A World Bank Group Flagship Report JANUARY 2019 Global Economic Prospects Darkening Skies JANUARY 2019 © 2019 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington, DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Some rights reserved. 1 2 3 4 22 21 20 19 This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. 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Summary of Contents Chapter 1 Global Outlook: Darkening Skies..................................................................... 1 Chapter 2 Regional Outlooks ....................................................................................... 55 Chapter 3 Growing in the Shadow: Challenges of Informality........................................ 127 Chapter 4 Two Topical Essays .................................................................................... 197 Debt in Low-Income Countries: Evolution, Implications, and Remedies ........ 199 Poverty Impact of Food Price Shocks and Policies ........................................ 209 Boxes Box 1.1 e great disin ation ...................................................................... 8 Box 1.2 Low-income countries: Recent developments and outlook................. 22 Box 1.3 Regional perspectives: Recent developments and outlook .................. 26 Box 2.1.1 Informality in East Asia and Paci c ................................................ 63 Box 2.2.1 Informality in Europe and Central Asia ........................................... 75 Box 2.3.1 Informality in Latin America and the Caribbean .............................. 85 Box 2.4.1 Informality in the Middle East and North Africa.............................. 95 Box 2.5.1 Informality in South Asia............................................................. 104 Box 2.6.1 Informality in Sub-Saharan Africa ................................................ 113 Box 3.1 Linkages between formal and informal sectors ................................ 132 Box 3.2 Regional dimensions of informality: An overview ............................140 Box 3.3 Casting a shadow: Productivity in formal and informal rms ......... 146 Box 3.4 Under the magnifying glass: How do policies affect informality? ...... 155 III Table of Contents Foreword..................................................................................................................................xiii Acknowledgments ..................................................................................................................... xv Executive Summary.................................................................................................................. xvii Abbreviations ........................................................................................................................... xix Chapter 1 Global Outlook: Darkening Skies..........................................................................1 Summary ............................................................................................................3 Major economies: Recent developments and outlook................................................7 United States ................................................................................................ 7 Euro Area ....................................................................................................13 Japan ..........................................................................................................13 China..........................................................................................................14 Global trends ..................................................................................................... 15 Global trade ................................................................................................. 15 Financial markets ......................................................................................... 17 Commodities .............................................................................................. 18 Emerging market and developing economies: Recent developments and outlook ....... 19 Recent developments .................................................................................... 20 EMDE outlook ............................................................................................ 28 Risks to the outlook............................................................................................ 30 Disorderly nancial market developments ....................................................... 31 Escalating trade restrictions ........................................................................... 32 Policy uncertainty and geopolitical tensions ..................................................... 33 Region-speci c downside risks ....................................................................... 35 Simultaneous slowdown in the two largest economies ....................................... 35 Possible productivity revival........................................................................... 37 Policy challenges ................................................................................................ 37 Challenges in advanced economies ................................................................. 37 Challenges in emerging market and developing economies ................................ 39 References ......................................................................................................... 47 Box 1.1 e great disin ation ...............................................................................8 Box 1.2 Low-income countries: Recent developments and outlook .......................... 22 Box 1.3 Regional perspectives: Recent developments and outlook ........................... 26 V Chapter 2 Regional Outlooks ............................................................................................ 55 East Asia and Pacific ......................................................................................... 57 Recent developments....................................................................................... 57 Outlook......................................................................................................... 59 Risks ............................................................................................................. 61 Box 2.1.1 Informality in East Asia and Pacific .................................................... 63 Europe and Central Asia ................................................................................... 69 Recent developments....................................................................................... 69 Outlook......................................................................................................... 70 Risks ............................................................................................................ 71 Box 2.2.1 Informality in Europe and Central Asia .............................................. 75 Latin America and the Caribbean ....................................................................... 79 Recent developments....................................................................................... 79 Outlook......................................................................................................... 80 Risks ............................................................................................................. 82 Box 2.3.1 Informality in Latin America and the Caribbean.................................. 85 Middle East and North Africa ............................................................................ 89 Recent developments....................................................................................... 89 Outlook......................................................................................................... 90 Risks ............................................................................................................. 91 Box 2.4.1 Informality in the Middle East and North Africa ................................. 95 South Asia ........................................................................................................ 99 Recent developments....................................................................................... 99 Outlook........................................................................................................100 Risks ............................................................................................................102 Box 2.5.1 Informality in South Asia ................................................................ 104 Sub-Saharan Africa ......................................................................................... 107 Recent developments......................................................................................107 Outlook........................................................................................................109 Risks ............................................................................................................110 Box 2.6.1 Informality in Sub-Saharan Africa.................................................... 113 References.....................................................................................................118 VI Chapter 3 Growing in the Shadow: Challenges of Informality.............................................127 Introduction .................................................................................................... 129 Informality: Conceptual considerations and measurement..................................... 136 Main features of the informal economy ............................................................... 137 Causes and implications of informality................................................................ 143 Correlates of informality ................................................................................... 144 Informality, poverty, and income inequality ........................................................ 152 Worker earnings differentials ....................................................................... 152 Aggregate income inequality and poverty....................................................... 154 Informality and fiscal outcomes.......................................................................... 158 Policy options .................................................................................................. 158 Fiscal policy measures.................................................................................. 159 Business climate and governance measures ..................................................... 160 From a comprehensive strategy to implementation ......................................... 162 Emerging policy opportunities and challenges ................................................ 162 Annex 3.1 Measures of informality ..................................................................... 163 Annex 3.2 Characteristics of informal-economy business cycles.............................. 167 Annex 3.3 Informality and earnings inequality: A meta-analysis approach ............... 167 Annex 3.4 Pre-existing informality and changes in poverty and income inequality ... 169 Annex 3.5 Labor legislation and informality ........................................................ 169 References ....................................................................................................... 184 Box 3.1 Linkages between formal and informal sectors.......................................... 132 Box 3.2 Regional dimensions of informality: An overview ..................................... 140 Box 3.3 Casting a shadow: Productivity in formal and informal firms ..................... 146 Box 3.4 Under the magnifying glass: How do policies affect informality ................. 155 Chapter 4 Two Topical Essays ........................................................................................ 197 Debt in Low-Income Countries: Evolution, Implications, and Remedies ................ 199 Introduction .............................................................................................. 199 Key characteristics of the recent rise in LIC debt ............................................ 199 Other LIC vulnerabilities ............................................................................ 202 Role of better debt management................................................................... 204 Complementary policy measures .................................................................. 206 Conclusion ................................................................................................ 207 Annex 4.1 Comparison of LIDCs and LICs................................................... 208 VII Poverty Impact of Food Price Shocks and Policies ................................................209 Introduction ..............................................................................................209 Food price shocks and their effects ................................................................211 Government interventions during food price shocks .......................................214 Poverty impact of the 2010-11 food price shock.............................................217 Conclusions ...............................................................................................220 Annex 4.2 Methodology ..............................................................................221 References........................................................................................................224 Statistical Appendix.............................................................................................................. 229 Selected Topics .................................................................................................................... 236 Figures 1.1 Summary - Global prospects ..................................................................... 5 1.2 Global risks and policy challenges.............................................................. 6 1.3 Advanced economies................................................................................ 7 1.1.1 Global inflation ....................................................................................... 9 1.1.2 Disinflation and factors associated with disinflation................................... 10 1.1.3 Inflation synchronization........................................................................ 12 1.1.4 Low inflation episodes............................................................................ 12 1.4 United States ........................................................................................ 13 1.5 Euro Area ............................................................................................. 14 1.6 Japan ................................................................................................... 14 1.7 China................................................................................................... 15 1.8 Global trade.......................................................................................... 16 1.9 Global finance....................................................................................... 17 1.10 Commodity markets .............................................................................. 18 1.11 Activity in EMDEs ................................................................................ 20 1.2.1 Recent developments in low-income countries .......................................... 23 1.2.2 Outlook ............................................................................................... 24 1.3.1 Regional growth .................................................................................... 27 1.12 EMDE growth prospects ........................................................................ 28 1.13 Poverty and per capita income growth ..................................................... 29 1.14 Risks: Tilted to the downside .................................................................. 30 1.15 Financial stress ...................................................................................... 32 1.16 Trade protectionism .............................................................................. 33 VIII 1.17 Policy uncertainty and other downside risks .........................................................34 1.18 Simultaneous slowdown in the two largest economies ...........................................35 1.19 Productivity revival ..........................................................................................37 1.20 Monetary and fiscal policy in advanced economies................................................38 1.21 Structural policies in advanced economies............................................................39 1.22 EMDE monetary policy .................................................................................... 40 1.23 EMDE fiscal policy........................................................................................... 41 1.24 EMDE structural policy .................................................................................... 43 2.1.1 EAP: Recent developments ................................................................................ 58 2.1.2 China: Recent developments .............................................................................. 59 2.1.3 EAP: Outlook and risks ..................................................................................... 60 2.1.1.1 Informality in East Asia and Pacific..................................................................... 64 2.1.1.2 Drivers and implications of informality in East Asia and Pacific ............................. 66 2.2.1 ECA: Recent developments................................................................................ 70 2.2.2 ECA: Outlook and risks ....................................................................................71 2.2.1.1 Informality in Europe and Central Asia .............................................................. 76 2.2.1.2 Correlates of informality in Europe and Central Asia ............................................ 78 2.3.1 LAC: Recent developments ................................................................................80 2.3.2 LAC: Outlook and risks ....................................................................................81 2.3.1.1 Informality in Latin America and the Caribbean................................................... 86 2.3.1.2 Evolution and correlates of informality in Latin America and the Caribbean............ 87 2.4.1 MENA: Recent developments ............................................................................90 2.4.2 MENA: Outlook and risks.................................................................................91 2.4.1.1 Informality in the Middle East and North Africa .................................................. 96 2.4.1.2 Correlates of informality and policy challenges in the Middle East and North Africa 97 2.5.1 SAR: Recent developments .............................................................................. 100 2.5.2 SAR: Outlook and risks ................................................................................... 101 2.5.1.1 Informality in South Asia................................................................................. 105 2.5.1.2 Drivers of informality in South Asia.................................................................. 106 2.6.1 SSA: Recent developments ............................................................................... 108 2.6.2 SSA: Outlook and risks ................................................................................... 109 2.6.1.1 Informality in Sub-Saharan Africa..................................................................... 114 2.6.1.2 Economic and institutional indicators in Sub-Saharan Africa ............................... 115 2.6.1.3 Correlates of informality in Sub-Saharan Africa.................................................. 116 2.6.1.4 Entrepreneurial conditions, entrepreneurship attitude, and informality indicators in Sub-Saharan Africa.................................................................................................. 117 IX 3.1 Informality: Magnitude and correlates ...............................................................131 3.1.1 Interaction between formal and informal economies ...........................................135 3.2 Informality in advanced economies and EMDEs.................................................138 3.3 Informality by EMDE region ...........................................................................139 3.2.1 Informality in EMDE regions...........................................................................141 3.2.2 Regional correlates of informality ......................................................................142 3.4 Changes in informality ....................................................................................144 3.5 Characteristics of informal- and formal-economy business cycles ..........................145 3.3.1 Characteristics of informal firms .......................................................................147 3.3.2 Formal firms facing informal competition ..........................................................149 3.3.3 Productivity of formal firms facing informal competition.....................................150 3.6 Correlates of informality: Economic and institutional factors ..............................151 3.7 EMDEs: Correlates of changes in informality .....................................................152 3.8 EMDEs: Estimates of informal-formal wage gap .................................................153 3.9 Informality, poverty, and income inequality .......................................................154 3.4.1 Overview of policy changes ..............................................................................157 3.10 EMDEs: Informality and fiscal outcomes...........................................................159 3.11 EMDEs: Policies to address challenges of informality ..........................................160 Annex Figure 3.5.1. Implications of relaxing the minimum wage restraint .........................171 4.1.1 LIC government finances ................................................................................200 4.1.2 Public debt in LICs .........................................................................................201 4.1.3 Risks to LIC debt sustainability ........................................................................203 4.1.4 External positions on LICs ...............................................................................205 4.1.5 LIC policy framework......................................................................................206 4.2.1 Global food prices ..........................................................................................210 4.2.2 Macroeconomic channels of transmission from global food prices ........................212 4.2.3 Microeconomic channels of transmission from global food prices ........................213 4.2.4 Food-related government policies .....................................................................215 4.2.5 Domestic and global food prices ......................................................................216 4.2.6 The extent of government interventions during the 2010-11 food price spike .......218 4.2.7 Poverty impact of policies implemented during the 2010-11 food price spike ........219 X Tables 1.1 Real GDP ........................................................................................................... 4 1.2.1 Low-income country forecasts ..............................................................................25 1.2 List of emerging market and developing economies.................................................46 2.1.1 East Asia and Pacific forecast summary ..................................................................62 2.1.2 East Asia and Pacific country forecasts...................................................................62 2.2.1 Europe and Central Asia forecast summary ............................................................73 2.2.2 Europe and Central Asia country forecasts .............................................................74 2.3.1 Latin America and the Caribbean forecast summary................................................83 2.3.2 Latin America and the Caribbean country forecasts.................................................84 2.4.1 Middle East and North Africa forecast summary ....................................................93 2.4.2 Middle East and North Africa economy forecasts ...................................................94 2.5.1 South Asia forecast summary .............................................................................. 103 2.5.2 South Asia country forecasts............................................................................... 103 2.6.1 Sub-Saharan Africa forecast summary.................................................................. 111 2.6.2 Sub-Saharan Africa country forecasts................................................................... 112 Annex Table 3.1 Labor productivity differential between types of firms (Percent) ................ 172 Annex Table 3.2 Labor productivity of formal and informal firms...................................... 173 Annex Table 3.3 Labor productivity of formal firms facing informal competition ................ 174 Annex Table 3.4 Survey of policy changes ....................................................................... 175 Annex Table 3.1.1 Data coverage ................................................................................... 178 Annex Table 3.1.2 MIMIC model estimation results (1993-2015) ..................................... 179 Annex Table 3.3.1 Database of studies for meta regressions analysis ................................... 180 Annex Table 3.3.2 Meta regression analysis summary ....................................................... 181 Annex Table 3.4.1 Pre-existing informality and changes in poverty and income inequality: OLS ............................................................................................................ 182 Annex Table 3.5.1 Sample............................................................................................. 183 Annex Table 4.1 List of countries in LIDCs and LICs ...................................................... 208 XI Foreword Achieving the Sustainable Development Goals, the The GEP does not just analyze short-run growth World Bank’s twin goals—or any other forecasts; it embeds these forecasts in a longer-run development goal for that matter—hinges on view of the economy. sustained economic growth in emerging market and developing economies (EMDEs). This growth This edition of the GEP continues that tradition in turn depends on macroeconomic stability. The with a comprehensive study of the informal semi-annual Global Economic Prospects (GEP) economy, something which could in the short-run report assesses the global outlook for growth and be a shock absorber, but in the long-run is stability in these countries. associated with low productivity. The analysis suggests that the informal sector’s role in The January 2019 edition, Darkening Skies, absorbing labor during downturns is limited. highlights how precarious the current economic However, the potential long-term gains from juncture is. In a nutshell, growth has weakened, increasing productivity in the informal sector are trade tensions remain high, several developing substantial. This edition also presents evidence economies have experienced financial stress, and that debt in low-income countries is on the rise, risks to the outlook have increased. As the report an issue that is being discussed extensively in points out, EMDEs face some of the greatest risks. policy circles. If a trade war between the United States and China contributes to a global slowdown, the The GEP tries to hit the sweet spot between spillover effects on EMDEs could be profound. discussing topical policy issues and undertaking Similarly, a sharp increase in global interest rates rigorous analytical work. On the one hand, would severely affect highly indebted EMDEs, as analysts, especially those in international Turkey and Argentina painfully discovered last organizations, are sometimes cautious about summer. speaking out on the global economy—especially when the prospects are not good—lest they Since the global outlook depends heavily on exacerbate the pessimism. On the other hand, the advanced economies, the GEP also flags the public is subject to so much half-baked analysis, implications of advanced-economy policies for half-truths, and fake news that an analytically EMDEs. In January 2018, when there was a rigorous report such as the GEP is critical to an celebratory mood about the synchronized recovery informed debate. among advanced economies and EMDEs, the Public policy is not made by “whispering in the GEP questioned its duration, even in its title: finance minister’s ear.” Rather, it is made by Broad-Based Upturn, but for How Long? That arriving at a political consensus. That consensus is skepticism came from a close study of potential more likely to improve people’s lives if the public growth—the amount by which the economy is informed with evidence. Like its predecessors, would grow if all factors were fully employed— this edition of the GEP is a contribution to that which found this to be wanting in many evidence. economies because of the previous years’ slowdown in productivity and investment growth. Shantayanan Devarajan Senior Director Development Economics Vice Presidency The World Bank Group XIII Acknowledgments This World Bank Group Flagship Report is a product of the Prospects Group in the Development Economics Vice Presidency. The project was managed by M. Ayhan Kose and Franziska Ohnsorge, under the general guidance of Shantayanan Devarajan. Global and regional surveillance work was coordinated Many reviewers offered extensive advice and by Carlos Arteta. Chapter 1 was prepared by Carlos comments. These included: Kishan Abeygunawardana, Arteta and Marc Stocker, with contributions from Issam Abousleiman, Abebe Adugna, Azamat Patrick Kirby, Ekaterine Vashakmadze, and Collette Agaidarov, Junaid Kamal Ahmad, Anna Carlotta Allen M. Wheeler. Additional inputs were provided by John Massingue, Sara Alnashar, Gallina Andronova Baffes, Alain Kabundi, Eung Ju Kim, Csilla Lakatos, Vincelette, Paloma Anos Casero, Jorge Araujo, Rabah Peter Nagle, Rudi Steinbach, and Shu Yu. Arezki, Kiatipong Ariyapruchya, Cindy Audiguier, Rajul Awasthi, Dilek Aykut, Marina Bakanova, Daniel Chapter 2 was coordinated by Marc Stocker and Barco, Kevin Barnes, Rafael Barroso, Davaadalai Patrick Kirby. The authors are Ekaterine Vashakmadze Batsuuri, Hans Anand Beck, John Beghin, Robert Carl (East Asia and Pacific), Yoki Okawa (Europe and Michael Beyer, Mesfin Bezawagaw, Andrew Central Asia), Dana Vorisek (Latin America and the Blackman, Enrique Blanco Armas, Fernando Blanco, Caribbean), Lei Sandy Ye (Middle East and North Monika Blaszkiewicz-Schwartzman, Daniel Kwabena Africa), Temel Taskin (South Asia), and Gerard Boakye, Zeljko Bogetic, Elena Bondarenko, Denis Kambou and Rudi Steinbach (Sub-Saharan Africa). Boskovski, Anne Brockmeyer, James Brumby, Cesar Calderon, Salvatore Capasso, Kevin Carey, Bledi Chapter 3, Chapter 4, and the boxes in Chapters 1 Celiku, Derek Chen, Massarongo Chivulele, Yew Keat and 2 were prepared by Sinem Kilic Celik, Jongrim Chong, Ajai Chopra, Ibrahim Chowdhury, Tamoya Ha, Patrick Kirby, Wee Chian Koh, M. Ayhan Kose, Christie, Kevin Chua, Kevin Clinton, Fabiano David Laborde, Csilla Lakatos, Will Martin, Franziska Colbano, Andrea Coppola, Barbara Cunha, Stefano Ohnsorge, Yoki Okawa, Rudi Steinbach, Temel Curto, Anna Custers, Andrew Dabalen, Somneuk Taskin, Ekaterine Vashakmadze, Dana Vorisek, Jinxin Davading, Simon Davies, Annette De Kleine Feige, Wu, Lei Sandy Ye, and Shu Yu, with contributions Gabriel Demombynes, Agim Demukaj, Allen Dennis, from Mohammad Amin, Sinem Kilic Celik, Sebastian Sebastien Dessus, Mame Fatou Diagne, Caroline Essl, Ergys Islamaj, Sergiy Kasyanenko, Gene Diaz-Bonilla, Tatiana Didier, Nora Carina Dihel, Viet Kindberg-Hanlon, Cedric Okou, Andre Proite, Tuan Dinh, Makhtar Diop, Ndiame Diop, Annette Naotaka Sugawara, and Collette M. Wheeler. Dixon, Mariam Dolidze, Jozef Draaisma, Bakyt Dubashov, Victor Duggan, Mark Andrew Dutz, Etaki Research assistance was provided by Miyoko Asai, Wa Dzon, Sebastian Eckardt, Kim Alan Edwards, Zhuo Chen, Liu Cui, Ishita Dugar, Brent Harrison, Khalid El Massnaoui, David Elmaleh, Olga Mengyi Li, Maria Hazel Macadangdang, Claudia Emelyanova, Wilfried Engelke, Jorge Familiar Marchini, Julia Roseman, Xinyue Wang, Jinxin Wu, Calderon, Yuting Fan, Marianne Fay, Manuela Ferro, and Heqing Zhao. Modeling and data work were Cornelius Fleischhaker, Manuela Francisco, Chisako provided by Rajesh Kumar Danda and Julia Roseman. Fukuda, Josip Funda, Kevin Thomas Garcia Cruz, The online publication was produced by Graeme Pedro Miguel Gaspar Martins, Michael Geiger, Littler and Mikael Reventar. Mark Felsenthal managed Rangeet Ghosh, Adnan Ashraf Ghumman, Frederico media relations and dissemination. Mark Felsenthal Gil Sander, Fernando Giuliano, Anastasia Golovach, and Graeme Littler provided editorial support, with Maria De los Angeles Cuqui Gonzalez Miranda, Errol contributions from Adriana Maximiliano. George Graham, Margaret Grosh, Poonam Gupta, Gohar Gyulumyan, Kiryl Haiduk, Fiseha Haile The print publication was produced by Maria Hazel Gebregziabher, Michael Hamaide, Birgit Hansl, Macadangdang, Adriana Maximiliano, and Quinn Marek Hanusch, Wissam Harake, Zeina Hasra, Faya Sutton, in collaboration with Luiz H. Almeida, Hayati, Johannes Herderschee, Sandra Hlivnjak, Bert Andrew Charles Berghauser, Adam Broadfoot, Aziz Hofman, Bingjie Hu, Sahar Sajjad Hussain, Elena Gökdemir, Michael Harrup, and Jewel McFadden. Ianchovichina, Stella Ilieva, Fernando Gabriel Im, XV Amina Iraqi, Yoichiro Ishihara, Ergys Islamaj, Ivailo Martin Raiser, Richard Record, Saadia Refaqat, Julio V. Izvorski, Evans Jadotte, Saroj Jha, Gloria Aitalohi E. Revilla, Alief Aulia Rezza, Daniel Riera-Crichton, Joseph-Raji, Gerard Kambou, Bertine Kamphuis, David Robinson, Alberto Rodriguez, Pedro Rodriguez, Soukeyna Kane, Lanre Kassim, Atsushi Kawamoto, Donato de Rosa, David Rosenblatt, Irina Rostovtseva, Majid Kazemi, Vera Kehayova, Zerihun Getachew Pablo Saavedra, James Sampi Bravo, Miguel Eduardo Kelbore, Nazmus Khan, Tehmina S. Khan, Ewa Sanchez Martin, Apurva Sanghi, Ilyas Sarsenov, Korczyc, Christos Kostopoulos, Megumi Kubota, Cristina Savescu, Tahseen Sayed, Kinnon Scott, Asli Chandana Kularatne, Aurelien Kruse, Jean Pierre Senkal, Claudia Paz Sepúlveda, Lazar Sestovic, Lacombe, Emmanuel Lartey, Daniel Lederman, Ran Natasha Sharma, Dhruv Sharma, Sudhir Shetty, Alta Li, John Litwack, Sodeth Ly, Julio Ricardo Loayza, Shiilegmaa, Emily Sinnott, Sophie Sirtaine, Karlis Norman Loayza, Julie Saty Lohi, J. Humberto Lopez, Smits, Abdoulaye Sy, Fulbert Tchana Tchana, Shakira José Roberto López-Cálix, Cal MacWilliam, Sanja Binti Teh Sharifuddin, Hans Timmer, Emilija Madzarevic-Sujster, Sandeep Mahajan, Shireen Timmis, Aby Toure, Christopher Towe, Robert Mahdi, William Maloney, Shiva Makki, Pierre Jean- Townsend, Melanie Simone Trost, Eskender Trushin, Claude Mandon, Kemoh Mansaray, Marie Francoise Michal Tulwin, Angélique Umutesi, Cevdet Cagdas Marie-Nelly, Daniela Marotta, Ashwaq Natiq Maseeh, Unal, Zainab Usman, Robert Utz, Ralph Van Doorn, Andrew D. Mason, Hideki Matsunaga, Elitza Mileva, Axel van Trotsenburg, Sona Varma, Carlos Végh, Deepak K. Mishra, Aghassi Mkrtchyan, Lalita Moorty, Julio Velasco, Marijn Verhoeven, Ekaterina Lili Mottaghi, Rafael Munoz Moreno, Rinku Murgai, Vostroknutova, Muhammed Waheed, Georgia A. Arvind Nair, Nur Nasser Eddin, Jean-Pascal Nganou, Wallen, Marina Wes, Siti Budi Wardhani, Maria Ha Nguyen, Francesca de Nicola, Eduardo Olaberria, Monica Wihardja, Christina Wood, Pinar Yasar, Pui Harun Onder, Abdoulaye Ouedraogo, John Panzer, Shen Yoong, Hoda Youssef, Gabriel Zaourak, Albert Jim Parks, Catalin Pauna, Ceyla Pazarbasioglu, Zeufack, Yan Michelle Zhang, Luan Zhao, and Fernanda Ailina Pedro, Keomanivone Phimmahasay, Bakhrom Ziyaev. Samuel Jaime Pienknagura, Emmanuel Pinto Moreira, Ruslan Pionkivsky, Abha Prasad, Mona Prasad, Rong Regional projections and write-ups were produced in Qian, Habib Rab, Erick Rabemananoro, Wojciech coordination with country teams, country directors, Pawel Rabiega, Martin Rama, Nadir Ramazanov, and the offices of the regional chief economists. XVI Executive Summary The outlook for the global economy has darkened. Global financing conditions have tightened, industrial production has moderated, trade tensions have intensified, and some large emerging market and developing economies have experienced significant financial market stress. Faced with these headwinds, the recovery in emerging market and developing economies has lost momentum. Downside risks have become more acute and include the possibility of disorderly financial market movements and an escalation of trade disputes. Debt vulnerabilities in emerging market and developing economies, particularly low-income countries, have increased. More frequent severe weather events would raise the possibility of large swings in international food prices, which could deepen poverty. In this difficult environment, it is of paramount importance for emerging market and developing economies to rebuild policy buffers while laying a stronger foundation for future growth by boosting human capital, promoting trade integration, and addressing the challenges associated with informality. Global Outlook. Moderating activity and slowdown in some large economies, and is heightened risks are clouding global economic projected to plateau over the next couple of years. prospects. International trade and investment Growth in regions with large numbers of have softened, trade tensions have intensified, and commodity importers was solid but has some large emerging market and developing decelerated and is expected to stabilize around economies (EMDEs) are experiencing substantial potential. For all regions, risks to the outlook are financial market pressures. Against this less increasingly tilted to the downside. favorable backdrop, EMDE growth has lost momentum, with a weaker-than-expected This edition of Global Economic Prospects also recovery in commodity exporters accompanied by includes a chapter on the challenges associated a deceleration in commodity importers. Downside with the presence of large informal sectors in risks have become more acute. Disorderly EMDEs and policy options to address financial market developments could disrupt informality; a box on the prospects for continued activity in the affected economies and lead to low inflation in EMDEs; and essays on rising debt contagion effects. Trade disputes could escalate or vulnerabilities in low-income countries and the become more widespread, denting activity in the implications of large food price spikes for poverty. involved economies and leading to negative global Growing in the Shadow: Challenges of spillovers. To confront this increasingly Informality. Informal sector output on average challenging environment, an immediate priority accounts for about one-third of GDP and for EMDE policymakers is to brace for possible informal employment constitutes about 70 bouts of financial market stress, rebuild percent of employment in EMDEs (of which self- macroeconomic policy buffers as appropriate, and employment accounts for more than a half). tackle adverse debt dynamics, all while sustaining Informality is more widespread in less developed historically low inflation. In the longer run, the economies with large agricultural sectors and need to foster more robust potential growth by higher shares of unskilled workers. While boosting human capital, removing barriers to sometimes providing the short-run advantage of investment, and promoting trade integration flexibility and employment, a larger informal remains. sector is associated with lower productivity, Regional Perspectives. The rebound in EMDE reduced tax revenues, and greater poverty and activity has stalled. The cyclical upswing in inequality. Overcoming the adverse implications regions with many commodity exporters has lost of informality will require a balanced mixture of momentum, partly reflecting a substantial policies that carefully take into account country- XVII specific drivers of informality. A well-designed substantially in recent years. Since 2013, median policy framework should include measures aimed government debt has risen by more than 17 at reducing regulatory and tax burdens, percentage points of GDP and has shifted toward expanding access to finance, improving education non-concessional and private financing. As a and other public services, and strengthening result, in most LICs, interest payments are public revenue frameworks. absorbing an increasing proportion of government revenues. The majority of LICs The Great Disinflation. Emerging market and would be hard hit by a sudden weakening in developing economies (EMDEs) have achieved a trade or global financial conditions given their remarkable decline in inflation, from 17.3 high levels of external debt, lack of fiscal space, percent in 1974 to about 3.5 percent in 2018. low foreign currency reserves, and undiversified This achievement has coincided with an even exports. Efforts to reduce debt-related sharper decline in inflation in advanced vulnerabilities are a policy priority for many economies. The great disinflation in EMDEs has LICs, and a key focus needs to be improving debt also been accompanied by growing inflation management and developing domestic financial synchronization as evidenced by the emergence of systems. a global inflation cycle. It has been supported by long-term trends such as the widespread adoption Poverty Impact of Food Price Shocks and of robust monetary policy frameworks and Policies. In the event of large swings in world strengthening of global trade and financial food prices, governments sometimes intervene to integration. More recently, the disruptions caused soften the impact on domestic prices and to by the global financial crisis also contributed to lessen the burden of adjustment for vulnerable the decline in inflation. However, a continuation groups. While individual countries can succeed at of low and stable EMDE inflation is by no means insulating their domestic markets from short- guaranteed. If the wave of structural and policy- term fluctuations in global food prices, the related factors that have driven disinflation since collective intervention of many countries may the 1970s loses momentum or is rolled back, exacerbate the volatility of world prices. Policies elevated inflation could re-emerge. If the global introduced during the 2010-11 food price spike inflation cycle turns up, policymakers may find may have accounted for 40 percent of the that maintaining low inflation can be as great a increase in the world price of wheat and one- challenge as achieving it. quarter of the increase in the world price of maize. Combined with government policy Debt in Low-Income Countries: Evolution, responses, the 2010-11 food price spike tipped Implications, and Remedies. Debt vulnerabilities 8.3 million people (almost 1 percent of the in low-income countries (LICs) have increased world’s poor) into poverty. XVIII Abbreviations ADB Asian Development Bank AE advanced economies CEMAC Central African Economic and Monetary Community CES constant elasticity of substitution CET constant elasticity of transformation CGE computable general equilibrium model CPI consumer price index DB Doing Business DGE dynamic general equilibrium DTF Distance to Frontier score EAP East Asia and Pacific ECA Europe and Central Asia ECM error correction model EMDE emerging market and developing economies EU European Union FAO Food and Agriculture Organization of the United Nations FAOSTAT FAO Statistical Databases FCV fragility, conflict, and violence-affected economies FICCI Federation of Indian Chambers of Commerce Fewsnet Famine Early Warning Systems Network G4 Euro Area, Japan, the United Kingdom, and the United States GCC Gulf Cooperation Council GDP gross domestic product GEP Global Economic Prospects GIEWS Global Information and Early Warning System GNFS goods and nonfactor services GTAP Global Trade Analysis Project HRW hard red wheat ICSE International Classification of Status in Employment ICT information and communication technology IEG Independent Evaluation Group ILO International Labour Organization IMF International Monetary Fund ISS International Sector Survey LAC Latin America and the Caribbean LES–CES linear expenditure system–constant elasticity of substitution LIC low-income country XIX MIC middle-income country MIMIC Multiple Indicators Multiple Causes model MMDA Metro Manila Developments Authority MENA Middle East and North Africa MSEs micro and small enterprises NBER National Bureau of Economic Research NEET not in employment, education, or training NPAs non-performing assets NRP nominal rate of protection OECD Organisation for Economic Co-operation and Development OLS ordinary least squares PPP purchasing power parity RHS right-hand side (in figures) SAR South Asia Region SDGs Sustainable Development Goals SEMP self-employment rate SMEs small and medium-sized enterprises SSA Sub-Saharan Africa SSRN Social Science Research Network UNCTAD United Nations Conference on Trade and Development UNDP United Nations Development Programme UNICEF United Nations International Children’s Emergency Fund USDA United States Department of Agriculture VAT Value-added taxation WDI World Development Indicators WEF World Economic Forum WGI World Governance Indicators WVS World Value Survey WHO World Health Organization WTO World Trade Organization XX CHAPTER 1 GLOBAL OUTLOOK Darkening Skies G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 3 Moderating activity and heightened risks are clouding global economic prospects. International trade and investment have softened, trade tensions remain elevated, and some large emerging market and developing economies (EMDEs) have experienced substantial financial market pressures. Against this challenging backdrop, EMDE growth has stalled, with a sharply weaker-than-expected recovery in commodity exporters accompanied by a deceleration in commodity importers. Downside risks have become more acute. Disorderly financial market developments could disrupt activity in the affected economies and lead to contagion effects. Trade disputes could escalate or become more widespread, denting activity in the economies involved and leading to negative global spillovers. To confront this increasingly difficult environment, the most urgent priority is for EMDE policymakers to prepare for possible bouts of financial market stress and rebuild macroeconomic policy buffers as appropriate. Equally critically, policymakers need to foster stronger potential growth by boosting human capital, removing barriers to investments, and promoting trade integration within a rules-based multilateral system. Such efforts would also help address the challenges associated with informality. Summary stimulus. In contrast, activity in the Euro Area has been somewhat weaker than previously expected, owing to slowing net exports. While growth in Global growth is moderating as the recovery in advanced economies is estimated to have slightly trade and manufacturing activity loses steam decelerated to 2.2 percent last year, it is still above (Figure 1.1). Despite ongoing negotiations, trade potential and in line with previous forecasts. tensions among major economies remain elevated. These tensions, combined with concerns about EMDE growth edged down to an estimated 4.2 softening global growth prospects, have weighed percent in 2018—0.3 percentage point slower on investor sentiment and contributed to declines than previously projected—as a number of in global equity prices. Borrowing costs for countries with elevated current account deficits emerging market and developing economies experienced substantial financial market pressures (EMDEs) have increased, in part as major and appreciable slowdowns in activity. More advanced-economy central banks continue to generally, as suggested by recent high-frequency withdraw policy accommodation in varying indicators, the recovery among commodity degrees. A strengthening U.S. dollar, heightened exporters has lost momentum significantly, largely financial market volatility, and rising risk owing to country-specific challenges within this premiums have intensified capital outflow and group. Activity in commodity importers, while currency pressures in some large EMDEs, with still robust, has slowed somewhat, reflecting some vulnerable countries experiencing substantial capacity constraints and decelerating export financial stress. Energy prices have fluctuated growth. In low-income countries (LICs), growth is markedly, mainly due to supply factors, with firming as infrastructure investment continues and sharp falls toward the end of 2018. Other easing drought conditions support a rebound in commodity prices—particularly metals—have also agricultural output. However, LIC metals weakened, posing renewed headwinds for exporters are struggling partly reflecting softer commodity exporters. metals prices. Central banks in many EMDEs have tightened policy to varying degrees to Economic activity in advanced economies has confront currency and inflation pressures. been diverging of late. Growth in the United States has remained solid, bolstered by fiscal In all, global growth is projected to moderate from a downwardly revised 3 percent in 2018 to 2.9 percent in 2019 and 2.8 percent in 2020-21, as Note: This chapter was prepared by Carlos Arteta and Marc Stocker, with contributions from Patrick Kirby, Ekaterine economic slack dissipates, monetary policy Vashakmadze, and Collette M. Wheeler. Additional inputs were accommodation in advanced economies is provided by John Baffes, Alain Kabundi, Eung Ju Kim, Csilla Lakatos, Peter Nagle, Rudi Steinbach, and Shu Yu. Research removed, and global trade gradually slows. assistance was provided by Liu Cui, Ishita Dugar, Brent Harrison, Growth in the United States will continue to be Mengyi Li, Claudia Marchini, Julia Roseman, and Jinxin Wu. supported by fiscal stimulus in the near term, 4 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 TABLE 1.1 Real GDP1 Percentage point differences (Percent change from previous year) from June 2018 projections 2016 2017 2018e 2019f 2020f 2021f 2018e 2019f 2020f World 2.4 3.1 3.0 2.9 2.8 2.8 -0.1 -0.1 -0.1 Advanced economies 1.7 2.3 2.2 2.0 1.6 1.5 0.0 0.0 -0.1 United States 1.6 2.2 2.9 2.5 1.7 1.6 0.2 0.0 -0.3 Euro Area 1.9 2.4 1.9 1.6 1.5 1.3 -0.2 -0.1 0.0 Japan 0.6 1.9 0.8 0.9 0.7 0.6 -0.2 0.1 0.2 Emerging market and developing economies 3.7 4.3 4.2 4.2 4.5 4.6 -0.3 -0.5 -0.2 (EMDEs) Commodity-exporting EMDEs 0.8 1.7 1.7 2.3 2.9 2.9 -0.8 -0.7 -0.1 Other EMDEs 5.9 6.1 5.8 5.5 5.6 5.6 0.0 -0.3 -0.1 Other EMDEs excluding China 4.9 5.2 5.0 4.7 4.9 5.1 -0.1 -0.4 -0.2 East Asia and Pacific 6.3 6.6 6.3 6.0 6.0 5.8 0.0 -0.1 0.0 China 6.7 6.9 6.5 6.2 6.2 6.0 0.0 -0.1 0.0 Indonesia 5.0 5.1 5.2 5.2 5.3 5.3 0.0 -0.1 -0.1 Thailand 3.3 3.9 4.1 3.8 3.9 3.9 0.0 0.0 0.1 Europe and Central Asia 1.7 4.0 3.1 2.3 2.7 2.9 -0.1 -0.8 -0.3 Russia -0.2 1.5 1.6 1.5 1.8 1.8 0.1 -0.3 0.0 Turkey 3.2 7.4 3.5 1.6 3.0 4.2 -1.0 -2.4 -1.0 Poland 3.1 4.8 5.0 4.0 3.6 3.3 0.8 0.3 0.1 Latin America and the Caribbean -1.5 0.8 0.6 1.7 2.4 2.5 -1.1 -0.6 -0.1 Brazil -3.3 1.1 1.2 2.2 2.4 2.4 -1.2 -0.3 0.0 Mexico 2.9 2.1 2.1 2.0 2.4 2.4 -0.2 -0.5 -0.3 Argentina -1.8 2.9 -2.8 -1.7 2.7 3.1 -4.5 -3.5 -0.1 Middle East and North Africa 5.1 1.2 1.7 1.9 2.7 2.7 -1.3 -1.4 -0.5 Saudi Arabia 1.7 -0.9 2.0 2.1 2.2 2.2 0.2 0.0 -0.1 Iran 13.4 3.8 -1.5 -3.6 1.1 1.1 -5.6 -7.7 -3.1 Egypt2 4.3 4.2 5.3 5.6 5.8 6.0 0.3 0.1 0.0 South Asia 7.5 6.2 6.9 7.1 7.1 7.1 0.0 0.0 -0.1 India3 7.1 6.7 7.3 7.5 7.5 7.5 0.0 0.0 0.0 Pakistan2 4.6 5.4 5.8 3.7 4.2 4.8 0.0 -1.3 -1.2 Bangladesh2 7.1 7.3 7.9 7.0 6.8 6.8 1.4 0.3 -0.2 Sub-Saharan Africa 1.3 2.6 2.7 3.4 3.6 3.7 -0.4 -0.1 -0.1 Nigeria -1.6 0.8 1.9 2.2 2.4 2.4 -0.2 0.0 0.0 South Africa 0.6 1.3 0.9 1.3 1.7 1.8 -0.5 -0.5 -0.2 Angola -2.6 -0.1 -1.8 2.9 2.6 2.8 -3.5 0.7 0.2 Memorandum items: Real GDP1 High-income countries 1.7 2.3 2.2 2.0 1.7 1.6 0.0 0.0 -0.1 Developing countries 4.0 4.6 4.4 4.4 4.7 4.7 -0.3 -0.4 -0.1 Low-income countries 4.8 5.5 5.6 5.9 6.2 6.3 -0.1 0.0 0.0 BRICS 4.4 5.2 5.3 5.2 5.3 5.3 -0.1 -0.2 -0.1 World (2010 PPP weights) 3.2 3.7 3.6 3.5 3.6 3.6 -0.2 -0.3 -0.1 World trade volume4 2.6 5.4 3.8 3.6 3.5 3.4 -0.5 -0.6 -0.5 Commodity prices5 Oil price -15.6 23.3 30.7 -2.9 0.0 0.0 -1.9 -1.5 -0.1 Non-energy commodity price index -2.8 5.3 1.7 1.0 1.2 1.2 -3.4 0.8 0.7 Source: World Bank. Note: PPP = purchasing power parity; e = estimate; f = forecast. World Bank forecasts are frequently updated based on new information. Consequently, projections presented here may differ from those contained in other World Bank documents, even if basic assessments of countries’ prospects do not differ at any given moment in time. Country classifications and lists of emerging market and developing economies (EMDEs) are presented in Table 1.2. BRICS include: Brazil, Russia, India, China, and South Africa. 1. Aggregate growth rates calculated using constant 2010 U.S. dollar GDP weights. 2. GDP growth values are on a fiscal year basis. Aggregates that include these countries are calculated using data compiled on a calendar year basis. Pakistan's growth rates are based on GDP at factor cost. The column labeled 2017 refers to FY2016/17. 3. The column labeled 2016 refers to FY2016/17. 4. World trade volume of goods and non-factor services. 5. Oil is the simple average of Brent, Dubai, and West Texas Intermediate. The non-energy index is comprised of the weighted average of 39 commodities (7 metals, 5 fertilizers, 27 agricultural commodities). For additional details, please see http://www.worldbank.org/en/research/commodity-markets. To download this data, please visit www.worldbank.org/gep. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 5 which will likely lead to larger and more persistent FIGURE 1.1 Summary – Global prospects fiscal deficits. Advanced-economy growth will Global growth is moderating, as industrial activity and trade decelerate, gradually decelerate toward potential, falling to negatively impacting investor sentiment and equity prices. The recovery in 1.5 percent by the end of the forecast horizon, as EMDEs has stalled, owing to softening external demand, tighter external financing conditions, and heightened policy uncertainties. Many EMDE monetary policy is normalized and capacity central banks have raised interest rates to fend off currency pressures. Per constraints become increasingly binding. capita growth will remain anemic in several EMDE regions—most notably in those with a large number of commodity exporters. Softening global trade and tighter financing A. Global growth B. Global industrial production and conditions will result in a more challenging new export orders external environment for EMDE economic activity. EMDE growth is expected to stall at 4.2 percent in 2019—0.5 percentage point below previous forecasts, partly reflecting the lingering effects of recent financial stress in some large economies (e.g., Argentina, Turkey), with a sharply weaker-than-expected pickup in commodity exporters accompanied by a deceleration in commodity importers. EMDE growth is projected to plateau at an average of 4.6 C. Global and EMDE equity prices D. Growth in EMDEs percent in 2020-21, as the recovery in commodity exporters levels off. Per capita growth will remain anemic in several EMDE regions—most notably, in those with a large number of commodity exporters—likely impeding further poverty alleviation. The projected gradual deceleration of global economic activity over the forecast horizon could be more severe than currently expected given the E. EMDE policy interest rates, by F. Per capita growth, by region extent of currency depreciation predominance of substantial downside risks against the U.S. dollar (Figure 1.2). A sharper-than-expected tightening of global financing conditions, or a renewed rapid appreciation of the U.S. dollar, could exert further downward pressure on activity in EMDEs, including in those with large current account deficits financed by portfolio and bank flows. Government and/or private sector debt has also risen in a majority of EMDEs over the last few years, including in many LICs, reducing the fiscal Source: Bloomberg, Haver Analytics, World Bank. room to respond to shocks and heightening the Note: EMDEs = emerging market and developing economies. exposure to shifts in market sentiment and rising A.D.F. Shaded areas indicate forecasts. Data for 2018 are estimates. Aggregate growth rates calculated using constant 2010 U.S. dollar GDP weights. borrowing costs. B. New export orders measured by Purchasing Managers’ Index (PMI). PMI readings above 50 indicate expansion in economic activity; readings below 50 indicate contraction. Last observation is November 2018 for new export orders and October 2018 for industrial production. Escalating trade tensions are another major C. Figure shows MSCI Global and Emerging Markets Indexes. Last observation is December 19, 2018. downside risk to the global outlook. If all tariffs D. Data for 2015-17 are simple averages. Green diamonds denote forecasts in the June 2018 edition of the Global Economic Prospects report. currently under consideration were implemented, E. The aggregate policy interest rates are calculated using constant 2010 U.S. dollar GDP weights. The above average and below average currency depreciation groups are defined by countries above they would affect about 5 percent of global trade or below the sample average of the year-to-date percent change in the bilateral exchange rate flows and could dampen growth in the economies against the U.S. dollar. The sample average is -9.3 percent and includes 27 EMDEs, of which 12 are above and 15 are below average. Last observation is November 2018. involved, leading to negative global spillovers. F. EAP = East Asia and Pacific, ECA = Europe and Central Asia, LAC = Latin America and the Caribbean, MNA = Middle East and North Africa, SAR = South Asia, and SSA = Sub-Saharan Africa. While some countries could benefit from trade 6 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 1.2 Global risks and policy challenges diversion in the short run, rising trade protectionism would stifle investment and severely Downside risks predominate, with the possibility of financial stress leading to further deterioration in activity in EMDEs. Escalating trade tensions disrupt global value chains, contributing to higher involving major economies could spread globally. A simultaneous sharp prices and lower productivity. Other downside slowdown in both the United States and China could have severe effects on the global outlook. Fiscal space is particularly limited in countries with risks—such as heightened political uncertainty, high foreign-currency-denominated debt. Informality remains widespread escalating geopolitical tensions, and conflict— in EMDEs and is associated with large productivity gaps between formal further cloud the outlook. and informal firms. Even though the probability of a recession in the A. Probability of 2020 global growth B. Growth forecast revisions and being 1-percentage-point below/above current account position, 2019 United States is still low, and the slowdown in baseline China is projected to be gradual, markedly weaker-than-expected activity in the world’s two largest economies could have a severe impact on global economic prospects. Stimulus measures have bolstered the near-term outlook in these two countries but could contribute to a more abrupt slowdown later on. A simultaneous occurrence of a severe U.S. downturn and a sharper-than- expected deceleration in China would significantly C. Imports affected by new tariffs D. Impact on global growth of 1- percentage-point growth slowdowns increase the probability of an abrupt global in the United States and China slowdown and thus negatively impact the outlook of other EMDEs through trade, financial, and commodity market channels. A global downturn would be particularly detrimental for those EMDEs with reduced policy space to respond to shocks. The softening outlook and heightened downside risks exacerbate various challenges faced by E. Fiscal sustainability gaps in F. Average productivity in formal and policymakers around the world. Advanced EMDEs, by extent of reliance on informal firms economies should use this period of above- foreign-currency-denominated debt potential growth to rebuild macroeconomic policy buffers and lay the foundation for stronger growth with reforms that bolster potential output. Care should be taken to avoid shifts in trade and immigration policies that could negatively affect longer-term growth prospects, both domestically and abroad. A renewed commitment to a rules- based international trading system would also help bolster confidence, investment, and trade. Source: Bloomberg; International Monetary Fund; Kose, Kurlat et al. (2017); Peterson Institute for International Economics; U.S. Census Bureau; World Bank. A. Probabilities are computed from the distribution of 24-month-ahead oil price futures, S&P 500 equity price futures, and term spread forecasts. Each of the risk factor weights are derived from the In a context of limited policy buffers, EMDE model described in Ohnsorge, Stocker, and Some (2016). Last observation is December 18, 2018. policymakers need to bolster the capacity to cope B. Forecast revisions for GDP growth in 2019 relative to June 2018. Sample includes 23 EMDEs. Current account position net of foreign direct investment in 2018. with possible bouts of financial market volatility, C. Import tariffs implemented in the United States and the rest of the world in 2018, as well as those under consideration, as a percent of global goods imports. including sharp exchange rate movements—while D. Blue and red bars show scenarios assuming a 1-percentage-point growth shock in China, the United States, and the combination of the two. Shocks are applied in the second half of 2019. Based undertaking measures to sustain the ongoing on the vector autoregression model presented in World Bank (2016). Deviations from baseline are all significantly different from zero. period of historically stable inflation (Box 1.1). E. FC debt = foreign-currency-denominated debt. A negative sustainability gap indicates government This immediate priority will require a credible debt is rising along an accelerated trajectory. The sample includes 27 EMDEs. The above (below) average foreign-currency-denominated debt groups are defined by countries above (below) the commitment to price stability from central sample average of external debt in foreign currency as a share of total external debt in 2017. F. Blue bars represent estimates and orange vertical lines indicate two standard deviation error banks, underpinned by strong institutional bands. World Bank’s Enterprise Survey data for 135 countries (2008-18). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 7 independence, as well as efforts by regulators and FIGURE 1.3 Advanced economies prudential authorities to reduce persistent Activity has softened but still points to above-potential growth in major financial fragilities. EMDEs also face substantial advanced economies. Growth is expected to continue to moderate over fiscal challenges and the risk of worsening debt the forecast period. Fiscal policy will boost U.S. activity in 2019 but will dynamics as global financing conditions tighten. become a drag thereafter. For many EMDEs, it will be imperative to restore fiscal space given cyclical conditions, as well as A. GDP and demand component B. Growth growth address the vulnerabilities associated with elevated foreign-currency-denominated debt. Equally critically, amid a projected deceleration in potential growth, EMDEs face the pressing challenge of ensuring sustained improvements in living standards. This will require investments in human capital and skills development to raise productivity and take full advantage of Source: World Bank. technological changes. In the current environment A.B Green diamonds correspond with the June 2018 edition of the Global Economic Prospects of limited fiscal resources, the urgency of these report. Shaded areas indicate forecasts. Data for 2018 are estimates. A. Aggregate growth rates and components calculated using constant 2010 U.S. dollar GDP weights. investments highlights the critical need to prioritize effective public spending and increase public sector efficiency. Incoming data in advanced economies have softened but still point to above-potential growth. Moreover, facilitating the expansion of small- and Unemployment rates have continued to decline, medium-sized enterprises, including by improving and for many countries are below levels seen their access to international markets and finance, prior to the global financial crisis. After slightly would also spur productivity and stimulate growth decelerating from 2.3 percent in 2017 to an -enhancing investments. For many EMDEs, there estimated 2.2 percent last year, advanced-economy is scope to further liberalize trade and improve growth is expected to continue slowing over the the extent to which they are integrated into global forecast period, with a notable slowdown in value chains, which would foster a more efficient investment and the eventual shift of U.S. allocation of resources, job creation, and export fiscal policy from stimulative to contractionary diversification. Policies that help improve (Figure 1.3). outcomes in these areas would also contribute to address the challenges associated with United States informality, thus reinforcing the basis for future productivity growth. U.S. growth in 2018 is estimated to have picked up to 2.9 percent, up 0.2 percentage point from Major economies: Recent previous projections, mostly reflecting stronger- than-expected domestic demand (Figure 1.4). developments and outlook Activity is being bolstered by procyclical fiscal stimulus and still-accommodative monetary Growth has moderated in most advanced economies, policy. with the notable exception of the United States, where fiscal stimulus is boosting activity. Over the The labor market remains robust, bolstering forecast horizon, growth in all major advanced consumption. The unemployment rate has fallen economies is projected to slow toward potential as to an almost 50-year low, despite an influx of new capacity constraints become increasingly binding and workers—about three-quarters of the monetary accommodation is withdrawn. In China, approximately 200,000 jobs being added every activity remains robust, but headwinds are increasing month are being filled by new entrants. Labor in a context of heightened trade tensions. productivity is showing signs of picking up. 8 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 1.1 The great disinflation “ e greatest threat to today’s low in ation, of course, would be a reversal of the modern trend towards enhanced central bank independence, particularly if trend economic growth were to slow, owing, say, to a retreat in globalization and economic liberalization.” Kenneth Rogo (2003) Emerging market and developing economies (EMDEs) have achieved a remarkable decline in in ation, from 17.3 percent in 1974 to about 3.5 percent in 2018. is achievement has coincided with an even sharper decline in in ation in advanced economies. e great disin ation in EMDEs has also been accompanied by growing in ation synchronization as evidenced by the emergence of a global in ation cycle. It has been supported by long-term trends such as the widespread adoption of robust monetary policy frameworks and strengthening of global trade and nancial integration. More recently, the disruptions caused by the global nancial crisis also contributed to the decline in in ation. However, a continuation of low and stable EMDE in ation is by no means guaranteed. If the wave of structural and policy-related factors that have driven disin ation since the 1970s loses momentum or is rolled back, elevated in ation could re-emerge. If the global in ation cycle turns up, policymakers may nd that maintaining low in ation can be as great a challenge as achieving it. Emerging market and developing economies (EMDEs) Evolution of EMDE inflation: A remarkable have achieved a remarkable decline in inflation since the conquest mid-1970s (Ha, Kose, and Ohnsorge 2019).1 Median annual national consumer price inflation in EMDEs fell Disinflation. EMDEs have witnessed a significant decline from stubbornly persistent double-digits during the 1970s in inflation since the mid-1970s, with median annual to about 3.5 percent in 2018 (Figure 1.1.1). By 2017, national consumer price inflation down from a peak of inflation was within or below central bank target ranges in 17.3 percent in 1974 to about 3.5 percent in 2018. three-quarters of the EMDEs that had adopted inflation Disinflation over recent decades has been broad-based targeting. Inflation has also fallen around the world, from across regions and country groups.2 For example, a peak of nearly 17 percent in 1974 to less than 2.5 disinflation occurred across all EMDE regions, including percent in 2018. The decline in inflation began in the mid those with a history of persistently high inflation, such as -1980s in advanced economies and in the mid-1990s in Latin America and Sub-Saharan Africa (Figure 1.1.2).3 EMDEs. By 2000, global inflation had stabilized at Even among low-income countries (LICs), inflation fell by historically low levels. two-thirds between the mid-1970s and 2017, to 5 percent. Low and stable inflation has historically been associated EMDE disinflation was set against the backdrop of sharper with greater output stability, higher growth and better disinflation among advanced economies, where median development outcomes. EMDEs can continue enjoying inflation dropped from its highest (15 percent in 1974) to the benefits of low inflation, but only if the confluence of its lowest level (0.3 percent in 2015) in more than 60 structural and policy related factors that have fostered years. Since then, it has risen somewhat to just over 1.5 global disinflation over the past decades is sustained. percent in 2018 but remains below the median inflation target of advanced-economy central banks. After 2008, Against this backdrop, this box addresses the following below-target inflation and, in some cases, deflation became questions: pervasive across advanced economies: for example, in 2015, inflation was negative in more than half of advanced • How has EMDE inflation evolved? economies. Some advanced-economy central banks have struggled to lift inflation back to their inflation targets over • How important is global inflation in explaining the past decade. national inflation in EMDEs? Drivers of low inflation. While the global financial crisis played a major role in pushing inflation down around the • Can EMDEs sustain the era of low inflation? 2 Disinflation is a decline in inflation rates, regardless of inflation being Note: This box was prepared by Jongrim Ha, M. Ayhan Kose, and Franziska Ohnsorge. negative (deflation) or positive. 3 However, inflation remains in double-digits in some relatively large 1 The “near-universal” character of the decline in inflation since the mid-1970s was recognized at an early stage by Rogoff (2003). EMDEs, in part reflecting currency depreciations. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 9 BOX 1.1 The great disinflation (continued) world over the past decade, the longer-term trend of disinflation has been supported by a wide range of FIGURE 1.1.1 Global inflation structural changes. The most significant of these have been EMDE inflation remains near historic lows despite a the wide-spread adoption of more effective and more recent normalization of inflation in advanced economies. transparent monetary, exchange rate, and fiscal policy Inflation is now within target ranges in the majority of frameworks as well as globalization (Figure 1.1.2).4 EMDEs. • Macroeconomic policies. In the second half of the A. Median CPI inflation, by country group 1980s and during the 1990s, many EMDEs implemented macroeconomic stabilization programs and structural reforms, and gave their central banks clear mandates to control inflation. The adoption of resilient policy frameworks has facilitated more effective control of inflation (Taylor 2014; Fischer 2015). Twenty-four EMDEs have introduced inflation targeting monetary policy frameworks since the late 1990s and, in the median EMDE, the index of central bank independence and transparency rose more than one-and-a-half-fold between 1990 and 2014. Inflation tends to be lower in countries that employ an inflation targeting framework and that have more independent and transparent central banks. Changes in fiscal policy frameworks have also B. Share of advanced economies and EMDEs with inflation contributed: fiscal rules have been adopted in 88 below or within target range countries, including 49 EMDEs. Other reforms, including labor market and product market liberalization, and the removal or easing of foreign exchange market controls, also assisted the disinflation process. • Trade and financial integration. Trade integration has contributed to lower prices, as higher shares of imports in consumption and production result in competitive pressures from foreign producers (Figure 1.1.4). Financial integration has helped discipline macroeconomic policies since more financially integrated economies are more likely to implement monetary policies targeting low and stable inflation Source: Bloomberg, Consensus Economics, Haver Analytics, World Bank. (Kose et al. 2010). In the median EMDE, as in the A. Median year-on-year consumer price inflation for 29 advanced median advanced economy, the ratio of trade to GDP economies and 123 EMDEs (including 28 LICs). B. All inflation rates refer to year-on-year inflation. Share of 11 advanced increased by half between 1970 and 2017, to 75 economies and 24 EMDEs with consumer price inflation below-target or percent of GDP, and international assets and within target range. Horizontal line indicates 50 percent. liabilities tripled (although they remain only half the level of advanced economies). Inflation tends to be lower in economies that are more open to trade and financial flows. Global inflation cycle: Getting stronger A critical feature of the international inflation experience 4 Other structural changes have also been important (Ha, Ivanova et of the past five decades has been the emergence of a al. 2019). For example, technological advances, including the “global inflation cycle” (Ciccarelli and Mojon 2010). This digitalization of services and automation of manufacturing have also transformed production processes, attenuating inflation pressures. is reflected in a growing contribution of a common global Population aging may also have contributed. factor to the variation in country-level inflation rates. To 10 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 1.1 The great disinflation (continued) FIGURE 1.1.2 Disinflation and factors associated with disinflation EMDE inflation has declined in all EMDE regions and low-income countries. In most EMDEs, inflation is now below 5 percent. Lower inflation is associated with greater trade and financial openness. Inflation also tends to be lower in countries that employ an inflation targeting framework and that have more independent and transparent central banks. A. Median CPI inflation, by region B. Inflation in low-income countries C. Distribution of inflation in EMDEs D. Inflation, by trade and financial E. Inflation, by index of central bank F. Inflation, by monetary policy regime openness independence and transparency Source: Ha, Kose, and Ohnsorge (2019); Haver Analytics; IMF International Financial Statistics and World Economic Outlook databases; OECDstat; World Bank. Note: Median headline CPI (consumer price index) inflation of 29 advanced economies and 123 EMDEs. A. All inflation rates refer to year-on-year inflation. EAP = East Asia and the Pacific, ECA = Eastern Europe and Central Asia, LAC = Latin America and the Caribbean, MNA = Middle East and North Africa, SAR = South Asia, and SSA = Sub-Saharan Africa. B. Solid line shows median year-on-year headline inflation and dotted lines refer to interquartile range, based on 28 LICs. C. Inflation refers to quarter-on-quarter annualized inflation. Sample includes 50 EMDEs. D. Columns indicate median inflation in countries high trade-to-GDP ratios (“Trade”) or financial assets and liabilities relative to GDP (“Finance”) in the top quartile (“high openness”) of 175 economies during 1970-2017. Horizontal bars indicate countries in the bottom quartile (“low openness”). Differences are statistically significant at the 5 percent level. E.F. Columns indicate median inflation in country-year pairs with a central bank independence and transparency index in the top quartile of the sample (E) or with inflation targeting monetary policy regimes (C). Horizontal bars denote medians in the bottom quartile (B) or with monetary policy regimes that are not inflation targeting (F). Differences are statistically significant at the 5 percent level. analyze its importance, a dynamic factor model is time: since 2001, it has almost doubled, and now accounts estimated for annual consumer price inflation rates in 25 for 22 percent of inflation variation (Ha, Kose et al. 2019). advanced economies and 74 EMDEs during 1970-2017 It has explained about one-fifth and one-quarter of EMDE (Ha, Kose et al. 2019). The model includes a common and advanced economy inflation variation, respectively, global factor as well as group factors specific to advanced since 2001. Over the past four decades, an EMDE-specific economies and EMDEs. The presence of group factors factor has also become more prominent. The rising allows the model to account for the large differences in importance of these global and group-specific factors country characteristics between advanced economies and indicates that inflation synchronization has become more EMDEs. broad-based over time. Global inflation factor. Inflation has become increasingly Global inflation versus global business cycle. Inflation globally synchronized (Figure 1.1.3). The contribution of synchronization is sizable by comparison with global the global factor to inflation variation has grown over business cycle synchronization. The international business G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 11 BOX 1.1 The great disinflation (continued) cycle literature has established the presence of a well- rule-based fiscal policies. Fiscal rules can become defined global business cycle (Kose, Otrok, and Prasad ineffective once commitment to them falters 2012). In the sample used here, the global business cycle, (Wyplosz 2012). Mounting public and private debt in as captured by a common global factor in output growth, EMDEs could also weaken commitment to strong has accounted for 5 percent of national output growth fiscal and monetary policy frameworks. Government fluctuations since 1970—less than half the degree of and/or private sector debt has risen in more than half inflation synchronization. of EMDEs since 2012, including in many LICs (World Bank 2018a). EMDE sovereign credit ratings Tradables versus non-tradables. The role of the global have continued to deteriorate, with some falling below factor has been more prominent in price baskets with a investment grade, reflecting concerns about rising larger tradables content. The global factor’s contribution debt and deteriorating growth prospects. to inflation variation was largest for import prices (54 percent in the median country) and smallest for core CPI If unwanted inflation makes a comeback, policy inflation (5 percent). Between these two extremes, the frameworks may be tested in EMDEs: their inflation global factor’s contribution to variation in PPI inflation expectations are less well-anchored, and the absence of was 42 percent and that for GDP deflator growth was 13 strong monetary policy frameworks in many of these percent and comparable to that for headline CPI inflation. economies means that inflation is sensitive to exchange Maintaining low inflation: A greater challenge rate movements (Kose et al. 2019; Ha, Stocker and Yilmazkuday 2019). Growing inflation synchronization also increases the risk of policy errors when the appropriate The achievement of low inflation cannot be taken for response differs depending on the origin of the underlying granted (Rogoff 2014; Draghi 2016; Carstens 2018). If inflation shock (IMF 2018a).5 EMDE central banks may cyclical and structural forces become less disinflationary struggle to contain inflationary pressures and may not over the next decade than they have been over the past five receive adequate support from fiscal policy in stabilizing decades, inflation could rise globally. Through the the business cycle. For some EMDEs, a significant increase strengthening global inflation cycle, this may put upward in inflation could set back poverty reduction efforts. pressure on EMDE inflation. More importantly, structural and policy related factors that have helped lower inflation The demise of previous periods of sustained low inflation over the past several decades may lose momentum or be is a reminder that low EMDE inflation is by no means rolled back amid mounting populist sentiment. guaranteed. Inflation has been low and stable before: during the Bretton Woods fixed exchange rate system of • Slowing globalization. The rising protectionist the post-war period up to 1971 and during the Gold sentiment of recent years may slow or even reverse the Standard of the early 1900s (Figure 1.1.4). Yet directly pace of globalization. New tariffs and import following the low inflation period that ended in the early restrictions have been put in place in advanced 1970s, the sharp increase in oil prices in 1973-74 led to a economies and EMDEs since 2017. The possibility of rapid acceleration in global inflation and sharp declines in further escalation in trade restrictions involving major growth in many countries (Kose and Terrones 2015). economies remains elevated. Global inflationary pressures also led to a significant increase in domestic inflation in developing economies, • Weakening monetary policy frameworks. A shift from including those that experienced relatively low and stable a strong mandate of inflation control, to objectives inflation in the late 1960s and early 1970s (Cline 1981). related to the financing of government, would All three episodes of sustained low inflation are undermine the credibility of monetary policy characterized by inflation below 5 percent for an extended frameworks and raise inflation expectations. Among period. It is notable, however, that the two earlier episodes EMDEs, a decline in central bank independence and were followed by sharply rising inflation. This illustrates transparency has been associated with significantly less well-anchored inflation expectations and greater pass- through of exchange rate movements to inflation. 5 Major advanced-economy central banks have also acknowledged the need to consider the global environment in setting monetary policy in • Weakening fiscal policy frameworks. Growing light of the highly synchronized nature of global inflation (Bernanke populist sentiment could lead to a move away from 2007; Draghi 2015; Carney 2015). 12 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 1.1 The great disinflation (continued) FIGURE 1.1.3 Inflation synchronization Inflation has become increasingly globally synchronized. The global factor accounted for a greater share of the inflation variance in advanced economies than in EMDEs. The global factor was more important in explaining the variance of price indices with a greater tradable goods and services content. The synchronization of inflation has been stronger than the synchronization of output growth, especially in EMDEs. A. Contribution of global factor to B. Contribution of global factors to C. Contribution of global factors to inflation variation inflation and output growth variation inflation variation, by inflation measure Source: World Bank; Ha, Kose, and Ohnsorge (2019). A.B. The results are based on a two-factor dynamic factor model with inflation (A,B) or output growth (B) using a sample of 99 economies (25 advanced economies and 74 EMDEs) for 1970-2017. The model includes global and group inflation factors. All numbers refer to median variance shares of total inflation (A,B) or output growth (B) variance accounted for by the global factor. C. The global inflation factors are estimated with two-factor dynamic factor models for annual inflation for each measure in 38 countries (25 advanced economies and 13 EMDEs) for the period 1970-2016, the size of the sample being constrained by data availability. “IMP” = import price index, “PPI” = producer price index, “CPI” = headline consumer price index, “DEF” = GDP deflator, and “CORE” = core consumer price index. FIGURE 1.1.4 Low inflation episodes Global inflation has been low and stable before: during the Bretton Woods fixed exchange rate system in the post-war period up to the early 1970s, and during the gold standard of the early 1900s. A. Global inflation B. Global inflation Source: World Bank; Ha, Kose and Ohnsorge (2019). A. Median of annual average inflation in a sample of 24 economies for which data are available across the full period. B. Cross-country average of annual average inflation. 1900-13 spans the gold standard, and 1944-71 the Bretton Woods system. that maintaining low inflation can be as great a challenge global shocks include strengthening institutions, including as achieving low inflation. central bank independence, and establishing fiscal frameworks that can both assure long-run debt EMDE policymakers need to recognize the increasing role sustainability and provide room for effective counter- of the global inflation cycle in driving domestic inflation. cyclical policies. Low inflation in EMDEs in the past two Options to help insulate economies from the impact of decades is no guarantee of low inflation in the future. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 13 Nominal wage gains have been outpacing FIGURE 1.4 United States inflation, resulting in modest real wage growth. The U.S. economy is experiencing robust growth, with strength in domestic Long-term inflation expectations have edged up demand. There are signs that productivity and labor participation are but remain contained. increasing. Nominal wages have been outpacing inflation, resulting in modest real wage gains. Fiscal and monetary policies will stimulate activity During 2018, the U.S. administration raised in the near term but are likely to become a drag by 2020. tariffs on about $300 billion worth of imports, A. Domestic demand and investment B. Additions to labor force and mostly from China; other countries have retaliated growth productivity growth with tariffs on about $150 billion worth of U.S. exports. In all, new tariffs have been imposed on about 12 percent of U.S. goods imports and may expand further, resulting in higher prices and elevated policy uncertainty (Kutlina-Dimitrova and Lakatos 2017; Lindé and Pescatori 2017). During the forecast horizon, growth is expected to decelerate as monetary policy accommodation is removed, and as fiscal stimulus fades and C. Real and nominal wage growth D. Stance of fiscal and monetary subsequently begins to drag on growth. Higher policy trade tariffs are expected to further weigh on activity, especially exports and investment. In all, U.S. growth is projected to slow to 2.5 percent in 2019 and to an average of 1.7 in 2020-21— roughly consistent with potential. Euro Area Euro Area growth slowed notably in 2018 to an Source: Bureau of Economic Analysis; Bureau of Labor Statistics; Federal Reserve Bank of St. Louis; estimated 1.9 percent, 0.2 percentage point below Haver Analytics; Holston, Laubach, and Williams (2016); International Monetary Fund; World Bank. A. Investment is measured using gross fixed capital formation. Total domestic demand is GDP less previous projections. In particular, exports have net exports of goods and services. Last observation is 2018Q3. B. Last observation is November 2018 for labor force data and 2018Q3 for productivity. softened, reflecting the earlier appreciation of the C. Wage growth is the average hourly earnings of private, non-farm production, and nonsupervisory euro and slowing external demand (Figure 1.5). employees. Last observation is November 2018. D. Policy rate is the mid-range of the federal funds target rates. Forecast for the policy rate and inflation are market expectations. The neutral rate is the nominal short-term interest rate consistent While unemployment has declined, inflation with the economy operating at its full potential once transitory shocks have abated, and is estimated according to Holston, Laubach, and Williams (2016). The neutral rate is assumed to remain remains stubbornly low. Headline inflation has unchanged at its latest value (November 28, 2018) until 2020. Shaded area indicates forecasts. risen to target, but largely due to a temporary acceleration in energy prices. Core inflation are likely to rise amid public pressures for remains around 1 percent, while long-term additional spending and tax relief. Italy’s inflation expectations continue to hover around borrowing costs have increased and remain 1.6 percent, as in the past three years. The volatile, reflecting uncertainties about the outlook European Central Bank has stopped adding to its for the country’s debt load. balance sheet, although it is expected to maintain its negative interest rate policy until at least mid- In all, Euro Area growth is projected to further 2019. Financial system lending and profitability decelerate toward potential over the forecast have continued to increase, though some horizon, to 1.6 percent in 2019 and an average of European banks may be exposed to financial stress 1.4 percent in 2020-21, as monetary stimulus is in some EMDEs. withdrawn and global trade growth moderates. Across the Euro Area, the stance of fiscal policy is Japan expected to be mildly expansionary. Increased German expenditures are envisioned to lead to Japanese growth slowed to an estimated 0.8 smaller surpluses, while deficits in France and Italy percent in 2018, reflecting contractions in the first 14 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 1.5 Euro Area to its balance sheet. It now holds about 40 percent A slowdown in exports has been the primary driver of cooling Euro Area of government debt. The government continues to activity. While headline inflation has risen to target, it is largely due to a run a primary deficit, and it has announced a temporary acceleration in energy prices. temporary stimulus package to offset the short- term impact of a VAT hike in late 2019. A. Export contribution to growth B. Inflation Growth is projected to pick up to 0.9 percent in 2019, reflecting a recovery from last year’s temporary disruptions. As employment growth slows and fiscal policy tightens, growth is expected to moderate to 0.7 percent in 2020 and 0.6 percent in 2021. China Source: Bloomberg, European Central Bank, Eurostat, Haver Analytics, World Bank. A. Last observation is 2018Q3. Growth is estimated to have slowed to a still B. Inflation expectations are derived from 5-year over 5-year forward inflation-linked swap rates, averaged over the quarter. Horizontal line represents 1.9 percent, consistent with the ECB's inflation robust 6.5 percent in 2018, supported by resilient target of close to, but below, 2 percent. Last observation is November 2018. consumption (Figure 1.7). A rebound in private fixed investment helped offset a decline in public infrastructure and other state spending. However, FIGURE 1.6 Japan industrial production and export growth have The economy is still growing above potential, as solid growth in decelerated, reflecting easing global manufacturing employment offsets subdued productivity. The Bank of Japan is providing activity. Import growth continued to outpace exceptionally supportive monetary policy by keeping long-term rates near zero and expanding its balance sheet, while the fiscal deficit is narrowing. export growth, contributing to a shrinking current account surplus. Net capital outflows have A. Employment and productivity B. Gross government debt and long- resumed, and international reserves have been growth term bond yields edging down. Stock prices and the renminbi have experienced continued downward pressures, and sovereign bond spreads have risen amid ongoing trade tensions and concerns about the growth outlook. New regulations on commercial bank exposures to shadow financing, together with stricter provisions for off-budget borrowing by local governments, Source: Bank of Japan; Cabinet Office of Japan; Haver Analytics; Japan Ministry of Finance; Japan have slowed credit growth to the non-financial Ministry of Health, Labor, and Welfare. A. Last observation is 2018Q3. sector. However, in mid- and late 2018, the B. BoJ = Bank of Japan. Bond yield is the quarterly average. Yellow horizontal line indicates the origin x-axis line corresponding to the right-hand scale (RHS). Last observation is 2018Q3. authorities reiterated their intention to pursue looser macroeconomic policies to counter the potential economic impact of trade disputes with and third quarters due to bad weather and natural the United States. Prices of newly constructed disasters. Nevertheless, the labor market has been residential buildings have rebounded, including in robust, with the unemployment rate at 2.4 Tier 1 cities, following several years of correction. percent, rising earnings, and the participation rate Consumer price inflation has generally moved up standing above 79 percent—up 1.5 percentage since mid-2018, partly reflecting currency points since the beginning of last year. Rising depreciation and higher energy and food prices in labor force inputs, however, have been offset by most of last year, but it remains below target. weak productivity (Figure 1.6). Growth is projected to decelerate to 6.2 percent in The Bank of Japan continues to provide stimulus 2019, slightly below previous projections as a by keeping long-term rates near zero and adding result of weaker exports, and to further moderate G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 15 to 6 percent by the end of the forecast horizon, FIGURE 1.7 China broadly in line with its potential pace. Domestic Growth in China remains robust, in part reflecting resilient consumption. demand is projected to remain robust aided by However, industrial production and new export orders have moderated, policies to boost consumption. Supportive fiscal asset prices have experienced downward pressures, and sovereign bond spreads have risen amid trade tensions. Prices of newly constructed and monetary policies undertaken or announced residential buildings have rebounded, including in Tier 1 cities following a so far are expected to largely offset the negative period of correction. impact of higher tariffs; however, additional stimulus may have the undesirable effect of A. Contribution to GDP growth B. Industrial production and new export orders slowing the deleveraging and de-risking process (World Bank 2018b). Global trends In 2018, global trade slowed more rapidly than expected, alongside softening industrial activity. Trade policy uncertainty remains elevated, dampening global investment and trade. Borrowing C. Bond spreads and equity prices D. Housing price growth costs have generally tightened in EMDEs following a broad-based appreciation of the U.S. dollar, bouts of investor risk aversion, and increased focus on country-specific vulnerabilities. External financing conditions are expected to continue deteriorating in 2019, as monetary policy accommodation in advanced economies is unwound. Oil prices were markedly volatile in the second half of 2018, mainly due to supply factors, with sharp falls toward the end of the year. Most other commodity prices— Source: National Bureau of Statistics of China, Haver Analytics, J.P. Morgan, World Bank. A. Investment refers to gross capital formation, which includes the change in inventories. particularly metals—also weakened, reflecting Consumption refers to total consumption, which includes public consumption and private consumption. Data for 2018 are estimates. heightened trade tensions. B. New export orders measured by Purchasing Managers’ Index (PMI). PMI readings above 50 indicate expansion in economic activity; readings below 50 indicate contraction. Last observation is November 2018. Global trade C. Bond spread measures the average spread of China’s sovereign debt (as measured by J.P. Morgan’s Emerging Market Bond Index) over its equivalent maturity U.S. Treasury bond. Equity index is the Shanghai Stock Exchange (SSE) Composite. Last observation is December 18, 2018. Following strong momentum in 2017, growth in D. Prices of newly constructed residential buildings. The National Bureau of Statistics of China surveys house prices in 70 cities and divides them into three tiers. The first tier includes Shanghai, global goods trade markedly slowed during the Beijing, Guangzhou, and Shenzhen. The second tier includes 31 provincial capital and sub-provincial capital cities. The third tier includes 35 other cities. The green bars are the February 2011 to first half of 2018 and has only partially recovered November 2018 averages. Data for 2017 reflect the average of monthly growth rates; 2018H2 covers data through November. Last observation is November 2018. since then. The deceleration was more pronounced than previously expected, as reflected in decelerating export orders and global The softening of global goods trade comes against manufacturing activity (Figure 1.8). the backdrop of ongoing trade tensions involving major economies. New tariffs introduced since the In particular, global capital goods production, beginning of last year have affected about 12 which is highly trade-intensive, has slowed notably percent of U.S. goods imports, 6.5 percent of in Europe and developing Asia, two tightly China’s goods imports, and about 2.5 percent of interconnected global manufacturing hubs global goods trade. In the United States, tariff (Raschen and Rehbock 2016). Nearly a third of increases were implemented citing national European exports and more than half of German security concerns and unfair trade practices. exports to developing Asia are of machinery and Import restrictions and tariff increases were also vehicles, while capital goods and electronics put in place in some EMDEs, as retaliatory actions account for a third of exports from developing or as measures aimed at reducing current account Asia to Europe. vulnerabilities in the face of intensifying capital 16 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 1.8 Global trade countervailing duties and safeguards), recent protectionist measures have disproportionately Global goods trade and industrial activity decelerated in 2018 amid trade tensions between major economies. A projected moderation of investment affected trade in parts and components, with growth in China and major advanced economies is expected to lead to negative repercussions for international value slower trade growth in coming years. Technological changes could chains (Baldwin 2018; Bown 2018; Johnson and continue to increase the share of services trade. Noguera 2017). Increased tariffs on certain goods, A. Global industrial production and B. Capital goods production, G20 including on U.S. steel imports, is associated with new export orders an especially large negative effect on producers in poorer and smaller EMDEs (Bown, Jung, and Zhang 2018). In contrast, some EMDEs may be benefiting in the short term from trade diversion, as rising tariffs increase the cost of targeted goods in the United States and China. The temporary pause in tariff hikes agreed by the United States and China during the G20 meeting C. Share of goods imports affected by D. Global trade growth, volumes in early December 2018 and the successful new tariffs, 2018 negotiations of the new United States-Mexico- Canada Agreement have somewhat tempered trade policy uncertainties. However, the possibility of escalating trade restrictions involving major economies remains elevated. This uncertainty is likely to weigh on firms’ willingness to invest, export, and engage in international value chains, with negative effects on the global trade outlook (Feng, Li, and Swenson 2017; Handley and Limão E. Import demand growth, volumes F. Global services trade, shares 2015; Osnago, Piermartini, and Rocha 2018). In addition, rising interest rates in advanced economies and economic rebalancing in China is expected to contribute to slower global investment and trade growth, with the latter projected to decelerate from 3.8 percent in 2018 to 3.4 percent by the end of the forecast horizon (Ahuja and Nabar 2012; Kose, Ohnsorge et al. 2017). Global trade is still projected to grow somewhat faster Source: Haver Analytics, World Bank, World Trade Organization. than global GDP, but at a much weaker pace than A. New export orders measured by Purchasing Managers’ Index (PMI). PMI readings above 50 previously envisaged, reflecting a deterioration in indicate expansion in economic activity; readings below 50 indicate contraction. Last observation is November 2018 for new export orders and October 2018 for industrial production. growth prospects in several large EMDEs and in B. Industrial production indexes weighted by gross domestic product at constant 2010 U.S. dollars. Sample includes the G20 countries for which capital goods data are available. Last observation is the Euro Area, as well as trade policy uncertainties. October 2018. C. Value of tariffs implemented as of December 19, 2018, as a share of total imports. D.E. Shaded areas indicate forecasts. Aggregate growth rates calculated using constant 2010 U.S. Structural factors continue to weigh on the dollar GDP weights. Trade measured as the average of export and import volumes. F. Trade measured as the average of export and import values. Trade and GDP measured in current medium-term outlook for global trade, including U.S. dollars. Data are 4-quarter moving averages. Last observation is 2018Q2. maturing international value chains (Constantinescu et al. 2018; ECB 2016; outflow pressures (e.g., Arab Republic of Egypt, Hoekman 2015). However, technological change Indonesia, Islamic Republic of Iran, Pakistan, Sri and progress in liberalization efforts under the Lanka, Turkey). Trade in Services Agreement (TiSA) should continue to increase the relative importance of Combined with the rising prevalence of temporary services in global trade flows (Lodefalk 2014; trade barriers (such as anti-dumping and Miroudot and Cadestin 2017). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 17 Financial markets FIGURE 1.9 Global finance Borrowing costs in advanced economies crept up Borrowing costs increased in the United States, as monetary policy accommodation continued to be withdrawn, while softening global growth during most of 2018, as inflation moved closer to prospects weighed on equity markets. Tighter external financing conditions central bank targets and monetary policy contributed to significant capital outflows and more significant currency pressures in more vulnerable EMDEs. International bond issuances slowed accommodation continued to be withdrawn. After markedly in some regions, with yields increasing at their fastest pace since notable fluctuations, U.S. long-term yields ended 2013. the year at 2.7 percent, up around 30 basis points from the start of 2018 (Figure 1.9). A. U.S. sovereign bond yields B. Global and EMDE equity prices Notwithstanding a scaling back of central bank asset purchases in the Euro Area and Japan, negative interest rate policies in these economies have continued to keep a lid on global bond yields, with more than $7.5 trillion of outstanding debt still trading at negative interest rates (15 percent of all bonds). Investor concerns about softening growth prospects and a search for higher -yielding safe assets have led to a further compression of the U.S. yield curve, despite higher C. EMDE portfolio flows during recent D. EMDE currency movements since stress episodes April 2018, by current account inflation and ballooning U.S. government deficits balance ex. FDI driven by fiscal stimulus measures. Global equity markets dropped in the final quarter of 2018, partly reflecting a deterioration in market sentiment regarding global activity and trade policy shifts. Divergent monetary policy among major economies also contributed to a significant appreciation of the U.S. dollar in 2018. This, together with increased investor risk aversion and E. EMDE new bond issuance, by region F. Largest annual changes in EMDE bond yields since 2000 renewed attention to external vulnerabilities, contributed to significant capital outflows in many EMDEs. Since the U.S. dollar started strengthening in April 2018, EMDE currencies fell by an average of about 10 percent—the most significant episode of sustained depreciation since early 2016. Cumulative portfolio outflows from EMDEs also surpassed those seen after the 2013 Taper Tantrum, reflecting a broad-based sell-off Source: Bloomberg, Dealogic, Haver Analytics, Institute of International Finance, International in both equity and bond funds. Monetary Fund, J.P. Morgan, World Bank. A. Sovereign yields reflect the yield on U.S. Treasury bonds. Last observation is December 19, 2018. While financial market stress was most B. Figure shows MSCI Global and Emerging Markets Indexes. Last observation is December 19, 2018. pronounced in Turkey and Argentina, many other C. Cumulative flows to major EMDEs, excluding China, for the 250 days following the start of the stress episode. The start dates for the stress episodes are: Taper Tantrum: May 23, 2013; China EMDEs also suffered from deteriorating market concerns: June 12, 2015; Latest episode: April 15, 2018. Last observation is December 19, 2018. sentiment. Countries with current account deficits D. FDI = foreign direct investment. Figure shows the median of cumulative changes in exchange rates since April 15, 2018. Orange lines indicate interquartile ranges. Last observation is December financed by volatile capital flows, as well as 19, 2018. E. EAP = East Asia and Pacific, ECA = Europe and Central Asia, LAC = Latin America and the countries with high short-term external debt, were Caribbean, MNA = Middle East and North Africa, SAR = South Asia, and SSA = Sub-Saharan Africa. Figure shows the total new bond issuance from January to November for each year. Last observation most severely impacted, pointing to heightened is November 2018. F. EMDE bond yields are calculated as the sum of the J.P. Morgan Emerging Market Bond Index investor focus on external vulnerabilities. Elevated (EMBI) spread and the 10-year U.S. Treasury yield. Last observation is December 19, 2018. domestic debt, above-target inflation, and idiosyncratic factors such as policy uncertainty 18 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 1.10 Commodity markets Coulibaly, and Zlate 2015; Eichengreen and Gupta 2014). Commodity prices are expected to generally stabilize in 2019, following sharp movements last year. Crude oil prices fluctuated markedly in the second half of 2018, mainly due to supply factors, with sharp declines Bond issuance has slowed markedly since mid- toward the end of the year. Trade tensions between the United States and 2018, particularly in Latin America and the China, including the imposition of tariffs on a range of products, have had varying effects on metal and agricultural commodities. In particular, the Caribbean and Eastern Europe and Central Asia, impact has depended on whether tariffs were broad-based or commodity amid worsening external financing conditions. specific, such as in the case of steel and soybeans. EMDE sovereign credit ratings have continued to deteriorate, with some falling below investment A. Commodity price forecasts, B. Crude oil prices, nominal nominal grade, reflecting concerns about rising debt and deteriorating growth prospects. Yields on EMDE debt issued in international bond markets rose by 140 basis points in 2018—the third largest increase over the last two decades. Demand for cross-border bank loans has also weakened, with the appreciation of the U.S. dollar putting upward pressure on dollar funding costs. Various EMDE central banks have responded to currency and capital outflow pressures with interest rate hikes, C. Change in oil supply in major D. Metals price indexes, nominal oil-producing economies leading to tighter domestic borrowing conditions and, in some cases, slower credit and domestic demand growth. In contrast to the deceleration in portfolio and bank flows, foreign direct investment (FDI) into EMDE is estimated to have stabilized in 2018, while remittance flows continued to increase (World Bank 2018c). Outward FDI from China remained robust, boosted by the Belt and Road E. Benchmark steel price indexes, F. Soybean spot prices Initiative. nominal Looking forward, global interest rates are likely to rise at a slower pace than previously expected, reflecting increased headwinds to global growth. Nevertheless, external financing conditions are expected to tighten further in EMDEs, and capital flows to remain moderate, particularly among more vulnerable economies. Source: Bloomberg, International Energy Agency, U.S. Department of Agriculture, World Bank. A. Nominal price indexes. Shaded area indicates forecast. Commodities B. WTI = West Texas Intermediate. Last observation is January 4, 2019. C. Chart shows the change in oil production of five major oil-producing economies from January 2018 to November 2018. Blue bars indicate total oil production in January and November. Red bars Energy prices fluctuated markedly in the second indicate a decline in an economy’s production over the period, and orange bars indicate an increase in production. half of 2018, mainly reflecting supply factors, with D. Last observation is December 18, 2018. sharp falls toward the end of the year. Prices of D.E. Indexes are based on nominal U.S. dollars. E.F. Last observation is December 19, 2018. most metals and, to a lesser extent, agricultural commodities also weakened, largely due to played a role as well. As in previous episodes, concerns about the effects of tariffs on global EMDEs with more liquid currency and equity growth and trade. Prices of the three commodity markets were particularly affected by shifting groups are expected to generally stabilize in 2019 market sentiment and contagion effects (Ahmed, (Figure 1.10). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 19 Oil prices averaged $68 per barrel (bbl) in 2018, a market concerns about global trade and touch lower than June forecasts but about 30 investment prospects; as a result, they have percent higher than in 2017. While robust global clouded the outlook for demand for commodities. oil consumption contributed to this increase, Industrial metals have been particularly responsive supply-side factors were the main drivers of price to these concerns given their many uses in the movements through the year. Continuing declines manufacture of tradable goods, with some metals in production in Venezuela and market concern such as nickel falling more than 20 percent. In about the impact of U.S. sanctions on Iran contrast, the price of steel and aluminum in the contributed to rising Brent crude oil prices, which United States rose following the announcement of peaked at $86/bbl in early October. However, specific tariffs on imports of those metals from a prices fell sharply in November after the United wide range of countries. Metals prices are expected States announced temporary waivers to the to stabilize in 2019 and 2020. sanctions on Iran for eight countries, including China and India. The decline in prices also While agricultural prices were roughly flat in 2018 reflected continued rapid growth in oil production as a whole, they declined appreciably in the second in the United States, as well as a substantial half of the year, with developments varying by increase in supply by the Organization of the commodity. Soybean prices in the United States Petroleum Exporting Countries (OPEC) and the fell substantially following the announcement of Russian Federation. tariffs by China on imports of U.S. soybeans, while prices were higher in other countries, Oil prices are expected to average $67/bbl in 2019 particularly in Brazil. The imposition of tariffs has and 2020, $2/bbl lower than June projections; led to trade diversion, with China’s imports of however, uncertainty around the forecast is high. soybeans from the United States 25 percent lower While growth in oil demand is expected to remain in 2018 relative to 2017, while those from Brazil robust in 2019, the expected loss in momentum have risen 22 percent. More recently, the gap in across EMDEs could have a greater impact on oil prices has closed, as China has resumed purchases demand than expected. The outlook for supply is of U.S. soybeans. Wheat prices were slightly uncertain and depends to a large extent on higher in 2018, as bad weather in Europe led to production decisions by OPEC and its non- smaller harvests. Estimates for the 2018-19 crop OPEC partners. While these producers have forecast have been revised up for most agreed to cut output by 1.2mb/d for six months commodities, and high stock-to-use ratios for rice starting January 2019, few details have been and wheat reduce the likelihood of a food price forthcoming about the distribution of the cuts, spike. In all, agricultural prices are projected to and they may prove insufficient to reduce the remain broadly stable in 2019 and 2020. oversupply of oil. Considerable uncertainty remains about the full impact of Iranian sanctions Emerging market and once the waivers end, as well as the outlook for Venezuelan production. Meanwhile, crude oil developing economies: output in the United States is expected to rise by a Recent developments further 1mb/d in 2019, with capacity constraints and outlook envisioned to ease in the second half of the year as new pipelines come onstream. EMDE growth is expected to stall at 4.2 percent in 2019, markedly below previous expectations. The Metals prices rose 6 percent, on average, in 2018, forecast reflects the lingering effects of recent financial less than previously expected. After increasing in market pressure in some large economies, with a the first half of last year, prices fell sharply in the substantially weaker-than-expected pickup in second half following the imposition of broad- commodity exporters accompanied by a deceleration based tariffs by the United States on China’s in commodity importers. Growth is projected to imports (World Bank 2018d). Heightened trade plateau at 4.6 percent toward the end of the forecast tensions involving these economies have raised horizon, as the recovery in commodity exporters levels 20 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 1.11 Activity in EMDEs renewed market attention to country-specific vulnerabilities and financial stress in some large EMDE activity has stalled, in part reflecting the effect of financial stress in some large economies with sizable current account deficits and high economies with persistent macroeconomic exposure to volatile capital flows. Domestic demand across EMDEs has fragilities—most notably, Argentina and Turkey. generally moderated, and trade flows have softened. High-frequency indicators suggest that the weakness continues, particularly in more More generally, the weakness in activity was most vulnerable economies. pronounced in EMDEs that suffered financial market pressures in a context of elevated current A. Growth B. Contribution to GDP growth account deficits and high exposure to portfolio and bank inflows (Figure 1.11). Many of these economies faced sizable currency depreciation, equity market declines, or foreign reserve losses (e.g., Angola, Argentina, Turkey, South Africa). Domestic demand across EMDEs has generally moderated , reflecting tighter domestic borrowing conditions, softer confidence, and policy tightening in some large economies to ward off C. Import growth, volumes D. Manufacturing PMIs domestic price and capital outflow pressures. A rebound in EMDE gross capital formation that began in 2015 has slowed, and investor sentiment has deteriorated. On the external front, import growth has softened, partly due to sharp currency depreciations in some large economies, while export growth has also moderated, reflecting weaker external demand—notably, moderating global investment. Recent high-frequency Source: Haver Analytics, International Monetary Fund, World Bank. indicators confirm the weaker momentum among A.-C. Aggregate growth rates calculated using constant 2010 U.S. dollar GDP weights. Data for 2018 are estimates. Data for 2015-16 are simple averages. EMDEs, particularly in those that have sizable A.-D. High CA def. ex. FDI = high current account deficit excluding foreign direct investment, which current account deficits and rely heavily on refers to countries with zero or negative values of current account balances net of foreign direct investment. Others refers to countries with positive values of current account balances net of foreign portfolio and bank flows. direct investment. A. Yellow diamonds correspond with the June 2018 edition of the Global Economic Prospects report. B. Domestic demand includes government consumption, private consumption, and gross capital Commodity-exporting EMDEs formation, which includes the change in inventories. Net exports are calculated as the volume of exports minus imports. C. Figure shows imports of goods and services. The pace of recovery in commodity exporters has D. Figure shows average Purchasing Managers’ Index (PMI) for manufacturing output for country weakened significantly, and activity across the groups. Readings above 50 indicate expansion in economic activity; readings below 50 indicate contraction. group has become more heterogenous. Investor confidence has generally worsened, especially toward economies with external vulnerabilities and off. In over 35 percent of EMDEs, per capita growth fragile domestic conditions (e.g., Angola, will be too low to avoid widening income gaps with Argentina, Nigeria, South Africa). Recent declines advanced economies. in oil and other commodity prices have posited Recent developments additional headwinds to activity. The recovery in EMDE activity has stagnated. Long-standing challenges in several large Aggregate growth in EMDEs edged down to an economies have resurfaced. In a number of estimated 4.2 percent in 2018—0.3 percentage countries, capital flows have softened, and asset point below previous projections—against the prices and currencies have come under significant backdrop of a substantial strengthening of the pressure amid weaker global trade, rising trade U.S. dollar, weakening capital flows, heightened restrictions, and renewed investor attention to trade tensions, and moderating global country-specific factors including sizable current manufacturing and trade. This more challenging account and fiscal deficits and elevated debt. As a international environment was accompanied by consequence, the rebound in domestic demand G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 21 has slowed and the recovery in investment has growth, and deteriorated conditions in some large stalled (e.g., Argentina, Iran, South Africa). Private economies with elevated vulnerabilities and consumption growth has also cooled following heightened policy uncertainty. Inflation has several years of continued recovery, partly generally moved up, partly in response to higher reflecting the dampening impact of higher energy prices in most of 2018 and closed or inflation and tighter lending conditions. positive output gaps. Price pressures, widening fiscal and current account deficits, or in some cases Among the largest commodity exporters, growth currency and financial market volatility have in Argentina plummeted following acute financial prompted a shift to less accommodative monetary market stress that resulted in sharp currency policy in some countries in this group (e.g., India, depreciation and monetary policy tightening. In Mexico, Pakistan, the Philippines, Romania). South Africa, activity contracted in the first half of 2018 and, despite a recovery in the second half, it The moderation in activity is most evident among remains subdued, reflecting challenges in mining commodity importers with increasing capacity production, low business confidence, and policy constraint, high current account deficits, or sizable uncertainty. Growth in Brazil was lackluster in public debt. The slowdown in Turkey—which 2018, reflecting a truckers’ strike mid-year and faced a substantial deterioration in foreign investor heightened policy uncertainty. In Russia, growth confidence—has been especially severe. Activity is has been resilient, supported by private also slowing, and financial conditions have consumption and exports; however, momentum tightened, in a number of other commodity has slowed, reflecting policy uncertainty, recent oil importers that have experienced financial market price declines, and renewed pressures on currency stress or continue to face widening fiscal and and asset prices. Output has contracted in a current account deficits (e.g., Pakistan, the number of other commodity exporters that Philippines, Romania). experienced declines in commodity production (e.g., Angola, Equatorial Guinea); social tensions Slowing Euro Area growth has diminished the (e.g., Nicaragua), or other idiosyncratic factors positive trade and financial spillovers that had (e.g., sanctions in Iran). previously supported activity in several countries in Europe and Central Asia (e.g., Bulgaria, In contrast, activity has firmed further in several Croatia, Montenegro). However, in some oil-exporting economies where oil production economies, moderate inflation and low interest rebounded in 2018 (e.g., Kuwait, United Arab rates have supported a pickup in growth (e.g., Emirates). Recoveries have also continued, to Hungary, Poland, Serbia). Growth in Mexico varying degrees, in some large energy exporters remains moderate, partly owing to tighter where significant adjustments were introduced in financing conditions and domestic policy-related response to the 2014-16 oil price plunge (e.g., uncertainty. Azerbaijan, Colombia, Saudi Arabia; World Bank 2018e, 2018f). Despite recent declines in Although activity continues to be generally more industrial metals prices, growth among some large solid in Asia, external headwinds have increased. metals exporters has continued to show resilience In India, growth has accelerated, driven by an (e.g., Chile, Mongolia, Peru). In addition, activity upswing in consumption, and investment growth in a number of countries has been supported by has firmed as the effects of temporary factors infrastructure spending and foreign direct wane. However, rising interest rates and currency investment flows (e.g., Benin, Côte d’Ivoire, volatility are weighing on activity (World Bank Ethiopia, Lao People’s Democratic Republic, 2018h). Other Asian economies (e.g., Bhutan, Morocco, Senegal, Uganda; World Bank 2018g). Cambodia, Vietnam) continue to benefit from pan-Asian infrastructure investment projects, Commodity-importing EMDEs including the China-led Belt and Road Initiative Growth in commodity importers has decelerated, (World Bank 2018b). reflecting capacity constraints, moderating export 22 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 1.2 Low-income countries: Recent developments and outlook Growth in low-income countries increased only slightly in 2018, to 5.6 percent, but is expected to rise to 5.9 percent in 2019 and average about 6.3 in 2020-21. Oil producers are benefitting from higher oil prices and output, while softer metals prices are weighing on growth in the metals exporters. Higher agricultural production and continued infrastructure spending has supported growth in non-resource-intensive countries. However, progress on poverty reduction across all low-income countries will remain slow. Downside risks to the outlook include the possibility that commodity prices will soften as a result of trade disputes, global financing conditions will tighten abruptly, fiscal policies will slip, or extreme weather-related or health crises will emerge. Recent developments exporters, such as Chad, recorded smaller deficits, helped by higher oil export earnings. Economic growth is gradually improving in most low- income countries (LICs), even though the external The financing of current account deficits has become more environment is becoming less favorable (Figure 1.2.1). challenging amid a less supportive external environment, Robust growth in several non-resource-intensive countries as foreign direct investment (FDI) inflows slowed in has been supported by agricultural production (e.g., almost 40 percent of countries (e.g., Mozambique, Rwanda, Uganda) and services (e.g., Nepal, Uganda) on Tanzania, Zimbabwe; UNCTAD 2018). FDI inflows, in the production side, and household consumption (e.g., particular to LICs, are more vulnerable to fluctuations in Togo, Tajikistan) and public investment (e.g., Benin, The international financial conditions (Burger and Gambia, Nepal, Tajikistan) on the demand side. However, Ianchovichina 2017). However, in some countries, in Ethiopia—the largest LIC—growth lost momentum as reduced political uncertainty and improved investor weaker activity in the construction and manufacturing sentiment have supported stronger FDI inflows (e.g., sectors was aggravated by foreign exchange shortages. Benin, The Gambia). In addition, remittance flows have Among exporters of industrial commodities, Chad recovered in several countries as growth in selected emerged from two years of recession partly due to the advanced economies improved in recent years (e.g., Benin, recovery in oil prices from their 2016 trough, as well as Guinea-Bissau, Haiti; World Bank 2018i). Nevertheless, increased oil production. In contrast, the growth for many LICs, the accumulation of sufficient performance of metals exporters was more subdued, international reserves remains difficult, leaving them below reflecting weaker metals prices and external demand, as the three-months-of-imports benchmark and highly well as mine closures (e.g., Sierra Leone), and heightened vulnerable to negative shocks. political uncertainty (e.g., Democratic Republic of Fiscal deficits generally widened among the LICs, with the Congo). median deficit increasing from 3.3 percent of GDP in 2017 to an estimated 3.5 percent in 2018. The Progress on poverty reduction in LICs continues to be deterioration reflected rising fiscal deficits among several disappointing, with more than 40 per cent of the industrial-commodity-exporting LICs as moderating population in these countries living in extreme poverty— metals prices dampened revenues. However, in oil- i.e., earning below $1.90 per day. And while this ratio has exporting countries (e.g., Chad), higher oil revenues remained broadly unchanged in recent years, insufficient combined with improved non-oil revenue collection per capita GDP growth, especially in economies affected yielded a fiscal surplus, and in some non-resource- by fragility, conflict, and violence, means that the poverty intensive countries, fiscal consolidation delivered narrower headcount is rising. fiscal deficits (e.g., Benin, The Gambia). Current account deficits are estimated to have widened in Debt levels remain elevated in many countries and several countries in 2018. Among non-resource-intensive continue to rise. In Liberia and Sierra Leone, the debt-to- economies, as well as metals exporters, external balances GDP ratio has increased more than twofold over the last have deteriorated as exports declined in response to weaker five years, driven by a significant slowdown in growth and external demand and moderating metals prices and the continually weak revenue collection (Liberia) and a effect of rising fuel prices on import bills. In contrast, oil depreciating exchange rate coupled with new borrowings (Sierra Leone). In addition to the rise in debt ratios, changes in the composition of debt have made some Note: This box was prepared by Rudi Steinbach. Research assistance countries more vulnerable to shifts in international was provided by Hazel Macadangdang. financing conditions (Chapter 4). As countries have gained G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 23 BOX 1.2 Low-income countries: Recent developments and outlook (continued) FIGURE 1.2.1 Recent developments in low-income countries Growth in LICs is gradually improving. Metals exporters are struggling owing to softer metals prices, while growth in non- resource-intensive countries is supported by higher agricultural production and infrastructure spending. However, the poverty headcount is rising, especially in economies affected by fragility, conflict, and violence. Current account and fiscal deficits have been widening, especially in metals exporters. Increased reliance on non-concessional debt is making LICs more vulnerable to global financial conditions, and the number of countries in debt distress has continued to rise. A. Growth B. Poverty headcount C. Current account balance D. Fiscal balance E. Non-concessional debt F. Debt distress Source: International Monetary Fund, World Bank. Note: LICs = low-income countries. Industrial-commodity-exporting countries include energy- and metal- exporting economies, and the sample includes 8 countries. Non-resource-intensive countries include agricultural-exporting economies and commodity importers, and the sample includes 22 countries. Data for 2018 are estimates. A. Aggregate growth rates calculated using constant 2010 U.S. dollar GDP weights. B. The number of people living on or below the international poverty line of $1.90 per day. Data for 2016-18 are estimates and calculated using data from World Bank (2018h). FCV = fragility, conflict, and violence. Per capita GDP represents the average growth rate from 2016 to 2019. C.D. Median of country groups. E. Includes 30 low-income countries and excludes Somalia, South Sudan, and Syria due to data restrictions. F. Percent of LICs eligible to access the IMF’s concessional lending facilities that are either at high risk of, or in, debt distress. The sample includes 30 low-income countries. access to international capital markets and non-resident framework. In addition, Ethiopia was downgraded during participation in domestic debt markets expanded, non- the year from a moderate-risk to high-risk rating. concessional debt has increased, reaching more than 30 percent of total public debt in several LICs (e.g., Ethiopia, Outlook Mozambique, Senegal) and over half of total public debt Growth in LICs is expected to improve, rising to 5.9 in Zimbabwe. percent in 2019 and an average of about 6.3 percent in As a result, debt sustainability has deteriorated in several 2020-21 (Figure 1.2.2). While the growth recovery among LICs. By late 2018, The Gambia, Mozambique, South the metals exporters is expected to be sluggish, as lower Sudan, and Zimbabwe were classified as in debt distress revenues constrain fiscal spending, growth among oil under the IMF–World Bank debt sustainability exporters is expected to be spurred by higher oil 24 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 1.2 Low-income countries: Recent developments and outlook production and improving domestic demand. Economic FIGURE 1.2.2 Outlook activity is also expected to remain robust in non-resource- intensive LICs. In fast-growing countries, such as Rwanda Growth among the LICs is expected to improve. In non- resource-intensive economies, growth will be supported and Tanzania, the expansion will be supported by public by stronger agriculture production and continued investment in infrastructure and strong agricultural infrastructure investment, while oil exporters should growth. Similarly, infrastructure, agriculture, and energy benefit from higher oil production. However, weaker investments related to structural reforms should sustain metals prices and subdued external demand imply a sluggish recovery in metals exporters. Moreover, Senegal’s growth recovery. While growth in Ethiopia is progress on poverty reduction in LICs is expected to be expected to remain strong, it will be weighed down by a slow, as per capita income growth still remains modest, tighter fiscal stance, as the government aims to stabilize especially among fragility, conflict, and violence- public debt. affected economies. Per capita GDP growth in LICs is expected to increase A. GDP growth forecasts only modestly from 2.7 percent in 2018 to 3.1 percent in 2019, and to an average of 3.5 percent in 2020-21. Moreover, among LICs affected by fragility, conflict, and violence, growth in per capita GDP is expected to be significantly lower—increasing from 0.5 percent in 2018 to an average of 1.6 per cent in 2020-21. In all, these rates are not sufficient to generate a marked reduction in poverty rates, and the number of people in LICs living below the international poverty line of $1.90 per day is expected to remain elevated. Risks The economic outlook is dominated by downside risks. On the external front, slower-than-projected growth in major world economies—such as the United States, Euro B. Per capita GDP growth Area, or China—would adversely affect export demand and investment in several LICs, specifically countries that are heavily dependent on these large economies for trade and investment flows. Moreover, escalating trade tensions involving major economies (e.g., rising tariffs between the United States and China) would be detrimental to LICs that depend on extractive industries—specifically metals producers, as metals prices are likely to fall faster than other commodity prices in response (World Bank 2018j). Furthermore, an unexpected deterioration in international financial conditions could disrupt capital inflows (IMF 2018b), fuel disorderly exchange rate depreciations, and raise financing costs, especially in LICs with weaker macroeconomic fundamentals or higher political risks. Sharp increases in debt-servicing costs, specifically foreign- Source: World Bank. currency-denominated debt, would undermine much- Note: Shaded area indicates forecasts. Industrial commodity countries include energy- and metal- based economies, and the sample includes 8 needed fiscal consolidation efforts and crowd out poverty- countries. Non-resource intensive countries include agricultural exporters and commodity importers, and the sample includes 22 countries. reducing expenditures. A. Aggregate growth rates calculated using constant 2010 U.S. dollar GDP weights. Risks to debt sustainability are high, as several countries B. FCV = fragility, conflict, and violence. Aggregate per capita growth rates calculated using the total GDP for each subgroup divided by its total are either already in debt distress or facing high risk population. Afghanistan, Liberia, and Tajikistan are excluded due to data thereof, according to the IMF–World Bank debt limitations. sustainability framework for LICs (Chapter 4). The recent increased reliance on foreign currency borrowing has G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 25 BOX 1.2 Low-income countries: Recent developments and outlook (continued) TABLE 1.2.1 Low-income country forecastsa Percentage point differences (Real GDP growth at market prices in percent, unless indicated otherwise) from June 2018 projectionsd 2016 2017 2018e 2019f 2020f 2021 2018e 2019f 2020f Low Income Country, GDP b 4.8 5.5 5.6 5.9 6.2 6.3 -0.1 0.0 0.0 Afghanistan 2.4 2.7 2.4 2.7 3.2 3.2 0.2 0.2 -0.1 Benin 4.0 5.8 6.0 6.2 6.5 6.6 0.0 0.1 0.2 Burkina Faso 5.9 6.3 6.0 6.0 6.0 6.0 0.0 0.0 0.0 Burundi -0.6 0.5 1.9 2.3 2.5 2.8 0.0 0.0 0.0 Chad -6.3 -3.0 3.1 4.6 6.1 4.9 0.5 2.1 0.3 Comoros 2.2 2.7 2.7 3.1 3.1 3.1 -0.2 0.1 0.1 Congo, Dem. Rep. 2.4 3.4 4.1 4.6 5.5 5.9 0.3 0.5 1.1 Ethiopiac 8.0 10.1 7.7 8.8 8.9 8.9 -1.9 -0.9 -1.0 Gambia, The 0.4 4.6 5.3 5.4 5.2 5.2 -0.1 0.2 0.3 Guinea 10.5 8.2 5.8 5.9 6.0 6.0 -0.2 0.0 0.0 Guinea-Bissau 5.8 5.9 3.9 4.2 4.4 4.5 -1.2 -1.0 -1.0 Haitic 1.5 1.2 1.6 2.3 2.4 2.5 -0.2 -0.1 0.0 Liberia -1.6 2.5 3.0 4.5 4.8 4.8 -0.2 -0.2 0.0 Madagascar 4.2 4.2 5.2 5.4 5.3 5.3 0.1 -0.2 0.0 Malawi 2.5 4.0 3.5 4.3 5.3 5.5 -0.2 0.2 0.4 Mali 5.8 5.4 4.9 5.0 4.9 4.8 -0.1 0.3 0.2 Mozambique 3.8 3.7 3.3 3.5 4.1 4.1 0.0 0.1 0.5 Nepalc 0.6 7.9 6.3 5.9 6.0 6.0 0.0 1.4 1.8 Niger 4.9 4.9 5.2 6.5 6.0 5.6 -0.1 1.1 0.2 Rwanda 6.0 6.1 7.2 7.8 8.0 8.0 0.4 0.7 0.5 Senegal 6.2 7.2 6.6 6.6 6.8 6.9 -0.2 -0.2 -0.2 Sierra Leone 6.3 3.7 3.7 5.1 6.3 6.3 -1.4 -0.6 -0.2 Tajikistan 6.9 7.1 6.0 6.0 6.0 6.0 -0.1 0.0 0.0 Tanzania 7.0 7.1 6.6 6.8 7.0 7.0 0.0 0.0 0.0 Togo 5.1 4.4 4.5 4.8 5.1 5.1 -0.3 -0.2 0.1 Ugandac 4.8 3.9 6.1 6.0 6.4 6.5 0.6 0.0 -0.1 Zimbabwe 0.6 3.2 3.0 3.7 4.0 4.0 0.3 -0.1 0.0 Source: World Bank. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not significantly differ at any given moment in time. a. Central African Republic, Democratic People’s Republic of Korea, Somalia, Syria, and Yemen are not forecast due to data limitations. b. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. c. GDP growth based on fiscal year data. For Nepal, the year 2017 refers to FY2016/17. d. Due to changes in the official list of countries classified as low income by the World Bank, the sample of LICs in this table is not comparable to June 2018. However, an identical sample is used for the comparison of the aggregate LIC GDP projection. To download this data, please visit www.worldbank.org/gep. increased the extent to which debt sustainability is many LICs, especially countries where agricultural activity vulnerable to sharp currency depreciations. accounts for a dominant share of domestic value added (e.g., Chad, Sierra Leone), or is the prevailing source Weather-related shocks, such as flooding or severe and of employment (e.g., Burkina Faso, Burundi; Chapter 4). prolonged drought episodes remain an important risk for many LICs. A return of the drought conditions Health crises are a continuous concern. The recent Ebola experienced in recent years would undermine the ongoing outbreak in the Democratic Republic of Congo could have recovery in agricultural production. In addition, lower a detrimental impact on economic activity in the country agricultural output, and the food price spikes that are and the sub-region should it spread to major urban centers likely to follow, could adversely affect poverty rates in and to neighboring countries. 26 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 1.3 Regional perspectives: Recent developments and outlook The cyclical upswing in regions with many commodity exporters (such as Latin America and the Caribbean, and the Middle East and North Africa) is proceeding at a more moderate pace than previously anticipated, partly reflecting a substantial slowdown in some large economies, and is expected to plateau toward the end of the forecast horizon. Growth in regions with large numbers of commodity importers (such as South Asia and East Asia and the Pacific) is projected to remain solid at around 6-7 percent. For all regions, risks to the outlook are increasingly tilted to the downside. East Asia and Pacific. Growth is projected to moderate to risks dominate, including the possibility of an abrupt a still-robust pace of about 6 percent in 2019 and remain further tightening of external financial conditions, a near that level over the forecast period, in line with earlier further escalation of domestic or international trade policy projections. In China, policies aimed at rebalancing the uncertainty, adverse market responses to fiscal conditions, economy and countering the impact of higher U.S. tariffs and disruptions from natural disasters. will continue to tilt activity toward consumption and away from exports. Excluding China, regional growth is Middle East and North Africa. Growth in the region is expected to remain steady at 5.2 percent over the forecast expected to pick up slightly in to 1.9 percent 2019, but horizon. Risks to regional growth are to the downside and prospects are uneven across countries. Accelerating activity have intensified. They include a further escalation of trade in Saudi Arabia and Egypt is expected to be offset by a restrictions and a faster-than-expected tightening of global sharp contraction in Iran following the imposition of U.S. financing conditions. Highly leveraged economies and sanctions. Increased oil production and fiscal easing are countries with sizable external financing needs are supporting the recovery in some oil exporters, while oil particularly vulnerable to disruptions in real and financial importers continue to benefit from policy reforms. activity. Regional growth is projected to rise to 2.7 percent in 2020-21, as domestic demand among both oil importers Europe and Central Asia: Growth fell to an estimated 3.1 and exporters shows a broad-based pickup, supported by percent in 2018, driven by a slowdown in Turkey and in reforms and diversification policies. Key downside risks Central European economies. Turkish growth for this year include the possibility of intensified geopolitical tensions, has been revised sharply down due to substantial financial renewed volatility in oil prices, rising global trade market stress and the associated economic effects, restrictions, an abrupt tightening of global financing contributing to a deceleration in regional growth in 2019 conditions, and delays in reform implementation. to 2.3 percent. Growth in the region is expected to pick up to 2.7 percent in 2020, as a rebound in Turkey offsets a South Asia. Growth is projected to accelerate to 7.1 moderation in activity among other commodity importers. percent in 2019. This mainly reflects strengthening Risks are tilted to the downside and growing. They domestic demand in India, as the benefits of structural include the possibility of renewed stress in Turkey reforms such as GST harmonization and bank alongside larger-than-expected spillovers to the rest of the recapitalization take effect. Elsewhere in the region, the region, and unexpected shifts in policy. forecast is for a moderation in activity, notably in Bangladesh and Pakistan. Over the medium term, growth Latin America and the Caribbean. Growth stalled at 0.6 is expected to remain at 7.1 percent, underpinned by percent in 2018, held back by a currency crisis and robust domestic demand in the region. External drought in Argentina, a truckers’ strike in Brazil, and vulnerabilities are rising, reflected in mounting external worsening conditions in Venezuela. Although regional debt, widening current account deficits, and eroding growth is projected to strengthen over the forecast foreign reserves. Risks to the outlook are to the downside. horizon, the improvement will be weaker than previously On the domestic front, vulnerabilities are being expected, partly owing to the effects of financial market exacerbated by fiscal slippages and rising inflation, and tightening and trade policy uncertainty. However, firming there is a risk of delays in structural reforms to address momentum in Brazil and Colombia, together with gradual balance sheet issues in the banking and non-financial improvements in Argentina, will push regional growth to corporate sectors. Key external risks include a further 1.7 percent in 2019 and 2.4 percent in 2020. Downside deterioration in current accounts and a faster-than- expected global financial tightening. Note: This box was prepared by Patrick Kirby, with contributions from Sub-Saharan Africa. Regional growth reached an Yoki Okawa, Rudi Steinbach, Temel Taskin, Ekaterine Vashakmadze, estimated 2.7 percent in 2018—a downward revision from Dana Vorisek, and Lei Ye. Research assistance was provided by Hazel previous projections, reflecting a sluggish expansion in the Macadangdang. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 27 BOX 1.3 Regional perspectives: Recent developments and outlook (continued) FIGURE 1.3.1 Regional growth The cyclical upswing in regions with many commodity exporters is proceeding at a more moderate pace than previously anticipated. Growth in regions with large numbers of commodity importers is projected to remain solid. A. Regional growth, weighted average B. Regional growth, unweighted average Source: World Bank. A.B. Bars denote latest forecast; diamonds correspond to June 2018 forecasts in the Global Economic Prospects report. Average for 1990-2017 is constructed depending on data availability. For Europe and Central Asia, the long-term average uses data for 1995-2017 to exclude the immediate aftermath of the collapse of the Soviet Union. A. Aggregate growth rates calculated using constant 2010 U.S. dollar GDP weights. Since largest economies account for about 50 percent of GDP in some regions, weighted averages predominantly reflect the developments in the largest economies in each region B. Unweighted average regional growth is used to ensure broad reflection of regional trends across all countries in the region. region’s largest economies amid moderate trade growth, predicted to remain well below its long-term average in tightening financial conditions, and weak prices for key many countries, yielding little progress in poverty metals and agricultural commodities. Regional growth is reduction. Downside risks include the possibility of expected to pick up, reaching 3.4 percent in 2019 and an slower-than-projected growth in China and the Euro Area, average of 3.7 in 2020-21, predicated on diminished further declines in commodity prices, a sharp tightening of policy uncertainty and improved investment in large global financing conditions, fiscal slippage, stalled economies, together with continued robust growth in non- structural reforms, and conflict. resource-intensive countries. Per capita income growth is Low-income countries Among exporters of industrial commodities, growth performances have varied. Chad emerged Economic activity has continued to strengthen in from two years of recession partly due to the most low-income countries (LICs; Box 1.2). recovery in oil prices from their 2016 trough, as Increased agricultural production in the wake of well as increased oil production. However, for easing drought conditions is supporting robust metal exporters, growth was more subdued, growth in several non-resource-intensive countries reflecting weaker metals prices and external (e.g., Rwanda, Uganda), as well as infrastructure demand. Lower export growth, combined with investment related to reforms (e.g., Benin, higher fuel-related imports, has caused current Senegal). However, in Ethiopia—the largest account deficits to widen in many LICs. In LIC—growth lost momentum as weaker activity addition, the less favorable external environment is in the construction and manufacturing sectors making the financing of these deficits more were aggravated by foreign exchange shortages. challenging. Moreover, government debt has 28 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 1.12 EMDE growth prospects previous projections. This reflects the lingering effects of recent financial market stress on several EMDE growth is expected to remain at 4.2 percent in 2019, well below previous forecasts, partly reflecting the lingering effects of financial stress large economies, a lackluster and notably softer- in some large economies. EMDE growth is subsequently projected to than-envisioned cyclical recovery in commodity plateau at 4.6 percent, as the recovery in commodity exporters levels off. Growth is close to upper estimates of potential in commodity importers, exporters, and a further deceleration in while slack remains in commodity exporters. A decreasing share of commodity importers (Figure 1.12). Growth EMDEs will see further acceleration in activity, in part reflecting a less across EMDEs in 2019 is expected to be close to favorable external environment. Drivers of long-term growth suggest softening potential over the next decade. the upper bound of estimates of its potential pace—particularly among commodity importers, A. Growth B. Projected and potential growth in where slack has largely been exhausted. 2019 Growth in EMDEs is foreseen to increase to 4.5 percent in 2020, with a large part of this acceleration reflecting the projected dissipation of severe headwinds in a few large economies (e.g., Argentina, Iran, Turkey). In 2021, EMDE growth is expected to plateau at 4.6 percent as the recovery in commodity exporters matures. Throughout the forecast horizon, the international context is expected to be increasingly less C. Number of EMDEs with increasing, D. Drivers of potential long-term favorable, in light of a projected slowdown in unchanged, or decreasing growth growth advanced-economy growth, weakening trade and investment, tighter financing conditions, and trade policy uncertainty. These factors will impede further acceleration in EMDE activity. Growth in commodity exporters is projected to pick up to 2.3 percent in 2019—sharply below previous expectations—and plateau at 2.9 percent in both 2020 and 2021. Some large economies Source: International Monetary Fund, Organisation for Economic Co-operation and Development, World Bank. that experienced sizable contractions in activity in A.-D. Aggregate growth rates are calculated using constant 2010 U.S. dollar GDP weights. 2018 are expected to gradually recover over the A.C.D. Shaded areas indicate forecasts. Data for 2018 are estimates. B.D. Potential growth estimates based on eight different methodologies (production function forecast horizon (e.g., Angola, Argentina, Iran). approach; multivariate filter; three univariate filters, including Hodrick-Prescott filter, Christiano- Fitzgerald filter, and Butterworth filter; IMF World Economic Outlook estimates; and OECD Economic The outlook for commodity exporters is uneven, Outlook and Long-Term Baseline Projections estimates). For further details on potential growth however, partly owing to renewed market estimates, refer to the January 2018 edition of the Global Economic Prospects report. A. Data for 2015-17 are simple averages. Green diamonds correspond with the June 2018 edition of attention to country-specific vulnerabilities. the Global Economic Prospects report. B. Blue bars refer to average projected growth for 2019. Vertical orange lines show minimum- maximum range of potential growth. Projections for about half of commodity exporters C. Sample includes 50 largest EMDEs. Increasing/decreasing growth are changes of at least 0.1 percentage point from the previous year. Countries with a slower pace of contraction from one year have been downgraded for 2019. Downward to the next are included in the increasing growth category. revisions reflect, to varying degrees, more adverse D. TFP = total factor productivity. The sample includes 23 EMDEs (11 EMDE commodity exporters and 12 EMDE commodity importers). financial conditions and the resulting policy adjustment, softening confidence, lingering effects of strikes and political uncertainty, and weaker continued to rise, as fiscal deficits remain elevated commodity prices and mining bottlenecks. These due to commodity-related declines in revenue, as downward revisions are also reflected in forecasts well as governance challenges in some countries for EMDE regions with a substantial number of (Chapter 4). commodity exporters (Box 1.3; Chapter 2). EMDE outlook Growth in commodity importers is expected to Growth outlook moderate to 5.5 percent in 2019 and remain EMDE growth is expected to stall at 4.2 percent steady at 5.6 percent in both 2020 and 2021— in 2019—down 0.5 percentage point relative to broadly in line with its potential rate. A structural G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 29 slowdown in China is expected to be partly offset FIGURE 1.13 Poverty and per capita income growth by a moderate pickup in other large economies in Per capita income growth in the near term will be insufficient to restart the this group. In commodity importers excluding catch-up with advanced economies in more than one-third of EMDEs. China, a downgrade to growth projections of 0.4 Poverty is increasingly concentrated in a few large lower-middle-income countries. Per capita GDP growth is expected to remain weak in EMDE percentage point this year partly reflects the regions with a large number of commodity exporters. worsened outlook for Turkey as a result of the effects of recent financial market stress, and, to a A. Share of EMDEs with widening B. Poverty in EMDEs, in 2015 lesser degree, in some other large economies (e.g., income per capita gaps with advanced Pakistan, Romania). economies Growth in LICs is expected to improve, rising to 5.9 percent in 2019 and 6.3 percent in 2020-21. However, for metals exporters, growth will be more sluggish than previously envisioned, with lower revenues constraining fiscal spending. In contrast, oil exporters should benefit from higher oil production and improving domestic demand. Economic activity is expected to remain robust in C. Poverty projections for India and D. Per capita growth, by region non-resource-intensive LICs. In fast-growing Nigeria countries (e.g., Rwanda, Tanzania), the expansion will be supported by public investment in infrastructure and strong agricultural growth. Similarly, infrastructure investment related to structural reforms should sustain Senegal’s growth recovery. While growth in Ethiopia is expected to remain strong, it will be weighed down by a tighter fiscal stance, as the government aims to stabilize public debt. Source: United Nations, World Bank. Note: EAP = East Asia and Pacific, ECA = Europe and Central Asia, LAC = Latin America and the In the longer run, the underlying potential growth Caribbean, MNA = Middle East and North Africa, SAR = South Asia, and SSA = Sub-Saharan Africa. of EMDEs has fallen considerably over the past A.D. Shaded areas indicate forecasts. Data for 2018 are estimates. A. EMDEs with per capita GDP growth of at least 0.1-percentage-point higher than advanced- decade, reflecting softening productivity growth economy per capita GDP growth are those counted as converging. Advanced-economy growth rates calculated using constant 2010 U.S. dollar GDP weights. Sample includes 117 EMDEs. and, to a lesser degree, slowing capital B. LICs = low-income countries, LMCs = lower-middle-income countries, and Other EMDEs = EMDEs not classified in LICs or LMCs. Aggregate poverty rates are weighted by total population. Data as of accumulation and less favorable demographic 2015, the latest available observation. trends (Vorisek et al. forthcoming; World Bank C. The number of poor are people living on or below the international poverty line of $1.90 per day. Shaded area indicates forecasts. Data for 2016-18 are estimates and calculated using data from 2018k). Potential growth in EMDEs is expected World Bank (2018l). D. Aggregate growth rates calculated using constant 2010 U.S. dollar GDP weights. to further decline, as its fundamental drivers continue to weaken. Moreover, tightening global financing conditions, higher borrowing costs, exporters (41 percent) and in countries affected by moderating capital flows, and lingering policy fragility, conflict, and violence (nearly 60 percent). uncertainty are likely to hamper investment growth in coming years, further constraining Although the extreme poverty rate—defined at a potential growth. threshold of $1.90 per day—has fallen below 3 percent in more than half of the world’s Outlook for per capita income and poverty economies in recent years, nearly one-fifth of countries faced rates above 30 percent in 2015, Per capita income growth in EMDEs is expected with the average for LICs standing above 40 to stabilize at 3 percent in 2019—insufficient to percent. Poverty rates remain the highest among narrow income gaps with advanced economies in LICs, but the majority of extreme poor currently over 35 percent of countries (Figure 1.13). The reside in large lower-middle-income countries, share will be even greater among commodity including India and Nigeria. Current growth 30 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 1.14 Risks: Tilted to the downside of the global poor residing in Sub-Saharan Africa could be as large as 87 percent by 2030 (World Past global recessions often came unexpectedly following periods of highly synchronized growth. Risks to global growth are predominantly to Bank 2018l). the downside amid trade tensions, rising borrowing costs, and deteriorating financial market sentiment. Risks to the outlook A. Share of countries in recession B. Probability distribution around The balance of risks is more firmly on the downside. global growth forecasts The risk of disorderly financial market developments has increased and could spread through EMDEs, amplified by elevated vulnerabilities in many countries. A marked intensification of trade restrictions remains possible, and its realization could be highly disruptive in the presence of complex value chains. Policy uncertainty and geopolitical risks remain elevated and could negatively impact confidence and investment both in the affected C. Probability of 2020 global growth D. Volatility and skewness in equity countries and globally. Although unlikely in the near being 1-percentage-point below/above price futures term, the simultaneous occurrence of a severe U.S. baseline downturn and a sharper-than-expected deceleration in China would trigger a marked slowdown in global activity. Global growth is projected to gradually slow over the forecast horizon as economic slack dissipates, major central banks remove policy accommodation, and the recovery in commodity exporters matures. This moderation is somewhat Source: Bloomberg, Kose and Terrones (2015), World Bank. more pronounced than previously expected, amid A. Recession is defined as a contraction in per capita GDP. Unbalanced sample includes 149 countries. Aggregate share is calculated using constant 2010 U.S. dollar GDP weights. Red bars softer-than-expected global trade and industrial show the four global recessions in 1975, 1982, 1991, and 2009, and orange bars show the two global slowdowns in 1998 and 2001. activity and heightened financial market pressures B.C.D. The fan chart shows the forecast distribution of global growth using time-varying estimates of the standard deviation and skewness extracted from the forecast distribution of three underlying risk in some EMDEs. While an abrupt slowdown is factors (oil price futures, the S&P 500 equity price futures, and term spread forecasts). Each of the risk factor’s weight is derived from the model described in Ohnsorge, Stocker, and Some (2016). only expected in countries that faced severe Values for 2019 are computed from the forecast distribution of 12-month-ahead oil price futures, S&P financial stress in 2018, the global outlook has 500 equity price futures, and term spread forecasts. Values for 2020 are based on 24-month-ahead forecast distributions. Last observation is December 18, 2018. become more uncertain, with downside risks C. Bars show the probability that global growth is 1 percentage point above or below baseline forecasts 24 months ahead. becoming more predominant. D. The implied volatility and skewness are derived from 12-month S&P 500 equity price futures. A faster-than-expected tightening of global financing conditions, or disorderly exchange rate projections suggest that the number of extreme movements, could have large adverse effects on poor should continue to fall rapidly in India, but activity, particularly among more vulnerable remain broadly unchanged in some other EMDEs. Escalating trade tensions represent countries, including Nigeria. While extreme another key risk to the global outlook, as they poverty has declined notably, progress in could significantly hamper cross-border trade and alleviating poverty at higher income levels has been investment, with the impact amplified by complex slower, with nearly a quarter of the world’s regional and global value chains. Loss of population still living with less than $3.20 per day. confidence in international trading rules could Worryingly, per capita income growth in Sub- inflict long-lasting damage, lowering opportunities Saharan Africa is expected to average only 0.9 for future growth in EMDEs. Rising political percent in 2019-21—insufficient to drive uncertainty and polarization, geopolitical risks, significant progress toward poverty alleviation. and conflict could also depress sentiment and Indeed, if recent growth trends persist, the fraction investment in the affected countries and globally. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 31 The materialization of one or several of these investors appear to foresee an end to the downside risks would result in a more abrupt tightening cycle in U.S. policy interest rates, the slowdown in global growth than currently Federal Reserve continues to signal additional envisioned. In particular, a simultaneous hikes, implying risks of disorderly market occurrence of a severe U.S. downturn and a reassessments (FOMC 2018). In this context, a sharper-than-expected deceleration in China sharper-than-expected rise in U.S. borrowing costs would significantly increase the likelihood of an remains possible. This could be triggered, for abrupt global slowdown. Past experience illustrates instance, by concerns about swelling fiscal deficits, that global slowdowns and recessions often come intensifying wage pressures, or slowing foreign unexpectedly after spells of highly synchronized demand for U.S. government debt (Andolfatto growth and rapid debt build-ups (Figure 1.14; and Spewak 2018; Kopp and Williams 2018). Kose and Terrones 2015). Following a decade of exceptionally low U.S. interest rates and growing debt levels, the effects of On the upside, a resolution of trade tensions a sudden rise in borrowing costs could be between major economies could lift sentiment and amplified by increased investor risk aversion and support global investment and trade. Furthermore, sudden stops in capital flows to EMDEs (Arteta et the ongoing cyclical recovery in global al. 2015; Buttiglione et al. 2014; Dobbs et al. productivity growth could prove more durable 2015; Mai 2018). The dampening effect could be than expected, especially if the pickup in particularly severe on cross-border bank loans to intangible investments in recent years leads to a EMDEs (Bräuning and Ivashina 2018). broader diffusion of productivity-enhancing technologies. If so, this would help counter the A further appreciation of the U.S. dollar, possibly dampening effect of population aging on potential triggered by diverging monetary policy and growth in the longer term. growth prospects among major economies, could also impact the outlook for EMDEs. Periods of A quantification of possible global growth dollar strength have been associated in the past outcomes around the baseline provides additional with an increased frequency of disorderly currency evidence of elevated forecast uncertainty and the depreciations in EMDEs. If currency crises were to predominance of downside risks. At current materialize, they would be associated with slowing market conditions, the probability of global growth or outright contractions. In the past, a growth being more than 1 percentage point below large proportion of crises were accompanied by a baseline in 2020 is estimated at 21 percent, while recession in the same year (Figure 1.15). When that of growth being more than 1 percentage currency crises are accompanied by banking crises, point above baseline is 17 percent. This reflects as is sometimes the case, the likelihood of large uncertainty embedded in the distribution of key output losses rises substantially (Laeven and risk factors, including equity price futures. Valencia 2018). These “twin” crises can occur in Disorderly financial market developments the presence of elevated foreign-currency- denominated debt or on the back of an abrupt end Risks of disorderly financial market developments to capital inflows and credit booms leading to have intensified substantially, reflecting the rising corporate defaults and large asset price possibility of a faster-than-expected tightening of corrections (Bordo and Meissner 2016; Caballero global financing conditions, sharp movements in 2014). major currencies, and contagion from financial stress in some EMDEs. Financial stress could spread through contagion effects. Excluding China and a few large regional Despite bouts of volatility in bond and equity economies (e.g., Brazil, Russia), direct trade and markets, as well as ongoing uncertainty about financial sector spillovers from most other EMDEs growth and inflation prospects, U.S. term are limited (World Bank 2016). However, premiums are still negative, raising the risks of contagion across countries can result from sudden upward adjustments (Crump, Eusepi, and heightened investor risk aversion and shifts in Moench 2018; Kopp and Williams 2018). While portfolio allocations between broad asset classes, 32 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 1.15 Financial stress increasingly relied on bond markets to finance rising debt levels, and now face significant More than a third of currency crises in EMDEs are associated with negative growth in the same year. Currency crises are sometimes refinancing needs amid rising interest rates (Lund accompanied by banking crises, and their simultaneous occurrence can et al. 2018). This could result in sudden increases be particularly damaging. Financial stress can be amplified by persistent in corporate default rates and have a sustained external vulnerabilities, potentially leading to further forecast downgrades for more exposed countries. negative effect on investment and financial stability (Borensztein and Ye 2018). On the A. Currency crises and growth in B. EMDE banking and sovereign debt external side, many EMDEs are faced with the EMDEs crises around currency crises challenge of financing large current account deficits and rely heavily on volatile capital inflows. Coupled with high levels of short-term external debt and low foreign currency reserves, this leaves them exposed to shifts in external financing conditions, which could exert further downward pressure on activity. In low-income countries (LICs), public debt D. Growth forecast revisions and burdens and vulnerabilities associated with a C. Share of EMDEs with negative growth around currency crises current account position, 2019 greater reliance on non-concessional financing are rising (Chapter 4). About 40 percent of LICs are in debt distress or at high risk of debt distress— roughly twice the share in 2015 (IMF 2018c; World Bank 2018g). Most LICs also suffer from a lack of transparency in public sector accounts, further exacerbating vulnerabilities. Escalating trade restrictions Source: Bloomberg, Institute of International Finance, Laeven and Valencia (2018), World Bank. A. Currency crises with negative or positive GDP growth during the year of the crisis. Currency crises The risk of rising trade protectionism remains are defined as nominal depreciation of the currency vis-à-vis the U.S. dollar of at least 30 percent that high. New U.S. tariffs and the retaliatory response is also at least 10-percentage-points higher than the rate of depreciation in the year before. B. The percent of EMDE currency crisis episodes that were preceded by, coincided with, or followed of trading partners now affect close to $430 billion by a banking or sovereign debt crisis, with t denoting the start of the currency crisis. Crises episodes are as defined in Laeven and Valencia (2018). of global imports—around 2.5 percent of global C. Share of countries that experienced negative growth in the current or next year following a currency crisis, a currency and banking crisis, or a currency, banking, and sovereign debt crisis goods trade (Figure 1.16). Despite a temporary between 1975-2017. pause in tariff hikes agreed by the United States D. Forecast revisions for GDP growth in 2019 relative to June 2018. Sample includes 23 EMDEs. Current account position net of foreign direct investment in 2018. and China in early December, unsuccessful negotiations could lead to a renewed escalation in amplifying the effects of shocks (Gelos 2012). trade restrictions. These, along with previous Historically, the correlation across EMDE assets measures, would affect close to all goods trade has been high and tends to increase during stress between the two countries. Additional tariffs on episodes (Eichengreen and Gupta 2016; Park and U.S. imports of motor vehicles and parts are also Mercado 2014). under consideration, which could cause serious adverse effects given tightly integrated global These risks are particularly salient in the current automotive value chains. context of persistent domestic and external vulnerabilities in EMDEs, as these can both If all proposed tariffs increases were to be amplify the impact of financial shocks and limit implemented, the average U.S. tariff rate would policy options in response to financial stress. On more than quadruple, rising to levels not seen the domestic front, many countries have sizable since the late 1960s. These new tariffs, and the government debt and primary fiscal deficits, associated retaliatory actions, could substantially elevated or rising private debt, and high non- depress bilateral U.S.-China trade, increase performing loans. Corporate borrowers have demand for costlier substitutes, and lead to lower G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 33 growth in both the United States and China. It is FIGURE 1.16 Trade protectionism also likely to affect investment strategies by If all new tariffs currently under consideration were to be implemented, multinational companies and lead to changes in more than 5 percent of global goods trade would be affected, and average some value chains. While some countries could U.S. tariff rates would increase to levels not seen since the late 1960s. The dampening impact of trade tensions involving major economies could be benefit from trade diversion in the short run, amplified by adverse confidence effects. The cost of protectionism can be including those with comparative advantages in multiplied through global value linkages, particularly in EMDEs. close substitutes to the goods subject to U.S. or China tariffs, adverse effects from weakening A. Imports affected by new tariffs B. Average import tariffs in the United growth and rising policy uncertainty involving the States world’s two largest economies would have predominantly negative repercussions. In this context, a further escalation of trade frictions between the United States and China, coupled with possible negative effects on confidence, could reduce global exports by up to 3 percent and global income by 1.7 percent over the medium term (Freund et al. 2018). More generally, a proliferation of trade barriers C. Impact on nominal GDP of tariff D. Magnification of tariffs due to hikes on all U.S.-China trade flows vertical specialization across both advanced economies and EMDEs could inflict lasting damage to the global economy. In particular, if all WTO members were to increase tariffs up to legally-allowed bound rates, this could translate into a decline in global trade flows of about 9 percent, similar to the drop seen during the global financial crisis in 2008-09 (Kutlina-Dimitrova and Lakatos 2017). In the presence of regional and global value chains, costs associated with increasing tariffs or Source: Freund et al. (2018), Peterson Institute for International Economics, U.S. Census Bureau, U.S. International Trade Commission, World Bank. other barriers to trade would cumulate through A. Import tariffs implemented in the United States and the rest of the world in 2018, as well as those different stages of production (Koopman, Wang, under consideration, as a percent of global goods imports. B. Ratio of duties collected to the total value of imports. Data for 2018-20 are forecast from tariffs and Wei 2014; World Bank et al. 2017). This under consideration, excluding car imports from Canada and Mexico, as of December 19, 2018. C. Blue bars depict the impact of a 25-percentage-point increase of the tariff surcharge on all bilateral amplification effect of vertical specialization would U.S.-China trade flows. Red bars depict the additional impact from adverse investor confidence. The additional confidence shock assumes a decline of the investment-to-GDP ratio of 0.5 percentage be particularly important for EMDEs, as the share point, similar to that observed during the global slowdown in 2001. The percent deviations from CGE of domestic value added in manufactured exports simulations are applied to GDP in current U.S. dollars. D. The magnification ratio of vertical specialization is estimated by comparing a country’s standard is usually lower and trade costs higher than in tariff on exports and the gross effective tariff rate faced in export markets. A country’s standard tariff on exports is defined as the trade-weighted tariff rate applied by a country’s trading partners advanced economies. In the automotive sector, (in ad-valorem equivalent). The gross effective tariff rate is defined as the standard tariff rate divided by the domestic content share and weighted by trade. Higher magnification ratios in EMDEs participation of EMDEs in global value chains has are partly driven by their lower domestic value-added share. proliferated in the past decade, intensifying risks in the event of sudden pullbacks (Van Biesebroeck and Sturgeon 2011). Policy uncertainty and geopolitical tensions Intensifying trade disputes could eventually Global policy uncertainty has increased since mid- threaten the stability of the rules-based global 2018, reflecting heightened trade tensions and trading system and undo the beneficial effects of geopolitical risks, as well as idiosyncratic trade liberalization and global integration achieved developments in a number of large advanced during decades of multilateral cooperation. economies and EMDEs. Elevated policy Uncertainty about future trade rules could uncertainty tends to encourage investors to require compound the negative effect of trade barriers on higher risk premiums to hedge against negative investment and activity (IMF 2018d; Kose, outcomes. Financial market volatility remained Ohnsorge et al. 2017). exceptionally low in 2018, implying the risk of 34 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 1.17 Policy uncertainty and other downside or remained elevated in a number of European risks countries—including in Italy where fiscal slippages Policy and geopolitical uncertainties remain above historical norms, which have led to a market reassessment of country risk, could eventually lead to an increase in financial market volatility from and in the United Kingdom as it transitions out of current low levels. More frequent armed conflicts and extreme weather the European Union (EU). In the absence of an patterns can significantly dampen prospects in the affected countries and globally. approved withdrawal agreement, the exit of the United Kingdom from the EU could be A. Global policy uncertainty, B. Long-term bond yield spread accompanied by significant disruptions to activity geopolitical risks, and financial between Italy and Germany in the short term and lasting economic losses over market volatility, 2018 the medium term (Bank of England 2018; H.M. Treasury 2018). A sustained period of financial market stress and interruptions in cross-border financial flows associated with a disorderly exit process could cause significant adverse spillover effects and become a source of financial stability risks in systematically large economies (ECB 2018; FSOC 2018). Electoral outcomes in a number of EMDEs and advanced economies could result in C. Number of armed conflicts D. Number of extreme weather events further polarization and political fragmentation, making it harder to govern and formulate policies. A backlash against trade and immigration could also spur more inward-looking and populist policies (Aksoy, Guriev, and Treisman 2018; Moriconi, Peri, and Turati 2018). Geopolitical risks intensified again in the Middle East, and persist in Central Asia, East Asia, and Source: Baker, Bloom, and Davis (2016); Bloomberg; Caldara and Iacoviello (2017); Centre for the Africa. An intensification of these risks could Study of Civil War at the Peace Research Institute Oslo (PRIO); EM-DAT, The CRED/OFDA International Disaster Database; Uppsala University; World Bank. impact growth in the affected regions, and their A. Z-scores computed as the index value minus the sample mean divided by the sample standard main trading partners. In the case of the Middle deviation. The global policy uncertainty index is computed by Baker, Bloom, and Davis (2016) and is based on the frequency of words in domestic newspapers mentioning economic policy uncertainty. East, disruptions to global oil supplies could result The geopolitical risk index is computed by Caldara and Iacoviello (2017) and is based on the frequency of words in domestic newspapers mentioning geopolitical tensions, including military, in higher-than-expected oil prices, with negative nuclear, war, and terrorism. Financial market volatility is measured by the Chicago Board Options Exchange (CBOE) VIX implied volatility index of option prices on the U.S. S&P 500 index. Last impacts on aggregate demand and trade balances observation is November 2018. in major oil importers (Baffes et al. 2015; Stocker B. Bond yield spread is the difference between 10-year government bond yields in Italy and Germany. Last observation is December 19, 2018. et al. 2018). C. Conflicts are defined as when the use of armed force between two parties, of which at least one is the government of a state, results in at least 25 battle-related deaths in one calendar year. D. Decadal simple averages. The number of armed conflicts also remains above historical averages. In particular, security conditions remain challenging in many countries in Sub-Sahara Africa, the Middle East, and North disorderly repricing of policy-related risks (Figure Africa. In the past, countries in conflict or in 1.17). A further escalation of policy uncertainty fragile situations suffered from below average could lead companies to delay or reconsider capital growth in income per capita, delaying or derailing spending, contributing to a more rapid their catchup with advanced economy levels (UN deceleration of global growth than currently and World Bank 2018). Beyond adverse short- projected. term effects on growth, conflict can also substantially set back efforts to reduce poverty and Political uncertainty is generally associated with child mortality, and can hamper access to lower growth in both advanced economies and education, implying longer lasting negative EMDEs (Aisen and Veiga 2013). It has increased repercussions on development (Gates et al. 2012). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 35 Region-specific downside risks FIGURE 1.18 Simultaneous slowdown in the two largest economies These global risks are compounded by multiple The U.S. expansion is on track to be the longest in more than a century. region-specific risks (Box 1.2; Chapter 2). Most The probability of a U.S. recession in the short term is still low, but has regions are vulnerable to sudden shifts in policy, increased, and corporate debt vulnerabilities are growing. Private debt in China exceeds levels that gave rise to significant adjustments in other which could result in fiscal slippage, reduced EMDEs in the past. A simultaneous sharp slowdown in both the United investment due to policy uncertainty, and weaker States and China could bring the global economy closer to a global potential growth resulting from insufficient recession. structural reforms. Security-related risks remain A. Duration of U.S. expansions B. Probability of U.S. recession present, in varying degrees, in Europe and Central Asia, the Middle East and North Africa, South Asia, and East Asia, and could rise in the face of renewed geopolitical tensions. A flare-up in violence would disrupt activity in various ways, weigh on potential output, and drive up refugee flows. A fall in the price of specific commodities could disrupt activity in large regional commodity exporters, with possible broader spillovers. C. Private sector debt in the United D. Private sector debt in China Severe weather events appear to be becoming more States compared with previous peaks in other EMDEs frequent, with particularly serious consequences for vulnerable countries, such as island nations in the Caribbean and East Asia and the Pacific. Adverse weather patterns are also problematic for countries with large agricultural sectors dependent on rainfall, including many in Sub-Saharan Africa and South Asia. In those countries, large food price increases could severely impact poverty (Chapter 4). For instance, the spike in food prices in 2010-11 is estimated to have increased extreme E. Share of EMDEs with growth F. Global per capita growth scenarios: slowdowns or crises after reaching Impact of growth slowdowns in the poverty by 8.3 million people. Other natural debt peaks United States and China disasters, such as earthquakes and hurricanes, can inflict severe damage in the affected countries. These events are unpredictable and often force countries to overly rely on aid for reconstruction, even though recent progress in disaster risk finance has created opportunities for preventive actions (Végh et al. 2018). Simultaneous slowdown in the two largest Source: Bank for International Settlements, Federal Reserve Bank of New York, Haver Analytics, economies Institute of International Finance, Kose and Terrones (2015), Laeven and Valencia (2018), National Bureau of Economic Research, World Bank. A. Shaded area indicates the number of months from January 2019 to December 2019. Fiscal measures undertaken in the United States B. Probability of a recession in 12 months derived from the U.S. yield curve model of the Federal Reserve Bank of New York. Last observation is November 2018. and China are supporting their near-term growth C. Shaded areas indicate recessions, as identified by the National Bureau of Economic Research (NBER). Last observation is 2018Q2. prospects; however, they could exacerbate D. Debt peaks are defined as the highest value of the private non-financial credit to GDP ratio over the period 1960Q1 to 2018Q2. Sample includes 15 EMDEs. For China, values are the last imbalances and amplify risks of a more abrupt observations in 2018Q2. downturn later on. A sharper-than-expected and E. Countries must have experienced a currency, systemic banking, or sovereign debt crisis within two years after reaching the peak debt-to-GDP ratio. A slowdown is defined as a 1 percentage point or simultaneous slowdown in these two economies more drop in GDP growth between the two years before and the two years after peak debt-to-GDP ratio. Sample includes 15 EMDEs from 1960Q1 to 2018Q2. could have severe consequences for the global F. Blue and red bars show scenarios assuming a 1-percentage-point growth shock in China, the United States, and the combination of the two. Shocks are applied in the second half of 2019. Based economy. on the vector autoregression model presented in World Bank (2016). Deviations from baseline are all significantly different from zero. 36 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 The policy mix in the United States will shift from stimulus measures could offset the adverse effect of expansionary to contractionary during the forecast trade tensions with the United States but may horizon, with monetary, fiscal, and trade policies delay efforts to contain credit growth and limit the all expected to become a drag on activity within buildup of balance sheet vulnerabilities of the next couple of years. In this context, relatively corporates, local governments, and financial small negative shocks have the potential to institutions (IMF 2017; World Bank 2018a, abruptly end the current expansion, which is on 2018k). Both the level and growth rate of private track to be the longest in more than century debt stocks are well above those observed during (Figure 1.18). Although the probability of a U.S. previous credit booms in other EMDEs—two recession in the short term is still low, at about half thirds of which ended in significant growth its level prior to previous recessions, it has slowdowns and more than a third in financial increased throughout 2018. crises (Acharya et al. 2015; Alter and Elekdag 2016). In the case of China, risks are somewhat Economic expansions do not end and give way to tempered by still low central government debt, recessions only because they have lasted long extensive capital controls, large foreign reserves, (Castro 2013; Diebold and Rudebusch 1999; and a low reliance on external financing. That Rudebusch 2016). Instead, they tend to end as a said, if financial stress were to materialize, it would reflection of corrections from imbalances likely translate into a significantly sharper-than- accumulated over the business cycle. In particular, expected slowdown in activity (Beltran, Garud, recessions often follow periods of rapid increase in and Rosenblum 2017; Bernadini and Forni 2017; debt levels and excessive asset price valuations Maliszewski et al. 2016). (Claessens, Kose, and Terrones 2012; Mendoza and Terrones 2012). These imbalances tend to The simultaneous occurrence of a severe downturn suddenly unwind, often during or shortly after the in the United States and a sharper-than-expected end of a monetary policy tightening cycle deceleration in China, although still unlikely in (Bernanke and Gertler 1995; Sims and Tao 2006). the near term, would substantially increase the risk In the United States, three of the last four of an abrupt global slowdown. These two tightening cycles were indeed followed by a economies are, together with the Euro Area, the recession within a year and a half, with the most most important source of global spillovers, and severe contractions following unsustainable can impact the outlook for EMDEs through trade, housing market booms (Berkovec, Chang, and confidence, financial-market, and commodity- McManus 2012; Gelain, Lansing, and Natvik market channels (World Bank 2016). 2018; Mian and Sufi 2009). The only exception was the productivity-driven growth revival around In all, a 1-percentage-point decline in U.S. growth mid-1990, which continued uninterrupted despite is estimated to translate after one year into a interest rate hikes in 1994-95. decline in other advanced economy and EMDE growth of 0.6 percentage point for both groups. At the present juncture, the rise in U.S. private The impact of slower growth in China is around debt is smaller than prior to past recessions, mostly half that of a U.S. slowdown for other advanced because of household and bank deleveraging since economies (-0.3 percentage point), but it is the global financial crisis. U.S. corporate debt is comparable for other EMDEs (-0.6 percentage starting to accumulate, however, raising the risk point)—and, among them, significantly larger for that corporate bond defaults could amplify the commodity exporters (-1.2 percentage points). next downturn (FSOC 2018). On balance, the Slower growth in China tends to dampen U.S. economy has some of the characteristics that commodity prices, as this country is a primary have preceded relatively mild recessions, but some driver of global demand for industrial corporate and non-bank financial sector risks are a commodities, especially of metals (World Bank source of concern (IMF 2018e). 2018d). Critically, a combined 1-percent negative growth shock in China and the United States In China, risks to the outlook are increasingly would have severe consequences for global growth, tilted to the downside. Fiscal and monetary policy reducing it by almost 1 percentage point after one G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 37 year. Should such a risk materialize in the second FIGURE 1.19 Productivity revival half of 2019, global per capita growth would drop A sustained revival in productivity growth following cyclical improvements to around 1 percent in 2020, bringing the global in 2017-18 could lead to stronger-than-expected global activity. A significant productivity gap between leading and lagging firms suggests economy somewhat closer to a global recession.1 an untapped potential for existing technologies. The probability of a global recession tends to increase noticeably when one or several A. Global productivity growth B. Productivity growth in frontier and non-frontier firms systemically large economies decelerate (Kose and Terrones 2015). For instance, a recession in the United States increases the probability of a global recession from 7 percent on an average year to 50 percent. The risk of a sharp global downturn could be magnified as policymakers’ ability to respond is constrained by a lack of fiscal and monetary space and by a reduced appetite for coordinated policy responses among major economies. High levels of private and public debt Source: Conference Board, Organisation for Economic Co-operation and Development, World Bank. A. Labor productivity per person employed. also make EMDEs particularly vulnerable to B. Productivity growth for frontier and non-frontier firms of the period 2001-13. The global frontier is defined as the top 5 percent of firms in terms of labor productivity levels within each two-digit industry adverse shocks (World Bank 2018k). The at the start of the period, while non-frontier firms refer to all other firms. Aggregate productivity is calculated as the unweighted average of log labor productivity across firms, which the initial year, materialization of a global downturn could set 2001, is indexed to 0 and separately for the manufacturing and services sectors. back efforts to alleviate extreme poverty— including in Sub-Saharan Africa, where progress has been slow in recent years. room, as the recovery could continue without generating overheating pressures. This could allow Possible productivity revival for a more gradual pace of monetary policy tightening than currently envisioned and facilitate Although global downside risks predominate, a the necessary restoration of fiscal buffers given sustained revival in productivity growth following higher revenues. A sustained pickup in cyclical improvements in 2017-18 could lead to productivity could also spur additional stronger-than-expected global activity in coming investments and trigger a virtuous cycle between years (Figure 1.19). An acceleration in patent capital deepening and growth. applications and growing investments in intangible assets could be tentative signs of such a revival. Greater connectivity, falling computing Policy challenges costs, and open software architectures could also Challenges in advanced economies facilitate the adoption of digital technologies and enable less productive firms to catch up with the Advanced-economy monetary policy is expected to be technological frontier (Andrews, Criscuolo, and less stimulative, especially in the United States, where Gal 2016; OECD 2018). Over the medium term, tightening is proceeding more quickly than elsewhere breakthroughs in data processing, artificial partly in response to pro-cyclical fiscal easing. intelligence, and manufacturing could drive Advanced economies should use this period of above- additional productivity-enhancing innovations potential growth to create the room to respond to (Brynjolfsson and McAfee 2014; Diamandis and future cyclical shocks. Longer-term prospects remain Kotler 2012). subdued and could be further eroded by major shifts in trade and immigration policies. Economies experiencing faster productivity growth would benefit from additional policy Monetary and nancial policies 1 Global recessions are defined as a decline in world real GDP per The U.S. Federal Reserve is gradually removing capita accompanied by a synchronized deceleration in multiple stimulus in response to low unemployment and measures of global activity, including industrial production, trade, capital flows, employment, and energy consumption (Kose and near-target inflation amid pro-cyclical fiscal Terrones 2015). stimulus. In contrast, the European Central Bank 38 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 1.20 Monetary and fiscal policy in advanced suggests that the Federal Reserve has significantly economies less room to cut rates before reaching the zero The U.S. policy rate is approaching the point where it may no longer be lower bound should a new downturn occur—in providing stimulus and is expected to peak at a lower level than in previous the last three downturns, the Federal Reserve cut tightening cycles, with significantly less room to cut rates. Government its policy rate by about 5 percentage points. debt has become the largest component of debt for advanced economies, which can lead to less effective fiscal stimulus during an economic slowdown. To varying degrees, central banks in other advanced economies currently have even less A. U.S. federal funds rate B. Peak and trough of Federal policy space. While unconventional monetary Reserve policy rates in previous policies could again be deployed, their cycles effectiveness in returning inflation to target and supporting growth is subject to debate (Bernanke 2017a; Engen, Laubach, and Reifschneider 2015; Greenlaw et al. 2018). This lack of monetary space highlights the importance of avoiding a policy-driven downturn in activity, combined with research into alternative methods of providing monetary policy stimulus (Bernanke 2017b; Williams 2017). C. Debt in advanced economies D. Fiscal multiplier, by level of fiscal space Fiscal policy In many advanced economies, government debt-to -GDP ratios have reached unprecedented levels, with government debt becoming the largest component of total debt. This limits the capacity of countries to provide counter-cyclical fiscal stimulus in response to economic slowdowns (Huidrom et al. 2016). Source: Board of Governors of the Federal Reserve System; Federal Reserve Bank of St. Louis; The United States has enacted significant fiscal Haver Analytics; Holston, Laubach, and Williams (2016); Huidrom et al. (2016); Institute of International Finance; National Bureau of Economic Research; World Bank. stimulus even though the economy is already at or A. The effective rate is the mid-range of the federal funds target rates. The long-run estimate is the federal funds rate that would be expected to prevail in the absence of shocks to the economy, as above full employment. This stimulus is expected assessed by members of the Federal Open Market Committee. The neutral rate is the nominal short- term interest rate consistent with the economy operating at its full potential once transitory shocks to result in persistent deficits equivalent to about 5 have abated, and is estimated according to Holston, Laubach, and Williams (2016). Shaded area indicates forecasts. Last observation is 2018Q3 for the effective rate and long-run estimate, and percent for most of the next decade (CBO 2018). 2018Q2 for the neutral rate. In these circumstances, the consequence of pro- B. Bars represent the peak policy rates in the four months prior the official recession dates of the National Bureau of Economic Research, and the trough policy rate in the subsequent expansion. cyclical stimulus is likely to be inflation pressures, C. Aggregates calculated using current U.S. dollar GDP weights. Sample includes: Australia, Canada, Denmark, Finland, the Euro Area, Japan, New Zealand, Norway, Sweden, Switzerland, the United higher domestic interest rates, a crowding out of States, and the United Kingdom. Last observation is 2018Q2. private sector activity, and a widening of the U.S. D. Figure shows fiscal multipliers 1 year on at different levels of fiscal space. These are based on estimates from the IPVAR model of Huidrom et al. (2016). A country is considered to have “wide” current account deficit. fiscal space if it is in the lowest quartile of advanced economies for government debt, and to have “narrow” fiscal space if it is in the highest quartile. Orange lines represent the 16-84 percent confidence bands. Structural policies Potential growth remains subdued in advanced and the Bank of Japan have signaled that they will economies and is likely to slow further in coming be holding policy rates at current levels in the near years, partly due to aging populations and term. declining birth rates (Figure 1.21; World Bank 2018k). An increasing number of countries are For the first time since the financial crisis, the raising barriers to immigration, which might main U.S. policy rate is approaching its neutral hasten this deceleration. Immigration is an level (Figure 1.20). However, the policy rate is important reason for rising labor forces in many expected to peak at about 3 percent, which advanced economies and may also contribute to G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 39 productivity growth; immigrants skew younger FIGURE 1.21 Structural policies in advanced economies than host populations, and younger populations Potential growth is expected to decelerate in advanced economies, partly have been associated with faster labor productivity due to demographic factors. This deceleration is likely to be more severe if growth for various industries and occupations government policies lead to heightened restrictions on immigration, as immigrants tend to be younger than the native population. (Maestas, Mullen, and Powell 2016; World Bank 2018m). Heightened restrictions on immigration could also worsen fiscal positions, by dampening A. Potential growth in advanced economies B. Immigrant versus native population age distribution to OECD destinations growth and the net contribution that immigrants typically provide to the government budget (Clements et al. 2015). Recent trade disputes represent a critical headwind to longer-term prospects. Rising tariffs may already be contributing to weaker productivity by increasing costs, disrupting global supply chains, stranding productive assets, and relocating activity away from the most efficient locations (Melitz Source: Organisation for Economic Co-operation and Development, World Bank. 2003). Lack of policy clarity also risks causing A. TFP = total factor productivity growth. Figure shows potential growth estimates based on the production function approach. For further details on potential growth estimates, refer to the January firms to delay investment because of uncertainty 2018 edition of the Global Economic Prospects report. Aggregates calculated using constant 2010 U.S. dollar GDP weights. Sample includes 30 advanced economies. over market access. This highlights the critical B. "Working age" includes population aged 25-64 years, "dependents" includes population aged 0-24 and above 65 years. Country-level age proportions are weighted by size of the immigrant importance of a continued commitment to a rules- population. Data are from the 2010-11 OECD Database on Immigrants in OECD and non-OECD Countries (DIOC-E). based international trading system. Increasing restrictions to trade and immigration could therefore result in weaker growth and lower productivity. While international trade and Policy challenges in China immigration can impose costs on some sectors of the economy or vulnerable groups of workers, a Authorities in China have shifted to looser better course is to adopt policies that mitigate monetary and fiscal policies in response to a more these costs and redistribute more equitably the challenging external environment, including benefits of globalization. heightened trade tensions. They have cut reserve requirements, introduced new tax breaks for Challenges in emerging market and financial institutions lending to small firms, and developing economies encouraged banks to buy more local government bonds. They have also reduced taxes and fees, Recent financial market stress in some EMDEs increased export tax rebates, and accelerated highlights the pressing need to strengthen buffers issuance of special purpose local government against the risk of less favorable global financial bonds to bolster infrastructure spending. In conditions. Fiscal positions remain fragile, addition, the authorities have stepped up their underscoring the urgency to improve domestic revenue structural reform efforts to improve the business mobilization and to commit to or deepen fiscal environment, including for foreign firms, have reforms aimed at controlling expenditures. In the strengthened intellectual property protection, and longer term, steps to enhance human capital, have lowered tariffs on imports—with the encourage regional economic integration, and lower exception of some tariffs on U.S. imports in barriers to investment for small- and medium-sized retaliation to U.S. tariffs on China’s goods. The enterprises would boost potential growth and help authorities’ commitment to growth stability and tackle challenges associated with high informality. structural reforms was reaffirmed in late December China’s key policy challenge is to foster the transition (Central Economic Work Conference 2018). to more sustainable growth while dealing with trade- related headwinds without overstimulating the The trade disputes with the United States, as well economy and delaying the deleveraging process. as the ongoing moderation of global trade, 40 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 1.22 EMDE monetary policy Additional efforts to enhance market competition, encourage a shift of capital and labor toward more Monetary and financial policy challenges have been compounded by recent financial market pressures. Policy interest rates and inflation ticked productive firms and sectors, and bolster up in EMDEs facing above-average currency depreciation against the U.S. household consumption would also be needed dollar in 2018. The share of EMDEs hiking policy rates during U.S. tightening cycles is markedly higher than the share of EMDEs cutting rates (World Bank 2018n). Advancing reforms that during U.S. easing periods, suggesting that ongoing U.S. normalization boost innovation, including through stronger may constrain the room of maneuvering for many EMDE central banks. intellectual property rights, would also help Higher borrowing costs contributed to an increase in sovereign bond spreads, especially in EMDEs with large current account deficits. alleviate trade frictions while enhancing China’s competitiveness in the medium term. In addition, A. Policy interest rates, by extent of B. Inflation, by extent of currency productivity-enhancing investments in health, currency depreciation against the U.S. depreciation against the U.S. dollar education, and research and development would dollar encourage a shift from growth that is dependent on physical capital and help offset the impact of adverse demographic trends. EMDE monetary and nancial policies Policy challenges across many EMDEs have been compounded by recent financial market pressures that have been associated with sizable currency C. Share of policy interest rate D. Change in sovereign bond spreads, depreciations and capital outflows. Among some changes following U.S. policy rate by extent of current account deficit in key EMDEs, currency and financial market hikes or cuts 2018 pressures were substantial (e.g., Argentina, Turkey), leading to significant policy tightening and markedly clouding the near-term macroeconomic and financial outlook. More generally, monetary policy became less accommodative in EMDEs that faced above- average currency depreciation, or that used up reserves to stem it (Figure 1.22). Source: Haver Analytics, International Monetary Fund, J.P. Morgan, Shambaugh (2004), World Bank. Weaker exchange rates have pushed up inflation A.B. The above average and below average currency depreciation groups are defined by countries above or below the sample average of the year-to-date percent change in the bilateral exchange rate across many EMDEs, particularly in some key against the U.S. dollar. The sample average is -9.3 percent and includes 27 EMDEs, of which 12 are above and 15 are below average. Last observation is November 2018. commodity exporters, highlighting the role of the A. The aggregate policy interest rates are calculated using constant 2010 U.S. dollar GDP weights. exchange rate pass-through to domestic prices B. Median consumer price inflation for each group. C. Pegged exchange rates are defined, based on a de facto classification, as exchange rates (e.g., Argentina, Brazil, South Africa; World Bank fluctuating within a +/-2 percent band or, at most, a one-time devaluation over the preceding 11-month period relative to a country-specific reference currency. Refer to Shambaugh (2004) for 2018p). Among commodity importers, price details. Unbalanced sample includes 108 non-LIC EMDEs and considers policy rate actions from 1970 onwards. Last observation is November 2018. pressures also reflect their cyclical positions, as D. The above average and below average current account deficit groups are defined by countries suggested by their positive output gaps. Higher above or below the 2018 sample average of the current account balance. The sample average is -1.6 percent of GDP. The sovereign bond spread is measured by J.P. Morgan Emerging Market Bond energy prices in most of 2018 also pushed up Index (EMBI). Sample includes 38 EMDEs. Last observation is December 19, 2018. inflation in a number of net oil importers (e.g., Egypt, Kenya, Mexico). highlight China’s key policy challenge to foster the The ongoing normalization of advanced-economy transition to more sustainable growth while monetary policy will continue to pose challenges dealing with trade-related headwinds without for EMDEs (Arteta et al. 2015; Obstfeld 2015; overstimulating the economy and delaying the Sobrun and Turner 2015). In particular, U.S. deleveraging process (World Bank 2018b). This tightening cycles spillover to EMDEs mainly will require continued reforms to reduce financial through the availability of foreign credit, especially vulnerabilities, including those associated with the through portfolio bond flows (Bräuning and accumulation of non-financial enterprise debt. Ivashina 2018; Koepke 2018). Moreover, the G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 41 share of EMDEs hiking policy rates during U.S. FIGURE 1.23 EMDE fiscal policy tightening cycles is markedly higher than the share For the first time in several years, fiscal deficits are projected to be wider in of EMDEs cutting rates during U.S. easing commodity importers than in commodity exporters. Government debt is periods, suggesting that ongoing U.S. rising among EMDEs with high foreign-currency-denominated debt or persistent current account deficits. In low-income countries, the cost of normalization may constrain the room servicing debt has risen as the composition has moved from of maneuvering for many EMDE central banks. concessionary to market financing. Greater government effectiveness is These challenges will be greater for those countries associated with stronger tax revenue collection. with large external vulnerabilities, such as sizable current account imbalances, weak foreign reserves, A. Fiscal deficits B. Fiscal sustainability gaps, by extent of reliance on foreign- and high inflation or external debt (Iacoviello and currency-denominated debt Navarro 2018). In addition, higher borrowing costs may cause balance sheet, debt service, and rollover difficulties for some EMDE sovereigns and corporates, which could undermine financial stability (Borensztein and Ye 2018; World Bank 2018a). These may be particularly acute in economies facing currency mismatches on corporate and household balance sheets (Davies et al. 2014). C. Interest rate payments on debt in D. Tax revenues, by extent of government effectiveness To confront these challenges, EMDE authorities LICs need to urgently address persistent vulnerabilities that render their countries more susceptible to tighter financing conditions, capital flow reversals, and financial market shocks. This includes shoring up the financing of current account deficits to reduce the effects of net portfolio flow reversals, improving public and corporate balance sheet management, and implementing macroprudential frameworks that bolster banking and corporate Source: Haver Analytics; International Monetary Fund; Kose, Kurlat et al. (2017); World Bank. A.C.D. Figures show medians across groups. sector resilience, such as countercyclical capital A. Shaded area indicates forecasts. Sample includes 151 EMDEs. buffers and stricter reserve ratio or leverage ratio B. FC debt = foreign-currency-denominated debt. The sustainability gap is measured as the difference between the primary balance and the debt-stabilizing primary balance, assuming historical requirements (Cerutti, Claessens, and Laeven median (1990-2016) interest rates and growth rates. A negative gap indicates government debt is rising along an accelerated trajectory. The aggregates are calculated using constant 2010 U.S. dollar 2015; Forbes 2018). In addition, reducing GDP weights. The sample includes 27 EMDEs. The above (below) average foreign-currency- denominated debt groups are defined by countries above (below) the sample average of external exposures to foreign currency borrowing and debt in foreign currency as a share of total external debt in 2017. The sample average is 86.9 percent of GDP. currency mismatches, as appropriate, can help C. Interest rate payments include those made on government debt to domestic and foreign residents. contain the financial system’s vulnerability to Solid line represents median and area between the dashed lines represents the interquartile range. The sample includes 30 low-income countries and excludes Somalia, South Sudan, and Syria due dislocating exchange rate movements (Ahnert et to data restrictions. D. Government effectiveness measured by the Worldwide Governance Indicators. Higher al. 2018). For EMDEs that have made progress on government effectiveness are EMDEs with 2000-17 averages above 0 (stronger governance); lower are EMDEs with 2000-17 average government effectiveness below 0 (weaker governance). macroprudential reforms, enhancing financial Unbalanced sample includes 150 EMDEs. deepening and improving governance could further boost resilience to shocks (Sahay et al. 2015). ongoing period of low and stable global inflation comes to an end, perhaps driven by a slowdown or EMDE policymakers also need to uphold a rollback of the structural factors that have held credible commitment to medium-term price inflation at bay in recent decades—in particular, stability—one that is supported by trade and financial integration—or an erosion of macroeconomic frameworks that set attainable central bank independence. The reversals of these inflation targets where appropriate, as well as long-term trends could coincide with cyclical maintain strong institutional independence and upward pressures on prices in some EMDEs, transparency. This will be especially critical if the reigniting inflation (Box 1.1). 42 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 EMDE scal policy Regaining policy buffers is a key priority to be able to use countercyclical fiscal policy to stabilize Government finances in many EMDEs are in a growth (World Bank 2015). Efforts to build fiscal fragile position, with deteriorating debt dynamics space could include implementing credible and limited fiscal space. In some cases, much medium-term expenditure or deficit targets, better needed reforms to improve fiscal space have either managing contingent liabilities to contain fiscal stalled or not been fully implemented, while risks, stabilizing debt, and reforming the tax funding new or increasing liabilities, such as system to improve domestic resource mobilization public-sector wage bills, have put further strain on and the investment climate—e.g., adjusting domestic revenues (e.g., Brazil, South Africa). statutory rates, broadening bases, eliminating loopholes and exemptions, and improving tax Oil exporters continue to face fiscal sustainability administration and compliance. Managing the challenges, with recent oil price volatility composition of debt can also help address public- highlighting the need for these countries to sector balance sheet vulnerabilities. For EMDEs continue to reduce their reliance on oil revenues with elevated foreign-currency-denominated debt, by deepening reforms that bolster the non- bolstering domestic-currency bond markets, if resource budget (e.g., Ecuador, Russia; IMF feasible, could help stem rollover and currency 2018f). In metals and agricultural producers, risks. weaker-than-envisaged commodity prices could put further pressure on already fragile public To complement these efforts, improving finances (e.g., South Africa, Zambia). Among government effectiveness and strengthening commodity importers, for the first time since the institutions would support tax revenue collection oil price collapse that began in 2014, fiscal deficits (Ajaz and Ahmad 2010; Prichard 2010). If fiscal are projected to be larger as a share of GDP than adjustment remains necessary to ensure long-term those in commodity exporters, as waning revenue fiscal sustainability, policymakers need to evaluate growth continues to be accompanied by strong the efficacy of public expenditures, prioritizing expenditure growth (Figure 1.23). spending on quality investment and safeguarding poverty-reducing social transfers, while reining in Across EMDEs, rising global interest rates will programs that are unproductive or inefficient make financing fiscal deficits through sovereign (World Bank 2018k, 2018p). EMDE fiscal debt issuance more costly, underscoring the need policymakers also need to confront the longer- to realign government spending with revenue and term challenges posed by high informality, as its to manage the composition of debt, particularly in prevalence in some regions reduces government countries with elevated foreign-currency- revenues through tax base erosion (Chapter 3). denominated debt or persistent current account deficits (Du and Schreger 2016). In a rising global EMDE structural policies interest rate environment, employing expansionary fiscal policy with limited fiscal space can amplify EMDEs also face substantial longer-term vulnerabilities by increasing market perceptions of challenges to ensure sustained improvements in sovereign credit risk, which may lead to higher incomes and living standards amid rapid sovereign bond yields and borrowing costs (Bi, technological and demographic changes. Meeting Shen, and Yang 2014; Corsetti et al. 2013). LICs these challenges will require, among other actions, are more vulnerable to rising global financial costs effective investments in human capital, efforts to than in the past, as LIC debt has increasingly accelerate regional and global integration, and shifted from concessionary to market financing measures to free up a large untapped potential for (Chapter 4; World Bank 2018a). More generally, growth and productivity gains among small- and EMDE governments with high private-sector debt medium-sized enterprises. Progress in these areas are exposed to contingent liabilities if banking would also help bring people and companies out sector stress materializes in a rising interest rate of informality. environment (World Bank 2018k). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 43 Improving human capital FIGURE 1.24 EMDE structural policies Under-investment in human capital has left large Learning-adjusted years of schooling are a good predictor of growth performance in EMDEs. Greater trade integration, as well as lower barriers parts of the workforce in EMDEs unprepared for to investment in small- and medium-sized enterprises, could help boost rapid technological changes and future skill productivity in EMDEs. Informality remains prevalent in EMDEs and is requirements (Flabbi and Gatti 2018). This generally associated with large productivity gaps between formal and informal sectors. represents a significant bottleneck to growth in many countries. Moreover, continued divergences A. Link between education measures B. Average productivity growth since in the demand for high- and low-skilled labor in 2000 and GDP growth in 2000-16 2000, by gross exports to GDP ratio could exacerbate income inequality over time. How education systems adapt to skills needs will be a key determinant of the productivity and distributional effects of technological change (Barro and Lee 2015). Improving student learning is particularly important, starting with an effective measurement of the performance of education systems. Measures that capture both the quantity and C. Productivity level, by firm size D. Share of fixed capital spending financed by retained earnings quality of learning, such as learning-adjusted years of schooling, reflect relevant dimensions of success and are better predictors of subsequent growth across EMDEs (Figure 1.24; Filmer et al. 2018). A focus on both schooling participation and learning results can more properly inform policy actions and support effective investments in human capital (World Bank forthcoming). Beyond a heightened focus on learning outcomes, E. Share of informal activity F. Average productivity in formal and a comprehensive approach to human capital informal firms improvements in EMDEs should also address other dimensions, including malnutrition and health throughout the life cycle. In this context, a human capital index has recently been developed to assess productivity gains that could be achieved by matching education and health outcomes to best practices (Kraay 2018). This benchmarking exercise helps to identify areas of intervention to improve public spending and governance in Source: Ayyagari, Demirgüç-Kunt, and Maksimovic (2017); Borensztein and Ye (2018); Elgin et al. education and health systems—and to raise (forthcoming); Filmer et al. (2018); Organisation for Economic Co-operation and Development; World Bank. awareness of the costs of inaction (World Bank A. LAYS = learning-adjusted years of schooling. Figure shows regression of three measures of 2018q). education in 2000—LAYS, average years of schooling, and average test score—on average GDP growth over the period 2000-16 across EMDEs. Test scores are from the mathematics assessment of the 1999 Trends in International Mathematics and Science Study (TIMSS) and 2000 Program for The urgency to bolster human capital comes in a International Student Assessment (PISA). Regression conditioned on original GDP per capita levels. B. Above average and below average indicate above and below average changes in gross exports to period of constrained public-sector resources and GDP ratios over the period 2000-14. C. Productivity is defined as the value added per person employed, measured in thousands of U.S. elevated debt levels, creating a notable policy dollars in current PPP terms. Data as of 2015, or latest available year. Advanced economies include Austria, Denmark, Finland, France, Germany, Italy, Netherlands, Spain, Sweden, and the United challenge. Accordingly, more effective spending in Kingdom. EMDEs include Brazil, Hungary, Mexico, Poland, and Turkey. education and health will need to be accompanied D. Proportion of the purchase of fixed assets financed by internal funds or retained earnings. E. Unweighted averages, in percent of official GDP. Estimates of informal output derived from a by renewed efforts to prioritize government deterministic dynamic general equilibrium model, as described in Chapter 3. F. Blue bars represent estimates and orange vertical lines indicate two standard deviation error spending, improve efficiency of public bands. World Bank’s Enterprise Survey data for 135 countries (2008-18). Labor productivity is administrations and revenue mobilization, and proxied by annual sales per worker. encourage private sector participation. 44 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 Boosting regional and international integration regional infrastructure can also help reduce the cost of trade and support increased openness If faced with growing protectionist measures, (Donaldson 2018). policymakers in EMDEs may be tempted to resort to retaliatory action or unilateral increases in That said, increased international integration and barriers to trade. While such measures could help participation in GVCs does not guarantee positive recapture some of their terms-of-trade losses, an and sustainable development outcomes for increase in trade barriers would likely lead to EMDEs. Targeted policies that encourage the significant distortionary effects and efficiency upgrading of domestic production are crucial in losses for EMDEs (Devarajan et al. 2018). Instead, ensuring that the social and development impacts continued commitment to regional and of GVC activities are optimized (Fessehaie and international integration through trade Morris 2018; Taglioni and Winkler 2016). liberalization, properly designed free trade agreements, and participation in global value Untapping SME growth potential chains (GVCs) within an open and rules-based multilateral trading system could yield significant, Supported with appropriate frameworks, small- previously untapped benefits for EMDEs. The call and medium-sized enterprises (SMEs) can be key of G20 members to consider additional reform of drivers of growth and job creation in EMDEs the World Trade Organization could be a chance (Ayyagari, Demirgüç-Kunt, and Maksimovic to maximize development opportunities for 2017). They can play a central role in industrial EMDEs. development and restructuring, support larger firms with inputs and services, and allow increased International integration enables firms of all sizes sectoral specialization. However, their growth to increase their participation in international potential continues to be hindered by many trade. In particular, participation in GVCs helps factors, including insufficient access to finance; tax companies specialize in tasks closely aligned with and regulatory burdens; skills mismatch; limited their comparative advantage and can contribute to access to infrastructure, particularly electricity; and a more efficient allocation of resources, job corruption (Wang 2016). Alleviating those creation, and export diversification. In turn, obstacles could lead to significant growth windfalls increased trade openness and GVC integration for EMDEs, given that SMEs have the largest boost productivity growth and helps the diffusion untapped potential for productivity catch-up with of technologies (Criscuolo and Timmis 2017; advanced economies (Cusolito, Safadi, and Elms and Low 2013). Taglioni 2017). Supporting SME development could also help reduce high informality in some Many EMDEs and LICs, however, still face regions, which is most prevalent among micro- important challenges in fostering an environment enterprises. conducive to greater GVC integration. Although their participation has increased during the last Limited access to finance is most often cited as a two decades, LICs still have little presence in key obstacle to SME growth in EMDEs, forcing GVCs. Participation is hindered by domestic these companies to rely on retained earnings to capacity constraints and restrictive trade and fund investment. This leads to sub-optimal capital investment regimes. Tariffs and other barriers to spending and an unrealized potential for trade increase costs for firms, reduce their ability expansion and job creation. Key obstacles include to access foreign inputs, and can impede the the lack of reliable credit information, the absence development of downstream industries (Miroudot, of suitable collateral, and weak legal institutions. Rouzet, and Spinelli 2013). Reducing these Increasing SME access to finance could help boost barriers remains a key priority to support GVC their average size and support innovation and job participation, and to increase trade gains for many creation (Ayyagari, Demirgüç-Kunt, and EMDEs (Kowalski at al. 2015). Closer physical Maksimovic 2017; Ayyagari et al. 2016). integration of transport networks and other Improved access to finance for women G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 1 45 entrepreneurs could also lead to more investment, While the informal economy provides an while access to savings account for female-headed important safety net to workers, particularly households could result in additional spending on during downturns, it can dampen growth by education (Demirgüç-Kunt et al. 2018; Sahay and weighing on physical and human capital Cihak 2018). Bankruptcy protection laws also lag formation (Docquier, Müller, and Naval 2017; international best practices in many EMDEs. Oviedo, Komas, and Karakurum-Ozdemir 2009). Historical experience suggests that strengthening In particular, firms operating in the informal bankruptcy protection can boost investment economy tend to limit their size to avoid detection activity and facilitate responsible corporate risk- and use less advanced production technologies taking, helping to relieve the costs of debt (Dabla-Norris et al. 2018). Their lack of overhang (Gopalan, Mukherjee, and Singh 2016; compliance with regulations and taxes may help World Bank 2014). them stay in business despite low productivity (La Porta and Shleifer 2014; Schneider and Enste Beyond basic education, technological know-how, 2000; Box 3.4). managerial capabilities, and tolerance for risk are also key factors underlying successful High informality can also limit fiscal revenues and entrepreneurship and vibrant firm dynamics thus can constrain the ability of governments to (Cusolito and Maloney 2018). Conditions that provide public services, conduct countercyclical encourage experimentation and do not penalize policies, and implement effective redistributive failure are crucial to support the upgrading of firm measures (Besley and Persson 2014; Ordóñez capabilities and diffusion of technological 2014). Both government revenues and progress. Tax, registration, and other expenditures are lower in EMDEs where administrative simplifications can also be informality is widespread. High informality is successful tools to facilitate SME creation and often associated with lack of development, limited expansion (Bruhn 2011). Finally, restrained access access to finance, low human capital, poor to infrastructure, particularly electricity, is often governance, and heavy regulatory burdens. If mentioned as a major barrier to the development properly designed, policies that help improve of SMEs and start-up companies in many outcomes in those areas would bolster growth EMDEs, especially in Sub-Saharan Africa. prospects and encourage workers to participate in Improvements in both traditional power line the formal economy, thus helping reduce supplies and off-grid solutions such as solar energy informality and its associated challenges. and micro grids need to be achieved in tandem, supported by proper policy incentives and effective Policies that are implemented with other purposes regulations (World Bank 2017). in mind also need to take into consideration the unintended consequences on informality. For Growing out of informality example, changes in labor market regulation accompanying the decentralization of minimum- Informality remains widespread in many EMDEs wage-setting responsibilities or the liberalization of (Chapter 3). It is particularly prevalent in less trade have resulted in higher informality in some developed regions, with South Asia and Sub- countries (Attanasio, Goldberg, and Pavcnik Saharan Africa accounting for nearly 60 percent of 2004; Goldberg and Pavcnik 2003; Chapter 3; all informal workers in EMDEs. It is also elevated Box 3.4). These experiences are a reminder of the in regions with weak institutions and high levels of need to design comprehensive reform packages fiscal and regulatory burdens, such as Latin that are calibrated to country circumstances. America and the Caribbean and Europe and Central Asia. 46 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 TABLE 1.2 List of emerging market and developing economies1 Commodity exporters2 Commodity importers3 Albania* Madagascar Afghanistan Panama Algeria* Malawi Antigua and Barbuda Philippines Angola* Malaysia* Bahamas, The Poland Argentina Mali Bangladesh Romania Armenia Mauritania Barbados Samoa Azerbaijan* Mongolia Belarus Serbia Bahrain* Morocco Bhutan Seychelles Belize Mozambique Bosnia and Herzegovina Solomon Islands Benin Myanmar* Bulgaria Sri Lanka Bolivia* Namibia Cabo Verde St. Kitts and Nevis Botswana Nicaragua Cambodia St. Lucia Brazil Niger China St. Vincent and the Grenadines Burkina Faso Nigeria* Comoros Thailand Burundi Oman* Croatia Tunisia Cameroon* Papua New Guinea Djibouti Turkey Chad* Paraguay Dominica Tuvalu Chile Peru Dominican Republic Vanuatu Colombia* Qatar* Egypt Vietnam Congo, Dem. Rep. Russia* El Salvador Congo, Rep.* Rwanda Eritrea Costa Rica Saudi Arabia* Eswatini Côte d’Ivoire Senegal Fiji Ecuador* Sierra Leone Georgia Equatorial Guinea* South Africa Grenada Ethiopia Sudan* Haiti Gabon* Suriname Hungary Gambia, The Tajikistan India Ghana* Tanzania Jamaica Guatemala Timor-Leste* Jordan Guinea Togo Kiribati Guinea-Bissau Tonga Lebanon Guyana Trinidad and Tobago* Lesotho Honduras Turkmenistan* Macedonia, FYR Indonesia* Uganda Maldives Iran* Ukraine Marshall Islands Iraq* United Arab Emirates* Mauritius Kazakhstan* Uruguay Mexico Kenya Uzbekistan Micronesia, Fed. Sts. Kosovo Venezuela* Moldova, Rep. Kuwait* West Bank and Gaza Montenegro Kyrgyz Republic Zambia Nepal Lao PDR Zimbabwe Pakistan Liberia Palau *Energy exporters. 1 Emerging market and developing economies (EMDEs) include all those that are not classified as advanced economies. Dependent territories are excluded. Advanced economies include Australia; Austria; Belgium; Canada; Cyprus; the Czech Republic; Denmark; Estonia; Finland; France; Germany; Greece; Hong Kong SAR, China; Iceland; Ireland; Israel; Italy; Japan; the Republic of Korea; Latvia; Lithuania; Luxembourg; Malta; Netherlands; New Zealand; Norway; Portugal; Singapore; the Slovak Republic; Slovenia; Spain; Sweden; Switzerland; the United Kingdom; and the United States. 2 An economy is defined as commodity exporter when, on average in 2012-14, either (i) total commodities exports accounted for 30 percent or more of total goods exports or (ii) exports of any single commodity accounted for 20 percent or more of total goods exports. Economies for which these thresholds were met as a result of re-exports were excluded. When data were not available, judgment was used. 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In China, policies aimed at rebalancing and countering external headwinds will continue to tilt activity toward domestic demand and away from exports. Risks to regional growth are to the downside and have intensified, including the possibility of further escalation of trade restrictions and faster-than-expected tightening of global financing conditions. Countries most vulnerable to disruptions in global trade and financial market activity are those with high debt, elevated current account deficits and high exposure to portfolio and bank inflows, and significant reliance on exports. Recent developments episodes and less than the EMDE average, reflecting continued strong investor confidence Growth in the East Asia and Pacific (EAP) region toward these economies. is estimated to have slowed to 6.3 percent in 2018 and momentum has weakened, reflecting China has been easing monetary and fiscal diminishing support from exports partly offset by policies in anticipation of slowing export growth robust domestic demand (Figure 2.1.1; Table amid trade tensions, while at the same time 2.1.1). External conditions have deteriorated, making progress at reducing growth in non-bank reflecting moderating global demand, heightened financing. In contrast, several countries, such as trade tensions, and a substantial tightening of Indonesia and the Philippines, have stemmed financing conditions. This less favorable capital outflows by tightening monetary policy. international environment has been accompanied Most EAP countries have taken advantage of by financial stress in some large emerging market flexible exchange rates, which has allowed their and developing economies (EMDEs). currencies to act as shock absorbers during times of stress. Indonesia has also implemented measures Several large economies in the region have faced to curb imports while taking steps to increase coal some combination of capital outflows, currency exports, as part of an effort to reduce the current depreciations, equity market corrections, and account deficit and relieve pressure on the rupiah foreign reserve losses (e.g., China, Indonesia, (World Bank 2018a; World Bank 2018b). Malaysia, the Philippines, Thailand). In addition to country-specific factors, the countries most Growth in China is estimated to have slowed to a affected were those with sizable or widening still robust 6.5 percent in 2018, with resilient current account deficits and dependence on domestic demand helping to offset a deceleration volatile portfolio flows, those with relatively high of exports (Figure 2.1.2). Consumption has asset valuations, or those with exposure to trade remained strong and private investment is disputes involving major economies (e.g., China, recovering, partly in response to more supportive Indonesia, Myanmar, the Philippines). Bond policies, as authorities attempt to offset the effects spreads in these countries have generally widened, of various United States trade restrictions. The but less than during the last two financial stress services sector has continued to outperform. Price growth of newly constructed residential buildings, Note: Ekaterine Vashakmadze. Research assistance was provided most notably in Tier 1 cities, has rebounded by Liu Cui. following several years of correction. 58 CHAPTER 2.1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 2.1.1 EAP: Recent developments On the external front, China’s current account Growth in EAP slowed to 6.3 percent in 2018, with robust domestic surplus has dissipated as import growth outpaced demand but softening export growth. Inflation has been trending up but is export growth. Export growth is estimated to have generally below targets. EAP economies faced some combination of dropped from about 9 percent in 2017 to around capital outflows, currency depreciations, equity market corrections, and foreign reserve losses during the 2018 financial market stress episode. 4-5 percent in 2018, reflecting the dampening Regional bond spreads have generally widened but less than during the effects of weaker global demand and new U.S. last two financial stress episodes and less than the EMDE average. tariffs. Since the beginning of 2018, substantial new tariffs have been introduced on bilateral trade A. Growth B. Export growth between China and the United States, accounting for about 11.4 percent of China’s goods exports and about 6.5 percent of imports. Capital outflows have resumed, and equities and the renminbi have been under pressure, reflecting heightened trade tensions and diverging monetary policy: a loosening by the People’s Bank of China (PBoC) and a tightening by the U.S. Federal Reserve. C. Inflation D. Balance of payments, EAP ex. China Growth in commodity-importing economies excluding China is moderating. In the Philippines, activity has slowed as surging inflation, capacity constraints, and currency pressures have prompted authorities to hike policy rates. Growth in Vietnam remains robust, helped by booming exports, but authorities have tightened fiscal policy as part of their commitment to reduce the E. Exchange rates and equity prices F. Bond spreads economic role of the state. In Thailand, a cyclical recovery continues, but its pace is moderating in response to tighter fiscal policies and the effects of softening global demand on export growth. In commodity-exporting EAP economies, the investment-led cyclical recovery is maturing, and the pace and composition of growth continues to reflect country-specific factors. In Indonesia, growth last year was led by rising investment on Source: Bloomberg, Haver Analytics, J.P. Morgan, World Bank. E.F. “Taper T. 2013” refers to mid-2013 global financial market stress episode; “China SM 2015” the back of accelerated infrastructure spending and refers to mid-2015 China stock market (SM) turbulence; “Episode 2018” refers to mid-2018 financial market volatility episode. The start dates for the stress episodes are: Taper Tantrum: May 23, 2013; investment in the mining sector (World Bank China SM 2015: June 12, 2015; Episode 2018: April 15, 2018. 2018c). In Malaysia, lower public investment is A. Aggregate growth rates are based on constant 2010 U.S. dollar GDP-weights and include Indonesia, Malaysia, Mongolia, Philippines, Thailand, and Vietnam. Last observation is 2018Q3. weighing on growth, reflecting the completion of B. Data include only goods. 12-month moving average. Aggregate growth rate excludes Cambodia, Fiji, Lao PDR, Mongolia, Myanmar, Solomon Islands, Papua New Guinea, Timor-Leste, Vanuatu, and several infrastructure projects and a more prudent Vietnam due to data limitations. Last observation is October 2018. C. Average year-on-year growth. The midpoints of targeted ranges in 2018 in Indonesia (2.5-4.5 approach toward new ones (World Bank 2018d). percent), Philippines (2-4 percent), Vietnam (4 percent), China (3 percent), and Thailand (1-4 In contrast to the regional trend, import growth in percent). For Malaysia, the midpoint of Bank Negara’s 2018 forecast of 2-3 percent is used. Last observation is November 2018. Malaysia has been weak, reflecting weak demand D. Current account balance is based on non-seasonally adjusted data. The aggregate includes Indonesia, Malaysia, Philippines, and Thailand. Net capital flows and change in reserves are for capital goods imports combined with lower estimates. Last observation is 2018Q3. E. Percent change of exchange rates (U.S. dollar vs. local currency) and equity prices in local imports of intermediate goods. currency over 247 days since the start dates of respective stress episodes. EAP aggregate exchange rate includes China, Indonesia, Malaysia, Mongolia, Philippines, Thailand and Vietnam. EAP aggregate equity price includes China, Indonesia, Malaysia, Philippines, Thailand and Vietnam. Despite the slowdown, EAP remains one of the Orange lines denote minimum-maximum ranges. Green diamonds denote EMDE averages. F. The change of bond spread over 247 days since the start dates of respective stress episodes. The world’s fastest-growing regions and has been average spread of a country’s sovereign debt (as measured by J.P. Morgan’s Emerging Markets relatively resilient to recent bouts of financial Bond Index) over their equivalent maturity U.S. Treasury bond. EAP aggregate bond spread includes China, Indonesia, Malaysia, Philippines and Vietnam. Orange lines denote minimum-maximum market volatility (Figure 2.1.3). One reason is that ranges. Red diamonds denote EMDE averages. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 EAST ASIA AND PACIFIC 59 most EAP countries (with the exception of the FIGURE 2.1.2 China: Recent developments Pacific Islands) continue to experience growth In China, growth is slowing but remains robust amid resilient consumption. above the EMDE average and maintain mostly China’s current account surplus has dissipated as import growth outpaced diminishing, but still positive current account export growth. Equities and the renminbi have been under pressure throughout 2018. Bond spreads, which widened between late-2017 and balances net of foreign direct investment (e.g., early-2018 on trade concerns, have been stable since mid-2018, reflecting China, Malaysia, Thailand, the Philippines, and continued strong investor confidence. The PBoC has been easing monetary policy, but keeping credit growth in check, by reducing shadow Vietnam). Another reason is that policy frame- financing. Prices of newly constructed residential buildings most notably in works across EAP region have improved over time Tier 1 cities, have rebounded following several years of correction. with the shift to floating exchange rates, economic diversification, and solid buffers. A. Contributions to growth B. Balance of payments That said, many countries have pockets of vulnerabilities, including elevated levels of public and private debt (e.g., China, Lao PDR, Malaysia, Mongolia, Papua New Guinea, Vietnam), external debt (e.g., Malaysia, Mongolia, Lao PDR), foreign participation in local-currency sovereign bond markets (e.g., Indonesia, Malaysia), fiscal deficits (e.g., Cambodia, Lao PDR, Mongolia, Vietnam), C. Exchange rates and equity prices D. Bond spreads and current account deficits and high reliance on volatile capital flows (e.g., Cambodia, Indonesia, Mongolia). In addition, deep regional and global integration makes the region vulnerable to trade shocks, as described in the risk section below. Outlook Regional growth is expected to moderate from 6.3 percent in 2018 to 6 percent in 2019 and stay at E. Total loan growth F. Housing prices that pace in 2020—broadly unchanged from June forecasts (Tables 2.1.1 and 2.1.2; Figure 2.1.3). The outlook is predicated on broadly stable commodity prices in the next two years, a moderation in global demand and trade, and a gradual tightening of global financing conditions. The structural slowdown in China is expected to continue. Growth is projected to slow from 6.5 percent in 2018 to 6.2 percent on average in Source: Bloomberg, Haver Analytics, J.P. Morgan, the National Bureau of Statistics of China, World Bank. 2019-20, and domestic and external rebalancing C.D. “Taper T. 2013” refers to mid-2013 global financial market stress episode; “China SM 2015” refers to mid-2015 China stock market (SM) turbulence; “Episode 2018” refers to mid-2018 financial are expected to endure. Authorities in China have market volatility episode. The start dates for the stress episodes are: Taper Tantrum: May 23, 2013; China stock market turbulence: June 12, 2015; Episode 2018: April 15, 2018. shifted to looser monetary and fiscal policies in A. Investment refers to gross capital formation, which includes change in inventories. Data for 2018 response to a more challenging external are estimates. B. Net capital flows and change in reserves are estimates. Data for 2018 are estimates. environment, including heightened trade tensions. C. Percent changes of exchange rates (U.S. dollar vs. Chinese renminbi) and equity prices in Chinese renminbi over 247 days since the start dates of respective stress episodes. Orange lines They have cut reserve requirements, reduced taxes denote EAP minimum-maximum ranges. Green diamonds denote EMDE averages. D. Change of bond spread over 247 days since the start dates of respective stress episodes. Bond and fees, increased export tax rebates, and spread measures the average spread of a country’s sovereign debt (as measured by J.P. Morgan’s accelerated issuance of special purpose local Emerging Markets Bond Index) over their equivalent maturity U.S. Treasury bond. Orange lines denote the EAP minimum-maximum ranges. Red diamonds denote EMDE averages. government bonds to bolster infrastructure E. Domestic and overseas loans. Data for 2018 is through November. Last observation is 2018Q3 for nominal GDP and November 2018 for total loan growth. spending. Authorities have also reiterated their F. The National Bureau of Statistics of China surveys house prices in 70 cities and divides them into three tiers. The first tier includes Shanghai, Beijing, Guangzhou, and Shenzhen. The second tier commitment to growth stability and structural includes 31 provincial capital and sub-provincial capital cities. The third tier includes 35 other cities. Dotted lines indicate February 2011-November 2018 averages. Last observation is November 2018. 60 CHAPTER 2.1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 2.1.3 Outlook and risks reform objectives in late-2018 (CEWC 2018). EAP growth is projected to gradually decelerate, reflecting a structural slowdown in China. Excluding China, growth is expected to remain stable These policy steps are expected to largely offset the in 2019-20. The region is characterized by deep regional and global direct negative impact of higher tariffs on China’s integration, which makes it vulnerable to external shocks. Domestic and exports, which would otherwise lower growth by external vulnerabilities would amplify the impact of external shocks, especially where policy buffers are limited. about 0.1-0.3 percentage point in 2019. In addition, the authorities have stepped up their A. Growth B. Global exposure by type of foreign structural reform efforts to improve the business inflows, 2013-17 environment, including for foreign firms, have lowered tariffs on imports, with the exception of some tariffs on U.S. imports in retaliation to U.S. tariffs on China’s goods, and have strengthened intellectual property protection. Growth in the rest of the region is projected to remain broadly unchanged at around 5.2 percent on average in 2019-20. Resilient domestic demand C. Impact of 1 percentage point D. Change in growth and current is expected to offset the negative impact of slowing decline in China’s growth on EAP account balance net of FDI, 2010-18 exports. Growth among commodity importers is projected to moderate in 2019 as it converges with its potential rate. Excluding China, the 2018 growth outlook for EAP commodity importers has been downgraded because of a moderation in private consumption amid rising inflation in the Philippines. Growth in commodity exporters is expected to E. External debt F. Fiscal balance and public debt remain broadly unchanged at about 5.1 percent in 2019, in line with potential, with significant cross-country differences. This forecast is slightly below that of June, reflecting a number of downward revisions (e.g., Lao PDR, Malaysia, Myanmar). Output gaps in most commodity exporting economies are expected to close over the forecast horizon, as investment growth stabilizes and trade flows decelerate. For both commodity Source: Haver Analytics, International Monetary Fund, World Bank. exporters and importers, inflation pressures are A. Commodity importers ex. China include Cambodia, Fiji, Philippines, Solomon Islands, Thailand, Vietnam, and Vanuatu. Commodity exporters include Indonesia, Lao PDR, Malaysia, Mongolia, expected to intensify over the forecast horizon, in Myanmar, Papua New Guinea, and Timor-Leste. Yellow diamonds denote forecasts in the June 2018 edition of the Global Economic Prospects report. Aggregates growth rates are calculated using 2010 part reflecting exchange rate pass-through as well U.S. dollar GDP-weights. Data in shaded areas are forecasts. as domestic demand pressures. B. EA = East Asia. PI = Pacific Islands. EA1 includes Brunei Darussalam, Cambodia, Malaysia, Mongolia, Thailand and Vietnam; EA2 includes Indonesia, Lao PDR, Myanmar and Philippines. PI1 includes Kiribati, Marshall Islands, Micronesia, Timor-Leste, Tonga and Tuvalu; PI2 includes Palau and Vanuatu; PI3 includes Fiji, Papua New Guinea, Samoa and Solomon Islands. Despite the projected robust activity in the region The linkages presented in this chart only present direct channels. Spillovers may propagate via indirect channels such as global and regional value chains. Diamond denotes direct exposure to in the near term, underlying potential growth— China. Hyphen denotes share of commodity exports in GDP. Direct exposure to China and the share which has fallen considerably over the past of commodity exports in GDP is not shown for PI1 and PI2 country groups due to data limitations. C. Median of posterior distribution. Estimates based on a Bayesian SVAR, using quarterly data for decade—is likely to decline further over the 1998Q1-2018Q1. The spillovers include the effects through indirect channels, including confidence and global and regional value chains. Cumulative impact on growth after two years. GDP weighted. long term. This reflects increasingly adverse D. CAB ex. FDI = Current Account Balance excluding Foreign Direct Investment. Orange hyphen denotes GDP growth in 2010; green hyphen—CAB ex. FDI in 2010. Data for 2018 are estimates. demographic patterns and a projected slowdown E. PNG = Papua New Guinea. External debt stock is defined as debt owed to nonresidents repayable in capital accumulation as credit growth is in foreign currency, goods, or services. It is the sum of public, publicly guaranteed, and private nonguaranteed debt. Data are in current U.S. dollars. Short-term debt includes all debt having an reined in. original maturity of one year or less and interest in arrears on long-term debt. Diamond denotes short- term external debt as share of GDP in 2018; hyphen—total external debt as share of GDP in 2010. F. Diamond denotes estimated fiscal balance as share of GDP in 2018; hyphen denotes public debt as share of GDP in 2010. The general government debt data for Mongolia is based on World Bank staff estimates. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 EAST ASIA AND PACIFIC 61 Risks medium term. The largest decline (up to 3.5 percent of income) would be felt in China Risks to the forecasts remain tilted to the (Freund et al. 2018).1 downside and have intensified. Heightened trade A significant disruption to activity in China would tensions involving large economies continue to have large regional effects, propagating through create uncertainty about the future of established bilateral trade, regional supply chains, and trading relationships. A potential disruption of financial linkages (Figure 2.1.3). A one-off, trade would disproportionately affect the more unexpected 1 percentage-point drop in China’s open economies in the region. The region is GDP growth would lower growth in the rest of characterized by deep regional and global the region by 0.5 percentage points after two years integration, which makes it vulnerable to external (World Bank 2016a, 2018a). Growth spillovers shocks. The region relies significantly on foreign from China would be particularly large for income, mostly from exports but also from returns commodity exporters, particularly Mongolia, due on foreign assets and direct investment. Total to their reliance on commodity exports to China, exports and gross capital inflows exceed 50 percent and for Cambodia and the Pacific Islands, which of GDP in more than two-thirds of the region’s depend on China for tourism and FDI. economies, and 100 percent in about one-third (Figure 2.1.3). In many regional economies, the Risks of disorderly financial market developments cost of rising import tariffs may be magnified by have also intensified (Chapter 1). A further participation in complex global value chains (e.g., tightening of global financial conditions could be Malaysia, Thailand, the Philippines; Chapter 1, triggered by rising inflation, swelling fiscal deficits, World Bank 2018a). Furthermore, the impact of or contagion from financial stress in other trade measures could be amplified regionally if it EMDEs, and could place further pressure on also weighs on investor confidence and reduces regional exchange rates and asset prices. High debt foreign direct investment (IMF 2018a; World levels and external vulnerabilities among some Bank 2018a). EAP countries could amplify the impact of external shocks such as a sudden stop in capital China’s baseline projection assumes that the fiscal flows or a rise in borrowing costs. If a and monetary policy stimulus that has been combination of downside risks were to materialize, introduced in response to rising U.S. tariffs will it could trigger an even sharper slowdown in offset the immediate economic impact of trade- regional growth. related headwinds. However, if authorities opt for additional and stronger fiscal and monetary stimulus initiatives—particularly in the form of unfunded mandates for local governments to increase public investment—the measures may also run counter to the needed deleveraging and de-risking process. These measures, could also undermine the efforts to contain credit growth and limit risks to corporate and bank balance sheets (Chapter 1; World Bank 2018a). A continued intensification of trade tensions, along with the previously introduced measures, would affect close to all goods trade between China and the United States. In the extreme case scenario, further escalation of trade tensions, 1 is scenario assumes a 25 percent tari surcharge on all coupled with a downturn in confidence and products traded between China and the United States, combined investment, could reduce global exports by up to 3 with a decline in investor con dence, resulting in a 0.5 percentage percent and global income by 1.7 percent over the point drop in global investment to GDP (Freund et al. 2018). 62 CHAPTER 2.1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 TABLE 2.1.1 East Asia and Pacific forecast summary Percentage point differences (Real GDP growth at market prices in percent, unless indicated otherwise) from June 2018 projections 2016 2017 2018e 2019f 2020f 2021f 20 2018e 2019f 2020f EMDE EAP, GDP1 6.3 6.6 6.3 6.0 6.0 5.8 0.0 -0.1 0.0 (Average including countries with full national accounts and balance of payments data only)2 EMDE EAP, GDP2 6.3 6.6 6.3 6.0 6.0 5.8 0.0 -0.1 0.0 GDP per capita (U.S. dollars) 5.6 5.9 5.7 5.4 5.4 5.3 0.0 -0.1 -0.1 PPP GDP 6.3 6.5 6.3 5.9 5.9 5.8 0.1 -0.2 -0.1 Private consumption 6.8 6.5 7.7 7.4 7.1 7.2 0.7 0.6 0.1 Public consumption 9.3 8.5 7.6 7.3 7.1 7.1 0.0 -0.2 -0.3 Fixed investment 6.6 4.5 5.6 5.3 5.2 5.1 0.1 0.0 -0.3 Exports, GNFS3 3.3 9.4 4.8 4.7 4.4 4.3 -0.9 -1.3 -1.4 Imports, GNFS3 5.4 8.1 6.8 6.5 5.9 5.8 1.0 0.4 -0.5 Net exports, contribution to growth -0.6 0.4 -0.6 -0.5 -0.5 -0.5 -0.6 -0.5 -0.3 Memo items: GDP East Asia excluding China 4.9 5.4 5.2 5.2 5.2 5.2 -0.2 -0.1 -0.1 China 6.7 6.9 6.5 6.2 6.2 6.0 0.0 -0.1 0.0 Indonesia 5.0 5.1 5.2 5.2 5.3 5.3 0.0 -0.1 -0.1 Thailand 3.3 3.9 4.1 3.8 3.9 3.9 0.0 0.0 0.1 Source: World Bank. Note: e = estimate; f = forecast. EMDE = emerging market and developing economy. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not differ at any given moment in time. 1. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. Excludes Democratic People’s Republic of Korea and dependent territories. 2. Sub-region aggregate excludes Democratic People’s Republic of Korea, dependent territories, Fiji, Kiribati, the Marshall Islands, the Federated States of Micronesia, Myanmar, Nauru, Palau, Papua New Guinea, Samoa, Timor-Leste, Tonga, and Tuvalu, for which data limitations prevent the forecasting of GDP components. 3. Exports and imports of goods and non-factor services (GNFS). To download this data, please visit www.worldbank.org/gep. TABLE 2.1.2 East Asia and Pacific country forecasts1 Percentage point differences (Real GDP growth at market prices in percent, unless indicated otherwise) from June 2018 projections) 2016 2017 2018e 2019f 2020f 2021f 2018e 2019f 2020f Cambodia 6.9 7.0 7.1 6.8 6.8 6.7 0.2 0.1 0.2 China 6.7 6.9 6.5 6.2 6.2 6.0 0.0 -0.1 0.0 Fiji 0.4 3.8 3.5 3.4 3.3 3.3 0.0 0.0 0.0 Indonesia 5.0 5.1 5.2 5.2 5.3 5.3 0.0 -0.1 -0.1 Lao PDR 7.0 6.9 6.5 6.6 6.7 6.6 -0.1 -0.3 -0.2 Malaysia 4.2 5.9 4.7 4.7 4.6 4.6 -0.7 -0.4 -0.2 Mongolia 1.4 5.4 5.9 6.6 6.3 6.2 0.6 0.2 -0.2 Myanmar 5.9 6.8 6.2 6.5 6.6 6.8 -0.5 -0.4 -0.5 Papua New Guinea 2.6 2.8 0.3 5.1 3.1 3.4 2.0 1.1 0.1 Philippines 6.9 6.7 6.4 6.5 6.6 6.6 -0.3 -0.2 0.0 Solomon Islands 3.5 3.5 3.4 2.9 2.8 2.7 0.4 0.0 0.0 Thailand 3.3 3.9 4.1 3.8 3.9 3.9 0.0 0.0 0.1 Timor-Leste2 5.3 -4.7 0.8 3.3 4.9 5.0 -1.4 -0.9 0.9 Vietnam 6.2 6.8 6.8 6.6 6.5 6.5 0.0 0.0 0.0 Source: World Bank. Note: e = estimate; f = forecast. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not significantly differ at any given moment in time. 1. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. 2. Non-oil GDP. Timor-Leste’s total GDP, including the oil economy, is roughly a double of its non-oil economy and is highly volatile as a result of sensitivity to changes in global oil prices and local production levels. To download this data, please visit www.worldbank.org/gep. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 EAST ASIA AND PACIFIC 63 BOX 2.1.1 Informality in East Asia and Pacific The share of informal output in East Asia and Pacific (EAP) region is below the EMDE average while the share of informal employment is above average. Within the region, informality is particularly high in lower-income countries, which are also characterized by a lack of diversification, large rural sectors, and weak institutions. Nonetheless, even higher-income economies within the region have urban informality. This diversity within the region argues for tailored policy approaches to address challenges associated with informality. Higher-income countries can prioritize urban planning and providing essential social protection to informal workers. Lower-income countries can focus on policies that increase productivity, lower costs, and increase the potential benefits of regulatory compliance. Introduction Informality in the EAP region has declined over the past two decades (Chapter 3; Schneider, Buehn, and The share of informal output in East Asia and Pacific Montenegro 2010). The share of informal output declined (EAP) is below the EMDE average.1 Nevertheless, despite from 35 percent of official GDP to 27 percent between a downward trend over the past 30 years, informality 1990-2000 and 2010-16—the fastest decline among remains high in the lower-middle-income economies, EMDE regions. Survey-based measures of informality also including Lao PDR, Myanmar, Cambodia. Higher- suggest a moderate decline in acceptance and perception of income countries in the region have made considerable informality. progress in integrating rural migrants into urban labor markets, but face challenges related to urban informality, The decline in informality has been accompanied by particularly in providing access to public services and sustained growth, rapid industrialization, urbanization, essential social protection. and improvements in institutional quality (Loayza 2016; Against this backdrop, this box examines the following World Bank 2015). A large number of informal, mainly questions: agricultural, workers in China have been successfully integrated into the formal labor force mainly by absorbing • How has informality evolved in East Asia and Pacific? migrants into the urban labor market (World Bank 2014a). Total employment in China rose by about 250 • What have been the macroeconomic and social million during 1990–2014, amid large-scale rural-to-urban implications of informality? migrant flows (Lam, Liu, and Schipke 2015). Between • What policy options are available to address 1990-2000 and 2010-16, the share of informal output challenges associated with informality? declined particularly rapidly in the fastest-growing countries, in part reflecting the effect of comprehensive Evolution of informality reforms (Cambodia, Myanmar, Lao PDR). For example, the informal share of output has fallen by 33 percentage In the EAP region, informal output accounted for about points in Myanmar (to below 30 percent in 2010-16) 30 percent of GDP on average in 2010-2016, slightly following broad-based liberalization measures. below the EMDE median (Figure 2.1.1.1). However, at 47 percent of total employment, informal employment in The region is characterized by significant cross-country EAP was above the EMDE average during the same heterogeneity in terms of institutional and socio-economic period.2 About 73 percent of the labor force in EAP lacked indicators (Figure 2.1.1.1). Per capita GDP levels vary basic pension coverage during 2001-10. widely across EAP, and those economies with higher per capita GDP generally have lower levels of informality (ILO 2018a; Loayza and Rigolini 2006). The share of Note: This box was prepared by Ekaterine Vashakmadze and Jinxin informal output in higher income countries is about 30 Wu. percentage points less than in lower-middle-income 1 Informality is often defined as market-based legal production of countries (Lao PDR and Myanmar). The share of informal goods and services that are hidden from public authorities for monetary, employment is also about one-quarter that of lower- regulatory, and institutional reasons (Schneider, Buehn, and Montenegro 2010). Informal output is measured as a percent of total output in official GDP. In this box, informality is estimated based on the Dynamic General Equilibrium (DGE) model used in Elgin and Oztunali (2012) (for more detailed discussion see Chapter 3 and Annex 3.1). workers are those workers who, working on their own account, with one 2 The most frequently used informal employment measure is the share or a few partners, or in a cooperative, hold the type of jobs defined as of self-employment in total employment, which represents a lower bound "self-employment jobs" (for more detailed discussion see Chapter 3 and of informal employment (La Porta and Shleifer 2014). Self-employed Annex 3.1). 64 CHAPTER 2.1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 2.1.1 Informality in East Asia and Pacific (continued) FIGURE 2.1.1.1 Informality in East Asia and Pacific Compared with other EMDE regions, East Asia and Pacific (EAP)’s share of informal output is moderate whereas its share of informal employment is above average. Informality is particularly high in lower income countries, which are also characterized by stringent labor regulations and lack of enforcement. A. Informal economy as share of total B. Share of labor force without pension; C. Perceived informal activities and economic output share of self-employed attitudes towards informality D. Informality by different measures E. Cross country difference in informality F. Institutional factors Sources: Elgin et al. (forthcoming), World Bank (Doing Business, World Development Indicators, World Governance Indicators), World Economic Forum, World Value Survey. Note: Blue bars show simple averages of the informal economy of the region. Red makers show the median of all EMDEs and the vertical lines denote interquartile range of all EMDEs. A. DGE = dynamic general equilibrium model. MIMIC = multiple indicators multiple causes model. The DGE model estimates the size of the informal sector as a percent of official GDP (see Elgin and Oztunali 2012). The MIMIC model is a structural equations model that considers multiple causes of informal activity and captures multiple outcome indicators of informal activity (see Schneider, Buehn, and Montenegro 2010). It also estimates the informal output as a percent of official GDP. DGE sample includes 12 EAP economies and 122 EMDEs; MIMIC sample includes 14 EAP economies and 124 EMDEs. B. Labor force without pension is presented as the share of the labor force that does not contribute to a retirement pension scheme, derived from data on pension coverage obtained from WDI. Self-employed is the presented as the share of self-employment in total employment. Labor force without pension sample includes 8 EAP economies and 103 EMDEs; self-employed sample includes 19 EAP economies and 134 EMDEs. C. WEF = World Economic Forum. WVS = World Values Survey. WEF index is the average response at the country-year level to the question: “In your country, how much economic activity do you estimate to be undeclared or unregistered? (1 = Most economic activity is undeclared or unregistered; 7 = Most economic activity is declared or registered).” WEF index is inverted; a higher average at the country level indicates a larger informal economy. The index does not use data for 2004–05 due to inconsistency in survey methods. The WVS asks whether respondents can justify cheating on taxes (1 = never justifiable; 10 = always justifiable). The average responses at the country-year level are used as a measure of attitude toward informality (or tax morality; Oviedo, Thomas, and Karakurum-Ozdemir 2009). WEF sample includes 12 EAP economies and 114 EMDEs; WVS sample includes 6 EAP economies and 66 EMDEs. D. Diamonds represent the average level of EAP region; bars denote the range of EAP countries in each measure. E. The upper bound of bar indicates the share of informal employment in total employment. The lower bound indicates the share of informal output in official GDP based on the Dynamic General Equilibrium (DGE) model. For Malaysia, the level of informal output is higher than the level of informal employment. F. All measures are taken from the latest year available. The first three institutional measures are taken from World Bank’s World Governance Indicators (World Bank 2018e), with a higher value indicating better institutional quality in year 2016. The “ease of doing business” and “ease of paying taxes” are taken from World Bank’s Doing Business database (World Bank 2018f) and measured as distance to frontier, with a higher value indicating a more favorable business environment. Sample includes 22 EAP economies and 149 EMDEs. An economy’s distance to frontier is reflected on a scale from 0 to 100, where 0 represents the lowest performance and 100 represents the frontier. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 EAST ASIA AND PACIFIC 65 BOX 2.1.1 Informality in East Asia and Pacific (continued) middle income economies.3 Informality is most pervasive Underinvestment in human capital. In EAP, investment in Lao PDR and Myanmar, at around 60-80 percent of in human capital and higher levels of educational total employment. Indonesia, Mongolia, and Vietnam attainment have increased labor productivity and have have below average informal output shares, but their been closely associated with a smaller share of the informal informal employment shares are above the EAP average economy (Figure 2.1.1.2; ILO 2018a; Moscoso-Boedo (ADB 2010; Handayani 2016). and D’Erasmo 2012). Workers with higher education levels are also more likely to be formally employed. This is Drivers and implications of informality also evident in cross-country comparisons. For example, in Indonesia, the results of the 2009 Informal Sector Survey Informality has been attributed to several drivers. These (ISS) in Yogyakarta and Banten suggest that persons who included large agricultural sectors, rapid urbanization, low are informally employed tended to have lower levels of human capital, and overly burdensome regulations. education than those with formal jobs (ADB 2010). Size of agricultural sectors. People living in rural areas are Malaysia is among the countries with the highest almost twice as likely to be in informal employment as educational attainment and the lowest share of informal those in urban areas, and agriculture is the sector with the employment (25 percent). In contrast, Lao PDR, highest share of informal employment (ILO 2018a). The Myanmar and Cambodia are characterized by low agricultural sector still accounts for about 30 percent of educational outcomes and high informality. employment in EAP on average, and these shares are Enterprise sector characteristics. In China and Vietnam, particularly high in Lao PDR, Myanmar, and Vietnam informal economies arose amid economic reforms that (ADB 2010; Figure 2.1.2). Informal workers constitute began in the 1970s and allowed the emergence of a private the vast majority of employment in the agriculture sector economy in the form of unregulated micro-enterprises, in Cambodia and Thailand, in part because high family enterprises, and individual entrepreneurs (Park, compliance costs discourage formal-sector activity of Wu, and Du 2012). The informal economy comprises agricultural small enterprises (ILO 2018a). more than 90 percent of micro and small enterprises Urbanization. Rapid urbanization in EAP has supported worldwide (ILO 2018b). In EAP, informal workers tend large-scale rural-to-urban migration, stimulated growth, to be employed in small, low-productivity firms. For productivity, and formal and informal job creation (Ghani example, in Indonesia, most informal firms are very small and Kanbur 2013). The urbanization process has (micro) firms with less than five employees. These firms coincided with the rapid structural transformation of tend to be less productive than larger firms and pay lower China and other fast-growing East Asian economies and wages. Their operations tend to be local, predominantly the shift of activity from agriculture to manufacturing and supplying local markets, with little desire for expansion services (McMillan, Rodrik, and Sepulveda 2017; Rodrik (Rothenberg et al. 2015). 2015). In general, a larger non-agricultural sector is Taxes and labor regulations. Informality is also a associated with a smaller informal sector, and informality consequence of higher tax burdens, stringent labor in manufacturing is significantly lower than in services regulations, limited enforcement capacity, and poor (Atesagaoglu, Bayram, and Elgin 2017). Although the governance (World Bank 2014a). In EAP, informality is growth of urban areas provides opportunities for many, higher in lower-income countries with markedly weaker urban expansion, if not well planned, can also contribute institutional quality, cumbersome rules and procedures, to rising urban informality and policy challenges. In and pervasive lack of awareness or adequate enforcement China, for example, unequal access to public services (Lao PDR, Myanmar; Figure 2.1.1.2). Within Malaysia, between citizens with urban household registrations the Philippines, Thailand, and Vietnam, informality has (hukou) and those without, although diminishing, has led been associated with more rigid business regulations and to unregistered urban households that lack essential social ineffective law enforcement (Loayza and Rigolini 2006). protection (Park, Wu, and Du 2012; World Bank 2014a). Informality has been associated with a number of adverse economic outcomes. These include urban poverty, household vulnerability to shocks and lower productivity. 3 Although the commonly observed link between income growth and Urban poverty and income inequality. EAP is the world’s informality generally holds in the EAP region, informality is nevertheless relatively high in Thailand despite its higher income status (Hassan and most rapidly urbanizing region, with an average annual Schneider 2016). urbanization rate of 3 percent (World Bank 2017a). The 66 CHAPTER 2.1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 2.1.1 Informality in East Asia and Pacific (continued) FIGURE 2.1.1.2 Drivers and implications of informality in East Asia and Pacific Better institutions and business environments, industrialization, and rapid urbanization are associated with low informality in higher-income economies. Countries with a high share of informality have higher income inequality and lower levels of educational attainment. A. Informality and institutions B. Institutional factors in countries with C. Employment in agriculture high and low informality D. Urban population as percent of total E. Year of total schooling F. Human capital index population Sources: Barro-Lee (2013), Elgin et al. (forthcoming), World Bank (Doing Business, World Development Indicators, World Governance Indicators). A. Higher MIC = China, Malaysia, and Thailand; Middle MICs = Indonesia, Mongolia, and the Philippines. Lower MICs = Cambodia, Lao PDR, Myanmar, and Vietnam.. The grouping of countries is based on GDP per capita. B. All measures are taken from the latest year available. The first three institutional measures are taken from World Bank’s World Governance Indicators (2017), with a higher value indicating better institutional quality in year 2016. Error bars reflect all EAP countries. C.-F. CHN = China, IDN = Indonesia, KHM = Cambodia, LAO = Lao PDR, MMR = Myanmar, MNG = Mongolia, MYS = Malaysia, PHL = Philippines, THA = Thailand, VNM = Vietnam. C. The vertical and horizonal lines denote EMDE averages. D. Latest data available is 2014. E. Data are from Barro-Lee (2013). Average years of total schooling is the average years of education completed among people over age 15. F. The HCI calculates the contributions of health and education to worker productivity. The final index score ranges from zero to one and measures the productivity as a future worker of child born today relative to the benchmark of full health and complete education. The vertical and horizonal lines denote EMDE averages. rapid growth of cities has created challenges that include China, Indonesia, and the Philippines, while the highest the lack of affordable housing, resulting in increasing urban poverty rates are in the Pacific Island countries of slums, poor provision of basic services, and widening Papua New Guinea, Timor-Leste, Vanuatu, and in inequality for urban dwellers. EAP hosts the world’s largest Indonesia and Lao PDR (World Bank 2016b, World Bank slum population, many of them informally employed: 2017a).4 around 35 percent of urban population (250 million people) live in slums. In Indonesia, 27 percent of the In China, the exceptional scale of rural to urban migration urban population do not have access to improved amplifies the challenges from informality. Many of these sanitation facilities (WHO and UNICEF 2015), followed by 21 percent in the Philippines (USAID 2017). The 4 Approximately 75 million people in EAP region live below the cities with the highest numbers of urban poor are in US$3.10/day poverty line. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 EAST ASIA AND PACIFIC 67 BOX 2.1.1 Informality in East Asia and Pacific (continued) workers—approximately 120-150 million— are migrant Policy challenges workers who are not registered to work in cities, and therefore lack a number of formal protections (Jutting and A tailored approach can help address the challenges Xenogiani 2007, Huang 2009). These urban migrants gain associated with informality (OECD 2015; World Bank a large wage premium by migrating; yet both rural and 2014a). Higher-income countries can prioritize providing urban migrants tend to work in informal jobs and lack essential social protection to informal workers; lower- adequate social protection (Gagnon, Xenogiani, and Xing income countries can focus on reforms to increase firm 2011). In Thailand, informally employed workers and worker productivity. systematically present lower earnings at all earnings levels, Essential social protection. In higher-income countries, and the difference increases with level of earnings (ILO essential social protection coverage can be expanded to 2015). shield informal workers from adverse shocks (Olivier, Household vulnerability to shocks. Informality may Masabo, and Kalula 2012). This would imply higher impose significant economic risk and result in public expenditure on social protection to extend at least underinvestment in human capital of current and future basic social protection coverage to all (ILO 2017). generations (Oviedo, Thomas, and Karakurum-Ozdemir Reforms to improve urban planning. Urban planning can 2009). It is characterized by a lack of adequate social help improve access to jobs, affordable housing, protection coverage, which increases household commercial services, public transportation, and health and vulnerability to shocks. For middle and lower income education services to ensure equal opportunity for countries in EAP region, pension coverage is extremely low disadvantaged communities (World Bank 2015; Judy and (Figure 2.1.1.2). In China, formal casual workers report Gadgil 2017). Examples of effective metropolitan lower monetary and subjective well-being than employees governance include Beijing, Jakarta, Kuala Lumpur, Metro and business owners (Liang, Appleton, and Song 2016). Manila Developments Authority (MMDA) and Shanghai (World Bank and DRCSC 2014; World Bank 2015). Low productivity. Countries characterized by larger informal sectors are associated with lower shares of skilled Reforms to increase firm productivity. Agglomeration workers and weaker total factor productivity. At the firm benefits can lower the unit costs of public service level, entering and operating in the formal sector is costly, provision, enabling governments to extend access to basic but provides firms with better access to technologies, services to more people (Ghani and Kanbur 2013; World skilled workers, and access to capital (Figure 2.1.1.2; Bank 2014a, 2018g). Policies to support small agricultural D’Erasmo, Moscoso Boedo, and Senkal 2014). There enterprises, which engage a large share of EAP’s workforce, exists a sharp productivity difference between firms of the and other micro, small- or medium-sized enterprises same size in the formal and informal sector when include improving access to services, decreasing red tape measured in terms of value added per employee, with and corruption, facilitating access to financial services, and formal firms being, on average, 30 percent more offering better education and training (OECD 2009; productive (Fajnzylber, Maloney, and Montes-Rojas 2011; World Bank 2018h). La Porta and Shleifer 2014; Monteiro and Assuncao 2012; Perry et al. 2007). Despite a well-documented gap Remove disincentives to formal employment. Removing between the performance of formal and informal firms, disincentives to formal employment could encourage a less is known about how the allocation of low-productivity shift of informal workers into formal employment. Reform firms in the informal sector affects productivity over time. options include lower registration costs; shorter If by operating informally firms are able to cut costs and registration procedures; streamlined registration services, stay more productive, then a shift from the informal to the for example, through information and communication formal sector will not necessarily lead to an increase in technologies; lower compliance costs by introducing productivity. Indeed, some recent studies find evidence simplified tax assessment and payment regimes; improved that a shift into the formal sector does not necessarily lead access to financial services; and improved access to to an increase in productivity for firms (De Mel, training, skills development, and business development McKenzie, and Woodruff 2013; Demenet, services (ILO 2016). As small firms have different Razafindrakoto, and Roubaud 2016; McKenzie and Sakho motivations to stay small and informal, measures to lower 2010). Overall, while individual motivations to become or cost and increase the potential benefits of regulatory stay informal may differ, the aggregate outcome can be compliance can be combined with a more effective characterized as low scale output and low productivity. enforcement regime. Regional growth is estimated to have decelerated to an estimated 3.1 percent in 2018 and is projected to further slow to 2.3 percent this year, mainly because of weakness in Turkey. Regional growth is expected to pick up modestly in 2020-21, as a gradual recovery in Turkey offsets moderating activity in Central Europe. The main risks to the region are weaker-than-expected investment due to heightened policy uncertainty, and a renewal of financial pressure in Turkey combined with possible contagion to the rest of the region. Recent developments Growth among the Central European economies slowed in 2018. Softening exports and labor Activity in Europe and Central Asia (ECA) is shortages restrained growth in Bulgaria, Croatia, estimated to have slowed to 3.1 percent in 2018 and Romania. In contrast, despite labor shortages, from 4 percent in 2017, reflecting the marked growth in Poland accelerated slightly because of weakness in activity in Turkey in the second half strong consumption and investment. Robust of the year. Excluding Turkey, regional growth domestic demand supported activity in the remained unchanged at an estimated 2.9 percent Western Balkans, except for Montenegro. In the in 2018, as slowing activity in countries in the Former Yugoslav Republic of Macedonia, growth western part of the region, such as Bulgaria and rebounded in 2018 as the formation of a new Romania, offset an acceleration in the eastern part government ended a prolonged political crisis and of the region that benefitted from higher oil prices improved investor sentiment (World Bank 2018i). (Figure 2.2.1). Regional trade growth declined The Russian Federation and other oil exporters during 2018. in Central Asia maintained steady growth in 2018, In Turkey, the lira declined around 30 percent supported by a rise in oil prices. Although over the course of 2018, reflecting capital outflows economic sanctions tightened, Russia experienced in response to accelerating inflation, a perceived relatively low and stable inflation and increased delay in monetary tightening, and rising private oil production. As a result of robust domestic sector debt. The country accumulated a sizable activity, the Russian economy expanded at a 1.6 current account deficit and a large foreign percent pace in the year just ended (World Bank currency-denominated debt load, leaving it 2018j). Higher-than-expected production in the vulnerable to shifting investor sentiment and Kashagan oil field and strong domestic demand currency depreciation. Output shrank by 1.1 supported growth in Kazakhstan. A stabilization in percent from the second quarter to the third the financial sector and higher oil prices quarter amid plummeting consumer confidence contributed to a slow recovery of growth in and credit scarcity. Despite this contraction, Azerbaijan in 2018. strong growth in the first half of the year will The stance of fiscal policy in the region varies. bring Turkish growth to an estimated 3.5 percent Turkey has committed to tight fiscal policy to help for 2018. curb high inflation and currency depreciation. Romania’s fiscal stance is mixed, with income tax Note: This section was prepared by Yoki Okawa. Research reductions and increased public sector benefits assistance was provided by Zhuo Chen and Mengyi Li. offset by an increase in social contribution 70 CHAPTER 2.2 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 2.2.1 ECA: Recent developments to have recorded its first surplus since 2012 in Regional growth is estimated to have slowed in 2018 reflecting financial 2018. As fiscal stimulus measures are phased out, stress in Turkey and weak regional trade. Financial stress in Turkey, which Kazakhstan has started to tighten its fiscal stance, experienced a sharp depreciation and an increase in bond spreads, does resulting in improvements in its non-oil fiscal not appear to have spilled over to other countries in the region. Slowing inflation in the eastern ECA region led to loosening in monetary policy, balance. Azerbaijan continues to rely on fiscal while a pickup in inflation from 2016 level in the western ECA has not yet measures to support its economy. led to monetary tightening. The fiscal stance in the region is mixed. For the majority of ECA countries, monetary A. Contribution to regional growth B. Trade policy is either stable or loosening. At the end of 2018, nine countries have policy rates lower than a year ago, while three countries have higher policy rates (Romania, Ukraine, Turkey). Inflation peaked at 25 percent in Turkey in October, significantly above the 5 percent target amid an overheating economy in the first half of 2018 and currency depreciation in the second. To ward off inflationary and currency pressures, Turkey’s central bank increased the average cost of funding C. Currency movements in Turkey D. EMBI spreads by more than 10 percentage points over the course of 2018. In Central Europe, tightening labor markets and increasing energy prices have pushed inflation up toward target, with monetary policy remaining stable in most countries. One exception is Romania, where robust domestic demand pushed inflation above the upper bound of the target band, prompting monetary policy tightening. Gradually accelerating inflation has E. Inflation F. Monetary and fiscal policy also led to policy tightening in Ukraine. In the Western Balkans, Albania, FYR Macedonia, and Serbia have lowered policy rates amid stable and below-target inflation. For oil exporters, such as Azerbaijan and Kazakhstan, the stabilization of currency following the 2014-16 oil price plunge has resulted in lower inflation and looser monetary policy. In Russia, monetary policy was tightened in late 2018 amid pressures on the currency. Source: Haver Analytics, World Bank. A. Aggregates growth rates calculated using constant 2010 U.S. dollar GDP weights. B. Three-month moving averages of GDP-weighted trade volume indexes for Russia, Turkey, Outlook Poland, Ukraine, Kazakhstan, Hungary, and Armenia. C. Cumulative change of exchange rate for 400 days from the starting date. Starting dates are February 1, 2001, May 2, 2013 and May 2, 2018 for 2001 crisis, Taper Tantrum, and 2018 crisis, The lingering effects of financial stress in Turkey respectively. Last observation for the 2018 crisis is December 19, 2018. E. Last observation is November for each year. are expected to further slow of regional growth in F. Monetary policy tightening/loosening is defined as increase/decrease of the central bank’s policy 2019. Growth is expected to slide to 2.3 percent, rate between January and November 2018. Fiscal policy tightening/loosening is defined as increase/ decrease of primary balance in estimated 2018 values compared to 2017. before recovering to 2.7 percent in 2020 (Figure 2.2.2). Excluding Turkey, regional growth is expected to average 2.6 percent during the forecast horizon, compared to 2.9 percent in 2018, with a revenue. Fiscal policy has become more procyclical gradual deceleration in Central Europe. This in some Central European countries. In the outlook is predicated on an orderly tightening of eastern part of the region, the Russian government global financial conditions, oil prices averaging has implemented a new fiscal rule and is estimated $67 in 2019-2021, a gradual slowdown in the G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 E URO PE AND CE NTRAL AS IA 71 Euro Area, and the absence of heightened FIGURE 2.2.2 ECA: Outlook and risks geopolitical tensions. Regional growth is expected to slow notably in 2019 and gradually accelerate in 2020-21, partly reflecting a sharp decline and subsequent While the outlook for Turkey is subject to recovery in Turkish growth. A number of countries in the region appear vulnerable to shifts in investor sentiment, as reflected by their high current considerable uncertainty, the country is expected account deficits and corporate debt. to be weighted down by high inflation, high interest rates, and low confidence, which will A. Actual and potential growth B. Growth forecast dampen consumption and investment. Turkish growth is expected to slow to 1.6 percent in 2019 and begin to recover by 2020 through a gradual improvement in domestic demand and continued strength in net exports. However, this outlook assumes that fiscal and monetary policy successfully avert further sharp falls in the lira and, that corporate debt restructurings help avert serious damage to the financial system. A comprehensive stabilization package with C. Trade openness D. Current account consistent policy framework, clear milestones, and effective communication would help reduce risks and support recovery. Spillovers from Turkey to the rest of the region are expected to remain modest, as trade and financial linkages are relatively limited. On the trade side, Azerbaijan has the largest exposure, as 9 percent of its exports are directed to Turkey. Financial linkages are also small—only Georgia E. Corporate debt F. Exchange rate risk in debt receives meaningful amounts of FDI from Turkey, and foreign bank ownership of Turkish assets is limited in scale. Growth in western ECA, excluding Turkey, is projected to gradually slow toward potential, driven by a slowdown in Central European economies. Domestic demand in this sub-region will be constrained by tight labor markets, while a Source: Haver Analytics, Institute of International Finance, International Monetary Fund, World Bank. A. Blue bars refer to GDP-weighted average actual growth and vertical orange line show continued slowdown in the Euro Area will limit minimum-maximum range of potential growth estimates based of five different methodologies (production function approach, multivariate filter, IMF World Economic Outlook five-year-ahead export growth. Poland is expected to slow from forecast, Consensus Forecasts, and potential growth estimates in OECD Economic Outlook and OECD Long-Term Baseline Projections). 5.0 percent in 2018 to 4.0 percent in 2019, as A. B. Data in shaded area are forecasts. Euro Area growth slows. C. Share of exports as a percentage of GDP in 2016. EAP = East Asia and Pacific, ECA = Europe and Central Asia, LAC = Latin America and the Caribbean, MNA = Middle East and North Africa, SAR = South Asia, and SSA = Sub-Saharan Africa. D. Current account balance as a percentage of GDP. Growth in eastern ECA is forecast to slow E-F. The data used are IIF end-of-period estimates of non-financial corporate debt as a percentage in 2019, as the large economies including Russia. of GDP. Kazakhstan and Ukraine decelerate. The VAT in Russia is expected to rise from 18 to 20 percent in 2019, weighing on near term growth. Risks Kazakhstan’s economy is also expected to decelerate as oil production growth levels off While there are some upside risks to the forecasts and fiscal consolidation efforts continue (World —for example, that stronger-than-expected energy Bank 2018k). prices may support activity in Russia and other 72 CHAPTER 2.2 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 energy exporters—the balance of risks is The potential for financial stress is more elevated increasingly tilted down. The most important in countries with domestic vulnerabilities like downside risk is the possibility that the recent Romania and Belarus, which have large current financial stress in Turkey worsens and triggers account deficits or large foreign-currency widespread bank failures. Turkish corporations denominated debt. Public debt, which remains carry significant debt, much of which is high despite recent declines, and private denominated in or linked to foreign currencies. borrowing in foreign currencies makes Central Although many corporations are hedged against European countries vulnerable to financial exchange rate risks, and corporate debt pressure. Public debt has also been trending up in restructuring is on its way, falling domestic Central Asia and the Western Balkans. demand and forex exposure of the non-tradable sector pose risks. Currency depreciation and high Increases in policy uncertainty could undermine interest rates could push corporate borrowers into confidence in the region and impact growth. A bankruptcy and depleting banks’ capital buffers. slowdown or reversal of ongoing structural Renewed pressure in currency markets and reforms remains a risk in many countries in the increased uncertainty about the policy framework region, especially in Armenia, Azerbaijan, Belarus, would increase the probability of a deepening Ukraine, and Turkey. Tension concerning Syria or crisis, implying a longer and more severe Ukraine could trigger new sanctions. Policy slowdown than currently forecast for Turkey disagreements between the European Union and (World Bank forthcoming). While direct linkages some Central European countries could deter between Turkey and the rest of the region are international investors and reduce fiscal transfers. small, an intensification of financial stress in An escalation of trade restrictions between the Turkey or other EMDEs could also lead investors United States and the Euro Area could have a to re-evaluate their exposure in the region, which negative impact on western ECA countries, as the in turn could lead to capital outflows, currency Euro Area is the largest trading partner for all depreciations, and rising borrowing costs. countries in the sub-region. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 E URO PE AND CE NTRAL AS IA 73 TABLE 2.2.1 Europe and Central Asia forecast summary Percentage point differences (Real GDP growth at market prices in percent, unless indicated otherwise) from June 2018 projections 2016 2017 2018e 2019f 2020f 2021f 2018e 2019f 2020f EMDE ECA, GDP 1 1.7 4.0 3.1 2.3 2.7 2.9 -0.1 -0.8 -0.3 EMDE ECA, GDP excl. Turkey 1.2 2.9 2.9 2.6 2.6 2.5 0.1 -0.2 -0.1 (Average including countries with full national accounts and balance of payments data only) 2 EMDE ECA, GDP2 1.6 4.0 3.0 2.3 2.7 2.9 -0.2 -0.8 -0.3 GDP per capita (U.S. dollars) 1.2 3.6 2.7 2.0 2.4 2.7 -0.1 -0.8 -0.3 PPP GDP 1.6 3.9 3.0 2.3 2.7 2.9 -0.2 -0.8 -0.3 Private consumption 1.2 4.8 3.0 2.4 3.2 2.9 -0.1 -0.8 0.1 Public consumption 2.9 2.1 1.9 2.5 2.2 2.1 0.4 1.1 0.9 Fixed investment 0.0 6.3 0.3 2.3 4.6 4.8 -4.9 -2.5 -0.1 Exports, GNFS3 3.4 6.9 5.5 5.3 4.3 4.5 0.7 0.6 -0.4 Imports, GNFS 3 3.2 10.4 2.8 5.1 5.8 5.8 -2.7 -0.4 0.6 Net exports, contribution to growth 0.2 -0.7 1.1 0.3 -0.2 -0.2 1.1 0.3 -0.2 Memo items: GDP Commodity exporters4 0.3 2.0 2.1 2.0 2.2 2.3 0.1 -0.3 -0.1 Commodity importers5 3.1 6.0 4.0 2.6 3.2 3.6 -0.3 -1.2 -0.5 Central Europe 6 3.4 4.9 4.5 3.6 3.3 3.0 0.3 -0.1 -0.2 Western Balkans7 3.0 2.5 3.5 3.5 3.8 3.8 0.3 0.1 0.0 Eastern Europe 8 0.8 2.6 3.5 2.9 3.1 3.4 0.2 -0.7 -0.4 South Caucasus9 -1.6 2.0 2.5 4.0 3.8 3.4 -0.1 0.0 0.1 Central Asia 10 3.3 4.8 4.4 4.2 4.0 4.1 0.0 0.0 0.0 Russia -0.2 1.5 1.6 1.5 1.8 1.8 0.1 -0.3 0.0 Turkey 3.2 7.4 3.5 1.6 3.0 4.2 -1.0 -2.4 -1.0 Poland 3.1 4.8 5.0 4.0 3.6 3.3 0.8 0.3 0.1 Source: World Bank. Note: e = estimate; f = forecast. EMDE = emerging market and developing economy. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not differ at any given moment in time. 1. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. 2. Sub-region aggregate excludes Bosnia and Herzegovina, Kosovo, Montenegro, Serbia, Tajikistan, and Turkmenistan, for which data limitations prevent the forecasting of GDP components. 3. Exports and imports of goods and non-factor services (GNFS). 4. Includes Albania, Armenia, Azerbaijan, Kazakhstan, the Kyrgyz Republic, Kosovo, Russia, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan. 5. Includes Belarus, Bosnia and Herzegovina, Bulgaria, Croatia, Georgia, Hungary, FYR Macedonia, Moldova, Montenegro, Poland, Romania, Serbia, and Turkey. 6. Includes Bulgaria, Croatia, Hungary, Poland, and Romania. 7. Includes Albania, Bosnia and Herzegovina, Kosovo, FYR Macedonia, Montenegro, and Serbia. 8. Includes Belarus, Moldova, and Ukraine. 9. Includes Armenia, Azerbaijan, and Georgia. 10. Includes Kazakhstan, the Kyrgyz Republic, Tajikistan, Turkmenistan, and Uzbekistan. To download this data, please visit www.worldbank.org/gep. 74 CHAPTER 2.2 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 TABLE 2.2.2 Europe and Central Asia country forecasts1 Percentage point differences (Real GDP growth at market prices in percent, unless indicated otherwise) from June 2018 projections 2016 2017 2018e 2019f 2020f 2021f 2018e 2019f 2020f Albania 3.4 3.8 4.0 3.6 3.5 3.5 0.4 0.1 0.0 Armenia 0.2 7.5 5.3 4.3 4.6 4.6 1.2 0.3 0.6 Azerbaijan -3.1 0.1 1.1 3.6 3.3 2.7 -0.7 -0.2 0.1 Belarus -2.5 2.4 3.4 2.7 2.5 2.5 0.5 0.0 0.0 Bosnia and Herzegovina2 3.1 3.0 3.2 3.4 3.9 4.0 0.0 0.0 -0.1 Bulgaria 3.9 3.8 3.3 3.1 3.0 2.8 -0.5 -0.5 -0.6 Croatia 3.5 2.9 2.7 2.8 2.8 2.6 0.1 0.1 0.0 Georgia 2.8 4.8 5.3 5.0 5.0 5.0 0.8 0.2 0.0 Hungary 2.3 4.1 4.6 3.2 2.8 2.4 0.5 0.0 -0.2 Kazakhstan 1.1 4.1 3.8 3.5 3.2 3.2 0.1 0.2 0.4 Kosovo 4.1 4.2 4.2 4.5 4.5 4.5 -0.6 -0.3 -0.3 Kyrgyz Republic 4.3 4.6 3.1 3.4 3.9 4.0 -1.1 -1.4 -1.1 Macedonia, FYR 2.8 0.2 2.5 2.9 3.2 3.3 0.2 0.2 0.2 Moldova 4.5 4.5 4.8 3.8 3.5 3.2 1.0 0.1 0.0 Montenegro 2.9 4.7 3.8 2.8 2.5 2.5 1.0 0.3 0.4 Poland 3.1 4.8 5.0 4.0 3.6 3.3 0.8 0.3 0.1 Romania 4.8 6.9 4.1 3.5 3.1 2.8 -1.0 -1.0 -1.0 Russia -0.2 1.5 1.6 1.5 1.8 1.8 0.1 -0.3 0.0 Serbia 2.8 1.9 3.5 3.5 4.0 4.0 0.5 0.0 0.0 Tajikistan 6.9 7.1 6.0 6.0 6.0 6.0 -0.1 0.0 0.0 Turkey 3.2 7.4 3.5 1.6 3.0 4.2 -1.0 -2.4 -1.0 Turkmenistan 6.2 6.5 6.2 5.6 5.1 4.9 -0.1 -0.7 -1.2 Ukraine 2.3 2.5 3.5 2.9 3.4 3.8 0.0 -1.1 -0.6 Uzbekistan 7.8 5.3 5.0 5.1 5.5 6.0 0.0 0.0 0.0 Source: World Bank. Note: e = estimate; f = forecast. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not significantly differ at any given moment in time. 1. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars, unless indicated otherwise. 2. GDP growth rate at constant prices is based on production approach. To download this data, please visit www.worldbank.org/gep. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 E URO PE AND CE NTRAL AS IA 75 BOX 2.2.1 Informality in Europe and Central Asia The share of informal output in Europe and Central Asia (ECA) is larger than the EMDE average, even after a decline from elevated 1995 levels, but informality in the labor market is below average and there is wide heterogeneity within the region. Informality in ECA has been associated with weak institutions, sizeable agricultural sectors, and large-scale migration as well as low productivity, fiscal revenue losses, and poor job prospects for youth. In some ECA countries, declines in informality have accompanied the simplification of tax systems and labor market reforms, as well as reforms to reduce corruption. Introduction in Central Europe still received “envelope wages” as recently as 2006, and the informal economy accounted for Informal output accounts for a larger share of official GDP 10 percentage points of GDP more than in the more (36 percent) in Europe and Central Asia (ECA) than in advanced EU19 economies in 1999-2007 (Fialová and the average EMDE (Figure 2.2.1.1).1 However, despite a Schneider 2011).3 In the eastern part of the region, the widely shared history of transition from centrally planned decline in informality has been considerably less to market economies, there is significant variation in pronounced, in part reflecting slower implementation of informality within the region, ranging from 22 percent to market liberalizing and other reforms, as well as 56 percent. persistently higher levels of corruption (Kaufmann and Against this backdrop, this box examines the following Kaliberda 1996). questions. Drivers of informality. Informality in ECA economies has • How has informality evolved in Europe and Central typically been attributed to three factors: Asia? • Agriculture. Higher labor market informality has been • What have been the macroeconomic and social associated with a larger share of workers in the correlates of informality? agricultural sector as they tend to be self-employed (Figure 2.2.1.2; Rutkowski 2006; World Bank 2011). • What policy options are available to address A larger agricultural sector has also been correlated challenges associated with informality? with greater informality in non-agricultural sectors (Atesagaoglu, Bayram, and Elgin 2017). Evolution and drivers of informality • Remittances. In countries with large diasporas, Evolution of informality. With the collapse of centrally informal activity has been higher among workers in planned economies in the late 1980s, many firms chose to households that receive sizeable remittances operate in the informal sector to avoid burdensome (Chatterjee and Turnovsky 2018; Shapiro and regulations, taxation, or corruption. Estimates based on Mandelman 2016). In Kazakhstan, FYR Macedonia, electricity consumption suggest that the average size of the Moldova, Serbia, Tajikistan, and Ukraine, remittances informal economy more than doubled during 1989-95 provided the capital to establish small businesses, (Johnson, Kaufmann, and Shleifer 1997). While which tend to be informal, and the income support informality declined in most countries once they began to needed to accept less secure but often more lucrative recover, there was considerable heterogeneity across informal work (Ivlevs 2016). countries. In the western part of the region, where institutions are stronger, informality has declined steeply.2 • Institutions. Institutional quality varies widely within Notwithstanding this decline, one in ten formal employees the region. The east has considerably weaker institutional quality indicators than the west, which implemented substantial reforms in the context of the Note: This section was prepared by Yoki Okawa. Research assistance EU accession process (Figure 2.2.1.2; Kaufmann and was provided by Zhuo Chen and Mengyi Li. Kaliberda 1996).4 In general, a favorable business 1 The methodology of informality estimates is discussed in Chapter 3. 2 The western part of the region includes Central Europe (Bulgaria, Croatia, Hungary, Poland and Romania) and the Western Balkans 3 “Envelope wages” refers to the practice of paying a portion of wages (Albania, Bosnia and Herzegovina, Kosovo, the Former Yugoslav Republic of Macedonia, Montenegro, and Serbia), and Turkey. The in undeclared cash to avoid tax and social contributions (see, for example, eastern part of the region comprises Eastern Europe (Belarus, Moldova, Horodnic 2016, and Williams and Padmore 2013). 4 Institutional indicators include the World Bank’s Doing Business and Ukraine), South Caucasus (Armenia, Azerbaijan and Georgia), Central Asia (Kazakhstan, Kyrgyz Republic, Tajikistan, Turkmenistan, Indicators and World Governance Indicators of government effectiveness, and Uzbekistan) and Russia. control of corruption, or rule of law. 76 CHAPTER 2.2 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 2.2.1 Informality in Europe and Central Asia (continued) FIGURE 2.2.1.1 Informality in Europe and Central Asia The share of informal output in the ECA region is higher than the EMDE median throughout the sample period, and it declined at the roughly same pace as in the other EMDE regions. However, employment informality is low, in part reflecting a low share of agriculture in some countries in the region. Institutional quality is on par with other regions, albeit with considerable hetero- geneity within the region. A. Share of informal economy in output B. Share of labor force without pension; C. Institutional quality share of self-employed Source: Elgin et al. (forthcoming), World Bank. Note: Blue bars show simple averages of the informal economy of the region. Red markers show the median average of all EMDEs and the vertical lines denote interquartile range of all EMDEs. A. Both DGE and MIMIC estimates measure the informal output in percent of official GDP. B. Labor force without pension is the fraction of the labor force that doesn’t contribute to a retirement pension scheme, which is derived from the original data on pension coverage obtained from WDI. Self-employed is the share of self-employment in total employment. C. All measures are taken from the latest year available. The first three institutional measures are taken from World Bank’s World Governance Indicators (2017), with a higher value indicating better institutional quality in year 2016. The “Ease of doing business” (DB 2018) and “Ease of paying taxes” (DB 2017) are taken from World Bank’s Doing Business database and measured as “Distance to Frontier”, with a higher value indicating an easier environment for businesses. environment encourages firms to do business in the growth in the formal sector (Sattar, Keller, and Baibagsy formal sector (Chapter 3). However, the transition Uulu 2015). from economies dominated by large state-owned enterprises to more private-business friendly Fiscal revenues. Large informal sectors erode tax revenues economies sometimes created more informal and hamper governments’ ability to provide public goods. employment and larger informal sectors (Earle and However, the magnitude of foregone revenues due to Sakova 2000). informality remains a matter of debate. One estimate suggests that tax revenue losses from informality could Correlates of informality have been as high as 7 percent of GDP in Central Asia and the Caucasus in 2004 (Grigorian and Davoodi 2007). Firm productivity. Some country-specific studies suggest However, estimates based on micro survey data suggest that informal firms tend to be less productive than formal only modest potential revenues gains (0.03-0.07 firms. In Turkey, for example, after controlling for firm percentage points of GDP) from turning informal workers characteristics, informal firms in the manufacturing and into formal workers in a country such as Ukraine in 2009, services sectors had 16 percent and 38 percent lower total as newly formalized are mainly low-skilled and subject to factor productivity than formal firms, respectively, with low tax rates (World Bank 2011). the productivity gap attributed to restricted access to public services and formal markets (Taymaz 2009). By Labor market prospects. Informal employment is more these estimates, shifting all informal firms in the Turkish common among young, low-skilled, and female workers. manufacturing and services sectors into the formal sector Some studies suggest that informal employment can could raise total output by 5 percent and 25 percent, damage long-term carrier prospects and entrench income respectively (Taymaz 2009). In Kyrgyz Republic, differentials (Taymaz 2009; World Bank 2007, 2011). productivity in the informal sector has declined However, informal employment can also be an income significantly since 2009, despite robust productivity source when formal employment opportunities are scarce, G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 E URO PE AND CE NTRAL AS IA 77 BOX 2.2.1 Informality in Europe and Central Asia (continued) as well as help develop human capital that can lead to (Fialová and Schneider 2011; Lehmann and Muravyev formal employment or self-employment, as has been found 2009). for Turkey and Russia(Guariglia and Kim 2006; Taymaz 2009).5 Better-paid informal activity may also encourage Fiscal policy. Several countries have changed tax rates or skilled professionals to forgo migration opportunities in tax enforcement, but the impact on informality has varied. highly regulated economies with large emigration, such as That said, reducing the tax compliance burden and Tajikistan (Abdulloev, Gang, and Landon-Lane 2011). subsidizing the transition to formal sectors have typically been accompanied by declines in informality.7 Inequality. In some countries, the low wages paid to informal workers (the “wage penalty”) compared with • Flat tax. A flat labor income tax rate has been formal workers have contributed to inequality. In Serbia, introduced in several ECA countries (e.g., Bulgaria, the wage penalty contributed to rising inequality between Poland, Russia, and Romania). The flat tax reform in 2002 and 2007 (Krstic and Sanfey 2010). A similar wage Russia was followed by a decline in informal penalty in Turkey was found for less educated workers employment and informal activity, especially in the (Taymaz 2009). However, in some cases informal workers top income bracket (Slonimczyk 2012). A simulation have been found to earn a wage premium, e.g., in Russia, suggests that the Polish flat tax reform in 2004 could Romania, Tajikistan, and Ukraine (Lehmann and have led to a 48 percent increase in reported business Norberto 2018; Shehu and Nilsson 2014; Staneva and income and 25 percent higher tax revenue, despite a Arabsheibani 2014; Zahariev 2003). In those countries, lower average marginal tax rate (Kopczuk 2012). the informal wage premium may compensate for the lack However, flat tax structures can be regressive and need of social security and lower job security (Lehmann and to be balanced with poverty fighting initiatives. Norberto 2018; Marcouiller, de Castrilla and Woodruff • Preferential tax schemes. Certain preferential tax 1997).6 schemes for the self-employed and small firms can encourage movement away from the informal sector. Policy challenges One such scheme, indirect assessments of tax The impact of policies on informality can depend on liabilities, has been shown to encourage country characteristics such as labor market flexibility, entrepreneurship, help revenue collection from hard- efficiency of tax collection or control of corruption. This to-tax sectors, and ease the transition from informal to underscores the importance of ensuring that reform efforts formal work. However, such preferential schemes can are carefully tailored to country circumstances to avoid also encourage formal workers to pursue the unintended increases in informality. preferential status and may encourage firms to remain small (Packard et al. 2014). Labor market policies. The impact of labor market reforms on informality has been mixed in ECA, and • Shift from labor to other taxation. Shifting from labor appears to have depended on the types of the reform. In a income taxes, which constitute a wedge between cross-sectional study of ECA countries, more restrictive informal and formal employment, to less distorting employment protection legislation has been associated and more easily enforced taxes, such as value-added with a higher share of the informal economy (both in taxes and progressive real estate taxes, can shrink the terms of GDP and labor force; Fialová 2011; Lehmann informal economy (Packard , Koettl, and Montenegro and Muravyev 2009). In contrast, there was no robust 2012). association of informality with more generous • Subsidies. A formal employment subsidy, such as the unemployment benefits or higher minimum wages one introduced in Turkey, can increase the number of registered jobs by encouraging informal workers to 5 This is consistent with the finding that informally employed youth have lower job satisfaction relative to their peers with formal jobs (Shehu 7 On the one hand, higher labor tax rates encourage a move of labor and Nilsson 2014). into untaxed informal employment, especially for low-wage earners 6 Controlling for worker characteristics and selection bias, the absence (Koettl and Weber 2012). On the other hand, higher labor tax rates have of male-female wage differentials in the informal economy—in the in some cases been associated with a lower share of informal employment, presence of large differentials in the formal economy—has been because higher revenue allow governments to provide better public goods interpreted as sign of lesser gender discrimination in the informal that can only be accessed in formal employment (Fialová and Schneider economy than in the formal economy in Turkey (Tansel 2000). 2011, Friedman et al. 2000 ). 78 CHAPTER 2.2 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 2.2.1 Informality in Europe and Central Asia (continued) FIGURE 2.2.1.2 Correlates of informality in Europe and Central Asia Informality as a percentage of GDP in the eastern part of the region is higher than the western part of the region, in part reflecting differences in institutional quality. Employment informality tends to be higher in countries with larger agricultural sectors. A. Informality in output B. Institutional quality C. Labor market informality and agricultural employment Source: Elgin et al. (forthcoming), European Bank of Reconstruction and Development, World Bank. A-B. Data are from the latest year available, usually 2016. The western part of the region includes Central Europe (Bulgaria, Croatia, Hungary, Poland and Romania) and the Western Balkans (Albania, Bosnia and Herzegovina, Kosovo, the Former Yugoslav Republic of Macedonia, Montenegro, and Serbia), and Turkey. The eastern part of the region comprises Eastern Europe (Belarus, Moldova, and Ukraine), South Caucasus (Armenia, Azerbaijan and Georgia), Central Asia (Kazakhstan, Kyrgyz Republic, Tajikistan, Turkmenistan, and Uzbekistan) and Russia. A. Orange diamonds indicate subsample average and blue bars indicate one standard deviation range. C. Agricultural employment and self-employment are shares of employment in agriculture or share of self-employed in total employment. transition to formal employment as well as provide corruption has been associated with greater informal better social protection (Betcherman, Daysal, Pagés activity in Poland, Romania, and Slovakia (Johnson et al. 2010). 2000). Conversely, better control of corruption has reduced the extent of informal activities in the countries Control of corruption. Better governance and more that joined the European Union in the mid-2000s (Fialová effective tax authorities can reduce the size of the informal and Schneider 2011). economy and increase tax revenue. Bureaucratic Growth in Latin America and the Caribbean was disappointingly weak in 2018, at an estimated 0.6 percent, and notably lower than previously expected. This reflected the impact of Argentina’s currency crisis, a truckers’ strike and policy uncertainty in Brazil, and worsening conditions in Venezuela. Growth is expected to pick up to 1.7 percent in 2019, as growth accelerates in Brazil and the recession in Argentina begins to fade. Per capita growth in LAC is projected to pick up moderately, and to outpace that in advanced economies starting in 2020, after six years of stalled convergence. Downside risks continue to dominate. Key external risks include further tightening of external financial conditions and additional escalation of international trade policy uncertainty. The region also faces intraregional and domestic risks, such as spillovers from larger-than-expected growth contractions in Argentina and Venezuela and the persistent threat of natural disasters and extreme weather. Recent developments Commodity price developments are also affecting LAC economies. The decline in copper prices in Growth in Latin America and the Caribbean the second half of 2018 contributed to slowing (LAC) stalled at a subdued 0.6 percent in 2018, growth momentum in Chile and Peru, after a an substantially weaker than previously projected. acceleration in the first half. Rising oil prices The disappointing growth outcome reflected underpinned accelerating growth in oil-producing softening global trade growth and tighter external Colombia, while they were one factor that financing conditions. Developments in Argentina, inhibited growth in oil-importing Central America Brazil, and Venezuela hindered regional growth, in 2018, despite the decline in prices at the end of despite better performance in several mid-size the year. The Central American sub-region was economies (e.g., Chile, Colombia, Peru). Growth also affected by weak confidence in Costa Rica moderated in Central America, reflecting a variety and Panama, political uncertainty in Guatemala, of factors, while it strengthened in almost all and social unrest in Nicaragua. Caribbean economies as the subregion began to recover from a severe 2017 hurricane season. A long-awaited rebound in regional fixed investment that began in 2017 was significantly In Brazil, growth bounced back in the second half weaker in 2018 than previously expected, after of 2018, following a strike-induced dip around losing momentum in the first half of the year mid-year, but remains subdued. In Argentina, the (Figure 2.3.1). Export growth in the region was currency crisis and associated sharp tightening of also lower than expected, owing to the drought in monetary and fiscal policies, together with the Argentina and slowing global trade growth. effect of a severe drought on the agriculture sector, resulted in a contraction in activity. Venezuela’s Nearly all LAC economies with floating exchange economic collapse has deepened, and there is no rates have experienced nominal depreciation indication that the latest redenomination of the against the U.S. dollar, particularly Argentina, currency has had a major impact on ongoing Brazil, Chile, and Uruguay. The adjustment in hyperinflationary dynamics. effective terms has been more modest. In most of these economies, especially Argentina, Note: This section was prepared by Dana Vorisek. Research depreciation is contributing to a rise in inflation. assistance was provided by Brent Harrison. Recent interest-rate hikes (e.g., in Chile) were 80 CHAPTER 2.3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 2.3.1 LAC: Recent developments Stocker, and Yilmazkuday 2019). Central banks in Investment and export momentum in LAC have slowed. Rising U.S. interest several countries have intervened in foreign rates and weakening investor sentiment toward EMDEs has translated into exchange markets using derivative instruments to diminished capital inflows and rising bond spreads and credit default swap spreads in LAC, while a strengthening U.S. dollar is putting upward reduce currency volatility (e.g., Brazil, Uruguay) pressure on inflation in some countries. Fiscal deficits narrowed in most or to build reserves (e.g., Colombia). LAC countries in 2018, mainly reflecting higher revenues, but debt continues to build. External financing conditions have tightened. Against the backdrop of rising U.S. interest rates, A. Investment and export growth B. Exchange rates against the U.S. dollar U.S. dollar appreciation, and weaker investor sentiment toward EMDEs, the region has experienced a generalized rise in bond and credit default swap spreads and a fall in equity prices. Capital inflows, particularly bond flows, steadily diminished through the third quarter of 2018. Current account deficits have widened in most commodity-exporting and commodity-importing economies. Several Caribbean economies that were not significantly damaged by hurricanes in C. Inflation D. Bond spreads 2017, however, registered narrowing deficits or widening surpluses as a share of GDP in 2018 on strong tourism inflows and rising oil prices (e.g., The Bahamas, Belize, St. Vincent and the Grenadines, and Trinidad and Tobago). Fiscal conditions across the region remain fragile, and government debt continues to build. Fiscal deficits narrowed slightly in most countries in E. Gross capital inflows F. Fiscal balances and government 2018, however. The improvement mainly debt reflected higher revenues, in part stemming from rising prices of key commodities. The fiscal austerity program in Argentina will be challenging to implement but should improve long-term fiscal sustainability, while a recently legislated fiscal reform in Costa Rica will boost revenues and should improve investor sentiment. In Colombia, a proposed tax reform would boost revenues in order to comply with fiscal targets. A proposed tax Sources: Bloomberg, CPB Netherlands Bureau for Economic Policy Analysis, Dealogic, Haver Analytics, International Monetary Fund, World Bank. reform in Chile would integrate and streamline A. Investment growth is the GDP-weighted average of 15 economies, excluding Venezuela, that represent 93 percent of regional GDP. Investment for 2018Q3 is estimated using actual data for the tax system. economies representing 87 percent of regional GDP. Last observation is 2018Q3. B. Last observation is December 19, 2018. C. Lines show group averages. Above average and below average groups are delineated according to currency depreciation against the U.S. dollar between January 2, 2018 and November 1, 2018. Outlook Sample includes 17 economies, excluding Argentina and Venezuela, and excluding those with conventional currency pegs and currency boards and those using the U.S. dollar as their official currency. Last inflation observation is November 2018. D. LAC line shows median of 15 economies. Last observation is December 19, 2018. Regional growth is projected to advance to a still E. Last observation is November 2018. modest 1.7 percent in 2019, lower than previously F. Sample includes 32 economies. projected, and build to 2.5 percent in 2021 (Figure 2.3.2). The acceleration will be supported mainly by a pickup in private consumption. made partly in reaction to exchange rate pass- Investment growth will accelerate, though at a through to domestic inflation, despite falling pass- slower pace this year than previously expected, in through ratios observed over the long term (Ha, view of tight financing conditions and planned G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 LATIN AME RIC A AN D THE C ARIBBE AN 81 public spending reductions in a number of FIGURE 2.3.2 LAC: Outlook and risks countries. Decelerating global trade will limit Growth in LAC is projected to accelerate only moderately through 2021, export growth during the forecast period. and at a slower pace than previously expected. Risks to the regional outlook are predominantly to the downside. Further tightening of global financing conditions and escalation of trade tensions among major Although the prices of key non-oil commodities economies are key external risks. The region also faces intraregional and such as soybeans and copper are projected to domestic risks, such as spillovers from a larger-than-expected growth continue rising through the forecast period, contraction in Argentina or a worsening collapse in Venezuela, and unexpected disruptions from natural disasters and extreme weather. copper prices will increase at a much slower pace through 2021 than in 2017 and 2018. Oil prices A. Growth B. Commodity prices are projected to be flat, on average, during 2019- 21, at $67 per barrel, potentially limiting fiscal and export revenue increases in oil-producing economies. In Brazil, growth is expected to steadily build momentum in 2019, from a weak base. The forecast of 2.2 percent for this year assumes that fiscal reforms are implemented expeditiously under the incoming administration, and that a C. Debt D. Current account deficit less FDI recovery of consumption and investment, resulting from improving confidence and investor sentiment, will outweigh the negative growth effect of reduced government spending. In Mexico, policy uncertainty and the prospect of still subdued investment is expected to keep growth at a moderate 2.0 percent in 2019, despite the decrease in trade-related uncertainty following the announcement of the United States-Mexico- Canada Agreement. Argentina’s economy is E. Exposure to Argentina, 2017 F. Elections expected to continue contracting in 2019 as deep fiscal consolidation results in a loss of employment and reduction in consumption and investment, and as high interest rates place corporate balance sheets under stress and dampen private investment. By 2020, a strengthening recovery in Brazil, modestly accelerating growth in Mexico, and solid Sources: Bank for International Settlements, Comtrade, Haver Analytics, International Monetary performance in Chile, Colombia, and Peru, are Fund, World Bank. B. Lines show change in nominal prices. expected to help push regional growth to 2.4 C. Bars show data for 2007Q4, 2012Q4, and 2018Q2. F. Chart shows GDP of LAC countries holding presidential or parliamentary elections in a given year percent, consistent with potential. Per capita GDP as a share of regional GDP. An economy is counted only once when both types of elections occur in a single year. growth in the region is also expected to accelerate moderately, and to outpace per capita growth in advanced economies starting in 2020, after six years of stalled convergence. education attainment, reduce labor market Achieving sustained improvements in potential inflexibility, deepen trade integration, and address growth in the region over the medium term will the negative economic and social outcomes of require implementing reforms in several areas. informality, among other challenges (World Bank There is need to improve infrastructure and 2018l; Chapter 3; Box 2.3). 82 CHAPTER 2.3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 2018m).1 However, in the medium and long term, Risks inward migration to Colombia could result in a growth boost as a result of a larger labor supply Risks to the regional outlook remain tilted to the and higher consumption and investment. downside. The experience of Argentina in 2018 is a stark reminder of the risk of sudden and Poor fiscal conditions and slow progress in widespread shifts in investor sentiment. addressing of fiscal imbalances are downside risks, Tightening global financing conditions are a and may have negative repercussions for debt particular concern for countries with large current sustainability and market confidence. In account deficits or reliance on volatile capital Argentina, for instance, adherence to the fiscal inflows (e.g., Argentina, Bolivia, and several consolidation plan is key to a quick emergence Caribbean countries), with high external debt from the recent currency crisis. Plans to loads (e.g., Jamaica, Nicaragua, Venezuela), or implement fiscal reform in other countries (e.g., with sizable foreign-currency-denominated debt as Costa Rica) need to be carried out to retain a share of GDP (e.g., Costa Rica, Honduras, investor confidence. In Brazil, the new Nicaragua). administration needs to urgently make plans to reduce fiscal vulnerabilities arising from an Trade tensions are another key external risk. unsustainable pension system. Although trade diversion in response to rising trade restrictions in the United States and Canada Election-related risks, which generated may benefit some LAC economies in the short considerable uncertainty in countries such as term, continued trade tensions may dampen Brazil and Mexico in 2018, are expected to recede, regional growth in the medium term through given that the elections scheduled in the next two export, confidence, and commodity market years are in economies representing a much lower channels. share of regional GDP. However, it will be LAC economies also face intraregional and incumbent on some new governments to domestic sources of risk. Thus far, the recession in implement challenging policy reforms. Argentina has had limited spillovers on the rest of Unexpected disruptions related to natural disasters the region. But a larger-than-expected contraction and extreme weather represent a significant in Argentina could spill over to the rest of the ongoing risk. Hurricanes, floods, droughts, and region through trade and financial flows. Bolivia earthquakes have long had detrimental impacts on and Paraguay are most reliant on Argentina as a growth in several economies in the region in destination for goods exports and a source of recent years. The region remains highly vulnerable remittance inflows. Although Uruguay has to such events, underscoring the need to use risk diversified its trading partners in recent years, it instruments such as catastrophe bonds and remains reliant on Argentina for services export domestic and multi-country catastrophe risk revenues through tourism. Cross-border bank insurance funds (Végh et al. 2018). lending data for Latin American economies is patchy but suggests that Panama is most exposed, although with bank claims on Argentina still limited at approximately 0.6 percent of domestic GDP. Continued outward migration from Venezuela is producing spillovers elsewhere in the region. In Colombia, the cost of providing basic public services to migrants and Colombian returnees at levels similar to those delivered to the local 1 Calculations of the cost of public services are made using the population is an estimated 0.2–0.4 percent of number of migrants and returnees in Colombia as of September GDP per year in the short term (World Bank 2018. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 LATIN AME RIC A AN D THE C ARIBBE AN 83 TABLE 2.3.1 Latin America and the Caribbean forecast summary (Real GDP growth at market prices in percent, unless indicated otherwise) Percentage point differences from June 2018 projections 2016 2017 2018e 2019f 2020f 2021f 2018e 2019f 2020f EMDE LAC, GDP1 -1.5 0.8 0.6 1.7 2.4 2.5 -1.1 -0.6 -0.1 (Average including countries with full national accounts and balance of payments data only) 2 EMDE LAC, GDP2 -1.4 0.8 0.6 1.7 2.4 2.5 -1.1 -0.6 -0.1 GDP per capita (U.S. dollars) -2.5 -0.2 -0.4 0.7 1.4 1.5 -1.1 -0.6 -0.1 PPP GDP -0.8 1.2 0.9 1.8 2.5 2.6 -1.0 -0.6 -0.1 Private consumption -1.6 1.6 0.5 1.8 2.7 2.8 -1.6 -0.7 0.0 Public consumption 0.1 -0.7 0.1 -0.1 0.1 0.4 0.3 -0.3 -0.6 Fixed investment -7.0 -0.6 1.4 2.1 4.8 4.6 -2.3 -1.9 0.2 Exports, GNFS 3 1.2 2.4 3.3 4.0 3.6 3.6 0.1 0.3 -0.3 Imports, GNFS3 -3.1 5.2 2.7 3.7 4.8 4.9 -1.6 -0.4 0.2 Net exports, contribution to growth 0.9 -0.6 0.2 0.1 -0.2 -0.3 0.4 0.2 0.0 Memo items: GDP South America4 -3.1 0.3 -0.1 1.4 2.3 2.4 -1.4 -0.7 0.0 Central America5 3.9 3.8 2.7 3.4 3.5 3.6 -1.0 -0.5 -0.4 Caribbean6 4.4 3.4 4.4 4.0 4.0 3.8 0.9 0.5 0.2 Brazil -3.3 1.1 1.2 2.2 2.4 2.4 -1.2 -0.3 0.0 Mexico 2.9 2.1 2.1 2.0 2.4 2.4 -0.2 -0.5 -0.3 Argentina -1.8 2.9 -2.8 -1.7 2.7 3.1 -4.5 -3.5 -0.1 Source: World Bank. Note: e = estimate; f = forecast. EMDE = emerging market and developing economy. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not differ at any given moment in time. 1. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. 2. Aggregate includes all countries in notes 4, 5, and 6, and Mexico, except those for which data limitations prevent the forecasting of demand-side GDP components: Dominica, Grenada, Guyana, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, Suriname, and Trinidad and Tobago. 3. Exports and imports of goods and non-factor services (GNFS). 4. Includes Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Paraguay, Peru, Uruguay, and Venezuela. 5. Includes Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, and Panama. 6. Includes Antigua and Barbuda, The Bahamas, Barbados, Belize, Dominica, Dominican Republic, Grenada, Guyana, Haiti, Jamaica, Suriname, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, and Trinidad and Tobago. To download this data, please visit www.worldbank.org/gep. 84 CHAPTER 2.3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 TABLE 2.3.2 Latin America and the Caribbean country forecasts1 (Real GDP growth at market prices in percent, unless indicated otherwise) Percentage point differences from June 2018 projections 2016 2017 2018e 2019f 2020f 2021f 2018e 2019f 2020f Argentina -1.8 2.9 -2.8 -1.7 2.7 3.1 -4.5 -3.5 -0.1 Belize -0.5 1.2 1.5 1.9 1.7 1.7 -0.5 0.0 0.0 Bolivia 4.3 4.2 4.5 4.3 3.8 3.4 0.6 0.7 0.4 Brazil -3.3 1.1 1.2 2.2 2.4 2.4 -1.2 -0.3 0.0 Chile 1.3 1.5 3.9 3.5 3.3 3.2 0.6 0.1 -0.2 Colombia 2.0 1.8 2.7 3.3 3.7 3.6 0.0 0.0 0.1 Costa Rica 4.2 3.3 2.7 2.7 2.8 3.0 -0.7 -0.9 -0.8 Dominican Republic 6.6 4.6 5.8 5.1 5.0 4.8 0.8 0.4 0.4 Ecuador -1.2 2.4 1.0 0.7 0.7 1.2 -1.2 -0.8 -0.2 El Salvador 2.6 2.3 2.8 2.5 2.4 2.4 0.5 0.3 0.2 Grenada 3.7 5.1 5.2 4.2 2.8 2.8 1.9 1.4 0.0 Guatemala 3.1 2.8 2.7 2.9 3.0 3.1 -0.4 -0.4 -0.3 Guyana 2.6 2.1 3.4 4.6 30.0 24.8 -0.4 0.8 1.0 Haiti 2 1.5 1.2 1.6 2.3 2.4 2.5 -0.2 -0.1 0.0 Honduras 3.8 4.8 3.6 3.8 3.8 3.7 0.1 0.2 0.0 Jamaica 1.4 1.0 1.7 1.8 2.0 2.0 0.0 -0.1 0.0 Mexico 2.9 2.1 2.1 2.0 2.4 2.4 -0.2 -0.5 -0.3 Nicaragua 4.7 4.9 -3.8 -0.5 2.6 3.6 -8.5 -5.0 -1.8 Panama 5.0 5.3 4.0 6.0 5.4 5.2 -1.6 0.4 -0.2 Paraguay 4.3 5.0 4.0 3.9 4.0 4.0 -0.3 -0.3 -0.2 Peru 4.0 2.5 3.9 3.8 3.8 3.7 0.4 0.0 0.0 St. Lucia 3.4 3.8 1.5 2.7 2.8 2.3 -1.3 0.4 0.5 St. Vincent and the Grenadines 1.3 0.5 1.2 1.6 1.6 2.0 -0.9 -0.9 -1.1 Suriname -5.6 1.7 1.4 1.6 1.8 1.9 0.3 -0.1 -0.3 Trinidad and Tobago -6.1 -2.6 1.0 0.9 1.2 1.2 -0.6 -1.0 0.0 Uruguay 1.7 2.7 2.1 2.1 2.3 2.5 -1.2 -1.0 -0.6 Venezuela -16.5 -14.5 -18.0 -8.0 -5.0 -4.0 -3.7 -1.0 -1.0 Source: World Bank. Note: e = estimate; f = forecast. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not significantly differ at any given moment in time. 1. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. 2. GDP is based on fiscal year, which runs from October to September of next year. To download this data, please visit www.worldbank.org/gep. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 LATIN AME RIC A AN D THE C ARIBBE AN 85 BOX 2.3.1 Informality in Latin America and the Caribbean Informal sector output in Latin America and the Caribbean, equivalent to about one-third of GDP, is slightly higher than in the median emerging market and developing economy, despite a steady decline during recent decades. Roughly six out of ten of those employed in the region are employed informally. Informality has been associated with lower growth, weaker productivity, and higher levels of inequality. Policies to reduce payroll taxes and increase labor inspections have been found to reduce informality. Introduction employment as a share of formal employment tends to be very low: 12 percent in Suriname (2014), 14 percent in Informality in Latin America and the Caribbean (LAC) The Bahamas (2011), and 17 percent in Barbados (2013). during the past decade was slightly higher than in the Again, Bolivia appears at the top end of the spectrum, with median emerging market and developing economy self-employment equivalent to 64 percent of formal (EMDE), whether measured in terms of informal output employment in 2015. In most countries, labor informality or the share of self-employment (Figure 2.3.1.1; Box 3.2). is higher than output informality, although Brazil, Yet there is substantial heterogeneity in the incidence of Guatemala, and several Caribbean countries are informality within the region. Informality tends to be exceptions. higher in countries with poorer institutional environments. Trend decline in output informality. Output informality Against this backdrop, this box addresses the following in the region has steadily declined since the early 2000s questions: (Figure 2.3.1.2). Several of the countries with the highest incidence of output informality (e.g., Bolivia, Panama, • How has informality evolved in Latin America and Peru) have also experienced some of the largest declines the Caribbean? during the past two decades, in part due to rapid formal job creation in the context of strong output growth. Yet • What have been the macroeconomic and social even where labor informality has fallen, the decline did not correlates of informality? necessarily affect all workers equally. In Argentina and • What policy options are available to address Brazil, two of the largest economies in LAC, middle-aged challenges associated with informality? men, the highly skilled, and those working full time were the most likely to shift from informal to formal Evolution and drivers of informality employment during the 2000s (Maurizio 2015). Moreover, the decline in output informality has not always Moderate informality. On average, the informal economy been accompanied by a similar decline in labor in LAC was equivalent to 34 percent of official GDP in informality, which has been persistently high in countries 2016, slightly above the median EMDE.1 Informal such as Bolivia, Colombia, Honduras, Jamaica, Nicaragua, employment averaged 62 percent of total employment in and Peru. 2016 (slightly below the EMDE median), while 38 percent of those employed were self-employed. Within the Correlates of informality region, informality varies considerably. Informality has been associated with weak institutions and Regional heterogeneity. The amount of output generated business climates as well as poor macroeconomic, by the informal sector (output informality) ranged from microeconomic, and social outcomes in LAC. These 16 percent of GDP in Chile, in line with rates observed in include lower output and productivity growth, weaker advanced economies, to 56 percent in Bolivia. Haiti also financial resilience of households, and greater poverty. has very high informality, at 61 percent of GDP.2 Survey- based measures of labor informality show a similarly wide Weak governance and business climates. Most of the range. For Caribbean countries with available data, self- institutional factors associated with informality are at or slightly above the EMDE average in LAC. However, LAC economies with below-average institutional quality have Note: This box was prepared by Dana Vorisek. Research assistance was also tended to be those with high informality. For provided by Brent Harrison and Jinxin Wu. instance, Peru’s higher labor informality compared to 1 Output informality based on DGE estimates of Elgin and Oztunali (2014), unless otherwise specified. 2 For lack of data on DGE estimates, this figure refers to MIMIC 3 Dougherty and Escobar (2013); Estevão and de Carvalho Filho estimates (Chapter 3). DGE and MIMIC estimates are similar at the (2012); Loayza (1997); Loayza, Servén, and Sugawara (2010); Vuletin country level. (2008). 86 CHAPTER 2.3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 2.3.1 Informality in Latin America and the Caribbean (continued) FIGURE 2.3.1.1 Informality in Latin America and the Caribbean Output-based informality in LAC has fallen since the 1990s, on average, yet remains above the median in EMDEs. Employ- ment-based informality in the region has risen slightly, to about the EMDE median. The key institutional factors that are often associated with informality, other than the difficulty of paying taxes, are slightly better in LAC than in all EMDEs. A. Informal activity as share of total B. Share of self-employed; perceived C. Institutional quality economic output informal activity Sources: Elgin et al. (forthcoming), Eurostat; Haver Analytics, Inter-American Development Bank, national statistical bureaus and offices, Organisation for Economic Co- operation and Development, World Bank (Doing Business, World Development Indicators, and World Governance Indicators). A.-C. Blue bars show simple averages of economies in the region. Red markers show the median of all EMDEs. Vertical lines denote interquartile range of all EMDEs. A. DGE = dynamic general equilibrium model. MIMIC = multiple indicators multiple causes model. The DGE model estimates the size of the informal sector as a percent of official GDP (see Elgin and Oztunali 2012). The MIMIC model is a structural equations model that considers multiple causes of informal activity and captures multiple outcome indicators of informal activity (see Schneider, Buehn, and Montenegro 2010). It also estimates the informal output as a percent of official GDP. DGE sample includes 26 LAC economies and 122 EMDEs; MIMIC sample includes 25 LAC economies and 124 EMDEs. B. Self-employed is the presented as the share of self-employment in total employment. WEF = World Economic Forum. WEF index is the average response at the country-year level to the question: “In your country, how much economic activity do you estimate to be undeclared or unregistered? (1 = Most economic activity is undeclared or unregistered; 7 = Most economic activity is declared or registered).” WEF index is inverted; a higher average at the country level indicates a larger informal economy. The index does not use data for 2004–05 due to inconsistency in survey methods. The WVS asks whether respondents can justify cheating on taxes (1 = never justifiable; 10 = always justifiable). The average responses at the country-year level are used as a measure of attitude toward informality (or tax morality; Oviedo, Thomas, and Karakurum-Ozdemir 2009). Self-employed sample includes 32 LAC economies and 134 EMDEs; WEF sample includes 25 LAC economies and 114 EMDEs. C. All measures are taken from the latest year available. The first three institutional measures are taken from World Bank’s World Governance Indicators (2017), with a higher value indicating better institutional quality in 2016. The “ease of doing business” and “ease of paying taxes” are taken from World Bank’s Doing Business database and measured as distance to frontier, with a higher value indicating a more favorable business environment. Sample includes 32 LAC economies and 149 EMDEs. Chile has been mostly attributed to poor governance the association between trade liberalization and informality (Loayza and Wada 2010a). One of the most common was ambiguous in the early literature (Bosch, Goñi- explanations for informality in LAC countries has been Pacchioni, and Maloney 2012; Goldberg and Pavcnik restrictive business and labor regulations, which discourage 2003; Menezes-Filho and Muendler 2011). However, firms from entering the formal sector.3 recent research has established that trade liberalization was followed by increased informality in Brazil, though only in High tax burdens. High tax rates or burdensome tax the long run (Dix-Carneiro and Kovak 2017; Dix- regulations have also encouraged informality in the region Carneiro et al. 2018). In Colombia, trade liberalization (Loayza 1997; Ordóñez 2014; Vuletin 2008). Both was associated with slightly higher informality, yet only corporate and personal income tax rates tend to be higher prior to a subsequent reform that increased labor market in LAC than in the average EMDE—indeed, LAC is the flexibility (Goldberg and Pavcnik 2003). only EMDE region where the average personal income tax rate has risen since the early 2000s. Sectoral and worker characteristics. Informality has been shown to be higher in the presence of large agricultural Trade liberalization amid inflexible labor markets. Some sectors. Other structural factors, such as poor education instances of trade liberalization have also been associated and skills, have also been identified as underlying reasons with rising informality in LAC. The reduction of trade for labor informality (Fernandez and Villar 2016). In some barriers in the 1980s and 1990s led to fears that domestic LAC countries, a considerable share of people working firms in the formal sector would be rendered informally entered the informal sector voluntarily. uncompetitive and shift to the informal sector. In Brazil, Switching between the formal and informal sectors has G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 LATIN AME RIC A AN D THE C ARIBBE AN 87 BOX 2.3.1 Informality in Latin America and the Caribbean (continued) FIGURE 2.3.1.2 Evolution and correlates of informality in Latin America and the Caribbean Although output-based informality in LAC has fallen, the incidence of informality still varies considerably within the region. In LAC economies where corruption and the burden of paying taxes is high, output-based informality tends to be high. Self- employment tends to be high where labor market efficiency is low. Both corporate and personal income tax rates are higher in LAC than in all EMDEs. A. DGE-based informal activity B. DGE-based informal activity, by C. DGE-based informal activity country D. DGE-based informal activity E. Self-employment F. Average tax rates Source: Elgin et al. (forthcoming), Haver Analytics, Inter-American Development Bank, national statistical bureaus and offices, Organisation for Economic Co-operation and Development, Végh and Vuletin (2015), World Bank (Doing Business, World Development Indicators, and World Governance Indicators), World Economic Forum (Global Competitiveness Index). A. Sample includes 23 economies. The median of the MIMIC-based estimate of informality shows a similar downward trend. B. CHL = Chile, ARG= Argentina, CRI= Costa Rica, BRB = Barbados, BHS = The Bahamas, ECU = Ecuador, MEX = Mexico, DOM = Dominican Republic, COL = Colombia, JAM = Jamaica, SUR = Suriname, BRA = Brazil, PRY = Paraguay, NIC = Nicaragua, SLV = El Salvador, BLZ = Belize, URY = Uruguay, HND = Honduras, PER = Peru, GTM = Guatemala, PAN = Panama, BOL = Bolivia. C. Bars show medians. Sample includes 21 LAC economies. D. Bars show medians. Sample includes 20 LAC economies. Tax burden is measured as the ease of paying taxes in the World Bank’s Doing Business indicators. E. Bars show medians. Sample includes 16 LAC economies. F. Corporate tax rate sample includes 17 LAC economies and 49 EMDEs; personal tax rate sample includes 17 LAC economies and 47 EMDEs. been common in the largest economies in the region less conclusive. In Mexico, for instance, informality has (Bosch and Maloney 2010; Fiess, Fugazza, and Maloney been accompanied by slowing growth, yet in Brazil, falling 2008; Perry et al. 2007). This may reflect a higher regard informality may not be associated with higher GDP (Levy for self-employment in LAC relative to other regions, or a 2008; Ulyssea 2018). response to adverse employment and income shocks in the formal sector. Lower productivity growth. The informality literature on LAC has established a link between informality and Lower output growth. In studies of a large number of aggregate productivity (Loayza, Servén, and Sugawara LAC economies, informality has been negatively associated 2010). Linkages between informality and productivity with growth, even after controlling for country have also been identified at the firm level. Informal firms characteristics (Loayza 1997; Loayza, Servén, and in Brazil, for instance, have been less productive than Sugawara 2010). However, studies at the country level are formal firms (de Paula and Scheinkman 2011). In 88 CHAPTER 2.3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 2.3.1 Informality in Latin America and the Caribbean (continued) Paraguay, not only are informal firms less productive, but Indeed, a large reduction in payroll tax rates in Colombia their low productivity has had negative spillovers to formal in 2012 reduced labor informality in the main firms (Vargas 2015). metropolitan areas by about 7 percentages points (Fernandez and Villar 2016). e results of Brazil’s Lower savings and access to finance for households and reduction and simpli cation of business taxes in 1996 have firms. For workers and firms, there are negative financial been more ambiguous. Early studies found that the reform implications of informality. Informal workers in Chile, for was associated with a signi cant increase in the incidence instance, have not been able to save as much as formal of formal rms, and that newly formalized rms achieved workers, and have had less access to finance than formal higher revenue and pro ts than those operating informally, firms (Schlcarek and Caggia 2015). In Brazil, poor access although the impact of the reform on informality varied to finance was the key reason for informal firms being across economic sectors (Fajnzylber, Maloney, and Montes small and unproductive: their cost of capital was at least -Rojas 2011; Monteiro and Assuncão 2012). Recent 1.3 times that of formal firms (de Paula and Scheinkman studies have found no evidence of increased formalization 2011). Similarly, in Ecuador, lower productivity and as a result of the reform (e.g., Piza 2016). profitability in informal firms was due in part to worse access to credit (Medvedev and Oviedo 2013). Across the Labor market regulation. Tighter labor inspections have region, rising informality has been associated with lower been effective in reducing informality in the region, pension contributions (Vuletin 2008). through a variety of mechanisms. In Brazil, tighter enforcement of labor market regulations raised wages and Higher poverty and inequality. Informality in LAC has output by improving the allocation of workers between the also been associated with inequality and poverty, in part formal and informal sectors (Meghir, Narita, and Robin reflecting the wage gap between the informal and formal 2015). More frequent labor inspections in Brazil also sectors. In Argentina, past poverty has been associated with induced some informal workers to become formal, albeit current informal employment, and past informality has due to wage rigidity in the formal sector (Almeida and been associated with current poverty (Devicienti, Carneiro 2012). Inspections were also more effective than Groisman, and Poggi 2015). The process of increasing incentives in convincing firms in Brazil to operate in the formal-sector employment contributed significantly to the formal sector (de Andrade, Bruhn, and McKenzie 2013). decline in inequality in Argentina and Uruguay during the 2000s (Aramante, Arim, and Yapor 2016; Beccaria, Other regulations. Policy reforms intended to ease barriers Maurizio, and Vazquez 2015). In Colombia, informal to entering the formal sector have had diverse outcomes. workers received lower wages than formal workers due not A reform that simplified the process of opening a business only to lower returns to their education, but also to in Mexico was successful in increasing the number educational mismatches (Herrera-Idárraga, López-Bazo, of registered businesses (Bruhn 2011; Kaplan, Piedra, and and Motellón 2015). Seira 2011). However, the reform had no impact on informality: the owners of the new businesses were former Policy options employees of formal firms, rather than informal workers. Financial deepening contributed to a reduction in Designing policies to address informality requires an informality in Uruguay, particularly for women and older understanding of its causes and characteristics. These vary workers (Gandelman and Rasteletti 2016). Finally, considerably, even within individual countries in LAC the emerging “gig” economy presents unique policy (Fernandez and Villar 2016; Perry et al. 2007). challenges that may require regulatory changes to smooth Tax system. Making tax policy less restrictive, by lowering economic risks for “gig” workers (World Bank 2014b, tax rates or simplifying tax systems, could incentivize firms 2016c, and 2018n). to become formal and increase demand for formal workers. Growth in the Middle East and North Africa is expected to follow a recovery in 2018 and rise slightly to 1.9 percent in 2019, supported by improvements in both oil exporters and oil importers. Rising investment and easing fiscal consolidation are supporting the recovery of some oil exporters, while oil importers continue to benefit from policy reforms. Regional growth is projected to reach 2.7 percent in 2020, as domestic demand remains generally resilient. Risks are tilted to the downside, including the possibility that activity will be constrained by intensified geopolitical tensions, stronger external trade headwinds, abrupt tightening of global financing conditions, and slower-than-expected reform pace. production and prices have eased the pressure for Recent developments fiscal consolidation, enabled higher public spending, and supported higher current account Growth in the Middle East and North Africa balances. Non-oil sector activity in the GCC has (MENA) region is estimated to have improved to largely been stable. Among non-GCC oil 1.7 percent in 2018, rebounding from a sharp exporters, activity in Iran has been severely deceleration a year earlier driven by oil production affected by U.S. sanctions and has been a cuts in oil exporters and fiscal tightening (Figure significant drag on oil exporters’ and regional 2.4.1).1 Growth among oil importers has picked growth. Growth in other non-GCC oil exporters up in the past two years and continues to garner has been supported by public spending and positive momentum. Although positive spillovers investment. to the region via external demand are softening amid weaker global economic prospects, domestic Among oil importers, growth has been steadily factors continue to support growth. These include improving as reforms proceed. In Egypt, the generally resilient domestic demand and policy largest country in this group, tourism and natural reforms that are helping the region’s transition gas activity have continued to show strength. Its away from dependence on commodity exports and unemployment rate has generally fallen, and the public sector. policy reforms have contributed to an upgrade of its sovereign rating in August 2018. Fiscal Growth in oil exporters is estimated to have adjustments in Egypt have also been steadily recovered further in 2018. In the Gulf progressing. More generally, robust agricultural Cooperation Council (GCC), increased oil production and tourism have helped support growth of the oil importers in the region, Note: This section was prepared by Lei Sandy Ye. Research especially Morocco and Tunisia. However, while assistance was provided by Mengyi Li. international reserves have strengthened in Egypt, 1 The World Bank’s Middle East and North Africa aggregate includes 16 economies and is grouped into three subregions. Bahrain, they have declined in other oil importers amid Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates higher external vulnerabilities. Policy reforms in comprise the Gulf Cooperation Council (GCC); all are oil exporters. oil importers have helped promote innovation Other oil exporters in the region are Algeria, the Islamic Republic of Iran, and Iraq. Oil importers in the region are Djibouti, the Arab capacity among firms, but the scope for Republic of Egypt, Jordan, Lebanon, Morocco, Tunisia, and West improvement remains large, given fundamental Bank and Gaza. Syrian Arab Republic, the Republic of Yemen, and challenges like the quality of electricity supply that Libya are excluded from regional growth aggregates due to data limitations. hinder the potential for private sector dynamism 90 CHAPTER 2.4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 2.4.1 MENA: Recent developments (Arezki et al. 2018). These reforms also address Growth in the MENA region is estimated to have improved to 1.7 percent in challenges in the labor market, including high 2018, supported by increased oil production and eased fiscal stance in the youth unemployment (Purfield et al. 2018; GCC. Growth among oil importers has been supported by policy reforms, Schiffbauer et al. 2015). contributing to greater capacity to innovate. The region continues to tackle long-term challenges, such as high youth unemployment and electricity access, through structural adjustment programs. Inflation has been volatile Headline inflation in Egypt remains near its end- in Egypt and Iran, but remains generally stable in the region. High public 2018 target level of 13 percent, despite edging up debt is a significant headwind to growth for oil importers. recently. Core inflation has been contained and the central bank has conducted two policy rate A. Growth B. Oil production: GCC cuts in 2018, despite tighter external financing conditions. In Iran, inflation rose sharply in the second half of 2018, partly reflecting the depreciation of the rial in the parallel market relative to early 2018. Inflation is generally contained across the rest of the MENA region, averaging less than 3 percent in the GCC, and rising moderately in smaller oil importers. C. Innovation capacity and electricity D. Youth unemployment: non-GCC Bond issuance across the region, particularly in the access: Oil importers GCC, was robust at the start of 2018, but slowed around mid-year amid tighter external financing conditions and rising investor risk aversion. Although international financing conditions have become less favorable, investor confidence in the region were supported by efforts by GCC countries to diversify their economies as well as their recent inclusion in the MSCI Emerging Markets Index (Saudi Arabia) or JP Morgan EMBI bond indexes (5 GCC economies). These E. Inflation F. Public debt positions developments kept the region somewhat insulated from the turmoil affecting many emerging markets and developing economies (EMDEs) in the second half of 2018. Outlook GDP growth is projected to rise slightly to 1.9 Source: Bank for International Settlements, Haver Analytics, International Energy Agency, percent in 2019 and pick up to 2.7 percent later in International Monetary Fund, World Bank, World Economic Forum. A. Weighted average growth rates of real GDP. Gray denotes forecasts. the forecast horizon. Both oil exporters and oil B. Sum of production in Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the UAE. Oil price denotes importers will show steady growth improvement average of Brent, Dubai, and WTI. C. Based on World Economic Forum surveys. “Capacity for Innovation” denotes response to the over the forecast period. Despite the headwinds question: “In your country, to what extent do companies have the capacity to innovate? [1 = not at all; 7 = to a great extent].” “Quality of Electricity Supply” denotes response to the question “In your from a less favorable international economic country, how reliable is the electricity supply (lack of interruptions and lack of voltage fluctuations)? [1 = extremely unreliable; 7 = extremely reliable].” Unweighted averages. Years denoted refer to edition environment, which is expected to be marked by year of data. Includes 5 oil importers. slower global trade growth and tighter external D. Youth unemployment as a percent of youth labor force (age 15-24). Includes 10 MENA economies. Unweighted averages. Based on 2017 data. financing conditions, domestic factors—in E. Monthly year-on-year growth rates of CPI inflation. Last observation is October 2018. F. General government debt as a ratio to GDP. 2018 data are estimates. Unweighted averages. particular, policy reforms—continue to bolster Includes 6 GCC economies, 3 non-GCC oil exporters, and 6 oil importers. growth in the region. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 MIDDLE EAST AND NORTH AFRICA 91 Among oil exporters, growth in 2019 is expected FIGURE 2.4.2 MENA: Outlook and risks to improve slightly, supported by continued Heightened geopolitical tensions have been associated with volatile strengthening in the GCC that is partly offset by sovereign default spreads and may amplify fragile economies’ significant weakness among the large non-GCC oil exporters. income losses. Trade disputes involving major economies may weigh on external demand of both oil exporters and importers, while a more abrupt- Higher investment and improved regulatory than-expected tightening of global financing costs may raise external debt environments are expected to support higher vulnerabilities, especially if accompanied by sharp dollar appreciation. growth in GCC economies. Over the medium term, growth among the GCC economies will A. Sovereign default spreads B. Per capita income: fragile economies remain steady, underpinned by planned diversification programs, infrastructure projects, and medium-term reform plans (World Bank 2018o, 2018p). Outside of the GCC, activity in Iran is expected to contract as U.S. sanctions bite. Algeria’s growth is projected to moderate after its budgeted strong increase in government spending in 2018 tapers. Among oil importers, growth is forecast to rise C. Export exposure D. External debt: oil importers further, led by improvements among the larger economies. Investment will be further supported by reforms that strengthen the business climate and a pickup in domestic demand (World Bank 2018q). Tourism is envisioned to continue supporting activity in Egypt, Morocco, and Tunisia. Positive spillovers via external demand in the Euro Area are likely to taper somewhat amid the area’s weaker growth prospects. While smaller oil importers’ growth is envisioned to pick up Source: Haver Analytics, International Monetary Fund, World Bank. A. Denotes 5 Year USD Credit Default Swap Par Mid Rate. Oil importers include 4 economies. Oil slightly, these economies continue to grapple with exporters include 6 economies. Three month-rolling unweighted averages. UAE denotes average of Abu Dhabi and Dubai. elevated public debt, and in some cases, the B. Estimated per capita income in thousands of US dollars. Data not available for Syria. C. Share of goods exports to respective economies denoted as a ratio to each country group’s total challenges associated with the ongoing refugee exports. Denotes latest available data in 2017. Includes 6 GCC economies, 3 non-GCC oil exporters, crisis. and 7 oil importers. D. Unweighted averages. 2018 data are estimates. Includes 6 oil importers. Medium-term growth forecasts for the MENA region are predicated on the assumption that there 2014b). Multilateral efforts to promote rural will not be a significant escalation of geopolitical transportation, electricity access, and private sector conflicts and that there will be limited regional financing (e.g., Gaza Solar Fund, Compact with spillovers from conflict-ridden economies. Africa) are likely to enhance the business climate. Continued IMF and World Bank programs in Collectively, policy reforms across the region are many economies (e.g., Egypt, Morocco) are expected to improve growth potential in the expected to provide a basis for needed structural medium term. adjustments (e.g., stronger fiscal management frameworks, higher public infrastructure quality), Risks as well as steps to address the vulnerabilities associated with the informal sector (Chapter 3; Risks to the regional outlook are tilted to the Box 2.4.1). Financial reforms—such as newly downside. A diverse range of geopolitical risks approved bankruptcy laws in Egypt, Saudi Arabia, have been associated with volatile sovereign and the United Arab Emirates—should help default spreads in both oil exporters and importers relieve financial constraints in the corporate sector (Figure 2.4.2). New conflicts in fragile economies and support investor confidence (World Bank illustrate the potential for an escalation of military 92 CHAPTER 2.4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 conflicts to inflict even greater damage to incomes with the gradual nature of advanced economy and economic activity (Devarajan and Mottaghi monetary policy normalization, the dampening 2017). These conflicts may also diminish access to effect on borrowing costs and non-oil activity health and water services in fragile economies, as associated with higher interest rates have so far well as compound the impact of the refugee crisis been modest. However, a more abrupt tightening on host and origin economies. Regional conflicts of advanced economy monetary policy could could also deter tourism, foreign direct weigh on capital flows to the region and dampen investment, and remittances. A substantial further foreign investor confidence in large GCC escalation of U.S.-Iran tensions could have adverse economies, which had recently relaxed foreign spillovers to the rest of the region.2 Geopolitical investment restrictions (World Bank 2018p). factors, as well as uncertainty in oil production in High external debt denominated in foreign response to these factors, could trigger volatility in currency in some oil importers implies that they oil prices. Together, these could complicate or stall are also vulnerable to unexpected sharp fiscal and current account adjustments in both oil appreciation of the U.S. dollar. exporters and importers. Post-election political uncertainty in some Escalating global trade tensions may negatively economies delayed the formation of new impact the MENA region. Although direct trade governments. This may slow the pace of reforms. exposure with the United States is low, the region Several oil importers also depend on IMF/WB is tightly interconnected to the European Union multi-year fiscal adjustments programs, which and, to a lesser degree, China. A further rise of hinge on progress in the pace of reforms. Potential trade tensions could weigh heavily on the demand delays in reforms may also be reflected in some oil for exports from the MENA region (World Bank exporters through inefficiencies in management of 2016a). This risk may be slightly mitigated by contingent liabilities and large investment deeper trade integration across regional neighbors projects. (e.g., Djibouti-Ethiopia). On the upside, rising reconstruction spending in Abrupt tightening of global financing conditions conflict affected economies (e.g., Iraq) may have may affect both oil exporters and importers. positive spillovers to neighboring economies, Interest rates in GCC economies have moved supporting higher investment in physical broadly in tandem with advanced economies’ infrastructure as well as soft infrastructure (e.g., policy rates, especially that of the U.S., and their broadband internet, mobile telephony) (Arezki et net external assets positions are strong. Combined al. 2018). 2 The current sanctions feature waivers from eight economies that import oil from Iran, as well as proposed Special Purpose Vehicles designed by the EU to facilitate transactions with Iran. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 MIDDLE EAST AND NORTH AFRICA 93 TABLE 2.4.1 Middle East and North Africa forecast summary Percentage point differences (Real GDP growth at market prices in percent, unless indicated otherwise) from June 2018 projections 2016 2017 2018e 2019f 2020f 2021f 2018e 2019f 2020f EMDE MENA, GDP 1 5.1 1.2 1.7 1.9 2.7 2.7 -1.3 -1.4 -0.5 (Average including countries with full national accounts and balance of payments data only)2 EMDE MENA, GDP2 4.8 1.4 1.7 1.6 2.7 2.7 -1.3 -1.7 -0.6 GDP per capita (U.S. dollars) 3.0 -0.3 0.1 0.1 1.3 1.4 -1.3 -1.7 -0.6 PPP GDP 5.1 1.7 1.8 1.6 2.8 2.8 -1.4 -1.8 -0.7 Private consumption 2.8 2.2 1.5 1.6 2.3 2.3 -1.9 -1.9 -1.2 Public consumption -6.3 2.3 3.4 1.1 1.9 1.9 2.1 -0.3 0.3 Fixed investment -2.0 1.0 2.8 3.6 4.7 4.8 -2.3 0.0 -0.1 Exports, GNFS3 8.5 2.9 1.9 1.8 3.4 3.4 -1.8 -2.3 -0.6 Imports, GNFS3 -1.2 5.1 1.3 1.9 3.1 3.1 -2.4 -1.2 -0.3 Net exports, contribution to growth 4.2 -0.4 0.5 0.2 0.5 0.5 0.0 -0.7 -0.3 Memo items: GDP Oil exporters4 5.6 0.6 1.2 1.4 2.3 2.3 -1.5 -1.7 -0.6 GCC countries5 2.4 -0.3 2.0 2.6 2.7 2.7 -0.1 -0.1 0.0 Saudi Arabia 1.7 -0.9 2.0 2.1 2.2 2.2 0.2 0.0 -0.1 Iran 13.4 3.8 -1.5 -3.6 1.1 1.1 -5.6 -7.7 -3.1 Oil importers 6 2.9 3.9 4.1 4.2 4.6 4.7 0.1 -0.2 0.0 Egypt 4.3 4.7 5.5 5.7 5.9 6.0 0.2 0.0 0.1 Fiscal year basis 7 4.3 4.2 5.3 5.6 5.8 6.0 0.3 0.1 0.0 Source: World Bank. Note: e = estimate; f = forecast. EMDE = emerging market and developing economy. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not differ at any given moment in time. 1. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. Excludes Libya, Syria, and Yemen due to data limitations. 2. Aggregate includes all countries in notes 4 and 6 except Djibouti, Iraq, Qatar, and West Bank and Gaza, for which data limitations prevent the forecasting of GDP components. 3. Exports and imports of goods and non-factor services (GNFS). 4. Oil exporters include Algeria, Bahrain, Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates. 5. The Gulf Cooperation Council (GCC) includes Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates. 6. Oil importers include Djibouti, Egypt, Jordan, Lebanon, Morocco, Tunisia, and West Bank and Gaza. 7. The fiscal year runs from July 1 to June 30 in Egypt; the column labeled 2017 reflects the fiscal year ended June 30, 2017. To download this data, please visit www.worldbank.org/gep. 94 CHAPTER 2.4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 TABLE 2.4.2 Middle East and North Africa economy forecasts1 (Real GDP growth at market prices in percent, unless indicated otherwise) Percentage point differences from June 2018 projections 2016 2017 2018e 2019f 2020f 2021f 2018e 2019f 2020f Algeria 3.2 1.4 2.5 2.3 1.8 1.8 -1.0 0.3 0.5 Bahrain 3.2 3.9 3.2 2.6 2.8 2.8 1.5 0.5 0.7 Djibouti 8.6 5.7 6.7 7.3 7.5 7.5 0.2 0.9 1.2 Egypt 4.3 4.7 5.5 5.7 5.9 6.0 0.2 0.0 0.1 Fiscal year basis2 4.3 4.2 5.3 5.6 5.8 6.0 0.3 0.1 0.0 Iran 13.4 3.8 -1.5 -3.6 1.1 1.1 -5.6 -7.7 -3.1 Iraq 13.0 -2.1 1.9 6.2 2.9 2.8 -0.6 2.1 1.0 Jordan 2.0 2.0 2.1 2.3 2.4 2.7 -0.1 -0.1 0.0 Kuwait 2.9 -3.5 1.7 3.6 3.6 3.6 -0.2 0.1 0.6 Lebanon 1.7 1.5 1.0 1.3 1.5 1.5 -1.0 -0.7 -0.5 Morocco 1.1 4.1 3.2 2.9 3.5 3.5 0.2 -0.6 -0.2 Oman 5.0 -0.9 1.9 3.4 2.8 2.8 -0.4 0.9 -0.1 Qatar 2.1 1.6 2.3 2.7 3.0 3.0 -0.5 -0.5 0.2 Saudi Arabia 1.7 -0.9 2.0 2.1 2.2 2.2 0.2 0.0 -0.1 Tunisia 1.1 2.0 2.6 2.9 3.4 3.6 0.2 0.0 0.0 United Arab Emirates 3.0 0.8 2.0 3.0 3.2 3.2 -0.5 -0.2 -0.1 West Bank and Gaza 4.7 3.1 1.7 1.9 1.9 1.9 -0.8 -0.4 -0.4 Source: World Bank. Note: e = estimate; f = forecast. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of economies’ prospects do not significantly differ at any given moment in time. 1. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. Excludes Libya, Syria, and Yemen due to data limitations. 2. The fiscal year runs from July 1 to June 30 in Egypt; the column labeled 2017 reflects the fiscal year ended June 30, 2017. To download this data, please visit www.worldbank.org/gep. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 MIDDLE EAST AND NORTH AFRICA 95 BOX 2.4.1 Informality in the Middle East and North Africa Middle East and North Africa’s (MENA’s) informal sector output, on average, amounts to nearly one quarter of official GDP. However, there is wide heterogeneity across the region. Informality is high among non-GCC economies, the young population, as well as the agricultural workforce. Levels of informality in the region are closely linked to its economic structure and governance climate, including low private sector vibrancy and limited economic diversification. Policy options that reduce regulatory barriers, streamline public sector efficiency, and enhance workforce skills can help improve access to the formal sector and unlock the potential of a relatively young informal workforce. Introduction exporters, a limited private sector, low labor mobility, and lack of economic diversification. The extent of informal output in the Middle East and Africa region amounts to nearly one quarter of official Regional heterogeneity. The moderate average level of GDP during 2008-16, lower than in other EMDE regions. informality masks disparate trends within the region. The However, there is considerable heterogeneity within the share of informal output in GCC economies is about 8 region, with higher informality among non-Gulf percentage points less than in non-GCC economies (18 Cooperation Council (GCC) economies. Moreover, percent and 26 percent, respectively), and the share of self- although the share of informal activity in MENA has been employment to total employment in non-GCC economies steady over the past two decades, perceptions of is about 10 times that of the GCC. informality in the MENA region have edged upward. Employment informality is high among lower-skilled Correlates of informality workers and the youth, which poses important challenges Informality in MENA has reflected a number of economic for MENA’s ongoing transition to a more diversified and development challenges. These ranged from limited economic structure and jobs-oriented growth. private sector activity to conflict situations. Large informal Against this backdrop, this box examines the following sectors have been associated with lower productivity, low questions: wages, and less inclusive growth. Although informality can provide helpful employment opportunities where the • How has informality evolved in the Middle East and formal sector features distortions and governance is poor, North Africa? the structural, policy, and institutional features that foster informality in MENA poses challenges for the region’s • What are the macroeconomic and social correlates of efforts to diversify and reduce its reliance on commodity informality? production and the public sector. • What policy options are available to address Economic structure. Low informality in the GCC reflects challenges associated with informality? high reliance on expatriate workers and high public employment for nationals (World Bank 2018o). In the Evolution of informality non-GCC economies, informal workers constitute the vast On average during 2008-2016, informal sector output in majority of the employed in the agriculture and mining MENA amounted to about one quarter of official GDP, sectors. Across countries, a higher share of agricultural lower than other EMDE regions (Figure 2.4.1.1; Chapter employment had been associated with higher informality 3). During the same period, about 24 percent of the labor (Elshamy 2015; Gatti et al. 2014; UNDP 2013; World employment are reported to be self-employed. Bank 2014c). Urban workers were also 5-12 percent less likely to be informally employed than rural workers (Angel Broadly stable over time. The extent of informal sector -Urdinola and Tanabe 2012), altogether consistent with output in MENA appears to have remained steady over the negative correlation between stage of development and the past two decades, although survey-based measures of informality. informality suggest that perceived informality may have increased. The persistence of informality is linked to the Governance and business climates. Informality in MENA long-standing economic structure of MENA economies, is closely linked to governance quality, which has been including dependence on commodities production in oil negatively correlated with informality (Elbadawi and Loayza 2008). In non-GCC economies, where informality is higher, institutional quality indicators also tend to be Note: This box was prepared by Lei Sandy Ye. Research assistance was markedly lower than in the GCC. This issue is further provided by Mengyi Li and Jinxin Wu. 96 CHAPTER 2.4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 2.4.1 Informality in the Middle East and North Africa (continued) FIGURE 2.4.1.1 Informality in the Middle East and North Africa MENA’s informal sector output comprises nearly one quarter of official GDP, lower than other EMDE regions. However, per- ceptions of informality in MENA has risen somewhat while they have declined in the median EMDE. A. Informal economy as share of B. Share of self-employed worker C. Perceived informal activity economic output Source: Elgin et al. (forthcoming), International Labor Organization, World Bank, World Economic Forum. A.-C. Blue bars show simple averages of economies in the region. Red markers show the median of all EMDEs. Vertical lines denote interquartile range of all EMDEs. A. DGE = dynamic general equilibrium model. MIMIC = multiple indicators multiple causes model. The DGE model estimates the size of the informal sector as a percent of official GDP (see Elgin and Oztunali 2012). The MIMIC model is a structural equations model that considers multiple causes of informal activity and captures multiple outcome indicators of informal activity (see Schneider, Buehn, and Montenegro 2010). It also estimates the informal output as a percent of official GDP. DGE measure includes 6 GCC economies and 9 non-GCC economies. MIMIC measure includes 6 GCC economies and 10 non-GCC economies. Excludes Djibouti, Iraq, Libya (DGE only), and West Bank and Gaza. B. Self-employed is the share of self-employment in total employment. Includes 6 GCC economies and 10 non-GCC economies (excludes Djibouti, Iraq, and Libya). C. WEF index is the average responses at the country-year level to the following question (surveyed by World Economic Forum): “In your country, how much economic activity do you estimate to be undeclared or unregistered? (1=Most economic activity is undeclared or unregistered; 7 = Most economic activity is declared or registered).” WEF indices are re-ordered (i.e. 1= Most economic activity is declared or registered; 7= Most economic activity is undeclared or unregistered) so that a higher average at the country level indicates a larger informal economy. The index does not use data for year 2004-2005 due to inconsistency in survey methods. Includes 6 GCC economies and 10 non-GCC economies (excludes Djibouti, Iraq, and West Bank and Gaza). compounded by poor public services and burdensome sector where productivity is lower.1 Moreover, based on regulatory environment, which raise the costs of operating enterprise survey data, a sizable portion of firms in oil in the formal sector (World Bank 2016d). importers (e.g., Morocco, Tunisia) consider competitors’ practices in the informal sector as hindering their own Conflict. In a number of countries (e.g., Syrian Arab business operations (Figure 2.4.1.2; World Bank 2004).2 Republic), wars and violent conflicts have severely limited the number of public sector jobs, which also led workers to Restricted market access. Informal workers in the region shift into the informal sector for lack of alternatives tend to be concentrated in small and medium-sized firms, (Devarajan and Mottaghi 2017; Ianchovichina and Ivanic which constitute more than 90 percent of MENA’s private 2014). In neighboring countries of fragile and war-torn enterprises (Purfield et al. 2018). Although these firms can economies (e.g., Jordan, Lebanon), the massive influx of include young start-ups with high entrepreneurial refugees—many of whom are unregistered—has boosted potential, they have tended to be oriented toward the informal sector, where jobs tend to be labor intensive local markets, with limited regional or global market access and low skilled. (World Bank 2004, 2016d). Among these enterprises, a 1 percentage point increase in the share of informal Lower productivity. High informality has been associated workers was associated with a 6-percentage-points lower with lower labor productivity and more limited export potential, partly reflected in its relatively low informal share of output compared to that of employment (Box 3.2; 1 Within small and medium-sized enterprises in MENA, a 1 Elbadawi and Loayza 2008; Gatti et al. 2014). Hindrances percentage point increase in the share of informal workers was associated with 3 percentage point lower relative wages (Elbadawi and Loayza in the formal sector, including regulatory barriers to entry 2008). and burdensome taxation, divert otherwise productive 2 Informal business operations may also imply lower contributions to firms and workers to enter and remain in the informal government revenues, while possibly raising resource utilization on public services, such as infrastructure use (Galal 2005; Gatti et al. 2014). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 MIDDLE EAST AND NORTH AFRICA 97 BOX 2.4.1 Informality in the Middle East and North Africa (continued) FIGURE 2.4.1.2 Correlates of informality and policy challenges Informal activity is higher among non-GCC economies in the MENA region, and competition from the informal sector presents a major obstacle to businesses in several large economies. Low wages for informal sector women workers have been associated with particularly low female labor force participation rates in the region. Informality is also high among the youth in MENA, a group that often has insufficient access to education and training programs. In non-GCC economies, where informality is more pervasive, policies that improve access to finance and public-sector effectiveness can help increase mobility from the informal to the formal sector. A. Informality in regional subgroups B. Firms citing informal sector competitor C. Female labor force participation business practices as biggest obstacle D. Youth unemployed or not in education E. Firms citing access to finance as a F. Public sector effectiveness: non-GCC major constraint Source: Elgin et al. (forthcoming), International Labor Organization, World Bank, World Economic Forum. A. Based on DGE estimates of informal output in percent of official GDP (chapter 3). 2008-16 averages. “EMDEs” denote the median of all EMDEs during the same period. Includes 6 GCC economies, 2 non-GCC oil exporters, and 5 oil importers. Excludes Djibouti, Iraq, Libya, Syria, Yemen, and West Bank and Gaza. B. Columns denote the percent of firms citing “informal business practices” as the biggest obstacle to their business. Based on the latest available World Bank Enterprise Survey year since 2013 for each economy denoted. C. Workforce as a percent of female population ages 15-64. Based on 2017 data. Unweighted averages. Includes 6 GCC economies, 3 Non-GCC oil exporters, and 7 oil importers. D. Denotes share of youth (aged 15-24 years) not in education, employment, or training in percent of youth population. Based on latest available data since 2010 for each country. E. Percent of firm citing access to finance as a major constraint to business, based on World Bank enterprise surveys (surveys in the MENA region only include non-GCC economies). EAP = East Asia and Pacific, ECA = Europe and Central Asia, LAC = Latin America and the Caribbean, MNA=Middle East and North Africa, SAR = South Asia, and SSA = Sub-Saharan Africa. Based on latest survey year since 2010 for each country. Includes 9 MNA economies. F. Based on the Worldwide Governance Indicators of regulatory quality and government effectiveness, in which a lower index denotes weaker regulatory quality and weaker effectiveness. Index ranges from -2.5 to 2.5. Includes 13 non-GCC economies. Unweighted averages. “EMDEs” denotes the year 2017. revenue share destined for non-local markets (Elbadawi premium was about 20 percent for males but more than and Loayza 2008). 50 percent for females (Gatti et al. 2014). Informality rates are higher among the young workers, who often do not Wage differentials. Informality presents a source of enter public sector jobs until later in age (Angel-Urdinola employment but also income vulnerability among women and Tanabe 2012; Elbadawi and Loayza 2008). In and the youth. The wage gap between informal and formal Morocco, the formal wage premium among the youth was workers (i.e., formality premium) has been higher for more than 50 percent (Gatti et al. 2014). Further, returns women than men. For example, in Egypt, the formal wage to education have been lower in the informal sector than 98 CHAPTER 2.4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 2.4.1 Informality in the Middle East and North Africa (continued) the formal sector, which has discouraged skills acquisition Access to finance. Access to finance is a larger obstacle to (Angel-Urdinola and Tanabe 2012).3 doing business in non-GCC MENA than in most other EMDE regions. Boosting access to finance, including Less inclusive growth. High informality in the region is through a stronger legal framework and improved credit associated with lower levels of educational attainment and protection regimes, can help promote private sector enrollment, as in many economies a majority of informal activity by increasing transparency of firms to investors workers are school dropouts or have not received a and facilitating investment (Farazi 2014; Straub 2005). A secondary education (Gatti et al. 2014). High informality number of economies in MENA have recently adopted is associated with limited access to health care and legal policies in this area, such as new insolvency resolution laws services, especially in fragile areas (Cho 2011). Workers in in Egypt, Saudi Arabia, and the United Arab Emirates. the informal sector have also reported harsher job The adoption of financial technologies (Fintech), such as conditions and poorer work safety, and among young innovations that automate financial transactions, can also informal workers, lower levels of job satisfaction (Gatti et facilitate financial services to informal unbanked al. 2014). These social disparities have the potential to individuals or small and medium-sized enterprises (Arezki slow reform momentum in the region by constraining et al. 2018; Lukonga 2018). consensus-building. Regulatory effectiveness. Beyond its large size, public Policy challenges sector effectiveness and regulatory quality in non-GCC MENA countries have deteriorated in the last decade. Informality in non-GCC MENA countries, where Corruption is cited among the biggest hindrances to informality is widespread, reflects deep-rooted economic MENA firm operations and increases incentives for firms structures. These economies have some of the highest and workers to operate informally (World Bank 2016d). youth unemployment rates and lowest female labor force Together with low regulatory efficiency, corruption participation rates among all EMDEs. Public sector reduces the effectiveness of labor market regulations and employment constitutes more than 15 percent of total enforcement (Gatti et al. 2014). Policies that reduce employment, about twice the EMDE average (IMF regulatory costs help increase mobility of MENA firms 2018b). Multi-pronged policies can aim to create a more between the informal and formal sector, while those that vibrant private sector and strengthen human capital of strengthen property rights may assist the rural or workers, part of building a new social contract in the agricultural-sector populations to access financing (e.g., region (Devarajan and Mottaghi 2015). Policies targeting enabling collateralized loans). Policies to promote specific vulnerable groups can lessen the negative entrepreneurial activities, such as easing of business externalities associated with informality. licensing requirements, can also facilitate entry of informal Fiscal reforms. Burdensome taxation has been a key workers into more productive jobs in the formal sector. constraint to formal sector firms in MENA (Gatti et al. Education. Policies that encourage higher education and 2014). In non-GCC MENA economies where informality expand job training can be especially relevant for younger is more pervasive, reforms to align tax systems with workers by facilitating their entry into more productive international best practices and strengthen enforcement formal jobs. Training programs may be particularly could further attract informal firms to productive formal effective if coupled with mechanisms to increase women’s activity while also raising revenue collection. Such reforms mobility, which is constrained in the region, and offer a may include reducing excessive corporate tax rate burdens combination of soft and hard skills. Training is also more and enhancing revenue collection through harmonized effective if extended to areas (e.g., rural) where educational electronic filing systems (e.g., Morocco). levels are lower, as MENA region’s training programs tended to serve higher income and more educated individuals (Angel-Urdinola, Semlali, and Brodmann 2010). A holistic approach that combines job training with 3 Evidence from Egypt, for example, suggests that a worker in the job creation efforts, such as through public-private sector formal sector who has completed 5 years of education earns comparable programs, can also be effective; given higher wages to those of an informal sector worker with 12-14 years of unemployment rates for university graduates than low- education (Angel-Urdinola and Tanabe 2012). skilled workers in the region (World Bank 2018r). South Asia remains the world’s fastest growing region. India’s domestic demand is strengthening as the country reaps the benefits of structural reforms and of a revival of credit growth. Growth in the region is projected to accelerate to 7.1 percent in 2019 from 6.9 in the previous year. Over the medium term, robust domestic demand will continue to underpin growth, which is expected to average 7.1 percent. However, risks to the outlook are tilted down. On the domestic side, vulnerabilities are being exacerbated by fiscal slippages and rising inflation, and the possibility of delays in needed structural reforms to address weaknesses in the balance sheets of banks and non-financial corporates. Key external risks include a further deterioration in current accounts and a faster-than-expected tightening of global financing conditions. Recent developments continued to strengthen amid GST harmonization and a rebound of credit growth, consumption Growth in South Asia accelerated to an estimated remained the major contributor to growth 6.9 percent in 2018 from 6.2 percent the previous (Ahmad et al. 2018). year, with domestic demand strengthening in Excluding India, regional growth moderated India as temporary disruptions fade and the slightly in 2018. Pakistan’s GDP (factor cost) is benefits from ongoing structural reforms start to estimated to have grown 5.8 percent in materialize. The recovery was in line with FY2017/18 (July 16 to July 15), with solid expectations, and recent high frequency data– contributions from consumption and investment. including purchasing managers’ indices and Activity was supported by strengthening in the industrial production–have broadly remained solid agricultural and industrial sectors, and a sustained (Figure 2.5.1). acceleration in services. Throughout the region, private consumption In Bangladesh, growth was broad-based, picked up in 2018 while investment remained remaining strong at an estimated 7.9 percent in solid. The solid investment was supported by the FY2017/18 (July 1 to June 30). Private fading of a number of temporary disruptions, a consumption was the main driver of growth, revival of credit growth, and ongoing supported by strong remittance inflows. Net infrastructure projects. Strong domestic demand exports turned negative because of rising food and boosted imports, while exports remained subdued capital machinery imports and weak exports amid weak global trade sentiment, causing current (World Bank 2018t). account deficits to widen (World Bank 2018s). In Sri Lanka, activity accelerated to an estimated India’s growth accelerated to an estimated 7.3 3.9 percent in 2018 on the back of a recovery in percent in FY2018/19 (April to March) as the agriculture and services sectors. In Nepal, economic activity continued to recover with economic activity remained solid with a 6.3 strong domestic demand. While investment percent growth in FY2017/18 (July 16 to July 15). Less favorable monsoons led to weakness in agricultural activity, but this was offset by a Note: This section was prepared by Temel Taskin. Research assistance was provided by Ishita Dugar and Brent Harrison. recovery in remittances and robust industrial 100 CHAPTER 2.5 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 2.5.1 SAR: Recent developments the Maldives. In Bhutan, hydropower and other South Asia remains the fastest growing EMDE region. High frequency infrastructure projects supported investment, and indicators of economic activity are mixed across the region but are broadly GDP expanded by an estimated 4.6 percent in consistent with the recovery underway. Remittance inflows are an important source of income in the region. Inflation is below official targets in FY2017/18 (July 1 to June 30). Maldives’ GDP general despite a recent acceleration in some countries. Sovereign credit accelerated to an estimated 8.0 percent in 2018, default spreads have been rising as the Federal Reserve continues to reflecting strength in tourism and construction. tighten monetary policy and U.S. dollar appreciates. Growth in Afghanistan is estimated to have edged down to 2.4 percent. Although activity was A. Growth B. Purchasing Managers’ Indexes supported by agriculture and services, subdued business confidence and security challenges continued to weigh on growth. There were some signs of rising inflation pressure across the region, and both India and Pakistan raised rates in 2018 to counter the effects of currency depreciation, rising energy prices, and domestic capacity constraints. C. Industrial production indexes D. Remittance inflows Sovereign bond yields surged in the region last year. Fiscal consolidation stalled owing to elections in several countries, contributing further to the region’s high levels of government debt. In India, the government deficit was higher than planned, reflecting lower-than-expected revenues from telecom spectrum auctions and low dividends from public sector enterprises (World Bank 2018v). The central government is budgeting a E. Inflation F. Sovereign credit default spreads reduction in the fiscal deficit for next fiscal year. Pakistan’s fiscal deficit rose to 6.6 percent of GDP last year, well above the government’s target of 4.1 percent, as tax collection fell short of expectations. External vulnerabilities are also rising in the region. In Sri Lanka and to some extent in Pakistan, external debt is sizable and current account deficits have deteriorated considerably. Source: Haver Analytics, International Monetary Fund, World Bank. Recent currency pressures have eroded Pakistan’s A. SAR = South Asia Region. Aggregate growth rates are calculated using constant 2010 U.S. dollar GDP-weights. Data for 2018 are estimates. Shaded areas indicate forecasts. foreign exchange reserves significantly—they B. PMI readings above 50 indicate expansion in economic activity; readings below 50 show currently amount to only around two months of contraction. Last observation is November 2018. C. Last observation is October 2018. imports. D. Data present the workers' remittances and compensation received by countries. Last observation is 2017. E. Last observation is October 2018. F. Data present five-year U.S. dollar credit default swap (mid-rate). Last observation is Outlook December 2018. The outlook for South Asia is robust, despite the financial stress that has affected a number of sector growth, particularly for manufacturing EMDEs and continued trade disputes. Regional activities (World Bank 2018u). growth is expected to accelerate in 2019, to 7.1 percent (Figure 2.5.2). Economic activity will be Investment and services remained the major underpinned by solid investment and robust contributor to economic activity in Bhutan and consumption. While exports and imports will be G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 SOUTH ASIA 101 held back owing to slowing global trade, the FIGURE 2.5.2 SAR: Outlook and risks region’s relatively low exposure to international Economic activity is projected to remain strong. Possible fiscal slippages trade will mitigate the impact of this slowdown on could further worsen already-high public debt positions. Non-performing the regional outlook. assets remain high despite recent efforts to improve the quality of financial sector balance sheets. External imbalances pose a risk to the outlook. Major economies in the region have tightened their monetary stance to India’s GDP is forecast to grow by 7.3 percent in stabilize inflation and mitigate external risks. FY2018/19 and 7.5 percent thereafter, in line with June forecasts. Private consumption is projected to A. Growth B. Fiscal balance remain robust and investment growth is expected to continue as the benefits of recent policy reforms begin to materialize and credit rebounds. Strong domestic demand is envisioned to widen the current account deficit to 2.6 percent of GDP next year. Inflation is projected to rise somewhat above the midpoint of the Reserve Bank of India’s target range of 2 to 6 percent, mainly owing to energy and food prices. C. Non-performing assets D. Net portfolio inflows In the rest of the region, economic activity will average 5.6 percent over the forecast horizon. In Pakistan, macroeconomic imbalances weigh on growth outlook. Pakistan is expected to face financing needs due to large current account and fiscal deficits combined with low international reserves. GDP growth is projected to decelerate to 3.7 percent in FY2018/19, with financial conditions tightening to help counter rising inflation and external vulnerabilities. Activity is E. Current account balance F. External debt projected to rebound and average 4.6 percent over the medium term with support from stabilizing macroeconomic conditions (World Bank 2018u). In Bangladesh, robust economic activity is expected to be sustained. GDP growth is forecast at 7.0 percent in FY2018/19 and is expected to decelerate only slightly over the forecast horizon. Activity will be supported by strong private Source: Haver Analytics, World Bank. consumption and investment on the back of A. SAR = South Asia Region. Aggregate growth rates are calculated using constant 2010 U.S. dollar GDP-weights. 2018 data are estimates. Shaded areas indicate forecasts. infrastructure projects. Net exports are projected B.E. 2018 data are estimates. Shaded areas indicate forecasts. The data represent fiscal years of to contribute negatively to GDP growth as countries except for Sri Lanka, as described in Table 2.5.1. C. Data present the ratio of bank non-performing loans to total gross loans. Last observation is 2017. imports outpace exports in response to strong D. Last observation is 2018 Q3 for Bangladesh and Pakistan, and 2018 Q2 for India and Sri Lanka. F. Gross external debt position including both public and private sectors, as of 2018 Q2. domestic demand. In Sri Lanka, last year’s recovery from adverse weather conditions is expected to continue in growth is forecast to decelerate to 5.9 percent 2019, with 4.0 percent GDP growth. Activity will in FY2018/19. Activity will be underpinned be supported by robust domestic demand as by strong infrastructure investment and consumption rebounds following natural disasters, consumption. and investment is boosted by infrastructure projects. Nepal’s strong post-earthquake In Bhutan and the Maldives, activity will remain momentum is expected to moderate—GDP reliant on construction and tourism. Bhutan’s 102 CHAPTER 2.5 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 growth is projected to accelerate to 7.6 percent affect the ongoing reform agenda and economic 2018/19, supported by ongoing infrastructure activity in some countries (e.g. Afghanistan, Sri projects and rising tourism. In the Maldives, Lanka). growth is expected to moderate to 6.3 percent in 2019 as construction activity returns to long-term In South Asia, non-performing assets (NPAs) are averages, and capital investment projects gradually still high despite recent measures taken to improve slow down. Afghanistan’s economy is expected to the recognition of these assets (Figure 2.5.2). remain subdued, expanding 2.7 percent in 2019, Especially, public sector banks in India, which as a result of security challenges ahead of elections, represent roughly 70 percent of the banking sector declining business confidence, and worsening assets, still report low profitability and high NPAs. drought conditions. Credit expansion could be limited in some major South Asia economies unless further steps are In South Asia, a large proportion of activity is taken to deal with financial and corporate balance informal, which may constrain productivity, sheets. wages, and access to social protection systems (Kanbur 2017). Investing in education and skills, On the external front, the region has relatively low improving the business environment by enhancing exposure to international trade, which limits the regulatory frameworks and boosting the quality of benefits from trade over the long term. However, government services provided to formal firms are the low exposure also suggests that that it could be among the policy measures which can encourage more insulated from the effects rising trade formal activity (Box 2). protectionism than other regions. Moreover, the region may even benefit from trade diversion amid the recent dispute between some major economies Risks (World Bank 2017b). The risks to the outlook are tilted downside. Persistent current account deficits and high levels Domestic vulnerabilities are being exacerbated by of external debt make the region more vulnerable fiscal slippages and rising inflation, escalation in to a faster-than-expected tightening of global political uncertainty, and the possibility of delays financial conditions. in the needed structural reforms to address weaknesses in balance sheets of banks and non- South Asia is one of the most vulnerable regions to financial corporates. Key external risks include a natural disasters (World Bank 2017c). In recent further deterioration in current accounts and a years, the number of affected people and faster-than-expected tightening of global financing geographical areas from natural disasters such as conditions. drought, floods, and earthquakes have risen in the region. Increasingly common natural disasters South Asian economies have high levels of public could disrupt infrastructure, agricultural output, debt in general. Fiscal slippages could further and economic activity in general. The realization worsen already-precarious public debt positions of these domestic or external risks could weaken and result in a costly rise in already- elevated investor confidence and result in capital outflows, interest payments. currency depreciation leading to rising external debt, a tightening of domestic financing The upcoming election cycle next year elevates conditions, and a slowdown in regional growth political uncertainty in the region. The chal- (Eichengreen and Gupta 2015; Kose et al. 2017). lenging political environment could adversely G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 SOUTH ASIA 103 TABLE 2.5.1 South Asia forecast summary Percentage point differences (Real GDP growth at market prices in percent, unless indicated otherwise) from June 2018 projections 2016 2017 2018e 2019f 2020f 2021f 2018e 2019f 2020f EMDE South Asia, GDP1, 2 7.5 6.2 6.9 7.1 7.1 7.1 0.0 0.0 -0.1 (Average including countries with full national accounts and balance of payments data only)3 EMDE South Asia, GDP3 7.6 6.2 6.9 7.1 7.2 7.1 0.0 -0.1 0.0 GDP per capita (U.S. dollars) 6.2 4.9 5.7 5.9 6.0 6.0 0.1 0.0 0.0 PPP GDP 7.6 6.2 6.9 7.1 7.2 7.1 0.0 0.0 0.0 Private consumption 7.6 6.0 6.9 7.0 7.0 7.0 0.3 0.1 0.0 Public consumption 8.5 11.1 10.7 9.1 8.5 8.5 1.0 0.3 0.0 Fixed investment 9.4 8.0 8.2 8.0 7.8 7.5 0.6 0.3 0.1 Exports, GNFS4 1.9 6.2 5.6 5.6 5.9 6.0 -0.1 -0.5 -0.2 Imports, GNFS4 2.6 14.6 8.5 6.3 6.7 6.8 1.0 -0.2 0.6 Net exports, contribution to growth -0.3 -2.3 -1.1 -0.6 -0.6 -0.6 -0.4 -0.2 -0.3 Memo items: GDP2 16/17 17/18 18/19e 19/20f 20/21f 21/22f 18/19e 19/20f 20/21f South Asia excluding India 5.8 5.9 5.7 5.5 5.6 5.6 0.1 -0.1 -0.1 India 7.1 6.7 7.3 7.5 7.5 7.5 0.0 0.0 0.0 Pakistan (factor cost) 5.4 5.8 3.7 4.2 4.8 4.8 -1.3 -1.2 -0.6 Bangladesh 7.3 7.9 7.0 6.8 6.8 6.8 0.3 -0.2 -0.2 Source: World Bank. Note: e = estimate; f = forecast. EMDE = emerging market and developing economy. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not differ at any given moment in time. 1. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. 2. National income and product account data refer to fiscal years (FY) for the South Asian countries, while aggregates are presented in calendar year (CY) terms. The fiscal year runs from July 1 through June 30 in Bangladesh, Bhutan, and Pakistan, from July 16 through July 15 in Nepal, and April 1 through March 31 in India. 3. Sub-region aggregate excludes Afghanistan, Bhutan, and Maldives, for which data limitations prevent the forecasting of GDP components. 4. Exports and imports of goods and non-factor services (GNFS). For additional information, please see www.worldbank.org/gep. TABLE 2.5.2 South Asia country forecasts Percentage point differences (Real GDP growth at market prices in percent, unless indicated otherwise) from June 2018 projections 2016 2017 2018e 2019f 2020f 2021f 2018e 2019f 2020f Calendar year basis 1 Afghanistan 2.4 2.7 2.4 2.7 3.2 3.2 0.2 0.2 -0.1 Maldives 6.2 7.1 8.0 6.3 5.6 5.6 2.5 1.8 0.7 Sri Lanka 4.5 3.3 3.9 4.0 4.1 4.1 -0.9 -0.5 -0.4 Fiscal year basis1 16/17 17/18 18/19e 19/20f 20/21f 21/22f 18/19e 19/20f 20/21f Bangladesh 7.3 7.9 7.0 6.8 6.8 6.8 0.3 -0.2 -0.2 Bhutan 5.8 4.6 7.6 6.4 6.4 6.4 2.2 0.4 -2.3 India 7.1 6.7 7.3 7.5 7.5 7.5 0.0 0.0 0.0 Nepal 7.9 6.3 5.9 6.0 6.0 6.0 1.4 1.8 1.8 Pakistan (factor cost) 5.4 5.8 3.7 4.2 4.8 4.8 -1.3 -1.2 -0.6 Source: World Bank. Note: e = estimate; f = forecast. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not differ at any given moment in time. 1. Historical data is reported on a market price basis. National income and product account data refer to fiscal years (FY) for the South Asian countries with the exception of Afghanistan, Maldives, and Sri Lanka, which report in calendar year (CY). The fiscal year runs from July 1 through June 30 in Bangladesh, Bhutan, and Pakistan, from July 16 through July 15 in Nepal, and April 1 through March 31 in India. For additional information, please see www.worldbank.org/gep. 104 CHAPTER 2.5 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 2.5.1 Informality in South Asia South Asia’s share of informal employment is the largest among EMDE regions, despite a below-average share of informal output. Heavy tax burdens, above-average corruption, and low government effectiveness have contributed to high employment informality. Informal employment is concentrated among low-skilled, young, female and rural workers. The sizable informal sector is associated with lower productivity, lower government revenues, and higher poverty in the region. Policy options to address these challenges include investing in human capital in the form of training programs and improving access to finance. Introduction the highest degree of informality (output in the informal sector is about 40 percent of total output) in 2016 and South Asia (SAR) is the EMDE region with the highest India had the lowest share (below 20 percent). However, average share of informal employment among EMDE this ranking is reversed using labor market indicators of regions, despite a below-median and declining share of informality: Sri Lanka has the lowest share of self- informal output. Nonetheless, there is significant employment (42 percent) and India the highest (76 heterogeneity in the share of employment as well as output percent) as of 2016. These differences are reflected in informality among South Asian countries. lower labor productivity in the informal sector (relative to the formal sector) in India than in Sri Lanka. Against this backdrop, this Box examines the following questions: Correlates of informality • How has informality evolved in South Asia? Business climates. Costs to doing business—such as tax burdens, labor regulation, and cost of starting business— • What have been the macroeconomic and social are among the main drivers of informality identified in the correlates of informality? empirical literature (FICCI 2017; Goldar and Aggarwal 2012). Over the past decade, SAR has suffered from • What policy options are available to address greater corruption and weaker government effectiveness challenges associated with informality? than other EMDE regions (Figure 2.5.1.2). Tax burdens and indicators of ease of doing business have also been less Evolution of informality favorable than in the average EMDE (World Bank 2017c). Among costs to doing business, heavy tax burdens were Informality in SAR. In aggregate, output informality in particularly strongly associated in India and Pakistan with the SAR region is below the average of other EMDE a larger fraction of firms operating unregistered (Ghani, regions—the size of informal sector relative to official Kerr, O’Connell 2013; Waseem 2013). GDP was on average 30 percent in South Asia compared with 35 percent in average EMDE during 2008-2016 Worker characteristics. South Asia’s informal labor force (Figure 2.5.1.1). During the same period, 96 percent of consists predominantly of low-skilled, female, rural, and workers lacked pension coverage and 63 percent were self- young workers (Bahadur and Parajuli 2014; Goldar and employed. Agarwal 2012; Gunatikala 2008; Williams, Shahid, and Martinez 2015). The intensity of informal employment in Evolution of informality in SAR. Output informality South Asia reflects a lack of formal jobs and skills, as well declined from 37 percent in 1990s to 32 percent in the as a preference towards self-employment (Arby, Malik, and 2010s, broadly in line with the decline in informality in Hanif 2010; Williams, Shahid, and Martinez 2015). This other EMDEs. However, labor informality over the same means that informal firms are usually small, agricultural, period persisted or rose depending on the measure of and consist mostly of self-employed workers (FICCI informality. For example, the share of the labor force 2017). without pension coverage rose from 88 percent to 96 and self-employment remained around 63 percent. Lower productivity and incomes. In South Asia, informal workers have had lower earnings, fewer skills, and less Regional heterogeneity. The extent of informality varies access to social protection systems; this has been reflected substantially across countries in South Asia. Sri Lanka had in lower productivity and higher poverty (Kanbur 2017; Likhi 2013). Informal employment among underrepresented groups in labor markets, such as women Note: This box was prepared by Temel Taskin. Research assistance was provided by Brent Harrison and Jinxin Wu. and the young, has grown over the past decade and G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 SOUTH ASIA 105 BOX 2.5.1 Informality in South Asia (continued) FIGURE 2.5.1.1 Informality in South Asia South Asia’s share of informal employment is the largest among EMDE regions, despite a below-average share of informal output. A. Output informality B. Labor informality C. Survey-based perceived informality Source: Elgin et al. (forthcoming); World Bank. A. DGE = dynamic general equilibrium model. MIMIC = multiple indicators multiple causes model. Both DGE and MIMIC estimates measure the informal output in percent of official GDP. B. Labor force without pension is the fraction of the labor force that doesn’t contribute to a retirement pension scheme, which is derived from the original data on pension coverage obtained from WDI. Self-employed is the share of self-employment in total employment. C. WEF = World Economic Forum. WVS = World Values Survey. WEF index is the average responses at the country-year level to the following question (surveyed by World Economic Forum): “In your country, how much economic activity do you estimate to be undeclared or unregistered? (1=Most economic activity is undeclared or unregistered; 7 = Most economic activity is declared or registered).” WEF indices are re-ordered (i.e. 1= Most economic activity is declared or registered; 7= Most economic activity is undeclared or unregistered) so that a higher average at the country level indicates a larger informal economy. The index does not use data for year 2004-2005 due to inconsistency in survey methods. The World Value Survey asks whether respondents can justify cheating on taxes, with responses ranging from 1 (never justifiable) to 10 (always justifiable). The average responses at the country-year level are used as a measure for attitudes towards informality (or tax morality, Oveido et al. 2009), labeled as WVS. A higher average at the country level implies that people find cheating on taxes more justifiable. constrained these groups’ income security. Low earnings Policy challenges and limited options available to informal workers constrain their benefit from economic growth, which means that In South Asia, informal employment is concentrated growth has been less inclusive than otherwise (ADB 2016; among young, low-skilled, female, and rural workers. Heintz 2012). Conversely, in India, an easing of labor Policies targeting training and education of these groups, market restrictions and measures to foster gender especially in rural areas, could help their transition to equality—such as increasing female education and formal employment (Khera 2016). strengthening law enforcement against gender There is significant room to improve the ease of doing discrimination—have been associated with stronger business in South Asia. This could reduce informality by growth as well as larger formal employment (Goldar and reducing the cost of entry and cost of operating in formal Aggarwal 2012; Khera 2016). sector. Measures to reduce the time, cost, and complexity of registration would also improve the business climate Lower government revenues. Large informal sectors—in and foster growth (FICCI 2017). addition to other factors such as inefficient tax administration and narrow tax base—weigh on tax High quality public services can also provide an incentive revenues in South Asian economies (Cevik 2016; Ilzetzki for informal firms to become formal in order to access and Lagakos 2017). On average, tax revenues as a percent these services. Enhanced monitoring and enforcement, in GDP have historically been below the EMDE average. including of tax regulations, could help discourage The lack of tax revenues ultimately affects the ability of informality (Ilzetzki and Lagakos 2017). Also, in India the governments to fund its infrastructure investment, social recent introduction of a Goods and Services Tax and steps programs, etc., and therefore limiting their ability to tackle toward demonetization are expected to encourage a shift poverty and inequality (Chapter 3). from the informal to the formal sector. 106 CHAPTER 2.5 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 2.5.1 Informality in South Asia (continued) FIGURE 2.5.1.2 Drivers of informality in South Asia Heavy tax burdens, above-average corruption, and low government effectiveness likely have contributed to high employment informality. The sizable informal sector is associated with weaker government revenues and higher poverty in the region. Youth unemployment is much higher among women who represent a higher share of informal workers than men. A. Doing business tax burden indicator: B. Doing business overall indicator C. Government effectiveness and control DTF of corruption D. Poverty E. Government revenues F. Youth employment and NEET Source: World Bank, World Development Indicators. A.B. Index denotes Distance to Frontier Score (100-regional score), where 100 equals international best practices. Greater distance indicates further below best practice score. D.E. Episodes are determined based on data availability. F. NEET stands for the share of youth Not in Employment, Education, or Training. Youth is defined as the population between ages of 15 and 24. South Asia’s self-employed, which account for about 80 employed and household enterprises could help them grow percent of informally employed, have limited access to into formality (Beck and Hoseini 2014). Microfinance can financial resources that could finance growth- or be an effective instrument for providing financial access to productivity-enhancing investment (Ghani, Kerr, and informal firms, as many of them are self-employed O’Connell 2013). Greater access to credit for the self- enterprises (ILO 2013; Likhi 2013). The recovery in Sub-Saharan Africa continues, albeit at a softer pace. Growth in the region is estimated at 2.7 percent in 2018, significantly slower than expected, partly due to weaknesses in Angola, Nigeria, and South Africa. Growth is foreseen to rise to 3.4 percent in 2019 and 3.7 percent in 2020-21, as reduced policy uncertainty helps support a cyclical rebound in these large economies. However, per capita income growth will remain modest, and progress in poverty reduction limited. Risks to the outlook are tilted to the downside. Key external risks include an unexpectedly sharp decline in commodity prices, an abrupt tightening of global financial conditions, and escalating trade tensions involving major economies. Domestic risks pertain to fiscal slippage, political uncertainty, domestic conflicts, and adverse weather conditions. Recent developments which fell sharply due to underinvestment and to key oil fields reaching maturity. South Africa’s The recovery in Sub-Saharan Africa (SSA) economy emerged from a technical recession in continued in 2018, but activity lost momentum in the second half of 2018, in part due to improved several countries. Growth in the region is activity in the agricultural and manufacturing estimated to have risen marginally from 2.6 sectors. However, growth remains subdued, as percent in 2017 to 2.7 percent in 2018, slower challenges in the mining sector and weak than expected and still below potential. This construction activity are compounded by policy reflected a sluggish expansion in the region’s three uncertainty and low business confidence. Against largest economies—Angola, Nigeria, and South this backdrop, the South African government Africa (Figure 2.6.1). The region faced a more announced measures to support the economy difficult external environment last year as global through reprioritized spending and structural trade growth moderated, financing conditions reforms to improve the business environment and tightened, and the U.S. dollar strengthened. infrastructure delivery. Commodity prices diverged, with metals and Growth in the rest of the region was broadly agriculture prices dampened by weakening global steady, although performance varied between demand, while oil prices were higher in most of country groups. While growth among metals 2018, mainly due to supply factors. exporters was subdued in 2018, activity in several In Nigeria, oil production fell, partly owing to oil exporters rebounded. In the Central African pipeline closures in mid-2018, while non-oil Economic and Monetary Community (CEMAC), activity was dampened by lackluster consumer growth benefitted from an increase in oil demand, as well as conflicts over land between production and higher oil prices. Economic farmers and herders that disrupted crop activity in non-resource-intensive countries production. In Angola—the region’s second remained robust, supported by agricultural largest oil exporter—stagnant non-oil activity was production and services on the production side, aggravated by a contraction in oil production, and household consumption and public investment on the demand side. Several countries in the West African Economic and Monetary Note: This section was prepared by Gerard Kambou and Rudi Union (WAEMU) grew at 6 percent or more, Steinbach. Research assistance was provided by Mengyi Li. including Benin, Burkina Faso, Côte d’Ivoire, and 108 CHAPTER 2.6 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 2.6.1 SSA: Recent developments across countries. For large oil exporters (e.g., The recovery in Sub-Saharan Africa has continued. However, growth Angola, Nigeria), external balances improved, remains well below its long-term average due to a sluggish expansion driven by higher oil prices and soft import in Angola, Nigeria, and South Africa—the region’s largest economies. The current account deficit has narrowed in oil exporters but deteriorated demand. The current account deficit also among metals exporters due to weaker export growth. Fiscal deficits narrowed significantly in CEMAC, underpinned have narrowed, mainly reflecting consolidation measures in some oil by strong fiscal adjustments. By contrast, external exporters. Public debt remains elevated, especially among non-resource- intensive countries due to their continued reliance on public investment to balances in metals exporters deteriorated amid boost growth. weaker exports in some countries and higher imports in others. In non-resource-intensive A. GDP growth B. Nigeria countries, current account deficits remained elevated due to high fuel imports and capital goods imports related to public infrastructure projects. Across the region, balance of payments financing became more difficult against the backdrop of rising external borrowing costs and weakening capital inflows. Eurobond issuance slowed markedly in the second half of the year, while FDI inflows remained subdued (UNCTAD 2018). C. South Africa D. Current account balance Currencies in the region depreciated in effective terms amid a broad-based strengthening of the U.S. dollar and weaker investor sentiment toward emerging markets. Investors’ renewed focus on country-specific vulnerabilities contributed to a rapid sell-off of the South African rand and the Zambian kwacha since mid-2018. Elsewhere in the region, the pace of currency depreciation has E. Fiscal balance F. Public debt been more modest. Inflationary pressures persist in the region. Despite steep declines, inflation in Angola and Nigeria remained in double digits, partly due to continued exchange rate depreciation (Angola) and elevated food price inflation (Nigeria). In South Africa, inflation stayed within the 3 to 6 percent target range. Among non-resource-intensive countries, inflation rose sharply in Ethiopia and Sudan, due Source: Haver Analytics; International Monetary Fund, World Economic Outlook; National Bureau of Statistics (Nigeria); Statistics South Africa; World Bank. to a rapid expansion in credit and currency A. Aggregate growth rates calculated using constant 2010 U.S. dollar weights. D.-F. Median of groups. Non-resource-intensive countries include agricultural exporters and depreciation (Ethiopia) and the monetization of a commodity importers. large fiscal deficit (Sudan). The median fiscal deficit for the region is Senegal. A strong rebound in agriculture in Kenya, estimated to have narrowed from 4 percent of Rwanda, and Uganda, following prior droughts, GDP in 2017 to 3.7 percent in 2018. The fiscal underpinned the pickup in activity in East Africa. balance improved sharply among many oil exporters. The narrower deficit in Angola partly The median current account deficit is estimated to stemmed from higher oil prices. CEMAC have widened from 5.8 percent of GDP in 2017 to countries substantially reduced their fiscal deficits 6.1 percent in 2018, but sizable differences persist through revenue mobilization efforts and cuts in G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 SUB-SAHARAN AFRICA 109 capital expenditures. By contrast, the fiscal deficit FIGURE 2.6.2 SSA: Outlook and risks remained elevated in Nigeria, due to low tax A gradual recovery is expected, as an increase in oil production supports a revenue collection. modest growth pickup in Angola and Nigeria, and easing drought conditions boosts agricultural production. A rise in investment, as policy uncertainty gradually recedes, should further boost growth in the large In metals exporters, the median fiscal deficit is economies. Activity in the rest of the region is expected to expand at a estimated to have deteriorated sharply, as spending solid pace. Nevertheless, sluggish per capita growth implies continued levels remain elevated in some countries, while slow progress in poverty reduction. A significant amount of international bonds are maturing, posing refinancing risks. Rising non-concessional revenues are suppressed. In non-resource-intensive debt is making countries more vulnerable to changes in international countries, the median fiscal deficit is estimated to financial conditions. have widened modestly, reflecting continued public investment supported by enhanced revenue A. Growth B. Growth per capita mobilization efforts. In all, vulnerabilities remain: government debt-to- GDP ratios are estimated to have risen in more than half of the countries in 2018 and were above 60 percent in one-third (World Bank 2018w). Exchange rate depreciations (e.g., Zambia), negative growth (e.g., Equatorial Guinea, Republic of Congo), and the reporting of C. International bond redemption in D. Non-concessional debt previously undisclosed debt (e.g., Mozambique, SSA Republic of Congo) contributed to the deterioration. In addition to the rise in debt ratios, changes in the composition of debt have made many countries more vulnerable to sharp movements in financing conditions (Chapter 4). As countries have gained access to international capital markets, and non-resident participation in domestic debt Source: Dealogic, World Bank. markets expanded, non-concessional debt has A.B. Aggregate growth rates calculated using constant 2010 U.S. dollar weights. Shaded areas represent forecasts. increased. Non-concessional financing accounted C. Data reflects the principal amount at date of maturity, and excludes any interest payments. for more than half of total public debt in many D. Excludes Equatorial Guinea, Eswatini, Namibia, Seychelles, Somalia, and South Sudan due to data limitations. countries (e.g., Cote d’Ivoire, Ghana, Republic of Congo, Sudan, Zambia, Zimbabwe). average in many countries, yielding little progress Outlook in poverty reduction, and highlighting the need for policy measures to raise potential output while Growth in Sub-Saharan Africa is expected to pick raising the productive capacity of the poor (World up to 3.4 percent in 2019, rising to an average of Bank 2018x). 3.7 percent in 2020-21 (Figure 2.6.2). This is predicated on diminished policy uncertainty and Growth in Nigeria is projected to rebound to 2.2 improved investment in large economies, together percent in 2019 and 2.4 percent in 2020-21. with continued robust growth in non-resource- These forecasts are unchanged from June and intensive countries. However, external headwinds assume that oil production will recover, but peak have intensified, as growth among main trading below government targets, while a slow partners moderates, global financial conditions improvement in private demand will constrain tighten, and trade policy uncertainty persists growth in the non-oil industrial sector. In Angola, (Chapter 1). Per capita income growth is the growth forecast has been upgraded to 2.9 predicted to remain well below its long-term percent in 2019, moderating to an average of 2.7 110 CHAPTER 2.6 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 percent in 2020-21. A recovery in the oil sector, as Nigeria. However, it may rise temporarily in new oil fields come on stream, is expected to boost Angola if the anticipated increases in utility tariffs growth, along with a pickup in activity in the non- and fuel prices are implemented. In addition, price oil sector as reforms bolster the business pressures are likely to intensify in Kenya, environment. Tanzania, and Uganda. Growth in South Africa is projected to recover Fiscal balances are expected to improve further, more slowly than previously expected, to 1.3 reflecting fiscal consolidation efforts among the percent in 2019, before rising to 1.7 percent in large oil exporters and continued adjustment in 2020-21. High unemployment and slow growth CEMAC. Policy tightening is likely to yield in household credit extension are expected to smaller fiscal deficits in metals exporters, while constrain domestic demand in 2019, while fiscal fiscal deficits in non-resource-intensive countries consolidation limits government spending. Higher should also continue to narrow as public growth in 2020 reflects the expectation that the investment spending slows to stabilize public debt. government’s structural reform agenda will gradually gather speed, helping to boost Risks investment growth, as policy uncertainty recedes and investor sentiment improves. Risks to the regional outlook are tilted to the downside. On the external front, slower-than- Excluding Angola, Nigeria, and South Africa, projected growth in China and the Euro Area, growth in the rest of Sub-Saharan Africa is which have strong trade and investment links with expected to remain relatively solid, but with Sub-Saharan Africa, would adversely affect the significant variation between country groups. region through lower export demand and Economic activity in CEMAC should benefit investment. Moreover, Sub-Saharan African from higher oil production and an increase in metals producers would likely be among the domestic demand as fiscal tightening eases. hardest hit by escalating trade tensions between Growth is expected to rise moderately among China and the United States, as metals prices metals exporters, supported in part by stronger would fall faster than other commodity prices as a mining activity. However, non-mining activity result of weakening demand from China (World remains subdued owing to weak business Bank 2018y). Furthermore, a faster-than-expected confidence, accelerating inflation in some normalization of advanced-economy monetary countries, and sluggish credit growth. policy could result in sharp reductions in capital inflows, higher financing costs, and disorderly Among non-resource-intensive countries, exchange rate depreciations, especially in countries economic activity is expected to remain robust in with weaker fundamentals or higher political risks fast-growing countries, such as Cote d’Ivoire, (Arteta et al. 2015; IMF 2018c). Sharp currency Kenya, and Tanzania, boosted by public declines would make the servicing of foreign- investment and strong agricultural production, currency-denominated debt, already a rising and in smaller economies, such as Madagascar, on concern in the region, more challenging. the back of solid export performance. While growth in Ethiopia is expected to remain strong, it The increased reliance on foreign currency will be weighed down by fiscal consolidation borrowing has heightened refinancing and interest efforts to stabilize public debt. rate risk in debtor countries (Chapter 4). Furthermore, the rise in non-resident participation Inflation is expected to pick up across the region in domestic debt markets has exposed some in 2019, reflecting the pass-through of currency countries to the risk of sudden capital outflows. In depreciations during 2018 and domestic price some countries, sizable loans to state-owned pressures among metals exporters and non- enterprises, backed by commodity exports, have resource-intensive countries. Notably, inflation is increased the risk that a negative commodity price envisioned to continue to recede in Angola and shock could trigger financial crises. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 SUB-SAHARAN AFRICA 111 Domestic risks, in particular, remain elevated. fiscal deficits or implement structural reforms, Political uncertainty and a concurrent weakening especially where public debt levels are high and of economic reforms could continue to weigh on rising. Insurgencies and armed conflicts, with the economic outlook in many countries. In their adverse effects on economic activity, remain countries holding elections in 2019 (e.g., an important risk in several countries. Adverse Malawi, Mozambique, Nigeria, South Africa), weather shocks and rising financial sector stress domestic political considerations could are additional risks. undermine the commitment needed to rein in TABLE 2.6.1 Sub-Saharan Africa forecast summary Percentage point differences (Real GDP growth at market prices in percent, unless indicated otherwise) from June 2018 projections 2016 2017 2018e 2019f 2020f 2021f 2018e 2019f 2020f EMDE SSA, GDP 1 1.3 2.6 2.7 3.4 3.6 3.7 -0.4 -0.1 -0.1 (Average including countries with full national accounts and balance of payments data only)2 EMDE SSA, GDP2,3 1.3 2.6 2.7 3.4 3.6 3.7 -0.4 -0.1 -0.1 GDP per capita (U.S. dollars) -1.4 -0.1 0.0 0.8 0.9 1.0 -0.4 0.0 -0.1 PPP GDP 1.6 2.8 3.0 3.7 3.8 3.9 -0.4 0.0 -0.1 Private consumption 0.5 1.8 2.5 2.8 2.9 2.5 -0.1 0.0 0.0 Public consumption 1.3 2.8 2.6 2.9 3.0 2.8 0.1 0.0 0.0 Fixed investment 1.5 4.5 5.2 6.9 7.0 7.5 -1.6 -0.5 -0.6 Exports, GNFS4 2.4 3.6 2.4 3.1 3.4 3.1 -0.8 -0.4 -0.4 Imports, GNFS 4 -0.4 3.1 3.2 3.5 3.6 3.8 0.2 0.2 0.2 Net exports, contribution 0.8 0.2 -0.2 -0.1 -0.1 -0.3 -0.3 -0.2 -0.3 to growth Memo items: GDP SSA excluding Nigeria, 4.3 4.7 4.7 5.4 5.4 5.4 -0.2 0.1 -0.1 South Africa, and Angola Oil exporters5 -0.7 1.4 1.7 2.9 2.8 2.8 -0.6 0.3 0.0 CFA countries 6 2.9 3.3 3.8 4.9 4.7 4.6 -0.3 0.4 -0.2 CEMAC -0.8 -0.2 1.0 3.0 2.6 2.3 -0.4 0.7 -0.4 WAEMU 6.5 6.6 6.3 6.4 6.4 6.3 -0.1 0.1 0.0 SSA3 -0.8 0.9 1.1 1.9 2.1 2.1 -0.6 -0.1 -0.1 Nigeria -1.6 0.8 1.9 2.2 2.4 2.4 -0.2 0.0 0.0 South Africa 0.6 1.3 0.9 1.3 1.7 1.8 -0.5 -0.5 -0.2 Angola -2.6 -0.1 -1.8 2.9 2.6 2.8 -3.5 0.7 0.2 Source: World Bank. Note: e = estimate; f = forecast. EMDE = emerging market and developing economy. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not differ at any given moment in time. 1. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. Excludes Central African Republic, São Tomé and Príncipe, Somalia, and South Sudan. 2. Sub-region aggregate excludes Central African Republic, São Tomé and Príncipe, Somalia, and South Sudan, for which data limitations prevent the forecasting of GDP components. 3. Sub-region historical growth rates may differ from the most recent edition of Africa’s Pulse (https://www.worldbank.org/en/region/afr/publication/africas-pulse) due to data revisions and the inclusion of the Central African Republic and São Tomé and Príncipe in the sub-region aggregate of that publication. 4. Exports and imports of goods and non-factor services (GNFS). 5. Includes Angola, Cameroon, Chad, Republic of Congo, Gabon, Ghana, Nigeria, and Sudan. 6. Includes Benin, Burkina Faso, Cameroon, Central African Republic, Chad, Republic of Congo, Côte d’Ivoire, Equatorial Guinea, Gabon, Mali, Niger, Senegal, and Togo. To download this data, please visit www.worldbank.org/gep. 112 CHAPTER 2.6 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 TABLE 2.6.2 Sub-Saharan Africa country forecasts1 Percentage point differences (Real GDP growth at market prices in percent, unless indicated otherwise) from June 2018 projections 2016 2017 2018e 2019f 2020f 2021f 2018e 2019f 2020f Angola -2.6 -0.1 -1.8 2.9 2.6 2.8 -3.5 0.7 0.2 Benin 4.0 5.8 6.0 6.2 6.5 6.6 0.0 0.1 0.2 Botswana2 4.3 2.4 4.4 3.9 4.1 4.1 1.4 0.6 0.3 Burkina Faso 5.9 6.3 6.0 6.0 6.0 6.0 0.0 0.0 0.0 Burundi -0.6 0.5 1.9 2.3 2.5 2.8 0.0 0.0 0.0 Cabo Verde 4.7 4.0 4.5 4.7 4.9 4.9 0.3 0.7 0.9 Cameroon 4.6 3.5 3.8 4.2 4.5 4.5 -0.1 0.1 0.2 Chad -6.3 -3.0 3.1 4.6 6.1 4.9 0.5 2.1 0.3 Comoros 2.2 2.7 2.7 3.1 3.1 3.1 -0.2 0.1 0.1 Congo, Dem. Rep. 2.4 3.4 4.1 4.6 5.5 5.9 0.3 0.5 1.1 Congo, Rep. -2.8 -3.1 1.0 3.2 -0.1 -1.5 0.3 -1.4 1.1 Côte d'Ivoire 8.0 7.7 7.5 7.3 7.4 6.8 0.1 0.1 0.2 Equatorial Guinea -8.5 -4.9 -8.8 -2.1 -5.8 -5.8 -2.4 4.9 -5.3 Eswatini3 3.2 1.9 -0.6 1.7 1.8 1.8 -1.7 0.0 0.0 Ethiopia2 8.0 10.1 7.7 8.8 8.9 8.9 -1.9 -0.9 -1.0 Gabon 2.1 0.5 2.0 3.0 3.7 3.7 -0.6 -0.7 -0.2 Gambia, The 0.4 4.6 5.3 5.4 5.2 5.2 -0.1 0.2 0.3 Ghana4 3.7 8.5 6.5 7.3 6.0 6.0 -0.4 0.6 0.6 Guinea 10.5 8.2 5.8 5.9 6.0 6.0 -0.2 0.0 0.0 Guinea-Bissau 5.8 5.9 3.9 4.2 4.4 4.5 -1.2 -1.0 -1.0 Kenya 5.9 4.9 5.7 5.8 6.0 6.0 0.2 -0.1 -0.1 Lesotho 3.1 -1.7 1.2 1.2 0.2 1.8 -0.6 -1.4 -2.6 Liberia -1.6 2.5 3.0 4.5 4.8 4.8 -0.2 -0.2 0.0 Madagascar 4.2 4.2 5.2 5.4 5.3 5.3 0.1 -0.2 0.0 Malawi 2.5 4.0 3.5 4.3 5.3 5.5 -0.2 0.2 0.4 Mali 5.8 5.4 4.9 5.0 4.9 4.8 -0.1 0.3 0.2 Mauritania 2.0 3.5 3.0 4.9 6.9 6.9 -0.6 0.3 1.7 Mauritius 3.8 3.9 3.9 4.0 3.6 3.6 -0.1 -0.1 -0.2 Mozambique 3.8 3.7 3.3 3.5 4.1 4.1 0.0 0.1 0.5 Namibia 0.6 -0.9 0.7 1.8 2.1 2.1 -0.8 -0.5 -0.9 Niger 4.9 4.9 5.2 6.5 6.0 5.6 -0.1 1.1 0.2 Nigeria -1.6 0.8 1.9 2.2 2.4 2.4 -0.2 0.0 0.0 Rwanda 6.0 6.1 7.2 7.8 8.0 8.0 0.4 0.7 0.5 Senegal 6.2 7.2 6.6 6.6 6.8 6.9 -0.2 -0.2 -0.2 Seychelles 4.5 5.3 3.6 3.4 3.3 2.9 -0.4 -0.4 -0.2 Sierra Leone 6.3 3.7 3.7 5.1 6.3 6.3 -1.4 -0.6 -0.2 South Africa 0.6 1.3 0.9 1.3 1.7 1.8 -0.5 -0.5 -0.2 Sudan 4.7 4.3 3.1 3.6 3.8 3.8 0.5 0.5 0.3 Tanzania 7.0 7.1 6.6 6.8 7.0 7.0 0.0 0.0 0.0 Togo 5.1 4.4 4.5 4.8 5.1 5.1 -0.3 -0.2 0.1 Uganda 2 4.8 3.9 6.1 6.0 6.4 6.5 0.6 0.0 -0.1 Zambia 3.8 3.5 3.3 3.6 3.8 3.8 -0.8 -0.9 -1.0 Zimbabwe 0.6 3.2 3.0 3.7 4.0 4.0 0.3 -0.1 0.0 Source: World Bank. Note: e = estimate; f = forecast. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not significantly differ at any given moment in time. 1. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. Excludes Central African Republic, São Tomé and Príncipe, Somalia, and South Sudan. 2. Fiscal-year-based numbers. 3. Formerly known as Swaziland. 4. Growth rates reflect GDP data prior to recent rebasing. To download this data, please visit www.worldbank.org/gep. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 SUB-SAHARAN AFRICA 113 BOX 2.6.1 Informality in Sub-Saharan Africa Sub-Saharan Africa has high levels of informality, especially in West and East Africa, low-income countries, fragile states, and commodity exporters. Policies to increase human capital and foster productivity, improve access to resources, reduce regulatory burdens, and strengthen governance have been associated with a decline in informality, which in turn has been associated with better macroeconomic and social outcomes. However, for these policies to be effective, they need to be tailored to the specific nature of informality and types of informal firms. Introduction self-employed workers in total employment during 2010- 16, at 80 percent and 68 percent, respectively. In contrast, Despite a decline over the past three decades, employment the shares of self-employed workers in Central and informality in Sub-Saharan Africa (SSA) remains among Southern Africa were 48 and 43 percent respectively, only the highest in emerging market and developing economies slightly above the EMDE average. Self-employment made (EMDEs), with nine out of ten workers informally up more than 85 percent of employment in Benin, employed (of which six are self-employed). Output Burundi, Madagascar, and Uganda whereas it was less than informality (around 40 percent of official GDP) and 20 percent in South Africa and Mauritius. perceptions of informality are also high compared to other regions. Yet, there is considerable heterogeneity within the Evolution of informality in SSA. Informality in SSA has region—informality is higher in West and East Africa, low declined gradually over the past three decades, broadly in -income countries, fragile states, and commodity exporters. line with the EMDE trend. Some countries, however, have Pervasive informality contributes to lower government tax made significant progress in lowering the shares of revenues, which limits the fiscal resources available for informal output and employment, such as Botswana, much-needed public investment and social programs. Ethiopia, Ghana, Malawi, Rwanda, and Tanzania. Against this backdrop, this box examines the following Correlates of informality questions: High informality in SSA reflects wide-ranging economic • How has informality evolved? and development challenges in the region. It also reflects economic structures and a dearth of skilled labor. • What are the macroeconomic and social correlates of informality? Weak growth and conflict. SSA hosts all but seven of the • What are the policy options to address challenges world’s 34 low-income countries and nearly half of the associated with informality? world’s 36 fragile states (World Bank 2018z, 2018aa). In general, informality is higher in low-income SSA countries Evolution of informality and, especially, fragile states. Economic disruptions during conflict and violence have forced people to earn their High average informality. On average in 2010-16, the livelihoods in the informal economy (Heintz and Valodia informal economy in SSA countries amounted to 36-40 2008). Employment losses during recessions or shocks to percent of official GDP, informal employment made up crop production have also been associated with increases in 90 percent of employment and, more narrowly, self- informal labor supply (Calvés and Schoumaker 2004; employment accounted for 58 percent of total Daniels 2003; Otsuka and Yamano 2006). employment (ILO 2018a; Figure 2.6.1.1).1 Alternative measures of informality, such as the share of the labor Economic structure. In commodity-exporting countries, force without pension coverage and perceptions of the capital-intensive mining sector creates few formal informal activity, were also high compared with other employment opportunities, and economies in most EMDE regions. countries in SSA have large agricultural sectors that have high rates of informal self-employment. In the non- Heterogeneity. There is wide cross-country heterogeneity. agricultural sector, there is also considerable self- West and East Africa had much higher average shares of employment in labor-intensive services such as street vendors, craftsmen, and home-based activities (Fox and Sohnesen 2012). Rural-urban migration and increased Note: This box was prepared by Wee Chian Koh with research labor force participation, especially among women, was assistance from Jinxin Wu. mostly absorbed by the informal sector (Kessides 2005). In 1 A recent enterprise census in Senegal finds that 97 percent of firms are informal (ANSD 2017). some societies, informal businesses are hereditary in 114 CHAPTER 2.6 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 2.6.1 Informality in Sub-Saharan Africa (continued) FIGURE 2.6.1.1 Informality in Sub-Saharan Africa Informality has declined in Sub-Saharan Africa, but remains among the highest in the world. Informality is higher in West and East Africa, low-income countries, fragile states, and commodity exporters. A. Measures of informality B. Self-employment in Sub-Saharan Africa C. Reduction in informality across countries Source: Elgin et al. (forthcoming), International Labor Organization, World Development Indicators. Note: A. Orange lines are the inter-quartile ranges for EMDEs. A. DGE = dynamic general equilibrium model. MIMIC = multiple indicators multiple causes model. The DGE model estimates the size of the informal sector as a percent of official GDP (see Elgin and Oztunali 2012). The MIMIC model is a structural equations model that considers multiple causes of informal activity and captures multiple outcome indicators of informal activity (see Schneider, Buehn, and Montenegro 2010). It also estimates the informal output as a percent of official GDP. Self-employed is the share of self-employment in total employment. B. World Bank classifications. Data for the period 1990-2016. C. BWA = Botswana, ETH = Ethiopia, GHA = Ghana, MWI = Malawi, RWA = Rwanda, TZA = Tanzania. Percent change between 1990-2009 and 2010-16. nature, where businesses are passed down to the next land (Ingram, Ramachandran, and Desai 2007). Limited generation (Chen 2012). In others, social norms restrict availability of resources curtails informal firms’ growth and the mobility of women, compelling them to be informally productivity improvements (Steel and Snodgrass 2008). employed (ILO 2009). There are also obstacles to market access, such as lack of telecommunications or transport infrastructure, which is Low human capital. The average years of schooling in SSA particularly important for firms that need to frequently are well below those in any other EMDE regions interact with suppliers and customers. Access to public (Figure 2.6.1.2). Informal workers in SSA tend to be lower space and urban amenities are also important (Heintz and skilled and less educated than formal workers (Adams, de Valodia 2008). Silva, and Razmara 2013). This limits opportunities for wage employment in the formal economy. Self-employed High regulatory burden. Compared with other EMDEs, workers with low human capital, and hence low SSA has considerably higher regulatory burdens. productivity, have an incentive to operate in the informal Burdensome regulations such as lengthy processes in economy to avoid paying taxes and incurring registering a business, complicated procedures in filing other administrative costs (Oviedo, Thomas, and taxes, high costs of export and import documentary Karakurum-Özdemir 2009). Informal firms often have compliance, strict labor regulations, and high tax burdens lower managerial ability and tend to produce low-quality can make it prohibitively expensive to operate in the inexpensive products with little demand from the formal economy (Mbaye and Benjamin 2015). formal sector (La Porta and Shleifer 2016). The HIV/ AIDS pandemic has also taken a large toll on human Weak governance. Compared with other EMDEs, SSA capital and forced workers into less secure informal has considerably weaker governance and institutions. Poor employment where discrimination is sometimes less governance and institutions may result in failures in pronounced (ILO 2009). enforcing regulations and containing corruption. This creates an environment for informal enterprises to easily Limited access to resources and markets. Informality is conceal their activities and evade taxes (Mbaye and associated with restricted access to electricity, finance, and Benjamin 2015). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 SUB-SAHARAN AFRICA 115 BOX 2.6.1 Informality in Sub-Saharan Africa (continued) FIGURE 2.6.1.2 Economic and institutional indicators in Sub-Saharan Africa Low human capital, limited access to resources, heavy regulatory burden, and weak governance are potentially important drivers of informality. A. Economic and social characteristics B. Doing business indicators C. Governance indicators Source: Barro and Lee (2013), World Bank (Doing Business, World Development Indicators, Worldwide Governance Indicators). Note: A.-C. Blue bars are +/- one standard deviation of SSA mean. Other EMDE refers to all EMDEs except SSA countries. A. GDP per capita is based on 2011 PPP in thousand dollars, expressed in logarithm. Life expectancy at birth is in years. Poverty is the headcount at $1.90 a day (2011 PPP) in percent of population. B. The index represents the distance to the frontier (100) in the World Bank’s Doing Business database. A higher index represents better performance. Data for the period 2004-16. C. The score is based on Worldwide Governance Indicators. It ranges from -2.5 to 2.5. A higher score represents better performance. Data for the period 1996-2016. Low productivity. Productivity differentials between the Policy challenges formal and informal sectors are large: value added per worker of informal firms is only 14 percent that of formal Unlocking the potential of the informal economy. While firms in the median SSA country, lower than the median informality is more pervasive in SSA than in other EMDE in other EMDEs (La Porta and Shleifer 2014). regions, the move from informality to formality is more Competition from informal firms, which do not shoulder dynamic: more SSA formal firms started out as informal the cost of compliances with taxes and regulations, also and the duration of informality is shorter than in other weigh on the profitability and investment of formal firms EMDEs (Figure 2.6.1.4). SSA also possesses a more (Oosthuizen et al. 2016; Box 3.3). Although practices of positive attitude toward business opportunities than other competitors in the informal sector is only the third biggest EMDE regions, despite a higher proportion of people who reported obstacle in SSA, after electricity and access to became entrepreneurs out of necessity. Two-thirds (65 finance, it is more problematic in SSA compared to other percent) of survey respondents believe they have the EMDEs (Dinh, Mavridis, and Nguyen 2010; La Porta and required skills and knowledge to start a business, 59 Shleifer 2016). In addition, since informal firms do not percent indicate they see good opportunities to start a pay taxes, governments’ ability to provide quality public firm, and 42 percent intend to start a business within three services is constrained. years. This intrinsic entrepreneurial spirit, despite high regulatory burdens and a weak entrepreneurship Poverty and social outcomes. While the informal ecosystem, could render the informal sector a reservoir of economy can provide important opportunities for untapped economic potential (De Soto 1989; Grimm, employment, the majority of those engaged in informal Knorringa, and Lay 2012). activities lack income security, employment benefits, and social protection. Moreover, higher informality in SSA is To unlock this potential, both broad-based policy tools— associated with lower life expectancy and worse poverty such as increasing human capital—and policy tools outcomes (Figure 2.6.1.3). Gender inequality is also targeted at specific parts of the informal sector are prevalent in the informal economy in SSA: women are available. In Kenya, for example, improved managerial often placed in the most hazardous jobs with no access to skills and new marketing channels induced by competition occupational health and safety measures (ILO 2009). helped metalwork enterprises in the Kariobangi Light 116 CHAPTER 2.6 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 2.6.1 Informality in Sub-Saharan Africa (continued) FIGURE 2.6.1.3 Correlates of informality in Sub-Saharan Africa Improvements in economic and institutional factors are associated with a reduction in informality. High informality is associated with worse macroeconomic and social outcomes. Years of schooling and primary school learning assessment scores in Sub-Saharan Africa are among the lowest in the world. Investing in human capital is critical to improve labor skills. A. Correlates of informality: Economic B. Correlates of informality: Regulation C. Correlates of informality: factors and governance Macroeconomic and social outcomes Source: Barro and Lee (2013), Elgin et al. (forthcoming), World Bank (Doing Business, World Development Indicators, Worldwide Governance Indicators). Note: The orange diamonds are the coefficient estimates and the blue bars denote the 90 percent confidence intervals. OLS estimators are applied, with country means over the sample period used for both the dependent and independent variables. The share of self-employed in total employment is the measure of informality. Informality is the dependent variable in A.-B., and it is the independent variable in C. 37 SSA countries are included in the regressions. The coefficient estimate measures the effect on the dependent variable of a unit change in the independent variable. For example, in A., a 1 percent increase in the tax rate is associated with a 0.2 percent increase in informality. In C., a 1 percent increase in informality is associated with a 1.6 percent decline in government tax revenue. A. GDP per capita is based on 2011 PPP in thousand dollars, expressed in logarithm. Trade openness is total trade (exports + imports) as a share of GDP. Financial development is proxied by private credit as a percentage of GDP. Tax burden is the total tax rate using data from Doing Business. Data for the period 1990-2016. B. The correlates are the distance to the frontier in Doing Business (data for the period 2004-16) and the scores based on Worldwide Governance Indicators (data for the period 1996-2016). C. Investment is gross fixed capital formation as a percentage of GDP. Tax revenue is expressed as a share of GDP. Life expectancy at birth is in years. Poverty is the headcount at $1.90 a day (2011 PPP) in percent of population. Industries grow and transition to the formal economy Increasing firm productivity. Small informal firms, (Sonobe, Akoten, and Otsuka 2011). The local lacking in human capital, would not sharply increase their government provided little support other than designating productivity by merely registering (La Porta and Shleifer an area for these artisans to operate, but that proved to be 2016). In contrast, large informal firms resemble formal sufficient.2 firms much more than their small informal counterparts: productivity differentials of large informal firms relative to Investing in human capital. Policies should be prioritized formal firms are minor (Benjamin and Mbaye 2012). In toward increasing human capital. Less than 20 percent of West Africa, the largest and fastest growing sectors are, in primary school students in Sub-Saharan Africa—typically fact, dominated by large informal firms. This argues for from poor households—pass a minimum proficiency policies to encourage small firms to grow into more threshold in learning assessment, which is the lowest productive formal firms, through skills upgrading and among EMDEs (World Bank 2018n). Teachers are also better access to inputs and resources such as business often absent from classrooms. These learning deficiencies development services, transport and communications amplify over time and eventually show up as weak labor connectivity, financial services, health services, land and skills. Although technically and politically difficult, serious property rights, infrastructure, technology, and product efforts must be made to improve learning outcomes. markets (Oosthuizen et al. 2016). As these firms become more productive and produce higher quality products, 2 Also in Kenya, the M-Pesa mobile money transfer system, combined they may be able to participate in supply chains in the with affordable ICT services, increased microenterprises’ profitability formal sector (La Porta and Shleifer 2016). For large firms (Mbogo 2010). Improving the survival chances of these microenterprises or those that voluntarily remain informal to evade taxes or is one pathway toward growing the formal economy. David et al. (2012) avoid labor codes, incentives to encourage formal provide other examples of successes at the local government level. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 SUB-SAHARAN AFRICA 117 BOX 2.6.1 Informality in Sub-Saharan Africa (continued) FIGURE 2.6.1.4 Entrepreneurial conditions, entrepreneurship attitude, and informality indicators in Sub-Saharan Africa Despite a higher proportion of necessity-driven informal entrepreneurs, Sub-Saharan Africa benefits from more dynamic entrepreneurial attitudes. More formal firms in Sub-Saharan Africa than in other EMDE regions started out as informal firms. However, small informal firms often lack managerial skills and resources. Skills upgrading and improving access to resources can help informal firms become more productive and therefore compete in the formal sector. A. Entrepreneurial framework conditions B. Entrepreneurship attitude C. Informality indicators Source: Global Entrepreneurship Monitor, World Bank Enterprise Surveys. Note: Blue bars are +/- one standard deviation of SSA mean. Other EMDE refers to all EMDEs except SSA countries. A. The score is based on National Expert Survey of the Global Entrepreneurship Monitor. It ranges from 1 to 9. A higher score represents better perceived condition. B. Data from the Adult Population Survey of the Global Entrepreneurship Monitor for the period 2001-16. Motivation index is the percentage of those who have recently started a business that are improvement-driven opportunity motivated divided by the percentage that is necessity-motivated. A lower ratio indicates a higher proportion that is necessity-driven. C. Data from the World Bank Enterprise Surveys for the period 2006-16. registration can be combined with tighter enforcement Stakeholder engagement. Governments can actively (Mbaye and Benjamin 2015). engage with the informal community to encourage a shift towards greater formality (ILO 2009). This can involve Building institutions. Regulatory and institutional reforms educating informal firms on the benefits of formal to build public trust can strengthen incentives for firms to registration, providing information on the procedures, operate formally (Mbaye and Benjamin 2015). This participating in social dialogues to understand pressing includes improving the business environment by removing issues for informal firms, customizing household surveys to unnecessary regulatory barriers, strengthening monitoring better capture important aspects of informality, and and enforcement capabilities, and upholding legal and collaborating with informal actors to design and judicial systems. These policies apply equally to formal implement effective development policies. firms as an enabling environment is critical for investment and employment generation. 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CHAPTER 3 GROWING IN THE SHADOW Challenges of Informality G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 129 The informal sector accounts for about a third of GDP and 70 percent of employment (of which self- employment is more than a half) in emerging market and developing economies. Informality is more widespread in lower-income countries with a large agricultural sector and a high share of unskilled workers. While offering the advantage of flexibility and employment in some economies, a larger informal sector is associated with lower productivity, reduced tax revenues, and greater poverty and inequality. Overcoming the challenges of informality requires a balanced mix of policies that carefully take into account country-specific drivers. A well- designed policy framework could complement lowering regulatory and tax burdens with increasing the efficiency of public revenue collection and regulatory frameworks. It could also include expanded access to finance, markets, and inputs to foster firm productivity and growth; better education to facilitate formal sector employment; improved public services to bolster tax morale; and enhanced safety nets to cushion household risks. Introduction countries, the informal sector is a major source of income to many low‐skilled individuals whose The livelihoods of the poor in emerging market income would otherwise fall below subsistence and developing economies (EMDEs) often (Docquier, Müller, and Naval 2017). These depend on informal activity. In these economies, reasons for participating in the informal economy informal sector output on average accounts for mean informal workers range from agricultural about one-third of GDP and informal day laborers to self-employed lawyers with a few employment constitutes about 70 percent of employees.2 employment (of which self-employment accounts Regardless of the reason why individual workers or for more than a half; Figure 3.1). In some firms choose between formal and informal countries in Sub-Saharan Africa, informal activity, a large informal sector has been associated employment accounts for more than 90 percent of with unfavorable macroeconomic and employment and informal output is as much as 62 development outcomes. On average, economies percent of official GDP (ILO 2018a). with larger informal sectors tend to have lower Informality is a multidimensional concept, productivity, slower physical and human capital differing in nature across workers and countries accumulation, higher poverty and inequality, and (Perry et al. 2007). Some workers and firms are smaller fiscal resources.3 The informal sector itself “excluded” from the modern economy or critical has, on average, lower productivity than the state benefits by tax and regulatory burdens (de Soto 1989; Loayza, Oviedo, and Servén 2006). This type of informality is frequently associated employment has attracted increasingly skilled workers. Blanchflower, with low productivity and poorly paid low-skilled Oswald, and Stutzer (2001) note that many workers in advanced economies, such as the United States and Portugal, report preferring employment (La Porta and Shleifer 2014; Loayza to be self-employed. 2018). Other informal workers voluntarily “exit” 2 Research suggests the coexistence of both “excluded” and “exiting” types of informality (e.g., Perry et al. 2007; Hazans 2011; the formal sector and choose informal activity for Bosh and Maloney 2008, 2010; Lehmann and Pignatti 2007; Fiess, its flexibility and independence (Maloney 2004; Fugazza, and Maloney 2010; Nordman, Rakotomanana, and Günther and Launov 2012).1 In lower-income Roubaud 2016). 3 La Porta and Shleifer (2014) provide evidence that informality is associated with lower productivity, less access to financing, and less- educated managers. Some studies show that informality is associated Note: This chapter was prepared by a team led by M. Ayhan with higher income inequality and poverty (Rosser, Rosser, and Kose, Franziska Ohnsorge and Shu Yu, and including Mohammad Ahmed 2000; Perry et al. 2007; Chong and Gradstein 2007; Amin, Sinem Kilic Celik, Gene Joseph Kindberg Hanlon, Ergys Loayza, Servén, and Sugawara 2010). Lower physical investment in Islamaj, Sergiy Kasyanenko, Cedric Okou, Naotaka Sugawara, Temel the informal sector could reflect an unwillingness of informal firms to Taskin, and Collette Wheeler. adopt technologies or scale up that would make them visible to tax 1 Several studies find that some informal workers in EMDEs and other authorities (Dabla-Norris and Inchauste 2008; Gandelman operate voluntarily in the informal sector. For instance, Falco et al. and Rasteletti 2017). Docquier, Müller, and Naval (2017) develop a (2015) use survey data from Ghana and find little evidence for the model that predicts that the informal sector would lead to slower overall inferiority of working in the informal sector compared with human capital formation. Less educated managers partially explain the formal sector. Falco and Haywood (2016) report that returns to lower labor productivity observed in informal firms (Cirera and productive characteristics in self-employment have increased Maloney 2017). Benjamin et al. (2014) show that informality is significantly in Ghana between 2004 and 2011 whilst self- associated with weaker international competitiveness. 130 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 formal sector because it tends to employ less- • Informality and fiscal indicators. e chapter skilled workers, have restricted access to funding, is the rst to document the empirical link services and markets, and lack economies of scale.4 between higher informality and unfavorable Employment in the informal sector can provide a aggregate scal outcomes, including revenues safety net by keeping or creating employment and expenditures. is goes beyond previous during periods when the formal sector is shedding studies that have focused on the implications jobs (Loayza and Rigolini 2011). However, for speci c tax categories, such as value-added workers in the informal economy are largely taxes (Keen 2008). excluded from the social security system and less protected against negative shocks than workers in • Informal competition and formal firm the formal sector (Box 3.1). productivity. e chapter presents the rst cross-country study that quanti es the lower Against this backdrop, this chapter examines the productivity of formal rms that face main features of informal economies and possible competition from informal rms. is adds to policies to address the challenges associated with the rich literature that documents the sizable informality. Specifically, it addresses the following productivity di erential between formal and questions: informal rms. • What are the main features of the informal • Policy implications. e chapter analyzes the economy? implications of country-speci c policy changes for the informal sector and synthesizes the • What are the empirical linkages between lessons from these changes to o er a menu of informality and development outcomes? policy options that takes into account the importance of complementarities. • Which policies can mitigate the adverse e ects The chapter reports the following main findings: of informality? • Main features of the informal economy. In The chapter makes the following contributions to EMDEs, the informal economy in 2016 on the literature on informality: average accounts for 32 percent of GDP and, 70 percent of employment, with self- • Broad database on informality. e chapter employment accounting for 43 percent of compiles a new database from a wide range of employment (Figure 3.1). Informality tends informality measures. It employs these to be higher in lower-income economies that measures to provide a rich set of stylized facts are less open to international trade, have larger on informality that are robust to the choice of agricultural sectors, and have larger pools of measure. young and unskilled workers. Both informal output and employment have declined since • Informality, poverty, and income (wage) 1990. Informality declined faster in countries inequality. e chapter documents that with higher output growth, rapid physical higher informality is associated with greater capital accumulation, and stronger poverty. is may, in part, re ect lower wages improvements in governance and business for informal workers than formal workers. climates. While many survey-based studies have documented the existence of such wage • Prevalence of informality. One-half of the di erentials (especially at the country-level), world’s informal output and 95 percent of its this chapter distills broader lessons from a informal employment is in EMDEs. ree large number of studies. EMDE regions (East Asia and Paci c (EAP), Latin America and the Caribbean (LAC), and Europe and Central Asia (ECA)) accounted 4 For details, see Jovanovic (1982), Amaral and Quintin (2006), for more than one-third of the world’s Galiani and Weinschelbaum (2012), Loayza (2018). informal output, but only one-quarter of its G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 131 formal output. Meanwhile, South Asia (SAR) FIGURE 3.1 Informality: Magnitude and correlates hosts almost half of the world’s informal The informal sector accounts for about a third of GDP and 70 percent of workers, although the region accounts for less employment (of which self-employment is more than a half) in emerging than one-tenth of the world’s formal market and developing economies (EMDEs). A large informal sector is associated with slower GDP growth and weaker governance as well as employment and less than one-twentieth of greater poverty and income inequality. Widespread informality is also seen the world’s formal output. Another 14 percent in economies with lower government expenditures and revenues, and a of the world’s informally employed are in skew towards trade-based taxation. Sub-Saharan Africa (SSA), two to ve times A. Share of informal output and B. Informality: Output, employment, the region’s share of the world’s formal output employment and perception or formal employment. • Informality and development outcomes. Higher informality is associated with lower output growth, lower productivity, and higher poverty and income inequality. Potential reasons for greater poverty in economies with higher informality may include a lack of scal resources to fund public services or wage D. Brazil: Share of informal workers C. Informal output and institutional di erentials between informal and formal quality, 2016 preferring informal over formal employment workers. Workers in the formal economy earn, on average, about 19 percent more than workers in the informal economy. ese wage di erentials largely re ect the characteristics of informal workers, who tend to be lower- skilled than formal workers. • Informality and firm productivity. e average informal rm in EMDEs is only one- quarter as productive as the average rm E. Informality, poverty, and income F. Differences in fiscal indicators inequality between the lowest and highest operating in the formal sector. Moreover, output informality in EMDEs rms in the formal sector that face informal competition are, on average, only three- quarters as productive as those that do not. Better business climates can mitigate some of these productivity di erentials. • Informality and fiscal indicators. In EMDEs with the most pervasive informality, government revenues are lower by 5-10 Source: Elgin et al. (forthcoming a); International Monetary Fund, World Economic Outlook; Maloney (2004); International Labour Organization; World Bank (Doing Business, World Development percentage points of GDP (and expenditures Indicators, World Governance Indicators); World Economic Forum; World Value Survey. A. Unweighted averages. Informal employment (in red) uses self-employment shares (with additional lower by 4-10 percentage points of GDP) informal employment shares in shaded red) in the closest (latest) available year around 1990 and than in those with the lowest levels 2016. World averages between 1990-2016 are in orange. EMDEs= Emerging market and developing economies. of informality. In developing economies, B. Unweighted average for each informality measure for latest available year (with the corresponding +/-1 standard deviation shown in vertical bars). See Annex 3.1 for details. pervasive informality further limits govern- C. Group averages of DGE-based informal output in percent of official GDP in year 2016 are shown in diamonds, with bars showing 95 percent confidence intervals. The dashed line shows the world ments’ limited ability to implement re- average. “High” (“Low”) indicates countries with above- (below-) median values in the following two measures: Doing Business distance-to-frontier and governance effectiveness (WGI). distributive measures, invest in public D. The shares of informal workers preferring informal over formal employment (Maloney 2004). infrastructure, or carry out other growth- E. Data are for 1990-2016. Group means (diamonds) and 95 percent confidence intervals (bars) are shown for poverty headcount ratio at $1.90 a day (2011 PPP, percent of population) and Gini enhancing policies. coefficients. “High informality” (“Low informality”) indicates countries with above- (below-) median informal output (DGE-based estimates). F. Differences in the 2000-16 average fiscal indicators among the third of EMDEs with the highest • Policy implications. A review of studies of and lowest informality (measured by the share of DGE-based informal output averaged during 2000- 16). Vertical bars indicate 90 percent confidence intervals of the difference. Sample includes 70 non- policy measures that have had repercussions energy exporting EMDEs with populations above 3 million people. 132 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 3.1 Linkages between formal and informal sectors Empirical evidence on the degree of cyclicality of the informal economy with the formal economy is mixed. The cyclicality and sensitivity of informal employment to formal business cycles depends on the sources of shocks driving business cycles, the presence of rigidities in the formal sector, the initial extent of informality, and the availability of informal jobs. While there is broad consensus that the informal economy Informal economy as a countercyclical safety net is sizable in emerging market and developing economies (EMDEs), evidence for its behavior over the business The informal sector can serve as buffers and safety nets for cycles remains inconclusive. An informal economy that the poor if it absorbs labor during recessions.3 This can expands while the formal economy contracts may support facilitate an economic recovery provided that re-entry into household incomes during economic downturns and could the formal sector is possible when the formal economy serve as a safety net (Loayza and Rigolini 2011). An returns to expansion (Colombo, Onnis, and Tirelli 2016; informal economy that behaves procyclically could IMF 2017; Loayza and Rigolini 2011). function as a “growth engine” by providing more services Macroeconomic evidence. Macroeconomic studies suggest and intermediate inputs to the formal economy during that the informal economy can behave “countercyclically” economic expansions but, conversely, could also amplify in the sense that the share of informal employment indeed the adverse effect of recessions (Dell’Anno 2008; Chen rises during business cycle downturns.4 Using data from 54 2005; Meagher 2013).1 Earlier work suggests that the countries for 1984-2008, Loayza and Rigolini (2011) show degree of cyclicality of the informal economy depends on that, on average, a one standard deviation slowdown in the measure of informality, the types of shocks causing GDP per capita growth (i.e., 3 percentage points) is linked business cycles, and country characteristics. with a short-run increase in the share of self-employment Against this backdrop, this box reviews the literature and in the total labor force by 1.2 percentage points. However, presents results from a set of empirical exercises to address they also find considerable heterogeneity across the following questions: countries—the counter-cyclicality of informal employment is much weaker in economies with more pervasive • What conclusions does the literature offer about the informality.5 cyclical behavior of the informal economy? Using quarterly data for Mexico, Fernández and Meza • How synchronized have been movements in informal (2015) find that the correlation between informal and formal economies? employment and official GDP is modest (about -0.3), whereas the correlation between formal employment and • What are the policy implications of cyclicality? formal output is strongly positive. The authors argue that this lowers cyclicality of total employment. Colombo, Literature review Onnis, and Tirelli (2016) use electricity consumption as a The literature on the cyclical behavior of the informal proxy for total economic activity to study cyclical economy offers mixed conclusions. Studies focusing on the properties of informality in 48 countries over the period share of the informal economy in total output or employment tend to find countercyclical behavior whereas studies focusing on output or employment levels tend to 3 Due to its flexibility, the informal sector is able to adjust in wages find procyclical behavior. The theoretical literature rather than employment during recessions, which explains the informal employment’s lack of responses to economic downturns (Maloney 2004; suggests that the degree of procyclicality depends on the Guriev, Speciale and Tuccio 2016). source of shocks causing business cycle fluctuations and on 4 Remittances, as a buffer against shocks to formal economy, may also the presence of labor market rigidities. This section influence the cyclicality of the informal sector. Remittances appear to be summarizes this literature.2 largely absorbed by the informal sector as Ivlevs (2016) finds that high level of remittances tends to be associated with more informality. Shapiro and Mandelman (2016) and Chatterjee and Turnovsky (2018) show that Note: This box was prepared by Sergiy Kasyanenko and Shu Yu. countercyclical remittances are associated with higher informal 1 See Meagher (2013) for a literature review on studies concerning the employment during recessions as formal employment declines. linkage between formal and informal economy. 5 The extent of countercyclicality drops as the share of informal 2 Several recent studies also argue that pervasive informality may employment in total employment increases and disappears when informal influence the measured cyclicality of the formal economy. For example, employment accounts for more than 42-43 percent of total employment. Restrepo-Echavarria (2014) and Horvath (2018) show that models with a Theoretically, Shapiro (2014) suggest that while the share of self- large and poorly measured informal sector can generate excess volatility of employment tends to decline during economic upturns, the ease of entry formal consumption relative to formal output – a common feature of into self-employment explains the differences in cyclical behavior across business cycles in many EMDEs. countries. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 133 BOX 3.1 Linkages between formal and informal sectors (continued) 1984-2005 and illustrate that the informal economy Macroeconomic evidence. Using informal output levels expands following a banking crisis. Finally, Kaufmann and (as opposed to the share of the informal economy), Bajada Kaliberda (1996), Busato and Chiarini (2004) and Elgin (2003), Giles (1997), Tedds and Giles (2000), and (2012) present empirical evidence that the informal Dell’Anno (2008) find that informal-economy output economy acts as a buffer, increasing its share of official movements correlate positively (i.e., move pro-cyclically) GDP during economic downturns.6 with formal-economy output movements in Australia, New Zealand, Canada, and a group of 19 Latin American More procyclical fiscal policy in less developed economies countries. In a group of developing countries, Fiess, with weaker institutions may contribute to counter- Fugazza, and Maloney (2010) identify episodes where cyclicality of informal activity. Fiscal policy tends to be relative demand or productivity shocks to the non- more procyclical in countries with higher informality tradables sector (as opposed to the tradables sector) are (Çiçek and Elgin 2011). In particular, procyclical fiscal associated with higher informal employment (hence, pro- consolidation during recessions, including through higher cyclicality). In Brazil and Mexico, higher separation rates taxes, may encourage more informal employment and from informal jobs and a large drop of the formal job strengthen the counter-cyclicality of informal activity. finding rate may induce labor outflows from the informal Microeconomic evidence. In work flow data for Brazilian sector during recessions (Bosch and Maloney 2008). Arvin metropolitan labor markets between 1983 and 2002, -Rad, Basu, and Willumsen (2010) develop a theoretical Bosch, Goni, and Maloney (2007) find that the informal model that establishes procyclical informal-formal sector sector is able to absorb more labor during economic linkages, particularly when formal firms sub-contract labor downturns as jobs became scarce in the formal sectors. -intensive stages of production to the informal sector. Bosch and Esteban-Pretel (2012) use the same data and Microeconomic evidence. Schneider (1998) reports that in find that the share of formal employment falls as formal- Germany and Austria at least two-thirds of the income economy output contracts, in part because the rate at earned in the informal economy is immediately spent in which workers find formal jobs plummets while that at the official economy resulting in considerable (positive) which they find informal jobs remains broadly stable.7 stimulating effects on the official economy. In firm-level Informal economy as an engine of growth data for India, Moreno-Monroy, Pieters, and Erumban (2014) find that formal and informal sector employment Since informal firms provide services, as well as final and are positively correlated, in part because subcontracting by intermediate goods to the formal sector, one would expect formal-sector firms to informal firms contributes to job a positive correlation between formal and informal sector creation in the informal sector. Data from Indian activity (Lubell 1991; Arvin-Rad, Basu, and Willumsen manufacturing firms show that the gross value added for 2010; Moreno-Monroy, Pieters, and Erumban 2014). In several predominantly informal industries is positively addition, informal-economy income can support formal- correlated with that in the formal sector and FDI. This economy demand.8 may be indicative of technological spillovers contributing to both formal and informal sectors (Beladi, Dutta, and Kar 2016). 6 This empirical relationship between informal and formal activities appears to be present in both advanced economies and EMDEs. For Factors determining the degree of procyclicality of the example, Kaufmann and Kaliberda (1996) cover a panel of 16 Central informal economy and Eastern European countries in 1989-1994; Busato and Chiarini (2004) used data on the share of informal output in total GDP from the Cross-country heterogeneity. There is considerable United States, Italy, the United Kingdom, and New Zealand over the cross-country heterogeneity in the degree of pro-cyclicality period 1960-1997; Elgin (2012) utilizes a panel of 152 countries from of informal employment. It tends to be higher when 1999 to 2007. 7 Job separation rates are countercyclical (i.e rise during recessions) for informality is greater (Loayza and Rigolini 2011), when both sectors, with a much higher probability of losing an informal job informal employment is more common (Shapiro 2014), during recessions. when there are stronger informal-formal sector linkages 8 See Schneider (1998), Gibson (2005), Docquier, Müller, and Naval such as through subcontracting (e.g., Moreno-Monroy, (2017), Kanbur (2017), Eliat and Zinnes (2002), and World Bank Pieters, and Erumban 2014; Mbaye, Benjamin, and (2014). Although the relationship between formal and informal sectors may be symbiotic in the short run especially when policymakers are Gueye 2017). concerned about the welfare of low-skilled working poor, argue that in the long-run pervasive informality may create poverty traps and stymie Source of shocks causing business cycles. The informal economic development. economy can move procyclically or countercyclically, 134 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 3.1 Linkages between formal and informal sectors (continued) depending on the sectoral origin of the shocks that peaks (Elgin et al. forthcoming b). In contrast, generate business cycles in the presence of wage rigidities, turning points in self-employment, as a proxy for especially in the formal sector (Fiess, Fugazza, and informal employment, rarely coincide with turning Maloney 2010). Positive relative demand or productivity points in formal employment or formal output. shocks to the non-tradable (largely informal) sector could increase informal employment, i.e. generate procyclicality • Correlations. Lead, lag, and contemporaneous in informal employment, especially when combined with correlations of formal-economy output with informal- wage rigidities in the formal sector. For instance, in economy output are highly and statistically significant Colombia, capital account liberalization in the context of whereas those between formal output and informal broader reforms during 1991-1996 raised permanent employment are statistically insignificant (Figure income and constituted a positive demand shock to the 3.1.1; Elgin et al. forthcoming b). This is consistent non-tradeable sector. This upturn resulted in an expanding with studies that find countercyclicality in the share of non-tradable informal sector. Conversely, in the presence the informal economy and those show that informal of wage rigidities, a negative shock to the tradables sector firms are flexible enough to adjust in wages rather would expand informal (nontradables) employment and than employment during economic downturns thus appear as countercyclicality. (Maloney 2004; Loayza and Rigolini 2011; Guriev, Speciale and Tuccio 2016).10 Synchronization in formal and informal-economy movements • Common factors. A dynamic factor model applied to formal and informal output and employment finds As in other studies that examine levels of employment and that a single common factor accounts for 38 and 40 output, the data set used in this chapter suggests that, at percent of the output variance of the informal and the macroeconomic level, formal employment levels and formal economies, respectively (Kose, Prasad, and informal output levels comove with formal output levels Terrones 2003; Elgin et al. forthcoming b). This but informal employment levels do not. Several common factor explains only a negligible share of the methodologies point to this finding, including analyses of variance in informal employment. volatility, business cycle turning points, correlations and factor models. Policy implications • Macroeconomic volatility. Since formal and informal A large degree of comovement of informal employment employment move marginally (but statistically and formal output in and of itself may not warrant policy significantly) in opposite directions, the volatility of action for two reasons. First, the direction of comovement total (formal and informal) employment is somewhat can change over time if business cycle fluctuations are lower than the volatility of each type of employment caused by changing sources of sectoral shocks. Second, the in isolation (Figure 3.1.1, Elgin et al. forthcoming a; appropriate policy response would depend on the source of Loayza and Rigolini 2011; Fernández and Meza the shock that generates comovement. If a procyclical 2015).9 Self-employment (as a proxy for informal expansion in informal employment is largely the reflection employment) is somewhat less volatile than formal of shocks in the nontradable sector, such as in employment. In contrast, informal output is construction, no policy response specifically related to somewhat less volatile than formal output, possibly informality may be needed. In contrast, if a countercyclical reflecting flexible adjustments in hours worked in the expansion in informal employment reflects a downturn in informal economy (Meghir, Narita, and Robin 2015; the tradable sector, such as in manufacturing, in the Guriev, Speciale, and Tuccio 2016). presence of labor market rigidities, measures to ease labor market rigidities may be the appropriate response (Fiess, • Business cycle turning points. About three fourths of Fugazza, and Maloney 2010). business cycle troughs in formal output coincide with a trough in the informal output; seven out of ten formal output peaks coincide with informal output 10 This lack of comovement between formal output and informal employment is particularly pronounced in EMDEs, possibly reflecting data challenges in EMDEs, genuinely lesser synchronicity between formal economic output and formal employment in advanced economies, or 9 The correlation between formal and informal employment growth higher labor market rigidities in EMDEs (Neumeyer and Perri 2005; rates is above 0.2 and significant at 1 percent level. Botero et al. 2004; Campos and Nugent 2012). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 135 BOX 3.1 Linkages between formal and informal sectors (continued) FIGURE 3.1.1 Interaction between formal and informal economies Formal employment and informal output levels tend to comove with formal output levels, whereas informal employment levels do not. Since formal and informal employment are marginally negatively correlated, total (formal and informal employment) is less volatile than each in isolation. A. Synchronization of turning points B. Volatility of output C. Volatility of employment Source: Elgin et al. (forthcoming a, forthcoming b). Note: Data are from 1990 to 2016. DGE-based estimates are used for informal output in A-B, while data on self-employment are used for informal employment. A. Troughs and peaks are identified as in Harding and Pagan (2002). The bars show the share of formal peaks (or troughs) that coincide with informal peaks (or troughs). B-C. Standard deviations in annual growth rates are shown in bars. “***” indicates statistically significant differences at least at 10 percent level between informal and informal output (employment). “+++” indicates statistically significant differences at least at 10 percent level between advanced economies and EMDEs. In addition to measures taken explicitly to address Carniero, Goldberg and Meghir 2018). Policy measures informality, many measures undertaken for other reasons, that—deliberately or inadvertently—reduce informality such as tax measures, may have implications for can therefore protect vulnerable population groups better informality. The discussion in this box highlights that if they are accompanied by strengthened social safety nets these implications warrant a carefully calibrated policy that can fulfill some of the roles of the informal sector. mix. Similarly, if comovement between formal and informal The resilience of informal employment to business cycle output reflects synergies, such as through subcontracting, swings, juxtaposed with the weaker development outcomes policy measures aimed at curtailing informal activity can associated with informality (discussed in the main text), disrupt formal activity. suggests a trade-off. In the short run, informal activity can provide a safety net during business cycle swings and labor These effects could be mitigated if measures that reduce dislocations caused by major structural changes such as informality were accompanied by greater labor and trade liberalizations; in the long term, however, the product market flexibility in the formal sector that informal sector can be a source of poverty and stymie facilitates a reallocation of informal workers and firms. development (Docquier, Müller, and Naval 2017; Dix- for informality highlights the need for a and product market exibility, and better comprehensive policy package that takes into access to resources for informal rms. Second, account country-speci c features that lead to policies to spur development, as a collateral informality and determine its consequences. bene t, can help reduce informality. Speci c First, strategies to reduce informality outright measures discussed in this chapter include may hurt vulnerable groups and disrupt simpli cation of tax codes and enhanced formal activity that relies on informal- enforcement of revenue collection, which can economy inputs. ese e ects can be reduce the incentive to operate informally mitigated by stronger safety nets, greater labor depending on country-speci c circumstances; 136 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 easing of labor market regulations to lower the 2009). Evaders are firms that are covered by the relative cost of employing formal workers and regulation but do not comply; avoiders are firms create a level playing eld for formal and that adjust to be outside the remit of the informal rms and workers; as well as greater regulation; outsiders are firms that are simply not access to nance and public services to help covered by the regulation. More recent studies increase productivity in the informal sector distinguish different types of informality by the and encourage a shift of activity to the formal entities engaged in informal activity, separate from sector. their motivation: within firms, formal and informal workers or activities (“interfirm margin”) Informality: Conceptual and, within sectors, informal and formal firms or considerations and workers (“intersectoral margin,” Maloney 2006; Ulyssea 2018).7 Individual country practices vary measurement widely but typically adhere to these broad principles. Definition of informality • Informal workers. Informal employment Informality is often defined as market-based legal covers all workers of the informal sector and production of goods and services that are hidden informal workers outside the informal sector from public authorities for monetary, regulatory, (ILO 2018a).8 e former comprises all and institutional reasons (Schneider, Buehn, and persons who were employed in at least one Montenegro 2010).5 This general definition informal rm. e latter group includes both encompasses many types of informal activity self-employed and workers that are not among workers and firms.6 Some studies employed in formal contractual arrangements distinguish different types of informality by the or not subject to social protection or motives of participating in the informal economy. employment bene ts. Some have de ned For example, some classify informal workers and informal employment more speci cally as that firms into those that are “excluded” and those that of workers without pension coverage, which is “voluntarily exit” from the formal sector (Perry et a part of social protection (Loayza, Servén, al. 2007). Others focus on “subsistence and Sugawara 2010). informality,” which is pervasive in lower-income countries and characterized by low‐skill • Informal firms. An informal rm satis es the technology. In the absence of such an informal following criteria (ILO 2018a).9 First, it is not economy, the income of low-skilled workers would fall below subsistence levels (Docquier, 7 See Perry et al. (2007, p.27) for a more detailed description of Müller, and Naval 2017). informal employment and di erent types of informal employment. 8 e most frequently used informal employment measure is the Some others classify informal workers and firms share of self-employment in total employment, which is a lower into evaders, avoiders, and outsiders depending on bound of informal employment (e.g., La Porta and Shleifer 2014). As de ned by the 1993 International Classi cation of Status in their compliance with regulations and regulations’ Employment (ICSE-93), self-employed workers are those workers applicability (Kanbur and Keen 2015; Kanbur who, working on their own account or with one or a few partners or in a cooperative, hold the type of jobs de ned as "self-employment jobs." e other measure, informal employment, comprises all workers of the informal sector and informal workers outside the 5 Monetary reasons include avoiding taxes and social security informal sector. e former covers all persons who, during a given contributions; regulatory reasons include avoiding government reference period, were employed in at least one informal sector bureaucracy or regulatory burdens, while institutional reasons include enterprise, irrespective of their status in employment and whether it corruption, the quality of political institutions and weak rule of law. was their main or a secondary job. e latter covers self-employment For the purposes of this chapter, the informal economy re ects and employees holding informal jobs. See Annex 3.1 for details. For activities that, if recorded, would contribute to GDP, and does not the remainder of the chapter, informal employment will be proxied cover illegal activities or household production (Schneider, Buehn, by self-employment since data on informal employment is not and Montenegro 2010; Medina and Schneider 2018). e di erence available for advanced economies. e numbers here refer to the between informal production and household production is that the latest available years. latter does not encounter monetary transactions. 9 Benjamin and Mbaye (2012) and Mbaye, Benjamin, and Gueye 6 e de nition and classi cation of informality is deeply context (2017) provide an alternative de nition of informal rms as a speci c. Similarly, the choice of informality measures largely depends continuum depending on size, registration, honest accounting, tax on the research question (see Elgin et al. forthcoming a, for details). payments, mobility of work-place and access to bank credit. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 137 an incorporated enterprise that is a legal entity Organization, World Development Indicators, separate from its owners, has its own complete and national statistical offices’ databases), which set of accounts, but is not owned nor stand out in their time and country coverage.11 controlled by one or a few household members. Second, it is a market enterprise Main features of the that sells its goods or services. ird, it falls into one of the following categories: it keeps informal economy the number of workers employed on a continuous basis and below a threshold Informality: Lower in advanced economies than determined by the country; it is not registered; in EMDEs. On average, the size of the informal or its workers are not registered. economy is about 32 percent of official GDP and, in EMDEs, 71 percent of total employment in Measurement of informality 2016, of which self-employment accounts for 43 percent of total employment (based on latest Reflecting the difficulty of measuring informality, available data for each country). A higher level of the literature has developed a wide range of development, e.g., as measured by per capita estimation methods to capture its extent. In this income, is associated with lower informality, chapter, a database of all commonly used measures regardless of the measure of informality or the year of informality is compiled (summarized in Annex chosen (La Porta and Shleifer 2014; Figure 3.2). Table 3.1.1), ranging from model-based estimates As a result, informality tends to be considerably of the share of informality in official GDP more pervasive in EMDEs than in advanced (MIMIC and DGE estimates), to survey-based economies: in advanced economies, informal measures of the share of informality in total output accounts for about 17 percent of output employment (share of self-employed and share of and self-employment accounts for 14 percent of workers covered by pension schemes), and public employment. Perceptions from business owners perceptions of the extent of informality (World and managers about the pervasiveness of Economic Forum index, World Value Survey informality also suggest greater informal activity in index, and Enterprise Surveys).10 The database EMDEs than in advanced economies. includes up to 196 economies (36 advanced and 160 emerging market and developing economies) Cross-country heterogeneity: Pronounced in over the 1990-2016 period. Both cross-country EMDEs. The size of the informal economy varies rankings and time trends are consistent for most widely across countries (Figure 3.2). In EMDEs, countries. That said, the chapter relies mainly on the informal economy ranged from around 10 (in the two model-based (DGE and MIMIC) China) to 69 (in Equatorial Guinea) percent of estimates of the share of informal output and the GDP—depending on the measure used—and self- share of self-employed (from International Labour employment ranged from near-zero (Qatar) to around 90 (Burundi) percent of employment. Among advanced economies, the share of informal 10 For the compiled data set, see Elgin et al. (forthcoming-a). In output in GDP has varied from less than 12 the data set, the Multiple Indicators Multiple Causes (MIMIC) percent, in Switzerland and Singapore, to about model is a model of structural equations that use observable causes and indicators to capture the latent level of informal output. Elgin et 32 percent in Estonia. During 2006-16, Greece al. (forthcoming a) follow Schneider, Buehn, and Montenegro (2010) registered the highest share of informal closely when estimating the MIMIC model for 160 countries over employment (37 percent) among advanced the period 1993-2015. e dynamic general equilibrium (DGE) model of Elgin and Oztunali (2014) provides an alternative estimate economies. of the size of the informal sector for 158 countries (36 AEs and 122 EMDEs) over the period 1950-2016. To make the measures comparable with those in the literature, both measures are reported in percent of o cial GDP. In the following sections, “in percent of 11 For presentational simplicity, throughout this chapter, the GDP or output” is used as the equivalent of “in percent of o cial output share of informality refers to the share of informal output GDP” in the context of the share of informal output (both DGE- based on DGE model estimates, unless otherwise noted. e main based and MIMIC-based estimates), while “in percent of results for features of informality, correlates of informality, and employment” is used as the equivalent of “in percent of total developmental implications are robust to the use of MIMIC-based employment.” estimates. 138 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 3.2 Informality in advanced economies and Regional informality: Common in all EMDE EMDEs regions. Informality is common in all EMDE There is wide cross-country heterogeneity in informality, especially among regions but takes different forms (World Bank EMDEs. Since 1990, the share of informal employment and output has 2012). On average, the informal economy’s share declined in both advanced economies and EMDEs, despite largely of output is highest in Sub-Saharan Africa (SSA), unchanged perceptions of the size of the informal sector. Europe and Central Asia (ECA), and Latin America and the Caribbean (LAC). The share of A. Share of informal activity B. Informal activity over time self-employment, however, is highest in Sub- Saharan Africa (SSA), South Asia (SAR), and East Asia and the Pacific (EAP; Figure 3.3). Two country examples illustrate differences across regions. In Brazil, the informal sector employs one-third of total employment and produces one- third of GDP. In Pakistan, the informal sector provides two-thirds of total employment but produces only about one-third of GDP. This C. Share of informal employment D. Informal employment over time difference points to considerably lower informal labor productivity relative to total labor productivity in Pakistan than in Brazil, in part reflecting lower educational attainment of informal workers (La Porta and Shleifer 2014; Loayza 2018). Three EMDE regions (EAP, LAC and ECA) alone accounted for more than one-third of the world’s informal output in 2016, but only one-quarter of E. Perceived informal activity F. Perceived informal activity over the world’s formal output. Almost half (42 time percent) of the world’s informal workers can be found in South Asia (SAR), although the region only accounts for 9 percent of the world’s formal employment and 3 percent of the world’s formal output (Box 3.2). Another 14 percent of the world’s informally employed are in Sub-Saharan Africa (SSA), well above SSA’s share of the world’s formal output (2 percent) or formal employment (5 percent). Source: Elgin et al. (forthcoming a); International Labour Organization; World Bank, World Development Indicators; World Economic Forum. Note: See Annex 3.1 for data definitions. Informality over time: Downward trend. The A.C.E. Group means for the period 2006-16 are shown in blues with +/-1 standard deviation shown in orange vertical bars. World means are shown in yellow lines (dashed line for MIMIC estimates in A). shares of both informal output and self- The group statistics are calculated for the world, advanced economies (AEs) and emerging market and developing economies (EMDEs). employment have declined since 1990, especially B.D.F. Group means are calculated for advanced economies (AEs, in blue) and emerging and developing economies (EMDEs, in red). Dashed lines are for MIMIC estimates in B. In D, missing in EMDEs (Figure 3.2 and 3.4). Between 1990- data for informal employment are extrapolated in EMDEs for earlier years and filled using the latest 16, on average, the share of informal output fell by available observation in recent years. E.F. WEF (World Economic Forum) index of informality. about 7 percentage points of GDP in EMDEs (to 32 percent of GDP) and by about 4 percentage points (to 17 percent of GDP) in advanced economies. Over the same period, the average share of self-employment declined by about 4 percentage points (to 14 percent of total employment) in advanced economies and by G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 139 about 4.5 percentage points (to 43 percent of total FIGURE 3.3 Informality by EMDE region employment) in EMDEs. These declines were Informality is common in all EMDE regions but takes different forms. On broad-based: the share of informal output declined average, the share of informal output is highest in Sub-Saharan Africa, by 5 percentage points of output or more between Europe and Central Asia, and Latin America and the Caribbean. The share of self-employment is highest in Sub-Saharan Africa, South Asia, and East 1990 and 2016 in all advanced economies and 86 Asia and the Pacific. percent of EMDEs.12 A. DGE-based informal activity B. MIMIC-based informal activity In EMDEs, the largest declines in the shares of informal output and employment occurred from the mid-2000s onwards in a reversal of a decade of rising informal employment and barely shrinking informal output.13 In advanced economies, the largest declines in the share of informal employment occurred between the late 1990s and the global financial crisis; they have since partly reversed, amid anemic post-crisis growth (Figure 3.2).14 Among EMDE regions, the informal C. Informal employment D. Labor force without pension economy’s share of output dropped most in EAP, LAC, and SAR, while the share of self- employment dropped most in EAP, ECA, and the Middle East and North Africa (MENA; Box 3.2). Characteristics of informal sector business cycles. The main features of recessions and recoveries in the formal economy, defined as in Harding and Pagan (2002) and Claessens, Kose, and Terrones (2012), do not differ statistically significantly from F. Share of EMDE regions of world E. Perceived informal activity those in the formal economy (Figure 3.5; Elgin et output and employment al. forthcoming a). On average, both formal and informal recessions last about 1.5 years, which are about 0.5 years shorter than formal and informal recoveries. The speeds of adjustment in recessions (about 4 percentage points decline per year) and of recoveries do not differ statistically significantly between formal and informal sector. Source: Elgin et al. (forthcoming a); International Labour Organization; World Bank, World Development 12 e DGE-based measure of informal output shows that Indicators; World Economic Forum. between 1990 and 2016, the share of informal output over o cial Note: See Annex 3.1 for data definitions. Blue and red bars indicate group means for 2006-16, with GDP fell in 140 (36 AEs and 104 EMDEs) out of 158 countries orange vertical bars indicating +/-1 standard deviation. EAP = East Asia and Pacific, ECA = Europe and Central Asia, LAC = Latin America and the Caribbean, MNA = Middle East and North Africa, SAR = where data are available. Similar results are found in MIMIC-based South Asia, and SSA = Sub-Saharan Africa. EMDEs = Emerging market and development economies. measure on informal output. During the same period, 84 (18 AEs C. Self-employment shares are used here. and 66 EMDEs) out of 127 countries experienced a drop in the share E. Informality index provided by World Economic Forum (a higher value indicates more informality). of self-employment. F. DGE-based estimates of informal output in each region as a proportion of total estimated informal GDP. Shares of self-employment are used as proxies for shares of informal employment. Formal output 13 e small-scale decline in the beginning of the 1990s is also is equivalent to official GDP. Estimates are based on their respective average shares of output and driven by the expanding informal sector in countries in Eastern and employment during 2010-16. Central Europe during their economic transition (Kaufmann and Kaliberda 1996). 14 A country-speci c regression of the share of the informal economy in GDP and employment on a time trend over the period 1990-2016 captures this secular decline. In 50 (WEF)-100 (DGE) percent of advanced economies (depending on the measure) and 48 (WEF)-81 (MIMIC) percent of EMDEs, there has been a signi cant downward trend in the share of the informal economy in GDP and employment. 140 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 3.2 Regional dimensions of informality: An overview Informality, especially employment informality, is most prevalent in less developed EMDE regions. Together, South Asia and Sub- Saharan Africa account for nearly 60 percent of all informal workers in EMDEs. However, even in some wealthier EMDE regions, such as Latin America and the Caribbean and Europe and Central Asia, informality remains significant in part due to weak institutions and high levels of taxation and regulation. Both the drivers and implications of informality vary across and within regions, suggesting the need for tailored policy responses. The informal economy accounts for a significant regions by formal GDP, accounting for one-quarter of the proportion of both employment and output across world’s formal output. EMDEs. Around three-quarters of EMDE employment is In terms of employment, almost half (42 percent) of the estimated to be in the informal sector. Self-employment, world’s informal workers can be found in South Asia which is relatively easy to measure and provides a lower (SAR), although the region accounts for just 9 percent of bound estimate of informality, is 43 percent of total the world’s formal employment and 3 percent of the employment in the average EMDE, although this world’s formal output (Figure 3.2.1). Sub-Saharan Africa proportion ranges from 22 percent in the Middle East and (SSA) is also over-represented in its share of informal North Africa (MENA), to 62 percent in Sub-Saharan employment, accounting for 14 percent of the world’s Africa (SSA).1 total, well above its share of the world’s formal output (2 Informality has both costs and benefits. It can provide an percent) or formal employment (5 percent). important source of income in EMDEs, often to those Informal-sector productivity in EMDE regions. In all with few available alternatives. That said, informal EMDE regions, the proportion of informal employment employment is often associated with lower and more exceeded the share of informal output, reflecting a uncertain incomes for workers and lower revenues tendency for the informal sector to be less productive than available for governments to fund their development the formal sector (La Porta and Shleifer 2014; Fajnzylber, objectives. Maloney, and Montes-Rojas 2011). This difference is particularly pronounced for SAR and SSA, where the The regional disparities in the scale of informality depend informal employment share is approximately double the on a wide range of factors. To summarize these regional informal output share. distinctions, this box addresses the following questions: Trend decline in informality. In all EMDE regions, the • Where is global informality concentrated? informal sector has steadily declined in relative importance since the 1990s. On average, informality has fallen by 5 • What have been the correlates of informality across percentage points of GDP since the 1990s, partially driven EMDE regions? by economic development and improvement in governance. The decline in relative importance was largest • What policy options are available? in EAP and SAR with informality falling by 8 percentage points in both regions. Faster-than-average formalization Where is global informality concentrated? of the economy in these two regions is likely to in part Regional composition of EMDE informal sectors. One- reflect faster-than-average per capita GDP growth since half of the world’s informal output and 95 percent of the 1990s. Conversely, informality in the Middle East and informal employment is located in EMDEs. Three EMDE North Africa (MENA) decreased only modestly amid regions alone accounted for one-third of the world’s persistently weak growth and entrenched weak governance. informal output in 2016: East Asia and Pacific (EAP), Within-region heterogeneity. The regions with the widest Latin America and the Caribbean (LAC), and Europe and per capita income heterogeneity were also those with the Central Asia (ECA). They are also the largest EMDE widest range of informality as a share of output or employment. Informality is significantly more prevalent in lower-income economies within EAP despite the relatively Note: This box was prepared by Gene Kindberg-Hanlon with research low share of informal output for the region as a whole. In assistance from Jinxin Wu and Zhuo Chen. It summarizes six boxes on MENA, the non-Gulf Cooperation Council (GCC) the regional dimensions of informality featured in Chapter 2. 1 For the purposes of this box, informal employment is proxied by self- economies have elevated levels of informality while the employment because of good data coverage, and the regional disparities share for MENA as a whole is the lowest of all EMDE identified in this box are robust to other measures. regions (Box 2.4). In contrast, in SSA, where the variation G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 141 BOX 3.2 Regional dimensions of informality: An overview (continued) FIGURE 3.2.1 Informality in EMDE regions Informality is pervasive across all EMDEs —although the share of informal output in GDP has been falling over time, its incidence is higher in the poorest regions. A. Share of EMDE regions of world B. Share of aggregate EMDE informal C. Employment and output share by output and employment employment and output region D. Share of informal GDP over time E. GDP per capita and share of informal F. GDP per capita and share of informal output employment Source: Elgin et al. (forthcoming a), World Bank. Note: Data are between 2010 and 2016. EAP = East Asia and Pacific, ECA = Europe and Central Asia, LAC = Latin America and the Caribbean, MNA = Middle East and North Africa, SAR = South Asia, and SSA = Sub-Saharan Africa. A.B. DGE-based estimates of informal output in each region as a proportion of total estimated informal GDP. Estimates of self-employment shares are used to proxy informal employment. Formal output equals official GDP. Estimates are based on their respective average shares of output and employment. C. Mean of informal output (DGE-based estimates, percent of official GDP) and employment estimate (self-employment, percent of total employment) in each region. D. Average DGE estimate of informal output relative to total output in each time period. E.F. Grey markers show average log GDP (2011 PPP $ - averaged 2010-16) relative to DGE/SEMP estimate of informal output/employment for 154 and 147 economies respectively, with the fitted lines shown in blue and the corresponding +1 and -1 standard errors shown in shaded gray areas. Regional markers show median GDP per capita and median informal output/employment in EMDE regions. of per capita incomes is one-fifth that of MENA (the Economic development. Informality is most prevalent in EMDE region with the largest per capita income EMDE regions with low income per capita, reflecting the heterogeneity), informality amounted to over 30 percent role of informality as both a driver and consequence of of output and 39 percent of employment in three-quarters poverty (La Porta and Shleifer 2014). None of the regional of countries. shares of informal output or employment deviates statistically significantly from what might have been What have been the correlates of informality expected based on average per capita incomes alone across regions? (Figure 3.2.1). Informality is concentrated in countries which are less Low human capital. Informality is also more prevalent developed and suffer from a range of institutional where educational attainment is weak.2 In SSA, where weaknesses. Poverty and low human capital are strongly associated with those regions with the highest incidence of 2 Docquier, Müller, and Naval (2017) demonstrates that a sizeable informality. In contrast, in wealthier regions such as LAC informal sector that competes with the formal sector for low-skilled and ECA, institutional weaknesses and tax policy have workers reduces the incentives to invest in human capital in the long run. In addition, weak educational attainment is a feature of lack of contributed to elevated levels of informality. development, which contributes to informality (Loayza 2016). 142 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 3.2 Regional dimensions of informality: An overview (continued) FIGURE 3.2.2 Regional correlates of informality Informality is most prevalent in regions with poor educational attainment and large agricultural sectors. In some regions where tax avoidance is relatively easy, there is a strong relationship between the region’s above-average tax rates and the level of informality. A. Years of schooling, by EMDE region B. Share of agricultural sector in total C. Corporate tax rates output, by EMDE region Sources: Barro and Lee (2013), Végh and Vuletin (2015), World Development Indicators, World Bank. Note: EAP = East Asia and Pacific, ECA = Europe and Central Asia, LAC = Latin America and the Caribbean, MNA = Middle East and North Africa, SAR = South Asia, and SSA = Sub-Saharan Africa. A. Average years of schooling for those aged 15 and older, taken from Barro and Lee (2013). B. Average agricultural output as a percentage of total GDP. C. Corporate tax rates are constructed as regional averages using Végh and Vuletin (2015). educational attainment is the lowest on average among • In ECA, a high share of informal output is partly a EMDEs, informal sector workers are much less likely to legacy of the collapse of the Soviet Union in the late have completed primary education than those in the 1980s and early 1990s as well large remittance inflows formal sector (Figure 3.2.2; Adams, de Silva, and Razmara that have financed informal sector activity (Box 2.2). 2013). Education levels have also been found to be an important correlate of informality in SAR, where • In some LAC economies, the trade liberalizations of attainment is also below the EMDE average.3 the 1990s have been identified as contributors to growing informality, as formal firms that were unable High regulatory and tax burdens. In LAC, several studies to compete in a liberalized formal economy retreated have found a strong relationship between the region’s into informality (Box 2.3). above-average tax rates and ease of tax avoidance, and the level of informality (Figure 3.2.2; Loayza 1996; Vuletin • In MENA, although informality is particularly 2008; Ordóñez 2014). For ECA, labor market regulations pronounced in non-GCC economies, in the GCC that are more restrictive than elsewhere have been informality is low partly because of its heavy reliance identified as drivers of informal employment (Fialová and on documented foreign workers and government Schneider 2011). employment (Box 2.4; World Bank 2018c). Weak institutions. Some economies in ECA have below- average institution quality, which may explain the region’s • In SSA, large agricultural sectors help explain slightly above-average degree of output informality despite widespread informal employment as does the conflict ECA’s relatively high per capita income. In non-GCC and violence that have afflicted the region and forced MENA economies, corruption has been cited among the people to earn their livelihoods in the informal biggest hindrances to firms which may increase incentives economy (Box 2.6). to operate informally (World Bank 2016). What policy options are available? Region-specific factors. A number of region-specific factors have contributed to informality. To mitigate the damaging e ects associated with informality, policy responses can be tailored to the circumstances and drivers of informality in that economy. 3 Williams, Shahid, and Martinez (2016), Bahadur and Parajuli Policy options can be broadly split into several categories: (2014), and Gunatikala (2008). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 143 BOX 3.2 Regional dimensions of informality: An overview (continued) Improving human capital. By investing in education and reducing informality. In ECA, where corporate tax rates social services to improve human capital, policy makers are lower than the EMDE average, higher taxation was can improve the productive capacity of workers that are associated with increased formalization in some studies currently uncompetitive in the formal sector. Training has because of the lack of public goods provided in regions been found to boost worker income and rm revenue in with insu cient tax revenue (Fialová and Schneider 2011; studies in the informal sectors of SSA and SAR (Verner Friedman et al. 2000). Separately, less restrictive and Verner 2005; Burki and Abbas 1991). employment protection has been associated with a smaller informal economy (both in employment and output) in Improving access to public services and finance. E orts to ECA countries (Fialová and Schneider 2011: Lehmann facilitate informal sector business can bene t informal and Muravyev 2009). sector workers and make them more competitive (Box 2.6; Sonobe, Akoten, and Otsuka 2011). For example, in SSA, Tightening enforcement. Enforcement that is providing informal traders public goods, such as a market economically and socially sensible can help reduce the to trade in or access to water and sanitation, has helped presence of the informal sector (Loayza 2018). In LAC, increase informal rm pro tability and product quality. In policies such as labor inspections have been found to SAR, a lack of access to nancial resources is common for induce informal workers and rms to formalize (De the self-employed (Ghani, Kerr, and O’Connell 2013; Box Andrade, Bruhn, and McKenzie 2013; and Almeida and 2.5). Enabling access to micro nance has been found to Carneiro 2012). Studies in ECA, SAR and EAP have also increase investment and productivity in the informal sector found that lower levels of enforcement are associated with (Likhi 2013; Donou-Adonsou and Sylwester 2017; Imai higher rates of informality (Box 3.4). Regulatory and tax and Azam 2012). compliance rates increase more if increased labor or tax inspections are accompanied by other measures such as Easing tax and regulatory burdens. Several studies in LAC awareness campaigns (Rani et al. 2013). have found that policies to reduce tax rates and simplify tax systems have incentivized rms to transition to the Reducing corruption. In ECA, where informality rose formal sector. Payroll or business tax cuts in Colombia, considerably following the disruptions associated with the Brazil and Uruguay have been associated with higher collapse of the Soviet Union, higher corruption has been formal employment and rm registration.4 However, in linked with higher informality (Friedman et al. 2000). regions where tax rates or tax compliance costs are not Economies in ECA that were slower to implement elevated, cutting taxes can be counterproductive in structural reforms and control corruption in the 1990s saw a smaller-than-average decline in informality (Kaufmann and Kaliberda 1996). Corruption is also a key disincentive 4 See Fernández and Villar (2016), Fajnzylber, Maloney, and Montes- to enter the formal sector in MENA according to rm Rojas (2011), and Monteiro and Assunção (2012). surveys. Causes and implications formal sector to absorb rural migrants during the urbanization process (Harris and Todaro of informality 1970; Fields 1975; Loayza 2016). Development can further shrink the informal Causes of informality. Theoretical models present sector because households tend to shift away two major reasons for the emergence of informal from agricultural and informal sector goods as activity: lack of development (Harris and Todaro their incomes grow (Saracoglu 2008). Finally, 1970; Loayza 2016), and poor governance limited access to credit, often associated with including burdensome regulations, corruption, or less development, constrains informal rms’ poor public services (de Soto 1989). ability to overcome barriers to entry into the formal sector.15 • Lack of development. Informality has often been attributed to under-development. is 15 See Ferreira-Tiyaki (2008), D’Erasmo and Moscoso Boedo re ects an inability of an urban modern (2012), and Capasso and Jappelli (2013). 144 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 3.4 Changes in informality Implications of informality. A sizeable informal sector could impede growth, encourage poor Informality declined in EMDEs during the period 1990-2016, with the share of output dropping especially in East Asia and the Pacific, Latin America governance, and limit a government’s ability to and Caribbean, and South Asia. reduce income inequality. A. Changes in informality: Income B. Changes in informality: EMDE • Slower growth. A sizeable informal sector that groups regions competes with the formal sector for low- skilled workers reduces the incentives to invest in human and physical capital and new technologies and slows growth in the long run (Docquier, Müller, and Naval 2017; Loayza 1996; Sarte 2000). • Poor governance. Several theoretical models attribute corruption and excessive regulations Source: Barro and Lee (2013), Elgin et al. (forthcoming a), World Bank (World Development Indicators). to the presence of an informal economy. Note: See Annex 3.1 for data definitions. Data are 1990-2016 group averages. EAP = East Asia and Government o cials are incentivized to Pacific, ECA = Europe and Central Asia, LAC = Latin America and the Caribbean, MNA = Middle East and North Africa, SAR = South Asia, and SSA = Sub-Saharan Africa. impose excessive regulations and permits to A. Unweighted group averages for advanced economies and EMDEs, with self-employment (in percent of total employment) shown in red and DGE-based informal output (in percent of official have the power to collect bribes in return for GDP) shown in blue. Unweighted world averages are shown in dashed lines. B. Unweighted group averages for EMDE regions, with self-employment (in percent of total providing permits (Shleifer and Vishny 1993). employment) shown in red and DGE-based informal output (in percent of official GDP) shown in blue. Others have argued that the government Unweighted EMDE averages are shown in dashed lines. strategically designs a system of poor governance to promote informality for the • Heavy-handed regulation. Higher taxation poor, which acts as an alternative and heavy-handed regulation increases rms’ redistributive strategy (Marjit, Mukherjee, and incentives to reduce taxation or the cost of Kolmar 2006). regulatory compliance by remaining informal (Ihrig and Moe 2004; Amaral and Quintin Correlates of informality 2006; D’Erasmo and Moscoso Boedo, 2012; Auriol and Warlters, 2005; Prado 2011; The causes and implications of informality Kanbur 2017; Dabla-Norris et al. 2018; predicted by theoretical models are also confirmed Ulyssea 2018).16 Excessive labor regulations by empirical studies as many correlates of encourage informal employment by increasing informality are symptoms of under-development. the cost of formal employment (Rauch 1991; A large informal economy is associated with Loayza 2016). weaker economic outcomes, such as a under- development, less access to credit, limited trade • Poor governance. Corruption and rent- openness, less skilled labor force, as well as weaker seeking bureaucracies increase rms’ output, investment and productivity growth (Box incentives to avoid interaction with the state 3.3). Informality is also associated with less by remaining informal (Sarte 2000; Choi and effective institutions, such as weak governance and um 2005; Freidman et al. 2000). excessive tax and regulatory burdens (Loayza, Conversely, access to productivity-enhancing Oviedo, and Servén 2006; Enste and Schneider public goods, such as to electricity or the 1998). court system, can lead to an increase in the share of formal production (Mendicino and Under-development. A lower level of Prado 2014). development, as measured by per capita income, is associated with higher informality (Figure 3.6).17 16 Also see Busato and Chiarini (2004), Charlot, Malherbet, and 17 See also Loayza, Servén, and Sugawara (2006) and La Porta and Terra (2015), Saracoğlu (2008), and Ordóñez (2014). Shleifer (2014). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 145 In the case of both output and employment FIGURE 3.5 Characteristics of informal- and formal- informality, GDP per capita in countries with economy business cycles below-median (“low”) informality is about 2-3 Informal-economy business cycles are not significantly different from times of those in countries with above-median formal-economy business cycles. (“high”) informality (Figure 3.6).18 The lower productivity and resource misallocation associated A. Recessions in the formal and B. Recoveries in the formal and informal sectors informal sectors with higher informality may also be reflected in slower output growth.19 Slower accumulation of physical and human capital. A larger informal economy is associated with a lower rate of output growth. This may reflect slower accumulation of physical or human capital (Ovedio, Thomas, and Karakurum- Ozdemir 2009). At the firm level, informality can Source: Elgin et al. (forthcoming a); Penn World Table; World Bank, World Development Indicators. limit access to conventional bank credit, because Note: Data are for the period 1990-2016. Diamonds indicate sample means; bars indicate 95 percent confidence intervals. Business cycle turning points are determined based on formal and informal of a lack of documentation for assets and GDP levels (i.e., official GDP statistics, DGE estimates) using the algorithm of Harding and Pagan inadequate financial statements.20 Investment (2002). Recession is defined as the phase from peak to trough, and recovery as the phase from trough to a return to pre-recession output levels. “Duration”, and “Speed of adjustment” (often termed activity in the informal sector may also be subdued as “Slope”) are defined as in Annex 3.2. because informal firms may be unwilling to adopt technologies that would make them more visible to tax and other authorities (Dabla-Norris and their formal counterparts; although this Inchauste 2008; Gandelman and Rasteletti 2017). productivity differential in part reflects the For example, about 11,600 firms that participated characteristics of informal firms.21 On average, in Enterprise Surveys in 18 countries during 2007- informal labor productivity is lower than total 2014, the fraction of firms that invested in any labor productivity in EMDEs, although not in given year in the formal sector was significantly advanced economies (Figure 3.6; Loayza 2018). In higher than that in the informal sector. In the long addition, competition from informal firms has run, the tendency to hire less skilled workers in been associated with lower productivity of formal the informal sector may slow human capital firms. The presence of informal competitors, accumulation. Indeed, countries with below- which do not shoulder regulatory and tax burdens, median informality tend to have significantly can reduce formal firms’ profitability, thus eroding higher levels of human capital (Maloney, 2004; their ability to invest in productivity-enhancing Docquier, Müller, and Naval 2017; Figure 3.6). technologies or human capital (Perry et al. 2007; Box 3.3). Slower productivity growth. At the macroeconomic level, the evidence for a Less trade openness. A smaller informal sector is correlation between productivity growth and associated with greater economic openness, informality has been mixed (Perry et al. 2007; especially to trade.22 On average, the trade-to- D’Erasmo and Moscoso Boedo 2012). At the firm GDP ratio is lower by 17 percentage points in level, in contrast, many studies have shown that informal firms tend to be less productive than 21 La Porta and Shleifer (2014), Fajnzylber, Maloney, and Montes-Rojas (2011), de Mel, McKenzie, and Woodru (2012), 18 Median informality amounts to about 32 percent of GDP for Demenet, Raza ndrakoto, and Roubaud (2016), and McKenzie and DGE-based informal output and 34 percent of total employment for Sakho (2010). self-employment. 22 Empirical studies, such as Goldberg and Pavcnik (2004, 2007), 19 See Hsieh and Klenow (2009), Loayza and Rigolini (2011), Sharma (2009), Boly (2018), and McCaig and Pavcnik (2018), show Docquier, Müller, and Naval (2017), Cirera and Maloney (2017), that informality declined following some trade liberalization episodes. Levy (2018), and Bachas, Jaef, and Jensen. (2018). Conversely, a short-term increase in informality has been attributed 20 See Koeda and Dabla-Norris (2008) for details. Empirically, to trade liberalization amid inflexible labor markets in studies such as greater access to credit has been associated with lower informality Goldberg and Pavcnik (2003), Attanasio, Goldberg and Pavcnik (Maloney 2004; Straub 2005; La Porta and Shleifer 2014). (2004), and Bosch, Goñi-Pacchioni, and Maloney (2012). 146 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 3.3 Casting a shadow: Productivity in formal and informal firms The average informal firm in emerging market and developing economies (EMDEs) is only one-quarter as productive as the average firm operating in the formal sector. Moreover, firms in the formal sector that face informal competition are, on average, only three-quarters as productive as those that do not. This suggests that competition from the informal sector can erode formal firms’ market share and resources available to boost productivity where formal firms shoulder the additional cost of regulatory compliance. More effective governance and stronger control of corruption can help mitigate these effects. e productivity di erential between formal and informal and type of activity (Amin and Huang 2014; Amin and rms is well established in the literature (Loayza and Islam 2015). Rigolini 2006; Oviedo 2009). However, there is mixed evidence on the impact of a large informal sector on Methodology. In this box, the productivity gap between formal rms’ productivity. Some studies suggest that the formal and informal rms is estimated using World Bank’s informal and formal sectors operate independently so that Enterprise Survey data collected over a period spanning there are no productivity spillovers (La Porta and Shleifer 2007 to 2014 for a cross-section of 4,036 informal rms 2014). Others report that competition from the informal and 7,558 formal rms in 18 EMDEs (Annex Table 3.1). sector may erode the pro tability of rms that operate in Formal rms are those that comply with tax, customs, the formal sector, which leads to limited resources to labor, and licensing regulations and register with the enhance rm productivity.1 e aggregate e ect depends relevant authorities; unregistered rms belong to the on country characteristics. informal sector. To estimate the productivity gap, a measure of labor productivity—log annual sales in 2009 Against this backdrop, this box documents the U.S. dollars per worker—is regressed on a dummy variable productivity gap between formal and informal rms and that takes the value 1 for informal rms and 0 otherwise their interactions. Speci cally, it addresses the following and a set of control variables capturing additional rm questions: characteristics (employment size, time in business, location, sector, country).3 • How large is the productivity di erential between formal and informal rms? Lower productivity in informal than formal firms. Virtually across the board, rm-level labor productivity is • To what extent are formal rms exposed to informal much lower in the informal sector than in the formal competition? sector (Annex Table 3.1).4 e productivity di erentials vary widely in this sample, from 48 (Côte-d’Ivoire) to 93 • How does informal competition a ect the percent (Argentina). On average across the whole sample, productivity of formal rms? the productivity of informal rms is only one-quarter of the productivity of formal rms (Figure 3.3.1). Productivity differential between formal and Drivers of productivity gap between informal and formal informal firms firms. Firm size, age, location in the capital city and manager experience are associated with signi cantly larger Literature review. e literature documents that informal productivity gaps between informal and formal sectors rms in EMDEs are less productive than formal (Figure 3.3.1, Annex Table 3.2).5 Formal rms appear to rms, with a productivity gap ranging between 30 to 216 be better equipped to reap the productivity bene ts from percent (Perry et al. 2007; La Porta and Shleifer 2008). size, age, and location than informal rms. is productivity gap between informal and formal rms is attributed to modest technological improvements, reliance on unskilled labor, limited economies of scale, 3 Commonly used revenue-based measures of productivity may and restricted access to services, markets, and funding.2 con ate e ciency and price e ects. Disentangling e ciency and price Moreover, labor productivity varies within the informal e ects, by relying on physical productivity measures, may shed new light sector along di erent dimensions such as rm size on productivity patterns, especially at the rm level (Jones and Nordhaus 2008; Cusolito and Maloney 2018). 4 Exceptions are Democratic Republic of Congo and Cabo Verde Note: This box was prepared by Mohammad Amin and Cedric Okou. possibly due to a low productivity of formal rms. 1 Gonzalez and Lamanna (2007), Heredia et al. (2017), Mendi and 5 e results are robust to comparing the coe cient estimates for the Costamagna (2017). informal- rm dummy between a baseline regression including all controls 2 Jovanovic (1982), Amaral and Quintin (2006), Galiani and and an alternative regression dropping each dummy one at a time (Annex Table 3.2). Weinschelbaum (2012). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 147 BOX 3.3 Casting a shadow: Productivity in formal and informal firms (continued) FIGURE 3.3.1 Characteristics of informal firms Among informal firms, those with managers with higher education and those without any employees other than the owner are significantly more productive. The average informal firm in emerging market and developing economies has only one-quarter of the productivity of the average firm operating in the formal sector. This productivity differential between formal and informal firms is particularly pronounced among larger and older firms that operate in the capital city and are led by experienced managers. A. Average productivity in formal and B. Productivity differential between C. Productivity differential between informal firms different types of informal firms formal and informal firms, by type of informal firms Source: World Bank. Notes: World Bank’s Enterprise Survey data for 135 countries (2008-18). Labor productivity is proxied by the annual sales in 2009 U.S. dollars per worker. Bars show the estimates with the corresponding +/- 2 standard errors shown in whiskers. A. Labor productivity in the average formal and average informal firm, controlling for firm characteristics (firm size and age, manufacturing sector activity, location in the capital city and country fixed effects) as shown in column (1) in Annex Table 3.2. B. Cross-country average of percent difference between labor productivity in the median informal firm with a manager with higher education or without any employees other than the owner, and the median informal firm with a manager without higher education or with more employees than the owner. Estimates from Annex Table 3.1. C. Difference in log of labor productivity between the average formal and average informal firm in each group, as estimated in coefficient estimates of Annex Table 3.2. “Other” stands for “not located in capital city”; “Cap.” stands for “located in capital city.” • Firm age. As rms grow older, they are either • Firm location. Capital cities are typically among su ciently productive to survive or they disappear countries’ largest economic centers and so can o er (“selection e ect”; Brandt, Van Biesenbroeck, and agglomeration bene ts: larger markets, better Zhang 2012). In addition, learning from experience infrastructure to access markets and operate, a larger may have taught older rms productivity gains pool of workers, greater technology spillovers (“learning e ect”; Luttmer 2007). ese e ects appear (Rosenthal and Strange 2004; Duranton and Puga to be much more pronounced among formal rms 2004). Again, formal rms appear to be better able to than among informal rms. As a result, the bene t from these locational advantages, but the e ect productivity di erential between formal and informal is economically modest (although statistically rms widens as the age of rms increases. Among one- signi cant). Among rms operating inside the capital year-old rms, informal rms have about half the city, informal rms’ productivity is 31 percent that of productivity of formal rms. Among ten-year-old similar formal rms; outside the capital city, informal rms, informal rms have less than one-quarter the rms’ productivity is 30 percent that of similar formal productivity of formal rms. rms. • Firm size. Larger rms can reap economies of scale • Manager experience. Managerial ability has been that raise their productivity compared to smaller associated with higher productivity, through a variety rms. Again, in this sample, this e ect appears to be of channels including hiring decisions and input stronger among formal rms than among informal choices (Fernandes 2008). Again, managerial rms. Among rms with one employee, informal experience appears to bene t formal rms’ rms have just under one-third the productivity of productivity more than informal rms’ productivity. formal rms; among rms with ten employees, Among rms managed by managers with one year of informal rms have less than one-quarter the experience, informal firms’ productivity is just over productivity of formal rms. one-third that of formal firms; among firms with 148 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 3.3 Casting a shadow: Productivity in formal and informal firms (continued) managers with ten years of experience, informal firms’ the formal sector yet choose to remain informal to bene t productivity is less than one-quarter that of formal from the cost advantage of noncompliance with (possibly firms. excessive) taxes and regulations (Maloney 2004; de Mel, McKenzie, and Woodru 2011).8 Such informal rms Productivity differentials across informal firms. Labor could constitute an untapped potential for a productivity productivity also differs across different types of informal boost (de Soto 1989). On the other hand, they can create firms, although the characteristics that are associated with aggressive competition with formal rms that do shoulder higher labor productivity of informal firms differ across the additional cost of tax and regulatory compliance. Such countries.6 In two-fifths of countries, informal firms informal competition can reduce the pro tability necessary managed by a manager with higher education or without for formal rms to invest in productivity-enhancing new any employees other than the owner are significantly more technologies or to innovate, especially in a context of weak productive than other informal firms (column (1) in property rights enforcement.9 Alternatively, this very Annex Table 3.2). Other informal firm characteristics, competition could force formal rms to increase such as operating in the services sector or being a startup, productivity or, for the lowest-productivity ones, to exit.10 are accompanied by higher productivity in some countries but lower productivity in other countries. Extent of informal- rm competition for formal rms. In the World Bank’s nationally representative survey data for Productivity of formal firms amid high 75,137 formal (registered) rms in 135 countries between informality 2008 and 2018, about 55 percent of formal rms reported facing competition form informal rms.11 e share of Impact of informal competition on formal firms: eory. informal rms competing against formal rms was about e extent of competition between formal and informal 60 percent in EMDEs, 13 percentage points higher than rms depends on the underlying reasons for the existence in advanced economies. e level of competition varied of informal rms.7 widely across countries, ranging from about 7 percent in Bhutan to 95 percent in Uganda. Smaller rms were Informality as a survival strategy of unproductive rms. Low- signi cantly more likely to be exposed to informal productivity rms may be forced into informal operations competition than larger rms but there is little evidence of or, even if they operate formally, employing informal any other systematic di erence between rms that were workers because this may reduce their costs (Ulyssea 2018; exposed and those that were not (Figure 3.3.2). Boly 2018). Operating in the informal sector and employing informal labor may, therefore, be a survival Impact of informal competition on the strategy for less-productive rms that belong to productivity of formal firms fundamentally di erent markets (La Porta and Shleifer 2014). “Surviving” informal rms are likely to operate in Methodology. OLS regressions are used to estimate the very di erent markets and sell di erent products than di erence in labor productivity between formal rms that formal rms (La Porta and Shleifer 2014). In such compete against informal rms and those that do not. In circumstances, competition between informal and formal the baseline speci cation, the dependent variable is again rms and its impact on formal rms may be limited. Informality as an evasion strategy of productive rms. Some informal rms may be su ciently productive to survive in 8 Such circumstances are likely to be associated with an environment of weak regulatory and tax enforcement (Quintin 2008; Dabla­Norris, Gradstein, and Inchauste 2008; Ulyssea 2010; Benjamin and Mbaye 2012). 6 Haltiwanger, Lane, and Spletzer (1999), Maloney (2004), 9 is has been documented for some Latin America countries, India, |Deininger, Jin, and Sur (2007), de Mel, McKenzie, and Woodru Poland, Portugal, Russia, and Turkey. For evidence, see Heredia et al. (2011), Grimm et al. (2012), Amin and Huang (2014), Amin and Islam (2017), Perry et al. (2007), Farrell (2004), Capp, Elstrodt, and Jones (2015), Islam (2018). (2005), Cunha (2006), Gonzalez and Lamanna (2007), Friesen and 7 is discussion assumes that rms are either formal or informal. In Wacker (2013), Allen and Schipper (2016), Iriyama, Kishore, and Ta- practice, the degree of informality can vary (Perry et al 2007; Ulyssea lukda (2016), and Distinguin, Rugemintwari, and Tacneng (2016). 2018). At the extensive margin are rms that operate fully informally, in 10 is has been documented for Egypt, see Ali and Najman (2017); product markets and labor markets. ey sell their output informally and Melitz (2003); Schipper (2016). 11 In the World Bank’s Enterprise Surveys, formal rms are asked the employ informal labor. At the intensive margin are rms that operate semi-formally: they sell their output into formal product markets but following question: “Does this establishment compete against unregis- employ, in part, informal labor, as observed in EMDEs and LICs. tered or informal rms?” G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 149 BOX 3.3 Casting a shadow: Productivity in formal and informal firms (continued) FIGURE 3.3.2 Formal firms facing informal competition On average, more than half (55 percent) of formal firms reported facing informal competition. Nearly 60 percent of formal firms in EMDEs were exposed to informal competition whereas 47 percent of formal firms in advanced economies reported facing informal competition. The degree of informal competition reported by formal firms was higher for smaller than larger firms, but comparable across sectors or formal firms’ productivity. A. Formal firms reporting competition B. Formal firms reporting competition C. Formal firms reporting competition from informal firms, by country from informal firms, by firm size from informal firms, by firm sector Source: World Bank. Note: World Bank’s Enterprise Survey data for 135 countries (2008-18). Figures show the shares of formal firms. labor productivity measured by the (log of) annual sales in shape the productivity gap between formal rms that face 2009 U.S. dollars per worker. e main explanatory informal competition and those that do not. is is variable is the informal competition indicator proxied by captured in interaction terms between the share of similar the proportion of formal rms in a cell that report facing formal rms reporting informal competition and competition from informal rms. A cell is de ned as a indicators of development (the logarithm of per capita group of rms of similar size and in the same region and GDP), the quality of business climate as proxied by the sector.12 distance to the frontier in the Doing Business Index, the control of corruption of the World Governance Indicators, Productivity gap between formal firms with and without and the Business Freedom index of the Economic informal competition. Formal rms that face informal Freedom indicators (Annex Table 3.3). Higher GDP per competition are, on average, 24 percent less productive capita, better control of corruption, and a business than those that do not (Figure 3.3.3; Annex Table 3.3). environment that is freer and closer to best-practices After controlling for the informal competition, formal dampen the detrimental impact of informal competition rms in the manufacturing and retail industries have on formal rm productivity. higher productivity than those in other services. Older, exporting, and foreign-owned formal rms also have • Development. e sample is split into those countries higher productivity even if they face competition from with per capita income in the highest quartile in the informal rms. sample and those in the lowest quartile in the sample. Formal rms that face informal competition in the Role of the business climate and development. Economic average country with the highest per capita incomes development and the business climate may substantially are only 14 percentage point less productive than formal rms that do not face such competition. In contrast, on average in countries in the lowest quartile 12 As a caveat, the informal competition faced by a speci c rm may of per capita incomes, formal rms facing informal also be driven by its productivity, thus generating endogeneity concerns. To address possible endogeneity issue, we use the proportion of formal competition are 30 percent less productive than those rms facing informal competition in a group of rms of similar size in the rms that do not face such competition. same region and sector (a “cell”) rather than a rm dummy. A cell proportion should be much less correlated with the productivity of a • Control of corruption. Again, the sample is split into speci c rm, and therefore, should be more robust to endogeneity concerns. those countries in the quartile of countries with the 150 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 3.3 Casting a shadow: Productivity in formal and informal firms (continued) FIGURE 3.3.3 Productivity of formal firms facing informal competition On average, formal firms that face informal competition have only three-quarters of the productivity of firms that do not face informal competition, after controlling for firm characteristics. Better business climates and governance and more economic development can narrow this productivity differential. A. Productivity differential of formal B. Productivity differential of formal C. Productivity differential of formal firms with and without informal firms with average informal competition firms with average informal competition competition, by intensity and without, conditional on level of and without, by business climate development indicator Source: World Bank. Note: Based on coefficient estimates from Annex Table 3.3, which shows results from an OLS regression with labor productivity as the dependent variable, as proxied by annual sales (in 2009 U.S. dollars, in thousands, logs) per worker, in a sample of World Bank’s Enterprise Survey data collected during 2007-14 for 4,036 informal firms and 7,558 formal firms in 18 countries. Bars show the estimates with the corresponding +/- 2 standard errors shown in whiskers. A. Log productivity differential between formal firms facing informal competition and formal firms not facing informal competition. Maximum informal competition assumes that all firms in a cell face informal competition. Average informal competition assumes that 55 percent of firms in a cell face informal competition. B-C. Log productivity differential between formal firms facing informal competition and formal firms not facing informal competition, conditional on development and institutional quality. It is assumed that 55 percent of firms in a cell face informal competition. Each bar conditions on the GDP per capita (B), control of corruption (C), ease of Doing Business (C), or Business Freedom index (C) of the median country in the top (“highest quartile”) or bottom (“lowest quartile”) quarter of countries in terms of GDP per capita, control of corruption, ease of Doing Business, or Business Freedom index. strongest control of corruption and those in the Macedonia (among the countries with the most quartile with the weakest control of corruption. In conducive business climates). countries with the strongest control of corruption, on average, formal rms that face informal competition Conclusion are only 22 percentage point less productive than formal rms that do not face such competition, e productivity gap between informal and formal rms is whereas in the countries with the weakest control of substantial in EMDEs, averaging 75 percent in a sample of corruption, this di erential grows to 35 percent. 18 EMDEs between 2007-14. Competition from informal rms also appears to weigh on the productivity of exposed • Ease of Doing Business. Similarly, the productivity formal rms: the productivity of formal rms that compete di erential between formal rms that face informal with informal rms is only three-quarters that of formal competition and those that do not might halve (to 21 rms that do not compete with informal rms, after percent) if a country like Angola (in the quartile of controlling for other rm characteristics. Improvements in countries with the most di cult business climates) the business climate, and economic development more were to improve its business climate to the level of a broadly, can mitigate some of these negative productivity country like the Former Yugoslav Republic of spillovers from informal to formal rms. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 151 countries with a greater share of self-employment FIGURE 3.6 Correlates of informality: Economic and than countries with a smaller share of self- institutional factors employment (Figure 3.6).23 Similarly, higher Higher informality is associated with lower levels of development, poorer capital account openness is associated with less access to credit, heavier regulatory burdens, and weaker governance. output and employment informality. That said, the impact of major trade liberalization episodes A. Economic correlates in EMDEs with B. Economic correlates in EMDEs with on informality varies across countries and differs high and low output informality high and low employment informality between the short and the long term (Box 3.4; Goldberg and Pavcnik 2003; Fugazza and Fiess 2010; Dix-Carneiro and Kovak 2017). Heavier regulatory burden. Both empirical and theoretical studies suggest that heavier regulatory (or administrative) burdens may encourage informality as workers and firms join the informal sector to avoid regulatory and administrative compliance costs.24 The Doing Business distance- C. Informality and GDP growth D. Ratio of informal labor productivity to-frontier scores for countries with below-median to total labor productivity informality (by DGE estimates) is 60 points— which is significantly higher (by about 6 points or three-fifths of a standard deviation) than in countries with high (above-median) output informality (Figure 3.6). Similarly, the Business Freedom index is 7.5 points (about half of a standard deviation) higher in countries with low (below-median) output informality than in countries with high (above-median) informality. E. Regulatory burdens in EMDEs with F. Governance in EMDEs with high high and low informality and low informality Weaker governance. Research points to the contribution of poor governance to the pervasive informality in some EMDEs, especially in Latin America and the Caribbean and Europe and Central Asia regions (Box 3.2).25 On average, countries with above-median informality over the period 1990-2016 have had weaker government Source: Barro and Lee (2013), Elgin et al. (forthcoming a), Heritage Foundation, 23 However, the trade-to-GDP ratio is not different between World Bank (Doing Business, World Development Indicators, World Governance Indicators). countries with a greater share of informal output than countries with Note: Data are between 1990 and 2016.The corresponding 90 percent confidence intervals are a smaller share of informal output. shown as bars (except in D). 24 Perry et al. (2007), Ulyssea (2010), Bruhn (2011), de Mel, A-B. The group means for the following correlates are calculated for EMDEs with “high informality” (i.e., above median DGE-based informal output measure, A; above median self- McKenzie, and Woodruff (2013), Rocha, Ulyssea, and Rachter employment share, B) and those with “low informality” (i.e., below median DGE-based informal output (2018). measure, A; below median self-employment share, B) over the period 1990-2016: GDP per capita (in 25 Loayza, Oviedo, and Servén (2006) logs, PPP, constant 2011 international $, WDI), access to credit (i.e., private sector credit in percent nd that poorer of GDP); human capital (i.e., average years of schooling), trade openness (i.e. the sum of exports bureaucratic quality is associated with more informality. Choi and and imports in percent of GDP). um (2005) and Dreher and Schneider (2010) report an association C. Annual GDP growth rates are regressed against the six measures of informality while controlling between higher informality and weaker law and order and control of for real GDP per capita (in logs, WDI), D. The average relative ratio of informal labor productivity over total labor productivity in 2016 are corruption. Iriyama, Kishore, and Talukda (2016) show that rms shown in bars for advanced economies, EMDEs, and world, with corresponding 95 percent are more likely to engage in corruption when facing competition confidence interval shown in orange vertical bars. The relative ratio is calculated using DGE-based from informal rms. Dabla-Norris, Gradstein, and Inchauste (2008) estimates and the share of self-employment following the method in Loayza (2018). E-F. Unweighted group averages over the period 1990-2016 (shown as the orange diamonds) for show that the quality of the legal framework is important in EMDEs with high informality (above median DGE-based informal output measure) and those with low determining the size of the informal sector. Loayza and Wada (2010) informality are shown for the following correlates: Doing Business (measured as the overall distance estimate, for example, that 75 percent of the di erence in labor to frontier with 100 being the frontier and 0 being the farthest from the frontier, Doing Business); Business Freedom and Economic Freedom (Heritage Foundation); government effectiveness, control informality between Peru and Chile is due to causes related to poor of corruption, and rules of law (as defined in World Governance Indicators). governance. 152 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 3.7 EMDEs: Correlates of changes in informality informal output and employment shares. Since 2000, perceptions have shifted significantly (into a Among EMDEs, countries with larger declines in informality also have faster physical accumulation, improved access to credit, and better different quartile of informality) in only 14 governance. percent of all EMDEs (Elgin et al. forthcoming a). A. Correlates of changes in informality: Economic factors B. Correlates of changes in informality: Governance Informality, poverty, and income inequality Many studies document that informal-sector wages are below those in the formal sector, for a variety of reasons.27 This raises concerns that, over the long term, informality may entrench earnings differentials and income inequality and may contribute to greater poverty in countries with Source: Barro and Lee (2013), Elgin et al. (forthcoming a), World Bank (World Development high informality.28 Indicators, World Governance Indicators). Note: See Annex 3.1 for data definitions. Data between 1990 and 2016 in EMDEs are used here. A-B. Diamonds show the coefficient estimates obtained from regressing the annual change in Worker earnings differentials informal output (DGE-based estimates in percent of official GDP) or informal employment (self-employment in total employment) upon annual changes in various economic and governance indicators, with the corresponding 90 percent confidence intervals shown in bars. The indicators include real GDP growth, investment (in percent of GDP), access to credit (private sector credit in Causes of wage differentials. Lower wage in the percent of GDP), human capital (average years of schooling), trade openness (the sum of exports and imports in percent of GDP) and three measures from WGI (2018). Fixed-effects estimators are informal sector could result from different worker used here. characteristics in the formal and informal sectors, possibly in response to the comparative advantage that some workers might have in informal sector effectiveness (by about 0.6 points, or three- activities, or to non-wage benefits that might quarters of a standard deviations) than countries accrue to work in the informal sector (Maloney with below-median informality (Figure 3.6). 2004; Heckman and Li 2003). Alternatively, wage Similar differences are found in the case of control differentials could stem from rigidities and other of corruption and rule of law. For example, in factors that create a wedge in wages between Georgia, during the period 1996-2016, the similar workers in informal and formal transition to a market economy brought employment. These factors can include labor significant improvements in government effec- regulations or tax provisions that force workers tiveness, control of corruption, and rule of law. into the informal sector (Harris and Todaro With output growth averaging about 6 percent 1970). An alternative to measuring wage per year, the share of informal output fell by 9 differentials could be an assessment of the percentage points of GDP, and the share of subjective well-being or job satisfaction of workers informal employment in total employment fell by in the formal and informal sectors where workers a similar magnitude. benefit from flexibility and independence (e.g., Correlates of the decline in informality since Blanchflower, Oswald, and Stutzer 2001; Sanfey 1990. The decline in informality was larger in and Teksoz 2007; Falco et al. 2015). countries with the bigger improvements in governance and, for output informality, faster growth in GDP and investment, and better access 27 Perry et al. (2007), Marcouiller, de Castilla, and Woodru to credit (Figure 3.7).26 Perceptions of informality (1997), Tansel and Kan (2012), Bargain and Kwenda (2014), Goldberg and Pavcnik (2003), Pavcnik et al. (2004), Goldberg and appear to change much more slowly than actual Pavcnik (2003, 2007), and Paz (2014) all document the existence of wage premia. Pratap and Quintin (2006), El Badaoui, Strobl, and Walsh (2008), El Badaoui, Strobl, and Walsh (2010) caution that this premium disappears depending on model speci cations, 26 A panel regression suggests that faster declines in the share of estimation methods or country samples. agricultural employment and faster increases in the share of industrial 28 e linkage between informality and poverty could also be due employment are associated with larger long-term reductions in to the absence of better formal jobs in underdeveloped countries informality, controlling for per capita GDP. (Perry et al. 2007). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 153 Methodology: Meta-Regression Analysis. A meta- FIGURE 3.8 EMDEs: Estimates of informal-formal regression analysis is employed to aggregate wage gap estimates of the formal wage premium from a set Estimates of informal-formal wage gaps vary considerably across countries of studies to obtain a quantitative assessment of and definitions of informality. Countries in Latin America and the Caribbean the sources of cross-study variation. The analysis and Sub-Saharan Africa tend to exhibit both a higher incidence of informality and a larger wage premium in the formal sector. focuses on 18 studies that test for the presence of significant wage differentials between formal and A. EMDEs: Informal-formal wage gaps B. Informal-formal wage gap: informal jobs, and its main sources (a detailed meta-analysis review of literature and methodology are presented in Annex 3.3). As is common practice in such meta-regression analyses, no study is excluded ex ante based on its source or its results, but rather the selection of studies is constrained to those that present numerical estimates with confidence bands for country samples since 2000. Empirical estimates of wage differentials. The estimates of the wage differential between informal C. Informal-formal wage gap and D. Changes in poverty headcount and income inequality by EMDE regions informality and formal workers in the 18 studies selected here range from a formal sector wage penalty of 50 percent in Tajikistan (Huber and Rahimov 2014) to a premium of 113 percent in South Africa (El Badaoui, Strobl, and Walsh 2008). The average formal wage premium in the studies is 19 percent (Figure 3.8). This wage differential between formal and informal jobs is particularly wide in LAC and SSA but below-average in ECA and SAR. It is also larger for informally employed than Source: Elgin et al. (forthcoming a); Gindling, Mossaad, and Newhouse (2016); World Bank, World Development Indicators. self-employed workers. Self-employed and Note: A positive wage gap indicates a penalty for working informally—a lower wage for informal contributing family members (predominantly workers than for comparable formal workers; a negative wage gap indicates a premium for working informally—a higher wage for informal workers than for comparable formal workers. EMDE regions women) constitute the majority of informal include ECA=Europe and Central Asia, EAP=East Asia and Pacific, LAC=Latin America and the Caribbean, MNA=Middle East and North Africa, SAR=South Asia Region, and SSA=Sub-Saharan workers in developing Asia and Africa, whereas Africa. Wage gap between wage employees in the informal and formal sectors is displayed on the vertical axis in A-C. informal employees dominate the informal sector A. Formal vs. informal=a wage gap between wage employees in the formal and informal sectors; formal vs. self-employed=a wage gap between workers with formal jobs and self-employed workers; in ECA and in LAC (ILO 2018b).29 Wage premia self-employed vs. informal: a wage gap between self-employed workers and wage employees in the in the formal sector tend to be higher where informal sector. B. UKR=Ukraine, VNM=Vietnam, RUS=Russia, BRA=Brazil, MEX=Mexico, MDG=Madagascar, informality is more widespread.30 PER=Peru, ECU=Ecuador, TUR=Turkey, CRI=Costa Rica, ZAF=South Africa, SLV=El Salvador. The number of studies or estimates for each country is shown in parenthesis; country means are calculated using a random-effects meta-analysis model. Sources of observed wage differentials. The C. Income inequality is measured as Gini coefficient provided by WDI. D. Self-employment is the percent of self-employed in total employment. Poverty headcount is the formal wage premium largely disappears in studies poverty headcount ratio at $1.90 a day (2011 PPP, percent of population). Informal output is the GDP weighted average of the World Bank country estimates of the informal output as a percent of official that control for unobserved characteristics of output. Average changes for these measures during the period 2005-15 are shown here. workers. Informal employment tends to be associated with lower education and with workers that are, on average, either younger or older than 29 In many EMDEs, informal employment is generally a more in the formal sector. It is also more prevalent in important source of employment for women than men and, for women, a more important source than formal employment (Chen, rural areas, where there are fewer alternatives in Vanek, and Heintz 2006; ILO 2017). the formal sector, and among women (Hazans 30 e association between the level of wage premia in the formal 2011; Gasparini and Tornarolli 2007). The sector and the level of informality could be driven by the stricter labor regulations that raise both wages and informality (Rauch 1991; informal sector employs more low-skilled labor Loayza 2016). than the formal sector, which can slow human 154 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 3.9 Informality, poverty, and income inequality Conversely, the decline in poverty rates across all EMDEs regions (and especially in SAR and SSA) A larger informal economy is associated with higher poverty rates and income inequality. It is also linked with smaller declines in poverty rates. during 2005-15 was accompanied by a contraction of informal activities (Figure 3.8). At the country- A. Informality and poverty B. Informality and income inequality level, a larger informal economy is associated with a higher poverty headcount (Figure 3.9). However, the direction of causality between informality and poverty remains an open question. Regression analysis. The relationship between pre-existing informality and changes in the share of the population living in extreme poverty (i.e., the poverty headcount ratio at $1.90 a day at 2011 PPP exchange rate in percent of the population) or C. Informality and change in poverty D. Informality and change in income the Gini coefficient (World Bank estimates) is inequality estimated in an ordinary least squares regression. Specifically, the annual average change in the poverty headcount ratio (or Gini coefficient) between the latest (in the period 2011-16) and earliest available data (in the period 1990-2005) for up to 74 countries is regressed on 1990-2005 average informality. To mitigate concerns about endogeneity, time horizons considered for informality measures precede those for the change Source: Elgin et al. (forthcoming a); World Bank, World Development Indicators. in the poverty rate or Gini coefficient (Loayza, Note: See Annex 3.1 for data definitions. “SEMP” is the share of self-employment in percent of total employment. Servén, and Sugawara 2010; Annex 3.4). The A.B. The average measure of poverty (i.e. the poverty headcount ratio at $1.90 a day at 2011 PPP exchange rate in percent of the population) and Gini coefficient (World Bank estimates) over 1990- regression controls for the initial level of poverty 2016 for countries with higher informality (above median) and those with lower informality (below median) are shown in diamonds with the 95 percent confidence intervals shown in bars. Output (or Gini coefficient) and income per capita, using informality is measured as DGE-based informal output in percent of official GDP, while employment informality is measured as self-employment in percent of total employment. the earliest available income data. C.D. Estimates from Annex Table 3.4.1. Informality indicators are averages over 1990-2005. Control variable, initial level of poverty rate (earliest year over 1990-2005), is included (the same applies to Gini index). The dependent variable is an annual change in poverty headcount ratio at $1.90 a day Pre-existing informality and changes in poverty. (2011 PPP, percent of population) over the earliest year and the latest year (as in C; or the annual change in Gini index over the earliest and the latest year in D). For the comparison and scaling The estimated impact of pre-existing informality issues, coefficients of DGE, MIMIC, and self-employment are multiplied by 10. Estimated coefficients are shown in diamonds while the corresponding 90 percent confidence intervals (calculated from on changes in the poverty rate (but in this sample robust standard error) are shown in bars. The results are robust when controlling for initial GDP per capita. not on inequality) is statistically significant (Figure 3.9).32 The association with changes in poverty is similar for employment and output informality. In capital accumulation in the long run (Docquier, the average EMDE, the share of extreme poor in Müller, and Naval 2017). Thus, differences in the population (the headcount ratio) declined by characteristics of workers (e.g., education) largely about 0.8 percentage point between 2011 and account for the formal sector wage premium. 2016. These estimates imply that a country with a 10 percentage points higher share of informal Aggregate income inequality and poverty output than its peers witnessed 0.1 percentage point slower poverty reduction per year. The wage gap between the formal economy and the informal economy has been associated with persistent income inequality and poverty.31 32 is is in line with other studies that nd an insigni cant Chong and Gradstein (2007), Amaral and Quintin (2006); 31 relationship between inequality and informality after controlling for Pratap and Quiten (2006), and Loayza, Servén, and Sugawara institutional outcomes (Perry et al. 2007) or focus on causality (2010). running from inequality to informality (Chong and Gradstein 2007). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 155 BOX 3.4 Under the magnifying glass: How do policies affect informality? Country-specific studies have found that reductions in tax and regulatory burdens have often been associated with lower informality. In contrast, trade liberalization that raised the competition level in the tradable sector has been associated with greater informality in the short run, unless it was accompanied by measures that increase labor market flexibility. The reduction in informality was greater for reforms accompanied by business development and training programs, public awareness campaigns and stronger enforcement. Cross-country studies have identi ed a range of policies activity, or for other purposes with collateral e ects on associated with lowering informality. ese policies have informal activity. Many of these reforms were typically fallen into three categories: tax reform, regulatory implemented as part of broad-based, multi-pronged reform, and trade liberalization.1 reform packages. Against this backdrop, this box compiles a comprehensive review of single-country studies on the • Tax reform. Lower tax rates, simpli ed tax systems, impact of policy changes on informal activity. Speci cally, harmonized tax regulations, technology-based the box addresses the following questions: monitoring and consolidated electronic tax payment systems can encourage rms and workers in the • Which policy changes have been studied? informal sector to move to the formal sector. • What are the common lessons from these policy • Regulatory reform. Lower minimum wages and lower changes? barriers to worker recruitment and dismissal have been associated with lower informal activity. In • What is the role of complementary policy measures? addition, a wide range of institutional factors have been associated with reduced informality: more Studies of policy changes e cient legal systems, better property rights protection, lower regulatory burdens, less Selection of studies. 19 studies are selected based on two cumbersome registration processes, easier access to criteria: (1) they examine speci c policy changes in a single credit, and lower corruption. EMDE and (2) they measure an outcome that relates to informal activity, such as the share of informal workers or • Trade liberalization. In Latin America, trade rms.2 ese studies cover 15 policy changes in Brazil liberalization has often been followed by an increase (mid-1980s, 1990s, 2003), Colombia (1980s, 1990s), in informal activity in the short run, unless Egypt (1998, 2004), Georgia (2010), India (1988-2000, accompanied by complementary measures to increase 2017), Indonesia (1996-2004), Mexico (2002-06), labor market exibility. Trade liberalization raises real Pakistan (2009), Russia (2001), Turkey (2004-05), and wages, by depressing prices, and thus encourages Vietnam (1999-2013). Five of these country cases worker entry into the informal economy where entry implemented tax changes, four implemented regulatory cost is lower than in the formal economy (Arias et al. changes in labor markets, two implemented other 2018). regulatory changes, and four implemented trade liberalization measures (Annex Table 3.4).3 Many EMDEs have implemented these types of reforms either with the explicit purpose of reducing informal Tax reform. e studies examined both tax rate changes and tax simpli cation. In 2017, India streamlined and Note: This box was prepared by Cedric Okou. 1 Lower tax rates have been associated with smaller informal sectors 2 Studies are identi ed from the English-language repositories of (Loayza and Rigolini 2006; Loayza 1996). Greater labor market flexibility academic articles and working papers, including EconLit, JSTOR, has been associated with lower informality (Maloney 1999; Heckman and EBSCO, Google Scholar, RePEc, Social Science Research Network Pagés 2004; Oviedo 2009). Institutional reforms that improve the (SSRN), the National Bureau of Economic Research (NBER), World business climate have been accompanied by lower informal activity (Beck, Bank Policy Research Working Paper Series, International Monetary Demirgüç-Kunt, and Maksimovic 2006; Bosch, Goni, and Maloney Fund Working Paper Series, and IZA Working Papers. 2007; Friedman et al. 2000; Loayza 1996; Loayza, Oviedo, and Servén 3 Other studies documented the outcomes of randomized experiments 2005; Loayza and Rigolini 2006; Monteiro and Assunção 2012; Perry et and counterfactual prototypical policies in Benin, Brazil, Cameroon, al. 2007; Rocha, Ulyssea, and Rachter 2018; Schneider and Enste 2000; Malawi, Sri Lanka and several other Sub-Saharan Africa countries Ulyssea 2018; Wellalage and Locke 2016). Trade liberalization in a (Nguimkeu 2015; Bandaogo 2016; Benhassine et al. 2016; Ulyssea 2018; context of labor market rigidity has been associated with higher Campos, Goldstein, and McKenzie 2015; de Mel, McKenzie, and informality in the short run (Goldberg and Pavcnik 2004, 2007). Woodru 2012). 156 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 BOX 3.4 Under the magnifying glass: How do policies affect informality? (continued) lowered the average tax rate of goods and services limits on union power (Busch, Goni and Maloney 2007).5 (Government of India 2017). Georgia introduced a In 1991, India liberalized trade, removed price controls, preferential tax regime for small businesses in 2010 (Bruhn and removed license requirements in most industries and Loeprick 2014). Russia introduced a at personal (Sharma 2009). income tax and cut payroll taxes and social security contributions in 2001 (Slonimczyk 2012). Conversely, Common lessons Pakistan raised income taxes on noncorporate partnership rms in 2009 (Waseem 2018). In addition to lowering the Most studies have found the expected impact of these average tax rate for small rms, the SIMPLES reform in policy changes on informality (Figure 3.4.1). Tax Brazil in 1996 simpli ed the tax and social security simpli cation, tax cuts and regulatory easing tended to contributions regime for small rms (Fajnzylber, Maloney, reduce informality. Trade liberalization tended to increase and Montes-Rojas 2011; Maloney and Mendez 2004).4 informality unless it was accompanied by increased labor market exibility. Regulatory changes. A few episodes of labor market and Tax simplification and tax cuts were associated with lower other regulatory reforms have been studied. In 2001, as informality in India, Russia, Georgia and Mexico—in the part of scal decentralization in Indonesia, minimum-wage form of greater formal rm registration (India, Brazil, setting responsibilities were transferred to provinces and Georgia), greater income reporting (Brazil, Russia), greater local governments. e move was accompanied by a sharp or a greater share of formal employment (Brazil, Russia). increase in the average real minimum wage (Comola and e reforms were followed by an increase in the number of Mello 2011). In 2004-05, Turkey implemented two registered rms by about 5 percent in Brazil and by 18-30 employment subsidy schemes that strengthened incentives percent in Georgia (Bruhn and Loeprick 2014; Fajnzylber, to register for the social security system (Betcherman, Maloney, and Montes-Rojas 2011). In India, the Daysal, and Pagés 2010). Mexico simpli ed business introduction of the Goods and Services Tax has been registration by introducing its Rapid Business Opening accompanied by a 50 percent increase in the number of System (SARE) in various municipalities during 2002-06 indirect taxpayers (Government of India 2017). (Fajnzylber, Maloney, and Montes-Rojas 2011). Conversely, Pakistan’s corporate tax hike was followed by Trade liberalization. Several studies have examined rising informality as rms switched business models and episodes of major trade liberalization. Comprehensive reported lower earning. trade liberalizations with drastic tari reductions were Regulatory changes to encourage reporting (Turkey) or implemented in Colombia in the late 1980s and early simplify business registration (Mexico) were associated 1990s. ey followed Colombia’s GATT accession in with greater formal employment and rm registration, 1981 (Goldberg and Pavcnik 2003; Attanasio, Goldberg whereas higher minimum wages were associated with and Pavcnik 2004). Egypt introduced gradual trade greater informal employment. Employment subsidy liberalization measures in 1998 and, more schemes in Turkey were followed by an increase in the comprehensively, again in 2004 in the context of number of registered jobs in eligible provinces by up to 13 macroeconomic stabilization plans (Selwaness and Zaki percent (Betcherman, Daysal and Pagés 2010). In India, 2015). In Vietnam, the U.S.-Vietnam bilateral trade following broad-based industrial liberalization measures, agreement (BAT) came into e ect in 2001 (McCaig and the number of informal establishments fell faster (by 25 Pavcnik 2015, 2018) and, in the span of ten years, turned percentage points) in states with more pro-employer labor the United States from Vietnam’s fth-largest to its largest laws than in states with less exible labor laws (Sharma export destination between 1998 and 2008. e trade 2009). A 5 percent increase in the number of registered agreement was followed by reforms in 2006 to increase rms was attributed to simpli ed business registration labor market exibility. In 1988, Brazil took initial steps to procedures in Mexico (Bruhn 2011, 2013). Conversely, in liberalize trade but at the same time restricted labor market Indonesia a 10 percentage point increase in the minimum exibility in its Constitutional Reform. e 1988 reform included cuts in maximum work hours, higher vacation pays, longer maternity leave, higher dismissal cost, and 5 Recent Bosch, Goni, and Maloney (2007) focus on this initial reform phase. From 1990-1997, the pace of trade liberalization picked up signi cantly (Ferreira and Rossi 2003) and was accompanied by the 1994 4 Recent studies (e.g., Piza 2016) found mixed results regarding Plano Real of scal reform, social security reform, state monopoly reform, robustness of Fajnzylber, Maloney and Montes-Rojas (2011)’s nding. and civil service reform. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 157 BOX 3.4 Under the magnifying glass: How do policies affect informality? (continued) FIGURE 3.4.1 Overview of policy changes Most surveyed policy changes, including five tax reforms, six regulatory reforms, and four trade reforms were conducted in Latin America and the Caribbean, East Asia and Pacific, and Europe and Central Asia. The bulk of these reforms delivered the expected outcomes and were implemented post-2000. A. Number of reform episodes across B. Share of reform episodes delivering C. Number of reform episodes over time regions expected informality outcomes Source: World Bank. Note: Descriptive summary of surveyed reform episodes. A. Number of surveyed policies across regions. EAP = East Asia and Pacific, ECA = Europe and Central Asia, LAC = Latin America and the Caribbean, MNA = Middle East and North Africa, SAR = South Asia, and SSA = Sub-Saharan Africa. “Other” includes MNA, SAR and SSA. B. “Yes (No)” means that the outcome of a policy intervention is (not) consistent with the expected impact. “Mixed” means that the outcome of a policy intervention varies over time. The expected impacts of reforms are: (1) reduced tax burden would reduce informality; (2) increased labor market flexibility would reduce informality; (3) lowered entry and exit barriers in formal sector would reduce informality; (4) trade liberalization would increase informality due to intense foreign competition that disrupts existing formal firms. C. Number of surveyed policies implemented before and after 2000. Waves of trade liberalization in Egypt were fielded pre- (1998) and post-2000. wage over the mean wage was associated with a 0.9-1.1 employment, a growing share of formal employment, and percent increase in informal employment (Comola and shrinking informal employment (McCaig and Pavcnik Mello 2011). 2018; Boly 2008). Trade liberalizations in Brazil, Colombia, and Egypt were Role of complementary policy measures typically associated with greater informality in the short run—unless accompanied by measures to improve labor Several of the policies discussed above were not primarily market exibility. During Colombia’s trade liberalization implemented with informality in mind. Yet, they had the in the 1980s and 1990s, a 10-percentage-point decline in unintended consequence of raising informality: tax tari s in a given industry was associated with a 1 increases in Pakistan, decentralization of minimum wage percentage point increase in the probability of informal regulation in Indonesia, and trade liberalization in Egypt, employment—but only for the period preceding a major Brazil and Colombia. Other reforms did not have as large labor market reform that increased labor market exibility an e ect on informality as expected, such as the tax reform (Goldberg and Pavcnik 2003; Attanasio, Goldberg, and in Georgia. ree factors accounted for these: interactions Pavcnik 2004). In Egypt, the trade liberalization of 1998 between multiple reforms; scale of reform; and was associated with increased informal employment enforcement. whereas the trade liberalization measures of 2004—which were preceded by 2003 reforms to increase labor market Interactions between multiple reforms. In Egypt, trade exibility—were not (Selwaness and Zaki 2015). Similarly, liberalization implemented in a supportive environment, trade liberalization accompanied by measures to reduce with reforms to increase labor market exibility, was labor market exibility, such as in Brazil in the late 1980s associated with lower informality in 2004 but, in the and early 1990s was accompanied by rising informal absence of labor reforms, informality increased following employment (Bosch, Goni, and Maloney 2007). In the 1998 trade liberalization. Similarly, trade liberalization Vietnam, rapid export growth was associated with a 5 combined with increased labor market rigidities raised percentage point higher share of formal manufacturing 158 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 Informality and fiscal BOX 3.4 Under the magnifying glass: How do policies affect informality? (continued) outcomes informality in Brazil in the late 1980s and early 1990s. When A large informal economy erodes the tax base and product markets were restructured, such as during trade constrains governments’ ability to provide public liberalization, greater labor market exibility facilitated the services, conduct countercyclical policies, serve reallocation of workers to more competitive industries. A debt, and implement redistributive measures large share of unskilled labor may also have increased the (Chapter 4; Ordóñez 2014; Besley and Persson likelihood that trade liberalization raised informal 2014). This puts a premium on designing tax and employment (Loayza and Rigolini 2006; Selwaness and Zaki 2015). In Brazil, Colombia, and Vietnam, the short-term social security systems that avoid unintended increase in informal employment was particularly incentives to shift activity from the formal to the pronounced among less skilled workers (Goldberg and informal sector and level the playfield for both Pavcnik 2003; McCaig and Pavcnik 2015). formal and informal sectors (Perry et al. 2007; Djankov et al. 2010; Loayza 2018; Dabla-Norris Scale of reform and persistence of effects. Some reforms et al. 2018). were simply too narrowly targeted to have a sizeable or lasting impact on informality. For example, the short-lived Revenue outcomes. Regardless of the measure of impact of tax reform found by some studies—only in the informality, on average, government revenues in rst year—has been attributed to the modest scale of EMDEs with the most pervasive informality have the reform (Bruhn and Loeprick 2014). Moreover, policy been 5-10 percentage points of GDP below those reforms may have di erent short- and long-run e ects with the least pervasive informality (Figure 3.10). on informality. For instance, trade liberalization may increase informality in the short run, but not necessarily in the The composition of tax revenues is tilted towards long run (Goldberg and Pavcnik 2003; Dix-Carneiro and trade taxes in economies with more pronounced Kovak 2017). informality. Revenues from trade taxes have been 0.7-1.0 percentage points of GDP higher in Weak enforcement. Particularly in environments with weak EMDEs with greater informality compared with enforcement of rm and employment regulation, higher those with the lowest levels of informality. Income taxes or minimum wages can encourage informal activity. In tax revenues, in contrast, tend to be lower in the Pakistan, Turkey, and Indonesia, weaker enforcement was EMDEs with the highest output informality. associated with greater informality.6 Greater reliance on indirect taxation makes the tax system less progressive and, hence, less Conclusion redistributive than a system based on more progressive direct taxation. e studies of microeconomic impacts of policy changes are a reminder of the importance of comprehensive reform packages. Several of the packages discussed above, as an Expenditure outcomes. Revenue weakness is also unintended consequence, raised informal employment or reflected in lower government expenditures. In rm activity. Such unintended reform impacts can be EMDEs with the most pervasive informality, mitigated by bundling mutually reinforcing reforms, such as government expenditures were 4-10 percentage trade liberalization with labor market reform, or tax and points of GDP lower than in those with the lowest minimum wage hikes with strengthened enforcement and informality (Figure 3.10). Insufficient resources public awareness campaigns. for redistributive policies may contribute to the correlation between informality and poverty. Policy options Many EMDE governments implemented policies 6Oviedo (2009), Betcherman, Daysal, and Pagés (2010), Vargas (2015), at the microeconomic level and found that the Waseem (2018), Comola and Mello (2011), and Loayza (1996). implications for informality were more benign when these reforms were implemented in a G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 159 supportive institutional and macroeconomic FIGURE 3.10 EMDEs: Informality and fiscal outcomes environment. For instance, trade liberalization Widespread informality is associated with lower government revenues, a programs that raised real wages and reduced firms’ skew towards trade-based taxation, and lower government expenditures. profitability in the tradable sector were associated with greater informality in the short term—unless A. Differential in fiscal indicators B. Differential in fiscal indicators they were accompanied by higher labor market between third of EMDEs with the between third of EMDEs with the lowest and highest output informality lowest and highest employment flexibility and more skilled labor force (Box 3.4; informality Goldberg and Pavcnik 2003; McCaig and Pavcnik 2015). Country experiences suggest the need for a comprehensive development strategy that is informed by the drivers of and challenges posed by informality and carefully tailored to country circumstances. Policies that seek to improve fiscal accounts, such as strengthened tax administration Source: Elgin et al. (forthcoming a); International Monetary Fund, World Economic Outlook; World or streamlined tax regulations, can be associated Bank, World Development Indicators. with lowering informality in some economies. Note: Fiscal indicators and informality measures are 2000-16 averages. Sample includes 70 non- energy exporting EMDEs with populations above 3 million people. Separately, policies that aim at invigorating private A.B. Difference (in percentage points of GDP) between the average fiscal indicators among the third of EMDEs with the highest and lowest informality by the share of informal output (as measured by the sector activity and productivity and leveling the DGE methodology) in percent of official GDP (A) or by the share of self-employment in percent of total employment (B). Vertical bars indicate 90 percent confidence intervals of the differences. playfield for all workers and firms, particularly measures to make the labor market more flexible, the regulatory framework more adaptable, and governance more effective, can lower informality technology and communication tools), and/or improve the working conditions in the building tax administrations’ capacity, informal sector. Finally, supportive macro- harmonizing tax regulations or forms (e.g., economic and social policies (such as enhancing across rms of di erent sizes), limiting the use public service and social protection) can ease the of cash transactions, and encouraging the use implementation of these reforms and facilitate a of bank-based tax payments (Morales and smoother transition from the informal sector to Medina 2016; Ulyssea 2018; Rocha, Ulyssea, the formal sector. and Rachter 2018; Awasthi and Engelschalk 2018). These policy measures can help lower informality while also spurring growth more broadly. They • Tax burdens have been reduced for formal should be accompanied by strengthening the basic rms by o ering tax relief for new employees social safety nets to preserve incomes of vulnerable or simplifying tax bases in industries with a groups. Disruptions to formal activity from high percentage of undeclared workers (e.g., interventions to lower informality could be domestic work). Reducing tax burdens has mitigated by reforms to increase labor and product been among the most common policy reforms market flexibility. in EMDEs, especially in East Asia and Paci c (EAP) and Latin America and Caribbean Fiscal policy measures (LAC; Figure 3.11).33 Some countries have implemented reforms to • Value-added taxation (VAT) can help address the fiscal challenges associated with strengthen tax collection even in the presence informality, including, in the collection process, to of a sizable informal sector (World Bank 2018 reduce fiscal barriers or incentives for firms to operate informally. 33 In China, for example, the computerization of VAT invoices • Tax compliance has been encouraged by between 1998-2007 explained roughly 15 percent of cumulative simplifying tax codes, improving tax VAT revenues and increased the effective average tax rate by enforcement (e.g., via the use of information approximately 5-14 percent paid by firms (Fan, et al. 2018). 160 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 3.11 EMDEs: Policies to address challenges of policies) and encourage informality may informality warrant reform. Governments have implemented a wide range of reforms that could affect informality. • An improved provision of public goods and services, such as better education or A. Reforms across regions, 2008-18 B. Reforms over time infrastructure, could help improve the productivity in both formal and informal sectors (Oviedo, omas, and Karakurum- Ozdemir 2009; Benjamin and Mbaye 2012; Kim, Loayza, and Meza-Cuadra 2016; World Bank 2018b). • Social security systems can be reformed to reduce the incentives to hire informal workers.35 Measures include steps to shift the Source: World Bank, Doing Business. burden of payments of contributions from Note: See Doing Business 2008-18 for reform details. A. The number of policy reforms that have been implemented after year 2008 and are regarded as employers to employees (e.g., in Latvia, “improvement” in the ease of doing business or “neutral” (which only applies to “labor market regulation”) by Doing Business 2008-18. Poland, Slovenia), to reduce employers’ social B. The annual average number of policy reforms that have been implemented during 2008-10 in comparison to the annual average number of reforms conducted during 2016-18 (shown in bars). security contributions (e.g., in Bulgaria), and to link social bene ts to personal contributions (e.g., in most EU 27 countries; b). Since informal rms would not be allowed Oviedo, omas, and Karakurum-Ozdemir to claim VAT refunds on taxed inputs, the 2009). Transitions from an employment- VAT would implicitly serve as an input tax based social security system to a well-designed (de Paula and Scheinkman 2010; Loayza model of risk sharing can provide a better 2018). Conversely, more e ective VAT safety net for informal workers and help administration, including through digi- protect both formal and informal workers talization of receipts, could raise tax revenues during economic downturns (World Bank while also increasing incentives to register for 2013, 2018a; Box 3.1). tax refunds.34 Business climate and governance measures • Better tax morale, re ecting the perception Many reforms that are designed to invigorate that tax dollars are spent judiciously (for the private sector growth can also help reduce appropriate objectives and in the correct way), informality, such as reducing corruption, can encourage greater tax compliance and improving business climates and governance, lessen informality (Sung, Awasthi, and Lee strengthening enforcement, or liberalizing labor 2017). Measures to cultivate better tax morale and product markets, including through trade include appeals to people to declare their liberalization.36 Policy measures that narrow the activities, campaigns to encourage a culture of earnings gap between informal and formal workers commitment to declaration, and e orts to or those that reduce the productivity gap between change perceptions of the tax system’s fairness informal and formal firms (for example, through (Williams and Schneider 2016). Tax systems measures to improve education or expand access to that create an unlevel play eld for di erent conventional sources of credit) can also help lower types of rms (e.g., size-dependent tax the extent of informal activity. Trade 34 See Loayza (2018) for a detailed discussion on how to reform 35 See Johnson, Kaufman and Zoido-Lobaton (1998), Djankov et the social security system to reduce informality. See World Bank al. (2002), Prado (2011), USAID (2015), Baksi and Bose (2016), (2018b) for a discussion on how to provide better social security to Kanbur (2017), and Divanbeigi and Ramalho (2015). informal workers. Levy (2008) and Maloney (2004) suggest that 36 Kuddo (2018) shows that about 60 percent of the reforms establishing parallel non-contributory systems in the presence of passed between 2007 and 2017 throughout the world aimed at informality could further encourage informality. improving labor market flexibility. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 161 liberalization, however, may encourage informality registration and lower registration costs can also in the short term unless complementary reforms encourage the entry of young and productive are implemented (Box 3.4; Figure 3.11). firms, which can boost the productivity of the economy (Haltiwanger, Jarmin, and Miranda Labor regulations. Over the past decade, 2013; Nguimkeu 2015; Loayza 2018). governments—especially in ECA, SSA and, more recently, LAC—have implemented reforms to Regulatory enforcement. While other policy increase labor market flexibility.37 These include options increase the benefits of joining the formal less restrictive regulations with respect to hiring economy, stricter enforcement can increase the and firing, to working arrangements, and to wage cost of remaining in the informal economy. Policy rates. Other types of policy changes, such as options include increasing the frequency of providing incentives for worker registration (e.g., inspections (in most EU15 countries and legalization of undocumented workers) and Bangladesh), creating a national-level firm or improved enforcement of existing labor laws, may employee registry (in Poland), and launching also encourage workers to move to the formal public awareness campaigns regarding tax sector (Anand and Khera 2016; Munkacsi and compliance (e.g., in China and Korea).39 Saxegaard 2017). For example, Japan has allowed However, these enforcement measures tend to be undeclared workers to claim certain social benefits, most effective when implemented in conjunction thereby improving the monitoring of their with steps to improve the governance and business employment. In rapidly urbanizing countries with climate (e.g., making the labor market flexible) still-large rural populations, easing labor market and when they are applied even-handedly to both regulation could play an important role in formal and informal firms (Loayza 2018). enabling workers to move into the urban, more productive and more modern sectors (Annex Education. Informal workers tend to be less Figure 3.5.1; Annex 3.5; Loayza 2016).38 productive than formal workers. To the extent that workers remain in the informal sector for lack Firm regulations. A variety of measures can of human capital or skills, better and more encourage firms to participate in the formal sector. accessible public education may help workers (or For example, formal entry of firms can be their dependents) to move into better paid formal facilitated and encouraged by creating “one-stop- employment (Maloney 2004; Perry et al. 2007; shop” registration to simplify the process (e.g., in Andrews, Sánchez, and Johansson 2011). This can Australia, Belgium, Ukraine), training and also have the benefit of reducing income business services can be provided to firms that inequality and poverty. register (e.g., in Mexico and Malawi; Campos, Goldstein, and McKenzie 2018), and access to Access to finance. Firms in the informal sector credit can be made easier for firms in the formal have more limited access to credit from the sector. EMDEs in the ECA and SSA regions have banking sector and capital markets, which restricts implemented an above-average number of reforms their ability to invest in productivity-enhancing to reduce the costs of starting a business during new technologies (Ferreira-Tiyaki 2008; the past decade (Figure 3.11). Easier firm D’Erasmo 2016; Capasso and Jappelli 2013). One of the options to have greater access to finance is to improve personal property registration, which 37 Loayza (2016) develops a theoretical model that traces makes loans more accessible for firms operating in informality, government regulations, economic growth and urban the informal economy (e.g., Czech Republic; migration through the process of development. e model highlights Doing Business 2012). Improving access to credit the potential e ect of the minimum wage on labor misallocation and on capital accumulation. A higher minimum wage slows capital has been a common policy reform in EAP, accumulation and pushes workers into the informal economy. See MENA, SAR and, more recently, in SSA. Annex 3.5 for details. Caballero et al. (2013) show that job security Separately, digital payment systems can provide an regulation hampers the creative-destruction process, which could impede growth. 38 See, for instance, Oviedo, omas, and Karakurum-Ozdemir 39 See, for instance, Oviedo, omas, and Karakurum-Ozdemir (2009), Bruhn and McKenzie (2014), Awasthi and Engelschalk (2009), Bruhn and McKenzie (2014), Awastchi and Engelschalk (2018), and De Giorgi, Ploenzke, and Rahman (2018). (2018), and De Giorgi, Ploenzke, and Rahman (2018). 162 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 entry point to the formal financial system and challenges with its higher accessibility, more fluid encourage a shift away from informal finance labor arrangements, and greater reliance on digital (World Bank 2017). technology than more traditional forms of informality. Since “gig” workers do not fully From a comprehensive strategy to participate in the social security system, they are, implementation by some definitions, informal workers (Loayza, A comprehensive strategy: The right policy mix. Servén, and Sugawara 2010). Regulatory changes, Policy interventions in isolation may only have a especially in the context of social security systems, limited impact on informality but can have may be needed to ensure that “gig” workers’ unintended consequences (Box 3.4; Ulyssea 2018; economic risks are manageable and that they do Oviedo, Thomas, and Karakurum-Ozdemir not permanently lose access to the formal 2009).40 A coherent reform strategy calls for economy (World Bank 2014, 2016, 2018b). Since well-integrated reforms that complement each these workers will likely take on many different other and address the complexity of informality assignments over the course of their careers, the (Loayza 2018). ability to learn and adapt will be essential. Policies can support this adaptability with more provision Tailoring implementation. Cross-country of education and (re)training programs (World experiences also highlight the importance of a Bank 2019; Card, Kluve, and Weber 2018). country-specific implementation plan: each Emphasis should also be given to the development reform component requires a diagnosis of the of cognitive skills in primary and secondary country’s current situation, followed by specific education or via intentional instruction at earlier reforms to address the main weaknesses associated ages, and the improvement of the terms of with and underlying sources of informality employment (Almeida, Behrman and Robalino, (Loayza 2018). In SSA, SAR, and the non-GCC 2012; World Bank, 2018a, 2018b). economies of MENA, for example, general education and training programs to raise human Harnessing new technology. New technologies capital could be prioritized (Box 3.2; Boxes offer governments an opportunity to both reduce 2.1-2.6). In LAC, reducing particularly high tax the incentives for and increase the cost of and regulatory costs to businesses could operating informally. For example, new incentivize firms to join the formal sector. In technologies can also help strengthen tax ECA, improving government effectiveness and administration and improve access to finance, reducing corruption could be policy priorities. including by improving the ability to broaden the The success of implementation also depends on tax net and assess credit worthiness (Gupta et al. careful monitoring of potential unintended 2017; Junquera-Varela et al. 2017; Awasthi and consequences and a supportive macroeconomic, Engelschalk 2018; Capasso, Monferra, and political and institutional environment. The latter Sampagnaro 2018). Digitalization can lower ensures the political and fiscal viability of the regulatory burdens, thus reducing the cost of implementation and reduces the transition costs operating in the formal economy. For example, for workers moving from the informal sector to Costa Rica reduced the time required to register a the formal sector. business by digitizing tax registration records and company books in 2009 (Doing Business 2009). Emerging policy opportunities and This was followed by a drop in the share of challenges informal employment by 4 percentage points of Human capital adaptability. The emerging “gig” total employment and a fall in the share of economy poses opportunities and policy informal output by about 2 percentage points of official GDP during 2009-16. Similar reforms have been carried out in Guyana (2010) and 40 Ulyssea (2018) shows that formalization policies di er in their Kenya (2011) (Doing Business 2010, 2011). impact on informality and GDP. For instance, reducing form sector’s entry costs is not as e ective in reducing informality as other formalization policies, but it leads to greater GDP and wages. e reverse holds for increasing enforcement. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 163 ANNEX 3.1 Measures of captures multiple outcome indicators of informal informality activity.2 Second, it estimates informal activity across country and over time. The data on causes The database includes most informality measures and indicators of informal activity identified in the employed by the literature. These measures cover literature are largely based on macroeconomic up to 196 economies (36 advanced economies and series in a panel setting and updated annually. 160 emerging market and developing economies) for as much as 1950-2016 (Annex Table 3.1.1). To estimate the size of the informal sector (i.e., in Measures can be divided into indirect (model- percent of official GDP) with the MIMIC model, based) estimates and direct (survey-based) this study closely follows Schneider, Buehn, and estimates. Montenegro (2010). Six causes and three indicators are used in the estimation to capture the Indirect estimates hypothesized relationships between the informal sector (the latent variable) and its causes and Previous studies use various indirect approaches to indicators. Once the relationships are identified estimate the size of the informal sector, including and the parameters are estimated, the estimation the currency-demand approach (e.g., Ardizzi et al. results are used to calculate the MIMIC index, 2014), and the electricity-demand approach (e.g., which gives the absolute values of the size of the Johnson, Kaufmann, and Shleifer 1997; Lackó informal sector after a benchmarking procedure. 2000), the Multiple Indicators Multiple Causes The MIMIC approach delivers a panel of (MIMIC) model (e.g., Schneider, Buehn, and estimates (labelled as MIMIC) for 160 economies Montenegro 2010), and the Dynamic General over the period 1993-2015. Equilibrium (DGE) model (e.g., Ihrig and Moe 2004; Elgin and Oztunali 2014; Orsi, Raggi, and Six causes and three indicators are used in the Turino 2014). Among all indirect estimation estimation (as in Schneider, Buehn, and methods, the MIMIC and DGE models stand out Montenegro 2010). The six cause variables used in their year and country coverage. The other two are: (1) size of government (general government indirect approaches, that is, the electricity-demand final consumption expenditure, as a percent of approach and the currency-demand approach, GDP, obtained from UN, spliced with WDI) as suffer from limited data availability and theoretical proxy for indirect taxation; (2) share of direct caveats (see Ahumada, Alvaredo, and Canavesa taxation (direct taxes in percent of overall taxation, 2007; Schneider and Buehn 2016 for details). WDI); (3) Fiscal Freedom index obtained from Therefore, the MIMIC and DGE models are used Heritage Foundation as a tax burden variable in a here to estimate the size of the informal sector. wide sense; (4) Business Freedom index provided by Heritage Foundation; (5) the unemployment The multiple indicators multiple causes model rate and GDP per capita to capture the state of the (MIMIC).1 The Multiple Indicators Multiple economy (obtained from WDI, the latter is Causes model is a model of structural equations spliced with IMF World Economic Outlook that can be applied to estimate the size of informal (WEO)); and (6) a measure on government economic activity. There are two features of effectiveness provided by Worldwide Governance MIMIC that make it a preferred estimation Indicators. The three indicator variables include: approach for some researchers. First, it explicitly (1) growth rate of GDP per capita (WDI, spliced considers multiple causes of informal activity and with IMF WEO); (2) the labor force participation rate (people over 15 economically active as a 1 e limitations of the standard MIMIC model of Schneider, Buehn, and Montenegro (2010) and others include (e.g., Medina and Schneider 2018; Feige 2016): (1) the use of GDP (GDP per capita 2 Indirect approaches like the currency demand approach or the and growth of GDP per capita) as both cause and indicator variables, electricity approach condense the full range of informal activity across (2) its reliance on another independent study’s base-year estimates on product and factor markets into just one indicator. However, the the informal economy to calibrate the size of informal economy in informal sector shows its e ects in various markets (Schneider, percent of GDP, and (3) the estimated coe cients are sensitive to Buehn, and Montenegro 2010), which would be captured better in a alternative model speci cations and sample coverage. MIMIC model. ῆt ῆt ^t η ^t = ῆt η η*2000 Ht > 0 ῆ2000 t ῆ2000 η*2000 max  C    U (C  t t ,I t ,K t 1 ,N It ,N Ft t ) t 0 ῆt t 0 s .t .C t  I t  (1   t )AFt K t N Ft 1   AIt N It η*2000 Kt+1 = It + (1 - δ)Kt η*2000 NIt + NFt = Ht β < 1 Ct It AFt Kt NIt, τt NIt AIt δ ∈ τt Gt {τt}, {C t , I t , K t 1 , N It , N Ft ,Gt }t0 t  0  t U (C t ) YIt YFt  AIt N It AFt K t N Ft 1 α γ Informal employment Kt Ct Employment (excl. formal NFt δ sector) τt AIt Kt Aft 6 δ, α, γ τt 166 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 covers self-employment and employees holding World Bank Enterprise Surveys compile responses informal jobs. ILO presents a detailed definition on various topics (including informality) from face of these two measures (http://www.ilo.org/ilostat- -to-face interviews with top managers and business files/Documents/description_ IFL_EN.pdf). owners in over 130,000 companies in 146 countries. The surveys yield the following Combining various cross-country databases and measures of informality (e.g., used in Amin and additional data from the national statistical offices Islam 2015; La Porta and Shleifer 2014): percent and other sources, the resulting data set on self- of firms competing against unregistered or employment is a panel of 180 economies over the informal firms (WB1), percent of firms formally period 1955-2016. The data set on informal registered when they started operations in the employment covers 53 countries/regions from country (WB2), (average) number of years firms various years during 2001-2016 while the data set operating without formal registration (WB3), and on employment outside the formal sector contains percent of firms identifying practices of 57 countries/regions from various years during competitors in the informal sector as a major 1999-2016. constraint (WB4). A higher value of WB1, WB3 and WB4 indicates a higher level of informality, Data on pension coverage (labeled as Pension while the reverse holds for WB2. coverage) are also gathered from various issues of the World Bank’s World Development Indicators In comparison to Enterprise Surveys, Executive (WDI book version, reported until 2012). The Opinion Surveys provide a more balanced panel measure is defined as the fraction of the labor data set, making them more suitable for business force that contributes to a retirement pension cycle analysis. World Economic Forum has been scheme Loayza, Oviedo, Servén 2010; WDI). It conducting the Executive Opinion Survey every yields a panel that covers 135 countries from 1990 year since 1979. As reported in the 2014 edition, to 2010. over 13,000 executives in 144 economies were surveyed. From year 2006, when conducting the Firm surveys. Two data sets of firm surveys have survey, the following question is asked, “In your comprehensive coverage: World Bank Enterprise country, how much economic activity do you Surveys, and Executive Opinion Surveys estimate to be undeclared or unregistered? conducted by World Economic Forum. World (1=Most economic activity is undeclared or Bank Enterprise Surveys cover 139 economies unregistered; 7 = Most economic activity is over the period 2006-2016 while Executive declared or registered).” The average responses at Opinion Surveys cover 151 countries over the the country-year level constitute a series of period 2006-2016. informality measures, labeled as WEF. A lower average at the country level indicates a larger Both surveys are answered by top managers and informal economy. business owners, who are business experts and should be familiar with the business climate in a Household surveys (HS). Household surveys country. The surveys could reflect some either report the extent of informality in an dimensions of informality (e.g., the extent of economy or report people’s opinions on informal competition from the informal sector) that are not economic activities. Among all, World Value captured in the other informality measures. Surveys (WVS) stand out in their country and Similar to labor-related measures, measures from year coverage with others focusing on European firm surveys also have the advantages of being free countries. It asks whether respondents can justify of strong assumptions and base-year estimates for calibration.9 this type of measures do not have much time variation. Both drawbacks limit their application in time-series analysis. However, 9 ere are two drawbacks of informality measures from rm they shed light on the perceived extent of informality in a country surveys. First, rm surveys tend to have limited year coverage. and provide guidance for constructing and validating indirect model Second, since people’s perception does not move much over time, estimates. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 167 cheating on taxes in five waves from 1981-1984 to ANNEX 3.3 Informality and 2010-2014. The responses range from 1 (never earnings inequality: justifiable) to 10 (always justifiable). In total, 94 A meta-analysis approach economies participated in the survey. The average responses at the country-year level are used as a Selection of studies. e collection of the measure for attitudes towards informality (or tax representative sample of studies on informality morality; Oviedo, Thomas, and Karakurum- and wage inequality follows selection guidelines Özdemir 2009), labeled as WVS. A higher average outlined in Stanley et al. (2013) and is broadly at the country level implies that people find similar to criteria applied by van der Sluis, van cheating on taxes more justifiable. Former studies Praag, and Vijverberg (2005). An initial search show that the lack of tax morality is associated was conducted in the major English language with a higher level of informality. repositories of academic articles and working papers.10 A study was included in the database if it: ANNEX 3.2 Characteristics of (1) provided a quantitative estimate of the informal-economy informal-formal wage gap and a corresponding business cycles standard error or a t-statistic; (2) used data from micro-level household or labor surveys to obtain Harding and Pagan (2002)’s approach is used these estimates; (3) analyzed a developing country to identify business cycle turning points in formal or a group of developing economies as de ned by and informal sectors in annual data: Peaks the World Bank classi cation; and (4) was (troughs) are identi ed in years when output is published after 1990.11 e resulting database higher (lower) than the two subsequent and two included 18 studies with a total of 83 individual preceding years. A recession is de ned as the coe cient estimates covering 20 emerging market period from a business cycle peak to a trough. and developing economies (Annex Table 3.3.1). An expansion is the converse, the period from a business cycle trough to its peak. A recovery is Definitions matter. Di erences in estimates of the the early part of an expansion and is de ned as incidence of informal employment and the wage the period from the business cycle trough to the di erentials between formal and informal workers year in which the output level recovers to that of in part re ect di erences in data coverage and the most recent business cycle peak (Claessens, de nitions of informal workers.12 Self-employed Kose, and Terrones 2012). e main workers constitute the core of informal characteristics of recessions and recoveries include employment since they typically lack registration duration and speed of adjustment (often termed as at the national level, do not contribute to social “slope”) are de ned as in Claessens, Kose, and security and are not entitled to paid annual and Terrones (2012). sick leave.13 However, not all informal workers are self-employed, while the informal sector itself may • Duration captures, for a recession, the period be divided into several tiers such as informal self- from peak to trough, for a recovery, the period it takes for output to return to its pre- trough peak, and for an expansion the period 10 Covered online databases include EconLit, JSTOR, EBSCO, from trough to peak. Google Scholar, RePEc, Social Science Research Network (SSRN), the National Bureau of Economic Research (NBER), World Bank Policy Research Working Paper Series, International Monetary Fund • Speed of adjustment (“slope”) measures the Working Paper Series, and IZA Working Papers. speed of a cyclical phase and is de ned as the 11 Prior to 1990, reliable and comparable individual or household ratio of amplitude over duration for a level survey data, which is used to estimate wage gaps between the formal and informal sectors, is very limited for developing countries. recession and the ratio of the change from the 12 Perry et al. (2007), Hussmanns (2004), ILO (2013). trough to the last peak divided by the 13 According to ILO 2018, nearly 90 percent of all own-account duration for a recovery (Claessens, Kose, and workers—the largest component of self-employed, in the emerging markets and developing economies—are in the informal sector ac- Terrones 2012). counting for over 45 percent of all informal jobs. ˆi ~ N (i , 2 ), σ2 ˆi ~ N (  , 2 ) μ τ2 τ2 I2=τ2/(τ2+σ2) k ˆ  i  j X ij  i i j ˆi ∈i ϑi τ2 i x i ,19902005 X(ij) • FEi 1 Initial 0 yi • FEMALEi 1 0 MALEi is 1 0 • • Self-employedi  y i   0  1x i ,19902005  2Initial y i  i y i i y i 170 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 only labor with a low-productivity technology. • Baseline scenario. e minimum wage rises at e modern economy, itself, consists of two the rate of labor productivity. sectors: a capital-intensive modern formal sector that complies with government-mandated labor • Reformist scenario. e minimum wage rises costs including the minimum wage; and a modern one percentage point more slowly than labor informal sector that is less capital intensive, pays productivity growth. low labor costs and high capital costs and e outcomes of both scenarios depend on the produces with lower productivity by contravening initial conditions of the country, future labor regulations. population and TFP growth rates, and the rate of A developing economy passes through three stages change of the minimum wage.22 In the baseline of development as it becomes richer. In the rst scenario, the minimum wage is assumed to grow phase, modern informal employment expands as in line with labor productivity growth, such that falling relative cost of urban living encourage rural informal rudimentary employment shrinks while workers (in the rudimentary informal sector) to the formal and informal modern employment migrate to cities. In the second phase, rural-urban expand at a similar rate. In the reformist scenario, migration slows, the relative shares of the modern slower minimum wage growth will speed up informal and formal sectors stabilize, but the capital accumulation, increase rural-urban relative size of the rudimentary informal sector migration, raise capital-labor ratio, reduce the shrinks.18 In the third phase, modern informal wage distortion created by the minimum wage, employment declines as rural-urban migration and result in an expanding modern and formal stalls and a rising capital-labor ratio reduces the sector. relative (and absolute) size of the modern informal sector.19 Global implications in theory: Employment in the modern economy. On average, in both the Theoretical impact of changes in minimum baseline and reformist scenarios, the employment wages on informality share of the modern economy is predicted to expand, by, respectively, 18 (more than one- e model provides a framework for tracing out quarter) and 23 (more than one-third) percentage the implications for growth and informality of points (Annex Figure 3.5.1). In both scenarios, changes to labor market regulations, here capital accumulation attracts rural workers from represented by the minimum wage.20 When the the rudimentary informal sector, reduces the wage minimum wage is higher than the unregulated distortion created by the minimum wage, and market wage, it creates a distortion in the labor results in allocating more labor in the modern market, which moves labors to the modern formal sector. In the baseline scenario, capital informal sector where the minimum wage is not accumulation encourages rural-urban migration binding. For 127 economies, of which 28 are and modern employment. Employment in both advanced and 99 are EMDEs, the evolution of the formal and informal modern sectors grow at relative size of informal output and employment similar rates. As a result, share of informal modern over 2015-2035 is considered for two scenarios.21 employment in modern employment remains steady but its share in total (modern and 18 e relative shares of modern informal sector remain stable due rudimentary) employment increases by 9 to the constant urban capital-labor ratio during the second phase. percentage points. 19 e size of the modern informal sector diminishes when the rate of natural increase in urban population is not too large and when In the reformist scenario, the slower growth in the the minimum legal wage is no longer binding. 20 e relative sizes of di erent sectors are projected using the minimum wage encourages faster capital accumu- parameter values, population projections and total factor productivity growth from Loayza and Meza-Suadra (2016). 2015 is taken as the starting year and the relative sizes of the three sectors are projected for year 2015-2035. e real cost of capital are assumed to match labor 22 e initial conditions include the capital stock, total factor productivity growth. productivity, and the labor force, and the share of formal and 21 e country classi cation is listed in Annex 3.5.1. See Loayza informal labor, both rudimentary and modern (See Loayza 2016 for (2016) for the list of countries. details). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 171 lation and migration to the modern economy, ANNEX FIGURE 3.5.1 Implications of relaxing the which speeds up the modernization process. minimum wage restraint Minimum wage growth below productivity Over the next two decades, according to the model, the employment share growth in the formal sector gradually widens the of the modern economy is expected to expand. In the baseline scenario, wage gap between the formal and informal wages the informal economy would grow faster than the formal economy, whereas the informal economy would shrink in the minimum wage restraint scenario. in the modern sector and encourages more formal, The theoretical model suggests that lowering the minimum wage would modern employment. As a result, the share of speed up formalization in regions like Europe and Central Asia and Middle formal modern employment in modern East and North Africa and accelerate economic modernization in South Asia and Sub-Saharan Africa. employment rises by 22 percentage points and the A. Employment composition, 2015 B. Employment composition, 2035 share of formal modern employment in total (modern and rudimentary) employment increases by 33 percentage points. Di erences between advanced economies and EMDEs. Advanced economies have small rural and modern informal sectors compared with EMDEs, to begin with. e rural sector is already negligible in advanced economies, accounting for 9 percent of employment, whereas it accounts for C. Employment composition, 2015 D. Employment composition, 2035: 44 percent of employment in EMDEs. e Baseline scenario modern informal sector already accounts for a similarly modest 8 percent of employment in advanced economies, but 28 percent of employment in EMDEs. Under the baseline scenario, and even more quickly and comprehensively under the reformist scenario, the modern informal and rudimentary sectors will virtually disappear in advanced economies, together accounting for about 10 percent of E. Employment composition, 2035: F. Average output growth, 2015-35: Baseline and reformist scenario Reformist scenario employment from 18 percent initially. In EMDEs, the rural sector will continue to play an important, albeit shrinking, role, accounting for 15-22 percent of employment. Rural-urban migration will continue to fuel the expansion of the modern economy, but only in the reformist scenario will this migration ensure that the modern formal sector grows more rapidly than the modern informal sector. Source: World Bank staff calculation using the model of Loayza (2016). Note: “MF” stands for employment in the modern formal sector (in orange), “MIF” stands for Di erences across EMDE regions. EMDE regions employment in the modern informal sector (in red), while “RIF” stands for employment in the rudimentary informal sector (in blue). The relative sizes of different sectors are projected using the di er widely in their initial conditions, hence also parameter values, population projections and total factor productivity growth from Loayza (2016). Under the baseline scenario, the minimum wage rises at the rate of labor productivity. Under the in the implications of policy changes. In 2015, reformist scenario, the minimum wage rises one percentage point more slowly than the rate of labor productivity growth. 2015 is taken as the starting year for the projection exercise. “Advanced Sub-Saharan Africa (SSA) and South Asia (SAR) economies” represents the unweighted average of the 28 advanced economies in the sample, while “EMDEs” represents the unweighted average of the 99 emerging markets and developing economies had large rural economies, accounting for more in the sample. These group averages are calculated for East Asia and Pacific (EAP), Europe and than 60 percent of employment, whereas Europe Central Asia (ECA), Latin America and Caribbean (LAC), Middle East and North Africa (MNA), South Asia (SAS), and Sub-Saharan Africa (SSA). and Central Asia (ECA) and the Middle East and A. The stacked bars show the average employment shares in 2015 for each sector in advanced economies and in EMDEs. North Africa (MNA) had predominantly modern B. The stacked bars show the average employment shares projected for 2035 in advanced economies and in EMDEs. economies, which accounted for about 80 percent C. The stacked bars show the average employment shares across all EMDE regions in the sample for of employment. Over the next two decades, each sector in 2015. D.E. The stacked bars show the average employment shares across all EMDE regions in the sample reformist or baseline policies would reduce the for each sector in 2035 under baseline and reformist scenario. F. The diamond shows average annual GDP growth between 2015-35 across all EMDE regions for the reformist scenario. The blue bars show the growth rate for the baseline scenario. 172 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 share of rural employment in SSA below the capital accumulation will raise the unregulated current EMDE regional median and would market wage, making minimum wage no longer virtually eliminate rural employment in ECA and binding in the formal modern sector and MNA (under reformist policies, also in East Asia allocating more labor in the formal modern sector. and Paci c, EAP, Latin America and the e reformist scenario could raise growth by 0.1- Caribbean, LAC, and South Asia, SAR). e 1.2 percentage point per year over the baseline reformist scenario would speed up this scenario. In SAR and SSA, the reformist scenario formalization process, especially in MNA and could generate the largest boosts to output growth LAC, where the migration to the modern because of their initially large rural sectors increase economy is almost coming to a halt and further the potential for rural-urban migration. ANNEX TABLE 3.1 Labor productivity differential between types of firms (percent) Informal firms Manager has Informal versus Main owner Services Firm has Single-employee Young firm higher formal firms is male sector bank loan firm (<=5 years) education Angola 45.8 70.0 44.9 -60.0 225.0 20.0 -75.5*** Argentina 25.0 200*** 0.0 0.0 11.1 -16.7 -92.5*** Burkina Faso -6.2 -6.2 28.6 6.7 66.7 -10.0 -79.8*** Botswana 89.4* 72.7** -29.1 100.0 -35.0 -18.2 -89.8*** Côte d'Ivoire 0.0 25.0 66.7** -40.0 50.0 40.0 -47.5* Cameroon -41.7* 36.4 77.8** -24.0 140.0*** 56.2** -55.8*** Congo, Dem. Rep. 33.3 0.0 36.0** 50.0 50.0*** 0.0 10.7 Cabo Verde 133.3 -25.0 185.7 1585** 566.7* 100.0 0.89 Ghana 0.0 12.5 0.0 25.0 66.7*** 0.0 -51.8*** Guatemala 25.0 46.7*** 33.3** 50.0 57.1*** -20.0 -86.0*** Kenya 50.0*** 6.7 -40*** 44.0** 12.0 -20.0** -81.6*** Madagascar 40.0 -33.3 100*** 33.3 60.0* 8.3 -88.1*** Mali 13.2 14.3 -19.4 31.4 57.1 -46.2** -71.3*** Myanmar 80.0* -11.1 63.6*** 11.3 31.2 0.0 -89.1*** Mauritius 66.7* 6.7 114.3*** 25.0 6.7 25.0 -82.9*** Nepal 11.1 0.0 0.0 33.3 150.0*** -16.7 -56.5*** Peru 28.6* 12.5 -50*** -11.1 2.9 -7.4 -74.2*** Rwanda 50.0*** 28.6** 25.0* -25.9 50.0*** -11.1 -91.4*** All countries 48.1*** 10.2 8.2 20.0** 41.2*** -6.7 -79.4*** Source: World Bank. Note: Productivity differential between the median informal and the median formal firm (last column) or between median informal firms among different groups of firms (all other columns). For example, “Manager has higher education” shows the difference in the median productivity among informal firms with managers with higher education and the median productivity among informal firms with managers without higher education. Other firm characteristics are not controlled for, hence results are similar but not identical to column (1) in Annex Table 3.2. Productivity is defined as annual sales (in 2009 U.S. dollars) relative to the number of workers. “All countries” is the unweighted average across each column. ***, **, * indicates statistical significance at the 1, 5, and 10 percent level. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 173 ANNEX TABLE 3.2 Labor productivity of formal and informal firms [1] [2] [3] [4] [5] Informal firm Y:1 N:0 -1.400*** -0.648*** -1.131*** -1.200*** -1.008*** (0.091) (0.184) (0.131) (0.121) (0.160) Firm age (logs) 0.120*** 0.285*** 0.118*** 0.116** 0.137*** (0.045) (0.053) (0.045) (0.045) (0.045) Firm size (logs, workers) -0.102*** -0.119*** -0.056* -0.104*** -0.108*** (0.027) (0.027) (0.032) (0.028) (0.028) Manufacturing Y:1 N:0 -0.402*** -0.407*** -0.401*** -0.401*** -0.399*** (0.056) (0.056) (0.056) (0.056) (0.056) Capital city Y:1 N:0 0.201*** 0.190*** 0.187*** 0.394*** 0.201*** (0.061) (0.061) (0.061) (0.087) (0.061) Manager experience (logs, years) 0.094** 0.141*** 0.107*** 0.091** 0.190*** (0.040) (0.041) (0.040) (0.040) (0.055) Informal firm * Firm age (logs) -0.353*** (0.069) Informal firm * Firm size (logs, workers) -0.208*** (0.066) Informal firm * Capital city Y:1 N:0 -0.360*** (0.114) Informal firm * Manager experience -0.176*** (logs, years) (0.060) Country fixed effects Yes Yes Yes Yes Yes Constant 9.013*** 8.552*** 8.859*** 8.909*** 8.748*** (0.131) (0.164) (0.149) (0.139) (0.162) Number of observations 10,527 10,527 10,527 10,527 10,527 R-squared 0.291 0.296 0.293 0.293 0.292 Source: World Bank. Note: Standard errors in brackets. Significance is denoted by *** (1 percent), ** (5 percent), * (10 percent). OLS regression with labor productivity as dependent variable, as proxied by annual sales (in 2009 U.S. dollars, in thousands, in logs) per worker, based on a sample using World Bank’s Enterprise Survey data collected during 2007-14 for 4,036 informal firms and 7,558 formal firms in 18 countries. “Informal firm” is a dummy variable taking the value of 1 if a firm is unregistered and 0 otherwise. “Manufacturing” is a dummy variable taking the value of 1 if a firm operates in the manufacturing sector and 0 otherwise. “Capital city” is a dummy variable taking the value of 1 if a firm is located in the capital city and 0 otherwise. 174 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 ANNEX TABLE 3.3 Labor productivity of formal firms facing informal competition [1] [2] [3] [4] [5] Informal Competition -0.268*** -1.642*** -1.919*** -0.574*** -1.657*** (Proportion of firms in the cell that report competing with (0.067) (0.602) (0.618) (0.059) (0.307) informal firms) Number of workers (logs) -0.197*** -0.150*** -0.175*** -0.166*** -0.179*** (0.016) (0.017) (0.019) (0.019) (0.020) Firm's age (logs) 0.208*** 0.215*** 0.296*** 0.286*** 0.356*** (0.023) (0.026) (0.032) (0.029) (0.032) Firm belongs to manufacturing sector: Yes 1 No 0 0.137*** 0.077* 0.164*** 0.157*** 0.139*** (0.044) (0.046) (0.052) (0.048) (0.053) Firm belongs to retail sector: Yes 1 No 0 0.695*** 0.747*** 0.896*** 0.862*** 0.879*** (0.045) (0.047) (0.053) (0.049) (0.054) Top manager is female: Yes 1 No 0 -0.051 -0.125** -0.128* -0.086 -0.063 (0.048) (0.058) (0.073) (0.067) (0.070) Exports (proportion of sales) 0.268** 0.403*** 0.431*** 0.385*** 0.397*** (0.114) (0.117) (0.145) (0.133) (0.148) Firm has foreign owners: Yes 1 No 0 0.638*** 0.836*** 0.821*** 0.658*** 0.781*** (0.063) (0.062) (0.070) (0.066) (0.074) Log GDP per capita (PPP, 2009 Int'l Dollars) 0.631*** (0.043) Informal Competition * Log GDP per capita 0.138** (0.067) Distance to Frontier (Doing Business) 0.031*** (Higher values imply better regulatory practices) (0.006) Informal Competition * DTF 0.022** (0.010) Corruption (Governance Indicators) 0.574*** (Higher values imply less corruption) (0.048) Informal Competition * Corruption 0.177** (0.085) Business Freedom index (Economic Freedom of the World) 0.015*** (Higher values imply less regulation and more freedom for businesses) (0.003) Informal Competition * Business Freedom index (Economic Freedom of the World) 0.016*** (0.005) Constant 8.771*** 3.818*** 7.469*** 9.410*** 8.163*** (0.178) (0.390) (0.381) (0.088) (0.224) Country fixed effects YES NO NO NO NO Number of observations 45,996 45,996 44,770 45,996 43,760 R-squared 0.404 0.259 0.184 0.191 0.154 Source: World Bank. Note: Standard errors in brackets. Significance is denoted by *** (1 percent), ** (5 percent), * (10 percent). OLS regression with labor productivity as dependent variable, as proxied by annual sales (in 2009 U.S. dollars, in thousands, in logs) per worker, based on a sample of formal firms only using World Bank’s Enterprise Survey data collected during 2007-14 for 4,036 informal firms and 7,558 formal firms in 18 countries. “Informal competition” is the share of firms in a cell (a group of firms of similar size in the same region and sector) that report competition from informal firms. It is worth mentioning that one could use a firm-level dummy rather than the proportion of formal firms in a cell to proxy informal competition. However, endogeneity concerns may arise because the informal competition faced by a specific firm may also be driven by its productivity. Therefore, the proportion of formal firms facing informal competition in a cell, which would be uncorrelated with the productivity of a specific firm, should be more robust to endogeneity concerns. “Manufacturing” is a dummy variable taking the value of 1 if a firm operates in the manufacturing sector and 0 otherwise. “Capital city” is a dummy variable taking the value of 1 if a firm is located in the capital city and 0 otherwise. ANNEX TABLE 3.4 Survey of policy changes Study Country Years Methodology Policy change Estimated impact as expected Tax reforms YES. The introduction of preferential tax regimes for micro and small businesses Introduction of preferential tax regimes Bruhn and Regression Discontinuity in 2010 increased the number of newly registered formal firms by 18-30 percent Georgia 2010 for micro and small businesses in Loeprick (2014) Design (RDD) regression below the eligibility threshold during the first year of the reform. No significant 2010. effect was seen in subsequent years. YES. SIMPLES raised the proportion of firms that have a license to operate by Fajnzylber, The SIMPLES program introduced in 4.5 percent (20.8 to 25.3 percent), are registered as a legal entity, pay taxes and Maloney, and November 1996 consolidated multiple make social security contributions. Newly created firms (with employees) that Montes-Rojas OLS regression on firm- taxes and social security contributions opted for operating formally achieved higher levels of revenue and profits, Brazil 1996 (2011); Maloney level survey data into a single payment and reduced tax employed more workers and were more capital intensive. This occurred, not and Mendez burdens (on average 8 percent) for through greater access to credit or contracts with larger firms, but through lower (2004) eligible small firms. cost of contracting labor that allowed the adoption of more productive G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 technologies. The GST reform introduced in 2017 simplified the taxation of goods and Keats (2017) India 2017 descriptive services and reduced the incidence of YES. The GST reform reduced the percentage of informal firms by 50 percent. taxation from 26.5 percent to 15-20 percent. The fiscal reform implemented in 2001 reduced payroll and social taxes. The Difference-In-Differences YES. The tax reform reduced the share of informal labor. The decline was Slonimczyk (2012) Russia 2001 reform lowered the average personal (DID) estimation sharpest among individuals with the largest gains from the tax reform. income tax (PIT) to a flat rate of 13 percent. The tax reform implemented in 2009 YES. In a context of weak enforcement and widespread informality, an increase Difference-In-Differences raised the income tax rate on earnings in the tax rate (from 5 to 25 percent) on noncorporate partnership income led Waseem (2018) Pakistan 2009 (DID) estimation for noncorporate partnership firms firms to report significantly lower earnings (roughly half), migrate into informality, from 5 to 25 percent. and switch business form to avoid the additional tax burden. CHAPTER 3 175 ANNEX TABLE 3.4 Survey of policy changes (continued) 176 Study Country Years Methodology Policy change Estimated impact as expected Regulatory (labor and business) reforms CHAPTER 3 The constitutional reform in 1988 cut YES. A large fraction of the 10 percentage point rise in informal employment Bosch, Goni, and Mid 1980s and Cross-section weighted maximum work hours, raised vacation Brazil in Brazil during 1990-2000 was driven by rising labor costs and reduced Maloney (2007) 1990s least squares pay, extended maternity leave, and flexibility. raised dismissal cost. Betcherman, YES. Employment subsidies significantly raised the number of registered jobs Difference-In-Differences Two employment subsidy schemes Daysal, and Turkey 2004 and 2005 in eligible provinces (5-13 percent for the first program and 11-15 percent for (DID) estimation were introduced in 2004 and 2005. Pagés (2010) the second). As part of fiscal decentralization, the YES. The fiscal decentralization led to a sharp increase in the real value of central government transferred the minimum wage. District-level survey data suggests that an increase in the Comola and Mello seemingly unrelated Indonesia 1996 to 2004 minimum-wage setting responsibilities ratio of the minimum wage to the mean wage by 10 percentage point was (2011) regression (SUR) to provinces and local governments associated with a rise in informal sector employment by 0.9-1.1 percentage after 2001. point and a drop in formal sector employment by 0.5-0.7 percentage point. YES. From 1999 to 2009, the labor force surged (up by 35 percent) in a fast- growing Vietnamese economy (with 78 percent increase in GDP per capita). Labor market reforms in 2006 McCaig and 1999 to 2009 This economic upturn led to a contraction of the informal employment (from established a new flexible system in Pavcnik (2015); Vietnam and 2005 to Linear probability model 86 to 79 percent). Younger and more educated male workers were more which minimum wages vary according and Boly (2018) 2013 likely to migrate from informal to formal activities, in sharp contrast to older to location and sector of employment. and poorly educated females. Firms opting out of informality achieved higher profit and greater value added. The major deregulation in 1991 in India YES. Informality dropped, and the reduction in informality was greatest in OLS regression on firm- removed license requirements on the states with more pro-employer labor laws. In states with pro-employer labor Sharma (2009) India 1988 to 2000 level survey data setup and expansion of factories in laws, the number of informal establishments declined by 25 percent more nearly half of all industries. than in states with less flexible labor laws. YES. SARE was exclusively implemented for eligible low-risk industries such The business registration reform as commerce and restaurants, excluding high-risk industries (e.g., chemical established a Rapid Business Opening Bruhn (2011, OLS regression on firm- plants, transportation). The reform induced a 5 percent increase in the Mexico 2002 to 2006 System (SARE) in various 2013) level survey data number of registered businesses. This increase was mainly driven by former municipalities in Mexico from 2002 to wage earners switching from ineligible industries to launch eligible 2006. businesses, rather than the registration of existing informal businesses. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 ANNEX TABLE 3.4. Survey of policy changes (continued) Study Country Years Methodology Policy change Estimated impact as expected Trade liberalization In addition to major changes in Bosch, Goni, Mid 1980s Cross-section weighted labor legislation, the constitutional YES. A small fraction of the 10 percentage point rise in informal employment in Brazil and Maloney Brazil and 1990s least squares reform in 1988 introduced trade during 1990-2000 was driven by trade liberalization in the mid1980s and 1990s. (2007) liberalization policies. Goldberg and YES. Employment informality expanded (i.e. a 1-percentage point decline in a tariff in a Pavcnik (2003); Two-step restricted Trade liberalization measures were 1980s and given industry is associated with a 0.1 percentage point increase in the probability of Attanasio, Colombia least squares implemented in the 1980s and 1990s informal employment), but only for the period preceding a major labor market reform that Goldberg, and estimation 1990s. increased labor market flexibility. Pavcnik (2004) G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 Waves of trade liberalization in MIXED (YES in 1998, NO in 2004). The impact depended on the observation period and 1998 and 2004 reduced tariffs OLS regression on the degree of labor market rigidity. Trade liberalization reforms increased informality Selwaness and 1998 and nearly by 70 percentage points, Egypt individual-level survey among workers in 1998, but lowered the likelihood of informal employment post-2004. Zaki (2015) 2004 from 110 percent at the end of the data This difference may be attributed to labor reforms implemented in 2003 that added 1980s to reach 40 percent by the flexibility to the market during the second wave liberalization. end of 1990’s. NO. Evidence from household surveys in 2001/2002 and 2003/2004 shows that US tariffs reduction (20.9 percent average annual drop) induced a sharp increase in exports to the US, which grew from 3.6 to 10.4 percent of Vietnam’s GDP. This positive export shock 2001/2002 US-Vietnam bilateral trade McCaig and on household survey generated 5 percentage point increase in the share of manufacturing workers in the Vietnam and agreement (BAT) went into effect in Pavcnik (2018) data formal sector. In addition, the prevailing labor productivity gap of 3.7 (when heterogeneity 2003/2004 2001. and measurement errors are accounted for) between the informal and the formal sector induced a reallocation of labor towards the formal sector, and increased the aggregate labor productivity within manufacturing by 2.8 percent per year. Source: World Bank. YES (NO) means that the outcome of a policy intervention is (not) consistent with the expected impact. MIXED means that the outcome of a policy intervention varies over time. The expected impacts of reforms are: (i) reduced tax burden would reduce informality; (ii) increased labor market flexibility would reduce informality; (iii) lowered entry and exit barriers in formal sector would reduce informality; (iv) trade liberalization would increase informality due to intense foreign competition that disrupts existing formal firms. CHAPTER 3 177 178 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 ANNEX TABLE 3.1.1 Data coverage Estimation # of Aspect Measures # of AE Time period method EMDE DGE (percent of GDP) 36 122 1950-2016 Indirect Output MIMIC (percent of GDP) 36 124 1993-2015 Pension coverage (percent of labor force) 31 104 1990-2010 Labor Force Surveys Employment Self-employment (percent of total employment) 36 144 1955-2016 Informal employment (percent of total employment) 0 53 2001-2016 Direct (survey-based) Employment outside the formal sector (percent of total employment) 0 57 1999-2016 (a) WEF(1-7=Most informal) 36 115 2006-2016 WB: percent Competing against informal firms 8 131 2006-2016 Firm surveys Perception WB: percent firms formally registered when founded 7 129 2006-2016 Firms WB: Number of years operated without registration 7 129 2006-2016 WB: percent firms that found competitors in the informal sector as a constraint 7 131 2006-2016 HS (b) WVS: Justifiable (Cheating on taxes) 26 68 1981-2010 Note: DGE is benchmarked to Schneider, Buehn, and Montenegro (2010). World Value Survey (WVS) asks whether cheating on taxes is justifiable (1 is “never justifiable” and 10 is “always justifiable”) and reports average responses at the country-year level, with a higher level suggesting that the country is more tolerant towards the informal sector. World Economic Forum (WEF) asks “In your country, how much economic activity do you estimate to be undeclared or unregistered? (1= Most economic activity is undeclared or unregistered; 7= Most economic activity is declared or registered)” and reports average responses at the country-year level. Here the average responses have been reordered to make “7= Most economic activity is undeclared or unregistered; 1= Most economic activity is declared or registered” where a higher level suggesting a larger informal sector in the country. The WEF data for year 2004 and 2005 are dropped since different ordering were used before 2006, which makes the numbers incomparable over time. WB shows the results for World Bank Enterprise Surveys. “HS” stands for “Household surveys”. “(a)” stands for “Output, and “(b)” stands for “Opinions/Tax Morality”. See Elgin et al (forthcoming a) for detailed information. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 179 ANNEX TABLE 3.1.2. MIMIC model estimation results (1993-2015) [1] [2] [3] [4] [5] 88 Developing 98 Developing 120 Countries 151 Countries 161 Countries Countries Countries Size of government 0.133*** 0.143*** 0.157*** 0.152*** 0.145*** (0.023) (0.021) (0.024) (0.019) (0.019) Share of direct taxation 0.035 0.009 (0.023) (0.022) Business Freedom 0.035 0.040** 0.058** (0.021) (0.020) (0.024) Fiscal Freedom 0.002 -0.010 -0.038 (0.023) (0.020) (0.025) Unemployment rate 0.078*** 0.105*** 0.055** 0.067*** 0.066*** (0.023) (0.021) (0.022) (0.019) (0.019) GDP per capita -0.342*** -0.324*** -0.393*** -0.381*** -0.385*** (0.035) (0.027) (0.029) (0.022) (0.022) Government effectiveness -0.069*** -0.043** -0.042** (0.020) (0.018) (0.018) Growth rate of GDP per capita -0.835*** -0.618*** -0.362*** -0.310*** -0.306*** (0.119) (0.085) (0.079) (0.064) (0.064) Labor force participation rate -0.321*** -0.219*** -0.167*** -0.155*** (0.091) (0.073) (0.053) (0.052) Growth rate of labor force -0.091 (0.064) Currency (M0/M1) 1.000 1.000 1.000 1.000 1.000 (0.000) (0.000) (0.000) (0.000) (0.000) Statistical tests RMSEA 0.061 0.057 0.070 0.087 0.089 p(RMSEA<=0.05) 0.097 0.190 0.002 0.000 0.000 Chi-squared (p) 63.922 (0.00) 60.646 (0.000) 124.517 (0.000) 153.29 (0.000) 160.63 (0.000) AIC 27388.448 33527.217 41436.305 43231.405 44080.904 BIC 27464.278 33602.241 41522.616 43306.446 44156.205 CFI 0.820 0.852 0.761 0.771 0.764 TLI 0.685 0.734 0.590 0.571 0.558 SRMR 0.033 0.030 0.041 0.046 0.047 CD 0.846 1 1 1 1 Number of observations 1,159 1,570 1,627 2,374 2,422 Note: Absolute z-statistics in parentheses. ***, **, * denote significance at the 1, 5, and 10percent significance levels. All variables are used as their standardized deviations from the mean. Data sources for variables used in the model are listed in Section II footnote 6. Following the MIMIC models’ identification rule, the currency (M0/M1) variable is fixed to an a priori value. The currency variable shows the level of money (cash) in circulation. “AIC” stands for “Akaike’s information criterion” and “BIC” stands for “Bayesian information criterion. “RMSEA” stands for “Root Mean Square Error of Approximation.” “TLI” stands for “Tucker Lewis Index.” “CFI” stands for “Comparative Fit Index.” “SRMR” stands for “Standardized Root Mean Square Residual” and “CD” shows the coefficient of determination. These are goodness-of-fit statistics. 180 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 ANNEX TABLE 3.3.1 Database of studies for meta regressions analysis Study Countries / Estimates Sample period Methodology Mean wage gap* Aydin, Hisarciklilar, Ilkkaracan (2010) 1/4 1998-2007 OLS, ML logit 57.75 Baskaya and Hulagu (2011) 1/2 2005-2009 OLS, PSM 15.45 Bargain and Kwenda (2014) 3/6 2001, 2005 OLS, FE 19.19 Botelho and Ponczek (2011) 1/2 1995-2001 OLS, FE 11.76 Earle and Sakova (2000) 6/6 1993, 1994 ML Logit -13.33 El Badaoui, Strobl, and Walsh (2008) 1/17 2001-2003 OLS, DID, PSM 28.48 El Badaoui, Strobl, and Walsh (2010) 1/6 1994 OLS, PSM 25.65 Funkhouser (1997) 1/4 1991-1992 OLS 23.82 Gindling (1991) 1/1 1982 OLS 28.50 Huber and Rahimov (2014) 1/2 2007 OLS -34.98 Lehmann and Pignatti (2007) 1/2 2004 OLS -6.80 Lehmann and Zaiceva (2013) 1/5 2003-2011 OLS, QR, FE 6.90 Magnac (1991) 1/1 1980 OLS 30.30 Marcouiller, de Castilla, and Woodruff (1997) 3/6 1990 OLS 16.50 Nguyen, Nordman, and Roubaud (2013) 1/4 2002-2006 OLS, FE 4.83 Nordman, Rakotomanana, and Roubaud (2016) 1/6 2000-2004 OLS, FE 15.33 Pratap and Quintin (2006) 1/3 1993-1995 OLS, FE 28.49 Tansel and Kan (2012) 1/6 2006-2009 OLS, FE 11.56 Source: World Bank. Note: OLS=pooled ordinary least squares, FE=fixed effects regression, ML logit=multinomial logit regression, PSM=propensity score matching, DID=difference-in-difference estimators, QR=quantile regression. The sample covers these EMDE countries: Argentina, Brazil, Columbia, Costa Rica, Czech Republic, Ecuador, El Salvador, Hungary, Madagascar, Mexico, Peru, Poland, Russia, Slovakia, South Africa, Tajikistan, Turkey, Ukraine and Vietnam. *Average formal sector premium across all estimates, percent; a negative number indicates a wage penalty for formal sector workers. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 181 ANNEX TABLE 3.3.2 Meta regression analysis summary Moderator variables [1] [2] [3] [4] [5] [6] [7] [8] µ 0.195*** 0.11** 0.23*** 0.21*** 0.14*** 0.24*** 0.17*** 0.18*** (0.03) (0.04) (0.03) (0.03) (0.04) (0.04) (0.05) (0.06) Female 0.16* 0.15* 0.12 0.12 (0.08) (0.08) (0.08) (0.08) Male 0.14** 0.13** 0.11* 0.10 (0.06) (0.06) (0.06) (0.06) Fixed Effects -0.15** -0.13** -0.14** -0.13** -0.13** (0.07) (0.06) (0.06) (0.06) (0.07) Self-employed -0.34* -0.32** -0.25* -0.26* (0.14) (0.13) (0.14) (0.14) Latin America and the Caribbean 0.00 (0.07) Europe and Central Asia -0.03 (0.07) Adjusted R-squared 7.8 5.8 6.4 12.0 11.4 14.8 12.4 Number of observations 83 83 83 83 83 83 83 83 τ 2 0.06 0.05 0.05 0.05 0.05 0.05 0.05 0.05 I 2 99.6 99.5 99.4 99.5 99.4 99.4 99.4 99.1 Source: World Bank. Note: *** p<0.01, ** p<0.05, * p<0.1; standard errors are in parenthesis. Within study standard errors of the estimates are used as weights to correct for the heterodasticity. The dependent variable is the informal-formal wage gap estimates by former studies (listed in Annex Table 3.3.1). τ 2 captures the degree of across-study variations, and I 2 reflects the impact of across- study heterogeneity. 182 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 ANNEX TABLE 3.4.1 Pre-existing informality and changes in poverty and income inequality: OLS [1] [2] [3] [4] [5] [6] Moderator variables Annual change in poverty Annual change in income inequality Initial poverty rate -0.024 -0.025 -0.029 Initial Gini index -0.020 -0.020 -0.017 (7.90)*** (7.94)*** (7.31)*** [-5.58]*** [-5.51]*** [-5.58]*** DGE 0.010 DGE 0.001 (1.84)* [0.24] MIMIC 0.011 MIMIC -0.000 (1.83)* [-0.04] Self-employment 0.010 Self-employment 0.001 (2.23)** [0.84] Constant -0.507 -0.533 -0.466 Constant 0.671 0.705 0.534 (2.13)** (2.13)** (2.81)*** [4.72]*** [4.91]*** [3.45]*** R-squared 0.48 0.47 0.45 R-squared 0.28 0.26 0.26 Number of observations 73 74 71 Number of observations 72 73 69 Source: World Bank. Note: Estimated by ordinary least squares method. Dependent variable in column [1]-[3]: Annual change in poverty headcount ratio (i.e., Poverty headcount ratio at $1.90 a day (2011 PPP), percent of population) over the earliest year and the latest year, in percentage points. Dependent variable in column [4]-[6]: Annual change in Gini index over the earliest year and the latest year, in percentage points. Annual change in poverty headcount ratio (i.e., Poverty headcount ratio at $1.90 a day (2011 PPP), percent of population) over the earliest year and the latest year, in percentage points. Initial poverty rate (or Gini index for column [4]-[6]) is the earliest available year between 1990-2005. Informality indicators are averages over 1990-2005. *, **, and *** denote that the coefficients are statistically significant at the 10 percent, 5 percent, and 1 percent levels, respectively. Heteroskedasticity-robust standard errors are estimated with t-statistics presented below the corresponding coefficients. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 3 183 ANNEX TABLE 3.5.1 Sample EMDEs (99) Advanced Economies (27) Angola Eswatini Niger Australia Albania Gambia, The Nigeria Austria Algeria Ghana Oman Belgium Argentina Guatemala Pakistan Canada Bahamas, The Guinea Panama Cyprus Bahrain Guinea-Bissau Paraguay Denmark Bangladesh Haiti Peru Finland Barbados Honduras Philippines France Belize Hungary Poland Germany Benin India Qatar Greece Bhutan Indonesia Romania Iceland Bolivia Iran Rwanda Ireland Botswana Iraq Saudi Arabia Israel Brazil Jamaica Senegal Italy Brunei Darussalam Jordan Sierra Leone Japan Bulgaria Kenya South Africa Korea, Rep. Burkina Faso Kuwait Sri Lanka Luxembourg Burundi Lao PDR St. Lucia Malta Cabo Verde Lebanon St. Vincent and the Grenadines Netherlands Cambodia Liberia Sudan Norway Cameroon Madagascar Tanzania Portugal Central African Republic Malawi Thailand Singapore Chad Malaysia Togo Spain Chile Mali Trinidad and Tobago Sweden China Mauritania Tunisia Switzerland Colombia Mauritius Turkey United Kingdom Congo, Dem. Rep. Mexico Uganda United States Congo, Rep. Mongolia Uruguay Côte d'Ivoire Morocco Venezuela Dominican Republic Mozambique Vietnam Ecuador Namibia West Bank and Gaza Egypt Nepal Zambia El Salvador Nicaragua Zimbabwe Source: World Bank. Note: The country sample and classification are taken from Loayza (2016). 184 C H A P TE R 3 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 9 Methodology, With an Application to Italy.” Review of References Income and Wealth 60 (4): 747-772. Adams, A. V., S. J. de Silva, and S. Razmara. 2013. Arias, O., and M. 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Locke. 2016. “Informality and Credit Constraints: Evidence from Sub-Saharan African MSEs.” Applied Economics 48 (29): 2756-2770. CHAPTER 4 TWO TOPICAL ESSAYS Debt in Low-Income Countries: Evolution, Implications, and Remedies Poverty Impact of Food Price Shocks and Policies G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 4 199 Debt in Low-Income Countries: Evolution, Implications, and Remedies Debt vulnerabilities in low-income countries (LICs) have increased substantially in recent years. Since 2013, median government debt has risen by about 20 percentage points of GDP and increasingly comes from non- concessional and private sources. As a result, in most LICs interest payments are absorbing an increasing proportion of government revenues. The majority of LICs would be hard hit by a sudden weakening in trade or global financial conditions given high levels of external debt, lack of fiscal space, low foreign currency reserves, and undiversified exports. A proactive effort to identify and reduce debt-related vulnerabilities is a priority for many LICs. Policymakers should focus on mobilizing domestic resources, improving debt transparency, and strengthening debt management practices. These efforts should be complemented by measures to strengthen fiscal frameworks, improve the efficiency of public expenditures and public investment management, and develop domestic financial systems. Introduction • What are the key characteristics of the recent rise in LIC debt? In recent years, many low-income countries (LICs) have gained access to additional sources of • How does rising debt relate to other LIC finance, including private and non-Paris Club vulnerabilities? creditors.1 While this has enabled these countries to fund important development needs, it has also • How can better debt management help reduce led to higher levels of public debt. The increasing LIC vulnerabilities? share of market-based debt exposes many LICs to • How can complementary policy measures interest rate, and refinancing risks. These trends reduce LIC vulnerabilities? take place as the external environment is becoming more challenging and borrowing costs are expected to rise around the world, as described Key characteristics of the in Chapter 1. This means that, in the event of an recent rise in LIC debt abrupt deterioration in market conditions, some LICs may struggle to refinance debts from foreign A recent sharp rise. Debt relief under the Heavily sources and are at risk of capital flow reversals and Indebted Poor Countries (HIPC) initiative and dislocating currency depreciations. In this context, the Multilateral Debt Relief Initiative (MDRI) it is important for LICs to develop their domestic helped to reduce public debt among LICs from a financial systems, strengthen capacity for domestic median debt-to-GDP ratio of close to 100 percent resource mobilization, improve macro-fiscal in the early 2000s to a median of just over 30 frameworks, and improve their resilience to shocks percent in 2013.2 This downward trend reversed through the sound management of public debt sharply thereafter, with the median debt ratio and investment. rising to above 50 percent by 2017 (Figure 4.1.1). The increase was large relative to other EMDEs, Against this backdrop, this essay addresses the whose median debt rose by less than 11 percentage following questions: points of GDP from 2013 to 2017, compared to 20 percentage points for LICs. It was also broad- based: debt ratios rose in almost 90 percent of This essay was prepared by Sinem Kilic Celik and Patrick Kirby in LICs, and a third experienced debt increases of collaboration with Andre Proite and Sebastian Essl from the Global Macro and Debt Analytics Group of the Macro, Trade, and more than 20 percentage points. Investment Global Practice. 1 LICs refers to countries meeting the World Bank Group’s definition of countries with per capita gross national income 2 Most LICs—27 out of 33—benefited from one or both of the below $995 per year in 2017. This group includes 33 countries (Annex 4.1.1). HIPC and MDRI programs. 200 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 4.1.1 LIC government finances growing deficits reflected a push to finance public investment, as suggested by the doubling of LIC government debt ratios have risen since 2013, in part because of widening fiscal deficits, but still remain well below levels in the early 2000s. median LIC public investment as a share of GDP from 3 percent in 2000 to 6 percent in 2015. This A. Gross government debt B. Gross government debt by LIC was the experience of Guinea-Bissau, Madagascar, category Mali, and Nepal, where wider fiscal deficits were matched by higher public investment (IMF 2018a). These countries form a minority, however, as a substantial part of LIC borrowing has been used to finance a rise in current consumption. In resource-intensive countries in Sub-Saharan Africa, for example, the bulk of increased spending enabled by a rise in commodity prices went to public sector wages C. Primary fiscal balance D. LICs with largest increase in (World Bank 2018a). Some borrowing may also government debt have been redirected toward the accumulation of private assets stored abroad.3 Dependence on external debt. Given their typically small local creditor base, a significant share of LIC borrowing comes from abroad and is denominated in foreign currencies. The resulting currency mismatch poses a challenge to LICs, as a depreciating currency can lead to a rise in the Source: International Monetary Fund, World Bank. domestic value of the country’s debt burden and A. Dashed blue lines denote the interquartile range, while the solid blue line is the median. A.B.C. The sample includes 30 low-income countries, of which 2 are oil exporters, 8 metals exporters, interest payments. This challenge is more severe in and the remaining 20 are non-resource-intensive. It excludes Somalia, South Sudan, and Syria due to countries with a significant share of external debt data restrictions. A.B. Figure shows median gross government debt in percent of GDP. priced at market rates, and less so for countries B.C.D. LICs= Low-income countries. benefiting from the low interest rates on concessional debt. The key role of fiscal deficits. Primary fiscal The median LIC carries external debt, including deficits had largely been closed among LICs by both public and private debt, equivalent to 28 2006, but widened steadily following the global percent of GDP and almost half of total debt. financial crisis, especially among commodity Median external debt as a share of GDP has risen exporters suffering from falling commodity prices. about 3 percentage points since 2012, with several Rising deficits may also be the result of LICs’ important outliers. Commercial debt issuances increased ability to borrow as a result of HIPC have contributed to especially sharp rises in and MDRI debt relief (Bayraktar and Fofack external debt burdens in Mozambique and 2011; Marcelino and Hakobyan 2014). The Tajikistan. In Uganda, external debt as a share of primary balance of most LICs has been negative GDP has more than doubled since 2012, to more since the mid-2000s, and all but five (of 31 with than 40 percent of GDP in 2017. The maturity available data) LICs had primary deficits in 2017, composition of LIC external debt has remained with a third carrying a primary deficit exceeding 3 broadly stable—short-term debt remained percent of GDP. moderate at 5 percent of total external debt in 2016. Uses of borrowed funds. A rising debt burden is typically less of a reason for concern if it is used to finance investment that raises a country’s potential 3 Ndikumana and Boyce (2011) find that for every dollar in output, and therefore its ability to repay loans in external loans to Sub-Saharan Africa, capital outflows increased by the future (World Bank 2017). In some LICs, roughly 60 cents in the same year. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 4 201 Shift toward non-traditional creditors. The FIGURE 4.1.2 Public debt in LICs composition of public debt has shifted over the Higher debt, and the shift from concessional to market financing, makes last decade, becoming increasingly non- LICs more vulnerable to rising interest rates. concessional as LICs have increased their reliance on financing from non-traditional sources (Figure A. Change in creditor composition B. Share of non-concessional debt of public and publicly guaranteed 4.1.2). The median share of non-concessional debt external debt, 2007-16 in public debt rose to 55 percent in 2016 (the latest year for which data are available), an increase of nearly 8 percentage points since 2013, and 15 percentage points compared with a decade earlier. Commercial creditors have become an important source of credit for some countries (World Bank and IMF 2018a). Ethiopia, Mozambique, Rwanda, Senegal, Tajikistan, and Tanzania have all issued commercial public debt since 2010, generally denominated in U.S. dollars.4 C. Interest payments D. Share of LICs in debt distress or at high risk of distress Non-Paris Club creditors, notably China, have also become a more important source of financing over the past decade, especially in Sub-Saharan Africa (World Bank 2015a). In 2016, non-Paris Club debt accounted for more than a fifth of the median LIC’s external debt, and about 13 percent of their public debt (World Bank 2018b). Major recipients of lending from non-Paris Club Source: International Monetary Fund, World Bank. creditors include the Democratic Republic of A. GDP-weighted average across 32 low-income countries. “Bilateral” includes public and publicly Congo, Ethiopia, Mozambique, Tanzania, guaranteed (PPG) loans from governments and their agencies (including central banks), loans from autonomous bodies, and direct loans from official export credit agencies. “Multilateral” includes PPG Uganda, and Zimbabwe (Atkins et al. 2017; Eom, loans and credits from the World Bank, regional development banks, and other multilateral and intergovernmental agencies. It excludes loans from funds administered by an international Brautigam and Benabdallah 2018). organization on behalf of a single donor government. “Bonds” include PPG bonds that are either publicly issued or privately placed. “Commercial” includes PPG debt from commercial bank loans from private banks and other private financial institutions, as well as export and supplier credits. Lending arrangements for commercial and non- B.C. Dashed blue lines denote the interquartile range, while solid blue line is the median. Includes 30 low-income countries and excludes Somalia, South Sudan, and Syria due to data restrictions. Paris Club debt are often not public, and they can D. Figure shows the percent of low-income countries eligible to access the IMF’s concessional lending facilities that are either at high risk of, or in, debt distress. A country is considered to be in be complex and varied (World Bank and IMF debt distress if it is experiencing difficulties in servicing its debt, as evidenced, for example, by the existence of arrears, ongoing or impending debt restructuring, or if there are indications that a future 2018b). Some of this debt is collateralized, which debt distress event is probable. The sample includes 30 low-income countries. could reduce budget flexibility by earmarking revenues, could weaken the creditor’s incentive to assess the borrower’s debt sustainability, and (if Rising cost of debt service. As debt loads have large) could increase funding costs from other grown and become less concessional, interest creditors who may reassess the probability of being payments have absorbed a growing share of repaid. Moreover, increased exposure to non-Paris government revenues. Among LICs, the median Club and commercial creditors may pose interest payments-to-revenue ratio rose to over 5 coordination challenges for debt resolutions in the percent in 2017, up from just over 3 percent in future, making the consequences of debt distress 2013. The increase in the ratio was due to rapidly even more disruptive, especially if debt is rising interest payments, with median interest collateralized (World Bank and IMF 2018c). payments among LICs having grown by over 128 percent versus 31 percent growth in government revenues. 4 Of 11 LIC debt issuances since 2010, all were denominated in Drivers of rising debt. Countries with the fastest U.S. dollars, with the exception of one of Senegal’s two issuances in rise in debt were often fragile and affected by a 2018, which was euro-denominated. 202 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 combination of conflict, weak governance, or LIC vulnerabilities are reflected by the fact that commodity-dependence (World Bank 2018c). In almost all LICs have the lowest or second lowest The Gambia, government debt increased from grade in the OECD’s country credit risk nearly 60 percent of GDP in 2013 to an estimated classification.6 Because of rising arrears or the need 88 percent in 2017, with interest payments for debt restructuring, eleven LICs were assessed as absorbing 42 percent of revenue. The rise in debt being in debt distress or at a high risk of debt was a result of loose fiscal policy, bailouts of state- distress as of November 2018, compared to only owned enterprises, and widespread misman- six in 2015.7 For LICs assessed at low or moderate agement by the previous government prior to a risk of debt distress, safety margins have eroded. transition to democracy in early 2017 (IMF 2018b). Other LIC vulnerabilities In Mozambique, the government debt-to-GDP Private debt. Due to shallow domestic capital ratio has increased by close to 50 percentage markets and limited access to international points since 2013, reaching an estimated 102 finance, the median LIC has total private debt percent in 2018, with interest payments rising equivalent to only 18 percent of GDP, from 2.6 percent of revenues to 16.5 percent over significantly less than the 41 percent ratio for the the same period. The deterioration was median non-LIC EMDE (Figure 4.1.3).8 underpinned by rising deficits as fiscal policy Nonetheless, LIC private sector debt has been on a remained loose amid lower commodity prices and steady upward trend since 2005, rising by almost subdued growth, and was aggravated by the 8 percentage points. Excess private debt can inclusion of previously undisclosed external sometimes be transformed into public debt, either commercial debt in 2016 (IMF 2018c). The directly through bailouts or indirectly through country is in debt distress, and several payments to countercyclical government spending in response external borrowers have been missed. to private deleveraging, suggesting that the line Zimbabwe is also classified as being in debt between public and private debt can blur (Mbaye, distress. Over the last five years, government debt Badia and Chae 2018). has risen substantially from just over 48 percent of GDP in 2013 to an estimated 82 percent in 2017. Growth subject to downside risks. Growth in Persistently large fiscal deficits have partly been LICs is expected to remain resilient, supporting the result of an elevated public wage bill, which their ability to service debt, but risks are tilted to absorbed 90 percent of revenues in 2017 (IMF the downside. LIC growth is expected to average 2017). In addition, revenues remain subdued 5.6 percent in 2018 and accelerate to just over 6 amid weak growth and structural rigidities, while percent in 2019-20, supported by rising transfers to the agricultural sector have kept non- agricultural output and continued infrastructure wage expenditure elevated. Moreover, the deficits investment (Chapter 1). However, over the next have partly been financed through an overdraft facility at the Reserve Bank of Zimbabwe that, 6 There is one exception: The credit rating for Senegal has given insufficient reserves, has led to money improved recently in the OECD credit risk classification, improving creation and exacerbated foreign-currency from 6 to 5 in a 0-7 rating system, with a higher number indicating higher credit risk (OECD 2018). shortages. 7 A country is considered to be in debt distress if it is experiencing difficulties in servicing its debt, as evidenced, for example, by the Risk of debt distress. Higher levels of public debt, existence of arrears, ongoing or impending debt restructuring, or if much of it external, and an increased reliance on there are indications that a future debt distress event is probable. LICs in debt distress are The Gambia, Mozambique, South Sudan, commercial loans make many LICs vulnerable to and Zimbabwe. LICs at high risk of debt distress are Afghanistan, currency, interest rate, and refinancing risks Burundi, Central African Republic, Chad, Ethiopia, Haiti, and (Devarajan 2018; Gill and Karakülah 2018a,b).5 Tajikistan. There is a total of 30 LICs who have a debt sustainability analysis (DSA) available under the Joint World Bank / IMF debt sustainability framework (DSF). 5 Separately, some countries such as The Gambia are vulnerable to 8 Private sector debt refers to the sum of commercial banks’ and rollover risk because of heavy reliance on short-term domestic debt other financial corporations’ claims on the non-financial private (IMF 2018d). sector, in percent of GDP. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 4 203 decade, weaker growth in major emerging markets FIGURE 4.1.3 Risks to LIC debt sustainability may slow global demand for metals, which Private sector debt has risen alongside public debt in LICs. LIC exports dampens growth prospects for LICs that depend tend to be concentrated in a few products, generally commodities. LIC on metals for government and export revenues growth is accelerating but risks are tilted to the downside. Over the medium term, demand for many commodities is expected to slow, which (World Bank 2018c). Downside risks to this may pose a challenge for exporters. outlook predominate and include the possibility of a faster-than-expected slowdown among major A. Private sector debt B. Median export concentration trading partners (including China, a major commodity consumer); a renewed plunge in commodity prices; a deterioration in international financial conditions; and the possibility of natural disasters, conflict, or severe weather events. Elevated debt, lower investment growth, increased risks. Rising levels of non-concessional public debt, often at variable rates, make some LICs susceptible to a sudden increase in C. Growth D. Global commodity demand growth borrowing costs, especially when they have substantial refinancing needs in coming years or have borrowed in foreign currencies. As advanced economies continue to withdraw monetary policy accommodation, new debt issuances and debt rollovers may become more expensive, resulting in rising LIC debt service costs that could weaken investment and lower medium-term growth (World Bank 2015b, 2016, and 2017). Fiscal Source: BP Statistical Review, Haver Analytics, United Nations, United States Department of consolidation, while often necessary, can also Agriculture, World Bank, World Bureau of Metals Statistics. A. Domestic credit to the non-financial private sector provided by commercial banks and, if data are dampen growth in the short term. available, by other financial corporations. Median debt, based on 148 EMDEs and 29 LICs. A.B. Non-LIC EMDEs= Emerging market and developing economies excluding LICs; LICs= Low- income countries. In the absence of sufficient lending made available B. Orange lines indicate interquartile ranges of Herfindahl-Hirschmann concentration index, which measures the degree of product concentration, with values closer to 100 indicating a country’s at concessional terms, there is a risk that high exports are highly concentrated in a few products. D. To ensure comparability, 2010-16 is model-predicted commodity demand growth. public debt will lead to higher interest rates, crowding out private investment and slowing growth.9 Similarly, rising interest payments to domestic creditors may encourage policymakers to LICs had current account deficits that widened by engage in financial repression—using admin- at least 3 percentage points of GDP over the last istrative or other means to channel domestic decade. Among metals exporters, rising deficits savings toward the purchase of public debt— reflected the pickup in import-intensive mining which can dampen private sector investment and investment, while in non-resource-intensive limit the development of domestic financial countries it often reflected high public investment. markets (Fry 1997). Countries relying on capital inflows to finance a Substantial current account deficits. Almost all large and persistent current account can be more LICs carry persistent, substantial current account vulnerable to currency crises, as weaker investor deficits, with an estimated median of 6.8 percent confidence can result in a slowdown in capital of GDP in 2017 (Figure 4.1.4). Forty percent of inflows, leading to higher borrowing costs, downward currency pressures, difficulties in rolling over debt, and possible macroeconomic 9 Bevan (2012) argues that although evidence in the literature for and financial market stress (Roubini and Wachtel the crowding out effect on investment in LICs is weak, it may be 1999). Current account deficits in LICs, however, more important where financial depth is low. are typically financed by capital inflows from 204 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 development assistance, remittances, foreign minimize fiscal risks stemming from contingent lending, and foreign direct investment. The stable, liabilities, such as guarantees or on-lending to long-term and often concessional nature of this state-owned enterprises or through public-private financing mitigates some of the risks usually partnerships, through effective monitoring and associated with large current account deficits. reporting. Foreign direct investment and development assistance flows were generally more than adequate The benefits of sound debt management are to finance LICs’ current account deficits—the fourfold: median LIC received inflows of these types 1.6 • Lowers debt servicing costs. In many LICs, times as large as its current account deficit. In debt service payments absorb a signi cant more than half of LICs, development assistance share of public revenues (notably in Burundi, alone was greater than the total current account the Central African Republic, and Chad), deficit. Median FDI inflows were equal to about re ecting a combination of low revenue bases, half the current account, except for metals sizable debt loads, and a shift toward non- exporters where it was considerably more. concessional terms. E ective debt FDI flows to LICs, however, are particularly management can help avoid excessive debt sensitive to fluctuations in global growth and service costs by increasing awareness of the liquidity (Burger and Ianchovichina 2017). nancial options available, enabling countries Among these countries, commodity exporters, to borrow at competitive costs with a prudent particularly metals exporters, are particularly degree of risk. vulnerable to sudden swings in FDI flows that • Supports financial sector development. More accompany changes in the external environment— developed local-currency bond markets can FDI flows are more than twice as volatile in metal- promote economic stability by reducing the exporting LICs than in other EMDEs. While reliance on external debt, facilitating the external vulnerabilities can be mitigated by a implementation of counter-cyclical scal strong foreign reserve position, more than 40 policies, and enhancing resilience to sudden percent of LICs with available data have reserves reversals of capital ows. Public debt close to or below three months of imports. instruments can serve as a benchmark for pricing of private sector debt instruments. Role of better debt Local-currency bond markets can enable management diversi cation from bank nancing and provide a savings vehicle for a variety of Goal of sound debt management. In most LICs, investors to support growth (World Bank and government debt is the largest domestic financial IMF 2014). portfolio, and debt management operations can be substantial relative to public spending and • Reduces economic volatility. E ective debt economic activity. A sound macro-fiscal policy management can reduce economic volatility framework requires that public debt is sustainable by selecting debt instruments that help and can be serviced under a wide range of insulate the government balance sheet from circumstances at reasonable costs. While ex ante uncertainties. Both currency and interest rate the level of debt is mainly determined by fiscal shocks can be mitigated in this fashion, policy, ex post the composition of debt can play making a country less susceptible to contagion an important role in safeguarding debt and nancial risks, and supporting cheaper sustainability. Effective debt management plays a and more stable funding for the private sector. critical role in funding the government’s financing • Enhances public sector transparency and needs in a timely fashion, helping ensure low debt medium-term planning. A key element of servicing costs at an acceptable degree of risk, and sound public debt management is the public supporting the development of domestic securities and comprehensive reporting of government markets. In addition, debt management can help debt, which improves the capacity of G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 4 205 policymakers and the broader public to assess FIGURE 4.1.4 External positions in LICs the scal position and appropriately weigh LICs carry persistent current account deficits, largely financed by public balance sheet risks alongside spending development assistance and FDI. However, FDI flows can be volatile, and revenue priorities. especially for metals exporters. Modest foreign exchange reserves make some countries vulnerable to changes in foreign investor sentiment. Evolution of debt management in LICs. Despite some improvements, debt management in LICs A. Current account balance B. Current account funding still suffers from substantial deficiencies. Weaknesses in debt transparency, notably in monitoring and reporting, are pervasive. Medium- term debt strategies are becoming more common but have shortcomings in quality and implementation. Capacity and institutional set-up are often lagging. • Debt transparency. Better compilation and monitoring of public debt and guarantees are C. Foreign direct investment D. Median foreign reserves needed to ensure that risks are detected before they materialize (World Bank 2007). Recent examples of hidden debt and discrepancies among debt statistics point to continued low debt recording capacity, weak legal frameworks, and governance challenges. Debt Management Performance Assessments (DeMPA) suggest that, of the seventeen LICs with available data, minimum requirements in Source: International Monetary Fund, World Bank. debt recording are met by only eight, and A. LICs= Low-income countries. Figure shows median current account balance in percent of GDP. The sample represents a total of 30 low-income countries, of which 2 are oil exporters, 8 are metals monitoring guarantees are met by only four. exporters, and the remaining 20 are non-resource-intensive. It excludes Somalia, South Sudan, and Syria due to data restrictions. Due to shortcomings in accuracy, timeliness, B. The sample represents a total of 21 low-income countries, including 6 metals-exporting LICs, with coverage and completeness of debt records, current account deficits in 2016. C. EMDEs= Emerging market and developing economies. Standard deviation represents the median only four of these seventeen countries met the standard deviation of foreign direct investment in percent of GDP from 2000 to 2017. D. LIDCs=Low-income developing countries; LICs=Low-income countries. See Annex 41 for details. minimum requirements for debt reporting Orange lines indicate interquartile range. Data is as of the last reported year, mostly 2016. and evaluation (Figure 4.1.5). Only a third of the 59 countries eligible for International Development Association borrowing report private sector external debt statistics (World • Broader issues. Some of the most pressing Bank and IMF 2018d). challenges include insu cient legal frame- works, weak capacity, lack of coordination • Debt management strategies. A growing between scal and monetary policy, ine cient number of countries are producing medium- term debt management strategies. However, their quality varies signi cantly, and supporting further improvements in debt recording and monitoring, implementation is often lagging. Few increasing debt transparency, and adding to debt management capacity. The DMF also seeks to strengthen macro-fiscal frameworks, countries are aligning the processes for including through improved domestic revenue mobilization, and to managing medium-term debt with their advance the implementation of growth-enhancing structural reforms. Since 2009, the DMF has supported over 280 Technical Assistance budget process.10 missions in 75 countries and 14 subnational governments, trained client practitioners and hosted around 40 debt management practitioners. A growing number of countries prepare and publish debt management strategies, the quality of debt records in many LICs 10 The World Bank, in partnership with the IMF, has been has improved, and many countries have well-structured debt supporting increasing debt management capacity in LICs through its management offices. Several countries have strengthened their legal Debt Management Facility (DMF). Building on the progress framework and improved their operational risks management with achieved and on lessons learned in recent years, this involves the support of the DMF. 206 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 4.1.5 LIC policy frameworks GDP in the median non-LIC EMDE, reflecting the prevalence of informal activity (Chapter 3). Debt management capacity in many LICs is low, especially in the areas of debt reporting and monitoring. Policy frameworks have improved in LICs, This highlights the need to broaden tax bases, with several countries adopting flexible exchange rates and strengthening especially for higher-income households, in a way their central banks’ independence. that minimizes economic distortions and that A. Countries meeting DeMPA B. Countries meeting DeMPA carefully manages trade-offs between efficiency minimum requirements, select minimum requirements, select and equity (World Bank 2018d). Unexpected categories categories revenue windfalls from sudden improvements in a country’s terms of trade can be set aside to reduce fiscal deficits and debt. Improving spending efficiency. LICs have significant infrastructure needs that require debt financing. However, debt sustainability concerns associated with the financing of infrastructure may be lessened if these expenditures are accompanied C. Central bank transparency index D. Exchange rate regimes by stronger long-term growth and better macro- fiscal, budgeting, and financing frameworks. There may also be room to cut unproductive spending (often subsidies) in order to allow for more growth-enhancing or better-targeted programs.11 Debt used to finance projects that generate a revenue stream is less likely to be unsustainable. There is also often considerable scope to improve the efficiency of investment spending by improving the institutions and Source: Bloomberg, Debt Management Performance Assessments (DeMPA), Dincer and Eichengreen (2014), International Monetary Fund, Shambaugh (2004), World Bank. procedures governing project appraisal, A.B. BCP=Business Continuity Planning; CBM=Cash Balance Management; CFF=Cash Flow Forecasting; DA=Debt Administration; DMS=Debt Management Strategy; DS=Data Security; procurement, and monitoring. By one estimate, a FP=Fiscal Policy; LGLD=Loan Guarantees, On lending Derivatives; MP=Monetary Policy; SD=Segregation of Duties; SC=Staff Capacity. Sample covers 17 low-income countries. country moving from the lowest quartile to the C. Unweighted averages. The range of the index is from 0-15, 0=least transparent and 15=most highest quartile in the efficiency of public transparent. D. De facto exchange rate regime from the Exchange Rate Regime Classification of Shambaugh investment could double the impact of that (2004) is used to determine whether a country has a pegged or flexible exchange rate. The original classification has four categories: “1” reflects no fluctuation at all, “2” indicates movements within investment on growth (IMF 2015). 1 percent bands, “3” indicates movements within 2 percent bands, and “4” indicates a one-time devaluation with 0 change in the remaining 11 months of the year. Shambaugh (2004) assesses these movements against relevant base currencies. The constructed dummy variable indicating a Development of local financial markets. Reliance pegged exchange rate regime was defined to equal 1 for countries classified as 1, 2, 3, or 4. A value of 0 is assigned to flexible exchange rates—i.e., exchange rates that routinely fluctuate outside a 2 on external funding means that there is often a percent band. Based on 31 LICs. currency mismatch in LIC borrowing and revenues, leaving countries vulnerable to swings in the value of the currency. The development of management of cash and scal risks, and poor local currency bond markets can help mitigate this audit and risk control procedures. risk, though they are often a relatively high-cost option. These markets require a functional money Complementary policy market, primary and secondary markets, a diverse base of investors, a stable regulatory system which measures includes reliable custody and settlement systems, Domestic resource mobilization. Among LICs, there is considerable scope to enhance tax revenues and reduce the need to rely on debt financing 11 Credible and well-designed institutional arrangements—such as fiscal rules, stabilization funds, and medium-term expenditure (Baum et al. 2017). In the median LIC, frameworks—can help build fiscal space, improve the management of government revenues accounted for only 19 revenue windfalls, and strengthen policy outcomes (Huidrom, Kose, percent of GDP in 2017, well below 28 percent of and Ohnsorge 2016). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 4 207 and a significant improvement in debt debt vulnerabilities. The Addis Ababa Action management capacity. Sound macroeconomic Agenda calls for debtors and creditors to work policy and financial sector stability are also critical, together to prevent and resolve unsustainable debt as is transparent and effective communication by situations. Creditors can aim for good practice in the government. Alongside improved debt lending, drawing on principles for sustainable management, growing local financial markets can lending such as those being championed by G20 help countries graduate from concessional lending countries (G20 2018). by mitigating some of the costs and risks associated with non-concessional debt. Conclusion Better data collection. Transparency about In recent years, a broad-based rise in borrowing balance sheets is a pre-requisite for sound debt has increased public debt vulnerabilities in LICs. management. Among other gaps, there is often The composition of debt has also shifted, as many limited data on contingent liabilities (especially LICs have increased their exposure to non-Paris those arising from state-owned enterprises and Club creditors and market-based debt, which may public-private partnerships) and the assets held by pose coordination challenges for any future debt LIC governments. These data limitations are resolution. While increased access to market especially acute for debt issued by commercial and funding has provided LICs with opportunities to non-Paris Club creditors. Improving data address development needs, it has also exposed collection practices for LIC debt would help some countries to currency, interest rate, and policymakers make informed and appropriate refinancing risks. borrowing decisions and allow the public to hold The number of LICs at high risk of debt distress the government accountable for its fiscal or in debt distress has increased significantly, and management (World Bank and IMF 2018d). safety margins in many LICs currently assessed at Monetary policy and exchange rate regimes. low or moderate risks of debt distress have eroded. More resilient monetary policy frameworks and External gross financing needs are likely to rise foreign reserve buffers can help mitigate the further as current account deficits widen and large impact of terms-of-trade and other shocks, international bonds fall due. By increasing the including on the fiscal position (Adler, Magud, effectiveness of resource mobilization, public and Werner 2017). More LICs could join the spending, and debt management—supported by growing number of EMDEs where improvements better data collection—LICs can reduce the in the monetary policy regime have reduced probability of costly defaults, enhance debt inflation and, where appropriate, allow greater transparency, support sustainable financial sector exchange rate flexibility to absorb shocks. development, and reduce economic volatility. Rigorous and transparent lending standards. Creditors also have a role to play in containing 208 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 ANNEX 4.1 Comparison of LIDCs and LICs This essay discusses LICs following the World Bank Group definition of countries with per capita gross national income below $995 per year. This group includes 33 countries. It differs from other reports (such as IMF 2018a and World Bank and IMF 2018c), which include additional middle-income countries following the IMF definition of low-income developing countries (LIDCs). The term “LIDC” refers to countries with low per capita gross national income and comparatively weak socioeconomic indicators. ANNEX TABLE 4.1 List of countries in LIDCs and LICs Low-income developing Low-income countries Low-income developing Low-income countries countries (LIDCs) (LICs) countries (LIDCs) (LICs) 1 Afghanistan 1 Afghanistan 31 Malawi 17 Malawi 2 Bangladesh 32 Mali 18 Mali 3 Benin 2 Benin 33 Mauritania 4 Bhutan 34 Moldova 5 Burkina Faso 3 Burkina Faso 35 Mozambique 19 Mozambique 6 Burundi 4 Burundi 36 Myanmar 7 Cambodia 37 Nepal 20 Nepal 8 Cameroon 38 Nicaragua 9 Central African Republic 5 Central African Republic 39 Niger 21 Niger 10 Chad 6 Chad 40 Nigeria 11 Comoros 7 Comoros 41 Papua New Guinea 12 Congo, Dem. Rep. of 8 Congo, Dem. Rep. of 42 Rwanda 22 Rwanda 13 Congo, Republic of 43 São Tomé and Príncipe 14 Côte d’Ivoire 44 Senegal 23 Senegal 15 Djibouti 45 Sierra Leone 24 Sierra Leone 16 Eritrea 9 Eritrea 46 Solomon Islands 17 Ethiopia 10 Ethiopia 47 Somalia 25 Somalia 18 Gambia, The 11 Gambia, The 48 South Sudan 26 South Sudan 19 Ghana 27 Syrian Arab Republic 20 Guinea 12 Guinea 49 Sudan 21 Guinea-Bissau 13 Guinea-Bissau 50 Tajikistan 28 Tajikistan 22 Haiti 14 Haiti 51 Tanzania, United Rep. of 29 Tanzania, United Rep. of 23 Honduras 52 Timor-Leste 24 Kenya 53 Togo 30 Togo 25 Kiribati 54 Uganda 31 Uganda 26 Kyrgyz Republic 55 Uzbekistan 27 Lao P.D.R. 56 Vietnam 28 Lesotho 57 Yemen, Rep. of 32 Yemen, Rep. of 29 Liberia 15 Liberia 58 Zambia 30 Madagascar 16 Madagascar 59 Zimbabwe 33 Zimbabwe (continues in the next column) Source: International Monetary Fund, World Bank. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 4 209 Poverty Impact of Food Price Shocks and Policies In the event of large swings in world food prices, countries often intervene to dampen the impact of international food price spikes on domestic prices and to lessen the burden of adjustment on vulnerable population groups. While individual countries can succeed at insulating their domestic markets from short-term fluctuations in global food prices, the collective intervention of many countries may exacerbate the volatility of world prices. Insulating policies introduced during the 2010-11 food price spike may have accounted for 40 percent of the increase in the world price of wheat and one-quarter of the increase in the world price of maize. Combined with government policy responses, the 2010-11 food price spike tipped 8.3 million people (almost 1 percent of the world’s poor) into poverty. Instead of trade policies, targeted safety net interventions such as cash transfers, food and in-kind transfers, and risk management instruments can be more effective in mitigating the negative effects of food price shocks on poor households. Introduction risks could materialize as a result of higher-than- expected energy prices, El Niño events, or trade In August 2011, nominal international food prices tensions. First, higher-than-expected energy prices, hit an all-time high.1 This followed shortly after a key input in the production of most agricultural the 2007-08 food price spike, which pushed an commodities, could raise grain and oilseed prices. estimated 105 million people into extreme poverty Energy prices affect agricultural production costs (Ivanic and Martin 2008). This event also directly (through fuel use) and indirectly (through prompted widespread concerns about the food fertilizer and other chemicals use and an incentive security of the poorest and fears over a potential to shift production to biofuels). Second, an El world food crisis. Although food prices have Niño event is expected with an 80 percent declined considerably since then, in real terms, probability during December 2018-February they are still significantly above their lows in 2000 2019. Should this materialize, heavier-than- (Figure 4.2.1). expected rains could occur in Central Asia, South America, and East Africa, while drier-than-normal Food price spikes such as in 2010-11 may conditions could affect Central America, the materialize again as the growing frequency of Caribbean, and Southern Africa, affecting the extreme weather events increases the risk of prices of many agricultural commodities. Finally, disruption to food production, setbacks in food although the escalation of existing trade frictions availability and access to food. World hunger and represents a downside risk for the price of severe food insecurity rose during 2014-17, agricultural commodities, policy measures reversing the decline of the previous decade. In introduced by major producers and exporters in 2017, the number of undernourished people response to higher tariffs could also affect prices reached 821 million, up by 5 percent since 2014 (World Bank 2018e). and a setback in achieving the Sustainable Development Goal of eradicating hunger by 2030 Several forces have raised food prices during the (FAO et al. 2018). G20 policy makers have 2000s. A dramatic increase in demand for recently reiterated the urgency of tackling the feedstock for biofuel production in the early 2000s challenges to achieving food security (G20 2018). put considerable pressure on markets for grain and contributed to a rundown in stocks (Akiyama et While agricultural and food prices are expected to al. 2001; Wright 2014). Population growth and rise only moderately in 2019, significant upside urbanization, as well as a shift in diets toward animal-based foods, created demand pressures Note: This essay was prepared by David Laborde, Csilla Lakatos, despite an increase in agricultural productivity in and Will Martin. Research assistance was provided by Xinyue Wang emerging market and developing economies and Heqing Zhao. (EMDEs; Fukase and Martin 2017). Slowing 1 Unless otherwise stated, the concept of food prices as used in this essay refers to the commodity price of major staple foods such as rice, yield growth and declining availability of wheat, and maize. agricultural land constrained food production 210 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 4.2.1 Global food prices (such as farmers, agricultural workers, and small land owners), rising food prices increase real In August 2011, shortly after the 2007-08 food price spike, international nominal food prices hit an all-time high. Although food prices have incomes. By contrast, they lower the real incomes declined considerably since then, in real terms, they are still significantly of households that are net buyers of food. On above their lows in the 2000s. Evidence points to a rise in world hunger and severe food insecurity between 2014 and 2017, reversing the average, sharp increases in food prices raise declining trend observed in the previous decade. poverty, reduce nutrition, and curtail the consumption of essential services such as A. Global food prices B. Global food price volatility education and health care (World Bank 2011).2 Countries often use policy interventions to dampen the domestic impact of international food price spikes and lessen the burden on vulnerable population groups. For example, during the 2007- 08 food price spike, close to three-quarters of EMDEs took policy action to insulate their domestic prices from the sharp increase in international food prices (World Bank 2009). In the event of food price spikes, net food-importing C. Undernourished people D. Prevalence of undernourished countries usually intervene by lowering trade protection (typically tariffs) on food items, while net food-exporting countries impose export restrictions or bans. These policies are often complemented with social safety net programs such as cash transfers or school feeding programs. To the extent that policy interventions reduce the transmission of international price spikes to Source: Food and Agriculture Organization of the United Nations, World Bank. domestic markets, they may appear to be A. Based on yearly commodity price indexes between 1960-2017. B. Based on monthly nominal commodity price indexes between January 1960 – November 2017. successful for individual countries. However, the C.D. Undernourishment is defined a state, lasting for at least one year, of inability to acquire enough combined intervention of many countries raises food, defined as a level of food intake insufficient to meet dietary energy requirements. international prices. These insulating policies tend to encourage consumption and reduce production during price spikes. This, in turn, results in higher growth. Extreme climate events (e.g., El Niño, import demand and reduced export supply that droughts, and natural disasters), particularly when further drive up global prices. During price agricultural stocks are low, and the financialization plunges, government interventions encourage of agricultural futures markets have also greater exports and greater global supply that contributed to food price volatility. further depresses prices. Only countries that Food price increases have important macro- and insulate themselves to an above-average degree can microeconomic impacts through several channels. reduce price volatility in their domestic markets At the macroeconomic level, food price increases (Anderson, Martin, and Ivanic 2017). result in higher inflation, which can reduce The international community has recognized the household real incomes. For food-importing importance of ensuring the stability and countries, high food prices can also result in availability of food supplies as key to addressing terms of trade shocks that lower growth and several development objectives. The Sustainable reduce government policy space. The microeconomic impact of food price increases 2 In the longer term, once producers and consumers have adjusted on poverty and inequality depends on the net food to the increases and wage rates have responded, sustained increases in seller/buyer status of the poorest households. For food prices may lower poverty by raising incomes of poor food producing households (Ivanic and Martin 2014a; Gillson and Fouad households that are net sellers of food products 2014). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 4 211 Development Goals (SDGs) give food security a combined interventions make global food high priority: the second SDG sets out explicitly prices more volatile. Insulating policies the goal to “end hunger, achieve food security and introduced during the 2010-11 food price improved nutrition, and promote sustainable spike accounted for 40 percent of the increase agriculture.” Other SDGs are strongly in the world price of wheat and one-quarter of interconnected: food, agriculture and nutrition the increase in the world price of maize. In play an important role in SDGs on ending contrast, a reversal of earlier government poverty, improving health, fostering sustainable interventions in rice markets dampened the consumption and production, and encouraging degree to which world prices increased by climate change adaptation and mitigation. about 50 percent. In this context, this essay addresses the following • The 2010-11 food price spike, and the wide- questions: spread government intervention that accompanied it, increased the number of poor • How do food price shocks affect EMDEs? living on less than $1.90 per day by almost 1 percent or 8.3 million. • How do countries intervene to reduce the impact of food price shocks? Food price shocks and What was the impact of the 2010-11 food • price shock on poverty? their effects At the macroeconomic level, a high share of The essay presents the following findings: agriculture and food in total output, consumption, • At the macroeconomic level, a high share of employment, trade, and government revenues agriculture and food in total output, heighten countries’ vulnerability to volatility in consumption, employment, trade, and international food prices. At the microeconomic government revenues heighten countries’ level, a high share of net food buyers among the vulnerability to volatility in international food poorest segments of society heightens the adverse prices. At the microeconomic level, food price effects of food price spikes on poverty and income spikes are felt most severely by the poorest inequality. segments of the population who tend to be net food buyers. Macroeconomic channels • Governments in EMDEs tend to respond Reliance on food imports and production. particularly strongly to sharp changes in world Agriculture accounts for close to one-third of total prices for staple foods—such as rice, wheat value added and two-thirds of total employment and maize—to smooth volatility. Domestic in LICs. This is almost three times their shares in food prices are considerably less volatile than the average EMDE (Figure 4.2.2; Aksoy and world food prices in the short run, but over Beghin 2004). For example, in Burkina Faso and the longer term, there is a tendency for Burundi, agriculture accounts for more than four- domestic and world prices to return to their fifths of total employment. In Chad and Sierra original relationship. In the short run, a 1 Leone, it accounts for more than half of domestic percent increase in the world price of rice, value added. In addition, more than three-quarters wheat and maize is associated with an increase of LICs are net food importers compared to only in domestic prices by 0.6 percent, 0.7 percent, half of EMDEs.3 In these net food-importing and 0.8 percent, respectively. LICs, net food imports amount to 5.4 percent of private consumption. Benin and Gambia are • While individual countries can succeed at insulating their domestic markets from short- 3 High trade costs, such as tariffs and border delays, can bias term fluctuations in global food prices, their downwards estimates of the share of food imports (Tombe 2015). 212 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 4.2.2 Macroeconomic channels of transmission Inflation. A surge in food prices increases from global food prices consumer price inflation. For example, the 2007- At the macroeconomic level, a high share of agriculture and food in total 08 and 2010-11, LIC inflation more than output, consumption, employment, trade, and government revenues doubled, from 7 to 15 percent during 2007-2008 heighten countries’ vulnerability to volatility in international food prices. and from 5 to 11 percent during 2010-2011. The increase in EMDE inflation was less pronounced, A. Share of agriculture in economy B. Net food imports and exports from 7 to 11 percent during 2007-2008 and from 5 to 6 percent during 2010-2011. Food prices accounted disproportionately for these increases in inflation—for about two-thirds in LICs and more than half in EMDEs. In vulnerable LICs such as Benin and Niger, where net food imports amount to 15 and 7 percent of household consumption, respectively, inflation surged from 1 percent to 8 percent and 0.2 percent to 11 percent, respectively, during the 2007-08 food price spike. C. Inflation in LICs D. Contribution of food prices to inflation Terms of trade. Sharp increases in food prices can constitute significant adverse terms of trade shocks that lower growth, especially in countries that are large net importers of food. More than three- quarters of LICs are net food importers. The median LIC’s terms of trade declined by 2 percent and 4 percent during the 2007-08 and 2010-11 food price spikes, respectively. In some, the deterioration was much steeper. For example, the E. Terms of trade in LICs F. Fiscal balance in LICs terms of trade of Sierra Leone, a LIC highly reliant on food imports, weakened by 10 percent during each of these food price spike episodes.5 In heavy food importers, the exchange rate depreciation typically associated with adverse terms of trade shocks can compel central banks to tighten monetary policy and further lower growth. Indeed, during the 2007-08 food price spike, close to half of EMDE central banks responded to Source: Kose et al. (2017), World Bank. rising inflation and depreciation by tightening A. Based on a sample of 93 non-LIC EMDEs and 21 LICs. Averages for 2010-16. B. Blue bars show the share of non-LIC EMDEs or LICs in which food imports exceed food exports monetary policy.6 (“Net food importers”) or food imports fall short of food exports (“Net food exporters”). Red bars show net food imports relative to consumption in non-LIC EMDE and LIC food exporters and importers. C. Average inflation based on a sample of 12 LICs. Fiscal policy constraints. Absent stabilizing fiscal D. Share of inflation accounted for by food price inflation. Yellow line indicates half. E. Net barter terms-of-trade index, 100=2000. arrangements, heavy reliance on food and F. Median based on a sample of 26 LICs. agricultural trade can contribute to volatility in public finances and erode fiscal sustainability: rising food prices may increase tax revenues from particularly vulnerable to high food prices, with the agricultural sector and encourage governments net food imports adding up to more than 10 to spend. Conversely, when food prices fall, percent of private consumption.4 5 Severe terms of trade shocks are considerably more common in LICs than in advanced economies and, of all possible external shocks, 4 Conversely, heavy reliance on food exports heightens tend to have the most severe output cost in LICs (IMF 2011; Becker vulnerability to food price declines. For example, in Malawi, net food and Mauro 2006). exports amount to 12 percent of total private consumption. 6 Based on a sample of 54 EMDEs. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 4 213 revenue losses in the agricultural sector are FIGURE 4.2.3 Microeconomic channels of transmission exacerbated by political pressures to subsidize food from global food prices production. During the sharp rise in food prices in At the microeconomic level, a high share of net food buyers among the 2007-08, LICs’ fiscal balances deteriorated, on poorest segments of the population heightens the adverse effects of food average, by close to 1 percentage point of GDP, in price spikes on income distribution and poverty. part due to higher food import bills. Food price spikes may also cause sociopolitical instability, A. Share of food in total consumption B. Consumption expenditure by expenditure product of the poorest households including political unrest and food riots (Barrett 2013). Microeconomic channels Rising food prices impact households through price and income effects. They reduce households’ purchasing power but raise income generated from food production. The overall impact on poverty and income inequality depends on the relative C. Share of net food sellers D. Share of income generated by food magnitude of these effects for households in in the income of the poor different segments of the income distribution. In LICs, households spend on average close to 60 percent of their income on food, more than one- third more than in EMDEs (Figure 4.2.3). In countries such as Burundi and Guinea, the share of food expenditures is even higher, accounting for more than 70 percent of total consumption of households. In LICs, more than one-third of Source: International Food Policy Research Institute, World Bank. households’ consumption expenditure on food is A. Based on data from the Global Consumption Database reflecting on the share of food in total consumption expenditure of households. Data is available for 63 non-LIC EMDEs and 25 LICs. The spent on staple foods such as cereals and base year of the household surveys differs but the data has been converted to a common reference year, 2010. The share of income spent on food is likely to be different. vegetables. These staple foods are considerably B. Based on data from the Global Consumption Database on the share of products in total household more exposed to international price volatility than consumption expenditure. Data is available for 63 non-LIC EMDEs and 25 LICs. The base year of the household surveys differs but the data has been converted to a common reference year, 2010. The domestically processed food products (Figure share of income spent on food is likely to be different. C.D. Averages weighted by the number of poor for a sample of 22 non-LIC EMDEs and 7 LICs. 4.2.1). Poverty line is defined as $1.90/day. For households that are net sellers of agricultural and food products (e.g., farmers), rising food prices raise incomes. More than one-fifth of cut consumption of essential services such as households around and below the poverty line of education and health care.7 For example, the $1.90 per day are net food sellers in the average 2007-08 rise in food prices is estimated to have EMDE and LIC. Households around and below raised the number of poor by 105 million the poverty line in these countries tend to generate (10 percent of the people living on less than a one about one-quarter of their incomes from food dollar a day; Ivanic and Martin 2008). In extreme production. In contrast, poor urban households cases, food price spikes can lead to food insecurity are typically net buyers of food that spend a large and hunger, with severely adverse long-term share of their consumption expenditure on food impacts on human capital. (Aksoy and Hoekman 2010). On average, many of the poor in EMDEs and LICs are net buyers of food. As a result, food price 7 Vulnerable groups such as women and children, are more likely spikes tend to raise poverty, reduce nutrition and to be disproportionately affected. 214 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 Government interventions 2009). The most commonly used interventions were reductions in taxes, including import duties during food price shocks and consumer taxes (Figure 4.2.4).10 Net importers frequently intervened by lowering In the event of large swings in global food prices, import tariffs or even by introducing import governments are confronted with difficult policy subsidies, while net exporters imposed export choices. One option is to allow domestic prices to restrictions or bans to dampen the increase in adjust to world food price changes, exposing domestic prices.11 domestic consumers and producers to changes in their real incomes. Even if a sizable non-tradeable Domestic and world food price dynamics service component in the cost of providing consumers with food such as transportation, Domestic food prices are considerably less volatile storage and retail dampens the pass-through of than global food prices in the short run, but over world food price shocks into domestic markets, the longer term, there is a tendency for domestic allowing domestic food prices to adjust may raise prices to return to their original relationship with inflation in the short run and, in countries where international prices (Figure 4.2.5). This does not inflation expectations are poorly anchored, in the necessarily imply that protection rates become medium to long run.8 zero, but that they return to their pre-spike levels. Alternatively, governments can spare consumers or Governments in EMDEs tend to respond producers from these losses by reducing the particularly strongly to sharp changes in the world transmission of international food price shocks to prices of staple foods—such as rice, wheat and domestic markets.9 As measured in this essay, maize—to reduce the volatility of domestic prices. policy intervention is reflected in the ratio of For staple foods, domestic price movements can domestic to world prices—the “protection rate.” diverge substantially from international price During a period of rising world prices, the movements in the short run, but converge in the protection rate declines when a country seeks to longer term. insulate its domestic markets from the increase in world prices. If the protection rate rises, The movements of world and domestic staples policymakers are compounding the increase in food prices during the latest two food price spikes world prices. (2007-08 and 2010-11) resembled similar earlier episodes: world prices rose rapidly, while domestic In practice, during the 2007-08 food price spike, prices rose only gradually. However, the 2010-11 close to three-quarters of EMDEs took policy spike was different from previous episodes in action to insulate their economies from the sharp several aspects. The 2007-08 increase in food increase in international food prices (World Bank prices came after a long period of stability in food prices. In 2007-08, world prices of all staple foods increased steeply, led by the strong increase in the 8 The decline in real incomes associated with higher inflation world price of rice. Most countries reacted would entail welfare losses, especially when consumers are loss- and strongly by introducing insulating policies. In risk-averse (Gouel and Jean 2015; Freund and Ozden 2008; contrast, the 2010-11 episode occurred when Giordani, Rocha, and Ruta 2016; Easterly and Fischer 2001). In principle, monetary policy tightening can offset inflationary effects world markets and policies were still normalizing from rising global food prices to ensure that rising food prices remain from the 2007-08 episode. Government a purely relative price change and do not become entrenched in higher inflation. However, this would come at the cost of reduced economic activity (Lustig 2009). 9 Policymakers may also have a longer-term goal to protect (or to 10 If countries are insulating primarily through subsidies and are tax) domestic agents (Grossman and Helpman 1994). In empirical fiscally constrained, their ability to insulate will be limited work based on political economy models, protection rates vary to (Ianchovichina, Leoning, and Wood 2014). 11 For net importers, untargeted food subsidies have implications reduce both the costs associated with adjusting prices and the costs of providing a rate of protection that differs from the long-run political for government revenues and fiscal space. If financed by aid, the equilibrium (Anderson and Nelgen 2011; Ivanic and Martin 2014b). impact on fiscal space is limited. Alternatively, targeted transfers may The less than perfect pass-through world price shocks into domestic be more effective in protecting vulnerable groups with limited markets is explicitly considered. macroeconomic repercussions. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 4 215 interventions differed considerably across FIGURE 4.2.4 Food-related government policies countries and across commodities. On average, Countries often use policy interventions to dampen the domestic impact of government interventions (or the unwinding of international food price spikes and lessen the burden on vulnerable earlier interventions) actually contributed to a population groups. In the short run, domestic markets for key staple foods, such as rice and wheat, are highly insulated from global food price swings. decline in the world price of rice. Insulation policies undertaken during the 2010-11 episode exacerbated the volatility of world prices and accounted for about 40 percent of the Rice. Rice was the staple food with the largest price increase in the world price of wheat and one-quarter of the increase in the increase during the 2007-08 food price spike. world price of maize. Between January 2007 and May 2008, world rice prices almost tripled.12 This sharp increase A. Interventions in agricultural B. Policy interventions during the markets 2007-08 food price spike reflected export restrictions introduced by major producers (e.g., India and Vietnam) motivated by food security concerns, panic buying by several large importers, a weak dollar, and record high prices of oil, which is a major input into food production (Childs and Kiawu 2009). During this episode, domestic markets were largely insulated from this global rice price spike (Ivanic and Martin 2008). By contrast, during the 2010-11 price spike, rice prices increased much less, by C. Insulation and correction D. Increase in world prices, 2010-11 about 30 percent between June 2010 and May coefficients 2012. In some countries, adverse supply conditions combined with changes in non-tariff trade policies resulted in domestic rice prices rising above world prices.13 Instead of insulating policies, on average, EMDEs implemented policies that raised domestic prices relative to world prices (Figure 4.2.5). Wheat. Between February 2007 and March 2008, Source: Ag-Incentives Database, Ivanic and Martin (2014b), World Bank. world wheat prices more than doubled, partly in A. Nominal Rate of Protection (NRP) is computed as the price difference between the farm gate price received by producers and an undistorted reference price at the farm gate level. The reference price response to lower-than-anticipated wheat at the farm gate level is defined as the net price of the product when it leaves the farm, after marketing costs have been subtracted. The undistorted farm gate price is defined as the price production caused by drought in Australia, prevailing in competitive world markets. B. Percent of respondents based on a survey of 80 EMDEs. Ukraine and other major exporters.14 Strong C. Estimates based on an Error Correction Model described in Annex 4.2.1. The coefficient of price policy intervention partially insulated domestic insulation ranges from 0 for countries that do not insulate against the rise in world prices, to -1 for countries that adopt policies that fully insulate domestic markets. The error correction term represents markets from the global wheat price spike and the cost of being out of equilibrium or the speed with which polices achieve the target level of protection or at which policymakers move back toward this equilibrium after being forced away from it their subsequent collapse in the aftermath of the by a shock to world prices. Based on data for 82 countries, of which 26 advanced economies, 44 non- LIC EMDEs, and 12 LICs for the period 1955-2011. global financial crisis in 2009-10. Similarly, D. Real terms. Estimates derived based on the methodology described in Annex 4.2.1. during the 2010-11 event, world wheat prices more than doubled between June 2010 and May 2011.15 This time, the increase in world prices was partly driven by lower-than-expected production and exports in Kazakhstan, Russia, and Ukraine and excessive rains in Australia that damaged 12 The world price of 5 percent broken white Thai rice increased wheat crops (World Bank 2010). Large orders from $313/mt to $902/mt. 13 In Vietnam, for instance, domestic rice prices rose by 41 percent from major wheat importers in the Middle East between July-October 2010 due to lower-than-expected production, and North Africa added to price pressures. Since prior commitments on exports, and high inflation from a 2011, global and domestic wheat prices have depreciating currency. 14 The world price of U.S. Hard Red Wheat (HRW) increased fluctuated, broadly synchronously. from $196/mt to $440/mt. 15 The world price of U.S. Hard Red Wheat (HRW) increased Maize. During the 2007-08 food price spike, the from $158/mt to $355/mt. world price of maize almost doubled, partly as a 216 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 4.2.5 Domestic and global food prices In contrast, many countries in Sub-Saharan Africa benefitted from excellent maize harvests, which in Domestic food prices tend to be less volatile than global food prices. This partly reflects a sizeable services component in the cost of providing combination with unpredictable trade policies led domestic consumers with food, but also policy intervention. to sharp falls in domestic prices. A. Price of staple foods B. Rice prices Insulation of domestic food markets Measuring the insulation of domestic markets. The degree of insulation of domestic markets from world food price swings can be quantified using an Error Correction Model (Annex 4.2.1). The model regresses the log of the protection rate on the log of world prices and the deviation from long-term “equilibrium” food prices. The model estimates the degree of insulation to global price C. Wheat prices D. Maize prices changes in both the short run (specifically, a negative coefficient on short-term changes in global food prices) and long run (specifically, a negative coefficient on the long-term relationship between domestic and global food prices). The sample used here includes annual data for 8 food commodity prices in 82 countries, of which 44 are EMDEs and 12 are LICs, during 1955-2011. Estimates of short-term insulation. Estimates E. Domestic and global staple food F. Average increase in world and prices during 2007-08 and 2010-11 domestic price index, 2010-11 point to considerable short-term insulation in markets for key staple foods such as rice and wheat (Figure 4.2.4). Among these key staples, insulation is the highest for rice. In the short run, a 1 percent increase in global rice, wheat, and maize prices is associated with an increase in domestic prices of 0.6 percent, 0.7 percent, and 0.8 percent, respectively. Effectiveness of insulating policy measures. Source: Ivanic and Martin (2014b), World Bank. Note: Trade-weighted averages. Certain types of interventions in markets for staple A. Rice, wheat, maize, oil, and sugar prices. foods have raised volatility in domestic markets. E. Event study based on monthly cross-country average domestic staples prices (average of wheat, rice and maize prices) and global staples prices (average of wheat, rice and maize) during 2007-08 For example, during the 2008-09 food price spike, and 2010-11. Period 0 represents the month of the peak of the world food price spike. F. Average percent increase in the price index. several African countries intervened using food pricing, marketing, and trade policies to stabilize domestic maize markets. Countries that result of increasing U.S. demand for maize intervened most intensively experienced the stimulated by mandatory targets for ethanol highest domestic price volatility, mostly because of production.16 Similarly, during the 2010-11 the ad hoc and unpredictable nature of these episode, the world price of maize increased interventions (Chapoto and Jayne 2009).17 The significantly. As in the case of wheat, adverse weather-related events in major maize exporting 17 After abstaining from the use of interventions in staple food countries contributed to the spike in world prices. markets for several years, policymakers in Eastern and Southern Africa used extensively pricing, marketing, and trade policy tools during the 2015-16 agricultural season to contain the impact of an El 16 Between January 2007 and June 2008, the world price of maize Niño-induced decline in output and food security (Al-Mamun et al. increased from $165/mt to $287/mt. 2017; Tschirley and Jayne 2010). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 4 217 use of an export ban during food price spikes, Martin and Anderson 2012; Ivanic and Martin possibly related to a domestic drought, illustrates 2014b).18 the trade off between different policy instruments: Poverty impact of the • Ensuring food security. By restricting the sale of food for exports, an export ban increases 2010-11 food price shock domestic supply and dampens domestic food price increases. This can help net-food buyers The impact of the 2010-11 food price shock on access food. poverty is quantified in two steps. The first step estimates the degree of policy intervention by • Alleviating poverty. Net food-selling farmers countries (Anderson, Ivanic, and Martin 2014). In are likely to be hardest-hit by a drought. An the second step, these estimates are fed into a export ban reduces their ability to mitigate computable general equilibrium (CGE) model in their production losses with higher incomes combination with household models for 285,000 from higher prices. If these farmers are among households from 31 countries to determine the the poorer segments of the income impact of policy interventions on poverty (Annex distribution, the export ban will likely increase 4.2.1; Laborde, Robichaud and Tokgoz 2013). poverty, as it did in Zambia during the 2016- Two scenarios are compared. In the first scenario, 17 El Niño event (Al-Mamun et al. 2017). the impact of countries’ own interventions on poverty is considered. In the second scenario, the • Volatility. While export bans may alleviate combined effect of all policy interventions on pressures during a specific situation, they global food markets and their feedback to heighten domestic price volatility by domestic poverty is quantified. preventing domestic shocks from being dissipated through changes in trade. If bans Impact of policy interventions on global and are backed up by stockholding measures such domestic prices as those used in India, they can be consistent Quantifying policy interventions. A primary with domestic price stabilization, although the shock, such as a weather shock, is assumed to fiscal costs of this policy approach tends to be generate initial production shortfalls that are high relative to that of price insulation calibrated to match the observed changes in (Gouel, Gautam, and Martin 2016). protection rates and world prices shown in Figure Synchronous policy measures. While individual 4.2.6.19 In attempting to insulate domestic countries can succeed at insulating their domestic markets from the increase in world prices, markets from short-term fluctuations in global governments take offsetting trade measures, such food prices, their combined policies may make as the introduction of export bans (food exporters) global food prices more volatile. Government or the reduction of import duties (food interventions tend to increase consumption and importers). These policy responses are calibrated reduce production during price spikes and support to match the observed protection rates and world production and discourage consumption during price increases in 2010-11. As the model price plunges. During price spikes, this results in distinguishes between domestic and imported higher import demand and, hence, higher global goods, two potential policy instruments are demand that further drives up global prices. considered—an import duty (or subsidy) and an During price plunges, it encourages greater exports from each country and, hence, greater global supply that further depresses prices. Only 18 Consistent with Martin and Anderson (2012) and Anderson, countries that insulate themselves to an above- Ivanic, and Martin (2014). 19 For example, a negative production shock of 55 percent for rice, average degree are able to reduce the transmission 27 percent for wheat, and 35 percent for maize in advanced of international price volatility to their domestic economies and Russia generates an increase of 10 percent in average markets (Anderson, Martin and Ivanic 2017; world prices for these commodities. 218 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 FIGURE 4.2.6 The extent of government interventions in domestic and world prices for 57 countries and during the 2010-11 food price spike 68 agricultural and food commodities during Some countries reduced trade barriers to insulate themselves from 2005-2015.21 Where data from the Ag-Incentives increasing world prices. Others resorted to policy interventions that database were unavailable, alternative data were ultimately raised domestic prices more than the increase in world prices. used from FAOSTAT, GIEWS and Fewsnet. A. Decline in protection rates, B. Increase in protection rates, Overall, this analysis covers 24 major food 2010-11 2010-11 producing and consuming countries, using data on household income sources and spending patterns from 2011. Of these, 18 are EMDEs and 6 are LICs. Impact of policy interventions on global prices. During the food price spike of 2010-11, world prices of maize, wheat and rice rose by 44, 39, and 6 percent, respectively, but domestic prices considerably less (Figure 4.2.4). Model results C. Change in EMDE protection rates, D. Change in LIC protection rates, suggest that the combined action of government 2010-11 2010-11 policies amplified global wheat and maize price increases, accounting for about 40 percent of the increase in world price of wheat and one-quarter of the increase in the price of maize. In contrast, combined policy action reduced the rice price surge compared to a non-action scenario.22 Wheat. Most EMDEs took measures to offset the increase in global wheat prices in 2010-11, Source: Ag-Incentives Database. broadly similar to those employed during the spike Notes: Estimates based on the methodology described in Annex 4.2.1. Changes in the rates of protection are presented in the form: Ti = ∆t/(1+t 0), where t is the initial rate of protection (positive if in wheat prices in 2007-08. Policymakers justified an import tariff or export subsidy) and ∆t is the change in this rate of protection. If the change in the rate of protection is negative during a period of rising world prices, countries are seeking to insulate efforts to dampen the impact of the global wheat their markets from the increase in prices. If it is positive, policymakers are compounding the increase in world prices with an increase in protection, which may be due to the correction of past “errors”: price spike by noting that the world wheat price If domestic prices fall below policymakers’ desired long-run level of protection, or if a policy that spike partly reflected a catching up with rising insulated the domestic market from world markets and a subsequent exogenous shock—such as a harvest shortfall—has caused the domestic price to rise relative to the world price. domestic wheat prices.23 The combined C.D. Median and interquartile range in the change for protection rates for rice, wheat, and maize in non-LIC EMDEs (C) and LICs (D). intervention of countries accounted for close to 50 percent of the increase in the world price of wheat. Maize. Although most countries insulated their export subsidy (or tax).20 These measures, in turn, domestic maize markets against maize price reinforce the original shock to world prices. The increase during 2010-11, there was considerable data used for quantifying the extent of trade policy interventions are taken primarily from the Ag- Incentives Consortium database reflecting changes 21 The data is available at www.ag-incentives.org. 22 This primarily reflects the elimination of export restrictions in India and the increased import protection in Pakistan, Indonesia, Uganda, and Yemen. 20 Many countries typically put in place flanking policies. In 2007- 23 Ethiopia is an exception, where domestic wheat prices rose 08, for example, Indonesia subsidized imports of wheat and rice, 28 percentage points more than world prices during 2010-11. respectively, to hold down domestic consumer prices. To avoid This reflected domestic supply shocks, combined with limited subsidizing exports of the same goods, export restrictions were also access to global wheat markets to alleviate shortages. In particular, introduced. Because rice, wheat, and maize are bulk commodities that wheat output fell by 10 percent in 2010-11 as a result of a are less strongly differentiated than manufactured products, two-way fungus that destroyed the wheat harvest and lowered stocks in 2011. trade in these goods is unusual—except when there are regional Wheat imports rose but were constrained by tight foreign exchange differences in varieties (for example, Indian exports of Basmati rice controls, effectively stopping private sector imports and ensuing and imports of Jasmine rice). Models of differentiated products are that all grain imports are channeled through the state-owned needed to adequately capture actual bilateral trade flows in these Ethiopian Grain Trade Enterprise (Wakeyo and Lanos 2014; Negassa commodities (Thursby, Johnson, and Grennes 1986). and Jayne 1997). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 4 219 heterogeneity in policy responses. In Bangladesh, FIGURE 4.2.7 Poverty impact of policies implemented Ecuador, Malawi, Tanzania, and Zambia, during the 2010-11 food price spike protection rates fell, fully offsetting the rise in The 2010-11 food price spike raised global poverty. The combined impact global maize prices. Ethiopia, Uganda, and Yemen of all government interventions raised poverty worldwide, except in a few increased protection rates or used policies that, in countries. Due to the dampening effect of interventions on the world price of rice, however, the impact of the combined interventions is found to have combination with domestic output shocks, raised poverty about 14 percent less than individual action. amplified the increase in domestic prices. A. Regional poverty impact of a 10 B. Global poverty impact of a 10 Rice. Some countries (e.g., Bangladesh, Nepal, percent rice, wheat, and maize price percent rice, wheat, and maize price increase increase Panama, Tanzania and Zambia) reduced trade barriers to partially offset the rise in world rice prices. However, important net rice exporters such as India, Pakistan, and Yemen implemented policy interventions that, ultimately, raised domestic rice prices more than the increase in world prices. In India, the world’s second-largest rice producer, quantitative restrictions imposed in 2007 initially prevented domestic price increases. However, the subsequent abolition of export quotas in C. Regional poverty impact of the D. Global poverty impact of policy 2010-11 food price shock responses to the 2010-11 food price September 2011 resulted in a surge in exports and shock a rise in domestic prices. In Pakistan, heavy summer flooding that affected one-fifth of the country’s land area and inflicted extensive damage to crops raised domestic rice prices relative to the world price over the same period. A large increase in domestic prices relative to external prices occurred in Yemen, amid persistent water shortages and a shift to less water-intensive non- staple crops and, in Ethiopia and Uganda, amid Source: World Bank. Note: Based on estimates using the MIRAGRODEP computable general equilibrium model described drought. The combined intervention of all in Annex 4.2.1. countries dampened the increase in the world A. Change in the poverty headcount measured at $1.90 per day. B. Poverty impact measured at $1.90 per day. price of rice by about 50 percent compared to a A.C. EAP = East Asia and Pacific; LAC = Latin America and the Caribbean; MNA = Middle East and North Africa; SAR = South Asia; and SSA = Sub-Saharan Africa. scenario without insulation policies. C.D. Assuming increases in the price of maize, rice, and wheat as represented in Figure 4.4.D and based on a poverty line of $1.90/day. Impact of policy intervention on poverty Poverty impact of 2010-11 food price spike with Poverty impact of hypothetical food price spikes policy intervention. When incorporating the without policy intervention. A hypothetical 10 effects of government intervention to reduce the percent surge in rice, wheat, and maize prices pass-through of rising global to domestic prices, raises the number of extreme poor living on less model results suggest that the food price spikes of than $1.90 per day by 0.22 percent or 2.1 million. 2010-11 still raised poverty in most countries Among staple foods, an increase in wheat prices (Figure 4.2.7). On average, the share of extreme raises the number of poor most (by 0.01 poor living on less than $1.90 per day increased by percentage points for a 10 percent wheat price 0.12 percentage point from 13.7 percent. This is increase). Rice price increases cause particularly equivalent to an additional 8.3 million, or a 1 large increases in the number of poor in Sub- percent increase in the number of extreme poor. Saharan Africa (0.13 percentage points). Finally, maize price increases tend to have a lesser impact Heterogeneity in poverty impact. The increase in on the number of poor. world food prices, combined with government intervention, was most strongly felt in countries 220 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 such as India and Uganda, where the extreme poor as India, imposed export restrictions to contain tend to be net food-buyers whose real incomes domestic rice price increases. These were gradually declined.24 The poverty impact of the 2010-11 unwound over the following years. In 2010-11, food price spike on some regions such as East Asia some large wheat and maize producers, such as and the Pacific (EAP), and Latin America and the Russia and Ukraine, introduced export restrictions Caribbean (LAC) is estimated to have been and import bans to contain domestic price limited: low rates of poverty combined with the pressures. benefits of the price increase for countries that are heavy exporters of rice (EAP) or maize (LAC) Conclusions offset some of the losses incurred due to the increase in prices. Even in Sub-Saharan Africa— During the 2010-11 food price shock, coming in the region that accounts for two-thirds of the short succession after the 2007-08 surge in food global increase in poverty—countries like Ethiopia prices, many countries used trade policies to and Nigeria implemented insulation policies that insulate domestic markets from the increase in reduced poverty. world prices. While each country’s policies can dampen domestic price movements, the combined Comparison with 2007-08 food price shock. use of policies by many countries increases global These poverty impacts are less pronounced than food price volatility. For example, widespread those induced by the 2007-08 food price shock. insulation policies accounted for 40 percent of the The 2007-08 food price shocks may have increase in world wheat prices and one-quarter for increased extreme poverty by 105 million (Ivanic world maize prices. The increase in food prices and Martin 2008). Government policies reduced combined with government policy responses in poverty impacts and their combined effect was 2010-11 raised global poverty by almost 1 percent close to zero (Anderson, Ivanic, and Martin 2014). (8.3 million). The difference in poverty impacts reflects the greater severity of the 2007-08 price shocks, the These findings highlight that the use of trade stronger transmission of price changes from world policy interventions to insulate domestic markets to domestic markets and higher initial poverty from food price shocks compounds the volatility rates (the poverty headcount in India, for instance, of international prices and may not be effective in fell from 31 percent in 2009 to 21 percent in protecting the most vulnerable populations 2011).25 While the 2007-08 event was led by rice groups. Instead, targeted safety net interventions prices, exacerbated by export restrictions imposed such as cash transfers, food and in-kind transfers, by major rice producers, the 2010-11 food price school feeding and public works programs can surge was led by maize and wheat prices, triggered mitigate the negative impact of food price shocks by adverse weather events in major wheat and on poor households. Measures such as crop and maize producers in Australia and the Black Sea weather insurance, warehouse receipt systems, Basin. During 2007-08, large rice consumers, such commodity exchanges and futures markets could also be used as risk management instruments. Additional policy interventions such as targeted 24 Results reported here do not take into account the impact of nutrition and health programs can contribute to safety-net programs such as India’s Public Distribution System, improving health outcomes in the medium term, which distributes food to poor households at fixed prices and so while regulatory interventions (taxing unhealthy automatically makes larger transfer to the poor when food prices rise. 25 World Bank (2012) estimate that the 2010-11 food price spike food) can improve health outcomes in the longer increased the number of poor by 50 million in the short run, and by term. 34 million in the long run. These higher estimates do not explicitly account for insulation policies and consider price increases of a wider More generally, in addition to targeted range of food commodities (also beef, chicken, dairy, vegetable oils and soybean prices). In addition, there is uncertainty around poverty interventions it is important to ensure that estimates due to systematic measurement errors in household surveys countries have detailed strategic framework for that may bias the poor’s dependence on food purchases (Headey and food crisis response in place and that these Martin 2016). Finally, Jacoby (2016) and Jacoby and Dasgupta (2018) highlight the importance of accounting for the endogenous programs are sufficiently resourced with agricultural wage response and spillover effects to non-agricultural administrative budgets. International financial wages (also accounted for in this essay). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 4 221 institutions (IFIs) can assist countries to better exportable/importable status, the elasticity of target the people most vulnerable to a food price import demand, and the share of real incomes crisis. IFIs can also help countries identify gains from higher protection that will accrue to practical mechanisms (including indicators) for politically organized producers (Anderson 1995; monitoring nutritional and welfare outcomes, in Grossman and Helpman 1994). measuring the impacts of food crises and mitigation programs, and work with them to The database on Distortions to Agricultural implement those mechanisms. The private sector Incentives (Anderson and Valenzuela 2008; can play a crucial role in enhancing investments in Anderson and Nelgen 2013) is the main data food supply in the short and medium term (World source for estimating the ECM model. It includes Bank 2013), while better collaboration among estimates of domestic and world price levels, which public and private stakeholders can improve risk also determine the level of protection. The price management and provide effective responses to data used in the model capture natural shocks (oil reduce the impacts of extreme weather on prices, weather events) and the impact of trade agriculture (G20 2018). policy interventions, the separate impact of which is not possible to disentangle. The model is estimated for eight food commodities with data for 82 countries, of which 26 are advanced economies, ANNEX 4.2 Methodology 44 EMDEs, and 12 LICs. Error Correction Model Measuring trade policy interventions The analytical framework used to represent the imperfect transmission of changes in international The approach to quantify the extent of trade prices into domestic markets relies on an Error policy interventions builds on that used in Correction Model (ECM) as described in Ivanic Anderson, Ivanic, and Martin (2014). It is assumed and Martin (2014a). As noted by Nickell (1985), that a primary shock, such as weather shock, this model represents a situation in which generates an initial change in domestic and world policymakers seek to reduce both the costs of prices. In attempting to insulate consumers and change, and the costs of being out of equilibrium. producers from price increases, governments make A simplified version model used by Ivanic and offsetting changes in protection measures, such as Martin (2014a), expressed in logs, is: the introduction of export bans or reduction in import duties. These measures, in turn, reinforce Δτ α pw - pwt-1 β pt-1 - γ pwt-1 , the original shock to world prices. When a country imposes an export restriction, the availability of where p represents domestic prices; pw world food to the rest of the world is reduced, what tends prices; τ the rate of protection, approximated by to push up world price. Similarly, when an p-pw ; α, α 0, the coefficient of price insulation importing country reduces its import tariffs, it ranging from 0 for countries that do no insulate increases the demand for imports and hence puts against the rise in world prices, to -1 for countries upward pressure on the world price. that adopt policies that fully insulate domestic markets; The impact of the changes in trade policies can be distinguished from those of the primary shocks by β, β 0, the cost of being out of equilibrium or in the following equation: the speed with which polices achieve the target level of protection or at which policymakers move ΣiSi i i Σi Di i , back toward this equilibrium after being forced away from it by a shock to world prices; γ where Si is supply in region i; Di is demand in determines the long-run relationship between a region i; i * 1 t i is the domestic price; * country’s protection and the global level of is the world price; ti is a country-specific trade agricultural protection; and pt-1 - γ pwt-1 is the barrier, such as a proportional tariff; and i is a deviation from the political-economy equilibrium. random production shift variable for region i. It depends on factors like income levels, Totally differentiating the equation above, 222 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 rearranging, and expressing the results in If products are homogeneous, and a country is percentage changes yields an expression of the small, the change in ∆t represents the change in impact of a set of changes in trade distortions on the domestic price of the good. Additionally, if T" i the world price: is negative in a period of rising world prices, Σi (Gi i - Hi γi) countries are seeking to insulate their markets ̂ *= from the increase in prices. If it is positive, Σi Hi ̂i + Σi (Hiγi - Gi i) Ti policymakers are compounding the increase in world prices with an increase in protection. This where ̂* is the proportional change in the may be due to the correction of past “errors”. This international price; î is an exogenous output might occur if domestic prices fall below shock such as might result from good or bad policymakers’ desired long-run level, or if policy seasonal conditions; i is the elasticity of demand insulated the domestic market from world markets in market i; γi is the elasticity of supply in market and an exogenous shock—such a harvest i; Gi is the share at world prices of country i in shortfall—has caused the domestic price to rise global demand; Hi is the share of country i in relative to the world price. Such insulation global production, and T" i 1 ti . patterns have been observed in the maize markets In other words, the impact on the world price of a in many African countries (Chapoto and Jayne change in trade policies in country is given as a 2009). weighted average of the changes in trade The MIRAGRODEP model distortions in different markets, with the weight on region i depending on the importance of that The analytical framework to measure the poverty country in global supply and demand, as well as implications of the 2010-11 food price spike relies the responsiveness of its production and on the MIRAGRODEP model (Laborde, consumption to price changes in the country, as Robichaud, and Tokgoz 2013) complemented represented by γi and i . with household surveys for more than 31 countries It is thus assumed that elasticities of demand are and 285,000 representative households. equal between countries, i.e., that imported and MIRAGRODEP is a dynamic, multi-country, and domestic goods are perfect substitutes, and that multi-sector computable general equilibrium there are no supply responses. Alternatively, one (CGE) model. The model relies on GTAP 9, a could allow for differentiation between imported global database for 2011. The GTAP database and domestic products, as well as a limited supply includes input-output tables linked by bilateral response (Jensen and Anderson 2017). The result trade flows for 140 regions (countries or country would be an expression with weights that depend aggregates) and 57 sectors. For the purposes of the on, for instance, the shares of imports in simulations these countries and sectors were consumption in each market. However, the overall aggregated into 31 countries/regions and 15 result is similar in expressing the change in world sectors among which rice, wheat, and maize are prices as a weighted sum of changes in trade represented separately. distortions. On the supply side, the production function is a To avoid having to deal with difficult-to-interpret Leontief function of value-added and intermediate interaction terms, all proportional changes are inputs. The intermediate inputs are represented by converted into log changes in Ti , i’s, and as: a nested, two-level constant elasticity of substitution (CES) function of all goods. Based on ̂ i ̂ T" i this, substitutability exists between intermediate Changes in relative prices are measured as in the goods, but these are more substitutable when they Agricultural Incentives database and capture a are in a same category (such as agricultural inputs wide range of policy measures used to assess or service inputs). Value-added is also represented agricultural trade distortions—including tariffs, by a nested structure of CES functions of export subsidies, export taxes, export bans and unskilled labor, land, natural resources, skilled import subsidies. labor, and capital. This nesting allows the modeler G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 CHAPTER 4 223 to incorporate some intermediate goods that are Beyond the standard features of a global dynamic substitutes of factors, such as energy or fertilizers. CGE model, the MIRAGRODEP model includes several improvements: sub-national land markets On the demand side, a representative consumer is (agro-ecological zones or administrative districts) assumed to have a constant propensity to save. and endogenous land supply; poverty analysis The remaining national income is used for the through either a top-down approach for global purchase of consumption goods. Consumers’ coverage or a bottom-up approach (for a subset of preferences are represented by a linear expenditure countries); dual-dual approach for formal/informal system–constant elasticity of substitution (LES– and rural/urban labor markets (Stifel and CES) function, calibrated based on the U.S. Thorbecke 2003); a consistent aggregator for trade Department of Agriculture Economic Research policies (Laborde, Martin, and van der Service income and price elasticities to best reflect Mensbrugghe 2017); differentiated data sets on non-homothetic demand patterns with changes in actual trade and farm policies and existing policy revenue. Given an increase in the price staple space for scenario design and endogenous policy foods, consumers substitute away to consume responses; macro nutrient (calories, fats, proteins) other food products. Armington elasticities, which accounting system based on FAOSTAT food measure the elasticity of substitution between balance sheets and a global Input-Output matrix; products of different countries, are drawn from and sensitivity analysis framework based on the GTAP database and are assumed to be the Monte-Carlo simulations. same across regions. While the elasticities of substitution for Factor endowments are assumed to be fully rice, wheat, and maize used in this model, are employed. The supply of capital goods is modified higher than for manufactured goods, they are not each year because of depreciation and investment. infinite as assumed using the perfect substitutes New capital is allocated among sectors according model (Thursby, Johnson, and Grennes 1986). to an investment function. Growth rates of labor This specification has important implications for supply are fixed exogenously. Land supply is both the economy-wide analysis and at the endogenous and depends on the real remuneration household level. Given these assumptions, an of land. Skilled labor is the only factor that is increase in the price of an imported good has a perfectly mobile; unskilled labor is imperfectly muted impact on the domestic consumer price of mobile between agricultural and nonagricultural that good. Since, with the Armington sectors according to a constant elasticity of assumption—imported goods differentiated based transformation (CET) function. Unskilled labor’s on their country of origin—, the composite price remuneration in agricultural activities is different of the consumer good is weighted by the shares of from that of nonagricultural activities. The only domestic and imported goods, the impact of a factor whose supply is constant is the natural unit change in the world price, or in trade policy, resources factor. It is, however, possible to is given by the share of imports in total endogenously change the factor endowment in the consumption. Because the share of imports in baseline in order to reflect long-term depletion of total consumption of staple foods is typically resources with respect to a price trajectory. small, the impact of trade policy on consumer prices is much more muted than under the The poverty impact is captured through a top- assumption of perfect substitution used in down approach using a data set of household Anderson, Ivanic, and Martin (2014). On the surveys for more than 31 countries and 285,000 production side, the assumption that each representative households. 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China 6.7 6.9 6.5 6.2 6.2 6.0 6.9 6.8 6.8 6.8 6.7 6.5 Fiji 0.4 3.8 3.5 3.4 3.3 3.3 .. .. .. .. .. .. Indonesia 5.0 5.1 5.2 5.2 5.3 5.3 5.0 5.1 5.2 5.1 5.3 5.2 Lao PDR 7.0 6.9 6.5 6.6 6.7 6.6 .. .. .. .. .. .. Malaysia 4.2 5.9 4.7 4.7 4.6 4.6 5.8 6.2 5.9 5.4 4.5 4.4 Mongolia 1.4 5.4 5.9 6.6 6.3 6.2 6.2 5.3 6.3 6.3 6.1 6.6 Myanmar 5.9 6.8 6.2 6.5 6.6 6.8 .. .. .. .. .. .. Papua New Guinea 2.6 2.8 0.3 5.1 3.1 3.4 .. .. .. .. .. .. Philippines 6.9 6.7 6.4 6.5 6.6 6.6 6.6 7.2 6.5 6.6 6.2 6.1 Solomon Islands 3.5 3.5 3.4 2.9 2.8 2.7 .. .. .. .. .. .. Thailand 3.3 3.9 4.1 3.8 3.9 3.9 3.9 4.3 4.0 4.9 4.6 3.3 Timor-Leste 5.3 -4.7 0.8 3.3 4.9 5.0 .. .. .. .. .. .. Vietnam 6.2 6.8 6.8 6.6 6.5 6.5 6.2 7.5 7.7 7.4 6.7 6.9 Europe and Central Asia 1.7 4.0 3.1 2.3 2.7 2.9 3.3 3.5 2.5 2.7 3.1 3.0 Albania 3.4 3.8 4.0 3.6 3.5 3.5 4.2 3.6 3.6 4.5 4.3 .. Armenia 0.2 7.5 5.3 4.3 4.6 4.6 .. .. .. .. .. .. Azerbaijan -3.1 0.1 1.1 3.6 3.3 2.7 .. .. .. .. .. .. Belarus -2.5 2.4 3.4 2.7 2.5 2.5 1.7 3.0 4.3 5.2 4.0 .. Bosnia and Herzegovina7 3.1 3.0 3.2 3.4 3.9 4.0 3.2 2.8 3.3 2.0 3.4 .. Bulgaria 3.9 3.8 3.3 3.1 3.0 2.8 3.8 4.3 3.3 3.5 3.2 2.7 Croatia 3.5 2.9 2.7 2.8 2.8 2.6 3.2 3.4 2.2 2.5 2.9 2.8 Georgia 2.8 4.8 5.3 5.0 5.0 5.0 4.8 4.0 5.3 5.2 5.6 3.7 Hungary 2.3 4.1 4.6 3.2 2.8 2.4 3.5 4.1 4.5 4.5 4.9 4.9 Kazakhstan 1.1 4.1 3.8 3.5 3.2 3.2 5.3 4.2 3.1 4.1 4.3 .. Kosovo 4.1 4.2 4.2 4.5 4.5 4.5 .. .. .. .. .. .. Kyrgyz Republic 4.3 4.6 3.1 3.4 3.9 4.0 .. .. .. .. .. .. Macedonia, FYR 2.8 0.2 2.5 2.9 3.2 3.3 -1.8 0.1 1.6 0.9 3.0 3.0 Moldova 4.5 4.5 4.8 3.8 3.5 3.2 .. .. .. .. .. .. Montenegro 5 2.9 4.7 3.8 2.8 2.5 2.5 5.0 4.8 3.9 4.5 4.9 .. Poland 3.1 4.8 5.0 4.0 3.6 3.3 4.4 5.4 4.5 5.1 5.1 5.1 Romania 4.8 6.9 4.1 3.5 3.1 2.8 6.1 8.8 6.7 4.0 4.1 4.3 Russia -0.2 1.5 1.6 1.5 1.8 1.8 2.5 2.2 0.9 1.3 1.9 1.5 Serbia 2.8 1.9 3.5 3.5 4.0 4.0 1.8 2.2 2.5 4.8 4.9 3.8 Tajikistan 6.9 7.1 6.0 6.0 6.0 6.0 .. .. .. .. .. .. Turkey 3.2 7.4 3.5 1.6 3.0 4.2 5.3 11.5 7.3 7.2 5.3 1.6 Turkmenistan 6.2 6.5 6.2 5.6 5.1 4.9 .. .. .. .. .. .. Ukraine 2.3 2.5 3.5 2.9 3.4 3.8 2.6 2.5 2.3 3.1 3.8 2.8 Uzbekistan 7.8 5.3 5.0 5.1 5.5 6.0 .. .. .. .. .. .. 232 S TATIS TICAL APP ENDIX G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 Real GDP growth (continued) Annual estimates and forecasts1 Quarterly growth2 2016 2017 2018e 2019f 2020f 2021f 17Q2 17Q3 17Q4 18Q1 18Q2 18Q3e Latin America and the Caribbean -1.5 0.8 0.6 1.7 2.4 2.5 1.5 1.9 2.3 1.9 1.6 1.6 Argentina -1.8 2.9 -2.8 -1.7 2.7 3.1 3.0 3.8 3.9 3.9 -4.0 -3.5 Belize -0.5 1.2 1.5 1.9 1.7 1.7 .. .. .. .. .. .. Bolivia 4.3 4.2 4.5 4.3 3.8 3.4 3.8 4.3 5.2 4.4 4.4 .. Brazil -3.3 1.1 1.2 2.2 2.4 2.4 0.6 1.4 2.2 1.2 0.9 1.3 Chile 1.3 1.5 3.9 3.5 3.3 3.2 0.5 2.5 3.3 4.5 5.4 2.8 Colombia 2.0 1.8 2.7 3.3 3.7 3.6 1.7 1.7 1.8 2.2 2.8 2.7 Costa Rica 4.2 3.3 2.7 2.7 2.8 3.0 3.7 2.7 3.0 2.8 3.6 .. Dominican Republic 6.6 4.6 5.8 5.1 5.0 4.8 3.1 3.1 6.5 6.4 7.1 .. Ecuador -1.2 2.4 1.0 0.7 0.7 1.2 2.1 2.9 2.8 1.6 0.9 .. El Salvador 2.6 2.3 2.8 2.5 2.4 2.4 0.3 3.2 2.5 2.7 2.9 .. Grenada 3.7 5.1 5.2 4.2 2.8 2.8 .. .. .. .. .. .. Guatemala 3.1 2.8 2.7 2.9 3.0 3.1 2.2 2.7 2.9 2.0 3.3 .. Guyana 2.6 2.1 3.4 4.6 30.0 24.8 .. .. .. .. .. .. Haiti 3 1.5 1.2 1.6 2.3 2.4 2.5 .. .. .. .. .. .. Honduras 3.8 4.8 3.6 3.8 3.8 3.7 3.5 5.9 4.2 3.0 4.0 .. Jamaica 1.4 1.0 1.7 1.8 2.0 2.0 0.1 1.0 1.2 1.4 2.2 .. Mexico 2.9 2.1 2.1 2.0 2.4 2.4 1.9 1.5 1.5 1.2 2.6 2.5 Nicaragua 4.7 4.9 -3.8 -0.5 2.6 3.6 4.1 3.2 4.7 2.5 -4.4 .. Panama 5.0 5.3 4.0 6.0 5.4 5.2 5.1 5.2 4.4 4.0 3.1 3.6 Paraguay 4.3 5.0 4.0 3.9 4.0 4.0 2.8 5.8 5.4 4.7 6.2 ... Peru 4.0 2.5 3.9 3.8 3.8 3.7 2.5 2.9 2.4 3.2 5.5 2.3 St. Lucia 3.4 3.8 1.5 2.7 2.8 2.3 .. .. .. .. .. .. St. Vincent and the Grenadines 1.3 0.5 1.2 1.6 1.6 2.0 .. .. .. .. .. .. Suriname -5.6 1.7 1.4 1.6 1.8 1.9 .. .. .. .. .. .. Trinidad and Tobago -6.1 -2.6 1.0 0.9 1.2 1.2 .. .. .. .. .. .. Uruguay 1.7 2.7 2.1 2.1 2.3 2.5 2.8 1.9 2.0 2.2 2.6 2.1 Venezuela -16.5 -14.5 -18.0 -8.0 -5.0 -4.0 .. .. .. .. .. .. Middle East and North Africa 5.1 1.2 1.7 1.9 2.7 2.7 1.3 2.3 1.1 2.3 2.6 2.6 Algeria 3.2 1.4 2.5 2.3 1.8 1.8 .. .. .. .. .. .. Bahrain 3.2 3.9 3.2 2.6 2.8 2.8 .. .. .. .. .. .. Djibouti 8.6 5.7 6.7 7.3 7.5 7.5 .. .. .. .. .. .. Egypt3 4.3 4.2 5.3 5.6 5.8 6.0 5.0 5.2 5.3 5.4 5.4 .. Iran 13.4 3.8 -1.5 -3.6 1.1 1.1 3.5 6.1 2.4 2.9 2.5 .. Iraq 13.0 -2.1 1.9 6.2 2.9 2.8 .. .. .. .. .. .. Jordan 2.0 2.0 2.1 2.3 2.4 2.7 .. .. .. .. .. .. Kuwait 2.9 -3.5 1.7 3.6 3.6 3.6 -2.9 -3.6 -2.7 -0.5 1.9 .. Lebanon 1.7 1.5 1.0 1.3 1.5 1.5 .. .. .. .. .. .. Morocco 1.1 4.1 3.2 2.9 3.5 3.5 .. .. .. .. .. .. Oman 5.0 -0.9 1.9 3.4 2.8 2.8 .. .. .. .. .. .. Qatar 2.1 1.6 2.3 2.7 3.0 3.0 0.8 0.7 3.3 2.0 2.5 .. Saudi Arabia 1.7 -0.9 2.0 2.1 2.2 2.2 -0.8 -0.3 -1.4 1.2 1.6 .. Tunisia 1.1 2.0 2.6 2.9 3.4 3.6 1.8 2.1 2.0 2.3 2.9 2.6 United Arab Emirates 3.0 0.8 2.0 3.0 3.2 3.2 .. .. .. .. .. .. West Bank and Gaza 4.7 3.1 1.7 1.9 1.9 1.9 .. .. .. .. .. .. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 S TATIS TICAL APP ENDIX 233 Real GDP growth (continued) Annual estimates and forecasts1 Quarterly growth2 2016 2017 2018e 2019f 2020f 2021f 17Q2 17Q3 17Q4 18Q1 18Q2 18Q3e South Asia 7.5 6.2 6.9 7.1 7.1 7.1 5.5 6.2 6.8 7.6 8.1 7.0 Afghanistan 2.4 2.7 2.4 2.7 3.2 3.2 .. .. .. .. .. .. Bangladesh3,4 7.1 7.3 7.9 7.0 6.8 6.8 .. .. .. .. .. .. Bhutan3,4 7.4 5.8 4.6 7.6 6.4 6.4 .. .. .. .. .. .. India 3,4 7.1 6.7 7.3 7.5 7.5 7.5 5.6 6.3 7.0 7.7 8.2 7.1 Maldives 6.2 7.1 8.0 6.3 5.6 5.6 .. .. .. .. .. .. Nepal3,4 0.6 7.9 6.3 5.9 6.0 6.0 .. .. .. .. .. .. Pakistan3,4 4.6 5.4 5.8 3.7 4.2 4.8 .. .. .. .. .. .. Sri Lanka 4.5 3.3 3.9 4.0 4.1 4.1 3.0 3.2 3.5 3.4 3.6 2.9 Sub-Saharan Africa 1.3 2.6 2.7 3.4 3.6 3.7 1.7 2.0 2.5 2.3 1.9 2.3 Angola -2.6 -0.1 -1.8 2.9 2.6 2.8 .. .. .. .. .. .. Benin 4.0 5.8 6.0 6.2 6.5 6.6 .. .. .. .. .. .. Botswana3 4.3 2.4 4.4 3.9 4.1 4.1 1.0 3.5 6.3 4.5 5.1 4.2 Burkina Faso 5.9 6.3 6.0 6.0 6.0 6.0 .. .. .. .. .. .. Burundi -0.6 0.5 1.9 2.3 2.5 2.8 .. .. .. .. .. .. Cabo Verde 4.7 4.0 4.5 4.7 4.9 4.9 .. .. .. .. .. .. Cameroon 4.6 3.5 3.8 4.2 4.5 4.5 .. .. .. .. .. .. Chad -6.3 -3.0 3.1 4.6 6.1 4.9 .. .. .. .. .. .. Comoros 2.2 2.7 2.7 3.1 3.1 3.1 .. .. .. .. .. .. Congo, Dem. Rep. 2.4 3.4 4.1 4.6 5.5 5.9 .. .. .. .. .. .. Congo, Rep. -2.8 -3.1 1.0 3.2 -0.1 -1.5 .. .. .. .. .. .. Côte d'Ivoire 8.0 7.7 7.5 7.3 7.4 6.8 .. .. .. .. .. .. Equatorial Guinea -8.5 -4.9 -8.8 -2.1 -5.8 -5.8 .. .. .. .. .. .. Eswatini 3.2 1.9 -0.6 1.7 1.8 1.8 .. .. .. .. .. .. Ethiopia3 8.0 10.1 7.7 8.8 8.9 8.9 .. .. .. .. .. .. Gabon 2.1 0.5 2.0 3.0 3.7 3.7 .. .. .. .. .. .. Gambia, The 0.4 4.6 5.3 5.4 5.2 5.2 .. .. .. .. .. .. Ghana6 3.7 8.5 6.5 7.3 6.0 6.0 .. .. .. .. .. .. Guinea 10.5 8.2 5.8 5.9 6.0 6.0 .. .. .. .. .. .. Guinea-Bissau 5.8 5.9 3.9 4.2 4.4 4.5 .. .. .. .. .. .. Kenya 5.9 4.9 5.7 5.8 6.0 6.0 4.7 4.7 5.4 5.7 6.3 .. Lesotho 3.1 -1.7 1.2 1.2 0.2 1.8 .. .. .. .. .. .. Liberia -1.6 2.5 3.0 4.5 4.8 4.8 .. .. .. .. .. .. Madagascar 4.2 4.2 5.2 5.4 5.3 5.3 .. .. .. .. .. .. Malawi 2.5 4.0 3.5 4.3 5.3 5.5 .. .. .. .. .. .. Mali 5.8 5.4 4.9 5.0 4.9 4.8 .. .. .. .. .. .. Mauritania 2.0 3.5 3.0 4.9 6.9 6.9 .. .. .. .. .. .. Mauritius 3.8 3.9 3.9 4.0 3.6 3.6 .. .. .. .. .. .. Mozambique 3.8 3.7 3.3 3.5 4.1 4.1 .. .. .. .. .. .. Namibia 0.6 -0.9 0.7 1.8 2.1 2.1 .. .. .. .. .. .. Niger 4.9 4.9 5.2 6.5 6.0 5.6 .. .. .. .. .. .. Nigeria -1.6 0.8 1.9 2.2 2.4 2.4 0.7 1.2 2.0 2.1 1.5 1.8 Rwanda 6.0 6.1 7.2 7.8 8.0 8.0 .. .. .. .. .. .. Senegal 6.2 7.2 6.6 6.6 6.8 6.9 .. .. .. .. .. .. Seychelles 4.5 5.3 3.6 3.4 3.3 2.9 .. .. .. .. .. .. 234 S TATIS TICAL APP ENDIX G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 Real GDP growth (continued) Annual estimates and forecasts1 Quarterly growth2 2016 2017 2018e 2019f 2020f 2021f 17Q2 17Q3 17Q4 18Q1 18Q2 18Q3e Sub-Saharan Africa (continued) Sierra Leone 6.3 3.7 3.7 5.1 6.3 6.3 .. .. .. .. .. .. South Africa 0.6 1.3 0.9 1.3 1.7 1.8 1.2 1.6 1.4 0.8 0.4 1.1 Sudan 4.7 4.3 3.1 3.6 3.8 3.8 .. .. .. .. .. .. Tanzania 7.0 7.1 6.6 6.8 7.0 7.0 7.8 6.8 8.4 .. .. .. Togo 5.1 4.4 4.5 4.8 5.1 5.1 .. .. .. .. .. .. Uganda3 4.8 3.9 6.1 6.0 6.4 6.5 6.4 7.0 6.1 6.2 5.0 .. Zambia 3.8 3.5 3.3 3.6 3.8 3.8 3.4 5.3 4.1 2.7 3.9 .. Zimbabwe 0.6 3.2 3.0 3.7 4.0 4.0 .. .. .. .. .. .. Sources: World Bank and Haver Analytics. Notes: e = estimate; f = forecast. 1. Aggregate growth rates calculated using constant 2010 U.S. dollars GDP weights. 2. Year-over-year quarterly growth of not-seasonally-adjusted real GDP, except for Ecuador, the Euro Area, Tunisia, and the United Kingdom. Regional averages are calculated based on data from following countries. East Asia and Pacific: China, Indonesia, Malaysia, Mongolia, Philippines, Thailand, and Vietnam. Europe and Central Asia: Albania, Belarus, Bosnia and Herzegovina, Bulgaria, Croatia, Georgia, Hungary, Kazakhstan, FYR Macedonia, Poland, Romania, Russia, Serbia, Turkey, and Ukraine. Latin America and the Caribbean: Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Ecuador, El Salvador, Guatemala, Honduras, Jamaica, Mexico, Nicaragua, Paraguay, Peru, and Uruguay. Middle East and North Africa: Egypt, Iran, Kuwait, Qatar, Saudi Arabia, and Tunisia. South Asia: India and Sri Lanka. Sub-Saharan Africa: Botswana, Kenya, Nigeria, South Africa, Tanzania, Uganda, and Zambia. 3. Annual GDP is on fiscal year basis, as per reporting practice in the country. 4. GDP data for Pakistan are based on factor cost. For Bangladesh, Bhutan, Nepal, and Pakistan, the column labeled 2017 refers to FY2016/17. For India, the column labeled 2016 refers to FY2016/17. 5. Quarterly data are preliminary. 6. Growth rates reflect GDP data prior to recent rebasing. 7. Growth rates based on the production approach. For additional information, please see www.worldbank.org/gep. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 S TATIS TICAL APP ENDIX 235 Data and Forecast Conventions The macroeconomic forecasts presented in this House Prices Indicators, IMF Balance of Pay- report are prepared by staff of the Prospects ments Statistics, and IMF International Financial Group of the Development Economics Vice- Statistics. Presidency, in coordination with staff from the Macroeconomics, Trade, and Investment Global Aggregations. Aggregate growth for the world and Practice and from regional and country offices, all sub-groups of countries (such as regions and and with input from regional Chief Economist income groups) is calculated as GDP-weighted offices. They are the result of an iterative process average (at 2010 prices) of country-specific that incorporates data, macroeconometric models, growth rates. Income groups are defined as in the and judgment. World Bank’s classification of country groups. Data. Data used to prepare country forecasts Forecast Process. The process starts with initial come from a variety of sources. National Income assumptions about advanced-economy growth Accounts (NIA), Balance of Payments (BOP), and and commodity price forecasts. These are used as fiscal data are from Haver Analytics; the World conditioning assumptions for the first set of Development Indicators by the World Bank; the growth forecasts for EMDEs, which are produced World Economic Outlook, Balance of Payments using macroeconometric models, accounting Statistics, and International Financial Statistics by frameworks to ensure national account identities the International Monetary Fund. Population and global consistency, estimates of spillovers data and forecasts are from the United Nations from major economies, and high-frequency World Population Prospects. Country- and indicators. These forecasts are then evaluated to lending-group classifications are from the World ensure consistency of treatment across similar Bank. DECPG databases include commodity EMDEs. This is followed by extensive discussions prices, data on previous forecast vintages, and in- with World Bank country teams, who conduct house country classifications. Other internal continuous macroeconomic monitoring and databases include high-frequency indicators such dialogue with country authorities. Throughout as industrial production, consumer price indexes, the forecasting process, staff use macro- house prices, exchange rates, exports, imports, and econometric models that allow the combination stock market indexes, based on data from of judgement and consistency with model-based Bloomberg, Haver Analytics, OECD Analytical insights. 236 S E L E C T E D TO P I C S G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 Global Economic Prospects: Selected Topics, 2015-19 Growth and Business Cycles Informality Growing in the shadow: Challenges of informality January 2019, Chapter 3 Linkages between formal and informal sectors January 2019, Box 3.1 Regional dimensions of informality: An overview January 2019, Box 3.2 Casting a shadow: Productivity in formal and informal firms January 2019, Box 3.3 Under the magnifying glass: How do policies affect informality? January 2019, Box 3.4 East Asia and Pacific January 2019, Box 2.1.1 Europe and Central Asia January 2019, Box 2.2.1 Latin America and the Caribbean January 2019, Box 2.3.1 Middle East and North Africa January 2019, Box 2.4.1 South Asia January 2019, Box 2.5.1 Sub-Saharan Africa January 2019, Box 2.6.1 Inflation The great disinflation January 2019, Box 1.1 Growth prospects Long-term growth prospects: Downgraded no more? June 2018, Box 1.1 Global output gap Is the global economy turning the corner? January 2018, Box 1.1 Potential growth Building solid foundations: How to promote potential growth January 2018, Chapter 3 What is potential growth? January 2018, Box 3.1 Understanding the recent productivity slowdown: Facts and explanations January 2018, Box 3.2 Moving together? Investment and potential output January 2018, Box 3.3 The long shadow of contractions over potential output January 2018, Box 3.4 Productivity and investment growth during reforms January 2018, Box 3.5 East Asia and Pacific January 2018, Box 2.1.1 Europe and Central Asia January 2018, Box 2.2.1 Latin America and the Caribbean January 2018, Box 2.3.1 Middle East and North Africa January 2018, Box 2.4.1 South Asia January 2018, Box 2.5.1 Sub-Saharan Africa January 2018, Box 2.6.1 Investment slowdown Weak investment in uncertain times: Causes, implications and policy responses January 2017, Chapter 3 Investment-less credit booms January 2017, Box 3.1 Implications of rising uncertainty for investment in EMDEs January 2017, Box 3.2 Investment slowdown in China January 2017, Box 3.3 Interactions between public and private investment January 2017, Box 3.4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 S E L E C T E D TO P I C S 237 Global Economic Prospects: Selected Topics, 2015-19 Growth and Business Cycles Investment slowdown (continued) East Asia and Pacific January 2017, Box 2.1.1 Europe and Central Asia January 2017, Box 2.2.1 Latin America and the Caribbean January 2017, Box 2.3.1 Middle East and North Africa January 2017, Box 2.4.1 South Asia January 2017, Box 2.5.1 Sub-Saharan Africa January 2017, Box 2.6.1 Forecast uncertainty Quantifying uncertainties in global growth forecasts June 2016, SF 2 Cross-border spillovers Who catches a cold when emerging markets sneeze? January 2016, Chapter 3 Sources of the growth slowdown in BRICS January 2016, Box 3.1 Understanding cross-border growth spillovers January 2016, Box 3.2 Within-region spillovers January 2016, Box 3.3 East Asia and Pacific January 2016, Box 2.1.1 Europe and Central Asia January 2016, Box 2.2.1 Latin America and the Caribbean January 2016, Box 2.3.1 Middle East and North Africa January 2016, Box 2.4.1 South Asia January 2016, Box 2.5.1 Sub-Saharan Africa January 2016, Box 2.6.1 Fiscal Space Having space and using it: Fiscal policy challenges and developing economies January 2015, Chapter 3 Fiscal policy in low-income countries January 2015, Box 3.1 What affects the size of fiscal multipliers? January 2015, Box 3.2 Chile’s fiscal rule—an example of success January 2015, Box 3.3 Narrow fiscal space and the risk of a debt crisis January 2015, Box 3.4 Revenue mobilization in South Asia: Policy challenges and recommendations January 2015, Box 2.3 Other topics Education demographics and global inequality January 2018, SF 2 Recent developments in emerging and developing country labor markets June 2015, Box 1.3 Linkages between China and Sub-Saharan Africa June 2015, Box 2.1 What does weak growth mean for poverty in the future? January 2015, Box 1.1 What does a slowdown in China mean for Latin America and the Caribbean? January 2015, Box 2.2 238 S E L E C T E D TO P I C S G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 Global Economic Prospects: Selected Topics, 2015-19 Commodity Markets The role of the EM7 in commodity production June 2018, SF1, Box SF1.1 Commodity consumption: Implications of government policies June 2018, SF1, Box SF1.2 With the benefit of hindsight: The impact of the 2014–16 oil price collapse January 2018, SF1 From commodity discovery to production: Vulnerabilities and policies in LICs January 2016, Chapter 1 After the commodities boom: What next for low-income countries? June 2015, Chapter 1, SF Low oil prices in perspective June 2015, Box 1.2 Understanding the plunge in oil prices: Sources and implications January 2015, Chapter 4 What do we know about the impact of oil prices on output and inflation? A brief survey January 2015, Box 4.1 Globalization of Trade and Financial Flows Poverty impact of food price shocks and policies January 2019, Chapter 4 Arm’s-Length trade: A source of post-crisis trade weakness June 2017, SF The U.S. economy and the world January 2017, SF Regulatory convergence in mega-regional trade agreements January 2016, Box 4.1.1 Can remittances help promote consumption stability? January 2016, Chapter 4 Potential macroeconomic implications of the Trans-Pacific Partnership Agreement January 2016, Chapter 4 Regulatory convergence in mega-regional trade agreements January 2016, Box 4.1.1 China’s integration in global supply chains: Review and implications January 2015, Box 2.1 What lies behind the global trade slowdown? January 2015, Chapter 4 Monetary and Exchange Rate Policies The great disinflation January 2019, Box 1.1 Corporate debt: Financial stability and investment implications June 2018, SF2 Recent credit surge in historical context June 2016, SF1 Peg and control? The links between exchange rate regimes and capital account policies January 2016, Chapter 4 Negative interest rates in Europe: A glance at their causes and implications June 2015, Box 1.1 Hoping for the best, preparing for the worst: Risks around U.S. rate liftoff and policy options June 2015, SF1.1 Countercyclical monetary policy in emerging markets: Review and evidence January 2015, Box 1.2 Fiscal Policies Debt in low-income countries: Evolution, implications, and remedies January 2019, Chapter 4 Debt dynamics in emerging market and developing economies: Time to act? June 2017, SF Having fiscal space and using it: Fiscal challenges in developing economies January 2015, Chapter 3 Revenue mobilization in South Asia: Policy challenges and recommendations January 2015, Box 2.3 Fiscal policy in low-income countries January 2015, Box 3.1 What affects the size of fiscal multipliers? January 2015, Box 3.2 Chile’s fiscal rule—An example of success January 2015, Box 3.3 Narrow fiscal space and the risk of a debt crisis January 2015, Box 3.4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2019 S E L E C T E D TO P I C S 239 Development Economics Prospects Group (DECPG): Selected Other Publications on the Global Economy, 2015-19 Commodity Markets Outlook Column1 The implications of tariffs for commodity markets October 2018, Box The changing of the guard: Shifts in industrial commodity demand October 2018, SF Oil exporters: Policies and challenges April, 2018, SF Investment weakness in commodity exporters January 2017, SF OPEC in historical context: Commodity agreements and market fundamentals October 2016, SF Energy and food prices: Moving in tandem? July 2016, SF Resource development in an era of cheap commodities April 2016, SF Weak growth in emerging market economies: What does it imply for commodity markets? January 2016, SF Understanding El Niño: What does it mean for commodity markets? October 2015, SF How important are China and India in global commodity consumption July 2015, SF Anatomy of the last four oil price crashes April 2015, SF Putting the recent plunge in oil prices in perspective January 2015, SF Inflation in Emerging and Developing Economies Inflation: Concepts, evolution, and correlates Chapter 1 Understanding global inflation synchronization Chapter 2 Sources of inflation: Global and domestic drivers Chapter 3 Inflation expectations: Review and evidence Chapter 4 Inflation and exchange rate pass-through Chapter 5 Inflation in low-income countries Chapter 6 Poverty impact of food price shocks and policies Chapter 7 High-Frequency Monitoring Column1 Global Monthly newsletter Global Weekly newsletter ECO-AUDIT Environmental Benefits Statement e World Bank Group is committed to reducing its environmental footprint. In support of this commitment, we leverage electronic publishing options and print-on-demand technology, which is located in regional hubs worldwide. Together, these initiatives enable print runs to be lowered and shipping distances decreased, resulting in reduced paper consumption, chemical use, greenhouse gas emissions, and waste. We follow the recommended standards for paper use set by the Green Press Initiative. e majority of our books are printed on Forest Stewardship Council (FSC)-certi ed paper, with nearly all containing 50-100 percent recycled content. e recycled ber in our book paper is either unbleached or bleached using totally chlorine-free (TCF), processed chlorine-free (PCF), or enhanced elemental chlorine-free (EECF) processes. More information about the Bank’s environmental philosophy can be found at http://www.worldbank.org/corporateresponsibility. EMBARGOED: NOT FOR PUBLICATION, BROADCAST, OR TRANSMISSION UNTIL TUESDAY, JANUARY 8, 2019 AT 4:00 PM EST (9:00 PM UTC/GMT) G lobal economic prospects have darkened. Financing conditions have tightened, industrial production has moderated, and trade tensions remain elevated. The recovery in emerging market and developing economies has stalled, and some countries have experienced significant financial stress. Downside risks have increased, including the possibility of disorderly financial market movements and escalating trade disputes. It is thus critical to rebuild policy buffers while fostering potential growth by boosting human capital, promoting trade integration, and addressing informality. In addition to discussing global and regional economic developments and prospects, this edition of Global Economic Prospects includes a chapter on the challenges posed by informality and associated policy options. The report also contains pieces on the remarkable decline in EMDE inflation over the past four to five decades, rising debt vulnerabilities in low-income countries, and the implications of large spikes in food prices for poverty. Global Economic Prospects is a World Bank Group Flagship Report that examines global economic developments and prospects, with a special focus on emerging market and developing countries, on a semiannual basis (in January and June). The January edition includes in-depth analyses of topical policy challenges faced by these economies, while the June edition contains shorter analytical pieces.