a rate perceived as particularly low when compared global trend of increased shares of FDI flowing to the regional USD 39 billion in FDI attracted in into developing countries. While both FDI and 2011. More strikingly, in Pakistan net FDI inflows portfolio investment flows move with the global have fallen by over USD 1.1 billion, or 70 percent business cycle, the relative stability of FDI becomes below the fiscal 2011 level, mostly due to increasing particularly relevant during “sudden stops,” or inter- security concerns and Balance of Payment distress. ruptions in capital flows. Capital flows skewed toward non-FDI types, such as bank lending and portfolio Experiencing annual average real GDP growth rates investments, may lead to increased volatility and vul- of 6.7 percent for a decade has made South Asia the nerability to economic shocks. This pattern certainly world’s third largest region in terms of GDP, while its FDI inflows as a share of GDP are the lowest of all developing regions, averaging just 1.5 percent 3 Empirical evidence points to FDI’s productivity-enhancing effects in advanced between 2000 and 2011. Unlike other regions, South economies—for the U.K., a 0.5 percent growth in productivity growth has been as- sociated with a 10 percent FDI increase; for the United States, FDI has meant a 14 Asian FDI inflows have never fully caught up with percent increase in productivity. Other research indicates similar outcomes in devel- GDP growth rates. Although the gap had been nar- oping countries: the Czech Republic, , Indonesia (Blalock, Garrick, and Paul J Gertler. “Learning from exporting revisited in a less developed setting.” Journal of Develop- rowing, it regressed somewhat after the global crisis. ment Economics (Elsevier) 75, no. 2 (December 2004): 397-416.), Lithuania (Javorcik, Beata S. “Does Foreign Direct Investment Increase the Productivity of Domestic Firms? In Search of Spillovers Through Backward Linkages.” American Economic Review FDI flows into South Asia are heavily skewed toward (American Economic Association) 94, no. 3 (June 2004): 605-627), among others. Other references include Levchenko, Andrei, and Paolo Mauro. “Do Some Forms of the services sector, with manufacturing and agricul- Financial Flows Protect from Sudden Stops?” The World Bank Economic Review 21, no. 3 (2007): 389-411; Frankel, Jeffrey A. The Natural Resource Curse: A Survey. working ture FDI as a share of GDP lagging almost all other papers 15836, Cambridge: National Bureau of Economic Research, Inc., 2010; regions (Figure 20). Led by India, South Asia is one Spring 2013 29 FIGURE 17: FDI and portfolio investment flows into South Asia have been increasing, particularly during the mid 2000 (USD, billions) 50 40 FDI 30 20 10 Portfolio Investment 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 -10 Source: UNCTAD statistics and World Bank Sta Calculations FIGURE 18: The importance of FDI inflows (as percent of GDP) across South Asian countries varies 0.08 0.07 0.06 0.05 0.04 0.03 0.02 0.01 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 -0.01 Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka Source: Source: World Bank (2013) FIGURE 19: When compared to other regions, South Asia’s growth significantly outpaces FDI inflows (right: Growth-FDI gap)  10 10 8 5 6 0 % % 4 -5 2 0 -10 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 FDI Net In ows (% of GDP) ECA AFR MENA Real GDP Growth Rate LAC EAP SAR Source: WDI Source: WDI and World Bank Sta Calcula3ons 30 South Asia Economic Focus FIGURE 20: South Asian FDI Inflows into manufacturing and agriculture lag levels in other regions, both as a share of GDP (left) and as a share of total FDI (right) 6 100 90 5 80 70 4 60 3 50 40 2 30 20 1 10 0 0 East Asia Europe Latin Middle South Sub-Saharan East Asia Europe Latin Middle South Sub-Saharan and Paci c and America East and Asia Africa and Paci c and America East and Asia Africa Central And North Central And North Asia Caribbean Africa Asia Caribbean Africa Other Services Manufacturing Agriculture and mining Source: Source: World Bank (2013) of the largest international hubs for the service indus- Asia’s initial stock of inward FDI as a hare of GDP try, particularly Business Process Outsourcing (BPO). was lowest across all developing regions, it actually When it comes to FDI inflows, the services sector helped inward FDI growth relatively more than for accounted for around USD 10 trillion in 2009, or 72 the average developing country. With regard to all percent of total inward FDI. At 1.77 percent of GDP, other key driving forces for South Asian FDI, the however, overall inward FDI as a share of GDP remains regional performance in terms of effects of policies modest—the lowest among six regions and well below on FDI growth over the last decade lags the aver- the developing country average of more than 3 percent. age developing country, more precisely South Asia featured the lowest reduction in corporate tax rates as a share of profits (and actual increases outside India), and hence a net negative effect on its FDI C. FDI inflows bear the growth, as well as the largest decline in investment potential to boost overall policy openness, the lowest level of natural resources investment and growth per capita, and largest deterioration in political stabil- ity (particularly for South Asia outside India), again mostly with a negative impact on inward FDI growth South Asia lags other developing regions when with the exception of a light positive effect from trade it comes to the performance of its main drivers of liberalization (Figure 21). FDI growth. A recent World Bank study identifies the key forces for attracting FDI to SAR countries: However, country performances vary substantial- investment policy openness, natural resource endow- ly. India, which accounts for 85 percent of regional ments, trade liberalization growth, changes in control FDI inflows, stands out with strong improvements of corruption, corporate tax changes, and the initial to investment policy and trade liberalization, which inward FDI stock as a share of GDP. 4 While South have played a positive role in enhancing growth in FDI as a share of GDP (FDI/GDP). In other characteristics that influence FDI, such as control of corruption and corporate tax changes, India is 4 World Bank (2013) “Getting the most from FDI in South Asia” (Gould, Tan and Sadeghi): The estimation results are based on a world panel (79 countries over the period 2000- quite similar to the rest of South Asia. For Pakistan, 2010) as well as subsample estimations for 33 developing countries. The econometric reductions in corporate tax rates have been a large technique can be described as a reduced form cross section regression of growth of in- ward FDI between 2000-10 on a comprehensive set of explanatory variables including positive in enhancing FDIGDP growth compared regional and oil fixed effects. Endogeneity is addressed implicitly by deriving explana- tory variables over the first 5 years only (2000-05), thereby attempting to match the to other developing countries and the rest of South model formulation with the actual process and time structure of investment decisions. Asia, while control of corruption and improvements Spring 2013 31 FIGURE 21: Factors significantly affecting FDI inflows to South Asia Region (SAR) show relative weakness vis-à-vis the average of developing countries 0.01 Changes in Investment Policy Openness 0.005 0 Initial Inward FDI/GDP Stock Natural Resources per capita -0.005 -0.01 -0.015 -0.02 Corporate Tax Reduction Trade Liberalization Note: Numbers here refer to SAR speci c total e ects on FDI growth over the estimated time span (i.e. SAR estimated coe cients multiplied by the explanatory variable’s value for South Asia) Developing Countries Source: Source: World Bank (2013) Changes in Control of Corruption in investment policy growth have been relatively of slightly above 30 percent (of which almost 24 large negatives. Overall levels of FDI/ GDP are rela- percent are private). However, due to its favorable tively small in Bhutan and Nepal, suggesting a large demographic transition, India’s savings rate can be potential for future FDI/GDP growth in countries expected to stay strong and hence be considered with high natural resource endowments due to as a strong investment driver in the middle term. unexploited hydropower potential. Nonetheless, Pakistan, on the other hand, features a much lower the deterioration in investment policies has been investment rate at around 13 percent of GDP for a relatively large deterrent to FDI/GDP growth 2012, which can be explained by a mix of dropping in Nepal. For Maldives, the current large stock of foreign investment (mainly FDI) due to secu- FDI/GDP suggests that potential for future FDI/ rity and macroeconomic stability concerns and low GDP growth is modest. Control of corruption is a domestic savings. The latter is mainly due to low significant hurdle to the in FDI/GDP growth for rates of return on deposits as well as a strong bias most countries in the region, with the exception of towards consumption. Bhutan, where improvements have been a positive contributor to foreign investment. However, Bhu- South Asia does well in other dimensions relevant tan has implemented some temporary trade control for growth and FDI and may continue to build on measures to manage the rupee shortage, somewhat those. The region has been stronger than others in offsetting the positive impact of the gains through human capital expansion; it has the largest reduc- controlling corruption. Overall, the results sug- tion in energy losses (despite weak improvements gest South Asia has the potential, through policy in India); financial sector development growth is changes, to take important steps toward becoming second only to the Europe and Central Asia regions; a much greater FDI magnet. and infrastructure growth has been second only to Sub-Saharan Africa. For India, trade liberalization Pakistan and Maldives stand out in terms of their (as measured by reduced effective rates of tariff pro- low savings rates, with Maldives actually dis- tection) and investment policy openness have been saving in 2012, while India recently experienced particularly strong between 2000-10, while the rest a decline in its savings rate vis-à-vis a high and of South Asia has shown only modest improvements constant investment rate. India’s savings rate or deterioration. However, except for overall trade came down to 29 percent of GDP for 2012 from liberalization and investment policy openness in a 37 percent high in 2009, which implies greater India, the analysis indicates these factors are not sig- reliance on foreign investment inflows for sus- nificant determinants of FDI/GDP in South Asia, taining the fairly stable domestic investment rate but they may be important contributors to growth. 32 South Asia Economic Focus FIGURE 22: Pakistan sticks out due to low investment and saving rates, while Maldives dis-saved in 2012 Total Investment (% of GDP) 50 45 40 BTN 35 IND LKA 30 25 AFG BGD 20 MDV 15 10 PAK 5 0 -10 -5 0 5 10 15 20 25 30 Total Savings Source: World Bank and IMF (% of GDP) TABLE 3: FDI inflows (percent of total FDI inflows over period 2003-11) into South Asian countries by source Source Countries     Middle Europe & Latin Sub-   East Asia East & South EU US India China Central America & Sahara Other   & Pacific North Asia Asia Caribbean Africa Africa AFGH 2.35 1.57 2.72 71.58 0.00 16.07 0.97 4.73 0.00 0.00 0.00 BANGL 38.33 11.95 23.88 3.79 10.02 8.62 0.49 0.00 0.00 0.40 2.52 Recipient Countries BHUT 0.00 16.91 48.75 0.00 24.67 0.00 0.00 0.00 0.00 0.00 9.67 IND 36.40 19.87 0.00 4.10 21.26 5.09 1.34 1.77 0.56 0.31 9.31 MAL 4.71 3.86 29.35 3.86 25.57 13.13 0.05 0.00 0.01 0.00 19.47 NEP 22.05 0.00 53.63 11.20 1.72 10.68 0.61 0.00 0.00 0.00 0.12 PAK 19.60 9.92 0.83 6.11 7.15 45.04 0.30 1.52 0.47 0.00 9.06 SL 18.09 2.95 37.41 9.19 8.10 2.71 0.22 0.00 0.15 8.36 12.82 Note East Asia& Pacific does not include China and South Asia does not include India as both are stated separately. Source: World Bank Staff Calculations This may partly explain the region’s relatively strong contributes 70 percent of intra-regional FDI; however, GDP growth over the past decade, a period of rela- total within-region FDI represents just 3.7 percent of tively weak growth in FDI inflows. all South Asian inward FDI (Table 3). India is the region’s largest market and a potential investment Significant scope exists for increasing South Asian magnet for the other South Asian countries; however, FDI flows and their positive economic effects by bilateral restrictions remain despite considerable im- addressing structural and policy constraints and provement in the country’s overall FDI policies. fostering regional integration and intra-regional investment flows. Two factors are at work—high While ongoing efforts are moving in the right di- overall regulatory restrictions on FDI and specific rection, a variety of policy challenges remain. Lib- restrictions placed on doing business with other coun- eralizing policy constraints in both trade and foreign tries in the region. Also limiting FDI flows are overall investment, keeping corporate tax rates competitive trade restrictiveness and weak institutions to protect and low, and improving governance and transparency foreign investors and facilitate investment. India could help to substantially improve FDI flows South Asia Economic Focus Spring 2013 35 IV South Asia Country Briefs In alphabetical order: Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka Photo: © World Bank/Sofie Tesson 36 South Asia Economic Focus Afghanistan Real GDP and Agriculture Growth Rates 50.0 While domestic developments helped to increase growth, Afghanistan’s external position remains weak. Follow- ing a strong performance in 2012, economic growth is 10.0 expected to slow down as a result of a weather induced 0.0 moderation in agricultural performance and uncertain- ties stemming from transition which constitute a signifi- cant downside risk. -10.0 -50.0 Recent Economic Developments  2003 2004 2005 2006 2007 2008 2009 2010 2011 2012* One year into the transition process, Afghanistan’s Real GDP growth (left axis) economy still gives an impression of strength. The positive aspects include an exceptional wheat Agriculture growth (right axis) harvest, favorable developments in the mining and services sectors, and increased real GDP growth, to 11.8 percent from 7.3 percent. Inflation has halved, and continuing high levels of aid have helped to nearly halved to USD 23 million in 2012. The lack further bolster international reserves. However, the of export response to the depreciation of the afghani transition is characterized by a loss of business con- illustrates Afghanistan’s limited export capacity. fidence, reflected in lower private sector investment and a depreciating exchange rate. This compounds Afghanistan’s external position in 2012 remains the already sluggish recovery of the banking sector weak. The huge trade deficit of 43 percent of GDP from the Kabul Bank crisis which hit the country was offset by large transfers—mainly foreign aid in 2010. Trends in public finance deserve attention: inflows—in the current account. Remittance inflows, more on-budget aid will pose challenges to execution believed to be large, are mostly informal and not through the relatively weak country systems. Growth captured by the balance of payments statistics. For- of domestic revenues is slowing due to worrisome eign direct investment remained stagnant at around developments in customs revenue collection. 2 percent of GDP. As result, the overall balance of payments in 2012 remained in surplus which con- Exports, estimated at USD 2.6 billion, declined by tributed to a further accumulation of international 5 percent in 2012, in spite of a weakening currency. reserves. Gross international reserves reached a re- In contrast, total imports increased by approximately cord high of USD 7.1 billion in December 2012 but 5 percent, to USD 11.2 billion in 2012, leading to had declined to USD 6.5 billion by March 2013. a higher nominal trade deficit, of USD 8.5 billion in 2012.5 The Afghan export base has relatively few Budget execution improved in real terms in 2012. tradable products and these are heavily concen- While the government executed only half of the trated in a few markets. Dry fruits, which account for development budget in 2012, as in fiscal 2011, nomi- around one-third of official exports, declined by 21 nally it disbursed almost as much in the nine months percent. Carpet exports, another major export item, (USD 1 billion) as it did over the full 12 months of the previous year (USD 1.1 billion). 5 These estimates include both official and unrecorded trade (smuggling), as well Domestic revenues increased by 13.1 percent in transit exchanges, but exclude opium trade. Forty percent of trade is believed to 2012 but fell short of targets. Revenues reached be unrecorded, mainly because of weaknesses in border security and customs. The Central Statistics Organization shows official (recorded) exports declined by nearly 20 Afs 81.7 billion (equivalent to USD 1.6 billion), percent in 2012 (January through December), while imports increased by more than 30 percent. Official exports were recorded at USD 346 million, which are less than 2 or 8 percent of GDP, but missed the target agreed percent of GDP. Official imports, on the other hand, reached USD 8.3 billion in 2012. with the IMF by 3.9 percent, mainly because of a Spring 2013 37 Current Account and Overall Balance at the Central Bank auctions. However, the afghani 100.0 remained stable against the euro, at Afs 65.4 on average in 2012 and appreciated by around 1 percent against the Pakistani rupee. Percent of GDP 0.0  Outlook and Policy Economic Growth is expected to slow in 2013. Political and security uncertainties are expected to limit private-sector growth in the coming years. -100.0 Increased public spending, however, will continue to fuel demand for services and construction through 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013. Mining should contribute more noticeably to growth with the increasing oil production at Amu CAB (excl. foreign aid) Darya (the expected contribution to the government Overall balance budget through royalties and taxes is projected to CAB (incl. foreign aid) be around USD 250 million annually for the next 25 years). On the agricultural front, however, only moderate rainfalls are forecast for this season, which would reduce the year’s harvest to a more normal lower revenue performance at customs. Customs output and slow GDP growth to 3.1 percent in 2013. revenues account for approximately one-fourth of total revenues and have been steadily increasing. But The transition process exposes Afghanistan to a last year these declined by 9.6 percent in spite of number of serious risks, such as rising financing higher import volumes—due in part to deteriorating for public service provision. Security considerations governance at customs. aside, promoting sources of inclusive economic growth, especially agriculture, and strengthening The mining sector, meanwhile, showed dynamic domestic revenue mobilization will be important to developments in 2012. Historically small, the share mitigate some of these risks. of mining in aggregate output increased from 0.6 percent of GDP in 2010 to an estimated 1.8 percent in 2012, due largely to the start of oil production at the Amu Darya fields. The oil fields are currently producing around 1,950 barrels per day and are expected to reach more than 4,000 barrels per day by end-2013. Trends in microfinance remain a concern. The sector has been going through a deep consolidation phase since 2008, resulting in slower growth of the loan portfolio, a decline in the number of active bor- rowers, and the exit of several institutions from the sector. The afghani depreciated by nearly 9 percent against the US dollar in 2012, falling to Afs 50.9/ USD 1.00 from an average Afs 46.9/USD 1.00 in 2011, probably due to increased uncertainty over security and the business environment. This was reflected in increased demand for foreign exchange 38 South Asia Economic Focus Bangladesh 10 GDP and Sector Growth Rate (%) Overall prudent macro management and a favorable downward trend in inflation helped sustain growth. While remittances are expected to remain strong and together with a decline in imports will help maintain Bangladesh’s positive external position, slow progress 5 on structural reforms and rising political fragility pose threats to future investment. Recent Economic Developments  0 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 GDP growth in fiscal 2013 is likely to fall to Overall GDP Growth Agriculture around 6 percent, from 6.3 percent in fiscal 2012. Industry Weak exports and investments resulting from the impact of the euro-area crisis, domestic supply Source : Bangladesh Bureau of Statistics constraints, and intensified strikes and unrest were principal reasons for the slowdown. However, strong remittance and robust service sector performance are non-bank institutions are not doing any better, and expected to help keep growth in healthy territory. An the confidence deficit in the capital market persists. increasingly fragile political situation, however, does not bode well for revival of the investment needed to Prudent monetary and fiscal management con- accelerate growth. tributed to sustained growth and macroeconomic stability. Monetary policy has gained credibility by A broad-based declining inflation trend appears adhering to the monetary program target for the first to be gaining ground. Average (twelve-monthly- half of fiscal 2013, but the shift towards an expan- moving) inflation has declined steadily over the sionary stance for the second half, albeit modest, may past ten months, from a peak of nearly 11 percent be premature. Fiscal policy is on track to maintain in February 2012 to 8.2 percent in February 2013, prudent levels of overall deficit and improve the reflecting declines in both food and non-food infla- composition of deficit financing towards lower mon- tion. Favorable international commodity prices, a etization and domestic bank financing, with a rise in stable exchange rate and monetary tightening helped the share of concessional external finance. to lower inflation. Progress on structural reforms has been slow. The The overall external balance continued to remain government has undertaken a reform program sup- positive with a record increase in reserves to over ported by the International Monetary Fund’s ECF. USD 13.8 billion (equivalent to 4.4 months of Structural measures in the program aim to modern- imports) by end-February 2013. The rapid increase ize the tax regime, bolster fiscal controls, strengthen in reserves reflects both the economy’s strengths in financial sector oversight, and improve the trade and attracting remittance and external assistance, and investment climate. Policy undertakings have been weaknesses in the form of depressed domestic de- broadly in line with program commitments of the mand growth leading to a decline in imports. ECF, but a number of structural benchmarks were not met, because of either delays in completion or Financial development is riding a bumpy road. the need for more time to make legislative changes Bangladesh slipped one notch in the Financial or reach internal policy consensus. Development Index, and is now ranked 57th out of 62 economies. Stability of the banking sector dete- Progress on the Millennium Development Goals riorated as a result of corporate governance failures, (MDGs) has been remarkably successful, with Spring 2013 39 In ation (FY1996, y-o-y, %) National Headcount Poverty (%, fys) 20 70 15 50 10 5 30 0 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 10 1992 1996 2000 2005 2010 2013p General Food Non-food Source : Bangladesh Bureau of Statistics Source: GoB, Household Income & Expend. Survey Bangladesh managing to bend the arc of poverty re- progress up the human development charts. Even duction to a remarkable degree and share prosperity with its outstanding achievements in reducing poverty during 2000-2010 far better than in the preceding and childhood under-nourishment at national level, decade. Bangladesh has already achieved three of the achieving all of the hunger MDGs remains a daunt- 28 MDG targets, and is on track with another 11, ing challenge. The country faces a rough road in ad- while needing to give attention to the remaining 14 dressing certain pockets of poverty that lag far behind (as of 2011). Poverty reduction during 2000-2010 the national averages (for example, in urban slums, was so dramatic that Bangladesh was listed among the hill tracts, coastal belts, and other ecologically the 18 “highlighted” countries of the South that made vulnerable areas). Enrollment in schools of the last 10 greater gains than expected in the Human Develop- percent of hard-to-reach children, ensuring quality of ment Index between 1990 and 2012, based on their education, and promoting gender equity in tertiary previous performance. Human development also has education are especially big challenges. The threat been more inclusive than before in Bangladesh. of climate change could also diminish hard-earned benefits from years of growth and development. The number of poor declined by 15 million in the first decade of the new millennium, compared with a decline of 2.3 million in the preceding decade. There have been improvements too in sev- Outlook and Policy  eral dimensions of non-consumption-based welfare. Inequality has stabilized and there has been some The outlook depends largely on how successfully regional convergence in consumption poverty levels Bangladesh seizes its opportunities and manages in the second half of the 2000-2010 decade. Growth the associated risks. Export product and market of labor income and declining dependency were the diversification as well as diversification of the main main indicators of poverty reduction in this period. migrant labor destination countries would provide Nevertheless, Bangladesh still has the highest rate of the wherewithal for accelerating economic growth. poverty in South Asia, when measured by continuing Experience from other countries suggests that export low real per-capita GDP. diversification is associated with generally strong economic performance. Current instability in the There needs to be more depth and breadth in Middle East and North Africa may have negative development for Bangladesh to sustain its stellar consequences for Bangladeshis living and working in 40 South Asia Economic Focus those regions, and hamper their ability to earn and will have to remain sufficiently restrained to contain remit money home. inflation and maintain reserves. In the near term, a further escalation of political tensions and deteriora- Recovery in the euro area and the United States will tion in the financial condition of state-owned com- be especially important to Bangladesh’s economic mercial banks pose the largest risk that may affect prospects. Global growth is projected to increase growth prospects and public finances. during 2013, but the near-term outlook for the euro area has been revised downward. Activity is now In the longer term, the central question is, where expected to contract by 0.2 percent instead of expand will Bangladesh’s good jobs come from? More than by that figure in 2013. Risks of prolonged stagnation half of the population depends on agriculture, but in the euro area as a whole will rise if the momentum that proportion will have to shrink if per-capita in- for reform is not maintained. Growth in the United comes in agriculture are to rise substantially. Industry States is forecast to average 2 percent in 2013, rising is creating jobs, but too many are low-productivity, above trend in the second half of the year. The projec- low-income, offering little protection, and no ben- tions are predicated on the assumption that the fiscal efits. Services jobs are relatively high productivity, sequester from March 1 2013 will have a relatively but employment growth in services has been slow small adverse impact on GDP growth. in recent years. Bangladesh’s challenge is to create the conditions for faster growth of productive jobs There is a downside balance of risks in the near outside of agriculture, especially in organized manu- term. The readymade garments (RMG) industry is facture and services, while at the same time improv- suffering from a severe image crisis in the interna- ing agricultural productivity. The reward for meeting tional markets because of concerns about labor safety that challenge is decades of strong, inclusive growth. arising from fire incidents in two garment factories. These prompted the US and EU to rethink the Gen- Domestic employment generation in the medium eralized System of Preference facilities provided to term is likely at best to barely absorb new entrants to Bangladesh. Sustainability of the recovery in remit- the domestic labor market. At current employment tance growth is subject to downside risks because of elasticity of growth (0.4) and under the baseline growth the uncertainties relating to manpower export pros- scenario, Bangladesh can expect to generate about 1.3 pects. An immediate hindrance to the acceleration to 1.6 million jobs per year. Its domestic labor force is of growth is the unprecedented political complexity projected to grow by 1.3 million per year.This will hardly that Bangladesh appears to have entered. make a dent in the stock of unemployed until growth picks up to 6.5 percent-plus after fiscal 2014. Even that Should these risks materialize, policy adjustments will not be enough to bring the unemployment rate will have to be primarily through exchange rate and down to single digits. Job creation on a significant scale fiscal channels. At the same time, monetary policy would require a lot more than business as usual. TABLE 4: Bangladesh Labor Market Projections Projections 2010 2011 2012 2013 2014 2015 2016 2017 Real GDP growth (%) 6.10 6.70 6.30 5.80 6.20 6.50 6.70 6.90 Labor force (in millions) 56.65 57.95 59.22 60.53 61.86 63.22 64.48 65.77 Percentage change in employment 2.44 2.68 2.52 2.32 2.48 2.60 2.68 2.76 Employment (in millions) 48.63 49.94 51.20 52.39 53.68 55.08 56.56 58.14 Change in employment (in millions) - 1.31 1.26 1.19 1.30 1.40 1.48 1.58 Unemployment (in millions) 8.03 8.01 8.02 8.14 8.17 8.14 7.93 7.63 Unemployment rate (%) 14.17 13.82 13.55 13.45 13.21 12.87 12.29 11.60 Note: Total unemployed persons by economic category are a combination of unemployed population aged 15 years and over, and unemployment equivalent of underemployed & unpaid family workers working less than 15 hours/week. Source: Calculated from Labor Force Survey, Bangladesh Bureau of Statistics, IMF. Spring 2013 41 Bhutan The pace of poverty reduction in Bhutan is one of the highest in the world. Similarly, with its new Anti-Corruption Law, Bhutan has emerged as South Asia’s most powerful anti-corruption authority, serv- Lingering effects of Bhutan’s overheated economy con- ing as a model for the region and beyond. tinue to challenge macroeconomic management. Poverty reduction and governance show significant signs of im- provement. The outlook on growth remains cautiously optimistic, with large hydro power projects in the pipe-  Outlook and Policy line, but also conditional on a proactive solution of the Rupee shortage and a stabilization of the financial sector. GDP growth is projected to moderate to 7.6 per- cent in fiscal 2013 and remain subdued until new hydro-power projects come on stream in fiscal 2018. Though the aim of adding 10,000 MW of Recent Economic Developments  electricity generation potential by 2020 is feasible, the growth path may be more gradual than earlier The overheating of the Bhutanese economy has envisaged, due in part to funding constraints and a ended with slowing private credit growth and desire to avoid another bout of overheating. moderation of near-term growth, but its aftermath continues to linger in the continued appetite for Private Credit Growth vs. Short-Term Borrowing rupee resources and vulnerabilities in the financial 20000 50 sector. Though private-sector credit growth slowed considerably during 2012, the use of short-term rupee borrowings continued to climb, reaching Nu 17 bil- lion by end-January 2013, an addition of Nu 6 billion since June 2012. Inflation retreated but is still high, at around 10 percent, as the wedge with India’s inflation 10000 persists. Prices of non-traded services are rising. The financial sector, though fundamentally sound with capital adequacy ratios above the thresholds, has become vulnerable with liquidity shortages 0 0 and deterioration in bank portfolio quality. Dec-11 Feb-12 Abr-12 Jun-12 Aug-12 Oct-12 Dec-12 Export revenues from electricity sales (about one- RMA Rupee Liabilities in million Nu third of total merchandise exports) were again (Left axis) lackluster through the peak July-October season. Private credit growth 3mMA, annual rate Export revenues have fluctuated with a slight down- (Right axis) ward drift reflecting the vagaries of hydrological flows, as no new projects have come on line since Private Credit Growth vs. Short-Term Borrowing 2006. Tourism has turned into an important source of export revenue. The period January through No- The government has taken steps to avoid repeating vember 2012 shows a surge of 17 percent in tourist a rupee shortage—engaging in short-term bor- arrivals and 32 percent in revenue receipts, to USD rowing and imposing controls on lending for new 60 million. houses and the import of cars. New lines of credit with the government of India for another Indian Poverty reduction and governance are two beacons Rs.3 billion and rupee-swap facility for USD 100 of positive achievement for Bhutan. The Bhutan million are some of the new measures. While these Living Standards Survey 2012 shows the percent- short-term measures may reassure the public, they age of people living below the poverty line fell to 12 could become counter-productive unless the public percent, from 23.3 percent in 2007, thus exceeding sector and households can be persuaded to raise sav- the 10th Five-Year Plan target of 15 percent by 2013. ings levels. 42 South Asia Economic Focus India Broad-based slowdown a ected all sectors (Percent y-o-y growth) 11 India’s continued slowdown is broad-based across sec- 9 tors. Vulnerabilities, mainly due to a wide current ac- count deficit and high inflation reducing macro buffers 7 and increasing reliance on investment, persist. Slower growth and tighter fiscal space may affect India’s progress 5 towards universal health coverage. 3 1 Recent Economic Developments  -1 Q1 2007-08 Q3 2007-08 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 The slowdown in growth that began last year continued in fiscal 2013. The growth of real GDP at factor cost fell to 4.5 percent (y-o-y) during the third quarter of fiscal 2013, the worst outturn in Agriculture Industry Services 16 quarters. For the entire fiscal year, the growth rate of real GDP is expected to fall to 5.0 percent, the slowest pace in a decade. The slowdown has been broad-based, affecting all major sectors of Macroeconomic vulnerabilities have increased. economic activity. The slump in the first half of the A record current account deficit, stubbornly high fiscal year was particularly pronounced in private inflation, and a halt to the declining trend in the consumption and especially investment, which debt-to-GDP ratio highlight the growing macro contracted by nearly 3 percent over the first two vulnerabilities and limit the policy room available to quarters of fiscal 2013, however, growth in final the authorities. The Reserve Bank of India (RBI) has consumption expenditure and gross fixed capital had to strike a difficult balance between monetary formation picked up in Q3 FY2013, suggesting stimulus and price restraint. Policy action to reduce that the slowdown in demand may be bottoming fuel subsidies and the recently presented fiscal 2014 out. Although persistent weakness in the global en- Union Budget reaffirmed the authorities’ commit- vironment contributed to the slowdown in growth, ment to fiscal consolidation. the adverse contagion effects from the Eurozone debt crisis explain only a small part of the overall The current account gap worsened due to a wid- deceleration. ening trade deficit. The current account deficit increased to a record 5.4 percent of GDP in the Continued weakness in the industrial sector first half of fiscal 2013, compared to 4.1 percent in dragged down growth in services, the original the corresponding period last year. The merchandise harbinger of India’s economic progress. Growth in trade deficit widened to 11 percent of GDP, from the industrial sector started weakening during fiscal 10 percent the previous year, the central cause of the 2012 as mining activity stalled and manufacturing deterioration in the current account balance. The output decelerated. These weaknesses continued in worsening in the current account balance occurred fiscal 2013, bringing down the average industrial despite a robust inflow of remittance, which increased growth to 3.3 percent from an average of 9.2 percent to 1.7 percent of GDP during Q1-Q3 FY2013, from during the preceding two years. This slowdown in 1.6 percent last year. services was most pronounced in the third quarter of fiscal 2013 as the services sector was adversely af- The trade balance has showed signs recently of fected by the industrial slowdown through forward improvement. Merchandise export growth (in US and backward demand linkages, bringing down its dollars) turned positive during the first two months projected rate of growth an 11-year low of 6.6 per- of 2013, slowing the decline in exports from 7 per- cent in fiscal 2013. cent (y-o-y) to 5 percent (y-o-y) in April-December. Spring 2013 43 The decline in exports can be attributed primarily Revenues underperformed as the pace of eco- to a fall in demand from Asian economies and for nomic activity slowed. Although gross tax revenue goods such as engineering and petroleum products. improved to 10.4 percent of GDP from 9.9 percent Growth in merchandise imports also slowed, to 1 a year ago, the increase was 0.2 percent of GDP less percent (y-o-y) during April-February, from 33 than the budgeted amount. Total revenue and grants percent last year. Import growth remains posi- reached 8.7 percent of GDP, 0.3 percent of GDP tive, however, even though gold imports declined higher than last year but 0.5 percent of GDP below relative to last year, primarily because of inelastic the budgeted amount. oil imports which grew at 13 percent y-o-y during April-December 2012. As a result, the trade deficit, The pace of fiscal consolidation by the central which touched an all-time high of USD 22 billion government continues to lag behind the targets in October (44 percent y-o-y growth), fell to USD set by the 13th Finance Commission (FC). The 15 billion by February (the same level as in February central government has pledged its commitment to 2012). bringing down the deficit to 3.0 percent of GDP by fiscal 2017, but at this deadline looks likely to slip. With output growth slowing, headline infla- The states, on the other hand, have largely achieved tion fell to its lowest level in over three years. It the FCs’ targets, except for a brief deviation after the prompted the RBI to lower the policy repo rate by global financial crisis, by acting on state-specific fis- 25 bps twice (in January and March) to 7.50 percent, cal legislation passed in fiscal 2005. According to FC after having held it constant for the previous seven targets, the states’ aggregate fiscal deficit-to-GDP meetings. Wholesale headline inflation averaged ratio should decline to 2.5 percent in this fiscal year. 7.4 percent during April-February, down from 9.1 percent in the same period last year. However, after The improvement in the central government’s December, headline retail inflation increased to more debt-to-GDP ratio over the last several years ap- than 10 percent (y-o-y). Food inflation remained pears to have lost momentum. In fiscal 2012, the high, widening the wedge between wholesale and central government’s internal liabilities rose for the retail inflation Food wholesale inflation averaged 9.3 first time in seven years, reaching 48.1 percent of percent y-o-y during April-February in fiscal 2013, GDP. It is expected to remain at about the same level significantly above 7.2 percent y-o-y during the same in the current fiscal year. period last year, due to a surge in vegetable prices. Some suppressed fuel inflation surfaced—rising to 10.5 percent (y-o-y) in February, from 7.1 percent in the month before—after the government allowed  Outlook and Policy phased deregulation of diesel prices. Economic growth will likely slow further in 2013 The Budget succeeded in containing the fiscal defi- but rebound somewhat through fiscal 2014 and cit. The overall deficit for fiscal 2013 was limited to beyond, although downside risks remain high. The 5.2 percent of GDP (by the government’s definition), slowing momentum of growth may have bottomed 0.1 percent above the goal set in last year’s budget out in the third quarter of fiscal 2013, but even a but below October’s revised target of 5.3 percent. By substantial pickup in the last quarter is unlikely to the World Bank’s definition, which discounts once- lift the rate of real GDP much beyond 5.0 percent. off divestment proceeds from revenues, the overall However, a minor increase in the trend-cycle com- deficit was unchanged from last year’s budget target ponent of GDP in the third quarter, an upturn in of 5.4 percent of GDP. This represents a 0.6 percent industrial production in February, and some modest of GDP improvement over the fiscal 2012 outcome improvements in investment and exports give rea- and a 1.4 percent of GDP reduction from the peak son for optimism that economic activity may have deficit in of 6.8 percent in fiscal 2010. However, the turned the corner. With these factors, and a gradual deficit remains well above the 3.7 percent of GDP improvement in the global environment, growth is average recorded during fiscal 2005-2008, after the expected to climb to 6.1 percent in fiscal 2014. Fiscal Responsibility law was enacted and before the countercyclical stimulus applied to counter the Downside risks remain high, however. Macro buf- global crisis. fers are largely depleted and the authorities’ ability to 44 South Asia Economic Focus respond to negative external shocks is likely to be much general government deficit is likely to remain below more limited than during the 2007-2009 global crisis. 8 percent of GDP in fiscal 2014 and fall to around The current account deficit is increasingly financed by 7.2 percent of GDP in fiscal 2015. more volatile portfolio flows. While two main rating agencies maintain a negative outlook on India’s sov- Debt ratios look likely to resume their decline but ereign debt, with specific concerns on the slowdown at a slower rate than before. This year, the central in economic growth, a third agency has recently government’s debt-to-GDP is expected to remain reaffirmed a stable outlook based on robust savings around 48 percent of GDP, just 0.1 percent of GDP and private sector dynamism. Continued progress on lower than last year, and decline gradually over the domestic reform agenda to encourage investment the next few years. Even if real interest rates rise, a and unlock supply constraints while adhering to fiscal recovery in growth and continued commitment to consolidation—especially important in the context of fiscal discipline are expected to offset any potential upcoming state and general elections—is critical to adverse effects on debt sustainability and contribute supporting growth and lowering macro vulnerabilities. to a slowing decline in central government’s debt to 47 percent of GDP by fiscal 2015. India’s growth drivers will increasingly have to come from domestic sources. The authorities’ com- Slower growth and narrowing fiscal space could mitment to fiscal discipline may give the Reserve affect India’s progress towards universal health Bank of India more room for accommodative mon- coverage. Based on recent trends in the roll-out of a etary policy, while a series of investor-friendly mea- new wave of government-sponsored health insurance sures announced in the fiscal 2014 budget will pro- schemes (GSHIS) launched since 2007, the share of vide additional incentives for increased investment. Indian population covered by some form of health insurance could rise from 25 percent in 2010 to 50 Inflationary pressures are expected to moder- percent by 2015. In particular, the coverage of GSHIS ate. Despite the surprise uptick in wholesale price could increase to more than 500 million persons by inflation in February and the pressure from food 2015. While the schemes are a crucial component of prices keeping consumer inflation persistently high, building human capital and fill an important niche for inflationary momentum is expected to wane over the an otherwise under-served population, the additional coming months. The RBI has remained staunch on expenditures required to finance the initiatives could inflation and is unlikely to lower rates prematurely amount to between 0.4 and 1.0 percent of GDP in or be very aggressive with rate cuts. The stabiliza- 2015. The central government looks likely to be able tion of the rupee following a bout of depreciation in to finance its share of the incremental expenditure the first half of calendar 2012 is also likely to limit towards broadening access to government-sponsored inflationary pressures. Good rainfall in the spring health insurance. However, divergence in growth and another solid wheat harvest should help alleviate performance at the state level and lower income flex- some push factors on food prices, although recent ibilities of public health expenditure at the state level, steps to curtail fuel subsidies are likely to contribute imply that a number of states may need to substan- to higher impetus from fuel prices in the short term. tially reallocate fiscal resources to finance the expan- sion of government-sponsored health insurance. Fiscal deficits are likely to decline as the au- thorities have renewed their commitment to fiscal In the global context, India’s growth could benefit consolidation. Following notable fiscal slippages from economic recovery in the high-income coun- in previous years, the authorities delivered on their tries, but this would not be sufficient to return it commitment to keep the fiscal 2013 central govern- to the record pace of the late-2000s. If high-income ment deficit within the revised target of 5.3 percent economies were to recover strongly—with growth of GDP. Even if divestment revenues in fiscal 2014 of, say, 3 percent in 2014 and 2015—global import fall short of expectation, the authorities are likely to demand could be expected to rise by about 5.5 be able to meet the deficit target of 4.8 percent of percent, which would buoy India’s exports by 4.5 GDP with expenditure compression and a recovery percent relative to the baseline for 2014 and 2015, in tax revenues as economic activity picks up. With and real GDP growth by 0.4-0.5 percentage point states’ fiscal performance roughly on target with in 2013 and 2014, and 0.2 percentage point the fol- the adjustment path recommended by the FC, the lowing year. If such auspicious developments were to Spring 2013 45 Favorable global environment has limited positive e ects on Indias’s growth 8 7 6 5 4 FY2011/12 FY2012/13 FY2013/14 FY2014/15 FY2015/16 History/baseline Lower oil prices No contagion from income countries be joined by positive investor and consumer senti- ment and an easing in financing constraints for firms globally, India’s GDP could accelerate by another 0.1 percentage points relative to the baseline.6 Despite the current slowdown in economic growth, India’s long-term prospects remain highly favour- able. The country possesses the fundamentals to grow at sustained high rates over the next several de- cades on the strengths of its demographic transition, high savings and investment rates, rising educational attainments, and increasing agglomeration effects (urbanization and growth of secondary cities). India is entering demographic transition much later than many other developing countries, and will still be a relatively young nation 20 years from now, even as its dependency ratio declines to 49 percent in 2030 from its current 56 percent. Even as economic activity fell to a decade-low pace this year, investment rates did not decline much below 30 percent; combined with the demographic dynamics and a rising age-savings profile, India is likely to generate significant volumes of savings and investment over the coming years. In combination, these are the foundations for strong growth for decades to come. 6 These calculations are based upon the World Bank’s global macro model, devel- oped by the Development Prospects Group, which covers some 150 economies and includes detailed trade linkages between each of these economies. 46 South Asia Economic Focus Maldives The fiscal position remains precarious, with the government cash-flow position considerably weakened. In response, the government has resorted to imprudent means of managing the cash flow: (i) Political instability paired with a precarious external ad-hoc borrowings from the banking and private situation constitutes the biggest threat to Maldives near sectors, at high interest rates, (ii) monetizing, and term economic future. The tourism sector and the fiscal (iii) running huge payment arrears, amounting to situation remain weak while debt sustainability may over 11 percent of GDP. become a major concern. The precarious external situation presents a seri- ous challenge to the country. The situation has been aggravated by continued high fiscal deficits as well Recent Economic Developments  as recent debt settlements. Current gross reserves are below two month of imports and in the face of The economy remains hostage to politics in Mal- increased monetization of the deficits, could deterio- dives, and the political situation is in flux with a rate further. series of crucial elections ahead. The Presidential elections are scheduled for early September 2013, In light of the precarious external situation, ex- and the Majlis (parliamentary) elections for April ternal debt sustainability has also become a major 2014, with local government polls thereafter. The concern. Under current trajectories, total external first two elections, at least, look to be keenly con- debt obligations are projected to reach over 115 tested, and the Majlis poll could result in another percent of GDP by 2015—a seriously vulnerable hung parliament. situation, given the recent slowdown in tourism, and the susceptibility of the economy to external shocks Real GDP growth is reckoned to have reached (such as commodity price hikes). 3.4 percent in 2012, on the back of sluggish tour- ism performance. Inflation has remained subdued on account of favorable global commodity prices, especially food and fuel. However, recent increases Outlook and Policy  in global fuel prices are likely to stoke inflationary pressures. The political tensions are likely to prevail through the lead-up to the elections—and beyond, if any of Maldives GDP and Tourism Growth, %, Real the major polls turn out inconclusive. An incon- 50 clusive or disputed outcome would likely prolong 40 tensions and policy uncertainty. 30 Growth prospects for 2013 and beyond may remain weak in the face of sluggish global prospects, with 20 the political crisis also a dampening factor. The 10 IMF predicts only slow growth over the medium term—reaching 3.8 percent in 2013, and thereafter 0 around 4 percent growth in 2014 and 2015. This 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012e -10 is strongly commensurate with the expected low growth in the tourism sector, mainly in view of the -20 falling average duration of stay. -30 The dire fiscal position and the government’s -40 recourse to highly imprudent financing of the cash-flow shortfall could have far-reaching con- Real GDP Tourism Growth sequences. The 2013 budget addressed the issue Sources: Maldives Monetary Authority and WB sta estimates by emphasizing consolidation of the fiscal situa- tion—increasing taxes and cutting expenditures. But Spring 2013 47 Monthly scal cost of subsidies in the Maldives Distribution of electricity subsidy bene ts in Male, 2012 (2009-11), million ruf iyaa (HIES estimates) 50 35% 45 30% 30% 40 Proportion of total subsidy bene ts 35 25% Millions. Rf 30 21% 19% 19% 20% 25 20 15% 12% 15 10% 10 5% 5 0 0% Jan 2010 July 2010 Jan 2011 July 2011 Jan 2012 Poorest 2 3 4 Richest quintile quintile Usage subsidy Fuel surcharge Total Source: World Bank sta estimates Source: World Bank sta estimates these measures are unlikely to succeed—particularly the expenditure cuts, which lack specific policies to ensure compliance. The authorities need to take more urgent action, such as (i) better targeting of the main subsidy schemes—particularly electricity and Aasandha health insurance, and (ii) freezing capital expenditure for the foreseeable future. In the medium term, the government should also seek to rein in the biggest scourge of the public finance system: the size of the public sector and associated high costs of pay and allowances. As long as the unsustainable fiscal deficits persist, the rufiyaa will be under pressure. The prospects of further money printing threaten the external stability and risk a sharp adjustment in the exchange rate. The biggest risk posed by a further exchange-rate adjust- ment is the possible impact it could have on poverty; the recent HIES shows that poverty rates remain high despite years of fast per-capital income growths. However, a move to a more flexible exchange rate system—perhaps through the widening of the exist- ing band of the managed float, or outright currency flotation—would be futile in the face of persistently high fiscal deficits. The monetary authorities need to liaise closely with their fiscal counterparts to bring about the necessary adjustments, even though such adjustments are bound to be painful. A proper and sufficient level of adjustment, on the other hand, would likely see the resumption of the stalled IMF program, and open the door f or more donor support. 48 South Asia Economic Focus Nepal positive but are dwindling as the deficit grows. It has increased by one percentage point of GDP per annum for the past five years (except in fiscal 2010, when it shot up to 26.2 percent of GDP). Nepal has Nepal experienced a significant slowdown to the lowest a narrow range of export products, whose total value levels of growth in a decade. Persistent political instabil- amounted to barely 5 percent of GDP. By contrast, ity, a related shortfall in public spending, a weak invest- consumption-fueled imports have been growing ment climate and its dependence on India’s business cycle steadily in share of GDP, and are now six times continue to shape Nepal’s economic near term outlook. higher in value than export earnings. Remittance inflows are financing the trade deficit but this may not be sustainable. Remittance inflows Recent Economic Developments  are estimated at 23.1 percent of GDP, which is just enough to cover the net deficit of goods and services, Political instability has governed economic per- amounting to 23 percent of GDP. The difference al- formance in the current fiscal year, with growth lowed Nepal to maintain a positive current account expected to be well below expectations with public balance in fiscal 2012 and to accumulate reserves spending having slowed sharply. In the short to equivalent to 10.3 months of imports of merchandise medium term, however, there are reasons for cautious and services, the highest yet seen. optimism: not only has the (partial) resolution of the political stalemate opened the possibility of a more Public expenditure dipped in the absence of a full normal fiscal stance, but overall risks—linked mostly budget (which might emerge in April). The inabil- to the financial sector—have also decreased, thanks ity of political parties to agree on either a consensus to the government’s active reforms in that area. government or budget through fiscal 2013 (to date) prompted the President to limit spending to the same The growth rate for fiscal 2013 is projected to be actual nominal expenditure of the previous fiscal 3.0-3.5 percent, the lowest in a decade. The initial year—while leaving tax rates unchanged and prohib- projection of 3.8 percent growth was downgraded iting domestic borrowing. Authorized expenditure to account for (i) a significant shortfall in public for fiscal 2013 amounts to 18.3 percent of GDP, spending, particularly on infrastructure; (ii) low the lowest in the past five years. A mid-term budget levels of private investment due to structural weak- review estimates a 1.1 percent of GDP shortfall in nesses such as power outages, labor issues, and allocations for the year under the current budget ar- policy inconsistencies, and political uncertainty; rangement. A budget ceiling of 22.7 percent of GDP (iii) strong linkages with India’s economy that is ex- is proposed for fiscal year 2014. pected to slow significantly in fiscal 2013; and (iv) a disappointing monsoon that depressed agricultural Budgetary issues aside, tax collection has improved production. with the use of progressive instruments. Revenue targets will be met, if not exceeded. In the first half Despite low growth, inflation is expected to re- of fiscal 2013, income, trade and VAT tax collec- main high and the current account to slip back into tion rates exceeded the six-month targets. Revenue deficit. Inflation, currently at 9.5 percent, is expected collection in January was NRs.134.6 billion, 102 to remain well above the policy target of 7.5 percent percent above the targeted NRs.131.9 billion. because of large remittance inflows, accommodative monetary policy, and supply-side rigidities. Both, Financial market liquidity stresses have eased from food and non-food prices rose in the first seven last fiscal year, but not disappeared. The overall months of the fiscal year (by 9.9 percent and 11.2 credit-to-deposit ratio was 82.2 percent (mid-Jan) percent), well above the rates for the same period in compared to 78.4 percent the year before and 76.2 fiscal 2012. percent in 2011. Aggressive lending by banking and financial institutions resulted in this mismatch with The trade deficit rose to nearly one-quarter of deposits growing at a rate of 4.4 percent (NRs.38 GDP in fiscal 2012 and remains on an upward billion) compared to credit growth of 12.3 percent course. Both current and reserve accounts remain (NRs.76 billion). Spring 2013 49 Nepal has met the MDG target of halving the GDP percentage of people living on less than USD 1.25 per day. The number of poor has declined dramati- 6 cally since the mid-1990s. In 1996, 68 percent of the 5.5 population lived under USD 1.25 per day; by 2011 4.8 5 this had fallen to 24.5 percent. The pace of poverty reduction accelerated sharply in the last decade, from 4 3.8 1.5 percentage point per year during 1996-2004, to 2.5 percentage points during 2004-2011—faster 3 even than that of Bangladesh. 2 Remittance—which accelerated in the post- conflict period—also played a key role in poverty 1 0.1 reduction. Nepal is the world’s largest recipient of 0 foreign remittance in proportion to GDP (25 per- 2001 2002-07 2008-12 2011-13 cent) among countries with populations bigger than Con ict Year Peace Constitution Three Year 10 million. The proportion of households receiving negotiation writing Plan period period Target remittance (internal or external) rose from 23 percent in fiscal 1996 to 32 percent in 2004, then jumped to GDP 56 percent in fiscal 2011. Can Nepal overcome its historic inertia to fully ex- ploit its geographic advantage between two of the Outlook and Policy  world’s most populous and fast-growing econo- mies in order to improve its investment climate, The economy could rebound if the trend towards fast-track completion of infrastructure projects, political stability firms. This, with the expected and open its abundant resources to foreign invest- recovery of India’s economy and pull from the ment? The establishment of the Investment Board construction and services sectors could push Nepal’s Nepal has begun to facilitate smoother processing growth above 5 percent, especially if the country of large investment projects, but Nepal’s poor imple- takes full advantage of China’s granting of zero-tariff mentation record suggests more challenges lie ahead. status on most Nepali products. However, much depends on the success of the upcoming elections and whether the new government will fully utilize its opportunities. Stability is essential to hydro and construction sec- tors which require significant upfront investments and long-term engagement. Financial agreement has been concluded to build a 750 MW medium- size hydro scheme in 2014, while another 309 MW medium-size hydro project is expected to begin generating power in fiscal 2015. Risks remain high, however, and the future rate of remittance inflows will be critical. The current slowdown in growth of remittance flows could put pressure on domestic borrowing to fund larger public expenditure outlays. The country remains at moder- ate risk of debt distress, and further pressure from the use of high interest-bearing channels could set the government on the edge of a “fiscal cliff ”. 50 South Asia Economic Focus Pakistan Progress on critical structural reforms, especially in tax administration and the energy sector, has ef- fectively stalled. The government has not increased power tariffs since May 2012 and unofficial estimates Pakistan has entered a new stage of external weakness. of the circular inter-agency debt are approaching The fiscal deficit is widening and stalled progress on Rs.600 billion. These constraints, together with dif- structural ref orms, in particular tax and energy related, ficulties encountered by the sector, such as reduced pose major near term challenges.The completion of a full allocations of the low-cost natural gas feedstock, term by the government marked a historic milestone in and delays in appointing professional boards (which the country’s democratic development. discourage private sector investment in electric- ity generation, leading to high load-shedding levels averaging 8 hours per day) continue to undermine growth. Recent Economic Developments  Power sector subsidies have continued to propel ex- penditures. Confounding government’s expectations, Pakistan’s economy is slowing, moving from power sector subsidies increased and by the end of borderline stagflation to deflation as real GDP the first half of the fiscal year, 80 percent (i.e., Rs.166 growth hovers around a mediocre 3.5 percent billion) of the total subsidy budget was already spent, with downward bias. Inflation has sunk into with power sector subsidies amounting to 0.7 percent single digits, although it appears likely to return to of GDP. With election politics likely to prohibit any double digits by mid-year. The agricultural sector, major adjustment in power tariffs, the electricity contributing one-fifth of national GDP, is pro- subsidies are likely to continue or even be accelerated, jected to grow at half of its targeted 4.2 percent. and by the close of the fiscal year will likely exceed the In the industrial sector, large-scale manufactur- target by around 0.8 percent of GDP. ing—accounting for 52 percent of sectoral out- put—showed mild signs of revival in the first half On the positive side, provincial finances seem to of fiscal 2013, growing by less than 2 percent. The be doing much better than anticipated. Provincial services sector, which accounts for over 53 percent expenditure has risen much less than expected: only of domestic output, is expected to grow at a rate 9 percent. Hence, the provincial fiscal surplus was close to but lower than the targeted 4.6 percent. 0.6 percent in the first half of the fiscal year, which Its growth will remain broad-based, benefitting implies that the provinces could generate a full-year from growth in the wholesale and retail trade, fiscal surplus of 0.8 percent of GDP. finance and insurance, and public administration sub-sectors. The public debt-to-GDP ratio has maintained an upward trajectory. At end-December 2012, the The external position deteriorated significantly public debt-to-GDP ratio stood at 58.0 percent during the first eight months of fiscal 2013. Net of the projected GDP, about 0.5 percentage point international reserves fell from about 2.6 months higher than at end-December 2011. The rising of next year’s imports to 1.8 months. This is not short-term financing pattern of the government, attributable to the current account; indeed, mild has exposed scarce budgetary resources to enormous export growth, declining imports associated to the interest outlays. Interest on floating debt alone was economic slowdown and strong inflows of workers’ 20 percent of total revenues in the first half of fiscal remittance have resulted in a low current account 2013, about 62 percent more than that paid on the deficit projected to be around 0.8 percent of GDP. same instruments in the corresponding period last The risk lies in the precipitous decline in financial year. IMF repayments dominated the external debt. inflows—especially in FDI to about one-third of The external debt of the country declined by USD its fiscal 2011 level—and scheduled external public 2.2 billion in the first half of fiscal 2013 mostly be- debt repayments that are draining reserves. Foreign cause of IMF repayments of about USD 1.2 billion. aid inflows remained weak during the first half of the year and are not expected to be significant in financ- The overall slowdown in economic activity is due ing the fiscal deficit. also in part to low credit to the private sector. The Spring 2013 51 Rs.104.5 billion disbursement to the private sector Real Policy and Weighted Average Lending Rates during the first half of fiscal 2013 appears much 6.0 lower than that of the same period in fiscal 2012 (Rs.194 billion). Credit to private sector businesses, which truly captures private sector activities, in- 4.0 creased modestly by Rs.153.5 billion during the first half of fiscal 2013 (Table 6), the biggest expansion 2.0 of the last three years. Most of this expansion came from meeting working capital needs, which stood at Rs.127.9 billion. 0.0 The balance of payments (BoP) situation -2.0 remains stressed: The reason for this is the sudden halt in financial inflows, aggravated by high scheduled debt repayments. The official -4.0 government inflows are barely sufficient to meet Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12 the amortization of medium- and long-term loans. Besides marginal improvement in the trade Real WALR Real Policy Rate deficit and robust growth in workers’ remittances, the external current account deficit for fiscal Source: State Bank of Pakistan Real rates calculated using y-o-y in ation 2013 is projected to remain at around 0.7 percent of GDP. (ROA) and return on equity (ROE) remained at The trade deficit of USD 8.8 billion from July- satisfactory levels of 2.1 percent and 22.9 percent January of fiscal 2013 is small. Although exports respectively, and the sector’s liquidity position grew by slightly less than 1 percent in this time, the improved. marginal improvement in the trade deficit was due to a contraction of 2.2 percent in imports. The overall Credit quality remains a risk, but shows signs slowdown in productive activity in the economy and of stabilizing. Non-performing loans (NPLs) the reduction in the prices and volumes of imports remain high, at 14.5 percent of loans in Decem- explain this result. ber 2012, and present a medium-term risk to the sector, but have declined over the past year (15.7 Inflationary pressures eased considerably over the percent in December 2011). The microfinance last eight months of fiscal 2013. But risks remain. sector is one of the most progressive and innova- CPI inflation declined to 7.4 percent (y-o-y) in tive globally, but lags substantially in its overall February 2013, from 11.3 percent in June 2012. outreach to demand, particularly women. The Both food and non-food groups contributed to this sector registered a 13.6 percent increase in active deceleration, but the share of the non-food group borrowers, 32.6 percent growth in gross loan port- was relatively higher than the food group. Food folio, 19 percent increase in savers, and 61 percent inflation declined from 10.3 percent in June 2012 in value of savings between December 2011 and to 5.3 percent in November 2012 before increasing December 2012. to 7.4 percent in February 2013. The State Bank of Pakistan (SBP) reduced the policy rate by 250 bps in the first half of fiscal 2013. The Net Foreign Assets (NFA) of the banking system contracted by Rs.80 Outlook and Policy  billion (negative growth of 22.3 percent y-o-y) dur- ing Jul 1-Feb 22, 2013. The major risk comes from the significant weaken- ing of the external position. The main issues are Financial Sector developments: The banking the sudden stoppage of financial inflows—especially system maintained profitability during 2012 with the fall in FDI to about one-third of its fiscal 2011 before-tax profit increasing 10 percent compared level—and scheduled external public debt repay- to the previous calendar year. Both return on assets ments that are draining reserves. 52 South Asia Economic Focus The fiscal situation is worrisome. Pakistan is poised high, at 14.5 percent of loans in December 2012, and yet again to miss all of its budget targets by large present a medium-term risk to the sector, but have margins. Expenditure overruns in an election year are declined over the past year (15.7 percent in Decem- likely to remain substantial, as power sector subsidies ber 2011). Vulnerability to default risk remains but remain high. Revenue shortfalls are expected to be has been mitigated so far by adequate provisioning large, due partly to the long-standing structural requirements and strong earnings (Net NPLs to problems with tax policy and tax administration but loans are at 4.6 percent compared to 5.4 percent also to an apparent slowdown in domestic economic in December 2011). Banks are moving aggressively activity and reduced oil imports (a major source of into new financing avenues, with some using mobile revenue). The budget deficit could balloon to 7 per- phone technology to reach to the un-banked seg- cent of GDP by the end of the year—well above the ment of the economy. budget target of 4.7 percent. There is a growing national consensus that the Collection of Selected Tax Revenues country needs to recover its external position. H1-FY2013 Talks begun in February for another IMF-supported 5.0% stand-by arrangement (SBA) but stalled because of 4.6% 4.5% the authorities’ failure during the election campaign 3.9% 4.0% to agree on satisfactory revenue generation measures and properly contain expenditure for fiscal consol- 3.5% idation—a situation aggravated by a questionable 3.0% 2.9% tax amnesty scheme. How soon the SBA negotia- Percent of GDP 2.5% 2.5% tions resume will likely depend in the near term on the caretaker or next government. Budget support 2.0% from the World Bank and other donors remains 1.5% 1.1% dependent on not only establishing a satisfactory 1.0% framework for economic stabilization and recovery, 1.7% 0.5% 0.5% 0.5% 1.4% 0.6% but on designing a comprehensive growth-oriented 0.3% 0.3% 0.5% 0.2% 0.2% set of structural reforms in areas such as power sector 0.0% Direct Customs Sales Tax Federal Petroleum reform, economic governance (business climate, and Taxes Excise Levy state-owned enterprises), trade diversification, job Budget creation and the safety-net system. The approaching Remaining Collected two-to-three-months transition period of the care- Source: Ministry of Finance taker government could help to restore momentum in the key reforms essential for not only recovering Credit quality shows signs of stabilizing but is solid macro fundamentals but fostering Pakistan’s still at risk. Non-performing loans (NPLs) remain growth agenda in the medium term. Spring 2013 53 Sri Lanka On the production side, favorable weather condi- tions supported good agricultural growth overall Sri Lanka’s growth moderated, however, remains at in 2012, while the industrial and services sector healthy levels. To sustain growth in the future, the coun- growth rate respectively stagnated and moderated. try will face the challenges of strengthening the revenue side of the fiscal balance as well as attracting greater While inflation has risen from 2011, it is still man- foreign investment flows. ageable, in single digits. Moderating demand has put downward pressure on inflation, counteracting cost-push pressures that would have driven it higher. Year-end inflation reached 9.2 percent (y-o-y) com- RECENT ECONOMIC pared to 4.9 percent in 2011, while the average for DEVELOPMENTS the year was 7.5 percent compared to 6.7 percent for 2011. The data for early 2013 indicate a further rise, though not beyond single digits—February’s Economic growth moderated in 2012, signaling a headline inflation coming in at 9.8 percent (y-o-y). tempering of the post-conflict boom. Nevertheless, GDP growth was still a healthy 6.4 percent in 2012, Monetary policy has turned back towards accom- far above regional peers, though significantly below modation, reversing a brief period of tightening. the 8.2 percent averaged through 2010 and 2011. The This was likely due to falling growth rates and the slowdown was due largely to (i) conscious macroeco- prevalence of low inflation. The central bank had nomic policies aimed at managing credit growth in raised policy interest rates in February and again the face of aggravating balance of payments (BoP) in April, keeping them steady until making a small issues, and (ii) dampened global economic condi- downward adjustment in December. tions that impacted particularly the country’s main export markets. The external balance improved because of a re- duction in imports, while continued inflows to Sri Lanka Performance vs. Regional Peers services, income and financial accounts provided a 12 more comfortable cushion against external risks in 2012 compared to 2011. The import bill declined by 10 5.8 percent in 2012 to USD 19.1 billion, largely be- cause of the policy measures introduced early in the 8 year, lower global commodity prices, and a weaker 6 rupee. The trade balance improved from a deficit of 16.4 percent of GDP to 15.8 percent, while the cur- 4 rent account deficit improved from nearly 8 percent of GDP to 6.6 percent. With these developments, 2 the country’s basic balance improved in 2012 to a - deficit of 5.2 percent of GDP from a deficit of 5.7 2007 2008 2009 2010 2011 2012f percent of GDP the year before. (2) (4) Lower middle income countries (average) Vietnam India Malaysia The Sri Lankan rupee depreciated rapidly with Bangladesh Sri Lanka Indonesia relaxation of the forex market in early 2012 but Sources: World Bank data, Global Economic Prospects 2012 settled to around SLRs.127/USD 1 by year’s end. and WB sta estimates, Economist Intelligence Unit By not intervening aggressively, the central bank managed to build up its foreign exchange reserves from a somewhat precarious three-and-a-half months of imports at end-2011 to a relatively better four-and-a-quarter months of imports by end-2012. 54 South Asia Economic Focus Spring 2013 The weakening of the currency had little impact on Sri Lanka Real E ective Exchange Rate, 2005=100 inflation, thanks to strong support from domestic 135 supply that helped contain price impacts, and the moderation of aggregate demand. In step with the 130 sharp currency depreciation, the real exchange rate also depreciated sharply post-February. However, 125 these trends reversed later in the year as positive inflation differentials built up and inflow of foreign 120 exchange, largely through the financial accounts of the BoP, maintained the strength of the currency. 115 Overall fiscal policy remained stimulatory while 110 the overall deficit narrowed only marginally to 6.4 percent of GDP in 2012, from 6.8 percent in 2011. 105 Several structural weaknesses in the fiscal structure + indicates appreciation came into sharp focus in 2012—notably weak rev- 100 enues, which reached their lowest levels in history. 2006M1 2006M5 2006M9 2007M1 2007M5 2007M9 2008M1 2008M5 2008M9 2009M1 2009M5 2009M9 2010M1 2010M5 2010M9 2011M1 2011M5 2011M9 2012M1 2012M5 2012M9 2012M13 Source: IMF  Outlook and Policy The country will need decisive policies to meet its increasing challenge of maintaining government ex- medium-term challenges. Fiscal policy, in particular, penditure on public investments at 6.0-6.5 percent of will need to place emphasis on reforming the state- GDP. The problem is aggravated by a lack of effective owned enterprise sector, and require a combination reform in the SOE sector, with several SOEs being of hard budget constraints and broad-based reforms a considerable drain on fiscal resources. Sri Lanka’s to stop the current hemorrhaging. The government long-term decline in exports gives reason for concern, needs also to adopt policies that attract greater highlighting a need to reverse the country’s increased foreign investment in order to buoy the country’s reliance on domestic sources for growth. growth potential. The long-term decline in exports gives cause for concern; the authorities need to focus The government’s medium-term revenue growth beyond traditional export markets, into more of the target appears ambitious, particularly in light of emerging markets. the poor revenue fundamentals in the country. Contemporary analysis shows that Sri Lanka has Structural limitations threaten Sri Lanka’s abil- one of the highest gaps between actual and potential ity to sustain the high level of economic growth of revenue in South Asia, with these gaps likely to recent years. Firstly, the country’s current investment worsen. Furthermore, Sri Lanka also records one levels are well below the rates required to spur the of the lowest revenue buoyancies in South Asia—a 8 percent-plus growth envisaged by the government. ratio close to 0.61, substantially below unity. Sri Investment rates in Sri Lanka rose to 30.6 percent Lanka’s low buoyancy seems to come from poor of GDP in 2012, from 30 percent in 2011. To sustain performance of all tax instruments. No individual 8 percent-plus growth Sri Lanka will require invest- tax category has buoyancy above 1.0, and buoyancy ment rates of 35-40 percent of GDP. This will require is particularly low for VAT, the single largest source increased domestic investment but also foreign invest- of tax revenue. Against this backdrop it is important ment—in particular foreign direct investment (FDI). that the government gives due cognizance to the rec- FDI is particularly important in the Sri Lankan con- ommendations of the Presidential Tax Commission text because it facilitates technology transfers which (PTC) that delivered its findings to the government support productivity and innovation. However, Sri in September 2010. While the 2011 budget did take Lanka has not shown a striking ability to attract suf- cognizance of some of these recommendations, a ficient FDI in the recent past. Sustaining economic lot more needs to be done to revamp the revenue growth will be subject to fiscal constraints and the machinery. South Asia Economic Focus Spring 2013 57 V South Asia at a Glance AFG (1) BGD (6) BTN (12) IND (16) MDV (24) NPL (29) PAK (34) LKA (44) SAR (50)   2010 8.4 6.1 10 10.5 7.1 3.9 3 (35) 8 10 Real GDP 2011 7.3 6.7(p) 9 6.3 7.0 4.6 3.7 8.3 7.2 Growth 2012 11.8 (e) 6.3(p) 7.6 (p) 4.7 (p) 3.4 (e) 3.0 (p) 3.5 (e) 6.4 (e) 4.7 2013 3.1 (e) 5.8 (p) 14 (p) 6.1 (p) 4.3 (p) 3.9 3 (e) 7 (e) 5.5 (f ) 2010 1.1 7.3 6.3 9.6 (17) 6.1 (e) 9.6 13.7 5.9 9.2 Inflation 2011 12.8 8.8 5.7 8.9 13 (e) 8.3 11 4.9 (Year end) 9.6 OUTPUT and PRICES (y-o-y) 2012 6.3 10.6 8.9 7.3 (p) 12.3 (e) 8 11.01 (e) 6.7 (average) 8.6 2013 7 (e) 7 (e) 9.1 6.9 (p) 5.8 (p) 8.03 (e) 10.4 (e) 7.5 (average) 8.4 (Feb 2013) 2010 9.8 (2) 4.8 .. 5.0 .. 5.8 9.3 7 .. 2011 15.9 6.8 .. 7.3 .. 6.4 9.9 6.9 .. Core Inflation 2012 7.6 11.5 .. 5.4 .. 10.7 10.6 5.8 .. 2013 .. 7.5 (7) .. 3.9 (18) .. 9.9 (30) 9.8 (36) 7.4 (45) .. 2010 -1.4 10.1 10(Q4) 14.2 12.4 13.5 .. 6.9 11.4 2011 12.1 12.8 9 (Q4) 7.9 12 13 11 9 11.4 Food Inflation 2012 4.6 7.5 12(Q4) 8.1 -8 8 9 5 4.9 2013 .. 7.8 .. 10.4 -2 10 8 12 7.5 (Feb 2013) 2010 2.8 1.8 (8) -1.39 (13) -2.7 -7.3 (e) -0.9 -0.7(37) -2.0 -2.6 Current 2011 2.2 0.2 -19.11 -4.2 -1.3 (e) 4.7 -1 -7.8 -3.1 Account 2012 3.9 (e)(3) 0.8 (e) -25.5 -5.1 (p) -4.2 (e) 0.6 (p) -0.8(p) -6.6 (e) -4.5 (% of GDP) 2013 1 (e) 0.8(f ) -20.77 -4.5 (p) -9.3 (p) -0.3 (p) -1(f ) -4.7 (e) -3.7 (f ) 2010 -45.9 -10.7 -7.92 -7.5 15.1 (e)(25) -26.2 -0.5 -9.7 -5 Trade Balance 2011 -43.6 -11.3 -31 -8.8 3 (e) -25.8 -8 -16.4 -6 (% of GDP) 2012 -43.1 (e) -10 -32.32 -10.9 -3.1 (e) -25.2 -7.4 (p) -15.8 .. BALANCE of PAYMENTS 2013 .. .. -28.25 .. -6 (p) .. .. .. .. 2010 5.1 5.5 36.9 (e) 28.8 14.2 (e) 10.2 14.9 31.8 16.0 Import 2011 6.7 41.8 39.4 (e) 24.2 33.8 (e) 3.4 12.8 50.7 17.8 Growth 2012 5.0 (e) 5.3 -3.3 (e) 11.9 1.5 (e) .. -2.2 -5.8 (e) 8.6 2013 0.6 (e) 2.1 (p) 2.4 (p) 18.6 (p) 5.1 (p) .. 6 (e) 11 (e) 5.8 (f ) 2010 4.8 4.1 7.1 (e) 37.5 25 (e) 13.2 28.9 21.0 14.0 Export 2011 4.2 41.5 21.8 (e) 17.9 15.9 (e) 5 -2.6 22.4 16.7 Growth 2012 -5.0 (e) 5.9 -1.6 (e) 13.5 (p) -4.2 (e) 6.9 (p) 1 -7.4 4.5 2013 -2 (e) 7.2 (p) 4.2 (p) 24 (p) 2 (p) 8.1 (p) 7 (e) 7 (e) 5.9 (f ) 2010 .. 10.9 (9) .. 54 (19) -0.19 3.5 (31) 9.7 (38) 4.2 (46) 82 (51) Remittances 2011 .. 12.1 .. 63 -0.22 4.2 12.3 5.2 97 Photo: © World Bank/Sofie Tesson 2012 .. 13.7 (e) .. 69.8 (e) .. 5.1 (e) 13.9 6.3 (e) 109 (e) 58 South Asia Economic Focus AFG (1) BGD (6) BTN (12) IND (16) MDV (24) NPL (29) PAK (34) LKA (44) SAR (50)   2010 0.9 (4) 3.7 -2.1 -6.8 (central govt) -7.3 (e)(26) -0.8 -6.4 -8 -8.7 Fiscal Deficit 2011 -0.9 4.1 -0.7 -6 -1.3 (e) -0.9 -8.5 -6.8 -7.6 GOVERNMENT FINANCES and MACRO POLICIES (% of GDP) 2012 1.6 (e) 4.5 -1.6 (p) -5.2 -4.2 (e) -0.6 -7 (p) -6.4 -9 (e) 2013 1 (e) 4.5 -1.4 (e) -5.4 -9.3 (p) 3.6 -7 (e) -5.8 (e) -8.3 (f ) 2010 13.8 .. 54 (e) 47.4 62 (e) 33.3 62 (e) 81.9 .. Debt to GDP 2011 13.2 .. 72 (e) 48.1 71 (e) 33.3 57.5 (Dec 2011) 78.5 .. Ratio (%) 2012 11 (e) .. 76 48.2 (f ) 86 31.3 58 (Dec 2012) 82 (end of 2012) .. 2013 .. .. 86 (e) 47 (f ) 105 (e) 30.7 63 (e) .. .. 2010 6.7 5.1 13.9 7.1 (20) 4 (end of 2010) 5.4 (32) 3.9 (39) 6.4 .. Reserves 2011 7 3.9 11.2 5.0 3 (end of 2011) 10.3 2.6 3.5 .. in Months 2012 7.7 (e) 3.3 9.5 4.4 (p) 2 (end of 2012) 6.2 (p) 2.6 (June 2012) 4.3 .. of Import 2013 .. 3.5 9.6 4 (p) .. .. 1.8 (Feb 2013) .. .. 2010 163.05 (5) 62.01 (10) 97.4 (e)(14) 54.42 (21) 124.53 (27) 54.08 (33) 71.86 (40) 81.97 (47) .. 2011 163.99 62.2 98.6 (p) 60.16 134.97 45.95 66.84 57.34 .. REER 2012 105.77 57.27 .. 60.88 120.31 40.31 52.85 47.8 .. 2013 127.32 (Q1) 48.11 (Q1)   51.08 (Q1) 95.73 (Q1) 47.11 (Q1) 42.33 (Q1) 40.83 (Q1)   2010 120 82 66.3 (e) 72.5 .. 88 90 66 .. Consumption 2011 120 84 64.1 (e) 72.8 .. 91 92 70 .. (% of GDP) 2012 .. .. 63.2 (e) 77 (p) .. 80 .. 69 (e) .. 2013 .. .. 60.7 (p) 75.5 (p) .. 88 (C) .. .. .. CONSUMPTION and INVESTMENT 2010 27 24.4 51.6 (e) 31.7 .. 32.5 16 28 28 Investment 2011 25 25.2 59.4 (e) 30.6 .. 32.8 12.5 29.9 27 (% of GDP) 2012 .. 25.4 61.8 (e) 30.5 (p) .. .. 11 30.6 (e) .. 2013 .. .. 65 (p) 31.3 (p) .. .. .. .. .. 2010 .. 0.9 0.019 (e) (15) 37.6 (22) 0.22 (e)(28) 0.1 1.6 (41) 0.4 (48) 30.4 (52) 2011 .. 0.8 0.016 (e) 38.6 0. 28 (e) 0.1 0.9 0.9 35.7 FDI 2012 .. 1.0 0.011 (e) 35 (p) 0.16 (e) .. 1.3 .. 29.7 (e) 2013 .. .. 0.011 (p) 44.5 (p) 0.22 (p) .. .. .. 36.9 (e) 2010 .. -0.07 (11) .. 28.2 (23) .. .. 0.3 (42) .. 29.9 (53) Portfolio 2011 .. 0.01 .. 16.6 .. .. -0.1 -0.2 (49) -4.8 Investment 2012 .. 0.06 .. 15 (p) .. .. 0.8 (43) 0.3 11.5 (e) 2013 .. .. .. 18 (p) .. .. .. .. 16.4 (f ) Spring 2013 59 Notes: (Table South Asia at a glance) e Estimate f Forecast p Projections Afghanistan 1 These numbers are for fiscal year unless otherwise mentioned. For example; for 2010 numbers, 2010-2011 values are used. 2 Core inflation (exc. Fuel and cereal, %) 3 Including grants 4 Overall Core Balance incl. grants 5 WB Staff Calculations Bangladesh 6 These numbers are for fiscal year unless otherwise mentioned. For example; for 2010 numbers, 2010-2011 values are used. 7 (Avg of Jan-Feb) 8 Current Account bal/GDP (%) is for calendar year 9 Remittances numbers are taken from GEP 2013 Jan report and they are calendar year numbers (USD billions) 10 WB Staff Calculations 11 Portfolio Investment Liabilities, US $ billions Bhutan 12 These numbers are for calendar year unless otherwise mentioned. 13 Current Account surplus or deficit (% of GDP) 14 WB Staff Calculations 15 Net private foreign direct investment (USD billion) India 16 These numbers are for fiscal year unless otherwise mentioned. For example; for 2010 numbers, 2010-2011 values are used. 17 Wholesale Price Index 18 (Avg of Jan-Feb) 19 Remittances numbers are taken from GEP 2013 Jan report and they are calendar year numbers (USD billions) 20 Foreign Exchange Reserves (in months of next year’s goods and services imports) 21 WB Staff Calculations 22 Foreign Investment (US billion) 23 Portfolio Investment, net (US billion) Maldives 24 These numbers are for calendar year unless otherwise mentioned. 25 WB Staff Calculations 26 WB Staff Calculations 27 WB Staff Calculations 28 Net private Foreign direct investment (USD billions) 60 South Asia Economic Focus Spring 2013 Nepal 29 These numbers are for fiscal year unless otherwise mentioned. For example; for 2010 numbers, 2010-2011 values are used. 30 (Avg of Jan-Feb) 31 Remittances numbers are taken from GEP 2013 Jan report and they are calendar year numbers (USD billions) 32 Gross official reserves in months of GNFS (goods and nonfactor services) imports 33 WB Staff Calculations 34 Pakistan 34 These numbers are for fiscal year unless otherwise mentioned. For example; for 2010 numbers, 2010-2011 values are used. 35 Real GDP Growth ( at factor cost) 36 (Avg of Jan-Feb) 37 Current Account Bal/GDP (%) is for calendar year 38 Remittances numbers are taken from GEP 2013 Jan report and they are calendar year numbers (USD billions) 39 SBP Gross Reserves exclude Cash Reserve Requirement, gold and foreign currency deposits of commercial banks held with SBP & In months of next year`s imports of goods and services. 40 WB Staff Calculations 41 & 42 USD billions 43 Portfolio Investment Liabilities Sri Lanka 44 These numbers are for calendar year unless otherwise mentioned. 45 (Avg of Jan-Feb) 46 Remittances numbers are taken from GEP 2013 Jan report and they are calendar year values which is same as the fiscal year (USD billions) 47 WB Staff Calculations 48 & 49 USD billions SAR 50 These numbers are for calendar year unless otherwise mentioned. 51 Remittances numbers are taken from GEP 2013 Jan report and they are calendar year numbers (USD billions) 52 & 53 USD billions Sources: World Bank, IMF, CEIC, National Authorities 1818 H Street, N.W. Washington, DC 20433