81681 WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Rebuilding Policy Buffers, Reinvigorating Growth WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Rebuilding Policy Buffers, Reinvigorating Growth © October 2013 The International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org All rights reserved 1 2 3 4 13 12 11 10 This volume is a product of the staff of the International Bank for Reconstruction and Development / The World Bank. The findings, interpretations, and conclusions expressed in this volume do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. 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All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2422; e-mail: pubrights@worldbank.org. ISSN: 2079-5874 Key title: World Bank East Asia and Pacific Economic Update … (Print) Abbreviated key title: World Bank East Asia Pac. Econ. Update (Print) Cover photo: The World Bank Photo Collection Contents  |  iii CONTENTS Abbreviationsix Preface and Acknowledgments x Executive Summary xi Part I. Recent Developments and Outlook 1 I.A. Recent Developments 2 Real Sector: Is Domestic Demand Weakening? 2 External Sector: Is Export Slowdown Bottoming Out? 5 Financial Markets: A Return to Volatility 8 Fiscal and Monetary Policy: Measured Responses 10 I.B. Outlook and Risks  13 EAP Region Will Contribute the Most to Global Growth this Year 13 Headline Risks Are On the Downside 16 I.C. Policy Considerations 20 Fiscal Policy: Rebuilding Buffers 20 Monetary Policy: Unwinding Stimulus 21 Exchange Rate Policy: Maintaining Flexibility 23 Structural Reforms: The Key to Future Growth  23 References26 Part II. Selected Emerging Issues 27 II.A. China’s Credit Boom May Have Run Its Course  28 Investment, Credit, and Shadow Banking: The Nexus 28 Overinvestment?32 Special Concerns: Shadow Banking and Local Government Debt 35 Policy Conclusions 37 References38 II.B. The End of Quantitative Easing  39 Quantitative Easing and its Tapering 39 Conceptual Framework 40 The Impact of Quantitative Easing So Far 40 Prospects45 Conclusions48 References50 Part III. The Medium-Term Development Agenda 51 III.A. At Work in East Asia and Pacific  52 The Triumph of Work for Well-Being 52 Rising Challenges to Well-Being from Work 53 Louder and More Frequent Calls for Action 55 How can Policy Sustain Well-Being from Work in East Asia and Pacific? 61 REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH iv  | Contents “Business as Usual” is no Longer an Option 64 References66 III.B. Aging in East Asia and Pacific  68 Rapid Demographic Changes 68 Social Security Systems 71 Policy Implications of Aging 72 Conclusions74 References75 Country Pages and Key Indicators 77 Cambodia78 China81 Fiji85 Indonesia89 Lao People’s Democratic Republic 93 Malaysia97 Mongolia101 Myanmar104 Papua New Guinea 108 Philippines112 Small Pacific Island Countries 116 The Solomon Islands 120 Thailand123 Timor-Leste127 Vietnam130 LIST OF BOXES Box III.1. Minimum Wages in the ASEAN-4 56 Box. An Opportunity for Growth and Resilience: The Vessel Day Scheme for Fisheries Management 119 WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Contents  |  v LIST OF FIGURES Recent Developments and Outlook Part I. Figure 1. Recovery is gaining momentum in the major advanced economies… 2 Figure 2. …as well as in developing countries 2 Figure 3. Growth continues to be largely driven by domestic demand in large EAP countries 3 Figure 4. Investment growth has moderated in the ASEAN-4…  4 Figure 5. …while urban FAI accelerated in China, helped by manufacturing investment and railway construction4 Figure 6. Consumption growth has held up relatively well in ASEAN-4 5 Figure 7.Retail sales improved modestly in China in August, on more spending for construction materials and home appliances 5 Figure 8. Export growth is picking up in China and several EAP countries 6 Figure 9. The Baltic Dry Index suggests that the global trade cycle may have bottomed out 6 Figure 10. Global commodity prices have been on a downward trend in recent years… 7 Figure 11. …hurting the terms of trade of EAP’s resource exporters 7 Figure 12. Current account balances have deteriorated in Indonesia, Thailand, and Malaysia… 7 Figure 13. …on higher investment and lower savings rate 7 Figure 14. Despite recent drawdowns, the foreign reserves situation in most EAP countries has improved in recent years 8 Figure 15. Recent withdrawals from EAP equity funds have been the largest for China… 9 Figure 16. …and from EAP bond funds, Indonesia 9 Figure 17. The regional stock market composite has lost 5 percent since May 22 9 Figure 18. And the regional bond market index has dropped 13 percent 9 Figure 19. All major EAP currencies had appreciated since September 2008 10 Figure 20. The Indonesian rupiah has practically unwound its recent appreciation 10 Figure 21. Most EAP countries have maintained accomodative policy rates 11 Figure 22. China has kept bank-required reserve ratios elevated 11 Figure 23. China interbank rates spiked in June 2013 12 Figure 24. Domestic credit growth has trended downward, most notably in Vietnam, although it remains above 20 percent in China and Indonesia 12 Figure 25. Global growth will pick up in 2014 and 2015, but remain modest 13 Figure 26. Global trade is also expected to expand albeit more slowly than previously expected 13 Figure 27 . Developing EAP will still lead high-income and all developing regions this year… 15 Figure 28. …and account for 40 percent of global growth, about the same proportion as last year 15 Figure 29. Industrial production improved in China in July and August 16 Figure 30. The PMI advanced above 50 in China in August and September, and in Indonesia and Vietnam in September, indicating a recovery in manufacturing 16 Figure 31. Mongolia and Lao PDR are most exposed to a slowdown in China… 17 Figure 32. …considering they ship mostly industrial raw materials that feed on China’s investment boom17 Figure 33. Foreign investors have sold EAP bonds since late May 18 Figure 34. Foreign holdings of local bonds are larger in Indonesia, Malaysia, and Thailand than in Japan or Korea 18 Figure 35. Japanese imports from developing EAP have started to improve 18 REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH vi  | Contents Figure 36. Japanese FDI to developing EAP , including to Thailand, revived in the first half of this year 18 Figure 37.China’s fiscal position is less favorable, when the quasi-fiscal activities of local governments are accounted for 21 Medium-term fiscal consolidation, including fuel subsidy reform, will help Malaysia control Figure 38.  government debt 21 Figure 39. Facing higher inflation, Indonesia hiked rates starting in June 22 Figure 40. Headline inflation has trended downward in Vietnam and the region’s smaller economies 22 Figure 41. Several EAP countries have seen rapid growth in credit in recent year 22 Figure 42. Household debt is largest, in percent of GDP , in Malaysia and Thailand 22 Figure 43. Most of developing EAP is growing at or near potential this year… 24 Figure 44. …and next year 24 Part II. Selected Emerging Issues Figure 1. Investment spending accelerated in response to the crisis 28 Figure 2. The central government limited fiscal support for the stimulus 28 Figure 3. State-owned enterprises ramped up capital spending during the crisis 29 Figure 4. Sales of land-use rights topped seven percent of GDP in 2010 and 2011 29 Figure 5. The central bank kept monetary policy loose for an extended period 30 Figure 6. Aggregate new credit topped 68 percent of GDP in the first quarter of 2009 30 Figure 7.N ew bank loans more than doubled between 2008 and 2009 and financed 16 percent of all fixed asset investment in 2009 30 Figure 8. Fixed asset investment funded by alternative credit has increased dramatically 30 Figure 9. Nonbank and off–balance-sheet bank credit has outpaced regular bank lending 31 Figure 10. Informal loans, not included in official credit data, rose by three percent of GDP during 2007–201131 Figure 11. Credit funded from banks’ wealth management products was estimated at five percent of GDP in 2012 31 Figure 12. China’s investment has been the highest among the major advanced and developing economies32 Figure 13. And its capital stock is comparatively large relative to output 32 Figure 14. Long-running efficiency gains reversed in the mid-2000s 33 Figure 15. Productivity growth was dropping as the investment spurt began 33 Figure 16. The growth efficiency of credit has deteriorated… 34 Figure 17 . …including when measured with different lags 34 Figure 18. “Augmented” general government debt exceeded 46 percent of GDP in 2012; total credit outstanding exceeded 186 percent of GDP 34 Figure 19. China’s national debt ratio high for emerging economies, but trails that of advanced economies34 Figure 20. Profitability has declined at industrial firms including at state-owned enterprises 35 Figure 21. Local government debt, including debt of Local Government Financing Vehicles, may have exceeded 32 percent of GDP in 2012 36 Figure 22. Sovereign credit default swap (CDS) spreads, East Asia and Pacific 42 Figure 23. Flows into bond and equity mutual funds and ETFs, East Asia and Pacific 42 WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Contents  |  vii Figure 24. Bond and equity indexes, East Asia and Pacific 43 Figure 25. New bond and equity issuances, East Asia and Pacific 43 Figure 26. New syndicated bank loans, East Asia and Pacific 44 Figure 27. Real effective exchange rates, East Asia and Pacific 44 Figure 28. Domestic credit growth 44 Figure 29. Debt stock outstanding 46 Figure 30. Bank nonperforming loans 46 Figure 31. Current account 47 Figure 32. Foreign exchange reserves 47 Part III. The Medium-Term Development Agenda Figure 1. Income from work explains a large share of the reduction in poverty 53 Figure 2. “Informal” forms of work are more common in East Asia and Pacific than other countries at similar levels of development 54 Figure 3. S ome countries in East Asia and Pacific have similar restrictions on dismissal as countries in Southern Europe 55 Figure BIII.1. Ratio of Minimum wages to average wages in East Asia and the OECD 56 Figure BIII.2. Self-employment rates in ASEAN+ 58 Youth Inactivity is high in some of the Pacific Island Countries, Indonesia, and the Figure 4.  Philippines59 Figure 5. Employers cite lack of skills among applicants as the top reason for persistent vacancies 60 Figure 6. C ountries can be classified into eight types by their specific challenges; most countries in EAP fall into more than one type 62 Figure 7. The constraints on growth from a large informal economy are a danger as countries age 64 Figure 8. Share of total population over age 60, 1950–2040 68 Figure 9. Fertility and life expectancy, 1955–2045 69 Figure 10. Elderly dependency ratio and GDP per capita (Purchasing Power Parity) 69 Figure 11. C hanges in share of youth, of working age, and of elderly populations, and in total dependency ratio, 2010–15 and 2020–25 70 Figure 12. Labor force participation rate for 60+ population, for selected regions and for China 70 Figure 13.  (l) Sources of support for 65+, for selected EAP countries, early-mid-2000s; (r) Rural Poverty rates 45+, for Vietnam, Indonesia, and China, late 2000s 71 Figure 14. Coverage of contributory pensions, in late 2000s 71 REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH viii  | Contents LIST OF TABLES Recent Developments and Outlook Part I. Table 1. Reserve adequacy ratios remain strong across the region 8 Table 2. East Asia and Pacific: GDP Growth Projections 14 Part II. Selected Emerging Issues Estimates of the size of China’s shadow banking system range from 24 Table 1.  to 69 percent of GDP 31 Table 2. Some Private-sector estimates of local government debt are even higher 36 Country Pages and Key Indicators Cambodia:Key Indicators 80 China: Key Indicators 84 Key Indicators Fiji:  88 Indonesia:  Key Indicators 92 Lao PDR:  Key Indicators 96 Malaysia:  Key Indicators 100 Mongolia:  Key Indicators 103 Myanmar: K  ey Indicators 107 Papua New Guinea:  Key Indicators 111 Philippines:  Key Indicators 115 Solomon Islands: K  ey Indicators 122 Thailand: Key Indicators 126 Vietnam: Key Indicators 133 WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013   |  ix ABBREVIATIONS ADB Asian Development Bank SOEs state-owned enterprises AMCs asset management companies TFR total fertility rate ASEAN Association of Southeast Asian Nations TSF Total Social Financing BI Bank Indonesia UMP unconventional monetary policy BIS Bank for International Settlements VDS Vessel Day Scheme BPO business processing outsourcing WMPs Wealth Management Products BPM5 Balance of Payments Manual, 5th edition yoy year-on-year BPM6 Balance of Payments Manual, 6th edition cif cost, insurance and freight Countries CPI Consumer Price Index CHN China EEZ exclusive economic zone FJI Fiji eop end of period IDN Indonesia ETF Exchange Traded Fund KHM Cambodia EU European Union LAO Lao PDR FAI fixed asset investment MMR Myanmar FDI foreign direct investment MNG Mongolia Fed U.S. Federal Reserve MYS Malaysia fob free on board PHL Philippines FY fiscal year PNG Papua New Guinea g&s goods and services SLB Solomon Islands GDP gross domestic product THA Thailand GFCF gross fixed capital formation VNM Vietnam GFS Government Finance Statistics GNI gross national income Regions, World Bank classification IMF International Monetary Fund EAP East Asia and Pacific JETRO Japan External Trade Organization ECA Europoe and Central Asia LFPR labor force participation rate LAC Latin America and the Carribean LGFV local government financing vehicles MENA Middle East and North Africa LNG liquefied natural gas SAS South Asia MIC middle-income country SSA Sub-Saharan Africa MSCI Morgan Stanley Capital International NCD noncommunicable disease Currency Units NIEs newly industrialized economies B Thai bhat OECD Organisation for Economic Co-operation CR Cambodian riel and Development D Vietnamese dong p.a. per annum F$ Fiji dollar PBC People’s Bank of China K Myanmar kyat PMI Purchasing Manager Index K Papua New Guinea kina PPI producer price index Kip Lao PDR PPP purchasing power parity P Philippine peso QE quantitative easing RM Malaysian ringgit q-o-q quarter-on-quarter RMB Chinese renminbi qoq-sa quarter-on-quarter, seasonally adjusted Rp Indonesian rupiah REER real effective exchange rate SI$ Solomon Islands dollar SAR special administrative region Tog Mongolia SDA special deposit account US$ Timor-Leste, United States SHIBOR Shanghai Interbank Offer Rate Y Chinese yuan SME small and medium-size enterprise REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH x  |  PREFACE AND ACKNOWLEDGMENTS The East Asia and Pacific Economic Update is a joint report of the East Asia Pacific Chief Economist’s Office and the East Asia Pacific Poverty Reduction and Economic Management Department. Part I was prepared by Antonio Ollero, Ekaterine Vashakmadze and Deepak Mishra. Part II was prepared by Antonio Ollero and Nikola Spatafora, with contributions from Roberto Rocha, Karlis Smits, Jun Wang and Sanket Mohapatra. Part III was prepared by Truman Packard, Tran Van Nguyen, Philip O’Keefe, Nithin Umapathi, and Aparnaa Somanathan. The work on Part I was supervised by Deepak Mishra. The work on Parts II and III was supervised by Nikola Spatafora. This report was prepared under the direction of Bert Hofman (Chief Economist, East Asia and Pacific Region), Sudhir Shetty (Director, Poverty Reduction and Economic Management, East Asia and Pacific Region), and Shubham Chaudhuri (Sector Manager, Poverty Reduction and Economic Management, East Asia and Pacific Region). World Bank country economists throughout the East Asia and Pacific Region provided country write-ups and tables and assisted with the analysis. They include: Karlis Smits, Bingjie Hu, Xiaofan Liu, Min Zhao, Ashley Taylor, Alex Sienaert, Magda Adriani, Fitria Fitrani, Frederico Gil Sander, Intan Nadia Jalil, Karl Kendrick Tiu Chua, Kai Kaiser, Paul Mariano, Kirida Bhaopichitr, Habib Rab, Viet Tuan Dinh, Enrique Aldaz-Carroll, Sodeth Ly, Alain D’Hoore, Somneuk Davading, Keomanivone Phimmahasay, Tae Hyun Lee, Altantsetseg Shiilegmaa, Khandtsooj Gombosuren, Khwima Nthara, May Thet Zin, Min Ye Paing Hein, Hans Anand Beck, Timothy John Bulman,Virginia Horscroft, Tobias Hauqe, Lucy Pan, and David Knight. The country economists worked under the supervsion of lead economists Chorching Goh, James Brumby, Mathew Verghis, Rogier J. E. Van Den Brink, Sandeep Mahajan, and Vivek Suri. Other World Bank officers and staff provided inputs to the report, including Andrew Burns and Theo N. Janse Van Rensberg of the Development Prospects Group (DECPG), and Carl Patrick Hanlon, Chisako Fukuda and David Llorico Llorito of East Asia and Pacific External Affairs (EAPXT). The report was edited by Diane Stamm and designed and typeset by Budy Wirasmo. Developing East Asia and Pacific as used in this report includes China, Indonesia, Malaysia, Philippines, Thailand, Vietnam, Cambodia, Lao People’s Democratic Republic (PDR), Mongolia, Myanmar, Timor-Leste, Fiji, Papua New Guinea, Solomon Islands and other island economies in the Pacific. The Newly Industrialized Economies (NIEs) include Hong Kong SAR, China; the Republic of Korea; Singapore; and Taiwan, China. The ASEAN member countries are Brunei Darussalam, Cambodia, Indonesia, Lao PDR, Malaysia, Myanmar, Philippines, Singapore, Thailand, and Vietnam. The ASEAN-4 are Indonesia, Malaysia, Philippines, and Thailand. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Executive Summary  |  xi EXECUTIVE SUMMARY PART I Global growth momentum accelerated during the second and third quarters of 2013, while many downside risks lingered in the background. The second quarter of 2013 marked the first time in 30 months that the economies of the Euro area, Japan, and the United States all posted positive growth. The Euro area exited from its long recession in the second quarter, registering a growth rate of 1.2 percent (quarter-on- quarter in seasonally adjusted terms). Recovery intensified in the United States, with its economy growing at 2.5 percent, while Japan’s economy expanded by a solid 3.8 percent. Similarly, growth accelerated in several emerging markets including in Brazil, China, Malaysia, South Africa, and Turkey. Leading indicators of economic activities also suggest that global production and trade cycles may have bottomed out in the third quarter. Yet the risks to the global recovery from the uncertainty surrounding the fiscal deadlock in the United States, the impact of the withdrawal of monetary stimulus from the advanced economies, an abrupt slowdown of investment in China, and unrests in the Middle-East remain prominent. Strengthening of global growth momentum will help developing East Asia maintain a growth rate in excess of 7 percent, retaining its status as the global growth leader. Growth in China is expected to meet the official indicative target of 7.5 percent in 2013—0.8 percentage points lower than our projected rate in April. In the medium term, China’s growth is expected to remain range bound between 7 .5 and 7.7 percent as the authorities emphasize productivity and innovation, and rebalance demand from investment-led to consumption- based growth. Growth in developing East Asia (excluding China) is expected to decline from 6.2 percent in 2012 to 5.2 percent in 2013, before rebounding to 5.3 and 5.7 percent in 2014 and 2015, respectively. The recovery in ASEAN countries, which include a few high-income countries, will be more gradual, with expected growth of 5.1 percent (2013), 5.1 percent (2014), and 5.4 percent (2015). Notwithstanding the modest decline in growth in 2013, the East Asia Pacific (EAP) region will contribute nearly two-fifths of global growth and one-third of global trade—higher than any other region in the world. Domestic demand, which has been the main driver of growth in the EAP region in the post-global financial crisis period, is slowing. Robust growth in private consumption and investment, supported by large stimulus programs, has contributed to more than 90 percent of growth in developing East Asia since 2009. But as stimulus programs are being phased out, domestic demand is weakening. Since mid-2012, the Indonesian economy has been affected by lower global commodity prices and a slowdown in private investment. Higher private sector debt has reduced the ability of Malaysia and Thailand to further reflate their economies, while Vietnam’s economy has been restrained by persistent problems in the banking sector and state-owned enterprises. And China is likely to seek further rebalancing of its economy by slowing credit growth and investment, although the pacing is likely to depend on overall growth. The decision by the U.S. Federal Reserve (Fed) to delay tapering of quantitative easing (QE) has restored capital flows to emerging markets, giving the authorities a second opportunity to take measures to lower risks from future volatility. The speculations about withdrawal of quantitative easing led to stock market sell- offs, depreciation of currencies, and a sharp rise in domestic bond yields. Indonesia was affected most, followed by Thailand, the Philippines, and Malaysia. Countries in the region that experienced comparatively larger fund withdrawals were the ones that had larger foreign participation in their financial markets, putting them at risk to further volatility. The financial markets have stabilized after the Fed decided to delay the withdrawal of QE— REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH xii  |  Executive Summary giving EAP countries a much- needed respite and a second opportunity to better prepare for eventual tapering. Measures to lower risks from tapering include reducing excessive reliance on short-term and foreign-currency- denominated debt, accepting a weaker exchange rate when growth is below potential, and building policy buffers to respond to changing global liquidity conditions. As the global growth cycle undergoes change, adjustments to fiscal and monetary policy are warranted in many EAP countries. Most EAP countries have eschewed large fiscal stimulus to support growth this year, and some have started addressing fiscal sustainability issues related to past expansive policies. Credit growth has moderated in several of the region’s large economies, though credit-to-GDP ratios remain elevated in most countries compared to the 2008 levels. The authorities are also employing macro-prudential measures to contain risks arising from recent credit expansion. At the same time, several EAP countries are trying to rationalize subsidy regimes—including fuel subsidies in Indonesia and Malaysia and the rice subsidy in Thailand. With growth running at or above potential for most countries in the region, progress at upgrading growth and reducing poverty depends crucially on structural reforms. China seems to be on the cusp of announcing significant reforms involving the country’s urbanization policy, land management system, residency (hukuo) system, financial systems, and fiscal decentralization. In Malaysia, the authorities continue to implement an “economic transformation program” aimed at raising Malaysia to high-income status by 2020. On the other hand, Indonesia needs a more open trade and investment regime and greater regulatory certainty, and the Philippines needs to enhance domestic competition and relax limits on foreign ownership. In Thailand, an appropriate medium-term fiscal framework should further strengthen investor confidence. Investment in infrastructure is crucial in all of these economies, which includes making public investment more efficient through better project selection, innovative financing, and effective implementation. While the balance of risks to our base case regional forecast lies on the downside, several upside risks have recently emerged. The three immediate headline risks include a less orderly tapering of the U.S.’s unconventional monetary policies, prolonged fiscal deadlock in the U.S., and a sharper than expected slowdown of the Chinese economy. However, not all risks are on the downside. First, stronger global growth will provide considerable tailwinds to EAP countries through expansion of global trade. This will enable them to wind down stimulus measures without losing much growth. Second, the impact of QE tapering on EAP capital inflows may to some degree be offset more depreciated currencies and by Japan’s new strategy to exit deflation and revive growth, which could spill over to EAP countries through expanded bank lending, portfolio rebalancing, and increased outward foreign direct investment. In short, countries that can minimize the risks of rising interest rates while maximizing the benefits from improved trade prospects will perform better. PART II  his report includes a special section focusing on two emerging regional issues: the sustainability of China’s T investment- and credit-intensive growth model, and the regional implications of any future tapering of quantitative easing in the United States. China’s credit boom may have run its course. China responded to the global financial crisis with a massive, investment-heavy stimulus program, supported by a vast credit expansion. The growth it triggered does not appear sustainable over the long term. Massive new lending in recent years has raised debt in all sectors of the economy, posing some risks to financial stability. The rapid expansion of shadow banking poses serious WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Executive Summary  |  xiii challenges, since shadow banking is closely linked to the banking system, is less regulated, and operates with implicit guarantees from banks and local governments. The rise in local government debt is also a concern, given the complexity and opacity of municipal finances. Policy action should focus on three key areas: containing the rapid growth of credit in the economy and tightening financial supervision; rationalizing municipal finance; and broadening and deepening financial sector reforms. The end of quantitative easing. Quantitative easing, particularly in its early stages, had a positive impact on capital flows to EAP and on regional financial markets. That said, quantitative easing accounted for only part of the total variation in capital inflows and asset prices. Conversely, any scaling back of quantitative easing in the United States will result in higher borrowing costs, lower capital inflows, and a decline in asset prices in EAP . This will affect investment and potential output, and raises concerns about potentially overextended domestic financial sectors. Estimates of the impact vary widely, but it is likely to prove larger in economies characterized by greater financial openness, significant current-account deficits, rapid credit growth in recent years, or large increases in debt. Countries may be able to reduce the cost of their borrowing by strengthening their own domestic institutions and further improving the investment climate. PART III  his report also includes a special section focusing on two medium-term regional development issues: labor- T market challenges, and the implications of population aging. At Work in East Asia Pacific. Labor markets and their contribution to growth and household well-being are a growing concern in EAP . Problems include high youth inactivity, rising inequality, and binding skills shortages. A key underlying issue is widespread economic informality, which increases household vulnerability to shocks, limits the tax base, and constrains innovation and productivity. Informality is both a consequence of relatively stringent labor regulations, and a reason for their widespread evasion. Key components of the appropriate policy response include macroeconomic stability, and a regulatory framework that encourages, in particular, the small and medium-size enterprises where most people in EAP work. It is also critical to “formalize” more work, so as to increase the coverage of essential work-risk and social protection, and to sustain growth. To this end, policies should encourage mobility of labor and human capital, and not favor some forms of employment (for instance, full-time wage employment in manufacturing) over others. Among the more specific challenges, mainly agrarian countries should focus on raising agricultural productivity. In urbanizing countries, good urban planning becomes critical. The Pacific Island Countries should provide youth with the human capital needed to succeed abroad. Aging in East Asia Pacific. EAP is in the midst of the most rapid population-aging process ever seen. Aging is driven by declining fertility and increasing life expectancy, and is occurring at relatively low income levels. It will have major effects on the labor force and aggregate growth, although with significant differences across countries. The effects may be compounded by urbanization, as a result of lower labor-force participation rates among the urban elderly. There are also growing concerns about the elderly poor, as family support networks become stretched. Aging raises several critical policy challenges. First, extending productive working lives, sustaining the skills of aging workers, and increasing labor-force participation rates. Second, reforming pension systems to increase coverage and financial protection, taking into account administrative capacity and fiscal sustainability. Third, reforming health-care systems, including in particular care for the aged and long-term care, also through changes in how healthcare providers are paid. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH |  1 Part I. Recent Developments and Outlook REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 2  |  Part I. Recent Developments and Outlook I.A. Recent Developments Global growth prospects have become more promising as recovery is picking up momentum in the major advanced economies. For the first time since mid-2010, the Euro area, Japan, and the United States have all reported positive growth (quarter-on-quarter in seasonally adjusted terms [qoq-sa]) during the second quarter of 2013 (Figure 1). After a record 18 months in economic contraction, the Euro area emerged from recession in July 2013. Japan’s economy has expanded at a higher than expected rate for the third straight quarter after its government decided to forcefully pursue more accommodative monetary and fiscal policies. And the U.S. economy, which slowed during the second half of 2012 and earlier this year, appears to have bounced back in the second quarter of 2013. Figure 1. Recovery is gaining momentum in the major Figure 2. …as well as in developing countries advanced economies… GDP growth, in percent, quarter-on-quarter, seasonally adjusted annualized GDP growth, in percent, quarter-on-quarter, seasonally adjusted annualized 15 10 9 10 8 7 5 6 5 0 4 3 -5 2 1 -10 0 Q1-11 Q2-11 Q3-11 Q4-11 Q1-11 Q2-11 Q3-11 Q4-11 Q1-12 Q2-12 Q3-12 Q4-12 Q1-13 Q2-13 Q1-12 Q2-12 Q3-12 Q4-12 Q1-13 Q2-13 Q1-10 Q2-10 Q3-10 Q4-10 ▬▬ United States ▬▬ Euro Area ▬▬ Japan ▬▬ Developing East Asia ▬▬ Developing countries (all) Source: Thomson Reuters Datastream. Source: Thomson Reuters Datastream and World Bank staff estimates. Growth momentum is strengthening in some of the large developing countries, as well. China’s annualized quarterly growth rate picked up to 7 .5 percent in the second quarter from 6.3 percent in the first quarter, and most recent industrial production and trade data suggest further strengthening of output in the third quarter of 2013. Similarly, growth accelerated in several major developing economies including Brazil (6 percent annualized), South Africa (3 percent), and Turkey (8 percent) among others (Figure 2). Other leading indicators of economic activities, for example, the Purchasing Manager Index (PMI), and the Baltic Dry Index, an indicator of global freight costs, seem to suggest that global production and trade cycles are bottoming out. However, not all large developing countries are experiencing a growth rebound (for example, India, the Russian Federation) and there are significant risks to the pace of global recovery. Real Sector: Is Domestic Demand Weakening? While growth momentum accelerated in the second and third quarters in many EAP countries, year- on-year (y-o-y) changes continue to show a decline. China’s growth rate is expected to be lower as the WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part I. Recent Developments and Outlook  |  3 economy transitions from a credit-fueled and investment-led boom to a more sustainable consumer- and services-oriented growth path (Figure 3). Lower global commodity prices have dampened export receipts and slowed private investment in the capital-intensive resource sectors of the Indonesian economy, depressing overall growth. Thailand’s growth sharply decelerated in the second quarter of 2013, as post-flood reconstruction drew to a close and some of the stimulus measures were removed. Malaysia’s economy expanded less than expected in the second quarter, and lower growth of exports dragged down growth. Vietnam extended its slow growth rate of last year, the lowest in 12 years, into the first half of this year. Problems at banks and state- owned enterprises (SOEs) continue to weigh down on domestic demand. Only the Philippines bucked the trend among the region’s larger middle-income economies, posting a growth rate of 7 .6 percent in the first half, more than 1 percentage point higher from a year ago. Consumption contributed three-fourths to growth in the second quarter, supported by resilient remittances. Figure 3. Growth continues to be largely driven by domestic demand in large EAP countries GDP growth, in percent, year-on-year, and Contribution to growth, in percentage points 20 15 10 5 0 -5 -10 China Indonesia Malaysia Philippines Thailand 2007 2008 2009 2010 2011 2012 Q1-13 Q2-13 2007 2008 2009 2010 2011 2012 Q1-13 Q2-13 2007 2008 2009 2010 2011 2012 Q1-13 Q2-13 2007 2008 2009 2010 2011 2012 Q1-13 Q2-13 2007 2008 2009 2010 2011 2012 Q1-13 Q2-13 JJ Consumption JJ Investment JJ Net exports QQ GDP growth Source: Haver Analytics and World Bank staff estimates. Growth in the region’s smaller economies has been encouraging. In Cambodia, garment exports and tourist arrivals expanded by double digits in the first six months from a year ago. An increase in acreage and better irrigation kept rice production high into the fifth year. In Lao PDR, the hydropower sector has generated positive spillover effects in construction and services. Two major projects are commencing operations this year, providing further impetus to economic activity. In Mongolia, growth rebounded in the second quarter of 2013. Agriculture led the double-digit growth thanks to favorable weather conditions. Construction, focused on infrastructure projects funded by last year’s massive global bond offering (US$1.5 billion of Chinggis bonds, equivalent to one-fifth the size of the economy), expanded strongly in the second quarter. This helped to offset modest growth in mining, the latter bogged down by a weak global coal market. Robust gas production and exports drove growth in Myanmar higher than the year before. In Timor-Leste, public sector spending was a drag on growth: budget execution was at 20 percent of plan in July, compared to 36 percent a year ago. In contrast, data on private sector activity in the first quarter was positive: electricity consumption and vehicle sales grew strongly over a year ago. Economic performance has been mixed in the Pacific Islands. In the absence of current and higher-frequency indicators, assessments can only be made from available data—mostly last year’s results. Papua New Guinea reported lower growth in 2012 than the year before. On a more positive note, the country’s large US$19 billion liquefied natural gas (LNG) project (GDP was US$15.1 billion last year) is close to completion this year. Growth halved from the previous year in the Solomon Islands, where weak commodity prices hurt agricultural and REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 4  |  Part I. Recent Developments and Outlook mineral production and investment, although government spending and bank lending supported consumption. In Fiji, Cyclone Evan, which struck in late 2012, damaged infrastructure and slowed tourism, a key driver of economic growth. Among the smaller islands, Kiribati and Vanuatu posted growth rates slightly higher than the historical average 2.0 percent. In Kiribati, growth was helped by major donor-funded infrastructure projects. Strong fishing license revenues enabled the fiscal deficit to narrow from double to single digits. Vanuatu performed better than in the last two years, supported by increased tourist arrivals. Growth in Samoa, Tonga, and Tuvalu came in under 2.0 percent. Remittances from seafarers continued to decline in Tuvalu. Significant increase in expenditure on recovery and rebuilding following Cyclone Evan has put Samoa at a high risk of debt distress. Tonga barely grew last year on low remittances, subdued tourism, and the winding down of fiscal stimulus following the completion of infrastructure projects financed by China. Domestic demand continues to drive growth, but investment is slowing, especially in the ASEAN-4 countries. Investment growth in Indonesia reached a three-year low in the second quarter. Investment is likely to face more headwinds: from interest rate hikes in response to rising inflation and capital outflows; from a slowdown in foreign direct investment (FDI), and from regulatory uncertainties. In Thailand, the end of large- scale government investment in response to the devastating floods in 2011 reduced investment growth in the second quarter. Major public transportation and water management projects were delayed, while private corporate investment in manufacturing equipment failed to provide any offset. Only private residential investment remained robust, against otherwise slowing growth. Malaysia reported significantly lower investment growth in the second quarter compared to the breakneck pace of the previous five quarters (Figure 4) and may slow further as global interest rates rise and the government considers sequencing investments with large import content. In the Philippines, in the first quarter, investment contributed the most to quarterly growth in more than 10 years. Private construction expanded 26 percent on the back of strong demand for residential and office space, and public construction, 46 percent, on better infrastructure project implementation and election-related spending. But investment growth returned to trend in the second quarter. Investment became the main driver of growth again in China, contributing to over half of GDP growth in the second quarter. (Figure 5). Figure 4. Investment growth has moderated in the Figure 5. …while urban FAI accelerated in China, helped ASEAN-4… by manufacturing investment and railway construction Gross fixed capital formation, national accounts basis, real growth, in percent Fixed Asset Investment, RMB trillion, in constant 2011 prices*, year-to-date year-on-year 30 40 25 35 20 30 15 25 10 20 5 0 15 -5 10 -10 5 -15 0 Q1-11 Q2-11 Q3-11 Q4-11 Q1-12 Q2-12 Q3-12 Q4-12 Q1-13 Q2-13 Q1-10 Q2-10 Q3-10 Q4-10 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec ▬▬ Indonesia ▬▬ Malaysia ▬▬ Philippines ▬▬ Thailand ▬▬ 2011 ▬▬ 2012 ▬▬ 2013 Source: Haver Analytics. Sources: Haver Analytics and World Bank staff estimates. Note: *Deflated by Produce Price Index (2011 = 100). Consumption growth remains generally robust, but some of its drivers are softening. Consumption managed to hold up well in the first half of the year in Indonesia, although higher prices following an increase in subsidized fuel prices in June are weighing on consumer sentiment. Private consumption grew at a healthy WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part I. Recent Developments and Outlook  |  5 pace in Malaysia in the second quarter, and public consumption accelerated, but mainly due to bonuses to civil servants and spending ahead of the general elections in May. Private consumption contributed half of GDP growth in the first half of the year in the Philippines, as remittances posted solid growth through midyear and a weaker peso boosted the purchasing power of remittance flows. In Thailand, rapid expansion of credit to households has weakened after some of the stimulus measures were withdrawn during the year (Figure 6). The contributions from various forms of government support have waned: households are more indebted now than they were four years ago, the tax rebate scheme on first car purchases expired at the end of last year, and the lift to consumer spending from post-flood investment has faded with the completion of reconstruction projects. In China, there has been some progress in rebalancing toward consumption: consumption contributed more to quarterly growth than investment in the last two years up to the first quarter, the share of labor in national income has been growing, and the share of services in output has risen. Still, the economy has yet to make the decisive turn toward consumer-based growth. Recent data show some recovery in consumption growth numbers at midyear (Figure 7). Figure 6. Consumption growth has held up relatively well Figure 7. Retail sales improved modestly in China in in ASEAN-4 August, on more spending for construction materials and home appliances Private consumption, national accounts basis, real growth, in percent year- RMB trillion, in current and constant Nominal growth rate, on-year 2011 prices* in percent year-on-year 14 2.5 25 12 10 2.0 20 8 1.5 15 6 4 1.0 10 2 0 0.5 5 -2 -4 0 0 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jan-13 Mar-13 Jul-12 May-13 Sep-12 Nov-12 Jul-13 Aug-13 Q1-11 Q2-11 Q3-11 Q4-11 Q1-12 Q2-12 Q3-12 Q4-12 Q1-13 Q2-13 Q1-10 Q2-10 Q3-10 Q4-10 ▬▬ Indonesia ▬▬ Malaysia ▬▬ Philippines ▬▬ Thailand ▬▬ Retail sales, in current prices …… Retail sales, in constant 2011 prices ▬▬ Retail sales, nominal change, rhs Source: Haver Analytics. Source: Haver Analytics. Note: *Deflated by Consumer Price Index (2011 = 100). rhs = right-hand side. External Sector: Is Export Slowdown Bottoming Out? Exports are showing signs of recovery beginning in the third quarter. In China, exports expanded 5 percent year-on-year (yoy) in July and 7 percent in August after contracting 3 percent in June. The average monthly export growth rate in China in the first eight months of the year is now higher than over the same period a year ago (Figure 8). In Vietnam, exports grew 16 percent yoy in August and 20 percent in September, pushing the average monthly export growth rate for the small developing EAP economies far ahead of its pace a year ago. And in Thailand, exports grew 4 percent yoy in August after declining during the three previous months. Average monthly export growth rates for the large EAP economies combined are still negative, however. Meanwhile, export growth among the region’s newly industrialized economies (NIEs) has turned positive over the first seven months of the year, compared to the same period last year. This augurs well for regional exports because the NIEs are important suppliers of and markets for parts and components in regional and global supply chains. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 6  |  Part I. Recent Developments and Outlook Moreover, the Baltic Dry Index, a leading indicator of global trade and production, has turned up in September, suggesting that the global trade cycle may have bottomed out (Figure 9). The recovery in export growth comes on the heels of a poor trade performance in the first half of the year. Developing East Asia’s exports grew 7 .2 percent during January to June over the same period a year ago in nominal value terms, barely improving on last year’s annual performance of 6.2 percent.1 External demand from the United States, the European Union, and Japan, the market for a combined 40 percent of the region’s exports, had been weak in the first half of the year. East Asia ships another 34 percent of its exports intra- regionally, including to the East Asian NIEs, but these consist mainly of parts and components used in regional and international production networks for which the final products are still bound for the advanced economies. Exports of computers, telecommunications equipment, and electrical machinery, which comprise 31 percent of the region’s total exports, picked up in the first quarter but trended down in the second, affecting, in particular, China, Malaysia, the Philippines, and Thailand.2 Exports of apparel and textiles, comprising 11 percent of the region’s total exports, were stable, however, a welcome development for Cambodia and, to a lesser extent, China and Fiji.3 Exports of vehicles and parts, the region’s third-largest manufacturing production network contributing 4 percent of the region’s total exports, were weak, affecting specially Thailand.4 Figure 8. Export growth is picking up in China and several Figure 9. The Baltic Dry Index suggests that the global EAP countries trade cycle may have bottomed out Exports, volume growth, in percent year-on-year, monthly average Baltic Dry Index, in points 30 4,500 4,000 25 3,500 20 3,000 15 2,500 2,000 10 1,500 5 1,000 0 500 0 4-Jan-10 4-Dec-10 4-Nov-11 4-Oct-12 26-Sep-13 -5 Dev. EAP Dev. EAP large economies NIEs China* small economies JJ January–July 2012 (ave. monthly) JJ January–July 2013 (ave. monthly) Source: CEIC. Source: Bloomberg. Note: Developing EAP large economies are Indonesia, Malaysia, the Philippines, and Thailand. Developing EAP small economies are Cambodia, Lao PDR, and Vietnam. * For China, January–August 2012 and January–August 2013 Subdued global commodity markets have hurt the region’s resource exporters. Metal and mineral prices have declined the most—46 percent from their post-crisis high in February 2011 to July this year (Figure 10). Agricultural food prices are down 14 percent from July last year and energy prices, 12 percent, from March. Resource exports are important foremost to Indonesia.5 Indonesia’s terms of trade has deteriorated sharply 1 Between 2002, when China joined the World Trade Organization, and 2008, before global trade collapsed with the global financial crisis, exports by developing East Asia grew an average 22 percent a year. 2 Computers, telecommunications equipment, and electrical machinery were 49 percent of the Philippines’ total exports in 2012, 34 percent of China’s, 33 percent of Malaysia’s, and 21 percent of Thailand’s. 3 Apparel and textiles comprised 75 percent of Cambodia’s total exports in 2012, 13 percent of China’s, and 10 percent of Fiji’s. 4 Vehicles and parts were 10 percent of Thailand’s total exports in 2012. 5 Fuels were 33 percent of Indonesia’s total exports in 2012; agricultural commodities, 24 percent; and ores and metals, 6 percent. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part I. Recent Developments and Outlook  |  7 since mid-2012 (Figure 11). Fuel exports are large in Malaysia and Vietnam.6 East Asian coal, petroleum, and natural gas exports have been in negative growth territory since mid-2012. Ore and metal exports are important to Mongolia and Lao PDR.7 Monthly ore and metal exports have been declining since January 2012. Agricultural exports are a significant part of total exports in Fiji and Samoa and are important as well to Thailand, Malaysia (palm oil) and, to a lesser extent, the Philippines.8 Figure 10. Global commodity prices have been on a Figure 11. …hurting the terms of trade of EAP’s resource downward trend in recent years… exporters Commodity prices in nominal US$, change in percent, from January 2011 to Change in percent year-on-year Change in percent year-on-year August 2013 20 50 4 40 3 10 2 0 30 1 -10 20 0 -20 10 -1 0 -2 -30 -3 -10 -40 -4 -20 -5 -50 -30 -6 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12 Feb-13 Apr-13 Jun-13 Aug-13 -60 Crude Natural Palm oil gas Coal Copper Aluminum Iron ore Rice oil Rubber ▬▬ International energy price ▬▬ International food price ▬▬ Indonesia terms of trade, rhs Source: World Bank staff estimates. Source: World Bank staff estimates. Current account balances deteriorated in most EAP economies in the first half of the year. Indonesia, which posted its first current account deficit since the Asian financial crisis last year, reported deficits in the first and second quarters of this year, as well (Figure 12). Private savings are under pressure from lower commodity prices, and public savings from slowing revenue growth and subsidy spending that remain high despite recent reductions (Figure 13). In Thailand, the current account balance, which was barely positive last year, turned into Figure 12. Current account balances have deteriorated in Figure 13. …on higher investment and lower savings rate Indonesia, Thailand, and Malaysia… Current account balance, in percent of GDP Gross domestic savings and Gross fixed capital formation, in percent of GDP 20 50 15 40 10 30 5 20 0 10 -5 -10 0 2007 2008 2009 2010 2011 2012 Q1-2013 Q2-2013 2007 2008 2009 2010 2011 2012 ▬▬ China ▬▬ Indonesia ▬▬ Malaysia ▬▬ Philippines ▬▬ Thailand ▬▬ Vietnam ▬▬ Indonesia (investment) ▬▬ Thailand (investment) ▬▬ Malaysia (investment) …… Indonesia (savings) …… Thailand (savings) …… Malaysia (savings) Source: Haver Analytics. Source: Haver Analytics. 6 Fuel exports were 20 percent of Malaysia’s total exports in 2012, and 9 percent of Vietnam’s. 7 Ore and metal exports were 42 percent of Mongolia’s total exports in 2012, and 53 percent of Laos’s. 8 Agricultural exports were 68 percent (including mineral water) of Fiji’s total exports in 2012, 31 percent of Samoa’s, 18 percent of Thailand’s, 15 percent of Malaysia’s, and 10 percent of the Philippines’. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 8  |  Part I. Recent Developments and Outlook a deficit in the second quarter. Savings rates have declined due to rising household leverage and fiscal support schemes, driving private consumption higher. In Malaysia, the current account surplus, in double digits since 2003, narrowed last year and compressed further in the second quarter. Public savings are lower following stimulus packages implemented since the global financial crisis. Meanwhile, in China, the current account balance, which narrowed from a historical high of 10.1 percent of GDP in 2007 to 2.3 percent of GDP last year, bounced back to 4.6 percent of GDP in the second quarter. Although several EAP countries have lost international reserves from current account deficits or capital outflows, reserves remain generally adequate across the region. Reductions in reserves since the beginning of the year (January to July) have been largest for Indonesia, US$20.1 billion; Thailand, US$7 .6 billion; and Malaysia, US$1.4 billion. Still, the recent drawdowns represent a fraction of the hefty buildup of reserves since the beginning of the global financial crisis five years ago. Reserves in Indonesia at the end of July are 1.6 times their levels in September 2008 (Figure 14). Moreover, reserve adequacy ratios are robust (Table 1). Figure 14. Despite recent drawdowns, the foreign Table 1. Reserve adequacy ratios remain strong across reserves situation in most EAP countries has improved in the region recent years Reserves excluding gold, index, September 2008 = 1.00 Reserves, in months imports, and Reserves to short-term debt ratio 2.5 Reserves, Reserves/ Reserves/ in months imports short-term debt due debt within one 2.0 year 2012 Jun-13 2012 2012 1.5 China 21.9 23.8 6.1 8.1 Indonesia 6.3 5.5 2.6 2.1 1.0 Malaysia 9.6 9.5 4.6 3.9 Philippines 11.9 11.8 9.9 4.7 0.5 Thailand 7.5 7.0 3.0 8.2 Vietnam 2.3 3.0 0 Jan-07 Feb-08 Mar-09 Apr-10 May-11 Jun-12 Aug-13 ▬▬ China ▬▬ Malaysia ▬▬ Thailand ▬▬ Indonesia ▬▬ Philippines ▬▬ Vietnam Source: Haver Analytics. Source: World Bank staff estimates based on IMF, International Financial Statistics, and BIS-OECD-IMF-WB, Joint External Debt Hub. Financial Markets: A Return to Volatility Portfolio flows to the region and other developing areas have become more volatile following talk by the U.S. Federal Reserve (Fed) of an imminent drawdown of the monetary stimulus. As U.S. Treasury yields rose markedly higher beginning in late May, international investors rebalanced their portfolios away from emerging market assets and into developed economy equities. According to survey data,9 some US$12 billion was withdrawn from developing EAP equity funds (mutual funds and exchange traded funds [ETFs], Figure 15) and US$3.4 billion from bond funds (Figure 16) in the four-month period from May 22 to September 18. The survey data represent only a part of total portfolio flows on a balance-of-payments (BOP) basis—about 9 The private data firm Emerging Portfolio Fund Research (EPFR) Global tracks traditional and alternative funds domiciled globally (the funds currently hold US$19 trillion in total assets) and reports individual and institutional fund flow and fund manager asset allocation data by country, sector, and security on a daily, weekly, and monthly basis. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part I. Recent Developments and Outlook  |  9 one-half for equity and one-eighth for bonds, according to one estimate (Miao and Pant 2012). Assuming these ratios apply to the total portfolio flows, the BOP portfolio equity outflows from developing EAP would have been US$24 billion, and the bond outflows, US$35.2 billion. While large on an average monthly basis, the fund outflows are a fraction of fund inflows accumulated previously,10 since the beginning of quantitative easing by the U.S. Federal Reserve in November 2008. Figure 15. Recent withdrawals from EAP equity funds Figure 16. …and from EAP bond funds, Indonesia have been the largest for China… Flows to developing EAP equity mutual funds and ETFs, in US$ billions Flows to developing EAP bond mutual funds and ETFs, in US$ billions 50 10 40 8 30 6 20 4 10 2 0 -10 0 -20 -2 CHN IDN MYS PHL THA VNM CHN IDN MYS PHL THA VNM JJ QE (Nov 10, 2008–May 21, 2013) JJ Talk of QE Tapering (May 22, 2013–Sep 18, 2013) JJ QE (Nov 10, 2008–May 21, 2013) JJ Talk of QE Tapering (May 22, 2013–Sep 18, 2013) Source: EPFR Global, via Haver Analytics. Source: EPFR Global, via Haver Analytics. The volatility in portfolio flows has been accompanied by volatility in financial asset prices. The regional composite index for emerging East Asia’s stock markets (the Morgan Stanley Capital International [MSCI] All Country Far East excluding Japan) lost more than 10 percent of its value in three months from May 22 to August 21 (Figure 17), before recovering 6 percent since. The Indonesian share market has been hardest hit, Figure 17. The regional stock market composite has lost Figure 18. And the regional bond market index has 5 percent since May 22 dropped 13 percent Stock market price indexes, January 1, 2007 = 100 Bond total return indexes, January 1, 2007 = 100 160 180 140 160 140 120 120 100 100 80 80 60 60 40 40 20 20 0 0 Jan-07 Feb-08 Mar-09 Apr-10 May-11 Jun-12 Jul-13 Sep-13 Jan-07 Feb-08 Mar-09 Apr-10 May-11 Jun-12 Jul-13 Oct-13 ▬▬ MSCI All Country World ▬▬ MSCI All Country Far East excl. Japan ▬▬ iBoxx ABF Pan Asia Total Return Index (Unhedged) ▬▬ iBoxx ABF Pan Asia Total Return Index (Hedged to US$)) Source: MSCI, via Thomson Reuters Datastream. Source: Markit, via Bloomberg. Note: The MSCI AC (All Country) Far East excluding Japan Index is a free-float-adjusted Note: The Markit iBoxx ABF Pan-Asia Index tracks the performance of local-currency- market-capitalization-weighted index that measures the equity market performance of denominated bonds issued by governments and quasi-government entities in China; China; Indonesia; Malaysia; the Philippines; Thailand; Hong Kong SAR, China; Republic Indonesia; Malaysia; the Philippines; Thailand; Hong Kong SAR, China; the Republic of of Korea; Singapore; and Taiwan, China. The MSCI World Index is a free-float-adjusted Korea; and Singapore. market-capitalization-weighted index that measures the equity market performance of 24 developed markets. 10 From November 10, 2008 (when the Federal Reserve embarked on its first quantitative easing operation, QE1) to May 21, 2013 (before the Federal Reserve signaled its intent to gradually taper quantitative easing, with the Chairman’s congressional testimony on May 22). REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 10  |  Part I. Recent Developments and Outlook losing 24 percent; followed by Thailand, 21 percent; and the Philippines, 20 percent. Meanwhile, the yields on 10-year local currency government bonds have risen sharply, meaning that bond prices have fallen (Figure 18). The 10-year yield rose most steeply for Indonesia, by 273 basis points; followed by Thailand, 86 basis points; and Malaysia, 76 basis points. By most standards, the recent changes are significant. However, the price corrections are small compared to the strong increase in asset values, since monetary stimuli in advanced economies spilled into developing economy financial markets. In Indonesia, the Philippines, and Thailand, for instance, share prices had climbed around 300 percent from November 2008 to May 2013. Since talk of QE tapering began in late May, exchange rates have unwound part of their recent appreciation. At the end of May, exchange rates in the region were 10 to 20 percent appreciated, in real effective terms, from their levels at the beginning of the global financial crisis (Figure 19). The paths taken by different currencies have varied, but most had appreciated since the start of the third round of quantitative easing by the United States in September last year. Part of that appreciation has been unwound since the start of the tapering talk (Figure 20). Currency appreciation in the past was considered to disadvantage developing East Asia economies because of their reliance on exports. The recent exchange rate depreciation could help to restore part of the lost competitive advantage. But it could also hurt unhedged foreign currency debtors in the region. Figure 19. All major EAP currencies had appreciated Figure 20. The Indonesian rupiah has practically since September 2008 unwound its recent appreciation Real effective exchange rate index, September 2008 = 100, Nominal exchange rate, local currency/US$, change in percent year-on-year, increase = appreciation + = depreciation 130 24.1 VNM 0.5 120 -14.7 THA 4.7 110 -14.9 PHL 5.1 100 15.0 MYS 7.0 90 -12.0 IDN 80 17.5 -10.1 CHN 70 -0.2 Jan-07 Feb-08 Mar-09 Apr-10 May-11 Jun-12 Jul-13 Appreciation Depreciation -20 -10 0 10 20 30 ▬▬ China ▬▬ Indonesia ▬▬ Thailand ▬▬ Malaysia ▬▬ Philippines ▬▬ Vietnam JJ QE (Nov 10, 2008–May 21, 2013) JJ Talk of QE Tapering (May 22, 2013–Sep 18, 2013) Source: IMF. Source: Thomson Reuters Datastream. Fiscal and Monetary Policy: Measured Responses Governments have eschewed large fiscal measures to support growth this year. In August, Indonesia offered fiscal incentives to promote foreign investment and help contain the current account deficit. The package includes tax deductions for export-oriented, labor-intensive industries, agriculture-based investment programs, and research and development activities. In July, China announced a set of fresh measures aimed at boosting growth that stand in marked contrast to the massive stimulus package of 2008–09. The new measures are limited and targeted: tax breaks for small businesses, reduced fees for exporters, and the opening up of the railway construction market to private participation. Vietnam, which recently amended its corporate income tax and value-added tax laws, decided to continue with its existing set of tax incentives for enterprises, despite their likely adverse effect on revenues. In January, the government announced deferrals of corporate and WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part I. Recent Developments and Outlook  |  11 value-added taxes for SMEs, labor-intensive enterprises in selected sectors, enterprises engaged in the sale and leasing of houses, and enterprises that produce iron, steel, cement, and construction tiles. The National Assembly voted in June to cut the corporate income tax rate from 25 to 22 percent starting January 1, 2014 and to 20 percent from January 1, 2016 for most enterprises, with even lower rates for the small and medium enterprises. Some countries have started to address issues involving fiscal sustainability. Notwithstanding political challenges ahead of the 2014 elections, the ruling coalition in Indonesia passed a revised 2013 budget raising prices on subsidized fuel—on petroleum by 44 percent and on diesel fuel by 22 percent—starting in late- June, while compensating low-income households with an Rp 3.0 trillion (US$273 million) cash transfer bill. The sizable increase in prices on subsidized fuel is a major reform and follows on the missed opportunity to adjust prices in 2012, when inflation was lower. The direct fiscal savings from the price hike is estimated at Rp 42 trillion (US$3.8 billion) in 2013, 0.4 percent of GDP, and Rp 85 trillion (US$7.7 billion) in 2014, 0.9 percent of GDP . In early September, Malaysia announced an immediate reduction in fuel subsidies by 10 percent, shaving RM 1.1 billion (US$343 million) off the subsidy bill, equivalent to 0.1 percent of GDP . More fiscal consolidation measures are expected, including the much anticipated goods and sales tax. Indonesia was the first developing East Asian country to tighten monetary policy, and the only one thus far. The central bank raised the policy rate (BI rate) and the overnight deposit rate (Fasilitas Bank Indonesia, FASBI) by 25 basis points in June, 50 basis points in July, and 75 basis points in September (Figure 21). The tightening was aimed at curbing inflation, which topped 8.8 percent in August from 4.3 percent last year in the aftermath of fuel price increases, and defending the Indonesian rupiah, which depreciated 13.2 percent in August from end-December last year. Elsewhere, monetary policies remain accommodative. Thailand cut the overnight policy rate 25 basis points in May, triggered by the disappointing growth in the first quarter. Exports had borne the brunt of a stronger Thai baht, which appreciated 5.0 percent in the year through April, the month before the rate adjustment. Vietnam cut the policy rate 100 basis points in March and another 100 basis points in April. Credit growth has not been responsive to the rate cuts as both banks and SOEs remain burdened with balance sheet problems. The rest of the Central Banks in the region remain on hold (Figure 21 and Figure 22): Malaysia, for two years and five months now (since May 2011); China, a year and two months (since July 2012); and the Philippines, 11 months (since October 2012). Figure 21. Most EAP countries have maintained Figure 22. China has kept bank-required reserve ratios accomodative policy rates elevated Policy rates, in percent per annum Required reserve ratios, in percent of deposits 16 25 14 20 12 10 15 8 6 10 4 5 2 0 0 Jan-07 Feb-08 Mar-09 Apr-10 May-11 Jun-12 Jul-13 Sep-13 Jan-07 Feb-08 Mar-09 Apr-10 May-11 Jun-12 Sep-13 ▬▬ Vietnam ▬▬ Indonesia ▬▬ China ▬▬ Philippines ▬▬ Thailand ▬▬ Malaysia ▬▬ China ▬▬ Indonesia ▬▬ Malaysia ▬▬ Philippines ▬▬ Thailand ▬▬ US Fed funds rate (effective) ▬▬ Vietnam (Dong demand deposits, less than 12 months) ▬▬ Vietnam (Foreign currency demand deposits, less than 12 months) Source: Haver Analytics. Source: Haver Analytics. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 12  |  Part I. Recent Developments and Outlook After a pickup mid-to-late last year, credit growth has moderated in several of the region’s larger economies. A temporary liquidity squeeze in the interbank market in June provided China an opportunity to trim credit expansion, which had topped Y1.0 trillion (US$163 billion) in the first 10 days of that month alone. The Central Bank withheld liquidity support to signal official disapproval of poor liquidity management at medium and small banks, particularly those that had grown excessively reliant on interbank borrowing. The decision unsettled credit and asset markets: interbank and repo rates spiked (Figure 23), investors exited the stock market, and offshore fund managers sold Chinese assets. The central bank subsequently intervened to prevent a credit crunch that would have unduly affected small borrowers, providing liquidity support to select banks using reverse repo operations. The intervention slashed interbank rates, although to levels higher than before the liquidity crunch. The episode illustrates how difficult unwinding expansive monetary policy has become. Credit growth in China remained robust during August at 21 percent, but is expected to moderate in the rest of the year. Elsewhere, credit growth slowed in the second quarter in Indonesia, Malaysia, the Philippines and Thailand (Figure 24). Figure 23. China interbank rates spiked in June 2013 Figure 24. Domestic credit growth has trended downward, most notably in Vietnam, although it remains above 20 percent in China and Indonesia Interbank interest rates, in percent per year Domestic credit growth, in percent year-on-year 16 70 14 60 12 50 10 40 8 30 6 20 4 10 2 0 0 4-Jan-07 4-May-08 4-Sep-09 4-Jan-11 4-May-12 4-Sep-13 -10 Q1-11 Q1-12 Q1-13 Q2-13 Q1-07 Q1-08 Q1-09 Q1-10 ▬▬ SHIBOR, overnight ▬▬ SHIBOR, 30-day ▬▬ China (broad credit) ▬▬ China ▬▬ Indonesia ▬▬ Malaysia ▬▬ Philippines ▬▬ Thailand ▬▬ Vietnam Source: IMF, International Financial Statistics. Source: CEIC. The authorities in the region have employed macro-prudential measures to contain the risks arising from recent credit expansion. China followed up on measures begun since 2011 to curb private property investment, which had grown by more than 30 percent in the last two years. In March, the State Council imposed a 20 percent tax on profits from the resale of homes and announced credit controls on purchases of second residences. Recently, the authorities announced further curbs: a limit to one home purchase for single persons, an increase in the minimum down payment for second homes in Beijing, and an increase in the down payment for second homes in Shanghai. Lower loan-to-value ratios for vehicle loans and property mortgages remain in place in Indonesia. In July, Malaysia’s central bank lowered the maximum term for personal loans from 25 to 10 years, and for property loans, from 45 to 35 years in a bid to hold down the rapid increase in household debt. Rising 12 percent per year over the last five year, a growth rate outpacing that of nominal GDP , household debt stood at 83 percent of GDP at the end of the first quarter, among the highest in developing East Asia. In the Philippines, the central bank has restricted trust funds from accessing the special deposit account (SDA), the central bank’s tool to mop up excess liquidity, starting in November. Some P1.6 trillion (US$36.4 billion), 17 percent of GDP and about the same size as that of the money supply (M1), is in the SDA at end-August, funds that may flow into deposits and thereby increase the level of liquidity in the system. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part I. Recent Developments and Outlook  |  13 I.B. Outlook and Risks The global economy is broadly on track to meet growth expectations this year—2.4 percent, slightly lower than last year’s 2.5 percent. The modest acceleration in growth among the advanced economies in the second quarter is expected to continue through the year. The gradual strengthening of quarterly growth in the high-income countries will show up in the whole-year growth of 2.1 percent in 2014 and 2.3 percent in 2015. Developing country growth is expected to improve from 4.8 percent this year to 5.3 percent in 2014 and 5.6 percent in 2015. The projections are broadly in line with underlying potential and will be supported by a gradual recovery in external demand from the high-income economies. Global growth should hit 3.1 percent in 2014 and 3.4 percent in 2015. Even then, the forecast global growth rates for 2014 and 2015 will remain below the pre-crisis growth rates of 4.0 percent in 2006 and 2007 (Figure 25). The comparatively modest recovery will be underpinned by a slower than expected upturn in global trade. Last April, we had forecasted a 5.8 percent expansion in global trade this year. At this time, seven months of data show that the likely annual growth rate in global trade will only be around 3.1 percent this year (Figure 26). Figure 25. Global growth will pick up in 2014 and 2015, Figure 26. Global trade is also expected to expand albeit but remain modest more slowly than previously expected GDP growth, in percent year-on-year Trade volume, growth, in percent year-on-year 10 20 8 15 6 10 4 5 2 0 0 -5 -2 -4 -10 -6 -15 2006 2007 2008 2009 2010 2011 2012 2013f 2014f 2015f 2006 2007 2008 2009 2010 2011 2012 2013f 2014f 2015f ▬▬ World ▬▬ High-income countries ▬▬ Developing countries ▬▬ April 2013 ▬▬ October 2013 Source: World Bank staff estimates. Source: World Bank staff estimates. EAP Region Will Contribute the Most to Global Growth this Year We are revising our earlier regional growth forecast (World Bank 2013a) for developing East Asia downward to 7.1 percent this year and 7.2 percent in 2014. Consistent with rebalancing objectives, growth in China is expected to ease to the official indicative target of 7.5 percent this year (Table 2). Previous projections had pinned greater weight on the effect of credit on investment than warranted by recent findings on the declining growth efficiency of both credit and investment (see Part II). The 7 .5 percent growth rate for the year would still mean more robust growth in the second half of the year compared to the first, which would carry over in next year’s projection of 7.7 percent. Adjusting to weaker terms of trade and tighter financial conditions, Indonesia’s growth rate will moderate this year. The adjustment will carry into next year, when growth is REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 14  |  Part I. Recent Developments and Outlook Table 2. East Asia and Pacific: GDP Growth Projections percent change from a year earlier Forecast Forecast Forecast Changes from Apr-13* (in percentage points) 2011 2012 2013 2014 2015 2013 2014 East Asia 7.1 5.9 6.0 6.4 6.4 -0.5 -0.3 Developing East Asia 8.3 7.5 7.1 7.2 7.2 -0.7 -0.4 China 9.3 7.8 7.5 7.7 7.5 -0.8 -0.3 Indonesia 6.5 6.2 5.6 5.3 5.8 -0.6 -1.2 Malaysia 5.1 5.6 4.3 4.8 4.8 -0.8 -0.6 Philippines 3.6 6.8 7.0 6.7 6.8 0.8 0.3 Thailand 0.1 6.5 4.0 4.5 5.0 -1.3 -0.5 Vietnam 6.2 5.2 5.3 5.4 5.4 0.1 -0.3 Cambodia 7.1 7.3 7.0 7.0 7.0 0.0 -0.2 Fiji 1.9 2.3 2.4 2.1 2.2 0.2 -0.2 Lao PDR 8.0 8.2 8.0 7.7 8.1 0.4 0.0 Mongolia 17.5 12.4 12.5 10.3 10.0 -0.5 -1.2 Myanmar 5.9 6.5 6.8 6.9 6.9 0.3 0.3 Papua New Guinea 10.7 8.7 4.5 10.0 20.0 0.5 2.5 Solomon Islands 10.7 4.8 4.0 3.5 3.7 0.0 -0.5 Timor-Leste 10.8 10.6 10.4 10.2 11.5 0.0 0.0 Developing East Asia excluding China 4.6 6.2 5.2 5.3 5.7 -0.5 -0.7 ASEAN 4.7 5.6 5.1 5.1 5.4 -0.3 -0.6 Assumptions about the external environment: World 3.1 2.5 2.3 3.1 3.4 0.0 0.7 High-income countries 1.8 1.6 1.3 2.1 2.3 0.0 0.6 Developing countries 6.3 4.7 4.8 5.3 5.6 -0.3 -0.2 Source: World Bank data and staff estimates. *World Bank, "East Asia and Pacific Economic Update: A Fine Balance", April 2013.  projected to be more than 1 percentage point weaker than previously forecast, on more modest investment. The largest downward adjustment is for Thailand, which entered into technical recession in the second quarter. But growth during the second-half of 2013 is expected to improve due to strong revival in exports and robust private consumption. Weak performance in the first half of the year, underpinned by poor exports, will drag down growth this year in Malaysia, developing East Asia’s most export-intensive economy. Fiscal consolidation and delays in public investment will keep growth lower than previously forecast in 2014. Vietnam is roughly on track to grow modestly this year. Growth will remain sluggish next year, with gains in macroeconomic stabilization still fragile and subject to several downside risks including more activist policies that, if pursued, are bound to stoke inflationary pressures and undermine stability gains. In contrast, the Philippines is expected to maintain its growth momentum into the near to medium term, spurred by strong private consumption, itself growing on the back of healthy remittances and a heady business process outsourcing (BPO) industry, as well as by a planned doubling of public infrastructure spending by 2016. We are revising baseline growth projections upward in 2013 and in 2014. We expect growth to further accelerate in 2015, with most EAP economies growing at the same or a modestly higher rate in 2015 compared to their 2014 levels. While expanding more slowly than our previous forecast, developing East Asia will continue to lead other regions (Figure 27) and contribute the most to global growth this year (Figure 28). The growth outlook for the region’s smaller economies is generally more encouraging. We are maintaining the forecast for Cambodia for 2013. Increases in rice production, an acceleration of garment exports, and more tourist arrivals will keep growth strong this year. Growth will be higher in Lao PDR this year than originally WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part I. Recent Developments and Outlook  |  15 Figure 27. Developing EAP will still lead high-income and Figure 28. …and account for 40 percent of global growth, all developing regions this year… about the same proportion as last year GDP growth, in percent year-on-year Contribution to global GDP growth, in percentage points 10 0.25 4 9 8 3 0.20 7 2 6 0.15 1 5 4 0 0.10 3 -1 2 0.05 -2 1 0 -3 0 large small Pacific CHN EAP EAP Islands SSA SAS MENA ECA LAC 2007 2008 2009 2010 2011 2012 2013 ▬▬ Developing EAP ▬▬ Developing countries excl. EAP JJ High income (excl. Asian NIEs) JJ Developing (excl. EAP) JJ EAP ▬▬ ASEAN, rhs ▬▬ High income QQ Average (2010–2012) Source: World Bank data and staff estimates. Source: World Bank data and staff estimates. Note: Excluding China, the other large developing EAP countries are Indonesia, Malaysia, the Philippines, and Thailand. The small countries are Cambodia, Lao PDR, Mongolia, Myanmar, Timor-Leste, and Vietnam. expected, based on upwardly revised data on cement and hydropower production. The development and completion of several large projects will keep the contribution of the hydropower sector to growth robust through the near term. An extraordinary expansion of construction and strong agricultural production will support growth to double digits again in Mongolia this year. Public infrastructure investment will progress further with ready financing from the proceeds of last year’s global bond issue, keeping growth also high next year. Growth is expected to be another half a percentage point higher this year than last in Myanmar. Foreign investment has been strong, including in energy, garments, and food and beverages. In Timor-Leste, prospects have not changed from April—growth will be slightly more moderate this year compared to last year. Lower agricultural production, hurt by a prolonged rainy season, and slower budget execution, due in part to a late budget approval and a longer adjustment period for the new government, are negative factors. In the Pacific Islands, the near-term prospects continue to be mixed, as they have historically been for these small, geographically isolated countries subject to numerous shocks including natural disasters. Post-cyclone reconstruction will provide a boost to growth in Fiji next year, as will additional investment in tourism and mining. In contrast, sugar production, currently half that from six years ago, will remain sluggish, keeping growth modest in 2014 and 2015. The near-completion of the huge US$19 billion LNG Project in Papua New Guineas sets the stage for a sharp rise in the level of aggregate GDP in 2014 and especially in 2015 as gas exports commence. However, the drawdown of project construction activity will put pressure on employment and incomes and amplify the effects on domestic demand of already weak global commodity prices, generating minimal growth in non-resource GDP . Growth will be lower than previously forecast in the Solomon Islands in 2014 and 2015. Slower output and revenue growth and tighter financing conditions underlie growth forecasts in the near term. In general, for the larger economies, the projections for 2013 are predicated on improvements in the second half of the year over the first. The expected uptrend will carry over into higher growth in 2014 (except in Indonesia, where the recovery will come in 2015). Early data for the third quarter lends some support to this view, at least for China. Industrial production surprised on the upside in July and August compared to June (Figure 29). The Purchasing Managers Index (PMI), a leading indicator, returned to levels signaling expansion REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 16  |  Part I. Recent Developments and Outlook Figure 29. Industrial production improved in China in Figure 30. The PMI advanced above 50 in China in July and August August and September, and in Indonesia and Vietnam in September, indicating a recovery in manufacturing Industrial production index, change, in percent month-on-month, Purchasing Managers Index, 50+ = expansion seasonally adjusted 25 52 51 20 50 15 49 10 48 5 47 46 0 45 -5 44 -10 43 Jan Feb Mar Apr May Jun Jul Aug China Indonesia Vietnam ▬▬ China ▬▬ Indonesia ▬▬ Malaysia ▬▬ Philippines ▬▬ Thailand JJ Jun-13 JJ Jul-13 JJ Aug-13 JJ Sep-13 Source: Haver Analytics. Source: Markit, via Haver Analytics. in August (Figure 30). In the ASEAN countries, the picture is rather mixed. Industrial production cycled up in Indonesia, Malaysia, and the Philippines in July. But the PMI, which improved in Vietnam, slid in Indonesia. Headline Risks Are On the Downside While the balance of risks to our base case regional forecast lies on the downside, recent strengthening of global production and the trade cycle could serve as a mitigating factor. Among the headline risks, a sharper than expected slowdown of investment in China will have an adverse impact on the EAP region, particularly on suppliers of capital goods and industrial raw materials to China. Also, as early evidence shows, a tapering of the exceptional U.S. monetary policy response to the global financial crisis will, through reduced capital flows and higher interest rates, affect real activity in many economies in the region. These risks will, to some extent, be offset by the improving global trade situation and depreciated currencies in several EAP countries. A greater than expected slowdown of investment in China would adversely affect the suppliers of capital goods and industrial raw materials that have benefited from China’s industrial expansion, infrastructure spending, and real estate development. Restructuring an economy as enormous and diverse as China’s is inherently complex and difficult. Our base case scenario assumes that the transition away from an export- and investment-led growth pattern and to a consumer- and services-based growth path will be gradual and orderly. However, because rebalancing involves the reversal of long-standing policies (low interest rates for manufacturers, state-owned enterprises, and property developers, for instance) that have successfully underpinned growth over three decades, the adjustment could be sharp and disorderly. An abrupt reduction in investment would drag down growth because of the large share of investment in output and the limits to which consumption could rise high enough and fast enough to offset the downturn. The ensuing slowdown would have global consequences because China’s investment boom has helped make up for part of the shortage in demand from advanced economies since the global financial crisis, benefiting both producers of capital goods and suppliers of industrial raw materials. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part I. Recent Developments and Outlook  |  17 A slower-growing China will affect commodity exporters the most. We had previously estimated that a sharp 5 percentage point decline in Chinese investment growth would cut GDP growth in China by 1.4 percent and in the EAP region by 0.6 percent (World Bank 2013b). More recent analyses (Ahuja and Nabar 2012; IMF 2012a, 2012b) show finer nuances: (i) that the growth effects on top global producers of capital goods (including Germany, Japan, and Korea) will be small but nontrivial; (ii) countries with strong supply chain links with China, including those in Asia (Korea and Malaysia) will also be affected including under second- and third-round effects; and (iii) in contrast to more diversified resource exporters (for example, Brazil and Canada), commodity suppliers with less well-diversified economies and with a disproportionate reliance on China for exports will be most vulnerable.11 Several EAP countries count in this third category, principally Mongolia and Lao PDR (Figure 31 and Figure 32). Figure 31. Mongolia and Lao PDR are most exposed to a Figure 32. …considering they ship mostly industrial raw slowdown in China… materials that feed on China’s investment boom Exports to China, in percent of total country exports, 2012 Exports to China by economic classification, in percent of total country exports, 2012 25 MNG 88.9 LAO 20 21.5 MYS 15 PHL 12.6 THA 11.8 11.7 11.4 10 11.2 IDN 5 VNM 2.5 KHM 0 MNG LAO MYS PHL THA IDN VNM KHM 0 20 40 60 80 100 JJ Food & beverages JJ Industrial supplies JJ Fuels JJ Capital goods, except transport JJ Parts and accessories JJ Transport equipment JJ Consumer goods JJ Others Source: IMF, Direction of Trade Statistics (DOTS). Sources: UNCTAD, COMTRADE. Although the normalization of monetary policy in the United States should ultimately benefit developing countries, the adjustment could be disruptive. The withdrawal of extraordinary monetary stimulus in the United States will reduce liquidity in the global economy; more normal capital flows will ease appreciation pressures on emerging market currencies. The withdrawal of monetary stimulus will also signify a firm recovery in the United States, benefiting countries integrated in trade and finance with the world’s largest economy. The adjustment, however, can turn out to be disruptive, as shown by the recent volatility in the financial markets of many developing countries at the time when tapering of QE became more likely (Figure 33). Since the U.S. Federal Reserve first signaled its intent to gradually withdraw monetary stimulus, interest rates have risen, portfolio flows have reversed, and asset prices have taken a fall in EAP and in other developing areas. Although the postponement of tapering in September brought some relief, volatility in financial markets is likely to persist for some time to come. Developing economies have recently proposed international monetary policy coordination, but the idea has been rebuffed by the United States and other advanced economy central banks, which contend that the conduct of domestic policy should be independent of its foreign effects. 11 See IMF 2012a and IMF 2012b. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 18  |  Part I. Recent Developments and Outlook Figure 33. Foreign investors have sold EAP bonds since Figure 34. Foreign holdings of local bonds are larger late May in Indonesia, Malaysia, and Thailand than in Japan or Korea Flows into developing EAP bond funds, in US$ millions, weekly Foreign holdings of local currency bonds, in percent of total outstanding 800 40 Net purchases 600 35 400 30 200 0 25 -200 20 -400 -600 15 Net sales -800 10 -1,000 5 -1,200 3-Jan-07 19-Dec-07 3-Dec-08 18-Nov-09 3-Nov-10 19-Oct-11 3-Oct-12 18-Sep-13 0 Mar-07 Jun-08 Sep-09 Dec-10 Mar-12 Jun-13 ▬▬ Indonesia ▬▬ Malaysia ▬▬ Thailand ▬▬ Japan ▬▬ Korea, Rep. Source: EPFR Global, via Haver Analytics. Source: ADB, Asian Bonds Online. The countries in the region reporting comparatively larger fund withdrawals have had comparatively larger foreign participation in their financial markets (Figure 34), putting them at risk to further volatility. They have also had either large current account deficits (Indonesia) or sharp credit expansions (Thailand and Malaysia). Economic imbalances and financial vulnerabilities put these economies at risk of a tightening of global financial conditions. Capital outflows and increases in long-term rates have real economic consequences. Higher interest rates, for one, may hurt fixed investment, and consequently, potential growth. In Part II of this volume, we document the impact of quantitative easing on the region, track the recent turbulence in financial markets, and assess the vulnerability of the region’s economies to the risks posed by the withdrawal of U.S. monetary stimulus. Progress in Japan’s reflation efforts may provide an upside to our base case growth forecasts for the region…  Efforts to boost money supply and to expand government spending have helped to strengthen consumption and lift growth in Japan in the first half of the year. Whether the impact of this round of extraordinary monetary and fiscal stimulus can be sustained in the long run depends crucially on progress in the “third arrow” of the turnaround plan—growth-promoting structural reforms. Detailed reform proposals are expected in the Figure 35. Japanese imports from developing EAP have Figure 36. Japanese FDI to developing EAP, including to started to improve Thailand, revived in the first half of this year Japan imports, change, in percent Japan FDI abroad, net flows, in Yen billions 25 2,000 20 1,500 15 10 1,000 5 0 500 -5 0 -10 -15 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 -500 2005 2012 Jan–Jun 2012 Jan–Jun 2013 ▬▬ 3-month over 3-month, seasonally adjusted annualized ▬▬ Year-on-year JJ China JJ Indonesia JJ Malaysia JJ Philippines JJ Thailand JJ Vietnam Source: IMF, Direction of Trade Statistics. Sources: Japan External Trade Organization (JETRO) and Japan Ministry of Finance. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part I. Recent Developments and Outlook  |  19 third quarter this year. Implementation of the consumption tax hike in 2014, a critical reform to ensure fiscal sustainability, is scheduled in the fourth quarter. So far, monetary expansion has weakened the yen 20 percent in real effective terms since September last year. Gains by Japanese exporters in third-country markets are expected to benefit East Asian suppliers of parts and components in regional production networks (World Bank 2013c). Recent data on Japanese exports and imports, including imports from the region, are starting to improve (Figure 35). …Including through more Japanese FDI. Japanese FDI to the region was 47 percent higher in 2012 than in 2005, despite a reversal of flows from Thailand because of the effects of the 2011 floods. In addition, FDI rose another 49 percent in January to June in 2013 over the same period a year ago (Figure 36). Specifically, positive flows returned to Thailand, at a rate twice the outflows a year ago. Expectations of an even weaker yen is encouraging Japanese companies to invest more, which should have positive spillover effects on EAP countries with strong trade and investment ties with Japan. The ability of the developing East Asian economies to gain from these developments will, in large measure, depend on their own structural reforms, which should solidify their FDI pull factors. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 20  |  Part I. Recent Developments and Outlook I.C. Policy Considerations As the global growth cycle undergoes change, adjustments to fiscal and monetary policy are needed in many EAP countries. In the East Asia and Pacific region, as in other developing areas that countered the global financial crisis with stimulus measures, adjustments to policy are needed to address the vulnerabilities that have built up since the crisis and from the expansive fiscal and monetary responses to the crisis. But while necessary in the short run, these adjustments will not, by themselves, be sufficient to lift potential output in the medium and long term. Complementary structural reforms will provide the foundation for sustainable and equitable growth going forward. Fiscal Policy: Rebuilding Buffers Governments in the region generally have to address fiscal risks, rebuild policy buffers, and create fiscal space, including the space necessary to spend in support of long-term growth objectives. In Vietnam, public finances have come under stress in recent years from slower growth, lower revenue buoyancy, and stimulus spending. The government will need to find savings from recurrent spending to bolster fiscal buffers. In China, the fiscal space is considerably more limited than official data suggest. The “augmented” general government deficit and debt measures, which account for off-budget funding and quasi-fiscal activity of local governments, are considerably higher than conventional measures of general government deficit and debt (Figure 37). Even the higher “augmented” measures remain modest, especially augmented debt-to-GDP ratio. Nevertheless, unwinding off-budget and quasi-fiscal activity is desirable—not least because off-budget borrowing is more expensive than on-budget borrowing. Henceforth, China should consider an on-budget stimulus, focused on consumption, in response to any sharp downturn in economic activity. In the Philippines, the government needs to create the fiscal space for infrastructure and social spending. A broadening of the tax base, improvements in tax compliance, and reductions in exemptions will aid the effort. The recently approved sin tax reform is a step in the right direction, but more needs to be done to get revenues at the desirable level of nearly 20 percent of GDP . The reform of subsidy systems, particularly of energy subsidies, is a challenge for several countries and remains integral to fiscal consolidation. Although aimed at protecting consumers, subsidies often aggravate fiscal imbalances, crowd out priority public spending, and depress private investment (IMF 2013b).12 In Indonesia, the June fuel subsidy cut was an important step, but its beneficial impact has already been dampened by a weaker Indonesian rupiah, and energy subsidies remain high. Therefore, there continues to be a strong case for building on the recent reforms by increasing the flexibility of subsidized prices and aligning them more with market prices. In Malaysia, the recent cut in fuel subsidies will need to be followed by medium-term fiscal measures to make a significant dent in federal government debt, which increased from 40 percent of 12 Energy subsidies are pervasive globally and impose fiscal and economic costs on most regions. On a pretax basis, energy subsidies amounted to 0.2 percent of global GDP or 2.0 percent of total government revenues for 176 countries in 2011. On a post-tax basis, which accounts for the negative externalities from energy consumption, the subsidies are much larger, reaching 2.9 percent of global GDP or 8.5 percent of total government revenues. The cost of the subsidies is particularly large for oil exporters: they account for two-thirds of the global pretax total and one-third of the global post-tax total. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part I. Recent Developments and Outlook  |  21 Figure 37. China’s fiscal position is less favorable, when Figure 38. Medium-term fiscal consolidation, including the quasi-fiscal activities of local governments are fuel subsidy reform, will help Malaysia control accounted for government debt General government balance, and General government debt, in percent of Central/general government balance, and Central/general government debt, GDP, 2007–13 in percent of GDP, 2007–13 60 60 50 50 2013f 40 40 2008 2007 30 30 2013f 2013f 20 2007 20 10 10 0 0 -15 -10 -5 0 5 -8 -6 -4 -2 0 ▬▬ China, general government ▬▬ China "augmented" general government ▬▬ Indonesia ▬▬ Malaysia ▬▬ Philippines ▬▬ Thailand Source: IMF 2013a. Source: World Bank data and staff estimates. Note: Data for 2013 are forecasts. Note: Data for 2013 are forecasts. GDP in 2008 to 53 percent in 2012 (Figure 38). The government is working on replacing universal fuel subsidies with cash transfers, but it is critical that these be targeted at the neediest to support fiscal sustainability. The rice subsidy program in Thailand, which intends to shore up rural incomes through higher support prices, will have to be financed either through loans by the Government or the release of stockpiles; the latter could lead to lower rice prices. Monetary Policy: Unwinding Stimulus The authorities in the region should be ready to respond to a rise in interest rates in the advanced economies. With policy rates steady for extended periods, central banks have the room to respond to potential capital outflows or foreign exchange pressures by raising policy rates. Indonesia hiked rates in June and July as headline inflation reached 5.9 and 8.6 percent (Figure 39). Inflation rose to 8.8 percent in August, triggering another rate hike in September, and may rise further in the fourth quarter, largely reflecting the fuel price hike in July. Elsewhere, subdued inflation continues to support monetary policy accommodation. In China, headline inflation remained flat at 2.6 percent in August, well below the government’s target of 3.5 percent. Forecasts for 2013 put the number at 3 percent. More modest food prices and stable fuel prices kept headline inflation in Malaysia at 2 percent in July. The recent reduction in fuel subsidies, pickup in external demand starting in the second half of 2013, and base effects will add to inflation risk next year, with the headline rate possibly reaching 3 percent in 2014. Similarly, lower commodity, particularly food, prices kept headline inflation in the Philippines at 2.8 percent through August, below the target range of 3 to 5 percent. Impending electricity price adjustments and outflows from the SDA will contribute to higher inflation next year, and the headline rate could reach 4 percent in 2014. Vietnam has successfully curbed its persistently high inflation rates, with headline inflation declining to 7.3 percent in July 2013, from 23.0 percent in August 2011 (Figure 40). Projections are for a7 .4 percent inflation rate in 2014. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 22  |  Part I. Recent Developments and Outlook Figure 39. Facing higher inflation, Indonesia hiked rates Figure 40. Headline inflation has trended downward in starting in June Vietnam and the region’s smaller economies CPI inflation, in percent CPI inflation, in percent 14 40 12 35 10 30 8 25 6 20 4 15 2 10 0 5 -2 0 -4 -5 -6 -10 Jan-07 May-08 Sep-09 Jan-11 May-12 Sep-13 Jan-07 May-08 Sep-09 Jan-11 May-12 Sep-13 ▬▬ China ▬▬ Indonesia ▬▬ Malaysia ▬▬ Philippines ▬▬ Thailand ▬▬ Cambodia ▬▬ Lao PDR ▬▬ Mongolia ▬▬ Vietnam Source: Haver Analytics. Source: Haver Analytics. Figure 41. Several EAP countries have seen rapid growth Figure 42. Household debt is largest, in percent of GDP, in credit in recent year in Malaysia and Thailand Domestic credit outstanding, in percent of GDP Debt, by debtor, in percent of GDP, end-2012 200 IDN 150 PHL 100 THA CHN 50 MYS 0 Q1-11 Q1-12 Q1-13 Q2-13 Q1-07 Q1-08 Q1-09 Q1-10 0 50 100 150 200 250 ▬▬ China (broad credit) ▬▬ China ▬▬ Malaysia ▬▬ Thailand JJ General government JJ Nonfinancial corporations ▬▬ Indonesia ▬▬ Philippines ▬▬ Vietnam (excludes credit to SOEs) JJ Households JJ Financial institutions Source: IMF, International Financial Statistics. Source: World Bank staff estimates. Central banks and financial sector supervisors must redouble their efforts to maintain financial stability. While credit growth has slowed in most of the region’s larger economies, the massive credit creation in response to the global economic crisis has built up vulnerabilities in the financial system and raised the risks to financial stability. In China, where the stock of broad credit (Total Social Financing) has increased by 60 percentage points of GDP in the five-year period from 2008 to 2012 (Figure 41), almost a third of all credit has originated from the shadow banking system, the less well-regulated and supervised part of the financial system. Recently China created a “financial regulatory inter-ministerial joint conference system” to better manage and coordinate regulatory policies across the financial system. In Malaysia, where household debt has exceeded 80 percent of GDP (Figure 42), recent measures to tighten personal and property lending may be followed by further increases in the real property gains tax to further temper credit growth. In Thailand, household debt now exceeds 60 percent of GDP , largely as a result of expansive policies following the 2011 floods. As the United States normalizes monetary policy and global interest starts to rise, these debts may be harder to service (see Part II for an assessment). WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part I. Recent Developments and Outlook  |  23 Exchange Rate Policy: Maintaining Flexibility Flexible exchange rates offer developing East Asia better protection against external shocks, and greater monetary policy independence. The developing EAP economies have commonly and frequently relied on foreign reserve accumulation to resist appreciation pressures on their currencies, including during the wave of capital inflows associated with the expansion of global liquidity following the global financial crisis. The developing EAP economies, however, have allowed relatively greater movement in their currencies in response to depreciation pressures. In principle, policy makers should allow exchange rates to respond to changing fundamentals. At the same time, if they need to guard against risks of disorderly adjustment, they may reasonably resort to intervention to smooth excessive exchange rate volatility. They may also encourage financial market participants to use hedging tools to address foreign exchange volatility risk. EAP economies face several policy options if the U.S. Federal Reserve decides to taper its QE program. Some of the preventive measures include reducing excessive reliance on short-term and foreign-currency- denominated debt and building policy buffers to respond to changing global liquidity conditions. Once tapering is announced, the appropriate response will involve a mix of exchange-rate depreciation and higher interest rates, so as to strengthen current account balances, maintain capital inflows, and avoid domestic overheating. The appropriate combination will depend on the economy’s starting position, including the level of economic activity, inflation, and the degree of exposure to foreign-currency-denominated liabilities. In addition, some intervention in foreign exchange markets, running down reserves, may help moderate excessive exchange-rate volatility or short-term liquidity pressures. Structural Reforms: The Key to Future Growth With growth running at or near potential level this year and next for most countries in the region, subsequent progress at upgrading growth and tackling poverty depends crucially on structural reforms. Countries need to pursue reforms that expand the productive capacity of their economies and afford their populations the opportunity to share in the gains of progress. Structural reforms are of primary importance at this stage for three reasons. First, closed or narrowing output gaps (Figure 43 and Figure 44) mean that further acceleration of growth cannot be realized without the expansion of capacity and gains in productivity. The reform agenda in many countries in the region is well understood, but the urgency of the reforms was overshadowed by the need to respond to the global financial crisis. Second, a nascent global upturn from the lingering effects of the financial crisis, led by firmer growth in the United States, affords most countries in the world and in the region the opportunity to rekindle reforms in a way that enables them to benefit from the recovery in the high-income economies and to put their own growth on a more solid footing and sustainable path. And third, the current political setting is conducive to further reforms in many countries in the region. The governments in China and Cambodia are new, the ruling coalition in Malaysia has won a fresh electoral mandate, and the administration in the Philippines is riding a high wave of popularity at midterm. The opportunity presents itself to expend political capital on reforms with solid returns. In China, the government aims to transition to a new growth model that is less credit-dependent, less investment-driven, and more efficient, sustainable, and inclusive. Since the global financial crisis, China REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 24  |  Part I. Recent Developments and Outlook Figure 43. Most of developing EAP is growing at or near Figure 44. …and next year potential this year… Output gap = Actual GDP minus potential GDP, in percent of potential GDP, Output gap = Actual GDP minus Potential GDP, in percent of Potential GDP, 2013(f) 2014(f) THA THA MYS MYS KHM CHN VNM VNM CHN IDN IDN KHM LAO LAO PHL MNG MNG PHL -2.0 -1.5 -1.0 -0.5 0 0.5 1.0 1.5 2.0 -2.0 -1.0 0 1.0 2.0 3.0 Source: World Bank staff estimates. Source: World Bank staff estimates. Note: Potential output is defined as the trend growth in productive capacity of the Note: Potential output is defined as the trend growth in productive capacity of the economy, that is, it is estimated level of output attained when the entirety of the capital economy, that is, it is estimated level of output attained when the entirety of the capital stock and effective labor supply is employed. stock and effective labor supply is employed. has made substantial progress in structuring a less export-dependent economy. It has remained resilient during and since the global financial crisis by embarking on a credit-supported investment-led stimulus program. However, the strategy is reaching its limits with a buildup of vulnerabilities and risks in the bank and nonbank financial sectors and in local government finances. In Part II of this report, we document the deterioration in the efficiency of credit use and the decline in the productivity of investment since China embarked on a rapid credit expansion five years ago. The structural reforms needed to address these challenges rebalance demand from investment-led to consumption-based growth are fundamentally difficult. The Central Committee of the Chinese Communist Party is expected to approve new economic policies during its forthcoming Plenum later this year. In this regard, it is likely that the authorities will consider reforms to the country’s urbanization strategy, land management, and residency (hukou) system. Reform of the financial system is also on the agenda so as to ensure that capital is allocated to its most productive uses. Finally, China is contemplating reforming local government finance, devolving more tax powers to lower-level governments, and restructuring local government debt. Among the region’s large middle-income countries, the enduring challenge is to raise investment in human and physical capital and to improve productivity. Indonesia needs a more open trade and investment regime and greater regulatory certainty, and the Philippines needs to enhance domestic competition and relax limits on foreign ownership—in order for both economies to catalyze private investment. In Thailand, an appropriate medium-term fiscal framework should further strengthen investor confidence. Investment in infrastructure is crucial in all of these economies. In Thailand, investment projects in the transportation sector should raise economy-wide productivity. The same priority holds for Indonesia, where improvements in connectivity and freight logistics, including hard and soft infrastructure investment, should help address supply bottlenecks. In the Philippines, infrastructure is generally poor in a wide range of sectors, from energy to transportation, and well-planned and well-executed public-private partnerships should help alleviate the deficiencies. Investment in human capital is as much a necessity, because it not only serves to raise productivity but also helps address the challenges of equity and inclusiveness. Indonesia needs to improve worker skills to raise the capacity of the economy to innovate. In Malaysia, the authorities continue to implement an “economic transformation program” aimed at raising Malaysia to high-income status by 2020. While progress in some areas of the structural reform agenda has been uneven (for example, a proposed new civil service pay scheme has been scrapped and the WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part I. Recent Developments and Outlook  |  25 minimum wage for foreign workers and certain firms has been delayed to 2014), key improvements have been made in revenue collection, and measures have been taken to increase women’s labor force participation. In the Philippines, despite strong economic performance over the last decade, the benefits of growth have yet to spread to the broader population, with unemployment stuck at around 7 percent and poverty stubbornly elevated. Expanded coverage of public health care, conditional cash transfers, and longer compulsory schooling should help address basic needs and support a more productive workforce. The Pacific Island countries share several structural reform priorities. Papua New Guinea and Timor-Leste face similar challenges in promoting growth outside the extractive sector. Priorities for Papua New Guinea and Timor-Leste include realizing agricultural potential through complementary investments in extension services or marketing, and investments in efficient public services to reduce the very high operating costs facing investors. In Timor-Leste, the government is preparing critical legislation to enable formal land management and usage rights. For the smaller Pacific Island countries, mitigating the impacts of inevitable exogenous shocks will, depending on the country, require accumulation of fiscal buffers, better design, and improved targeting of social protection mechanisms and measures to strengthen disaster risk reduction. Continued investment in human capital through strengthened public health and education systems will support higher living standards and increased access of Pacific workers to larger regional labor markets. Improved management of natural resources, including fisheries and forests, is a priority, with strengthened regulatory frameworks necessary to increase revenues and ensure sustainable management of stocks. Targeted improvement in infrastructure and the business environment has the potential to spur increased tourism investment in some cases. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 26  |  Part I. Recent Developments and Outlook REFERENCES Ahuja, Ashvin, and Malhar Nabar. 2012. “Investment-Led Growth in China; Global Spillovers. ” IMF Working Paper WP/12/267 , International Monetary Fund, Washington, DC, November. IMF (International Monetary Fund). 2012a. “Investment-led Growth in China: Global Spillovers. ” In Spillover Report: Background Papers, Paper No. 13. Washington, DC: International Monetary Fund. ———. 2012b. “China’s Trade Balance Adjustment: Spillover Effects. ” In Spillover Report: Background Papers, Paper No. 14. Washington, DC: International Monetary Fund. ———. 2013a. “People’s Republic of China – Staff Report for the 2013 Article IV Consultation. ” International Monetary Fund, Washington, DC, June. ———. 2013b. “Energy Subsidy Reform: Lessons and Implications. ” International Monetary Fund, Washington, DC. Miao, Yanliang, and Malika Pant. 2012. “Coincident Indicators of Capital Flows. ” IMF Working Paper, WP/12/55, International Monetary Fund. Washington, DC, February. World Bank. 2103a. “East Asia and Pacific Economic Update: A Fine Balance. ” World Bank, Washington, DC, April. ———. 2103b. “Global Economic Prospects: Assuring Growth over the Medium-Term. ” World Bank, Washington, DC, January. ———. 2103c. “Global Economic Prospects: Less Volatile, But Slower Growth. ” World Bank, Washington, DC, June. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 |  27 Part II. Selected Emerging Issues REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 28  |  Part II. Selected Emerging Issues II.A. China’s Credit Boom May Have Run Its Course1 China responded to the global financial crisis with a massive, investment-heavy stimulus program, supported by a vast credit expansion. The growth it triggered does not appear sustainable over the long term. Massive new lending in recent years has raised debt in all sectors of the economy, posing some risks to financial stability. The rapid expansion of shadow banking poses serious challenges, since shadow banking is closely linked to the banking system, is less regulated, and operates with implicit guarantees from banks and local governments. The rise in local government debt is also a concern, given the complexity and opacity of municipal finances. Policy action should focus on three key areas: containing the rapid growth of credit in the economy and tightening financial supervision; rationalizing municipal finance; and broadening and deepening financial sector reforms. Investment, Credit, and Shadow Banking: The Nexus China responded to the global financial crisis with a massive, investment-heavy stimulus program. Investment had grown steadily in China, rising from under 30 percent of GDP in 1980 to nearly 40 percent of GDP in 2005, and accounting for two-fifths of the average 10 percent GDP growth over the period. But the stimulus program, amounting to 12 percent of GDP over three years, provided further impetus to investment: between 2007 and 2009, gross fixed capital formation rose from 39 to 45 percent of GDP , and fixed asset investment (FAI)2 from 52 to 66 percent of GDP (Figure 1). The government budget’s contribution to the stimulus program Figure 1. Investment spending accelerated in response to Figure 2. The central government limited fiscal support the crisis for the stimulus in percent of GDP General government balance, in percent of GDP 80 1.0 70 0.5 60 0 50 -0.5 40 -1.0 30 -1.5 20 -2.0 10 -2.5 0 -3.0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 ▬▬ Gross fixed capital formation ▬▬ Fixed asset investment Source: CEIC and Haver Analytics. Source: IMF 1 This note was prepared by Tony Ollero, with contributions from Roberto Rocha, Karlis Smits, and Jun Wang. 2 FAI is a much broader concept and measure of investment than gross fixed capital formation (GFCF). Used in official national accounts, GFCF corresponds to the concept of gross capital formation and represents the acquisition of fixed assets as well as additions to the value of nonproduced assets. China’s FAI, however, includes land sales and purchases of used capital, both of which are excluded from GFCF because they represent the transfer of assets rather than the creation of new capital. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part II. Selected Emerging Issues  |  29 was modest: focusing on countercyclical infrastructure spending, a fiscal surplus of 0.9 percent of GDP in 2007 turned into a deficit of 2.4 percent of GDP in 2009 and 1.5 percent in 2010 (Figure 2). More significant stimulus support was provided by state-owned enterprises (SOEs) and by local governments, through off-budget and quasi-fiscal activities. SOEs temporarily reversed their declining share in aggregate investment, accounting for as much as 40 percent of the incremental FAI in 2009 (Figure 3). And local government projects, financed largely through local government financing vehicles (LGFVs), which were assigned the revenues from sales of land-use rights (Figure 4),3 vastly exceeded central government projects. Figure 3. State-owned enterprises ramped up capital Figure 4. Sales of land-use rights topped seven percent spending during the crisis of GDP in 2010 and 2011 SOE FAI, in percent share in percent of GDP in million m2 45 14 1,400 40 12 35 1,200 30 10 1,000 25 8 800 20 6 15 600 10 4 400 5 2 200 0 -5 0 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 JJ SOE share of annual incremental FAI ▬▬ SOE share of annual total FAI ▬▬ Gross revenue from sale of land-use rights ▬▬ Real estate investment ▬▬ Land purchased by real estate enterprises (rhs) Source: CEIC. Sources: OECD (2013) and CEIC. The acceleration in investment spending following the onset of the global financial crisis was supported by a vast credit expansion. The bulk of investment in China has historically been financed by retained earnings, reflecting both the robust profits of and the low dividend payouts by Chinese corporates. But credit played a crucial role in the recent run-up in investment. China placed the burden of supporting the stimulus program and the domestic-demand-led recovery on monetary policy. The People’s Bank of China (PBC) cut the policy rate four times from 7 .5 percent in August 2008 to 5.3 percent in December 2008, and then kept the rate pegged through September 2010 (Figure 5). The central bank also lowered the required reserve ratio on RMB deposits at large and small banks from 17 .5 percent in August 2008 to 13.5 percent in December 2008. Moreover, the central bank relaxed bank loan quotas and lifted broad money (M2) growth targets in late 2008 and through 2010. This loose monetary policy spurred massive credit creation: total credit flows4 doubled, from 21 percent of GDP in 2007 to 40 percent of GDP in 2009 (Figure 6). Bank loans, which still form the bulk of new 3 Specifically, LGFVs are separate legal entities organized to engage in long-term infrastructure projects for local governments. Local governments converted land from agricultural to commercial use, sold the land-use rights to property developers, and assigned the revenue stream to LGFVs. LGFVs used the land revenues as collateral for credit. Property developers increased their land acquisitions and accelerated real estate investment to 14 percent of GDP by 2012 (these land acquisitions, recorded in FAI, and the rise in land prices, partly account for the difference between FAI and gross fixed capital formation). The ensuing rise in land values allowed local governments to become even more leveraged. 4 Credit flows are derived from the PBC’s Total Social Financing (TSF) statistics. TSF is a measure constructed by the central bank to reflect the amount of liquidity provided by the aggregate financial system to the real economy. The bulk of TSF consists of credit flows: bank loans, in RMB and foreign currencies; undiscounted bank acceptance bills (short-term debt issued by a firm and guaranteed by a commercial bank, which treats them as an off-balance-sheet item); trust loans (trust company client funds invested as loans to the real sector); entrust loans (loans that corporates lend to each other using banks as book entry entities); and corporate bond financing (corporate bonds held by financial institutions). A residual category lumped as other sources includes insurance, micro lending, and industry funds. TSF also includes enterprise equity financing (nonfinancial corporate equity held by financial institutions), which, however, is small (around 3 percent of total TSF beginning in 2002, when the data first become available). Enterprise equity financing from credit flows are excluded here. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 30  |  Part II. Selected Emerging Issues Figure 5. The central bank kept monetary policy loose for Figure 6. Aggregate new credit topped 68 percent of GDP an extended period in the first quarter of 2009 Policy rate, in percent per year Required reserve ratio, Credit flows, in percent of GDP in percent of deposits 8 25 80 7 20 60 6 5 15 40 4 3 10 20 2 5 0 1 0 0 -20 Jan-03 Jun-03 Jan-04 Jun-04 Jan-05 Jun-05 Jan-06 Jun-06 Jan-07 Jun-07 Jan-08 Jun-08 Jan-09 Jun-09 Jan-10 Jun-10 Jan-11 Jun-11 Jan-12 Jun-12 Jun-13 Q1-03 Q3-03 Q1-04 Q3-04 Q1-05 Q3-05 Q1-06 Q3-06 Q1-07 Q3-07 Q1-08 Q3-08 Q1-09 Q3-09 Q1-10 Q1-13 Q3-10 Q1-11 Q3-11 Q1-12 Q3-12 ▬▬ Policy rate ▬▬ RRR on RMB deposits at small banks, rhs JJ Bank loans - RMB JJ Bank loans - foreign currency JJ Trust loans ▬▬ RRR on RMB deposits at large banks, rhs JJ Entrust loans JJ Undiscounted bankers' acceptances JJ Corp. bonds, net financing Source: Haver Analytics. Source: CEIC. Figure 7. New bank loans more than doubled between Figure 8. Fixed asset investment funded by alternative 2008 and 2009 and financed 16 percent of all fixed asset credit has increased dramatically investment in 2009 New RMB and foreign currency loans, in RMB trillion FAI by funding source, in RMB trillion 120,000 45 40 100,000 35 80,000 30 25 60,000 20 40,000 15 10 20,000 5 0 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 ▬▬ RMB loans ▬▬ RMB + foregin currency loans JJ State budget JJ Domestic loans JJ Foreign investment JJ Fund raising JJ Others Source: CEIC. Source: CEIC. Notes: Alternative credit is included in the financing category “Fund Raising” . A precise breakdown is not available for all years; staff estimates for selected years are discussed in the main text. credit (accounting for 59 percent of total new credit in 2012), more than doubled between 2008 and 2009 (Figure 7), financing 16 percent of all FAI in 2009. Alternative credit instruments (principally entrust loans, trust loans, bankers’ acceptances, and financial institution holdings of corporate bonds) have gained in importance over time, growing from 19 percent of all credit flows in 2009 to 33 percent in 2012. The share of alternative instruments in FAI financing is harder to trace (Figure 8), but our estimates suggest that it equaled 11 percent in 2012, rising sharply to approximately 25 percent in the first quarter of 2013. The large expansion of alternative credit reflects the rise of the shadow banking system in China, particularly in the aftermath of the global financial crisis and the subsequent loose monetary policies. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part II. Selected Emerging Issues  |  31 The development of China’s shadow banking system5 predates the global financial crisis. Its growth was broadly associated with two factors. On the supply side, households’ desire to diversify away from bank deposits, whose interest rates are regulated. On the demand side are the relatively low borrowing costs of corporates and their strong demand for credit, which could not be fully satisfied by the formal banking system owing to reserve requirements and other prudential restrictions (Goldman Sachs 2013). Since the crisis, the shadow banking system has grown, reflecting the expansion in global and domestic liquidity, subsequent efforts by commercial banks to avoid restrictions (such as credit quotas, loan-to-deposit caps, and capital adequacy ratios) in the regulated banking sector by securitizing loans, and efforts by regulators to diversify credit risks away from commercial banks by promoting direct financing. Figure 9. Nonbank and off–balance-sheet bank credit has Figure 10. Informal loans, not included in official credit outpaced regular bank lending data, rose by three percent of GDP during 2007–2011 TSF bank and alternative credit outstanding, in percent of GDP Estimated informal loans outstanding, in percent of GDP 200 12 180 10 160 140 8 120 100 6 80 4 60 40 2 20 0 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 JJ Bank loans - outstanding JJ Alternative credit - stock Source: IMF 2013a. Source: Goldman Sachs (2013). Figure 11. Credit funded from banks’ wealth management Table 1. Estimates of the size of China’s shadow banking products was estimated at five percent of GDP in 2012 system range from 24 to 69 percent of GDP Estimated bank WMP assets under management, and portion invested in Assets of the shadow banking system, in RMB and USD trillion, and in credit products, in percent of GDP percent of GDP 16 Estimate Size Size % GDP Date (RMB trillion) (USD trillion) 14 UBS (low) Oct-12 13.7 2.2 24 12 BA Jul-12 14.5 2.3 28 10 ANZ (low) Dec-12 15.0 2.4 29 8 ANZ (high) Dec-12 17.0 2.7 33 S&P Apr-13 22.9 3.7 44 6 GS Feb-13 23.5 3.7 45 4 UBS (high) Oct-12 24.4 3.9 46 2 Hua Tai Dec-12 25.0 4.0 48 0 Barclays Dec-12 25.6 4.1 49 2006 2007 2008 2009 2010 2011 2012 Citibank Jan-13 28.0 4.5 54 ▬▬ Total assets under management ▬▬ Invested in credit GF Sec. Dec-12 30.0 4.8 57 JPM May-13 36.0 5.9 69 Source: Goldman Sachs (2013). Source: Federal Reserve Bank of San Francisco 2013; and JPMorgan 2013. 5 The Financial Stability Board defines shadow banking as consisting of “credit intermediation involving entities and activities outside the regular banking system” (Financial Stability Board 2012). The World Bank’s definition is similarly worded: “a set of activities, markets, contracts and institutions that operate partially or fully outside the commercial banking sector, and, as such, are either lightly regulated or not regulated at all” (World Bank 2012). REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 32  |  Part II. Selected Emerging Issues Crude estimates of the size of the shadow banking system, based on the PBC’s Total Social Financing (TSF) statistics,6 suggest that nonbank and off-balance-sheet bank credit flows amounted to 12 percent of GDP in 2012, and their outstanding credit stock stood at approximately 50 percent of GDP  (Figure 9). This number is an underestimate, since TSF data do not include either informal loans7 (Figure 10) or loans securitized through brokers’ asset management channels. Moreover, credit funneled from bank’s Wealth Management Products (WMPs) may be greater than reported by the banks (Figure 11). In fact, some estimates of the size of China’s shadow banking system are much larger than what can be derived using TSF data alone—as much as 69 percent of GDP (Table 1). Overinvestment? Although China’s credit-induced, investment-led intervention supported growth during the global financial crisis, neither an investment- nor credit-intensive growth model appears sustainable over the long term. There is growing evidence, although no firm consensus in the existing macroeconomic literature, that China overinvests.8 China’s investment-to-GDP ratio is high by most standards (Geng and N’Diaye 2012), whether compared to countries with similar development strategies during equivalent periods in their history, countries with similar income levels, or the major advanced and developing economies (Figure 12). And China’s capital stock, while relatively modest on a per worker basis,9 is large relative to GDP (Figure 13). One important recent study concludes that China has been overinvesting over the last decade, currently by as much as 10 percent of GDP (Lee, Syed, and Xueyan 2012).10 As a result, the same authors suggest a rationalization of Figure 12. China’s investment has been the highest Figure 13. And its capital stock is comparatively large among the major advanced and developing economies relative to output Gross fixed capital formation, in percent of GDP, average 2003–12 Capital, in percent of GDP, end 2011 45 900 40 800 35 700 30 600 25 500 20 400 15 300 10 200 5 100 0 0 CHN IND KOR JPN CAN MEX ITA RUS FRA ZAF DEU USA BRA GBR CHN ZAF JPN KOR MEX USA DEU RUS BRA Source: World Bank, World Development Indicators. Source: World Bank staff estimates using capital stock data from OECD 2013. 6 We define shadow banking credits as the sum of trust loans, entrust loans, undiscounted bankers’ acceptances, and corporate bonds held by financial institutions. In contrast, RMB bank loans and foreign currency bank loans are classified as regular bank credit 7 That is, loans provided by individuals to corporates without using financial institutions as intermediaries. 8 See Ding, Guariglia, and Knight (2010) for a comprehensive survey of the literature. 9 The capital stock per worker at end-2011 stood at US$68,000 in China, compared to US$317 ,000 for top-ranked Japan, US$215,000 for the United States, US$175,000 for Germany, US$141,000 for the Republic of Korea, and US$83,000 for South Africa (OECD 2013). 10 China’s investment-to GDP-ratio is rated against a “norm, ” computed from a regression (a panel of 36 countries, including China’s East Asian peers, during 1955– 2009) on fundamentals including the level of economic development of a country (real GDP); the availability of financing (savings-to-GDP and credit-to-GDP); the cost of capital (real lending rate); the potential contribution of the external sector to investment (exports-to-GDP); demographics (the age dependency ratio); and macroeconomic uncertainty (standard deviation of the three-year rolling real GDP growth rate). WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part II. Selected Emerging Issues  |  33 investment and its reorientation away from manufacturing and real estate and toward agriculture and services (Lee, Syed, and Xueyan 2013). Many microeconomic studies also find strong evidence of the inefficiency of investment in, and the misallocation of investment across, various sectors of the economy, both of which indicate that China overinvests. These inefficiencies are associated with investment by SOEs (Dollar and Wei 2007), and in the Western and inland provinces compared to those along the Eastern coast (Wu 2008). Over time, the efficiency of investment has declined (Figure 14). During the global crisis, the growth of productivity was falling even as China embarked on an investment boom (Figure 15). Greater investment in manufacturing has raised industrial capacity in many sectors at a time of slowing overall growth.11 The authorities recognize that growth has become too dependent on the continued expansion of investment and have articulated the need to internally rebalance the economy toward consumption-led growth, starting with the current five-year development plan. Figure 14. Long-running efficiency gains reversed in the Figure 15. Productivity growth was dropping as the mid-2000s investment spurt began Growth rate, yoy Incremental capital-to-output ratio in percent yoy in percent of GDP 40 6 16 80 35 14 70 5 30 12 60 4 25 10 50 20 3 8 40 15 6 30 2 10 4 20 1 5 2 10 0 0 0 0 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 JJ Gross capital formation JJ GDP ▬▬ ICOR, rhs ▬▬ Productivity growth ▬▬ FAI, rhs Source: World Bank, World Development Indicators, and staff estimates. Source: Haver Analytics and CEIC. Note: ICOR=change in capital stock, higher values indicate lower efficiency of investment. Note: Productivity=output per employed person. Similarly, the efficiency with which credit is used in the economy has deteriorated during the recent credit expansion. Before the global financial crisis, 1.4 units of credit were sufficient to generate one unit of GDP (measured with a one-quarter lag). That ratio has risen to an average 2.7 since 2009, topping 4.6 in the last quarter of 2008 and 5.4 in the first quarter of 2009 as the stimulus got underway (Figure 16). The pattern is robust to measuring the growth efficiency of credit with a two-quarter or even a four-quarter lag (Figure 17). Credit growth picked up again in the second half of 2012, with new credit flows exceeding 50 percent of GDP in the first quarter of 2013. As credit growth picked up, the inefficiency indicator similarly inched higher. The declining marginal impact of credit on growth partly reflects the growing inefficiency of the investment that is supported by the new credit creation, including real estate development and local government infrastructure. But it is also indicative of the deployment of credit for purposes other than real economic activity. Using credit to service existing debt, for instance, does not generate new investment and activity. 11 Industrial capacity utilization was 78 percent in the first half of 2013, including 75 percent for the steel industry, well below the international average. Since July, the Ministry of Trade and Information has issued administrative orders to more than 1,500 companies, in industries ranging from steel to chemicals, to cut excess production capacity by end-2013. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 34  |  Part II. Selected Emerging Issues Figure 16. The growth efficiency of credit has Figure 17. …including when measured with different lags deteriorated… Absolute change in TSF credit divided by absolute change in real GDP, Absolute change in TSF credit divided by absolute change in real GDP, annualized, one-quarter lag annualized 6 6 5 5 4 4 3 3 2 2 1 1 0 0 Q1-03 Q3-03 Q1-04 Q3-04 Q1-05 Q3-05 Q1-06 Q3-06 Q1-07 Q3-07 Q1-08 Q3-08 Q1-09 Q1-03 Q3-03 Q1-04 Q3-09 Q1-10 Q1-11 Q1-12 Q1-13 Q3-04 Q1-05 Q3-10 Q3-05 Q1-06 Q3-06 Q1-07 Q3-07 Q1-08 Q3-08 Q1-09 Q3-09 Q1-10 Q1-11 Q1-12 Q1-13 Q3-11 Q3-12 Q3-10 Q3-11 Q3-12 JJ 2-quarter lag JJ 4-quarter lag Source: World Bank staff estimates. Source: World Bank staff estimates. Massive new lending in recent years has raised debt everywhere in the economy. “Augmented” general government debt, a measure that includes off-budget and quasi-fiscal borrowing by the government,12 reached 46 percent of GDP in 2012 (Figure 18); and even these are only partial estimates of total government debt.13 Total credit outstanding in the economy, measured by the stock of TSF credit, rose from 127 percent of GDP in 2008 to 187 percent of GDP in 2012. Private sector estimates (including, for example, by McKinsey) place Chinese national debt (central government, households, nonfinancial corporates, and the financial sector) well Figure 18. “Augmented” general government debt Figure 19. China’s national debt ratio high for emerging exceeded 46 percent of GDP in 2012; total credit economies, but trails that of advanced economies outstanding exceeded 186 percent of GDP Debt outstanding, in percent of GDP, 2008–2012 Debt outstanding, in percent of GDP, end–2011 200 RUS IND 180 BRA 160 CHN GRC 140 CAN 120 DEU USA 100 KOR 80 ITA FRA 60 PRT ESP 40 GBR 20 JPN IRL 0 2008 2009 2010 2011 2012 0 100 200 300 400 500 600 700 ▬▬ General government debt ▬▬ “Augmented” general government debt JJ Government JJ Nonfinance corporation (business) JJ Households ▬▬ Total Social Financing (TSF) (broad credit) outstanding JJ Financial institutions Source: IMF 2013a. Source: McKinsey Global Institute 2010. 12 The general government sector consists of all government units (the central government, state governments, and local governments) and all nonmarket nonprofit institutions controlled by government units (see IMF 2001). The IMF has constructed an “augmented” general government account for China that includes off- budget funds and LGFVs, to cover the considerable off-budget and quasi-fiscal activity in China that is conducted primarily at the local-government level (IMF 2013a). 13 The IMF’s “augmented” fiscal debt data for China, because it is intended to provide a picture of fiscal policy stance rather than net worth in a balance sheet sense, excludes several liabilities including the debt of the Ministry of Railways, which has been moved to a new SOE (part of the public corporations sector, but not of the augmented general government); contingent liabilities: the debt of nonfinancial SOEs, the outstanding debt of policy banks, the nonperforming loans in the banking sector, the old nonperforming loans assumed by the asset management companies, and pension fund liabilities; and social security funds (since China does not consolidate social security into the general government accounts). WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part II. Selected Emerging Issues  |  35 in excess of 200 percent of GDP at end-2011 (Figure Figure 20. Profitability has declined at industrial firms 19). Overall, total debt has clearly risen rapidly to a including at state-owned enterprises historically high level. Profits, in percent of sales revenues 10 China’s rising debt stock poses some risks to the 8 economy. The combination of rapid credit creation and slowing growth creates vulnerabilities. Debt 6 service capacity is potentially an issue given declining 4 profitability among industrial enterprises, particularly SOEs (Figure 20). Profits of SOEs had been healthy 2 since 2000, following their restructuring beginning in the mid-1990s (Lee 2009; Naughton 2007). But 0 2011 2007 2003 2012 Mar-13 2009 2010 2008 2006 2005 2004 robust profits had been due in no small part to the ▬▬ All industrial enterprises ▬▬ SOEs and SOE shareholding enterprises strong monopoly position of large SOEs in core Source: CEIC sectors of the economy, the low cost of capital and other factor inputs, and continuing financial support from the state and state-owned banks. The recent global economic downturn, excess industrial capacity, and lower sales volumes have since pressured profits, particularly at manufacturing enterprises, and consequently diminished their ability to service debt. Debt service is also a potential problem for the non-SOE corporate sector, as evidenced by the falling ratio of earnings before interest and taxes (EBIT) to interest expenses among listed private companies.14 That said, China’s national debt as a share of GDP is still not as high as that of the major advanced economies, much less that of the highly indebted euro area crisis countries. Moreover, since much credit creation in China is supported by high domestic savings, a debt crisis appears unlikely when assessed against dependency on external finance: gross domestic savings has exceeded gross investment in all years since 1994. And emerging economies with high savings rates generally have high debt levels (UBS 2013). Special Concerns: Shadow Banking and Local Government Debt The rapid expansion of shadow banking poses challenges to financial stability, given that shadow banking is closely linked to the banking system, is less regulated, and operates with implicit guarantees from banks and local governments. China’s shadow banking system is small compared to more advanced countries15 and is still relatively simple, consisting largely of direct credit and informal securitization16 rather than more complex intermediation and risk transformation. But it has grown rapidly in a short period, and now supplies a significant part of domestic credit. As a result, shadow banking can pose systemic risks to the stability of the financial system, for three reasons. 14 IMF (2013b). See Box 1.1 in Chapter 1 for recent trends in the EBIT to Interest Expenditure ratio for a panel of 917 nonfinancial companies. 15 According to the Financial Stability Board (2012), three markets account for 81 percent of the US$67 trillion total assets of the global shadow banking system: the United States, with US$132 trillion (152 percent of GDP), 35 percent of the total; the euro area, US$22 trillion (168 percent of GDP), 33 percent of the total; and the United Kingdom, US$9 trillion (370 percent of GDP), 13 percent of the total. 16 China began experimenting with formal securitization before the global financial crisis, with China Construction Bank issuing the first asset-backed securities (ABS) deal in 2005. Regulators halted these pilot efforts during the crisis and restarted them in 2012. But progress has been slow, and credit-based ABS comprised under 1 percent of total bonds outstanding at mid-2013. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 36  |  Part II. Selected Emerging Issues First, the shadow banking and the banking sectors in China are closely interconnected, through direct and indirect linkages.17 Second, many aspects of shadow banking are unregulated or only lightly regulated. For instance, informal loans, which charge higher interest, indicating higher risk, have no capital requirement. Likewise, banks are exposed to risks in WMPs. They offer high-interest on off-balance-sheet WMPs to attract funds and then allow the WMPs to mature before the end of the month, so that the funds flow back to the bank balance sheet as deposits to meet regulatory loan-to-deposit ratios. Third, loss attribution rules in shadow banking are fuzzy. Investors consider trust products and WMPs to be guaranteed by banks because previous cases of loss were compensated for by the banks, at the behest of regulators. There is also a general perception that LGFV debt is guaranteed by local governments, and some of it is in fact informally guaranteed, legal restrictions notwithstanding. The rise in local government debt is also a concern, given the complexity and opacity of municipal finances. This lack of transparency has led to debt levels higher than would otherwise be acceptable to lenders, investors, and policy makers. Local governments are not allowed by law to incur a budget deficit and can only issue bonds with the approval of the State Council. A trial program allowing local units to issue bonds directly and under quota limits was begun in 2011 but remains limited. With few formal ways to borrow, local governments have instead borrowed through LGFVs, some 6,576 of which had been set up by 2010. The National Audit Office estimated local government debt at 27 percent of GDP at end-2010, a sevenfold absolute increase over just two years. Some four-fifths of this debt was in the form of bank loans. The IMF’s “augmented” general government debt data place local government debt at 32 percent of GDP in 2012, up from 20 percent in 2008 (Figure 21).18 Figure 21. Local government debt, including debt of Local Table 2. Some Private-sector estimates of local Government Financing Vehicles, may have exceeded government debt are even higher 32 percent of GDP in 2012 in percent of GDP, 2008–2012 60 Estimate Yuan % GDP date (trillion) 50 Local government debt at end–2010: National Audit Office Jun-11 10.7 27 40 Local government debt at end–2012: 30 Moody’s Jun-13 12.1 23 Fitch Apr-13 12.9 25 20 UBS Apr-13 16.5 32 Credit Suisse 36 10 Standard Chartered 38 0 Oxford Analytica May-13 20.0 40 2008 2009 2010 2011 2012 JJ Central government debt JJ Local government debt ▬▬ “Augmented” general government debt Source: IMF 2013a. Sources: Moody’s Investors Service 2013; Oxford Analytica 2013; Standard Chartered 2011; UBS 2013. Many private-sector estimates are higher, at as much as 40 percent of GDP at end-2012 (Table 2). Moreover, alternative credit figures prominently in recent new lending: trust loans and LGFV bond issuance 17 For instance, trusts are distributed by banks for a fee income. Entrust loans work as bridge loans, by which corporates repay or roll over bank loans, and have banks acting as book entry entities. Corporate bonds are commonly underwritten by banks, which bought a little over half of corporate bond issues last year. Banks lend to corporates and securitize the loans through their WMPs. The WMPs are created, managed, and distributed by banks, for which they earn fee income. Loans securitized from brokers’ WMPs are created at the request of banks. And informal loans work as bridge loans by which small and medium enterprises and property developers repay or roll over bank loans. 18 These data include the debt of LGFVs but exclude the debt of local-government-owned SOEs (IMF 2013a). The latter are classified as part of the public corporation sector, which is distinct from the general government sector. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part II. Selected Emerging Issues  |  37 grew by three-fourths in 2012 (UBS 2013). Local governments do have significant assets to meet their liabilities: they hold land reserves worth 10 percent of GDP , and own shares in local SOEs worth a similar amount.19 This lends support to the view that local governments are not facing a solvency crisis. In addition, the central government has the financial capacity to support troubled local governments. Nonetheless, the above concerns about debt servicing and asset quality apply also to local government debt and assets. As the economy slows, local governments may face weaker revenues from taxes and land sales, and may not have sufficient cash-flow to pay interest. Anecdotal evidence of new debt being incurred to service older debt is plentiful, although the information has yet to be compiled in any systematic official or private data series.20 Similarly, questions have been raised about the rates of return of LGFV projects (Oxford Analytica 2013). Policy Conclusions The internal rebalancing of the economy away from an investment-dependent growth model provides the context for addressing the issues and risks associated with the recent episode of credit expansion and debt accumulation. Policy action in three key areas will help advance the reform agenda. First, the authorities need to contain the rapid growth of credit in the economy and tighten financial supervision. This applies particularly to those parts of the financial system that are less well regulated, and from which credit has flowed massively and rapidly. Greater financial sector discipline will help ensure that only positive net present value real sector investment projects are funded. Second, municipal finance should be rationalized. The framework for local government financing of capital projects must be revamped. The system of local government borrowing should be reformed within strict limits, with clear rules on borrowing, on allowed sources of borrowing, on debt resolution, and on the disclosure of comprehensive financial accounts by local governments. Closely related is the reform of land management. A stronger local tax base, and stricter rules on land taking and compensation for it, would reduce both the need and the possibilities for land financing. Third, policy makers should broaden and deepen financial sector reforms. A gradual reduction in the government’s role in the financial system, as exemplified by interest rate regulation, together with improved governance in banks, will promote efficient financing and investment decisions. A recent decision to remove the floor on lending rates, giving banks more freedom to set borrowing costs, constitutes a step in the right direction. 19 UBS (2013) assumes a conservative 40 percent ownership stake of local governments in local SOEs, whose equity value (including both listed and unlisted firms) is estimated by the Ministry of Finance at Y 13 trillion as of end-March 2013. 20 Standard Chartered warned of local government insolvency in 2011, suggesting that 80 percent of local government loans would not be able to cover debt service. In June 2013, the National Audit Office reported an inability to repay debt and an increase in debt rollovers in a sample of 36 local governments and their LGFVs. Recently, State Council directed the National Audit Office to conduct a nationwide audit of all government-related debt obligations. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 38  |  Part II. Selected Emerging Issues REFERENCES Ding, Sai, Alessandra Guariglia, and John Knight. 2010. “Does China Overinvest? Evidence from a Panel of Chinese Firms. ” Oxford University Discussion Paper Series No. 520, December. Dollar, David, and Shang-Jin Wei. 2007 . “Das (Wasted) Capital: Firm Ownership and Investment Efficiency in China.” IMF Working Paper 07/9, Washington, DC. Federal Reserve Bank of San Francisco. 2013. “Shadow Banking in China – Expanding Scale, Evolving Structure. ” San Francisco, April. Financial Stability Board. 2012. “Global Shadow Banking Monitoring Report, ” Basel, November 18. Geng, Nan, and Papa N’Diaye. 2012. “Determinants of Corporate Investment in China: Evidence from Cross- Country Firm Level Data. ” IMF Working Paper 12/80, March, Washington, DC. Goldman Sachs. 2013. “China Banks – Casting a Light on Shadow Banking. ” Equity Research, Beijing, February 26. IMF (International Monetary Fund). 2001. Government Finance Statistics Manual. International Monetary Fund, Washington, DC. ———. 2013a. “People’s Republic of China - Staff Report for the 2013 Article IV Consultation. ” Washington, DC, June. ———. 2013b. Global Financial Stability Report, “Old Risks, New Challenges. ” International Monetary Fund, Washington, DC, April. JPMorgan. 2013. “Shadow Banking in China. ” New York, May 3. Lee, Junyeop. 2009. “State-Owned Enterprises in China – The Evidence. ” Occasional Paper, Working Group on Privatization and Corporate Governance of State-Owned Assets, OECD, Paris, January 26. Lee, Il Houng, Murtaza Syed, and Liu Xueyan. 2012. “Is China Over-Investing and Does It Matter. ” IMF Working Paper WP/12/277 , Washington, DC, November. ———. 2013. “China’s Path to Consumer-Based Growth: Reorienting Investment and Enhancing Efficiency. ” IMF Working Paper 13/83, Washington, DC, March. McKinsey Global Institute. 2010. “Debt and Deleveraging: The Global Credit Bubble and Its Economic Consequences. ” Washington, DC, January, (updated). Naughton, Barry. 2007 . The Chinese Economy. Cambridge, MA: MIT Press, Chapters 13 and 19. OECD (Organisation for Economic Co-operation and Development). 2013. “Economic Survey of China 2013. ” OECD, Paris, March. ” Oxford, May 23. Oxford Analytica. 2013. “Local Borrowing Will Stress China’s Stability. Standard Chartered. 2011. “China – Solving the Local Government Debt Problem. ” Special Report, Shanghai, July 18. UBS (Union Bank of Switzerland). 2013. “How Bad is China’s Debt Problem?” UBS Investment Research, Basel, April 30. World Bank. 2012. “Chasing Shadows: How Significant is Shadow Banking in Emerging Markets. ” Economic Premise No. 88, World Bank, Washington, DC, September. Wu, Yanrui. 2008. “Has China Invested Too Much? A Study of Capital Efficiency and its Determinants.” Discussion Paper 36, China Policy Institute, University of Nottingham. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part II. Selected Emerging Issues  |  39 II.B. The End of Quantitative Easing21 Quantitative easing (QE), particularly in its early stages, had a positive impact on capital flows to East Asia and Pacific and on regional financial markets. That said, QE accounted for only part of the total variation in capital inflows and asset prices. Conversely, any scaling back of QE in the United States will result in higher borrowing costs, lower capital inflows, and a decline in asset prices in East Asia and Pacific. This will affect investment and potential output, and raises concerns about potentially overextended domestic financial sectors. Estimates of the impact vary widely, but it is likely to prove larger in economies characterized by greater financial openness, significant current-account deficits, rapid credit growth in recent years, or large increases in debt. Countries may be able to reduce the cost of their borrowing by strengthening their own domestic institutions and further improving the investment climate. Quantitative Easing and its Tapering In the aftermath of the 2007–08 global financial crisis, major advanced economy central banks turned to unconventional monetary policy (UMP) measures. The goals were first to unfreeze financial markets, and subsequently to provide stimulus to the economy. The measures involved purchasing private and public assets, supplying liquidity to banks through refinancing windows, and extending lending maturities. This was supplemented by “forward guidance” to market participants, in the form of public commitments to keep monetary policy expansionary for a considerable time to come. Recent statements by the U.S. Federal Reserve indicate plans to gradually unwind, or “taper, ” its Quantitative Easing (QE) program; this has led to significant volatility in regional financial markets. From late May through 22 June, and again in late August, concerns about rapid tapering were associated with increased yields on U.S. treasuries, declines in capital flows to East Asia and Pacific (EAP), and broad-based and brutal falls in regional asset prices. The greatest impact was felt in Indonesia, but the asset sell-off affected most of the region’s emerging markets, including Malaysia, the Philippines, and Thailand (see below, as well as Part I of this Economic Update, for more details). Many of these adjustments were largely reversed in September, as it became clear that any tapering would occur later than anticipated. This note discusses the impact of past UMP , and the potential impact of any future tapering of QE, on regional capital inflows and asset prices. It also briefly discusses the wider implications for economic activity in the region. 21 This note was prepared by Tony Ollero and Nikola Spatafora. Sanket Mohapatra (DECPG) provided substantive contributions to Section III. The note draws on analytical work carried out by the World Bank’s DEC group, including, in particular, Dilek Aykut and Aart Kraay. Eung Ju Kim provided data support. 22 See Chairman Bernanke’s Congressional testimony on May 22, 2013, and his press conferences on June 19 and September 18, 2013: www.federalreserve. gov/newsevents/testimony/bernanke20130522a.htm; www.federalreserve.gov/mediacenter/files/FOMCpresconf20130619.pdf; www.federalreserve.gov/ mediacenter/files/FOMCpresconf20130918.pdf. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 40  |  Part II. Selected Emerging Issues Conceptual Framework UMP programs have had two broad objectives: repairing financial markets and easing credit conditions.23 Early on, the goal was to inject liquidity into financial markets to stabilize them, shore up confidence, avoid abrupt deleveraging and asset-price collapses, and bring down liquidity and risk premia. Later, the aim became to lower real interest rates, ease credit conditions, and encourage spending by firms and households, so as to promote growth and employment. Unconventional measures were required because short-term nominal policy rates were already near zero, limiting the scope for traditional interventions. The programs varied in their details, but all involved significant increases in the size, and changes in the composition, of central banks’ balance sheets. The U.S. Federal Reserve and the Bank of England have focused on bond markets, purchasing government bonds and/or mortgage-backed securities on a large scale to increase market depth and liquidity, extend maturities, and drive long rates down. The European Central Bank has concentrated on direct lending to banks, while the Bank of Japan has adopted a hybrid approach. UMP may exert international spillovers. Regardless of the precise nature of the intervention, large-scale UMP that significantly reduces advanced economy borrowing costs and increases confidence may, in an environment of financial globalization and trade openness, exert spillovers on developing EAP. Two key transmission mechanisms are: 24 yy Portfolio Rebalancing. Lower long-term risk-adjusted yields in advanced economies (whether on bank loans, corporate bonds, government bonds, or equities) will spur investors to search abroad for higher yields. As a result, capital flows to developing countries will increase. yy Confidence. A credible commitment to backstop financial markets will reduce perceived risk and risk aversion. A broad-based increase in confidence may also encourage flows into riskier asset classes, including emerging markets. That said, increased confidence in advanced economies may actually reduce the pressure for capital outflows to developing countries. To the extent that UMP increases either capital flows to developing countries or general confidence, it will encourage increases in local (debt and equity) asset prices and investment. Greater capital inflows will also create pressures for exchange-rate appreciation. Conversely, a tapering of QE would reduce capital flows to developing countries, local asset prices, and investment, and act to depreciate their exchange rate. The Impact of Quantitative Easing So Far The UMP-driven search for yield, coupled with stronger growth in developing countries vis-à-vis advanced economies, appears to have triggered a surge in capital flows to developing countries, and to EAP in particular. Between 2008 and 2012, net capital flows to developing countries rebounded from 23 See IMF (2013a) for an extensive review of UMPs. 24 See Chen et al. (2012) and Fratscher, Lo Duca, and Straub (2013) for further discussion of the potential transmission mechanisms underlying international spillovers from QE. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part II. Selected Emerging Issues  |  41 US$490 billion to over $800 billion (World Bank 2013). Flows to EAP more than doubled, to reach US$460 billion (4.6 percent of GDP). This note focuses on the impact of QE in the United States, given its global importance, and on the prospects for its gradual unwinding. There were four main episodes of QE: yy QE1. Major Federal Reserve purchases of mortgage-backed securities and other “toxic assets” in the early stages of the crisis, beginning in late 2008. yy QE2. Federal Reserve purchases of U.S. Treasury securities in the second half of 2010. yy “Operation Twist. ” Federal Reserve purchases of long-term bonds and corresponding sales of short-term bonds, starting in late 2011. yy QE3. A renewed program of Federal Reserve purchases of private mortgage-backed securities beginning in late 2012. There is a broad consensus that QE helped restore the functioning of financial markets and significantly reduced domestic long-term yields and credit spreads, especially in its early phases, at the peak of market turmoil ( IMF 2013a). In the United States, the cumulative effects of QE on long-term Treasury bonds are estimated at between 90 and 200 basis points (bps). Initial announcements were especially effective, partly by decreasing the risks of financial collapse and a sharp recession, and partly because they were less widely anticipated. In the U.K. and especially Japan, the overall impact has been smaller. The limited existing literature on international spillovers from QE concludes that these programs did lift asset prices globally  (IMF 2013b). Identifying the precise effects of QE is complicated, given that the policies were announced and implemented in the midst of significant turmoil in global financial markets. Analyses focusing on East Asia find that QE, and in particular QE1, by lowering U.S. yields and credit default swap spreads, significantly contributed to the postcrisis rebound in capital flows to EAP (Cho and Rhee 2013). Studies dealing with emerging markets more broadly confirm that QE, and again QE1, in particular, lifted local bond and equity prices. The evidence on capital flows and exchange rates is more mixed: QE1 had an ambiguous effect, reflecting its positive impact on confidence in the U.S. economy, whereas QE3 was more clearly associated with rebalancing toward emerging markets.25 QE2 also had some announcement effects, although the euro area crisis makes it difficult to evaluate its medium-term impact. The literature also suggests that the magnitude of the international spillovers from QE depends on market conditions, and has diminished as markets normalized. Later QE rounds had small effects relative to the underlying volatility in the relevant series.26 In part, this may reflect a reduction in the “surprise content” 25 For instance, Fratzscher, Lo Duca, and Straub (2013), analyzing data on flows into bond and equity mutual funds, find that QE1 was followed by capital flows from emerging markets into the United States, partly reflecting a generalized “flight to quality” at the start of the crisis. In contrast, QE2 and QE3 were followed by capital outflows from the United States to emerging markets. Ahmed and Zlate (2013), analyzing balance-of-payments data for a smaller set of emerging markets, find that growth and interest rate differentials, as well as capital controls, are significant predictors of capital flows. However, QE did not have a statistically significant impact on overall emerging market capital inflows; it did change their composition toward portfolio inflows, but was only one among several important factors. Chen et al. (2012) find that QE1, in particular, substantially reduced global yields, and increased emerging market capital inflows and asset prices. Likewise, the IMF (2013b) finds a significant impact of QE on emerging market capital inflows, and in particular on bond inflows. 26 For instance, Moore et al. (2013) conclude that QE1 and QE2 reduced emerging market government bond yields by, respectively, 17 bps and 2 bps. More generally, each 10-basis-point reduction in long-term U.S. Treasury yields lowers emerging market yields by only 1.7 bps. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 42  |  Part II. Selected Emerging Issues of the announcements (IMF 2013b); substantial, unexpected shifts could still have strong effects. But it also points to the importance of country-specific factors in driving capital inflows. This section gauges international spillovers to EAP using event studies. In particular, the section considers market developments (a) when important announcements were made about each QE program, (b) when the programs were implemented,27 and (c) in the aftermath of Chairman Bernanke’s speech of May 22 on QE tapering. The data broadly confirm that QE, especially in its early stages, had a positive impact on capital flows to EAP and on regional financial markets. That said, QE accounted for only part of the total variation in capital inflows and asset prices. Country-specific factors, as well as global shifts in perceptions of financial risk, also had a significant impact, particularly on equity markets. More specifically, analyzing the various elements in the transmission mechanism: yy QE helped calm markets and reduce perceived sovereign risks. Sovereign credit default swap spreads28 for EAP reacted positively to the QE announcements, particularly QE1, Operation Twist, and QE3 (Figure 22). QE2 had no effect, possibly because it was widely anticipated. Overall, average spreads compressed from a peak of 590 bps, immediately before the QE1 announcement, to 80 bps in mid-May 2013. Figure 22. Sovereign credit default swap (CDS) spreads, Figure 23. Flows into bond and equity mutual funds and East Asia and Pacific ETFs, East Asia and Pacific in basis points in U.S. dollar billions, 3–month moving average 700 8 QE1 QE1 QE3 QE3 QE2 QE2 Operation Twist Tapering Talk Operation Twist Tapering Talk 600 6 500 4 2 400 0 300 -2 200 -4 100 -6 0 -8 1-Jan-08 6-May-08 9-Sep-08 13-Jan-09 19-May-09 22-Sep-09 26-Jan-10 1-Jun-10 5-Oct-10 8-Feb-11 14-Jun-11 18-Oct-11 21-Feb-12 26-Jun-12 30-Oct-12 5-Mar-13 9-Jul-13 12-Aug-13 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jan-13 Aug-13 Jul-12 ▬▬ Equity funds ▬▬ Bond funds Source: Thomson Datastream. Source: EPFR Global. Note: Shaded segments designate the announcement windows for each QE program, Note: Shaded segments designate the announcement windows for each QE program, together with the 30-day period following the May 22 speech on QE tapering. “East together with the 30-day period following the May 22 speech on QE tapering. “East Asia Asia and Pacific” refers to the composite of credit default swap spreads for five-year and Pacific” refers to China, Indonesia, Thailand, Malaysia, the Philippines, and Vietnam. governments for China, Indonesia, Malaysia, the Philippines, and Thailand. yy There were strong flows into EAP bond and equity funds after the QE1 announcement and through its implementation, reversing the outflows during the global financial crisis (Figure 23). These inflows fell off and were volatile during QE2 implementation, reflecting the euro area sovereign debt crisis, and during Operation Twist. The inflows increased sharply during and immediately after the QE3 announcement. In 2012, net portfolio equity inflows and bond inflows reached, respectively, 0.3 percent and 0.4 percent of 27 Following IMF (2013c), Cho and Rhee (2013), and publicly available information, the following announcement and implementation windows were considered. QE1: announced November 2008–March 2009, implemented December 2008–August 2010. QE2: announced November 2010, implemented November 2010–June 2011. Operation Twist: announced September 2011, implemented September 2011–December 2012. QE3: announced September–December 2012, implemented January 2013 onward. 28 Credit default swap spreads represent the cost of insuring sovereign debt against default; hence, they serve as a measure of sovereign credit risk. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part II. Selected Emerging Issues  |  43 regional GDP. Following that, flows declined steeply beginning in February 2013. In general, equity flows have proved much more volatile than bond flows, with far less of the variation explainable in terms of QE announcements. yy 10-year government bond yields declined after each QE announcement, experiencing a broad fall through May 2013 (Figure 24). The Morgan Stanley Capital International (MSCI) equity indexes for EAP recovered rapidly following the QE1 announcement and during its implementation. Prominent examples include the equity markets in Hong Kong, SAR; the Republic of Korea; and Indonesia. The indexes remained at high levels during QE2 implementation, although they fell during late 2011, again reflecting the euro area crisis. The indexes also reacted positively to the QE3 announcement, remaining fairly stable until May 2013. Overall, between end-2008 and May 2013, stock prices quadrupled in Indonesia and the Philippines, and rose nearly as much in Thailand. Figure 24. Bond and equity indexes, East Asia and Pacific Figure 25. New bond and equity issuances, East Asia and Pacific January 1, 2008 = 100 in U.S. dollar billions, 3–month moving average 110 15 QE1 QE1 QE3 QE3 QE2 QE2 Operation Twist Tapering Talk Operation Twist Tapering Talk 100 13 90 11 80 9 70 7 60 5 50 3 40 1 30 -1 1-Jan-08 6-May-08 9-Sep-08 13-Jan-09 19-May-09 22-Sep-09 26-Jan-10 1-Jun-10 5-Oct-10 8-Feb-11 14-Jun-11 18-Oct-11 21-Feb-12 26-Jun-12 30-Oct-12 5-Mar-13 9-Jul-13 20-Aug-13 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jan-13 Jun-13 Jul-12 ▬▬ MSCI All Country Far East excluding Japan ▬▬ Equity issuances ▬▬ Bond issuances ▬▬ iBoxx ABF Pan Asia Total Return Index (Unhedged) Source: Thomson Datastream and Bloomberg. Source: Dealogic. Note: Shaded segments designate the announcement windows for each QE program, Note: Shaded segments designate the announcement windows for each QE program, together with the 30-day period following the May 22 speech on QE tapering. The together with the 30-day period following the May 22 speech on QE tapering. “MSCI AC (All Country) Far East excluding Japan Index” is a free-float–adjusted, market-capitalization–weighted index that measures the equity market performance of China, Hong Kong SAR, Indonesia, the Republic of Korea, Malaysia, the Philippines, Thailand, Singapore, and Taiwan, China. The “Markit iBoxx ABF Pan-Asia Index” tracks the performance of local-currency–denominated bonds issued by governments and quasi- government entities in China, Hong Kong SAR, Indonesia, the Republic of Korea, Malaysia, the Philippines, Thailand, and Singapore. yy Likewise, new bond and equity issuances reacted positively to the QE1 announcement and implementation (Figure 25). There was a drop-off starting in January 2010, but flows recovered after mid- 2010. For equity, the QE2 announcement was followed by a peak in issuance. Activity then fell off during QE2 implementation, stabilizing at around US$5 billion per month late in Operation Twist and through much of the QE3 period. For bonds, activity proved extremely volatile during QE2 and Operation Twist. It recovered sharply following the QE3 announcement, reaching a postcrisis peak of US$9 billion in May 2013. yy Similarly, new syndicated bank borrowing rose steadily after the QE1 announcement (Figure 26). Activity reacted positively to the QE2 announcement, but like bond issuance proved volatile during the QE2 and Operation Twist period. It rose sharply during QE3 implementation, exceeding US$7 .5 billion in June 2013. Overall, cross-border loans accounted for two-thirds of total inflows over the last three years. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 44  |  Part II. Selected Emerging Issues Figure 26. New syndicated bank loans, East Asia and Figure 27. Real effective exchange rates, East Asia and Pacific Pacific in U.S. dollar billions, 3–month moving average January 2008 = 100 (increase = appreciation) 10 140 QE1 QE1 QE3 QE3 QE2 QE2 Operation Twist Tapering Talk Operation Twist Tapering Talk 9 130 8 7 120 6 5 110 4 100 3 2 90 1 0 80 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jun-13 Jan-08 Jul-08 Jan-09 Jul-12 Jan-13 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jan-13 Jul-13 Jul-12 ▬▬ China ▬▬ Indonesia ▬▬ Thailand ▬▬ Malaysia ▬▬ Philippines ▬▬ Vietnam Source: Dealogic. Source: IMF. Notes: Shaded segments designate the announcement windows for each QE program, Notes: Shaded segments designate the announcement windows for each QE program, together with the 30-day period following the May 22 speech on QE tapering. together with the 30-day period following the May 22 speech on QE tapering. As part of the macroeconomic response to QE:  yy Real effective exchange rates appreciated by 5 to 25 percent overall between January 2008 and June 2013 (Figure 27). Individual exchange-rate paths varied significantly.29 In those economies where currencies appreciated relatively less (such as Hong Kong, SAR; and Malaysia), housing prices increased relatively more (Cho and Rhee 2013). yy International reserves increased significantly, and current accounts remained relatively solid. The major exception was Indonesia, whose current account swung into deficit in 2012 (reflecting weaker prices for commodities such as coal and palm oil), and has since deteriorated to a 4.4 percent of GDP deficit (2013 Q2). Related to this, Indonesia’s reserves have decreased by 20 percent over the last two years. yy Monetary conditions eased significantly. Figure 28. Domestic credit growth Some countries, such as Thailand, lowered the in percent, year-on-year policy rate; others, such as Indonesia, lowered 70 the bottom of the interest-rate corridor. Between 60 2008 and 2012, domestic credit in Indonesia 50 grew at a particularly rapid average 21 percent 40 per year. Malaysia, the Philippines, and Thailand 30 also recorded fast credit growth, on the order of 20 10 percent or more per year on average (Figure 10 28). 0 -10 Q1-11 Q1-12 Q1-13 Q2-13 Q1-07 Q1-08 Q1-09 Q1-10 yy Only limited use was made of tighter ▬▬ China (broad credit) ▬▬ China ▬▬ Indonesia ▬▬ Malaysia ▬▬ Philippines macroprudential regulation and capital- ▬▬ Thailand ▬▬ Vietnam flow management measures. For instance, Sources: CEIC and IMF, IFS. 29 China and Vietnam depreciated during QE1, but then appreciated. Indonesia appreciated sharply during QE1 implementation, stabilized through QE2, depreciated through Operation Twist, and then appreciated during QE2. Thailand depreciated midway through QE1, recovered midway through QE2, and then appreciated more sharply through May 2013. Malaysia and the Philippines followed a similar pattern. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part II. Selected Emerging Issues  |  45 Indonesia introduced and then tightened capital-flow management measures, including a minimum holding period for central bank bills; and also introduced prudential limits on consumer and mortgage lending. Thailand relaxed controls on capital outflows. Conversely, recent uncertainty surrounding the tapering of QE has led to considerable financial turbulence in EAP; Indonesia has been affected most strongly. Between late May and end-August 2013, amid expectations of rapid tapering and a generalized repricing of risk, U.S. long-term yields spiked by approximately 100 bps, average credit default swap spreads for EAP widened to 120 bps, and regional equity and bond funds experienced outflows of more than US$25 billion. Long-term bond yields rose by over 320 bps in Indonesia, and approximately 100 bps in Malaysia, the Philippines, and Thailand. Emerging Asia’s composite stock market index fell by more than 10 percent, with Indonesia, the Philippines, and Thailand all undergoing declines of 20 percent or more. Long-term bond yields rose by over 250 bps in Indonesia, and 75 bps in Malaysia and Thailand. New equity and bond issuances moderated. And currencies depreciated (in nominal dollar terms) by over 10 percent in Indonesia, and over 6 percent in Malaysia, the Philippines, and Thailand. In September, as concerns about tapering diminished (especially in the wake of the Federal Reserve FOMC meeting on September 18), many of these developments were largely reversed.30 Prospects The tapering of QE will increase global interest rates and reduce capital flows to developing countries. Existing studies identify a strong impact of U.S. monetary policy on global interest rates (Kennedy and Palerm 2013). Likewise, global push factors, including, in particular, increases in U.S. interest rates, do affect capital flows to emerging markets, through the portfolio-rebalancing channel (IMF 2013b). In addition, higher U.S. interest rates may encourage a reassessment of country-specific vulnerabilities. Bond flows may be particularly sensitive, and hence a particularly important potential source of risk. Economies may be especially vulnerable to the extent that they have significant external financing requirements, saw rapid credit growth when interest rates were low, or have experienced large increases in debt. Indeed, markets appear to be discriminating on the basis of country fundamentals. Indonesia’s high bond yields partly reflect its current-account deficit. Again, in Indonesia, and in Malaysia, the Philippines, and Thailand, there are concerns about rapid credit growth leading to financial-sector overextension. Gross national debt now exceeds 150 percent of GDP in Malaysia, China, and Thailand, and 100 percent of GDP in the Philippines (Figure 29; see also note on “China’s Credit Binge May Have Run Its Course,” in this Economic Update). Specific concerns include a sharp increase over the last few years in household debt in Malaysia and Thailand,31 and high leverage in state-owned enterprises in Vietnam. In addition, nonperforming loans are relatively high in Indonesia, the Philippines, and Thailand (Figure 30). 30 For instance, during the first three weeks of September, stock markets in Indonesia, the Philippines, and Thailand recovered more than the half of the losses incurred after May 22, and those in Malaysia rose above the May 22 levels. Likewise, most EAP currencies appreciated against the U.S. dollar, with some returning to their May 22 levels. 31 For instance, loans to households in Thailand increased from nearly 55 percent to 77 percent of GDP between 2009 and 2013. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 46  |  Part II. Selected Emerging Issues Figure 29. Debt stock outstanding Figure 30. Bank nonperforming loans in percent of GDP, end-2012 in percent of total loans 8 IDN 7 PHL 6 5 THA 4 3 CHN 2 MYS 1 0 0 50 100 150 200 250 China 1/ Indonesia 2/ Malaysia /3 Philippines /4 Thailand /5 JJ General government JJ Nonfinancial corporations JJ Households JJ Dec-07 JJ Latest JJ Financial institutions Sources: World Bank staff estimates. Sources: National Statistical Agencies. Note: Latest values refer to either June 2013 (China and Thailand) or March 2013 (all other countries). The values are exclusive of bad-loan transfers to asset management companies (AMCs). Quantitatively, the likely impact of tapering on 1. Covers only the major commercial banks for 2002–04, and all commercial banks for 2005–10. yields and capital flows remains unclear, but 2. Excludes the Indonesian Bank Restructuring Agency’s AMC. Data for 1997 to 2002 may well prove relatively large. Two factors will exclude state banks; the data source is the Monetary Division of Bank Indonesia. Data from 2003 cover all commercial banks including state banks; the data source is the amplify the impact of tapering, compared with the Banking Supervision Division of Bank Indonesia. 3. Excludes Danaharta. This series, used by Bank Negara Malaysia, is net of provisions relatively small effects often associated with the and excludes interest in suspense. Beginning financial year 2010, banking institutions are required to report impaired loans in accordance with the Guideline on the Classification later stages of QE. First, tapering was relatively and Impairment Provisions for Loans/Financing. The reporting of nonperforming loans has since been discontinued. unanticipated. Second, and related, tapering may 4. Includes interbank loans. 5. Excludes transfers to AMCs. The jump in headline nonperforming loans in December lead to a significant reevaluation of country-specific 2002 was a one-off increase, reflecting a change in definition, and did not affect provisioning. risks. Still, the lack of consensus suggests that volatility is likely to remain elevated for an extended period. World Bank (2013) points out that, if real base rates return to their long-term averages, they could rise from 190 bps in June 2013 to approximately 320 bps (the mean level during 1990–2007). In turn, this could cause developing-country yields to rise by between 150 and 270 bps, with countries with worse credit histories and greater spreads toward the upper end of this range. As for capital inflows, IMF (2013b) implies that a 130 bps increase in the U.S. 10-year yield would reduce capital flows to emerging markets by only 2 percent—significantly less than what was observed between end- May and August 2013. However, these effects could be compounded by induced changes in risk perceptions and risk appetite. In contrast, IMF (2011) suggests that an unanticipated 130 bps rise in U.S. real interest rates may on average cause a significantly higher 13-percentage-point-of-GDP reduction in net capital inflows in the first quarter, and a 32.5-percentage-point-of-GDP cumulative reduction after two years. The impact would be larger in countries with greater financial links with the United States, and would primarily affect bond rather than equity flows. Higher interest rates and lower capital inflows will in turn affect broader economic activity and output. Over the long run, investment and potential output will decrease. Simulations suggest a 130 bps increase in U.S. long-term yields may reduce potential output growth rates in developing countries by 0.6 percent per year (World Bank 2013). In the short run, and in line with our discussion of country-specific vulnerabilities, there are concerns about potentially overextended domestic financial sectors, which could experience sharp, sudden WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part II. Selected Emerging Issues  |  47 adjustments, disruptions, and difficulties in rolling over loans. Tighter global financing conditions may be reflected in a “sudden stop” in capital inflows, a particular concern in those economies, such as Indonesia and Malaysia, where foreign holdings of local securities have been rising rapidly.32 The effects would be compounded by currency depreciation in the presence of unhedged foreign-currency exposure. More broadly, a rise in global interest rates will affect credit conditions in any economy financially integrated with the rest of the world. Higher global interest rates will, among other things, reduce emerging-market asset prices, with potentially disruptive adverse balance-sheet effects for any leveraged asset holders, including banks and households. And all these effects would be exacerbated by a general slowdown in the region, reflecting, for instance, rebalancing in China (see Part I of this Economic Update). Still, most EAP economies are in a relatively strong position to face this shock, with significantly lower vulnerabilities than in the run-up to the 1997–98 Asian crises. Exchange rate regimes are more flexible. Current account positions are relatively solid, with the above-mentioned exception of Indonesia (Figure 31), and net external debt has diminished. Foreign-exchange reserves have increased, and are adequate to cover short- term external financing requirements (Figure 32); again, the main outlier is Indonesia, where short-term external debt stands at 49 percent of reserves (end-2012). Financial systems are better regulated, nonperforming loans have decreased steadily over time, and reliance on external borrowing in foreign currency has declined sharply, reducing vulnerability to currency mismatches during periods of sharp exchange rate volatility (Citi Research 2013). For instance, the banking sector in Indonesia retains a solid 16 percent ratio of capital to risk-weighted assets. And public debt remains relatively low; one outlier is Thailand, where public debt exceeds 45 percent of GDP and is projected to rise. Figure 31. Current account Figure 32. Foreign exchange reserves in percent of GDP Relative to total external financing requirements (short-term external debt repayments, plus current-account deficit), in percent 20 2,000 1,800 15 1,600 1,400 10 1,200 5 1,000 800 0 600 400 -5 200 -10 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013f 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 ▬▬ China ▬▬ Indonesia ▬▬ Malaysia ▬▬ Philippines ▬▬ Thailand ▬▬ China ▬▬ Indonesia ▬▬ Malaysia ▬▬ Philippines ▬▬ Thailand Sources: CEIC, IMF. Sources: BIS-IMF-OECD-World Bank Joint External Debt Hub, IMF. The impact of QE tapering on EAP capital inflows may to some degree be offset by monetary accommodation in Japan. Japan’s new strategy to exit deflation and revive growth involves aggressive monetary easing, fiscal expansion, and growth-enhancing structural reforms. In particular, the Bank of Japan’s new Quantitative and Qualitative Monetary Easing framework seeks to double the monetary base (an increase of 27 percent of GDP) in two years, expanding the scope and scale of asset purchases to achieve the recently adopted 2 percent inflation target. The potential financial spillovers, through expanded bank lending, portfolio 32 Nonresidents accounted for approximately 32 percent of local-currency bonds in Indonesia, 28 percent in Malaysia, and 15 percent in Thailand (as of April 2013). REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 48  |  Part II. Selected Emerging Issues rebalancing, and increased outward foreign direct investment, remain unclear and will depend on developments in both interest rates and Japan’s domestic outlook. Capital outflows have so far remained moderate, reflecting Japan’s relatively inward-looking financial system. Also, based on past trends, only a modest share of any additional portfolio flows will go to emerging EAP economies (IMF 2013b). Nevertheless, the impact on recipient countries with relatively thin capital markets could be large. The impact on regional output will additionally depend on exchange rate developments, with the yen already weakening by 20 percent since the announcement of the new strategy, and on the success of Japan’s fiscal expansion and structural reforms. Conclusions Plans by the Federal Reserve to taper its QE program will result in a less favorable external financing environment for EAP . The region will face higher borrowing costs, lower capital inflows, and a decline in regional asset prices. In the long run, this will affect investment and potential output. In the short run, it also raises concerns about potentially overextended domestic financial sectors. Estimates of the impact vary widely, but it is likely to prove larger in economies characterized by greater financial openness, significant current account deficits, rapid credit growth in recent years, or large increases in debt. However, changes in U.S. monetary policy will themselves reflect, and may be partly offset by, broader economic developments. An unwinding of the U.S. monetary stimulus will occur if, and to the extent that, the U.S. economy is strengthening. This will be a welcome development for countries that benefit, through trade or other linkages, from stronger U.S. growth. In the short term, EAP economies face several policy options. In general, macroeconomic policy stances will need to be adjusted to contain or prevent a deteriorating current account, inflation, and asset-price bubbles, and to maintain capital inflows. The appropriate response will involve a mix of exchange-rate depreciation and higher interest rates, with the correct balance depending on the starting level of economic activity, inflation, and the degree of exposure to foreign-currency-denominated liabilities. Monetary tightening will help minimize any inflationary impact, but will affect growth negatively. In some countries, fiscal consolidation may help restore market confidence. In addition, some intervention in foreign exchange markets, running down reserves, may help moderate excessive exchange-rate volatility or short-term liquidity pressures. Those countries most vulnerable to swings in global capital flows should also reduce their reliance on short-term and foreign-currency- denominated debt.33 Over the longer term, developing EAP can reduce the cost of its borrowing by strengthening its domestic institutions and further improving the investment climate. Several economies have failed to generate ” in sufficient, high-quality employment, particularly for their youth (see note on “At Work in East Asia and Pacific, this Economic Update). Many are failing to develop a sufficiently sophisticated manufacturing industry. Potential measures to boost competitiveness and enhance stability include: yy Strengthening the rule of law and property rights, including by reducing rent-seeking opportunities 33 In contrast, capital flow management measures on outflows should only be used in a crisis situation, and “should always be part of a broader policy package that also includes macroeconomic, financial sector, and structural adjustment to address the fundamental causes of the crisis” (IMF 2012, 26). WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part II. Selected Emerging Issues  |  49 yy Reforming financial systems, including by enhancing the quality of macroprudential and other financial regulations (as is on the agenda in China) yy Accelerating the pace of structural reforms, including in labor markets (for instance, increasing female labor force participation and boosting labor skills in Malaysia), and in subsidy regimes (for instance, reforming fuel subsidies in Indonesia and Malaysia and rice subsidies in Thailand) yy Improving infrastructure, including in power and transportation (including in Indonesia, the Philippines, and Thailand). This will require significant progress in project appraisal, selection, implementation, and evaluation, coupled with mobilizing private financing yy Liberalizing foreign direct investment inflows, including in the natural resource and banking sectors (including in Indonesia and the Philippines). Several economies failed to use the breathing space afforded by an extended period of low interest rates to improve their fundamentals. They should not now waste the near-term relief provided by developments in September. Still, the outlook for most EAP economies is relatively favorable. Their vulnerabilities are far more limited than in the past. Until recently, the key concern in emerging markets was excessive capital inflows. Lower capital flows will instead weaken pressures for exchange rate appreciation, ease concerns about a potential loss of competitiveness, and reduce the risk of asset bubbles. And global interest rates, even if significantly increased, remain at historic lows. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 50  |  Part II. Selected Emerging Issues REFERENCES Ahmed, Shaghil, and Andrei Zlate. 2013. “Capital Flows to Emerging Market Economies: A Brave New World?” International Finance Discussion Papers 1081, Board of Governors of the Federal Reserve System. www.federalreserve.gov/pubs/ifdp/2013/1081/ifdp1081.pdf. Chen, Qianying, Andrew Filardo, Dong He, and Feng Zhu. 2012. “International Spillovers of Central Bank Balance Sheet Policies. ” In Are Central Bank Balance Sheets in Asia Too Large?, Bank for International Settlements Papers 66, pp. 230–274. www.bis.org/publ/bppdf/bispap66p.pdf. Cho, Dongchul, and Changyong Rhee. 2013. “Effects of Quantitative Easing on Asia: Capital Flows and Financial Markets. ” ADB Economics Working Paper 350, Asian Development Bank, Manila, June. www.adb.org/ sites/default/files/pub/2013/ewp-350.pdf. ” Citi Research. 2013. “Asia Macro View: External Vulnerabilities in Historical Context. Fratzscher, Marcel, Marco Lo Duca, and Roland Straub. 2013. “On the International Spillovers of US Quantitative Easing.” European Central Bank Working Paper 1557 , Frankfurt. www.ecb.int/pub/pdf/scpwps/ ecbwp1557 .pdf. IMF (International Monetary Fund). 2011. “International Capital Flows: Reliable or Fickle?.” In World Economic Outlook: Tensions from the Two-Speed Recovery: Unemployment, Commodities, and Capital Flows, Ch.4, April. Washington, DC: International Monetary Fund. http://www.imf.org/external/pubs/ft/ weo/2011/01/pdf/text.pdf. IMF (International Monetary Fund). 2012. “The Liberalization and Management of Capital Flows: An Institutional View.” International Monetary Fund, Washington, DC. ———. 2013a. “Unconventional Monetary Policies—Recent Experience and Prospects. ” International Monetary Fund, Washington, DC, April. www.imf.org/external/np/pp/eng/2013/041813a.pdf. ———. 2013b. 2013 Spillover Report. IMF Policy Paper, International Monetary Fund, Washington, DC, July. www.imf.org/external/np/pp/eng/2013/070213.pdf. ———. 2013c. Global Financial Stability Report: Old Risks, New Challenges. International Monetary Fund, Washington, DC, April. www.imf.org/external/pubs/ft/gfsr/2013/01/pdf/text.pdf. Kennedy, Michael, and Angel Palerm. 2013. “Emerging Market Bond Spreads: The role of Global and Domestic Factors from 2002 to 2011. ” Unpublished. Moore, Jeffrey, Sunwoo Nam, Myeongguk Suh, and Alexander Tepper. 2013. “Estimating the Impacts of U.S. LSAPs on Emerging Market Economies’ Local Currency Bond Markets. ” Federal Reserve Bank of New York Staff Report 595. www.newyorkfed.org/research/staff_reports/sr595.pdf. World Bank. 2013. Global Economic Prospects, June 2013: Less Volatile but Slower Growth. Washington, DC: World Bank. http://hdl.handle.net/10986/13892. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 |  51 Part III. The Medium-Term Development Agenda REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 52  |  Part III. The Medium-Term Development Agenda III.A. At Work in East Asia and Pacific1 Labor markets and their contribution to growth and household well-being are a growing concern in East Asia and Pacific. Problems include high youth inactivity, rising inequality, and binding skills shortages. A key underlying issue is widespread economic informality, which increases household vulnerability to shocks, limits the tax base, and constrains innovation and productivity. Informality is both a consequence of relatively stringent labor regulations, and a reason for their widespread evasion. Key components of the appropriate policy response include macroeconomic stability, and a regulatory framework that encourages, in particular, the small and medium-size enterprises where most people in East Asia and Pacific work. It is also critical to “formalize” more work, so as to increase the coverage of essential work- risk and social protection, and to sustain growth. To this end, policies should encourage mobility of labor and human capital, and not favor some forms of employment (for instance, full-time wage employment in manufacturing) over others. Among the more specific challenges, mainly agrarian countries should focus on raising agricultural productivity. In urbanizing countries, good urban planning becomes critical. The Pacific Island Countries should provide youth with the human capital needed to succeed abroad as migrant workers. The Triumph of Work for Well-Being Economic development in East Asia and Pacific (EAP) is a triumph of working people. EAP has experienced industrialization, urbanization, and economic diversification at historically unprecedented rates. In the last two decades, rapid changes boosted agricultural output and triggered large movements of people to towns and cities and into work in factories and firms, raising factor productivity in most of the region. The concentration of working people and enterprises boosted output in fast-growing cities. Countries that were low income a generation ago successfully integrated into the global value chain, exploiting their labor cost advantage. In 1990, the region held about a third of the world’s labor force. Leveraging this comparative advantage, developing EAP’s share of global GDP grew from 7 percent during 1990–92 to 17 percent during 2009–11. Sound policies and good economic institutions have encouraged private-sector-led growth and demand for work, and enhanced resilience. Price stability, low public debt, and relatively light taxation in many parts of the region facilitated doing business and investment. Widespread access to adequate health and education ensured a strong foundation of human capital. Given these strong fundamentals and increasing integration with the global economy, EAP was able to sustain high growth rates and maintain its resilience during the global financial crisis of 2008–10. A number of EAP countries continued to generate employment in 2009 and 2010, in contrast to the job losses experienced by most Central and Eastern Europe countries, and muted employment growth in other developing regions. 1 ” This note was prepared by Truman Packard and Trang Van Nguyen and is based on a forthcoming World Bank report, “At Work in East Asia Pacific. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part III. The Medium-Term Development Agenda  |  53 Sustained high rates of economic growth have been necessary, though not sufficient, to ensure well- being from work. Growth has improved employment outcomes, fueled gains in living standards, and mitigated social tensions. The rise in labor productivity in EAP during the 1990s and 2000s was far greater than in Latin America, Eastern Europe, and the OECD countries. China’s threefold and Vietnam’s almost twofold growth in labor productivity since 2000 are particularly impressive. Households reaped the benefits of greater productivity in higher earnings: rising labor income accounted for more than 40 percent of poverty reduction in the late 2000s in a number of EAP countries (Figure 1). The share of the region’s population living in extreme poverty (that is, on less than US$1.25 a day) declined by more than half since 1990, from the highest level across all regions to among the lowest. Working people experienced stark changes in their lives within a generation: shifts from rural farms to urban factories, the breakdown of village institutions and community property rights, and Figure 1. Income from work explains a large share of the the weakening of extended family structures. But reduction in poverty these changes neither created significant political Results from a decomposition of poverty changes into different components 150 debate nor catalyzed social tension, because so many were moving out of poverty and into the urban 100 middle class, against a backdrop of fast growth. In 50 that sense, as argued in the World Development Report 2013: Jobs (World Bank 2012), work has 0 been the conduit connecting and enabling three -50 critical development transformations: productivity -100 gains, improvements in living standards, and greater social cohesion—which are collectively referred to -150 here as increases in “well-being. ” For much of their KHM THA PHL MNG VNM TMP JJ Wage JJ Farm JJ Nonfarm recent history, EAP countries have managed to JJ Nonlabor JJ Share of adults JJ Share of working adults achieve these three development transformations in Sources: Staff estimates based on Cambodia Socio-Economic Survey (2007 , 2010), Thailand Household Socio-Economic Survey (2006, 2009), Philippines Family Income and tandem. Expenditure Survey (2006, 2009), Vietnam Living Standards Measurement Survey (2004, 2010), Mongolia Household Socio-Economic Survey (2007/8, 2011), and Timor-Leste Survey of Living Standards (2001, 2007). Rising Challenges to Well-Being from Work In the last few years, the news headlines about work in EAP have started to change. Among the usual articles about growth, productivity, and poverty reduction are stories of a very different character. Since 2009, reports of discontent and sometimes drastic action by Chinese factory workers in protest against poor working conditions have become more frequent. There have been growing instances of strikes in Indonesia, a twofold increase of “wildcat” strikes in Vietnam over 2011, and frequent clashes between garment-factory workers and police in Cambodia. These reports seem at odds with the widely accepted narrative of the region’s rise, and signal rising demand for government action to sustain household and social well-being from work. Widespread economic informality—work and other transactions in unregulated and untaxed markets— is critical to understanding the growing concerns about work and well-being, despite the region’s successes. The exact dimensions of the informal economy are difficult to measure, because only proxies are available. As a region, EAP has the second-highest share of the labor force working outside of wage and salaried employment, surpassed only by countries in Sub-Saharan Africa. A large portion of this activity in agrarian countries like Lao PDR, Cambodia, and Papua New Guinea reflects “structural informality,” since REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 54  |  Part III. The Medium-Term Development Agenda many still work in subsistence or small-shareholder farming. Typically, this type of informal work decreases with structural change away from agriculture. However, in all middle-income countries, even those with large manufacturing and service sectors, a persistent share of the labor force continues to work beyond the reach of taxation, regulation, and protection. This informal work (whether measured as nonfarm self-employment, those working without a labor contract, people working in microenterprises with five or fewer workers, or the segment of the workforce that fails to contribute to social security) is higher in many EAP countries than in other countries at similar income levels (Figure 2). Figure 2. “Informal” forms of work are more common in East Asia and Pacific than other countries at similar levels of development a. Own Account and Unpaid Family Workers as a Share b. Share of the Labor Force that Contributes to Pensions of the Labor Force (2010) (Latest Available Year) Vulnerable employment, in percent Share of pension contributors in the labor force, latest year, in percent 100 2 100 R = 0.6873 JPN 90 90 AUS LAO 80 80 KOR Vanuatu 70 Timor-Leste 70 KHM VNM 60 60 IDN MNG Tonga THA MYS 50 50 MNG PHL 40 40 Fiji CHN 30 30 KOR PHL 20 MYS 20 VNM THA JPN 10 10 IDN New Zealand Australia SGP TLS PNG 0 0 KHM LAO 500 10,500 20,500 30,500 40,500 50,500 60,500 70,500 80,500 500 1,000 2,000 4,000 8,000 16,000 32,000 64,000 Income per capita PPP (2005 international $) GDP per capita 2010 ($2005) ‹‹ World QQ East Asia SS Pacific ▬▬ Expon. (World) QQ EAP ‹‹ ECA ‹‹ OECD ‹‹ LAC ‹‹ MENA ‹‹ SAR ‹‹ SSA Source: Staff estimates, using World Development Indicators. Sources: World Bank Pensions Database (2013) and World Development Indicators. High levels of informal work in EAP are not per se harmful, but may have undesirable side effects. The informal economy provides a living to many who would otherwise be destitute. And, across the region, many informal workers and enterprises are well integrated into domestic, regional, and international production chains. Often, the output of the informal economy either is an intermediate input to formal-sector factories and firms, or is consumed by people who themselves work in or provide services to the formal economy. The problem arises when the prevalence of informal economic activity constrains innovation and productivity, when the tax base is so small that governments find it difficult to provide public goods, and when working informally limits households’ options for managing shocks to their well-being or makes it more difficult for them to seize opportunities. The high levels of informal work in EAP are both a consequence of relatively stringent de jure labor and social protection policies, and a reason for their widespread evasion. Overall, the history of state intervention in labor and social protection policy in EAP is modest relative to that of countries in other regions. EAP governments started regulating their labor market much later than in Latin America and Central and Eastern Europe, and provide fewer social programs. But several governments in emerging East Asia have recently stepped into this arena of policy making with levels of intervention similar to Southern European countries (Figure 3). For instance, formal employment protection legislation is highly restrictive in Indonesia, where workers whose employment is regulated enjoy more de jure protection than workers in France, Greece, or Portugal, and only slightly less protection than workers in Spain. In China, workers in regulated employment are de jure more difficult to dismiss than workers in Belgium and Italy. In the Philippines, as a result of labor WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part III. The Medium-Term Development Agenda  |  55 Figure 3. Some countries in East Asia and Pacific have similar restrictions on dismissal as countries in Southern Europe Employment protection legislation index (2008–2010) 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0 USA SGP* CAN GBR MYS* NZL IRL AUS BRN JPN CHE MNG* KOR DNK SVK CZE HUN SWE NLD FIN THA* LAO* KHM* POL AUT PHL* VNM* DEU ISL ITA BEL LUX NOR CHN* FRA* PRT GRC IDN* ESP MEX TUR ASEAN+ OECD-30 ECA JJ Protection of permanent workers against (individual) dismissal JJ Regulation on temporary forms of employment JJ Specific requirements for collective dismissal Source: Staff estimates. Notes: Score ranges from 0 (least stringent) to 6 (most restrictive). *denotes ASEAN+ countries. OECD average includes a sample of 30 countries; values refer to 2010. ECA values are for 2007, and only reflect a total (with no breakdown by category). regulation, the average statutory minimum wage, relative to value added per worker, exceeds the level in 90 percent of countries in the world.2 Cambodia and Indonesia are not far behind. Even labor regulations set at reasonable levels but poorly implemented can aggravate the market failures they were designed to overcome. Evidence on the impact of minimum wages and employment protection legislation on employment outcomes across countries is mixed. Set at reasonable levels, the impact of these regulations has been found to be negligible in countries with strong institutions and higher administrative capacity. However, even where labor regulations have a limited impact on overall employment, unemployment, and wages, they have distributional consequences that favor prime-aged men at the expense of women, young people, and those who work part time and in self-employment. For instance, minimum wages in ASEAN disproportionally lower the employment opportunities of low-skilled people, women, youth, and recent entrants into the labor market (Box III.1). The prejudicial impact of labor regulation on the forms of work that are prevalent in most EAP countries is a growing problem that creates both segmentation and exclusion. The extent of informal activity is positively associated with levels of de jure employment protection and labor taxation. In China, the 2008 Labor Contract Law attempted to expand social insurance coverage, financing it through increased payroll taxes. This was associated with a lower probability of local employed residents’ being protected (Giles, Wang, and Park 2013). Louder and More Frequent Calls for Action Questions about the links between work and well-being have started to surface in EAP with greater frequency and urgency. This is to be expected since most EAP countries, including the most populous (China and Indonesia), are now at a development stage where the three transformations propelled by work (gains in 2 For instance, it is much higher than in Belgium and France, as well as in high-income countries in the region, such as Australia and New Zealand. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 56  |  Part III. The Medium-Term Development Agenda Box III.1. Minimum Wages in the ASEAN-41 Introduction Rising inequality and persistent poverty in East Figure BIII.1. Ratio of Minimum wages to average Asia are generating increasing interest in the wages in East Asia and the OECD use of minimum wage policies. In Indonesia, the in percent Philippines, Thailand, and Vietnam, major reforms 80 to minimum-wage policies have been recently 70 60 implemented or are under discussion. Thailand, for 50 instance, introduced a nationwide minimum wage 40 of 300 baht per day early in 2013, while Indonesia 30 is discussing the movement to a two-tier monthly 20 minimum wage. Both policy changes entail quite 10 dramatic increases over previous levels,2 and 0 concerns exist as to their effects, especially given PHL (2011) IDN (2012) KHM (2010) MNG (2010) THA (2011) VNM (2010) CHN (2010) LAO (2009) NZL FRA SVN AUS BEL IRL NDL LTA CAN PRT GBR POL LTU SVK HUN LUX ESP TUR EST GRC KOR JPN ROU CZE USA MEX OECD-26 the already high levels of statutory minimum wages in ASEAN countries (Figure BIII.1).3 Source: World Bank (2013a). Note: OECD figures are for 2010. Overview of Minimum Wage Regimes in the ASEAN-4 Minimum wage regimes in the ASEAN-4 are complex. As is common throughout the developing world, the ASEAN-4 countries differentiate minimum wages by age, geographical area, sector, and/or category of work, with Indonesia and the Philippines delegating wage setting to subnational authorities, and Vietnam also providing for regional variation.4 In the Philippines, this results in over 200 different daily minima, ranging from P190 to P426, which are frequently changed.5 Multiple minimum wage regimes are designed to tailor wages to sectoral differences in productivity and labor intensity, and to account for regional cost-of-living differences. However, these regimes necessitate a complex system of oversight by the relevant authorities or by trade unions (Cunningham 2007). In recent years, many ASEAN-4 countries have put forth policies to reform minimum wage regimes. In early 2013, Thailand unified 32 minimum wages into a common rate of 300 baht per day, making it the only country in the region with a national minimum, albeit a very high one. Vietnam, after long applying different rates to the foreign and domestic sectors, homogenized the private-sector minimum wage in 2011, leaving only four region-specific minimum wages. Indonesia, which currently presides over a variegated regime similar to the Philippines, has mooted introducing two-tier monthly minimums of US$228 for Jakarta and US$ 208 for the rest of the country. The Philippines is piloting the adoption of a two-tier regime, with a mandatory fixed “floor 1 This box was prepared by Andrew Beath. The box is based on the forthcoming World Bank report, Minimum Wage Policy: Lessons with a Focus on the ASEAN Region, by Ximena Del Carpio and Laura Pabon. 2 For Thailand, a 39.5 percent increase in the prevailing minimum wage in the 70 poorest provinces. For Indonesia, a 44 percent increase in the minimum wage in Jakarta. 3 The ratio of minimum wages to average wages exceeds 50 percent in Cambodia, Indonesia, Mongolia, the Philippines, and Thailand. Indeed, in the Manila region, in 2012, minimum wages were set at almost 90 percent of average wages (World Bank 2013b). The ratio of minimum wages to average value added per worker exceeds 40 percent in Cambodia, Indonesia, Lao PDR, the Philippines, and Vietnam—levels unmatched by any OECD country. 4 In contrast, advanced economies in the region, such as Hong Kong and South Korea, apply minimum wages to all employees without regard to regional or occupational differences. 5 Since 1989, when Congress decentralized minimum wage setting to the regions, minimum wages have been adjusted almost every year. The minimum wage in the Manila region, for instance, has been adjusted 17 times in the last 22 years (World Bank 2013b). WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part III. The Medium-Term Development Agenda  |  57 wage” set by the regional wage boards based on the poverty threshold and average wage, supplemented by an optional second tier consisting of an industry- or firm-specific rate based on productivity. Complex regimes, abundant exceptions, lax enforcement, and high levels of informality limit the coverage of minimum wages in the ASEAN-4. In Thailand, minimum wages do not apply to government, domestic, or agricultural employees, or to part-time or student workers. Similarly, the Philippines applies minimum wages only to wage and salary workers in certain private companies; as a result, minimum wages are estimated to cover less than a third of the country’s workforce.6 Enforcement regimes are generally underresourced,7 resulting in widespread noncompliance even in the formal sector. Currently, over half of agricultural and nonagricultural workers in the Philippines earn less than the minimum, while noncompliance rates are estimated at around one-third in Thailand and Indonesia and approximately 10 percent in Vietnam. The Impact of Increases in the Minimum Wage Economic theory provides limited guidance as to the effects of minimum wages. Neoclassical economic analysis, assuming perfect information and competitive labor markets, implies that imposing minimum wages above market-clearing levels will increase wages but reduce (formal) employment. However, when these assumptions are relaxed, predictions become less clear. Where an employer enjoys monopsony power (that is, hiring decisions by one firm affect the market-clearing wage), minimum wage increases need not reduce employment. Hence, contextual factors (including the competitiveness of the labor market, enforceability of minimum wage laws, elasticities of labor demand, information asymmetries, and impediments to labor mobility) ultimately determine the overall effects of minimum wages. Context-specific empirical evidence is thus critical to understanding the impacts of changes to minimum wages in particular countries. Empirical evidence on minimum wages in the ASEAN-4 is thin, but indicates that high minimum wages limit the access of poor workers to formal sector jobs. Studies of labor markets in Indonesia, Thailand, and Vietnam show that increases in minimum wages are associated with a reduction in formal sector employment,8 although the change may be at least partially offset by increased informal employment.9 Evidence from the Philippines indicates that a 10 percent minimum wage increase in the manufacturing industry reduced formal employment in the sector by up to 8 percent, and that the high level of minimum wages may inadvertently undermine the country’s garment industry (World Bank 2013b). Low-income or otherwise vulnerable workers (including women, youth, recent labor-market entrants, the low-skilled, nonmanagerial nonproduction workers such as cleaners or guards, elderly workers, and those employed by small firms) are particularly likely to be shut out of the formal labor market as a result of overly high minimum wages.10 6 World Bank (2013b). In the Philippines, the following firms can be temporarily exempted from paying minimum wages: (i) firms with less than 10 employees, (ii) firms less than three years old, (iii) firms having economic difficulties, (iv) firms that have suffered from disasters, and (v) worker-owned firms. 7 In 2011, the Philippines possessed only 270 labor inspectors, who were each assigned approximately 238 covered firms. An ILO report estimates that 40 percent of the Thai workforce is subject to labor legislation. 8 In Indonesia, minimum wages had a negative effect on levels of formal employment, particularly among small firms (Alatas and Cameron 2008; Del Carpio, Nguyen, and Wang 2012; Harrison and Scorse 2010). In Vietnam, increases in the real minimum wage reduced employment in domestic, but not foreign firms (Del Carpio, Nguyen, and Wang 2013). In the Philippines, real minimum-wage increases had negligible effects on overall employment, owing to the limited coverage of minimum wage rules and high noncompliance (Del Carpio, Margolis, and Okamura 2013). However, sectors with high coverage and compliance experienced negative employment effects (Lanzona 2012). 9 Comola and De Mello (2011) find that an increase in the minimum-to-mean ratio produces growth in informal employment and a positive net increase in total employment. 10 See Del Carpio, Nguyen, and Wang (2012) and Hallward-Driemeier, Rijkers, and Waxman (2010) for Indonesia; Del Carpio, Messina, and Sanz-de- Galdeano (2013) for Thailand; and Del Carpio, Nguyen, and Wang (2013) for Vietnam. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 58  |  Part III. The Medium-Term Development Agenda Given the limited coverage of minimum wages in Figure BIII.2. Self-employment rates in ASEAN+ the ASEAN-4, the vast majority of poor workers in in percent of total employment the region do not benefit directly from minimum 100 wage increases.11 The majority of poor workers 90 80 in the ASEAN-4 are self-employed, employed in 70 the informal sector, or otherwise exempt from 60 minimum wages (Figure BIII.2). There is some 50 evidence from developing economies outside 40 30 the region that minimum wage increases benefit 20 informal sector workers indirectly, by boosting their 10 bargaining power or through so-called “lighthouse” 0 LAO (2005) KHM (2008) IDN (2009) MNG (2009) THA (2009) PHL (2008) MYS (2009) SGP (2009) OECD (2009) ECA (2009) SSA (2009) LAC (2008) EAP (2008) SA (2008) or benchmarking effects.12 However, studies for ASEAN find no evidence of these positive wage Source: World Bank Indicators, 2010. effects for informal workers.13 The existence of multiple minimum-wage regimes in the ASEAN-4 creates serious problems.These complicated regimes are hard to administer and enforce. They are poorly understood by employers and workers, limiting their ability to serve as benchmarks for informal or otherwise uncovered workers (see above) (Cunningham 2007). Multiple minimum-wage regimes potentially “crowd out” firm-level wage bargaining; in addition, they can distort the economy by discouraging sectors or regions with relatively high minimum wages (ILO 2008). Policy Recommendations Minimum wages have not proved to be an effective tool for reducing poverty or inequality in the ASEAN-4. Under current regimes, poor workers are generally not covered by minimum wage policies, and therefore do not directly benefit from them. In addition, the limited number of poor workers with formal sector jobs have suffered most from the adverse employment effects of minimum wage increases, including by being pushed into informal employment. Minimum wages should be set at levels appropriate for vulnerable workers. Minimum wages should be benchmarks that limit the exploitation of vulnerable workers and protect their purchasing power, but do not inadvertently cause their exclusion from formal employment. To this end, minimum wages should be set at levels consistent with the productivity levels of unskilled workers. In some ASEAN-4 economies, minimum wages have served as a method of wage fixing, and have been set at levels which are unrealistically high for all but a subset of workers (ILO 2008). Such policies invite noncompliance and promote informal jobs, reducing social protections and tax revenues. Simplifying, standardizing, and enforcing minimum wages is a key priority. Among the ASEAN-4 economies, only Thailand has instituted a unified national minimum wage. By moving to appropriately set, standardized minimum wages, governments can reduce compliance costs and improve predictability for employers, enhance benchmarking effects for informal workers, stimulate firm-level collective bargaining, and reduce 11 Over half of the benefits from minimum wage increases in Indonesia in 2003 accrued to nonpoor households, and only one-in-four poor households experienced a wage increase (Bird and Manning 2004). 12 See Boeri et. al. (2010); Dinkelman and Ranchhod (2010); and Gindling and Terrell (2004). 13 For instance, Chun and Khor (2010) find that increases in the minimum wage for formal-sector employees in Indonesia have no spillover effects on the income of the self-employed. An additional consideration is that minimum wages may increase poverty by increasing the price of basic goods (Bird and Manning 2004 2008). WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part III. The Medium-Term Development Agenda  |  59 distortions. Where it proves necessary to make accommodations for special groups, such as youth, alternative policies should be considered, including training or wage subsidies. Finally, to increase compliance with minimum-wage policies, sufficient resources should be allocated to labor inspectors to audit employers and impose penalties. productivity, living standards, and social cohesion) are no longer happening at similar rates. Some countries experience direct threats to social cohesion, specifically from high youth unemployment and inactivity, as well as high and rising income and consumption inequality. For the region as a whole, more than 30 percent of people aged 15–24 are not in employment, education, or training. Fiji, Indonesia, the Philippines, Tuvalu, and Vanuatu have among the highest rates of youth inactivity in the world (Figure 4). High levels of youth inactivity have been linked to violence and eroding social cohesion, providing a strong motivation for governments to pay closer attention to the opportunities for youth to work or build human capital. Even where violence is not yet a concern, high rates of disengagement among youth can have a lasting impact on their future economic prospects, and ultimately limit the productive potential of a country as a whole. Figure 4. Youth Inactivity is high in some of the Pacific Island Countries, Indonesia, and the Philippines Youth (15–24) not in employment, education, or training, in percent, circa 2010 100 90 80 70 60 50 40 30 20 10 0 KHM VNM LAO MOZ SVK THA LTU CHN ECU NPL POL TZA CZE PAK PRY HND IND EST PAN ROU PER LVA BRA MYS BEL CRI HUN PRT SLV MNG DOM URY COL LKA ARG TLS BOL GRC PNG BGR IDN W.BANK/ GAZA ESP FJI PHL ITA TUR SRB MRT BWA MUS VUT TUV JJ Yound men JJ Young women Source: World Development Report 2013 Core Statistical Tables, based on the World Bank’s International Income Distribution Database (I2D2). While the region’s economic success has been accompanied by gains in average living standards, growing skill premia have led to rising inequality, for instance in China, Indonesia, and Lao PDR.3 Rising skill premia in many parts of the region raise concerns among policy makers about widening income disparities and the risk of social polarization. But the threats to well-being from work are wider ranging: the growing challenges to social cohesion are linked to a general slowing of economic growth in the region. The challenges are more pronounced in countries where productivity and living standards have been lagging for some time. For instance, in recent 3 The Gini coefficient of consumption inequality in China increased from approximately 35 percent in the mid-1990s to 42 percent in the mid-to-late 2000s. Among salaried workers in Indonesia, annual wage increases between 1999 and 2003 amounted to 9.3 percent for nonpoor employees, but only 6 percent for poor and near-poor employees. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 60  |  Part III. The Medium-Term Development Agenda years, despite economic growth, the Philippines experienced much slower poverty reduction than its neighbors, reflecting the low productivity of most forms of employment created by the economy. Many economies, including Cambodia, Lao PDR, Indonesia, and the Philippines, need to find ways to create and sustain productive work, amidst more difficult global economic prospects and more intense competition. Countries can ill afford to ignore what appear to be increasingly restrictive business environments.4 In addition, skills shortages in the labor force in many EAP countries are becoming a binding constraint. Skill gaps threaten growth when health and education systems and the existing labor force adjust slowly to fast-evolving demand, and when incentives for people to invest in skills, and for firms to choose technologies, are distorted by outdated policies. Shortages in basic skills in Cambodia, Lao PDR, and several Pacific Island Countries, as well as gaps in advanced skills across the region’s labor force, are motivating more government attention to health, education, and training systems (Figure 5). Slower growth rates in the region, and slower gains in living standards than many have come to expect over the last two decades, have led to louder and more frequent calls for governments to become more active to ensure sustained and more widespread well- being from work. Figure 5. Employers cite lack of skills among applicants as the top reason for persistent vacancies a. Yunnan STEP 2011: Reasons cited for difficult in filling b. Lao PDR STEP 2012: Reasons cited for difficulty in positions (technicians and associate professionals) filling positions 0.9 0.9 0.8 0.8 0.7 0.7 0.6 0.6 0.5 0.5 0.4 0.4 0.3 0.3 0.2 0.2 0.1 0.1 0 0 Applicants lacked Applicants expected Applicants did not No or few Applicants lacked Applicants expected No or few Applicants did not required skills higher wages like working conditions applicants required skills higher wages applicants like working conditions JJ Technician JJ Professional Source: Liang and Chen (2013), based on the Skills toward Employability and Productivity (STEP) employer survey. The discussion of well-being from work is pushing to the political forefront and, if ignored, can threaten the social contract. In contrast to the history of today’s high-income countries, the rapid economic changes in emerging EAP countries have not been accompanied by a parallel development of social and civic institutions to accommodate the interest of different groups and classes. As a result, many countries now face the difficult challenges of slowing growth, increasing inequality, and an unprecedented pace of structural transformation without the support of strong formal civic, labor, and social welfare institutions. Against this backdrop, households and governments in the region are starting to question how policies can ensure that work continues to improve well-being through higher productivity and living standards, and greater social cohesion. The development trajectories of East Asia’s high-income success stories also included periods when similar calls for “inclusive growth” and “jobs strategies” were heard. But the answers that made sense for those countries at the time may not be viable today in a far more integrated, rules-based global economy. 4 In the World Bank’s Ease of Doing Business indicator, Indonesia (ranked 129th), the Philippines (138th), and Cambodia (140th) score poorly. China (91st) and Vietnam (98th) score moderately. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part III. The Medium-Term Development Agenda  |  61 How can Policy Sustain Well-Being from Work in East Asia and Pacific? The most powerful policies to sustain well-being from work reach far beyond the labor market, and aim to establish sound fundamentals. The most important policies are those that ensure price stability, maintain a fiscal stance that encourages investment and innovation, and implement a regulatory framework for factor and product markets that encourages enterprise, particularly in the small and medium-size enterprises (SMEs), where most people in EAP work. In setting the fundamentals of macroeconomic policy, the business environment, and human capital development, policy makers should take into account all forms of economic units (from farms to microenterprises, SMEs to corporations), as well as all forms of work (wage and nonwage, full time and part time) that exist in the region. Policy makers should be alert to laws and regulations that intentionally or unintentionally influence firms’ decisions about how much capital or labor to employ, or household decisions about where and how much labor to supply. A policy stance that biases firms’ and households’ decisions will result in structural imbalances: too much capital and not enough labor in one part of the economy, or vice versa. These imbalances can become embedded economically and politically, and hinder countries’ ability to adjust, evolve, and grow. With sound fundamentals in place, as policy makers turn their attention to the market for labor and human capital, and to social protection, they should pay close attention to the many ways people in EAP earn a living. Governments stepping further into this still relatively new arena of policy making should not respond to increasing calls for intervention with policies that were designed and evolved in very different contexts. The prevailing models of labor regulation and social protection developed in countries where salaried employment was the most common way to work, and during periods in their history when men were by far the largest group in the work force. Indeed, evidence, including from EAP , shows that these models benefit prime-aged men in full-time wage employment. Policy makers should focus on measures that favor all working people, even if they work for themselves or hire others to work for them. In principle, labor regulation and social protection should benefit all working people and their dependents, and not favor any sector, location, or manner of economic engagement. For instance, the new emphasis in several Scandinavian countries on protecting people rather than jobs is a way of providing protection against labor market risks, without tying this protection to where or how a person works. A national system of modest, noncontributory unemployment benefits, financed by general revenues, could relieve employers of costly severance schemes, lower the distortionary impact of labor taxes, and provide some incentive for workers currently without any protection to register their work and businesses. In several countries, governments are already experimenting with delinking financial protection and risk pooling for health from where and how people work. Thailand’s universal health coverage model is the most successful example of this approach, and is credited with extending both coverage and usage. Governments also have a role in making and sustaining investments in public goods, and in capturing opportunities to increase well-being from work that would remain unexploited if left purely to market incentives. The World Development Report 2013 offers a typology that policy makers can apply to identify their particular challenges in maximizing well-being from work, and with which they can prioritize public investments. The typology takes account of countries’ levels of development, demography, natural endowments, and political circumstances, and helps policy makers determine which of these factors are dominant in shaping the opportunities and constraints on the demand and supply for labor and human capital. The eight country types REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 62  |  Part III. The Medium-Term Development Agenda Figure 6. Countries can be classified into eight types by their specific challenges; most countries in EAP fall into more than one type a. Types and defining characteristics b. Plausible mapping of EAP countries Majority of the population lives in rural Cambodia, Lao PDR, Myanmar, Papua Agrarian areas Agrarian New Guinea, Thailand, Timor-Leste, Conflict-affected Livelihoods altered by war and violence Vietnam Agricultural modernization and rural-urban Conflict-affected Solomon Islands, Timor-Leste Urbanizing migration rapidly taking place China, Indonesia, Lao PDR, Malaysia, Urbanizing Extractive industries make a substantial Mongolia, Philippines, Vietnam Resource-rich contribution to exports Indonesia, Lao PDR, Mongolia, Myanmar, Resource-rich The size of the population doesn’t support Papua New Guinea, Timor-Leste Small islands economies of scale or specialization Fiji, Kiribati, Marshall Islands, Micronesia, High youth Youth unemployment rates and idleness Small islands Palau, Samoa, Solomon Islands, Tonga, unemployment rates at unusually high levels Tuvalu, Vanuatu An urban middle class and a large share of High youth Formalizing Indonesia, Mongolia, Philippines informal employment coexist unemployment Rapidly increasing old-age dependency Formalizing China, Malaysia, Mongolia, Philippines Aging ratios Aging China, Indonesia, Thailand, Vietnam Source: Staff analysis, based on the World Development Report 2013. are Aging, Agrarian, Conflict-Affected, Formalizing, High-Youth Unemployment, Resource-Rich, Small Island State and Urbanizing (Figure 6). The above typology of challenges to well-being from work offers new and useful insights. First, the typology demonstrates how diverse the region is, in that EAP countries can be mapped to at least one of all eight types. There is no single dominant set of challenges, as there is in other emerging market regions.5 Second, most countries can reasonably be mapped to more than one type, reflecting the dynamism of the region. Third, setting aside the types determined by natural endowments (such as the small Pacific Island states and “resource-rich” economies), most EAP countries are “agrarian” or “urbanizing. ” Indeed, given the stage of development of the region’s population giants, most people in EAP live and work in the “agrarian” or “urbanizing” contexts. This is important because, as stressed in the World Development Report 2013, when countries are (or are close to) urbanizing, all three development transformations tend to happen at a similar pace: productivity and wages are increasing, living standards are rising, and there is greater social cohesion as more people move out of poverty and into the middle class. But when countries have substantially urbanized, one or more of the transformations can start to lag. This story is unfolding in the region now, prompting demand for policy attention. Applying the typology to EAP countries suggests the following guidance as to the most salient policy challenges. Small island countries. In small island countries, employment creation led by private enterprise is significantly constrained by small and dispersed populations. Outside of niche sectors, small size makes it almost impossible to achieve economies of scale. Moreover, the Pacific Island Countries are particularly constrained by great distances, which conspire against their gaining competitiveness even in activities where endowments would otherwise give them a comparative advantage. Given these constraints, policy makers have to focus on preparing young people with the human capital they will need to succeed abroad as migrant workers. In doing 5 For instance, the dominant challenge in Europe and Central Asia is mostly aging, in Latin America and the Caribbean it is mostly formalizing, and in the Middle East and North Africa it is mostly high youth unemployment. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part III. The Medium-Term Development Agenda  |  63 so, service provision itself can become a force for employment creation when populations are dispersed on difficult-to-reach islands. And while the Pacific Island Countries are too constrained by economic geography to compete in manufacturing, and find it difficult to process their natural resources for export, managing the exploitation of these resources and tourism nevertheless offers opportunities for work. Also, as improvements in information and communications technology bring the islands closer to distant markets, opportunities for work in call centers and other business services may become more readily available. Again, investments in human capital to prepare people to take advantage of these opportunities would be wise. Agrarian economies. For countries that are still mainly agrarian (particularly Cambodia, Lao PDR, Myanmar, Papua New Guinea, and Timor-Leste), the policy priority to increase well-being from work is to raise agricultural productivity, in order to free labor and human capital to work in rural off-farm enterprises and eventually to migrate to towns and cities. The instruments to increase agricultural productivity and facilitate the structural transition are land reform, agriculture extension programs, price deregulation, rural infrastructure, and good- quality education and health services. Ignoring such measures will result in low productivity and persistently high poverty, as discussed in the Philippines Development Report 2013: Creating More and Better Jobs (World Bank 2013a). To sustain well-being from work, governments should identify and remove policies and programs that create implicit or explicit restrictions on working people moving off the farm and into rural nonfarm industry or urban manufacturing and services. Vietnam’s experience in the 1990s and the first decade of the 21st century is an often-cited example of success. The danger to be avoided is urbanization despite policy rather than being enabled by policy, characterized by efforts to discourage people from moving, unproductive use of land, people migrating in search of better health and education services, cities unprepared for fast population growth, and rapid divergence in living standards between town and country. Urbanizing economies. For countries that are rapidly urbanizing (particularly China, Indonesia, Mongolia, the Philippines, and Vietnam), the policy priority is to make cities work better. Somewhat counterintuitively in a discussion of well-being from work, the factor market that policy makers should pay the greatest attention to is the market for land. Since land is the least mobile factor of production, good urban planning becomes the key to increasing the flexibility and efficiency of land use. Urban planning becomes the area of policy with the greatest impact on the incentives of firms in towns and cities to form, to grow, to move up the value chain, and thus to create and sustain demand for labor and human capital. Also important are urban infrastructure and service provision, to ensure that growing cities with plenty of skilled people foster economies from agglomeration rather than incur burdening costs from congestion. The examples of both Japan and the Republic of Korea are instructive in this regard. Formalizing economies. In several countries where urbanization is well advanced (including China, Malaysia, Mongolia, and Vietnam), governments are also facing the challenges of “formalizing” more work, in part to increase the coverage of essential work-risk and social protection. The key is to avoid forming or entrenching a policy and regulatory framework that creates labor market segmentation. Segmentation can be caused by differences in how income from different sources is taxed; by rules for providing credit that explicitly or implicitly exclude self-employed people and small businesses, as well as businesses owned by women; by differences in the types of work that are recognized in the labor code and the types that have no legal recognition or accommodation; and especially by how nonwage social protection benefits are designed and financed. Models of labor regulation and social protection that tie eligibility to certain places, industries, and forms of work, and that are financed by mandatory contributions from employees and employers, create segmentation by design. In most low- and middle-income countries, this segmentation is further aggravated by institutional and administrative weaknesses. The typical result is the exclusion and disenfranchisement of many working people REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 64  |  Part III. The Medium-Term Development Agenda from social protection and labor institutions. To avoid segmentation, policies in the areas of macroeconomics, business regulation, human capital development, and labor and social protection should take into account all forms of economic production and all forms of work in the region. Doing so will encourage factor mobility and an efficient factor allocation, helping countries make the difficult transition out of middle-income status. “Business as Usual” is no Longer an Option The EAP faces a future of moderating rates of economic growth, and pressure to respond to rising threats to well-being from work. Not taking action will increasingly threaten social cohesion, constrain productivity, and limit gains in living standards. Policy makers in EAP have greater opportunity to respond appropriately than their counterparts in other regions. The good news is that the history of policy interventions in EAP , particularly in the arenas of labor and social protection, is short relative to that of countries in Latin America and Central Europe. As a result, the costs of transitioning from a biased stance (that favors certain factors of production, sectors of activity, or ways of working over others) to a policy stance that favors all working people are likely to be much lower. For instance, while Latin American and Central European governments might find it appealing to provide “noncontributory” forms of social protection, instead of those financed by employer and worker contributions, the transition costs of such a shift may be hard to afford for those often heavily indebted governments. In contrast, EAP governments face limited “legacy costs, ” fiscally as well as politically: there are relatively fewer vested interests and social protection “sacred cows” in the region. On the flip side, the risks of ignoring or aggravating Figure 7. The constraints on growth from a large informal biases in the current policy framework are economy are a danger as countries age relatively high for EAP , since its population is Overlapping Challenges: Aging and Formalizing Jobs (bubble size = income per capita, 2010) aging faster than any other region in history (see note on “Aging in East Asia and Pacific,  ” in this Formalizing - Share of pension contributors in the labor force, 2010 100 Aging Threshold Economic Update). In China, the statistics authorities 90 AUS JPN reported the first ever contraction of their working- 80 KOR age population in 2012. The Republic of Korea 70 Formalizing Upper Threshold already has the lowest population replacement rates 60 MYS in the world. And if life expectancy in Japan is a 50 MNG 40 suitable benchmark, many people in East Asia can 30 CHN expect to live very long lives. Even in the relatively 20 PHL VNM THA Formalizing LowerThreshold youthful countries of the Pacific, an epidemic of 10 TLS IDN PNG noncommunicable, “lifestyle” diseases will soon 0 KHM LAO 0 5 10 15 20 25 30 35 40 45 impose health care costs similar to those of old age. Aging - Old-age dependency ratio, 2010 The challenges of population aging will accompany, Sources: World Bank Pension Database 2013; and United Nations Population Division. and complicate attempts to tackle, the challenges discussed above, such as the need to formalize work (Figure 7). WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part III. The Medium-Term Development Agenda  |  65 Most policy models currently in place in EAP are likely to discourage longer working lives, c  onstrain the productivity of older working people, deprive working people of the foundational skills they need to easily reskill throughout their lives, or discourage forms of work that appeal to the elderly (in particular, part-time, irregular hours). Across the entire region, greater emphasis on better nutrition and prevention could lengthen productive working lives and ease the burden of health care costs. The policy options presented in the forthcoming report, “At Work in East Asia Pacific” (World Bank 2013b), will help EAP countries boost productivity and sustain growth, becoming rich before they get old. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 66  |  Part III. The Medium-Term Development Agenda REFERENCES Alatas, Vivi, and Lisa Cameron. 2008. “The Impact of Minimum Wages on Employment in a Low-Income Country: A Quasi-Natural Experiment in Indonesia. ” Industrial & Labor Relations Review 61 (2): 201–23. Bird, Kelly, and Chris Manning. 2004. “The Impact of Minimum Wage Policy on Employment in the Formal and Informal Sectors.” Australian National University, Division of Economics, Working Papers in Trade and Development, Canberra. ———. 2008. “Minimum Wages and Poverty in a Developing Country: Simulations from Indonesia’s Household Survey. ” World Development 36 (5): 916–33. Boeri, Tito, and Jan Van Ours. 2008. The Economics of Imperfect Labor Markets. Princeton: Princeton University Press. Boeri, Tito, and Juan Jimeno. 2005. “The Effects of Employment Protection: Learning from Variable Enforcement. ” European Economic Review 49 (8): 2057–77 . Chun, Natalie, and Niny Khor. 2010. “Minimum Wages and Changing Wage Inequality in Indonesia. ” Asian Development Bank Economics Working Paper Series 196, Manila. Comola, Margherita, and Luiz De Mello. 2011. “How Does Decentralized Minimum Wage Setting Affect Employment and Informality? The Case of Indonesia. ” Review of Income and Wealth (57) 5: S79–S99. Cunningham, Wendy. 2007 . Minimum Wages and Social Policy: Lessons from Developing Countries. Washington, DC: World Bank. Del Carpio, Ximena, Cuong Nguyen, and Liang Choon Wang. 2013. “The Impacts of Minimum Wages on Employment, Wages and Welfare: The Case of Vietnam. ” East Asia and Pacific Social Protection and Labor Unit, World Bank, Washington, DC. Del Carpio, Ximena, David Margolis, and Yuko Okamura. 2013. “Effects of Minimum Wages on Labor Markets and Welfare in the Philippines: A Micro-Simulation-Based Estimation. ” East Asia and Pacific Social Protection and Labor Unit, World Bank, Washington, DC. Del Carpio, Ximena, Ha Nguyen, and Liang Choon Wang. 2012. “Does the Minimum Wage Affect Employment? Evidence from the Manufacturing Sector in Indonesia. ” World Bank Policy Research Working Paper 6147 , World Bank, Washington, DC. Del Carpio, Ximena, Julian Messina, and Anna Sanz-de-Galdeano. 2013. “Minimum Wages and Labor Market Outcomes in Thailand. ” East Asia and Pacific Social Protection and Labor Unit, World Bank, Washington, DC. Dinkelman, Taryn, and Vimal Ranchhod. 2012. “Evidence on the Impact of Minimum Wage Laws in an Informal Sector: Domestic Workers in South Africa. ” Journal of Development Economics 99 (1): 27–45. Giles, John, Dewen Wang, and Albert Park. 2013. “Expanding Social Insurance Coverage in Urban China. ” World Bank Policy Research Working Paper 6497 , World Bank, Washington, DC. Gindling, Thomas, and Katherine Terrell. 2007 . “The Effects of Multiple Minimum Wages throughout the Labor Market: The Case of Costa Rica. ” Labour Economics 14 (3): 485–511. Hallward-Driemeier, Mary, Robert Rijkers, and Andrew Waxman. 2010. “Can Minimum Wages Close the Gender Wage Gap? Evidence from Indonesia. ” World Bank, Washington, DC. Harrison, Ann, and Jason Scorse. 2010. “Multinationals and Anti-Sweatshop Activism. ” American Economic Review 100 (1): 247–73. ILO (International Labour Office). 2008. Global Wage Report 2008/09: Minimum Wages and Collective Bargaining: Towards Policy Coherence. Geneva: International Labour Office. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part III. The Medium-Term Development Agenda  |  67 Lanzona, Leonardo. 2012. “The Impact of Minimum Wages on Output and Employment in Labor-Intensive ” Background paper for the Philippine Development Report Manufacturing Industries in the Philippines. 2013, World Bank, Manila. Liang, Xiaoyan, and Shuang Chen. 2013. Developing Skills for Economic Transformation and Social Harmony in Yunnan, China. Directions in Development Series. Washington, DC: World Bank. World Bank. 2012. World Development Report 2013: Jobs. Washington, DC: World Bank. http://hdl.handle. net/10986/11843. ———. 2013a. Philippines Development Report 2013: Creating More and Better Jobs. Manila: World Bank. ———. 2013b. At Work in East Asia Pacific. Washington, DC: World Bank. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 68  |  Part III. The Medium-Term Development Agenda III.B. Aging in East Asia and Pacific6 East Asia and Pacific is in the midst of the most rapid population-aging process ever seen. Aging is driven by declining fertility and increasing life expectancy and is occurring at relatively low income levels. It will have major effects on the labor force and aggregate growth, although with significant differences across countries. The effects may be compounded by urbanization, as a result of lower labor force participation rates among the urban elderly. There are also growing concerns about the elderly poor, as family support networks become stretched. Aging raises several critical policy challenges. First, extending productive working lives, sustaining the skills of aging workers, and increasing labor force participation rates. Second, reforming pension systems to increase coverage and financial protection, taking into account administrative capacity and fiscal sustainability. Third, reforming health care systems, including, in particular, care for the aged and long-term care, and through changes in how health care providers are paid. Rapid Demographic Changes East Asia and Pacific (EAP) is in the midst of the Figure 8. Share of total population over age 60, 1950–2040 most rapid population aging process ever seen. in percent Several East Asian countries are experiencing within 40 a period of 30 years a change in age composition 35 that took a century or more to unfold in the OECD 30 countries. Japan already has the oldest population 25 in the world, and the Republic of Korea, China, and 20 Thailand are tracking its path (Figure 8). A number 15 of “younger” countries like Indonesia and Vietnam 10 will also start to age rapidly in the coming decade. 5 Across the region, population aging is driven by a 0 combination of dramatic falls in fertility and sharp 1960 1950 1975 1985 1995 2005 2015 2025 2035 2045 ▬▬ Cambodia, Lao PDR, Myanmar, Papua New Guinea, Philippines, Timor-Leste increases in life expectancy (Figure 9). The most ▬▬ China, Indonesia, Malaysia, Mongolia, Thailand, Vietnam advanced economies, such as Korea and Japan, are ▬▬ Hong Kong, SAR China, Japan, Korea, Rep., Singapore leading the way with total fertility rates (TFRs) of Source: United Nations World Population Prospects (UNWPP) 2010 revision (medium TFR scenario). 1.1 to 1.3. An intermediate group of largely middle- Notes: Group averages not weighted by population. income countries (MICs) is also aging rapidly: TFRs have fallen to 1.5 in China (and as low as 0.7 in Shanghai), and 1.6 to 1.7 in Thailand and Vietnam. At the other end of the spectrum, the Pacific countries, Cambodia, Lao PDR, and Timor-Leste, still have relatively young populations, but they are also witnessing rapid fertility declines and increases in average age. 6 This note was prepared by Philip O’Keefe, Nithin Umapathi, and Aparnaa Somanathan, and is based on work being carried out in a preparation for a World Bank report to be published in 2014. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part III. The Medium-Term Development Agenda  |  69 Figure 9. Fertility and life expectancy, 1955–2045 Average total fertility (children per woman) Average life expectancy at birth 7 83 6 80 74 5 70 67 4 3.0 3 60 1.9 2 50 1 1.4 40 0 1955 1965 1975 1985 1995 2005 2015 2025 2035 2045 1955 1965 1975 1985 1995 2005 2015 2025 2035 2045 ▬▬ Hong Kong, SAR China, Japan, Korea, Rep., Singapore ▬▬ Hong Kong, SAR China, Japan, Korea, Rep., Singapore ▬▬ Cambodia, Lao PDR, Myanmar, Papua New Guinea, Philippines, Timor-Leste ▬▬ Cambodia, Lao PDR, Myanmar, Papua New Guinea, Philippines, Timor-Leste ▬▬ China, Indonesia, Malaysia, Mongolia, Thailand, Vietnam ▬▬ China, Indonesia, Malaysia, Mongolia, Thailand, Vietnam Source: United Nations World Population Prospects (UNWPP) 2010 revision (medium TFR scenario). Note: Group averages not weighted by population. Population aging in developing EAP is occurring Figure 10. Elderly dependency ratio and GDP per capita at relatively low income levels. Developing EAP (Purchasing Power Parity) is three to five times poorer than advanced EAP GDP per capita, PPP (constant 2005 international $) 55 economies were at comparable stages of elderly 50 SGP dependency (Figure 10). The same is true for OECD 45 MYS countries. This is giving rise to concerns about 40 35 ” “getting old before getting rich. 30 JPN KOR 25 Fertility decline and increased life expectancy 20 in developing EAP will have major effects over 15 MYS 10 the coming decades on the labor force and CHN THA 5 KHM MNG IDN TLSPHL VNM dependency ratio, although with significant 0 PNG LAO differences across countries. Aging is universal 0.03 0.06 0.09 0.12 0.15 0.18 0.21 0.24 0.27 0.30 0.33 0.36 Elderly dependency ratio across EAP , but the relationship between youth, ▬▬ Cambodia, Lao PDR, Myanmar, Papua New Guinea, Philippines, Timor-Leste working age, and elderly populations varies ▬▬ China, Indonesia, Malaysia, Mongolia, Thailand, Vietnam ▬▬ Hong Kong, SAR China, Japan, Korea, Rep., Singapore markedly across the region (Figure 11). In this Source: World Development Indicators. decade, throughout developing EAP , the increase in the elderly share will be offset by a decline in the youth share, leading to a rising share of the working-age population and a fall in total dependency ratios (defined as the youth and elderly, relative to the working-age population). However, by the 2020s, for the intermediate, largely MIC group, the rising elderly share of the population will begin to translate into flat or declining working-age populations. In contrast, for younger EAP countries, there will still be modest growth in the working-age population share and a continued fall in total dependency ratios. The elderly in EAP are more likely to work than in most other regions; however, there is substantial variation across countries, and the picture may change with further urbanization. The labor force participation rate (LFPR) for people over 60 in EAP is significantly higher than in Europe and Central Asia (ECA) or in the OECD, and approximately the same as in Latin America and the Caribbean (Figure 12). However, in some EAP countries, the LFPR of elderly rural people significantly exceeds that of elderly urban people; further, in countries like China, the LFPR of elderly urban people is falling. This raises the concern that elderly LFPR may REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 70  |  Part III. The Medium-Term Development Agenda Figure 11. Changes in share of youth, of working age, and of elderly populations, and in total dependency ratio, 2010–15 and 2020–25 Percent change, 2010–2015 Percent change, 2010–2015 30 30 25 25 22 20 20 18 14 15 12 15 10 10 5 6 4 5 5 2 2 0 0 0 -2 0 -5 -3 -2 -5 -3 -3 -4 -3 -5 -4 -5 -6 -6 -6 -5 -5 -6 -10 -10 -7 -9 -10 -15 -17 -13 -15 LAO KHM VNM MMR PHL MYS TLS IDN CHN PNG SGP THA MNG HKG KOR JPN LAO PNG KHM PHL IDN TLS MYS MMR VNM MNG THA JPN CHN KOR SGP HKG JJ Youth (0–14) JJ Elederly (65+) JJ Working age (15–64) SS Total dependency ratio JJ Youth (0–14) JJ Elederly (65+) JJ Working age (15–64) SS Total dependency ratio Sources: UNWPP 2010 revision (medium TFR scenario); Bank staff estimates. Note: Total dependency ratio = (youth + elderly) /working-age population. fall in the face of ongoing urbanization, and potential Figure 12. Labor force participation rate for accompanying factors such as higher coverage of 60+ population, for selected regions and for China pension schemes. The experience of Japan, Korea, in percent 50 and Singapore demonstrates the necessity of exploring policies to boost labor force participation, 40 both among older people (especially in urban areas) and among working-age women. 30 20 Demographic shifts will affect aggregate growth in East Asia negatively; again, the effects will 10 vary across countries. During 1965–90, the sharp increase in the working-age population 0 share, together with the associated increases in 1990 2000 2010 2020 ▬▬ EAP ▬▬ LAC ▬▬ China ▬▬ ECA ▬▬ OECD savings, investment, and human capital, yielded a Source: LABORSTA (ILO). “demographic dividend, ” which accounted for as Note: Average labor force participation rates not weighted by population. much as a third of East Asian growth (Bloom and Canning 2003). Conversely, future declines in the share of the working-age population will exert a drag on economic performance. However, the effects will vary sharply across EAP . Importantly, in all aging developing countries, such as China, Indonesia, Malaysia, and Vietnam, there is still substantial scope for productivity convergence through TFP growth and human capital deepening to offset demographic impacts on growth. There are growing concerns about the elderly poor in EAP as populations age and traditional support networks become stretched. EAP societies pride themselves on the role of family and informal networks in providing support to the elderly (Figure 13, left-hand panel). Despite this, in East Asia poverty tends to be higher among the elderly, with the exception of the very old (Figure 13, right-hand panel). In addition, in some countries urbanization is reducing the share of the elderly who reside with their adult children. China, for instance, has seen a decline in the co-residence of the 65+ with adult children from over 70 percent to 38 percent between 1990 and 2011. Finally, the attitudes of both the elderly and their children toward whether the state, the family, or older people themselves should be the primary source of old-age support are shifting, with likely implications for how robust the traditional networks will remain. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part III. The Medium-Term Development Agenda  |  71 Figure 13. (l) Sources of support for 65+, for selected EAP countries, early-mid-2000s; (r) Rural Poverty rates 45+, for Vietnam, Indonesia, and China, late 2000s Share of 65+ consumption net of labor income 1.3 60 1.1 50 0.9 40 0.7 0.5 30 0.3 20 0.1 10 -0.1 -0.3 0 IDN JPN PHL KOR TWN THA 45–49 50–54 55–59 60–64 65–69 70–74 75–79 80+ JJ Public transfers JJ Sales of own assets JJ Familial transfers ▬▬ Vitenam (VHLSS 2010) ▬▬ Indonesia (IFLS) ▬▬ China (CHNS 2009) Source: National Transfer Accounts Database. Sources: CHNS 2009; IFLS 2007; VHLSS 2010. Social Security Systems Developing EAP is aging, with pension systems that provide significantly lower coverage and substantially less financial protection than OECD and ECA countries at comparable stages of the demographic transition (Figure 14). At the same time, several countries (including China, Vietnam, and Indonesia) have committed to rapid coverage expansion. Other countries, such as Thailand, Timor-Leste, and several Pacific islands, have achieved universal coverage of noncontributory elderly social pensions. But balancing adequacy and fiscal sustainability remains a challenge, whatever the approach to expanding coverage. As EAP countries age, they are also undergoing Figure 14. Coverage of contributory pensions, in late a rapid change in disease patterns: health 2000s systems will have to transform in response to in percent 90 the growing importance of noncommunicable 80 diseases (NCDs). In China, over 80 percent of 70 deaths are already due to NCDs, and years of life 60 lost from NCDs will increase by approximately 40 50 percent between 2010 and 2030 as a result of aging 40 and other factors (World Bank 2011). Aging is also 30 associated with increased morbidity and a greater 20 need for chronic and long-term care services. Health 10 systems in developing EAP are not well placed to 0 respond to an increase in NCDs and aging. There KHM CHN FJI IDN KOR LAO MYS MNG PNG PHL SGP THA VUT VNM Source: World Bank Pensions Database. is overreliance on hospital care for everything from Note: “Coverage” is defined as (active participants/labor force). primary to long-term care, a situation exacerbated by weak gatekeeping and referral systems. At all levels of care, spending on pharmaceuticals is excessive, reflecting both overprescription and inefficiencies in procurement. This skews the composition of health spending (for instance, pharmaceuticals consume over half of total health spending in Vietnam), and has a particular impact on the elderly, who tend to be more reliant on medication. Efforts to prevent NCDs by addressing lifestyle-related conditions are underdeveloped. And most countries have no long-term care system, beyond hospitals and the REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 72  |  Part III. The Medium-Term Development Agenda family. There are also too few qualified general practitioners (GPs), who should form the backbone of primary care systems (for instance, China has less than 0.1 GP per 1,000 population, compared to approximately 1.7 in Australia and 0.7 in Korea). Many EAP governments have committed to achieving universal health coverage through social health insurance and/or tax financing in the coming decades, a policy of particular importance for the elderly. Out-of-pocket payments currently account for a large share of health financing (over 45 percent in all low- and middle-income EAP , and as high as 80 percent in Myanmar), leaving households, and especially the elderly, vulnerable to catastrophic health care costs. While most health systems have higher coverage than pension systems (China, around 95 percent; Vietnam, over 60 percent; and general-revenue-financed systems, such as the Pacific islands, in principle have universal coverage), the financial protection offered is partial and variable. Policy Implications of Aging The implications of aging cut across several areas of economic and social policy, and differ in their acuteness and urgency across EAP countries at different stages of the demographic transition. While aging presents serious challenges, most countries in developing EAP face a relatively blank policy canvas that is not overly constrained by unaffordable legacy commitments to the elderly. This inheritance is reinforced ” EAP can also draw upon a century of global by societal attitudes that do not expect the state to “do it all. experience, including from older EAP countries such as Japan and Korea. At the same time, social expectations are shifting and there are growing demands on the state to support the elderly. As a result, EAP countries are redefining the social contract between the state and both older and younger citizens. In this process, they confront several policy challenges. Increasing the Effective Labor Force Extending productive working lives as populations age is an imperative, which involves several elements. The first is the removal of disincentives to continue working later in life. Tax treatment of work and transfer incomes should not create a penalty for working beyond the official retirement age. Pensions also need to be reformed (see below). Second is the introduction of flexible work arrangements, such as job sharing and part- ” Japan’s “continued employment” legislative time work, to make retirement less of a “cliff” and more of a “glide. mandate to employ older workers provides an interesting example; for instance, Toyota is piloting a half-time system for workers over age 60. Third is the cost-effective adaptations of workplaces to make them responsive to older workers’ needs. Firms such as BMW, through simple and low-cost workplace adjustments, have substantially enhanced the productivity and satisfaction of older workers. Related to all this, the differences in age profiles across EAP economies offer major opportunities for intraregional migration to mitigate the effects of rapid aging, even though the political economy challenges should not be underestimated. A particularly complex policy challenge lies in sustaining or even enhancing the skills of aging workers. While there is support for lifelong learning that promotes competency upgrading across the life cycle, it is less clear how to reform training systems to achieve that goal, and how to improve on the cost-effectiveness of training interventions for older workers. More research is also needed on the productivity of older workers in WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part III. The Medium-Term Development Agenda  |  73 EAP; here, global research indicates a nuanced picture depending on the nature of skills demanded and the primary labor market challenges faced by older workers (Skirbekk 2008). Enhancing the productivity of the aging population also has a sectoral dimension, since in many EAP countries older workers are more likely to be found in agriculture. Measures are needed to increase the LFPR of working-age people, especially women. While labor force participation rates among women are relatively high in EAP , they remain notably lower than among men, with a substantial gap in countries like Malaysia. This is a particular concern since women live longer than men, and are therefore disproportionately represented among the elderly. In this area, the experience of countries such as China, Korea, Singapore, and Taiwan, China, with paid parental leave and public subsidies for child care provides lessons for developing EAP , albeit ones that need to take account of fiscal possibilities and suitable delivery models. Less clear is the relevance to developing EAP of pronatalist policies, which directly subsidize child bearing, such as baby bonuses, child allowances, and preferential tax treatment for families with children (Jones 2011). Pension Reform Aging makes the challenges of pension reform pressing, with a need to balance coverage, financial protection, administrative capacity, and fiscal sustainability. Reforms of existing systems to enhance sustainability and labor market incentives are needed, at the same time that countries are aiming to expand pension coverage from often low bases. With respect to existing pension systems, several countries recognize the need to raise the average age of retirement among those entitled to pensions. In a number of cases, this involves raising the normal retirement age, introducing actuarially fair early retirement provisions, and gradually harmonizing male and female retirement ages (as both ECA countries, and EAP countries including Japan, Korea, and the Philippines, have done). Beyond this, some countries need to assess the sustainability of formal pension schemes to ensure that key parameters (such as replacement rates and indexation rules) are sustainable, while still providing adequate old-age protection. Some of these policy choices assume particular significance in countries where workers have experienced large, sustained wage increases over their working lives. There are also structural questions for pension reform. One is the appropriate balance between contribution- based and general-revenue financing of pensions and elderly support. A number of countries (for instance, Thailand, Timor-Leste, and several Pacific countries) already have general-revenue-financed universal social pensions over age 60/65. Others subsidize contributory schemes from the budget to incentivize informal sector participation (for instance, China and Thailand). Developing affordable approaches to extend coverage to the massive informal sectors in EAP will require creative thinking on the financing mix and scheme design. For instance, China has since 2010 brought over 350 million informal workers into innovative new pension schemes, albeit ones with modest benefits. A second question is the appropriate balance between defined- benefit and defined-contribution elements in existing schemes. A third question is the appropriate degree of differentiation between different types of workers (public sector versus private sector, or formal sector versus informal sector), and what degree of scheme integration best balances the need to incentivize participation of nonformal workers with appropriate labor market incentives and the need for labor mobility. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 74  |  Part III. The Medium-Term Development Agenda Health Care Reform Aging requires reform of health care systems, including, in particular, care for the aged and long-term care (LTC). Reforms are needed in any event to address the noncommunicable disease (NCD) epidemic, but aging increases their urgency. One necessary structural reform is a major strengthening of primary care, in terms of both primary prevention (for instance, diabetes screening) and better management of NCDs (for instance, antihypertensives and statins). This requires comprehensive reform of medical education to produce a new cadre of GPs and family doctors, and other investments to ensure that the primary level can effectively perform its service and referral functions. These must be reinforced by reforms to payment systems to remove financial incentives for treatment in hospitals. Once primary care is strengthened, referral systems should ensure effective gatekeeping to control unnecessary visits to hospitals, especially for chronic conditions from which older people disproportionately suffer. It is also crucial to reform how health care providers are paid, moving away from fee-for-service payment systems, toward systems that do not directly link payments to utilization and include explicit caps based on population norms or other clinical criteria. This will also encourage case-based management of patients, particularly those such as the elderly with chronic conditions. Also, excess cost growth must be controlled through the introduction of more effective price and volume controls, better governance, and other reforms that aimed at addressing inefficiencies in the system. An important component of this involves strengthening pharmaceutical policy, for instance, through more efficient procurement, and incentives to increase use of generics. Such reforms will also slow the growth of out-of-pocket payments and thus improve financial protection for all, but especially for older people with chronic conditions. Financing LTC on top of existing health expenditures poses challenges. OECD countries have tended to formalize LTC financing through insurance or budgetary allocations, and institutionalize LTC delivery. While this may be needed in the long run in EAP , there are innovative examples of community-based approaches to LTC and aged-care services in the region that build on traditions of family-based care (for instance, Thailand), and need to be explored. Conclusions In addressing the aging challenge, EAP countries still largely have their destiny in their own hands, through the policy choices that they are currently making or will make in the near future. In contrast, in the OECD, ECA, and Latin America and the Caribbean countries, legacy commitments made decades ago with limited attention to demographic trends make reforms challenging. Of course, EAP countries do not face a blank policy slate. There are existing policy commitments (for instance, defined-benefit pension schemes) that shape the response to aging. However, in relative terms, the policy space for EAP countries to shape a sustainable, positive, and balanced response to aging is significant. And for many, there is a demographic window that allows for considered policy formulation, and adjustment of existing policies, before the peak of the aging wave. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Part III. The Medium-Term Development Agenda  |  75 REFERENCES Bloom, David, and David Canning. 2003. “How Demographic Change Can Bolster Economic Performance in Developing Countries. ” World Economics 4 (4) (October–December): 1–14. Jones, Gavin. 2011. “Recent Fertility Trends, Policy Responses and Fertility Prospects in Low Fertility Countries of East and Southeast Asia. ” United Nations Population Division Expert Paper 2011/5, United Nations, New York. Lee, Ronald, and Andrew Mason. 2011. Population Aging and the Generational Economy: A Global Perspective. Cheltenham, UK, and Northampton, MA: Edward Elgar. Skirbekk, Vegard. 2008. “Age and Productive Capacity: Descriptions, Causes and Policy Options. ” Aging Horizons 8: 4–12, Oxford Institute of Aging, Oxford, UK. United Nations Department of Economic and Social Affairs. 2010. “World Population Prospects. ” United Nations, New York. World Bank. 2011. Toward a Healthy and Harmonious Life in China: Stemming the Rising Tide of Non- Communicable Diseases. Beijing: World Bank, Human Development Unit, East Asia and Pacific Region. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH |  77 Country Pages and Key Indicators REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 78  |  Country Pages and Key Indicators CAMBODIA Adaptation to changes in destination markets for garments, expanded cultivated area, and a diversification in sources of tourism have helped Cambodia’s three key engines of GDP growth sustain their momentum. The garment export industry has adapted to export market conditions, focusing on lower-end garment products for the U.S. market and higher-end products for the European market. In the agricultural sector, rice production has continued its high growth. Rising cultivated areas of rice crops (both area expansion and irrigation) account for up to 80 percent of annual rice production increase Population 14.9 million during the last four years. Successful diversification Population growth 1.8 percent of tourism markets, attracting arrivals from Eastern GDP (PPP , int’l US$) 37.1 billion Europe, East Asia, and the Pacific regions, has GDP per capita (PPP , int’l US$) 2,494 Surface area 181,040 sq. km. resulted in a continued high growth in the tourism Capital Phnom Penh sector. During the first six months of 2013, garment Source: World Development Indicators. exports accelerated further, growing at 18 percent year-on-year (yoy), while the tourism sector Summary continues its high-growth trajectory, with a tourist arrival growth rate of 19 percent yoy. The Cambodian economy remains robust amidst a challenging global economic environment, and As a result of the rapid pace and pattern of growth prospects for meeting the growth projection that enables benefits to be shared by a larger number of 7 percent in 2013 appear favorable. Overall of people, Cambodian poverty has fallen sharply. macroeconomic outlook remains positive, having Economic growth broadened over the last years sustained agricultural growth with favorable weather thanks in large part due to the sustained growth in conditions, continued strong performance of the the agricultural sector favored by increases in rice tourism sector, and a resilient garment sector. The prices in the global markets. The percentage of poor economic outlook, however, faces some risks. It is people was more than halved within seven years to unclear how big an impact the political uncertainty around 20 percent in 2011. Despite this large poverty postelections is having on foreign direct investment reduction, the vast majority of the families who were (FDI) and growth, even with some improvements on lifted out of poverty were so only by a small margin, the external front with initial signs of improvements implying that those families moved from being poor in the U.S. and European Union (EU) economies. to being just near poor. The current account deficit (excluding official Recent Economic Developments transfers) widened to 10.1 percent of GDP in 2012 from 7 .9 percent of GDP in 2011. Compared to The Cambodian economy remains robust amidst the 2011, higher imports in 2012 were driven mainly by challenging global economic environment. Real GDP rising petroleum, motor vehicle, and construction growth was 7 .3 percent in 2012, and is projected to materials imports. The large current account deficit reach around 7 percent in 2013. GDP growth has (as a percentage of GDP) that Cambodia runs is been driven by a sustained strong agricultural sector helping address the importing needs of investment. growth, resilient exports, rebounding construction activity, and a robust tourism sector. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  79 The capital account surplus substantially increased, During the first five months of 2013, domestic thanks to the increasingly large FDI, which peaked revenue continued to improve but at a slower pace, at US$1.4 billion in 2012. FDI continued to grow over rising only at 9.6 percent yoy, compared to the first half of 2013, and investor interest appeared 24.7 percent in 2012.2 Public expenditure to continue during the election period, unlike in past performance, however, appears slow. The budget elections. deficit (excluding grants) should remain as budgeted at around 5.4 percent of GDP . Fiscal management As a result of the capital account surplus, the overall remains appropriate and supportive of balance of payments remains positive, increasing macroeconomic stability, but there is significant international reserves. Gross international reserves room for domestic revenues to be further improved rose to US$3.5 billion or 3.7 months of imports in and for greater efficiency in spending. In 2012, 2012, compared to US$3.0 billion or 3.4 months of Cambodia restored its fiscal space, thanks to a high imports in 2011. By June 2013, the gross international growth of revenue, estimated to reach 14.4 percent reserves reached US$3.6 billion. of GDP in 2012, compared to 13.1 percent in 2011. The government, however, continues to depend The Consumer Price Index (CPI) has eased, dropping heavily on donors, whose funds account for almost to 2.5 percent by the end of 2012, compared to 80 percent of the total public investments or 4.9 percent in 2011. This is due to the stabilization of 34 percent of the total public outlays. the main product categories, in particular food prices, which represent 43 percent of the consumer basket. Outlook and Emerging Challenges In June 2013, yoy inflation picked up marginally, reaching 2.9 percent due to slightly elevated foods The overall macroeconomic outlook remains positive, prices. Inflation is projected to remain in low single- due to sustained agricultural growth with favorable digit figures during the short term. weather conditions, continued strong performance of the tourism sector, and a resilient garment sector. The nominal exchange rate has remained stable, The economic outlook, however, faces some risks. It while financial deepening continues. The Cambodian is unclear how big an impact the political uncertainty riel (CR) is pegged to the U.S. dollar, and has been postelections is having on FDI and growth, even in hovering at around CR 4,000 per dollar. The exchange light of some improvements on the external front. rate slightly depreciated and reached CR 4,062 GDP growth in 2013 is projected at around 7 percent per dollar in June 2013.1 The financial deepening and in 2014 could be close to 7 percent. continues and a growing number of banks are entering the Cambodian market. Competition among The overall debt sustainability outlook remains banks has contributed to narrowing the U.S. dollar favorable. The 2012 joint Word Bank/IMF Debt interest rate spread, and driving some efficiency into Sustainability Analysis shows that Cambodia’s debt the market; however, there are also significant risks distress rating remains low. The government’s policy to having a large number of banks due to supervision of avoiding nonconcessional borrowing has been a key capacity challenges. The recent credit growth of factor in sustainable debt management. Cambodia’s about 30 percent yoy has benefited the agricultural external public debt and publicly guaranteed debt sector, which received US$570 million or 10 percent stock is estimated to reach 30.1 percent of GDP in of the total credits by end-2012, compared to only nominal terms by the end of 2012. US$100 million or 5 percent of the total credits by end-2008. 1 Official midpoint exchange rate, the National Bank of Cambodia. 2 Preliminary fiscal data for 2013 REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 80  |  Country Pages and Key Indicators Cambodia:Key Indicators 2011 2012 2013f 2014f 2015f Year Year Year Year Year Output, Employment, and Prices Real GDP (% change yoy) 7.1 7.3 7.0 7.0 7.0 Domestic demand (% change yoy) 1.0 11.9 9.0 8.3 8.7 Industrial Production Index (2000=100) 300.8 315.9 341.1 363.3 388.7 (% change yoy) 14.5 5.0 8.0 7.0 7.0 Consumer Price Index (% change yoy) 4.9 2.5 5.0 6.0 5.0 Public Sector Government revenues (% GDP) 13.2 14.4 14.2 14.5 14.8 Government expenditures (% GDP) 22.8 19.7 19.6 20.0 19.0 Government balance (% GDP) -9.6 -5.3 -5.4 -5.5 -4.2 Foreign Trade, BOP , and External Debt Trade balance (millions US$) -1,490 -1,949 -2,082 -2,637 -2,956 Exports of goods (millions US$) 5,220 6,016 6,918 7 ,714 9,102 (% change yoy) 34.4 11.4 15.0 11.5 18.0 Key export (% change yoy) 1/ 31.7 7.0 18.0 15.5 20.0 Imports of goods (millions US$) 6,710 7 ,965 9,000 10,350 12,058 (% change yoy) 22.7 18.7 13.0 15.0 16.5 Current account balance (millions US$) 2/ -1,015 -1,437 -1,499 -2,066 -2,217 (% GDP) -7.9 -10.1 -9.6 -12.0 -11.8 Foreign direct investment (millions US$) 3/ 785 1,410.2 1,452.5 1,626.8 1,748.8 External debt (millions US$) 3,611 4,281 4,726 5,229 5,634 (% GDP) 28.1 30.2 30.2 30.4 29.9 Short-term debt (millions US$) 66.8 67.0 66.9 66.7 66.5 Debt service ratio (% exports of g&s) 1.2 1.2 1.3 1.5 1.5 Foreign exchange reserves, gross (millions US$) 3,032 3,463 3,844 4,151 4,525 (months of imports of g&s) 3.4 3.3 3.2 3.1 3.0 Financial Markets Domestic credit (% change yoy) 37.7 34.0 28.0 25.0 25.0 Short-term interest rate (% p.a.) 15.0 13.7 13.0 13.5 13.5 Exchange rate (CR/US$, eop) 4,039.0 3,995.0 4,000.0 4,063.6 4,076.0 Real effective exchange rate (2000=100) 124.8 128.6 (% change yoy) 1.9 3.0 Memo: Nominal GDP (millions US$) 12,828 14,196 15,649 17,214 18,845 Sources: National data sources; IMF; and World Bank staff estimates. e = estimate. f = forecast. p = projection. 1/ Garments. 2/ Excluding official transfers. 3/ From 2011, includes FDI related to public-private power sector projects.   WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  81 CHINA that of consumption (3.4 percentage points) and net exports (0.1 percentage point). Q2 data suggest that investment has been the main driver of growth. However, recent activity data point toward stabilization of the slowdown. Leading indicators such as the purchasing managers’ index suggest a recovery in economic activities. The Purchasing Managers Index (PMI) dropped to near the borderline of 50 in June, but picked up in August to 51.0, indicating a recovery in the manufacturing sector. Population 1.4 billion On the supply side, industrial production growth Population growth 0.5 percent weakened in June but then recovered in recent GDP (PPP , int’l US$) 11.5 trillion months. The reading dropped to 8.9 percent yoy in GDP per capita (PPP , int’l US$) 9,233 Surface area 9,6000,000 sq. km. June from 9.2 percent in May, but then improved Capital Beijing to 9.7 percent in July and surprised on the upside Source: World Development Indicators. in August (10.4 percent yoy). More specifically, the output growth of power and steel accelerated in recent months, suggesting a stabilization of the Summary moderation in the economy. Recent activity data point toward stabilization of On the demand side, investment growth remains the slowdown. Annual GDP growth is expected to robust. Urban fixed asset investment growth was be 7 .5 percent for 2013. Nevertheless, risks have flat in July compared to June (19.3 percent yoy) built up in the Chinese economy. First, the key risk but rebounded to 21.4 percent yoy in August. is a disorderly rebalancing from investment-led to Manufacturing fixed asset investment (FAI) growth consumption-based growth. Second, investment improved in line with improved export. Railway is increasingly dependent on credit growth and FAI growth picked up in August, likely driven by low borrowing costs. Third, rapid credit growth the government’s efforts to boost railway project has increased the level of local government debt. construction. In contrast, property FAI growth edged The government acknowledges that the economy down, and the growth of new home starts dropped is facing some headwinds, but says risks are to -20.1 percent in August from 45.2 percent in July. manageable and is planning to introduce reforms that address these vulnerabilities. As another indicator of domestic demand, retail sales growth accelerated. In real terms, it rose to 11.6 percent in August from 11.3 percent in July. Recent Economic Developments However, data by component suggest that the improvement mainly comes from that in government- China’s Q2 GDP growth registered 7 .5 percent (yoy), spending-related items, construction material, and down from 7 .7 percent in 2013Q1. According to official home appliance sales. In contrast, gold, jewelry, and data, sequential quarter-on-quarter (qoq) growth automobile sales growth has recently moderated. rose to 1.7 percent in Q2 (7 .0 percent annualized) from 1.6 percent (6.6 percent annualized) in Q1. For Export growth recovered in recent months, indicating the first half of 2013, the contribution of investment an improvement in external demand. China’s export to growth was 4.1 percentage points, followed by growth jumped to 5.1 percent yoy in July from REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 82  |  Country Pages and Key Indicators -3.1 percent in June. It further accelerated to the government may continue the moderate fiscal 7.2 percent yoy in August, surprising the markets on measures in infrastructure, public housing, and the upside. Import growth moderated to 7 .0 percent renewable energy sectors to ensure that growth yoy in August from 10.9 percent in July. Trade surplus does not fall below the target. Monetary policy will widened to US$28.6 billion in August from likely remain neutral, given the moderate inflation US$17 .8 billion in July. Monthly data by destination and the risks accumulated in the financial sector. show that the growth in export was led by that for ASEAN (30.8 percent yoy), Hong Kong (6.4 percent), Despite the slowdown in Q2, China’s economic the United States (6.1 percent), and the EU outlook has significantly improved, given the latest (2.5 percent), implying a strengthening external data. July and August data point toward a recovery environment. in growth momentum in Q3. However, the pickup in domestic demand is still mainly government led, The recovery in exports together with improved and thus might be unsustainable. In the meantime, economic outlook might reverse the direction of advanced economies have started to show signs capital outflows to inflows. In the meantime, the Y/ of recovery, albeit slowly. The contribution of net US$ exchange rate may be stabilized given the rising exports to China’s growth may recover gradually. strength of the U.S. dollar and the keenness of the Given these factors, annual GDP growth is expected Chinese government to maintain confidence and to be 7.5 percent for 2013. financial stability. There are upside risks to our 2013 projection. First, Headline CPI inflation remains mild, and producer the external environment might recover at a faster price index (PPI) deflation is moderating. CPI pace than expected. Second, the impact of the inflation remained flat at 2.6 percent yoy in August, ongoing growth-supportive fiscal measures may be well within the government’s 3.5 percent target. greater than we anticipate. Meanwhile, PPI deflation eased further, helping firms recover their profit margins. We expect GDP growth for 2014 to be 7 .7 percent, noting the carryover effect due to the slowdown The latest credit data suggest stable and robust in the first half of 2013. Our baseline assumption credit growth. Total Social Financing (TSF) jumped is a steady qoq growth rate of around 1.8 percent. to Y 1,570 billion in August from Y 809 billion in For 2015, we expect 7 .5 percent annual growth, July, while yoy growth of outstanding TSF remained assuming a robust but slightly moderating growth around 21 percent. New loans rebounded slightly path. to Y 711 billion in August from Y 700 billion in July, with yoy outstanding loans growth moderating to In summary, given the anticipated reforms and the 14.1 percent in August from 14.3 percent in July. latest developments, China’s economic outlook has Credit growth might moderate in the rest of 2013 brightened. Nevertheless, risks have built up in the due to seasonality reasons. However, another Chinese economy, and the risks and concerns are interbank liquidity squeeze may be unlikely, since as follows. the government will be less willing to disturb the financial markets using administrative measures. First, the key risk is a disorderly rebalancing from investment-led to consumption-based growth. Capital accumulation plays a more important role in Outlook and Emerging Challenges driving growth, but the economy has rapidly become less efficient over time, as indicated by falling total The state media have reaffirmed the official factor productivity. Other growth drivers such as net growth target of 7.5 percent, which implies that exports and consumption will likely remain weak. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  83 Therefore, when investment can no longer be the main source of growth, the economy will suffer a major downturn. Second, investment is increasingly dependent on credit growth and low borrowing costs. Thus, a cutback in credit growth or an increase in borrowing costs will likely dampen investment going forward. Restraints on traditional bank lending, if they occur, will likely affect investment in sectors of the economy that are dominated by state-owned enterprises, principally gas, water, electricity, rail transport, and urban public transport. Restraints on nontraditional bank lending, which seem more likely given recent policy pronouncements, will likely affect investments in real estate development and local government infrastructure. Third, rapid credit growth has increased the level of local government debt. The level of local government debt is estimated to be within the range of 30 to 39 percent of GDP as of end 2012, but levels vary across municipalities. The leadership acknowledges that the economy is facing some headwinds, but says risks are manageable and is planning to introduce reforms that address these vulnerabilities. The Central Committee of the Chinese Communist Party is expected to hold its third plenum in November. In particular, the plenum may give signals on fiscal reform, devolution of powers to lower-level governments, the financial sector, debt levels, urbanization and the residency (hukou) system, and land rights. These are complex and politically sensitive interconnected issues, requiring careful reform if the government is not to lose control over the process. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 84  |  Country Pages and Key Indicators  ey Indicators China: K 2011 2012 2013f 2014f 2015f 2012 2013 2013 Year Year Year Year Year Q3 Q4 Q1 Q2 May Jun Jul Aug Output, Employment, and Prices Real GDP (% change yoy) 9.3 7.8 7.5 7.7 7.5 7.4 7.9 7.7 7.5 Domestic demand (% change yoy) 10.2 8.3 7.2 7.5 7.1 Industrial production index /1 (% change yoy) 10.4 7.9 7.5 7.5 7.5 9.1 10.0 9.6 9.1 9.2 8.9 9.7 10.4 Unemployment (%) 2/ 4.1 4.1 4.1 4.1 4.1 4.1 4.1 4.1 4.1 Real wages (% change yoy) 8.5 9.1 9.0 9.0 9.0 Consumer Price Index 5.4 2.6 2.7 3.0 3.0 1.9 2.1 2.4 2.4 2.1 2.7 2.7 2.6 (% change yoy) Public Sector Government revenues (% GDP) 22.0 22.6 22.3 21.8 21.3 Government expenditures (% GDP) 23.1 24.1 23.9 23.5 23.2 Government balance (% GDP) -1.8 -1.5 -1.6 -1.7 -1.8 Domestic public sector debt 15.2 14.9 15.1 15.4 15.7 (% GDP) /3 Foreign Trade, BOP , and External Debt Trade balance (billions US$) 157 .9 232.8 304.0 368.0 414.0 79.5 83.3 43.5 65.7 20.4 27.1 17.8 28.5 Exports of goods (billions US$) 1,899.3 2,050.1 2,216.0 2,403.0 2,591.0 541.3 554.2 508.9 544.1 182.8 174.3 186.0 190.6 (% change yoy) 4/ 20.3 8.0 8.1 8.4 7.8 4.5 9.4 18.3 3.7 0.9 -3.3 5.1 7.2 Key export (% change yoy) 5/ 20.2 7.3 8.1 7.9 7.3 4.9 9.7 19.2 3.5 0.6 -3.4 4.9 Imports of goods (billions US$) 1,741.4 1,817.3 1,912.0 2,035.0 2,177.0 461.8 470.9 465.4 478.4 162.3 147.2 168.2 162.1 (% change yoy) 4/ 24.9 4.3 5.2 6.4 7.0 1.6 2.7 8.5 5.0 -0.1 -0.9 10.8 7.0 Current account balance 136.1 193.1 218 249 285 70.8 45.1 47.6 48.2 (billions US$) (% GDP) 1.8 2.3 2.4 2.4 2.5 Foreign direct investment 116.0 111.7 24.3 28.3 29.9 32.1 9.3 14.4 9.4 (billions US$) /6 External debt (billions US$) 695.0 737.0 (% GDP) 9.3 8.9 Short-term debt (billions US$) 500.9 540.9 Debt service ratio 1.7 1.6 (% exports of g&s) Foreign exchange reserves, gross 3,187 .6 3,318.1 3,603.4 3,902.5 4,218.6 3,291.7 3,318.2 3,449.2 3,503.3 3,521.4 3,503.3 (billions US$) (months of imports of g&s) 22.0 21.9 21.2 21.3 21.5 85.5 84.6 88.9 87.9 21.7 23.8 Financial Markets Domestic credit (% change yoy) 14.3 15.0 16.3 15.0 14.9 14.2 14.5 14.2 14.3 Short-term interest rate (% p.a.) 7/ 3.3 3.3 3.3 3.3 3.3 3.3 3.3 3.3 3.3 3.3 Exchange rate (RMB/US$, eop) 6.30 6.29 6.17 6.10 6.06 6.34 6.29 6.27 6.17 6.18 6.18 6.18 6.17 Real effective exchange rate 115.8 118.3 115.5 118.3 122.6 124.8 124.8 124.8 126.0 (2000=100) (% change yoy) 6.1 2.2 1.4 2.2 5.3 6.9 6.8 6.9 7.9 Stock market index 2,199 2,269 2,086 2,269 2,237 1,979 2,301 1,979 1,994 2,098 (Dec. 19, 1990=100)/8 Memo: Nominal GDP (billions US$) 7,508.5 8,226.9 9,250.0 10,277.0 11,403.0 ,, ,, ,, ,, ,, ,, ,, ,, Source: National data sources. f = forecast. 1/ Annual data are not comparable with the quarterly and monthly data. Annual data cover all industrial enterprises, while the quarterly and monthly data refer only to those enterprises with sales value above Y 5.0 million.  2/ Official urban unemployment only, not including laid-off workers.  3/ Central government debt/GDP .  4/ Nominal growth rate. 5/ Manufactured exports.  6/ Gross FDI used.  7/ Central Bank loans to financial institutions, less than 20 days.  8/ Shanghai Stock Exchange A-Share Price Composite. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  85 FIJI arrivals to Fiji. However, post-cyclone reconstruction activity is expected to provide a boost to the economy. The economy will also be supported by additional investment in the tourism and mining sectors, as well as by infrastructure projects such as roads. Private consumption growth is expected to be driven by tax cuts, public sector pay raises, and low interest rates. However, the performance of the sugar industry will remain sluggish. Sugar output was poor in 2012, and the industry’s long-term structural problems (low productivity Population 874,742 of growers and mill inefficiencies) are no closer to Population growth 0.8 percent being solved. According to the Ministry of Finance, GDP (PPP , int’l US$) 4.3 billion the government’s reform program spent around GDP per capita (PPP , int’l US$) 4,943 Surface area 18,270 sq. km. US$84 million between mid-2011 and late 2012 on Capital Suva the rehabilitation of mills, debt restructuring, and Source: World Development Indicators. improving the production of sugarcane. However, sugar production in 2012, at 155,000 tons, was around half of the output reported in 2006. Although Summary the fall in sugar production is partly a result of natural disasters, higher production costs and land lease Fiji’s economy is estimated to have grown by payments have also played a part. Meanwhile, the 2.3 percent in 2012, and is expected to grow by a price paid for sugar by the EU under its Cotonou further 2.4 percent in 2013, largely on the back of Agreement will continue to decline rapidly, and a additional investment in the tourism and mining large portion of aid that would otherwise have been sectors, as well as government funded infrastructure provided to Fiji by the EU to smooth the transition to projects. While fiscal policy has been supportive of lower prices will be withheld until elections are held growth, Fiji faces challenges in the short to medium in 2014. term in addressing fiscal sustainability, particularly accumulating government debt. More specifically, Investment in the tourism and mining sectors is the state’s guarantee on debt to fund the purchase expected to continue in 2013 and 2014. In May of the new fleet of airplanes (by the national airline) 2013, Chinese-owned DRK Energy purchased a will not only cause a significant deterioration in the 19.2 percent stake in the Vatukoula gold mine. DRK current account in 2013, but increase contingent and Vatukoula have announced that they will work liabilities to nearly 30 percent of GDP. together on a planned expansion program aimed at boosting production for export. Construction of Fiji’s first casino began in June 2013. The US$290 million Recent Economic Developments casino will add 200 rooms to the resort area of Denarau Island, and is expected to take around two The Fijian economy is estimated to have grown by years to complete. The quarterly construction survey 2.3 percent in 2012, and is expected to grow by a estimates that the value of construction works put in further 2.4 percent in 2013. This is lower than the place in the first quarter of 2013 was US$40 million, official projection since it incorporates the negative up 10 percent compared to the same quarter in 2012. impacts of Cyclone Evan in late 2012 and early 2013, which resulted in damages and weaker tourist REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 86  |  Country Pages and Key Indicators Inflation is expected to remain moderate. In April to tax rates. Operating expenditure is expected 2013, inflation fell to just 1 percent, the lowest year- to rise from US$779 million (21.5 percent of GDP) on-year (yoy) increase in more than three years, to US$825 million (21.7 percent of GDP), partly before rising to 1.7 percent in June. Inflation is explained by an increase in staff salaries and wages. expected to pick up to a moderate level of 3 percent The minimum salary for all established staff will rise by year end, reflecting potential domestic price to F$10,000 (US$5,320), while government wage pressures stemming from the effects of public earners will receive a 10 percent across-the-board sector pay rises. increase. The budget also allows for an expansion of welfare assistance to the poorest Fijians by The current account balance is projected to broadening the social safety net to cover to poorest deteriorate substantially in 2013, largely explained by 10 percent of the population and introducing a social the purchase of three aircraft by the national airline— pension scheme to benefit those aged 70 and above. valued at around US$600 million (15 percent of Capital expenditure, mainly on roads, is expected to GDP). In the first four months of 2013, a 13.4 percent increase from US$295 million (8.1 percent of GDP) decline was noted for export earnings due to declines to US$385 million (10.1 percent of GDP). in sugar, timber, and gold exports. However, imports, excluding aircraft, grew by 3.7 percent for the same Revenue collections outperformed in the first half of period, together leading to a 21.5 percent widening the year, although 60 percent of forecast revenue of the trade deficit. The recent opening of a second remains to be collected in the second half of 2013. large hydroelectric power station and the expected According to the Fiji Revenue and Customs Authority introduction of sugarcane-based biofuel generation (FRCA), the government collected US$440 million could help reduce fossil fuel dependency, which in total revenue during January–June, which was may offset increases in other import categories. US$16 million (3.8 percent) higher than forecast in Tourist arrivals fell by around 5 percent in the first the budget for 2013, and represented an increase quarter of 2013 compared to the same period in of 11.7 percent over the same period from a year 2012. This is largely a result of recent cyclones. The earlier. The better-than-expected outturn mainly outlook for the country’s tourism industry is more resulted from stronger consumer spending, which encouraging—forward booking is reportedly up and pushed up value-added-tax revenues. Reductions in air services have become more frequent, enabled by personal income tax rates, wage increases, higher the purchase of new aircraft by Fiji Airways. However, remittances, and better employment prospects are the recent depreciation of the Australian dollar could likely to have contributed to stronger consumer dampen tourist arrival from the main source country. spending. Increased consumer demand for foreign Inward remittances rose by 20 percent cumulative goods has also pushed up the collection of import to May 2013 compared to the same period in 2012. duty, which, at US$105 million in the first half of Foreign reserves improved to US$941 million at 2013, was US$3.2 million ahead of the budget and the end of July 2013, equivalent to 5.1 months of up by 22 percent y-o-y. The strong performance imports of goods and nonfactor services (GNFS). also reflected improved tax compliance, which is an important theme in the 2013 budget. The FRCA The announced 2013 budget projects a widening has reportedly clawed back a significant amount of of the deficit, from 1.7 percent of GDP in 2012 revenue after several investigations were initiated to just under 3 percent of GDP in 2013, largely in early 2013, and lower tax rates have possibly explained by a 30 percent increase in infrastructure encouraged greater tax compliance. However, spending. Operating revenue is expected to rise lightening the income tax burden has inevitably from US$991 million (27 .4 percent of GDP) to reduced tax revenue from this source, with income US$1,053 million (27.6 percent of GDP) on the back tax collection during January–June falling by of expected growth in the economy and changes WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  87 11.6 percent y-o-y, and coming in at US$2.7 million under target. Outlook and Emerging Challenges Fiji faces challenges in the short to medium term to address fiscal sustainability, particularly accumulating government debt. Public debt has remained above 50 percent of GDP . Although the 2013 budget indicates the government’s plans on fiscal consolidation, the projected increase in government borrowing unveiled in the 2013 budget will add to public debt. Furthermore, according to Standard and Poor’s 2013 ratings assessment of Fiji, the state’s guarantee on debt to fund the purchase of the new fleet of airplanes will increase contingent liabilities to nearly 30 percent of GDP . However, reforms to the national pension fund have significantly reduced the financial risk to the government from this entity. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 88  |  Country Pages and Key Indicators Key Indicators Fiji:  2011e 2012e 2013f 2014f 2015f Year Year Year Year Year Output, Employment, and Prices Real GDP (% change yoy) 1.9 2.3 2.4 2.1 2.2 Tourist arrivals (thousands) 675 661 670 670 690 (% change yoy) Unemployment rate (%) Consumer Price Index (% change yoy) 7.7 1.5 3.0 3.0 3.0 Public Sector Government revenues (% GDP) 26.2 27 .9 28.8 28.8 28.9 Government expenditures (% GDP) 27 .6 29.6 31.8 31.6 31.5 Government balance (% GDP) -1.4 -1.7 -3.0 -2.8 -2.6 Domestic public sector debt (% GDP) 40.6 40.2 40.3 41.2 41.5 Foreign Trade, BOP , and External Debt 1/ Trade balance (millions US$) -837 -744 -1,333 -899 -937 Exports of goods (millions US$) 554 625 575 601 629 (% change yoy) 2.7 12.7 -8.0 4.5 4.7 Key export (% change yoy) 2/ 147 .3 7.3 -24.5 -0.5 -0.4 Imports of goods (millions US$) 1,898 1,950 2,495 2,090 2,163 (% change yoy) 22.9 2.7 27.9 -16.2 3.5 Current account balance millions US$) -183 -41 -632 -210 -226 (% GDP) -4.9 -1.1 -15.9 -5.2 -5.4 Foreign direct investment (millions US$) 416 266 Total external debt (millions US$) 612 679 (% GDP) 16.3 17 .9 Short-term debt (millions US$) Debt service ratio (% exports of g&s) 9.0 2.6 Foreign exchange reserves, gross (millions US$) 830 923 (months of imports g&s) 5.0 5.2 Financial Markets Domestic credit (% change yoy) 3/ 3.9 6.6 Short-term interest rate % p.a.) 2.2 0.6 Exchange rate (F$/US$, eop) 1.82 1.77 Real effective exchange rate (2000=100) 91.9 96.0 (% change yoy) 4.6 4.5 Memo: Nominal GDP (millions US$) 3,754 3,785 3,879 3,968 4,083 Source: National data sources. e = estimate. f = forecast. 1/ BOP time series undergoing revisions. Rise in debt service ratio in 2011 reflects the maturity of the US$150 million global bond. 2/ Sugar. 3/ Domestic credit to the private sector. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  89 INDONESIA 4.7 percent yoy in the second quarter, well off its recent peak of 12.5 percent growth yoy in Q2 2012. Capital goods imports have fallen accordingly, but import volumes overall still picked up in the second quarter. Export volume growth, while positive, has remained weak. On the production side, nontradable sectors such as construction (up 6.9 percent yoy in Q2) and services (up 7.5 percent) have continued to drive growth. In contrast, weakness is evident in the commodities sector, where real output shrank by 1.2 percent yoy in Q2. Outright price deflation in the mining sector has also helped push down overall Population 246.9 million GDP inflation to 14-year lows, causing nominal GDP Population growth 1.2 percent growth to decelerate much more significantly than GDP (PPP , int’l US$) 1.2 trillion real GDP growth, roughly halving from a 15 percent GDP per capita (PPP , int’l US$) 4,956 Surface area 1,904,570 sq. km. average annual pace in 2011, to 7 .8 percent in Q2 Capital Jakarta 2013. Source: World Development Indicators. Following the first annual current account deficit Summary since 1997 , of 2.8 percent of GDP in 2012, Indonesia’s external balances have continued to be in focus. Indonesia’s economy is adjusting to weaker terms of In the second quarter, a record quarterly current trade and tighter international liquidity. Policy settings account deficit of US$9.8 billion was registered, have shifted so as to support this adjustment, equivalent to 4.4 percent of GDP and significantly notably including an increase in subsidized fuel wider than the 2.2 percent of GDP quarterly deficit prices. In the baseline scenario, growth should seen in the first quarter. The wider current account moderate but remain resilient. However, the risk of a reflected the combination of flat export revenues, more significant dislocation cannot be ruled out. This and a seasonal rise in income outflows and import places a premium on continued macroeconomic demand ahead of the Lebaran holiday period. policy flexibility, making more progress to lift the Significant portfolio investment outflows since May, competitiveness and sustainable growth rate of the as seen also in many other emerging markets, added economy, and on protecting the vulnerable from the to the pressure on the overall balance of payments, impact of moderating growth and current inflationary which recorded a deficit of US$2.5 billion. pressures. Against the backdrop of mounting economic pressures, and following the passing of a revised Recent Economic Developments budget in June, the government raised subsidized fuel prices for the first time since 2005, by a Indonesia’s economy has slowed over 2013, with substantial 33 percent, on average, alongside an Rp growth weighed down by sluggish export growth and 30 trillion package of compensation measures to help weaker investment momentum. Real GDP growth shield the poor from the impact of higher fuel prices. in the second quarter was 5.8 percent year-on-year While spending on energy subsidies is still projected (yoy), down from 6.0 percent in the first quarter to remain substantial, this price adjustment marks and annual growth of 6.2 percent in 2012. Fixed an important step forward in improving the quality of investment demand, in particular, has moderated public spending. This welcome reform has, however, significantly, with gross fixed capital formation up by come at the cost of a temporary increase in inflation, REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 90  |  Country Pages and Key Indicators which increased to 8.8 percent yoy in August 2013, before narrowing in 2014 to 2.6 percent of GDP . reflecting primarily a fuel-price-induced jump in the The overall balance of payments is also expected to CPI in July. record a sizable deficit in 2013, reflecting a shortfall in net investment inflows relative to the current As in many other major emerging markets and as account financing need, and resulting in a drawdown discussed elsewhere in this report, Indonesia’s of approximately US$18 billion in foreign currency financial markets have been under pressure since reserves. The overall balance-of-payments deficit is May, as global liquidity tightened in anticipation of expected to shrink significantly in 2014, reflecting U.S. Federal Reserve asset purchase “tapering. ” a smaller current account deficit and overall net Exchange and interest rates have been responding investment inflows. to these market pressures. The rupiah has weakened by 20 percent against the U.S. dollar year-to-date, Inflation pressures are projected to moderate in and official currency reserves have declined by month-on-month terms following the mid-2013 US$19.7 billion over 2013 to US$93 billion in August. price surge triggered by the June subsidized Bank Indonesia has lifted its overnight deposit and fuel price increase and the seasonal impact of reference interest rates by 150 basis points since Ramadan. Headline inflation in Q4 2013 is projected June, along with taking a series of measures aimed at at 9.8 percent yoy compared with 4.3 percent yoy improving currency market conditions, streamlining in Q4 2012, and inflation to average 7 .3 percent liquidity management, and selectively reigning in in 2013 and 6.7 percent in 2014. This base case credit growth (notably in the property sector). In assumes that second-round inflation will remain response to the particularly marked deterioration in contained, allowing the price impact of the June fuel market conditions in early August, the government price increase to drop out of the base by mid-2014. also announced a package comprising a range of However, while core inflation has so far remained measures designed to support exports and FDI, little changed, there is a clear risk of some second- dampen import demand, and limit the negative round effects from the recent spike in headline employment and poverty impacts of slower growth inflation, particularly given other cost-push inflation and higher inflation. pressures. Risks to the economic outlook are sizable and to Outlook and Emerging Challenges the downside, as domestic demand is impacted by higher generalized consumer price inflation (eroding In the base case, GDP growth in 2013 is projected purchasing power and consumer confidence), to slow moderately to 5.6 percent, declining to 5.3 higher interest rates (dampening hitherto rapid percent in 2014. Private consumption is expected credit growth), and potential negative wealth and to remain the main driver of growth, potentially corporate investment activity effects from the boosted by early preelection spending toward the stock price and currency declines seen since May. end of 2013 and into 2014. Investment is expected Forecast uncertainty is amplified by the difficulty in to expand at a much more moderate pace than in predicting how consumer and investor sentiment 2012. Unlike in 2012, net exports are not expected to will respond to significant, ongoing economic and be a significant drag on growth over the remainder policy adjustments. Much also depends on the of 2013, as import volume growth decelerates in line future course of external demand from key trading with slower investment growth, and export volume partners such as China and the United States, and growth remains positive, albeit subdued. international commodity prices. The current account deficit is expected to stand The likely narrowing of Indonesia’s growth at US$29.3 billion, or 3.4 percent of GDP, in 2013, differential with its major trading partners is broadly WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  91 positive for restoring its external balances. However, the significant market and policy adjustments now occurring do bring risks, placing a premium on clear macroeconomic policy communication and coordination, and on effectively mitigating the negative impact of higher inflation and lower growth on the vulnerable. In this respect, the implementation and timing details of the government package announced in August will be closely watched, as will the composition of the 2014 budget, expected to be approved by late October. In general, as the political cycle intensifies ahead of elections in 2014, maintaining the momentum on improving the regulatory environment, and lifting public infrastructure investment and social spending (including by redirecting wasteful, and still very costly, energy subsidy spending) can help Indonesia reinforce the structural underpinnings of strong growth and maintain a favorable outlook for economic growth and development. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 92  |  Country Pages and Key Indicators Key Indicators Indonesia:  2011 2012 2013f 2014f 2015f 2012 2013 2013 Year Year Year Year Year Q3 Q4 Q1 Q2 May Jun Jul Aug Output, Employment, and Prices Real GDP (% change yoy) 1/ 6.5 6.2 5.6 5.3 5.8 6.2 6.1 6.0 5.8 Domestic demand (% change yoy) 5.7 6.2 5.1 5.0 5.0 6.0 4.8 5.0 4.7 Industrial Production Index 140.0 142.9 138.7 149.3 144.7 (2000=100) (% change yoy) 4.1 2.1 13.7 6.9 3.8 Unemployment (%) 6.6 6.3 Real wages (% change yoy) 4.7 Consumer Price Index 3.8 4.3 9.8 4.4 4.8 4.3 4.3 5.9 5.9 5.5 5.9 8.6 8.8 (% change yoy) 2/ Public Sector 3/ Government revenues (% GDP) 16.3 16.2 16.0 16.0 16.0 Government expenditures (% GDP) 17 .4 18.1 18.6 18.3 18.1 Government balance (% GDP) -1.1 -1.9 -2.5 -2.3 -2.1 Government debt (% GDP) 24.3 23.9 23.5 24.1 24.0 23.7 23.4 13.0 12.9 Foreign Trade, BOP , and External Debt Trade balance (billions US$) 4/ 24.2 -1.7 0.8 -2.4 -0.9 -3.7 -0.6 -0.8 Exports of goods (billions US$) 5/ 200.8 188.5 45.5 47.1 45.2 45.7 16.1 14.7 (% change yoy) 27 .0 -6.1 -13.0 -7.2 -6.5 -3.9 -1.8 -3.7 Key export (% change yoy) 6/ 32.8 -6.6 -20.3 -10.4 -13.4 -13.1 Imports of goods (billions US$) 5/ 166.0 179.9 42.4 46.3 43.6 46.3 16.7 15.6 (% change yoy) 30.3 8.4 -0.7 4.9 -2.1 -1.0 -1.4 -3.4 Current account balance 1.7 -24.4 -5.3 -7.8 -5.8 -9.8 (billions US$) (% GDP) 0.2 -2.8 -3.4 -2.6 -1.9 -2.4 -3.6 -2.6 -4.4 Foreign direct investment 19.2 19.4 5.9 5.7 4.1 4.2 (billions US$) External debt (billions US$) 224.8 252.4 243.6 252.4 254.3 258.0 258.5 258.0 260 (% GDP) 26.6 28.7 28.0 28.8 28.9 29.1 Debt service 92.5 169.4 (% exports of g&s) 46.1 89.9 Foreign exchange reserves, gross 110.1 112.8 110.2 112.8 104.8 104.8 105.1 98.1 92.7 93.0 (billions US$) (months of imports of g&s) 6.7 6.3 6.3 6.3 5.9 5.5 Financial Markets Domestic credit (% change yoy) 24.4 24.2 23.9 22.7 22.9 21.2 21.0 20.6 Short-term interest rate (% p.a.) 7/ 6.6 5.8 5.8 5.8 5.8 5.8 5.8 6.0 6.5 7.0 Exchange rate (Rp/US$, ave) 8,770 9,387 10,400 11,400 11,400 9,544 9,630 9,695 9,818 9,802 9,929 10,278 10,924 Real effective exchange rate 160.1 158.8 158.0 156.0 160.0 163.2 163.8 163.5 161.2 161.2 (2000=100) (% change yoy) -0.1 -0.8 -2.0 -2.3 -0.2 2.0 2.3 2.4 0.9 1.6 Stock market index 3,746 4,119 3,977 4,314 4,730 4,974 5,069 4,819 4,610 4,195 (Aug. 1982=100) 8/ Memo: Nominal GDP (billions US$) 846.3 878.0 836.9 803.9 850.5 222.1 217.9 221.2 225.1 Sources: National data sources and World Bank staff estimates. f = forecast. 1/ Based on GDP 2000 base. 2/ End of period. 3/ Government projections. 4/ Goods and services trade balance. 5/ Goods trade on BOP basis from Bank Indonesia with exception of monthly figures from Budan Pasat Statistik (BPS). 6/ Crude oil and gas exports. 7/ Policy rate. 8/ Jakarta Composite Index, end of period. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  93 LAO PEOPLE’S DEMOCRATIC REPUBLIC growth in 2014 and an easing in emerging fiscal and external imbalances. Recent Economic Developments The Lao economy is expected to grow at 8 percent in 2013, fueled by a vibrant resource sector, continued FDI-financed investment in hydropower, and accommodative macroeconomic policies. The hydropower sector (both completed projects in operation and projects in the construction/ Population 6.6 million development phase), and the construction, food Population growth 1.9 percent processing, and services sectors remain the major GDP (PPP , int’l US$) 19.4 billion contributors to this growth. The upward revision GDP per capita (PPP , int’l US$) 2,926 Surface area 236,800 sq. km. of 0.4 percentage points from November 2012’s Capital Vientiane projection reflects recent data for cement and Source: World Development Indicators. hydropower outputs. Furthermore, the hydropower contribution to GDP will benefit from the completion3 and development of several large hydropower Summary projects including the Hongsa Lignite, Sayaboury, Nam Ou, and Xepian Xe Namnoi projects, which Lao PDR is expected to maintain high GDP growth of also offer a positive spillover to the construction, about 8 percent in 2013. High growth continues to be food, and services sectors. Growth in the services driven by construction and new production activity in sector was strong across main subsectors, in the hydropower sector, and by strong activity in the wholesale and retail trade, tourism, transportation services, construction, and food processing sectors, and telecommunication, and banking. aided in part by accommodative macroeconomic policies. Overall inflation has generally trended Overall inflation has continued to rise since early upward, fueled by nonrice food prices. The fiscal 2013 due to a continuous increase in nonrice food deficit widened sharply in FY12/13 because of a prices. Overall CPI inflation is projected at 6 percent combination of an increase in public sector wages for 2013, compared to 4.3 percent in 2012. Headline and compensation, and a decline in mining revenue. inflation increased from 6 percent year-on-year (yoy) In addition, domestic credit has continued to grow in February 2013 to 6.8 percent in August primarily at a fast clip, with an accommodative monetary due to high food inflation, which rose from about policy and buoyant demand in the construction, 12 percent to 17 percent during the same period. commerce, and service sectors. Strong foreign A key driver of this effect is the continued surge direct investment (FDI) and accommodative fiscal in meat and the fast increase in vegetable prices, and monetary policies have contributed to a further owing to, reportedly, unusual developments in widening of the external current account deficit. local demand and supply conditions.4 While energy Foreign reserves have continued to decline, and the reserve coverage of imports is expected to reach the lowest level in a decade. There are indications 3 Completed projects that will commence full operations in 2013 include that the expansionary bias of fiscal and monetary Nam Ngum 5 and the Theun Hinboun expansion project. policies observed so far in 2013 may be partly 4 In response, the Ministry of Industry and Commerce (MOIC) recently issued an order (MOIC Order No. 650, dated April 1, 2013) to temporarily removed, which could lead to marginally slower suspend exports of livestock and divert them for local supply. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 94  |  Country Pages and Key Indicators inflation has remained low, core inflation moderated US$530 million in June, down 12.4 percent yoy for slightly during the same period. Q2 2013, while net foreign assets fell significantly by 57 percent yoy. Reserves coverage is expected In FY12/13, the fiscal deficit is expected to worsen to reach the lowest level in a decade, with only due to a combination of a large increase in public 1.6 months of goods and services imports, or sector wages and benefits, and a decline in mining about 2.6 months of nonresource imports. The revenues. Total revenue growth is expected to slow ratio of reserve-to-foreign-currency deposits fell due to lower grants and lower mining revenue in progressively from about 60 percent two years ago 2012 as a result of a fall in copper prices and higher to around 26 percent in June 2013. mining production costs that partly offset the volume and gold price gains in 2012. Nevertheless, Domestic banking credit growth has slowed, nonresource taxes (particularly the value-added but remained high in June 2013, at 28.2 percent tax and excise taxes) have a positive performance yoy, driven mainly by private sector credit. Private outlook. For the year as a whole, the public wage sector credit growth has primarily come about from bill will have risen by about 125 percent in 2013 from accommodative policy in the face of increasingly the previous year. As the new wage increase was buoyant credit demand growth in the construction, implemented, total expenditure in the first half of commerce, and service sectors. Broad money grew FY12/13 increased by 35 percent yoy compared to by 28 percent yoy in June supported by deposits and 10 percent yoy in the first half of the last fiscal year. credit growth. As a result, the fiscal deficit is expected to widen sharply to 6.1 percent of GDP , from 1.3 percent in 2012. The overall nonresource fiscal deficit is Outlook and Emerging Challenges expected to climb to 9.7 percent in FY12/13 while the nonmining fiscal deficit is likely to reach 8.8 percent Growth in 2014 is projected to moderate at 7.7 percent from 5.5 and 4.6 percent, respectively. The rapid taking into account the increased downside risks in widening in the deficit appears to have strained the the regional economy and the slowdown in some cash position of the government in recent months real sectors. There are also indications that the and may be encouraging the authorities to take authorities may pull back somewhat on the strongly offsetting measures on short-term spending. expansionary bias in their fiscal and monetary policies. Key growth drivers are expected to come Further fiscal pressure has also emanated from from services (wholesale and retail, transportation, a growing trend of local government reported and telecommunication), and food processing encouragement of private prefinancing and and beverages, supported by continued domestic execution of public infrastructure projects. These demand. Construction and construction-related projects are prefinanced by private contractors industry are expected to still grow fast, albeit at a citing development priorities of concerned regional slower pace compared to the high base in recent authorities despite limited prior budget allocations, years. The resource sector is expected to provide a with related risks of creating contingent liabilities and smaller contribution this year since new commercial intensifying pressure on the budget and the fiscal operation of major power projects is not expected to stance. While the current number and size of active come onstream in 2014. and planned prefinancing arrangements remains unclear, the authorities will need to develop clear Inflation is projected at 6 percent (yoy) in 2014, in regulations and policies to manage these projects. line with 2013. The key driver has been an upward pressure from food inflation, especially from nonrice Foreign exchange reserves and net foreign assets food items in light of stronger internal consumption continue to fall in mid-2013. Reserves stood at demand. Even with slightly less accommodative WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  95 macroeconomic policies going into 2014, the manufacturing and services sectors, are reporting inflation momentum is expected to remain steady in difficulty in finding labor (even unskilled labor) due to the near future. demand and supply mismatch, relatively high labor turnover, and migration. The government is working The fiscal deficit in FY13/14 is projected at 5.8 percent on updating its Human Resource Development of GDP , assuming, on current policy plans, a further Strategy that will provide an important framework 35 percent increase in public wages. Fiscal policy for education and labor market development going would focus on expenditure containment measures forward. for nonwage recurrent expenditures, as well as efforts to improve revenue administration, including at the decentralized level. There are indications, however, that the authorities may go some way to tightening their fiscal policy, contain spending growth, and seek additional revenue efforts, although specific details remain unclear at the current juncture. With strong past and projected GDP growth, the assessment of risks of debt distress has been revised from high to moderate in 2012, and remains so in 2013 and for the medium term, even despite the recent widening of the fiscal deficit. This said, debt sustainability would need to be reassessed altogether if the government went ahead with plans for large infrastructure projects. The overall balance of payment is expected to exhibit a slight surplus in 2014 as strong capital inflows are expected to compensate the still widening current account deficit. The current account deficit is expected to remain high due in part to the large need for capital goods imports supporting the ongoing construction of large-scale hydropower projects. In addition, nonresource imports growth is likely to outpace nonresource exports growth. At the same time, the uncertainty in the global economy and possible moderation of growth in some emerging markets could have further implications for Laos, including through lower FDI and lower mining export prices, with a negative impact on Lao export earnings and government revenues. As regards prospects for longer-term inclusive growth, shortages of labor, especially skilled labor, has remained one of the top constraints in doing business and is a potential hindrance to nonresource sector growth. Businesses, particularly in the REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 96  |  Country Pages and Key Indicators Key Indicators Lao PDR:  2011e 2012e 2013f 2014f 2015f Year Year Year Year Year Output, Employment, and Prices Real GDP (% change yoy) 8.0 8.2 8.0 7.7 8.1 Consumer Price Index (% change yoy) 7.6 4.3 6.0 6.0 6.0 Public Sector 1/ Government revenues (% GDP) 18.5 19.7 18.7 18.9 19.2 Government expenditures (% GDP) 21.2 21.0 24.8 24.7 25.1 Government balance (% GDP) 2/ -2.7 -1.3 -6.1 -5.8 -6.0 Foreign Trade, BOP , and External Debt Trade balance (millions US$) -760 -1,477 -2,310 -2,450 -2,588 Exports of goods (millions US$) 2,628 2,892 2,939 3,004 3,201 (% change yoy) 22.3 10.0 1.6 2.2 6.6 Key export (% change yoy) 16.1 11.8 -0.1 0.9 0.3 Imports of goods (millions US$) 3,388 4,369 5,249 5,454 5,789 (% change yoy) 30.8 29.0 20.1 3.9 6.1 Current account balance (millions US$) -850 -1,440 -2,322 -2,498 -2,677 (% GDP) -10.3 -15.3 -20.8 -20.0 -18.9 Foreign direct investment (millions US$) 1,067 1,764 2,618 2,491 2,572 External debt (millions US$) 7 ,623 8,887 10,419 12,181 13,332 (% GDP) 82.9 87.5 94.2 102.0 102.3 Debt service ratio (% exports of g&s) 63.2 60.5 78.5 76.0 69.1 Foreign exchange reserves, gross (millions US$) 3/ 679 739 707 785 886 (months of imports of g&s) 2.3 1.9 1.6 1.7 1.8 Financial Markets Domestic credit (% change yoy) 4/ 38.2 26.6 24.3 23.2 21.3 Short-term interest rate (% p.a.) 5/ 7.0 Exchange rate (Kip/US$, ave) 8,058 7,982 7,862 8,000 8,000 Exchange rate (Kip/US$, eop) 8,004 7,967 7,931 8,000 8,000 Real effective exchange rate (2000=100) 127 .2 (% change yoy) 4.0 Memo: Nominal GDP (millions US$) 8,253 9,418 11,176 12,493 14,138 Source: National data sources. e = estimate. f = forecast. 1/ Fiscal year basis. 2/ After grants. 3/ Excluding gold. 4/ Domestic credit, excluding government lending funds. 5/ Treasury bill rate.   WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  97 MALAYSIA expanded 4.2 percent year-on-year (yoy) compared to 5.9 percent in the previous six months (2.5 percent compared to 6.0 percent on a sequential or Seasonally Adjusted Annual Rate [SAAR] basis). On the demand side, the weakness can be attributed primarily to exports, whereas domestic demand remained robust, with the value added produced and absorbed domestically estimated to have expanded by a faster rate in the first half of 2013 compared to the previous six months (9.3 percent compared to 8.8 percent). Most sectors of the economy slowed, especially agricultural commodity Population 29.2 million sectors (palm oil and rubber) and financial services. Population growth 1.7 percent The mining sector improved upon the contraction GDP (PPP , int’l US$) 501.2 billion in the previous quarter, while strength in domestic GDP per capita (PPP , int’l US$) 17,143 Surface area 330,800 sq. km. demand was aligned with the expansion in services, Capital Kuala Lampur which accelerated by 4.3 percent over the last Source: World Development Indicators. quarter (Q1’13: 3.8 percent, SAAR). Fixed investment slowed in the second quarter Summary of 2013, while household and government consumption remained robust. Following strong Although Malaysia’s economy slowed in the first half performance in the previous five quarters, gross of the year, domestic demand kept GDP growth at fixed capital formation contracted on a sequential 4.2 percent despite further contraction in exports. basis (-2.9 percent quarter-on-quarter [qoq] SAAR in Strong domestic demand drove faster growth of Q2 compared to 44 percent qoq SAAR in Q1; yoy imports, especially of capital goods, compared to growth remained positive, however), while private exports. As a result, the current account surplus and public consumption remained strong. Despite narrowed to its lowest level since the Asian softer commodity prices, particularly for crude financial crisis. Responding to capital outflows and palm oil, private consumption was bolstered by a a downgrade to its sovereign ratings outlook that round of higher salaries and bonuses for the civil drove government bond yields higher and equity service, accommodative credit conditions, and the markets lower, Malaysia’s policy makers took action Bantuan Rakyat 1 Malaysia (BR1M) cash transfers, to rein in the fiscal deficit and contain the decline in which were distributed to close to 70 percent of the current account surplus. The economy is likely to Malaysian households in early 2013. Growth in face greater domestic headwinds going forward as public consumption expanded markedly in Q2 2013, fiscal consolidation takes a bite out of consumption reflecting higher spending on supplies and services and investment. The external outlook has improved, and sustained spending on emoluments. however, and both exports and production appeared to have turned the corner since July. Exports contracted on a year-on-year basis for the fourth quarter in a row as commodity exports (especially palm oil and rubber) slowed and electrical Recent Economic Developments and electronic exports showed no signs of recovery. While imports of intermediate goods mirrored weak GDP growth slowed in the first half of 2013 exports, and imports of capital goods contracted from largely on account of weak external demand. GDP the previous quarter in line with fixed investment, as REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 98  |  Country Pages and Key Indicators a result of the larger decline in exports and softer ” government bond yields, and fears of a “twin deficit, commodity prices, the current account surplus the government in early September announced an narrowed to the lowest level since the fourth quarter immediate 10 percent cut in fuel subsidies and a of 1997, at 4.6 percent of GDP (Q1’13: 5.1 percent “sequencing” (delay) of public investments. More of GDP). Despite the deterioration in the current measures toward fiscal consolidation are expected account, the balance-of-payments deficit narrowed to be included in the upcoming budget, notably modestly to -0.4 percent of GDP (Q1’13: -1.6 percent additional cuts to fuel and food subsidies, and the of GDP) due to stronger capital inflows in the announcement of a Goods and Services Tax (GST) beginning of the quarter. likely to be implemented in 2015. A combination of the U.S. Fed’s mulling about the Inflation has remained subdued. Although there were timing of “tapering” its highly accommodative expectations that prices would pick up in 2013 from monetary policy and concerns about the sustainability a weak 1.7 percent in 2012, inflation has so far been of large current account deficits in some countries, modest, underpinned by relatively stable energy notably India and Indonesia, led to large capital prices and by a moderation in food inflation further outflows in June and August. Although vulnerabilities to slower increases in global food prices. Given the in Malaysia were not as pronounced compared to fuel price hike in September and the prospect for other countries, investors were concerned about further subsidy cuts, including to industrial prices the sharp reduction in the current account surplus, of electricity, inflation is expected to pick up in the large degree of foreign holdings of domestic debt, fourth quarter of 2013 and into 2014. and initial lack of fiscal reforms following the general election. As a result of capital outflows, the currency Monetary policy remains stable to manage offsetting depreciated and government bond yields increased: forces. The policy interest rate has been kept at the ringgit declined 10 percent against the U.S. dollar 3 percent for the last 27 months. The strength in since late May, and as of early September, Malaysia’s domestic demand, credit growth, and the prospect of 10-year ringgit yield had jumped 44 basis points. higher interest rates in advanced economies would Malaysia’s stock market was also not spared, losing suggest higher rates, but low inflation, continued about 7 .3 percent of market capitalization between weakness in the export sector, and the potential July and end-August before recovering since then. impact of higher policy rates on household budgets (and by implication banks) argue for a continuation of While eventual Fed tapering is likely to lead to further the current interest rate environment. capital outflows, risks of a crisis are limited. Malaysia has significant external assets (at end-August, international reserves stood at US$134.8 billion, Outlook and Emerging Challenges down from US$141.4 billion at end-May), equivalent to 9.3 months of imports, and a deep domestic The near-term outlook for Malaysia suggests a financial system that can absorb securities sold by pickup in growth in the second half of the year as foreigners. Moreover, the government has embarked external demand bottoms out along with increased on more meaningful fiscal consolidation, and a confidence in the recovery of advanced economies. degree of currency depreciation will be welcomed Domestic demand will start facing headwinds from by the struggling export sector. fiscal consolidation earlier and more extensively than previously anticipated, although investment The government has taken further steps toward growth should retain some momentum given the fiscal consolidation. Pressured in July and August by extended implementation period of many ongoing a downgrade of the outlook of its foreign currency projects. GDP growth for 2013 is now estimated at ratings by Fitch, capital outflows that raised 4.3 percent, with the bulk of the downgrade in the WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  99 forecast coming from the weak performance in the first half of the year. The impact of further fiscal consolidation and possibly tighter credit conditions on domestic demand will weigh on the growth outlook in 2014 and 2015, although the improved external environment would partly mitigate those headwinds. While consumption growth is expected to pick up modestly in 2015 as the effects of fiscal consolidation start to wear out, growth in capital formation is expected to slow further, while still remaining at elevated levels compared to pre-2008 levels. An acceleration of Malaysia’s structural reform agenda could present upside risks to the 2015 forecasts. Fiscal policy is expected to remain on a track of consolidation through 2015, with the goal of reaching a deficit of 3 percent of GDP . This will require that the government adopt a medium-term perspective to fiscal policy and a commitment to controlling emoluments and supplies and services, as well as continued efforts to raise nonoil tax revenues. Under current baseline assumptions, the deficit is expected to narrow from 4.1 percent in 2013 to 3.6 percent in 2014 and 3.3 percent in 2015. On the external side, the current account surplus is expected to narrow to 3.4 percent of GDP in 2013. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 100  |  Country Pages and Key Indicators Key Indicators Malaysia:  2011 2012 2013f 2014f 2015f 2012 2013 2013 Year Year Year Year Year Q3 Q4 Q1 Q2 May Jun Jul Aug Output, Employment, and Prices Real GDP (% change yoy) 5.1 5.6 4.3 4.8 4.8 5.3 6.5 4.1 4.3 Domestic demand (% change yoy) 6.8 11.3 7.8 6.7 6.5 13.4 8.4 8.7 8.3 Industrial Production Index 108.4 113.1 112.2 116.9 111.8 115.7 116.8 115.8 118.9 (2000=100) (% change yoy) 1.2 4.4 2.5 5.8 -0.1 3.7 3.3 3.3 7.6 Unemployment (%) 3.1 3.0 3.0 3.1 3.2 3.0 3.3 2.8 3.0 Real wages (% change yoy) 1/ 0.6 4.7 3.1 5.1 5.3 4.4 3.3 7.0 6.2 Consumer Price Index 3.2 1.7 2.5 3.2 3.0 1.4 1.3 1.5 1.8 1.8 1.8 2.0 (% change yoy) Public Sector Government revenues (% GDP) 2/ 21.0 22.1 21.4 21.7 21.9 Government expenditures 25.8 26.5 25.5 25.3 25.2 (% GDP) 2/ Government balance (% GDP) 2/ -4.8 -4.5 -4.1 -3.6 -3.3 Total public sector debt (% GDP) 2/ 51.6 53.3 53.5 52.9 51.9 52.2 53.3 53.8 54.6 Foreign Trade, BOP , and External Debt Trade balance (billions US$) 3/ 47.5 36.2 36.6 43.0 34.6 7.5 10.5 6.9 4.9 0.9 1.4 0.9 Exports of goods (billions US$) 228.8 227 .9 55.9 57 .9 55.0 53.1 18.1 17.9 18.7 (% change yoy) 14.6 -0.4 -1.6 -2.4 -2.6 -8.5 -5.1 -6.9 4.5 Key export (% change yoy) 4/ 9.4 -5.0 -3.6 -2.8 0.9 -2.9 1.7 -3.9 12.0 Imports of goods (billions US$) 179.2 187 .2 47 .7 46.6 47 .0 47 .1 17.2 16.5 17.8 (% change yoy) 14.1 4.4 6.8 -0.7 4.8 -2.6 -2.3 1.3 6.2 Current account balance 33.5 18.6 3.1 7.5 2.8 0.8 (billions US$) (% GDP) 11.0 6.4 3.4 2.6 3.0 4.1 9.4 3.7 1.1 Foreign direct investment 12.0 9.4 3.1 1.9 3.0 2.9 (billions US$) 5/ External debt (billions US$) 81.0 82.6 84.7 82.6 85.6 89.6 (% GDP) 28.0 27.1 28.4 27.1 28.0 29.0 Short-term debt (billions US$) 32.7 30.4 32.8 30.4 32.8 36.0 Debt service ratio 10.3 10.1 10.0 9.8 10.4 11.1 (% exports of g&s) Foreign exchange reserves, gross 133.6 139.7 137.5 139.7 139.7 136.1 141.4 136.1 137.8 (billions US$) (months of imports of g&s) 3/ 9.3 9.6 9.0 9.7 9.7 9.1 Financial Markets Domestic credit (% change yoy) 6/ 13.2 12.0 12.4 11.1 11.1 9.6 9.3 9.1 9.3 9.4 Short-term interest rate (% p.a.) 7/ 2.9 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 Exchange rate (RM/US$, eop) 3.18 3.06 3.07 3.06 3.09 3.18 3.09 3.18 3.25 3.30 Real effective exchange rate 99.8 99.7 99.0 100.0 100.4 102.5 104.6 100.5 99.6 96.79 (2000=100) 8/ (% change yoy) -0.2 -0.2 -0.7 2.2 0.0 3.3 4.9 2.2 1.1 -2.6 Stock market index (Jan. 1, 1,509 1,610 1,637 1,689 1,672 1,774 1,769 1,774 1,773 1,728 1997=100) 9/ Memo: Nominal GDP (billions US$) 289.2 305.1 76.2 79.7 75.4 77.2 Source: National data sources, World Bank staff estimates. f = forecast. 1/ Manufacturing wages only.  2/ Federal government only.  3/ Balance of goods and services.  4/ Thermionic valves and tubes, photocells, etc. 5/ Inward FDI.  6/ Total loans in the banking system.  7/ Overnight Policy Rate (OPR).  8/ Source: BIS.  9/ FTSE Bursa Malaysia Composite, end-period. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  101 MONGOLIA quarter. Despite the moderate pace of expansion in the mining sector, at 7 .4 percent amidst the weak global coal market, robust agricultural production growth at over 20 percent and strong expansion in construction led the strong growth in the second quarter, which largely benefited from the aggressive monetary easing and public infrastructure projects funded by the Chinggis bond issued last year. National inflation rose to 9.4 percent in August from 8.1 percent in July, a turnaround from its downward trend throughout the year. Despite the Population 2.8 million loose monetary policy, inflation pressure has been Population growth 1.5 percent contained at the single-digit level by supply-side GDP (PPP , int’l US$) 15.3 billion measures including for meat, fuel, and imported GDP per capita (PPP , int’l US$) 5,462 Surface area 1,564,120 sq. km. goods through the Price Stabilization Program of the Capital Ulaanbaatar central bank. Source: World Development Indicators. A significant current account deficit (US$2 billion) continued for the first seven months of the year, Summary while capital inflow declined significantly, putting heavy pressure on the local currency value. Total Mongolia’s economy recorded another double-digit exports (US$2.7 billion) were down by 5.9 percent growth period in the first half of 2013 and is expected from a year ago, mainly due to a significant drop in to continue double-digit growth in the latter half of coal exports (down by 49 percent). Meanwhile, the the year, largely due to the new copper production net capital inflow (US$1.2 billion) slowed significantly from the Oyu Tolgoi mine. Yet, the economy has from a year ago (US$2.4 billion), largely due to a become increasingly vulnerable due to large external significant drop in FDI. Net FDI was US$1.4 billion for imbalances, significant off-budget spending, and the first seven months, a 46 percent decrease from rapid credit growth, amidst an uncertain external a year ago. A large external imbalance and loose environment. Meanwhile, foreign and domestic monetary policy has been putting pressure on the investor confidence remains fragile and translates foreign exchange market. The exchange rate against into weaker FDI. Macroeconomic management the U.S. dollar has depreciated by around 20 percent needs to put more focus on economic stability, since July through mid-September. and continuous efforts are needed to improve the investment environment. After recording an 8.2 percent budget deficit in 2012, the budget has been experiencing a significant revenue shortfall in 2013, and a fiscal consolidation Recent Economic Developments plan was announced in September. As a revenue shortage became highly likely given the fiscal The Mongolian economy grew at 11.3 percent in the outturn over the first eight months of 2013, the first half of 2013, down from 12.4 percent in 2012 government announced a fiscal consolidation plan and its peak of 17 .5 percent in 2011. The double-digit to reduce the budget deficit to the structural deficit growth in the first half was possible due to the strong ceiling of 2 percent of GDP stipulated by the Fiscal rebound of growth in the second quarter (14.3 percent Stability Law. The plan is expected to be finalized on a year-on-year basis) from 7 .1 percent in the first through Cabinet discussions by end-September. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 102  |  Country Pages and Key Indicators Yet, the fiscal consolidation plan does not include since the fast growth translates into continuous off-budget public investment projects that are being large import demand, given the limited capacity of financed by the proceeds of the Chinggis bond the domestic manufacturing industry. Inflation will (US$1.5 billion) that was issued in November 2012. likely be under continuous pressure from the recent Off-budget spending will likely increase significantly depreciation trend of the local currency and an in the second half, despite the consolidation plan of expansionary macroeconomic policy. the official budget expenditure. The authorities have not released information on disbursements of the In light of the uncertain external environment Chinggis bond proceeds. and growing economic imbalances, economic management needs to focus on ensuring economic Monetary policy has been increasingly loose through stability based on a sustainable economic policy various policy lending channels. The Bank of Mongolia framework. Macroeconomic policies need to be loosened the monetary stance by cutting policy rates readjusted to strengthen the policy space against by 275 basis points in the first half of the year, which future economic shock and to reduce pressure on was accompanied by a significant liquidity injection. economic imbalances. The first priority is to ensure The monetary easing was done through (a) provision proper implementation of the Fiscal Stability Law. of discounted loans to select industries under the The recent announcement of a fiscal consolidation Price Stabilization Program since November 2012; plan is a positive sign, but the off-budget spending of (b) liquidity injection to banks in the form of one- the sovereign bond proceeds needs to be included year deposits since May to stimulate the economy; in the budget, as well. It is also important that the and (c) a housing sector lending program including fiscal resources are “spent well. ” Spending growth Tog 800 billion in low-interest rate mortgage lending needs to be curbed to a manageable level, given the since June. As a result, the central bank’s loans to limited absorptive capacity of the economy. Public commercial banks jumped by Tog 2.8 trillion between projects need to be implemented under a proper and November 2012 and July 2013—equivalent to over transparent management process. The monetary 15 percent of GDP—and the reserve money grew authorities need to reassess the impact of the loose by 59 percent in July from a year ago. One of the monetary policy on external and internal economic systematically important banks—Savings Bank— balances. The rapid growth of private sector credit declared bankruptcy and its asset and liabilities may increase the vulnerability of the banking sector were transferred to the government-owned State to abrupt external shocks or an economic downturn. Bank on July 22, after a default of significant lending Strengthened supervision of banks and close to its major shareholder. The swift action of the monitoring of the soundness of banks are required. Bank of Mongolia and the Ministry of Finance in Finally, efforts to restore long-term capital inflow managing the degrading situation of Savings Bank into the economy are critical for stable investment. contributed to maintaining the stability of the overall The new draft Investment Law currently under banking system. However, the failure of Savings discussion could provide a good foundation on Bank highlights the importance of a transparent and which to strengthen the business climate for foreign accountable banking system. and domestic investors. Outlook and Emerging Challenges The Mongolian economy is likely to continue double- digit growth in 2013, thanks mainly to the expansion of copper exports from the new Oyu Tolgoi mine. However, the large trade deficit will likely remain, WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  103 Key Indicators Mongolia:  2011 2012e 2013f 2014f 2015f Year Year Year Year Year Output and Prices Real GDP (% change yoy) 17.5 12.4 12.5 10.3 10.0 Mineral GDP (% change yoy) 7.3 8.0 13.4 25.6 15.3 Consumer Price Index, Ulaanbaatar (% change yoy) 9.4 14.2 10.0 12.0 9.5 Public Sector Government revenues (% of GDP) 40.3 35.7 35.4 33.5 32.6 Government expenditures (% of GDP) 45.1 46.6 47.2 41.1 38.5 Government balance (% of GDP) -4.8 -10.9 -11.8 -7.6 -5.9 Public sector debt (% of GDP) 36.7 61.4 Foreign Trade, BOP , and External Debt Exports of goods (millions US$) 4,817 4,384 4,261 5,113 5,883 (% change yoy) 65.6 -9.0 -2.8 19.9 15.0 Imports of goods (millions US$) 6,598 6,738 6,522 6,717 7,388 ( % change yoy) 101.3 2.1 -3.2 2.9 9.8 Current account balance (millions US$) -2,758 -3,362 -3,259 -2,198 -1,856 (% of GDP) -31.7 -32.8 -29.7 -16.7 -11.6 Foreign direct investment (millions US$) 4,620 4,407 1,951 2,228 Gross official reserves (millions US$) 2,630 4,126 2,188 Financial Markets Domestic credit (% change yoy, eop) 75.8 -7.5 Base policy rate (% p.a., eop) 12.3 13.3 Exchange rate (Tog/US$, eop) 1,395.40 1,392.10 Real effective exchange rate 8.6 2.9 (% change yoy, eop) -5.6 8.0 Stock market index (2000=100, eop) 4,059 3,444 Memo: Nominal GDP (billions US$) 7.9 10.1 Sources: National data sources, World Bank staff estimates. e = estimate. f = forecast.   REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 104  |  Country Pages and Key Indicators MYANMAR Recent Economic Developments The economy continued to accelerate in 2012/13, with real GDP growth estimated to have been 6.5 percent, driven mainly by gas production, construction, and services. Gas exports are estimated to have reached US$4 billion in 2012/13, surpassing the 2011/12 record of US$3.5 billion. In the services sector, growth was strong in the tourism and financial sectors. The economy also showed strong performance in other areas. Foreign direct investment grew from 3.7 percent of GDP in 2011/12 Population 52.8 million to 5.2 percent in 2012/13. Most of this investment Population growth 0.8 percent was in the energy sector, garment industry, GDP (PPP , int’l US$ billions) information technology, and food and beverages. In GDP per capita (PPP , int’l US$) Surface area 676,590 sq. km. agriculture, rice production declined slightly due to Capital Nay Pyi Taw flooding in some areas and drought in others, but Source: World Development Indicators. exports in 2012/13 doubled to 1.5 million tons. This was due to a significant increase in exports to China, Summary where demand for imported rice surged after the introduction of a government price support scheme The Myanmar economy continues to be strong and saw domestic rice prices increase from US$272 per the outlook remains positive. Real growth in 2012/13 ton in 2010 to US$421 in 2013. In 2013/14, real GDP reached 6.5 percent and is projected to increase growth in Myanmar is projected at 6.8 percent due further to 6.8 percent in 2013/14. Average inflation to continued growth in foreign investment and a in 2012/13 was very low at 2.8 percent but has risen stronger performance in agriculture. noticeably in recent months, as has money supply and credit. Following a steady trend of appreciation Inflation in 2012/13 averaged a low 2.8 percent but in the last half of calendar year 2012, the nominal has risen noticeably in recent months, as has money exchange rate depreciated significantly since the supply and credit. In 2012, inflation was generally turn of 2013 but has recently stabilized. A strong tax very low, but the second half of the year saw a revenue performance in 2012/13 ensured that the steady increase mainly due to rising food costs. Year- overall fiscal deficit declined despite expenditure on-year inflation rose from 0.76 percent in June 2012 increases. While gross international reserves to 6.0 percent in December 2012. Since January continue to accumulate, the current account deficit 2013, inflation started declining again and reached has been widening, mainly due to a continued surge 4.7 percent in April 2013. However, inflation rose to in imports in response to the relaxation of many 5.5 percent in May, and indications are that it has restrictions. Following the resolution of arrears to continued to rise and may have reached 7 percent in bilateral and multilateral creditors, Myanmar has August 2013. Key drivers of recent inflation increases recently been classified as being at low risk of debt are food prices, housing rental costs, and fuel. As distress by a joint World Bank-IMF Debt Sustainability a result, average inflation in 2013/14 is projected Analysis. The continuing reform momentum points at 5.6 percent. Board money is estimated to have to a positive outlook in the short to medium term, grown by almost 70 percent in 2012/13, up from although a key challenge will be the capacity of the 26 percent in 2011/12, although close to 25 percent government to remain focused on the economic of this growth was due to a revaluation of foreign- agenda in the run-up to the 2015 elections. currency deposits following the introduction of a WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  105 managed float exchange rate regime. Commercial The current account deficit is estimated to bank lending to the private sector grew by 50 percent have widened to around -4.4 percent of GDP in in 2012/13, slightly lower than the 60 percent growth 2012/13, up from -2.4 percent in 2011/12, but gross registered in 2011/12. international reserves continued to accumulate. The widening of the current account deficit is mainly Following a steady trend of appreciation in the last due to a surge in imports following a relaxation of half of calendar year 2012, the nominal exchange some import and foreign exchange restrictions. rate depreciated significantly since the turn of These include the abolition of the export first policy 2013, but has recently stabilized. The nominal where, previously, only those importers who had exchange rate between the Myanmar kyat (K) and earned foreign exchange through exports could be the U.S. dollar appreciated by 3 percent between allowed to buy foreign exchange for imports, and August and December 2012, which raised concerns more recently, the removal of import (and export) about its negative impact on Myanmar’s export licensing requirements. Gross international reserves competitiveness, more especially as inflation was are estimated to have reached US$4.6 billion in also rising. However, the exchange rate depreciated 2012/13, equivalent to 3.7 months of imports. The by almost 14 percent in the first half of 2013, growing reserves indicate that the current account reaching a high of K 970 to one U.S. dollar in June deficit is more than covered through capital account 2013. More recently, the exchange rate appears to inflows. have stabilized around this level. Meanwhile, the gap between the official and parallel exchange rates has Following the resolution of arrears, total external narrowed significantly since the kyat was floated. debt ended at 24.8 percent of GDP in 2012/13, and A look at selected time data points shows that the a recent joint World Bank-IMF Debt Sustainability gap has narrowed to less than 1 percent, down from Analysis assessed Myanmar as being at low risk of 5 percent in May 2012. debt distress. In January 2013, arrears to multilateral institutions (the World Bank and the Asian Despite expenditure increases, the fiscal deficit in Development Bank) amounting to US$932 billion 2012/13 is estimated to have declined to -3.7 percent were cleared, while an agreement was reached on of GDP , down from -4.6 percent in 2011/12, due to the resolution of the US$10 billion arrears to Paris strong revenue performance.There were expenditure Club creditors which included a 50 percent write- increases due to increased civil service salaries and off of arrears and restructuring of the remainder. higher allocations to education and health. However, This has resulted in a decline in Myanmar’s total these were compensated for by higher gas and tax external debt, from 27 .3 percent of GDP in 2011/12 revenues. Tax revenues increased from 3.9 percent to 24.8 percent in 2012/13. Further, a recent Debt of GDP in 2011/12 to 6.4 percent in 2012/13, Sustainability Analysis conducted jointly by the although the underlying factors behind this strong World Bank and IMF concluded that Myanmar was tax revenue performance are not clear. The approved at low risk of debt distress. budget for 2013/14 shows a continued increase in the allocation of resources to health and education, which have been significantly underfunded in Outlook and Emerging Challenges Myanmar. Although still very low, the allocation to education increased from 0.8 percent of GDP in The outlook remains positive in the short to medium 2011/12 to 1.5 percent in 2012/13 and to 1.8 percent term, but there are also challenges, particularly in the 2013/14 budget approved in March 2013. The from the political front. Gas production is expected allocation to health increased from 0.2 percent in to increase significantly, with new fields coming 2011/12 to 0.8 percent in 2012/13 and 0.9 percent in onstream in 2013/14, while many development the 2013/14 budget. partners, including the World Bank, are likely to ramp REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 106  |  Country Pages and Key Indicators up their support to Myanmar following progress in the country’s reengagement process with the international community. Further, opportunities for increased exports recently improved with the reinstatement of trade preferences to Myanmar under the EU’s Generalized System for Preferences for least-developed countries, which will give Myanmar duty- and quota-free access to the EU market for all its exports, except arms and ammunition. The continued momentum for economic reforms is expected to result in higher foreign investment and trade. Significant recent reforms include the enactment of a new Central Bank Law that provides for a more autonomous Central Bank, further progress on exchange rate unification by phasing out Foreign Exchange Certificates, the award of licenses to two foreign mobile telephone service providers, and the passage of a new telecommunications law. However, an emerging challenge is likely to be the capacity of the government to remain focused on the economic reform agenda in the run-up to the fast approaching watershed elections in 2015. Likely sources of pressure include the need for lasting peace agreements with the ceasefire groups and the constitutional reform process. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  107 Key Indicators Myanmar:  2011/12 2012/13e 2013/14p 2014/15p 2015/16p Year Year Year Year Year Output, Employment, and Prices Real GDP (% change yoy)1/ 5.9 6.5 6.8 6.9 6.9 Industrial Production Index 2/ (% change yoy) 6.5 Consumer Price Index (% change yoy, period average) 2.8 2.8 5.6 6.3 6.0 Public Sector Government revenues (% GDP) 3/ 12.0 23.0 23.4 23.9 24.5 Government expenditures (% GDP) 3/ 16.6 26.6 28.4 28.7 29.3 Government balance, official (% GDP) 3/ -4.6 -3.7 -5.0 -4.8 -4.8 Public sector debt (% GDP) 22.5 22.6 22.4 22.3 22.4 Foreign Trade, BOP , and External Debt Trade balance (millions US$) -369 -2,022 -1,700 -1,229 -1,668 Exports of goods (millions US$) 9,427 9,644 11,276 13,707 15,142 (% change yoy) 19.4 2.3 16.9 21.6 10.5 Imports of goods (millions US$) -9,795 -11,666 -12,919 -14,998 -16,810 (% change yoy) 30.8 19.1 10.7 16.1 12.1 Current account balance including grants (millions US$) -1,264 -2,281 -2,436 -2,766 -3,068 (% GDP) -2.4 -4.4 -4.3 -4.5 -4.6 Foreign direct investment (millions US$) 1,949 2,696 2,153 2,397 2,868 External debt arrears (billions US$) 4/ 10.8 4.8 Total external debt including arrears (billions US$) 15.3 13.7 11.7 13.2 14.7 (% GDP) 27.3 24.8 19.7 20.3 20.6 Debt service ratio (% exports of g&s) 10.7 2.2 4.2 3.9 3.7 Foreign exchange reserves, gross (millions US$) 4,026 4,599 5,537 6,477 7,625 (months of imports of g&s) 3.5 3.7 3.9 4.0 4.1 Financial Markets Domestic credit (% change yoy) 25.1 6.2 29.2 24.5 18.4 Short-term interest rate (% p.a.) Official exchange rate (K/US$) 5/ 5.6 880.0 Parallel effective exchange rate 5/ 822.0 878.0 (% change yoy) -4.3 6.8 Memo: Nominal GDP (millions US$) 6/ 52,663 51,849 56,661 61,468 66,706 Sources: Myanmar Central Statistics Office, Ministry of Finance and Revenue, Central Bank of Myanmar, and World Bank staff estimates. e = estimate. p = projections. 1/ Staff working estimates. 2/ Including manufacturing, power, construction, and energy and mining. 3/ Consolidated public sector including Union Government and State Economic Enterprises. 4/ In FY2012/13 and FY2013/14, the terms of bilateral arrears clearance agreement with Japan, the World Bank, and the ADB are incorporated. 5/ Authorities adopted a managed float on April 1, 2012. 6/ Real GDP is rebased to 2010/11 prices by the authorities. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 108  |  Country Pages and Key Indicators PAPUA NEW GUINEA Recent Economic Developments Ninety percent of the US$19 billion PNG LNG project had been constructed by August 2013, and it appears set for its first exports in the second half of 2014. This represents an important inflexion point for the PNG economy. On the positive side, significant fiscal and investment risks associated with the project have diminished greatly, and overall GDP is expected to expand significantly in 2014 and 2015 as exports commence. On the negative side, discharging of the PNG LNG construction Population 7.2 million workforce is already amplifying the weakening in Population growth 2.2 percent commodity prices and production, and to cut into GDP (PPP , int’l US$) 20.8 billion incomes and domestic demand and associated spin- GDP per capita (PPP , int’l US$) 2,898 Surface area 462,840 sq. km. off investment activity, while fiscal pressures mount Capital Port Moresby as the government expenditure remains elevated Source: World Development Indicators. despite weakening revenues. Further, the impact of PNG LNG production on GNI will be far smaller than the impact on GDP , given that the project is Summary approximately four-fifths owned by nonresidents, and tax-reducing allowances are expected to delay Papua New Guinea’s (PNG’s) economy is slowing first significant tax payments until early in the next from the very strong growth rates of recent years, decade. as construction of the PNG liquefied natural gas (LNG) facility nears completion and weaker external Economic indicators over the first half of 2013 demand weighs on domestic activity. Indicators give have been mixed. The government raised its mixed signals about the extent of the slowdown. growth forecasts for 2013, from near 4 percent Fiscal policy is stimulatory, since revenues are to near 6 percent, and several other observers weaker than budget expectations, while the also upwardly revised their growth expectations. government expects to disburse its greatly expanded The Treasury Department attributed its upgrade spending plans it has budgeted for 2013, especially to stronger production from various resource for subnational and capital spending. This provides projects, greater government spending on capital some offset from weaker commodity-related works, and to an adjustment in its profile of PNG incomes across the country and the conclusion LNG construction expenditure, with the Treasury of the PNG LNG construction phase. Stabilizing or measuring significantly more domestic LNG weakening in nonresource production and incomes construction activity in 2013 than it had previously are expected to continue into the medium term. The estimated. In contrast to these upward revisions, start of LNG exports will raise headline GDP by as private sector operators across most sectors of the much as 50 percent, although the impact on gross economy reported sales and investment conditions national income (GNI), the current account, and declining, generally by more than they had expected. government revenues will be far more modest. The international prices of PNG’s exports continued to fall, with some offset for local producers’ incomes from the 11 percent depreciation in the PNG kina against the U.S. dollar between January and August 2013. Lower commodity prices have impacted both WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  109 existing resource operations and new investments, than expected due to the lower value of turnover leading to a reinforcing cycle of lower demand, across the economy. job cuts at manufacturers, and lower profitability for various investors. Most notable have been the Inflation, as reported by the National Statistics Newcrest-owned mining projects, with hundreds of Office, rose somewhat through the first half of national and international jobs reportedly cut from 2013, to 3.2 percent year-on-year. This modest rise the Lihir Gold operation. Project preparation on the in prices appears to be due to tobacco and betalnut. Wafi-Golpu gold and copper resource has been The kina’s depreciation creates some upside risks delayed, with substantial multiplier effects reducing for inflation. The Bank of Papua New Guinea (BPNG) economic activity across the northern region of has intervened to slow the depreciation, resulting PNG. Domestic firms are yet to report significant in a drop in foreign exchange reserves of almost support from the budgeted increases in government US$0.5 billion between late 2012 and May 2013. spending. However, weakening demand and new supply, especially in the urban property markets, are likely Government revenues in the first half of 2013 were to slow overall price growth. The PNG CPI, based on somewhat weaker than had been anticipated or was 1976 consumption patterns, has been out of date for achieved in the same period of 2012. The government many years, bringing significant risks of policy not expects revenues to be only modestly lower than its reacting to the actual rate of inflation. budget forecasts, notwithstanding sharp downward adjustments to assumed export prices (for example, average prices in 2013 of gold revised down US$280 Outlook and Emerging Challenges to US$1,409 per ounce; copper prices revised down US$809 to US$7 ,238 per ton). Despite these Overall, while nonresource activity is expected adjustments, the assumptions were again above to stabilize near current levels following a decade prevailing spot prices. The government expects of strong growth, the risks to these forecasts are stronger domestic tax receipts (notably, the goods tilted to the downside. In the short term, there are and services tax and personal income taxes) to reports of significant weather-related disruptions to partially offset the impact of weaker commodity production at the Ok Tedi mine midyear, while cash prices, despite the reports of lower turnover and crop production remains weak. Into the medium worsening labor market conditions across the term, the probability of any of the new resource economy. or other projects currently under preparation being approved has declined, due to lower expected In contrast, the government expects its spending to returns, scarcer capital, and higher investment exceed budgeted levels, due to overruns in provincial costs. Various proposals for the second LNG project personnel emoluments. The government expects to continue to be discussed, ranging from constructing fully disburse its expanded development budget, a new liquefaction facility at a greenfield site in despite significant delays in the first half of the Gulf province, through to a joint venture with year and the usual lags in preparing more complex Exxon that uses the additional capacity at the PNG projects of the type included in the 2013 budget. LNG site to construct a third and perhaps a fourth Overall, weaker revenues and stronger spending production train. But these have been discussed for raise the government’s projection of its deficit some years, and it is not clear when an investment toward 8 percent of GDP . However, if development decision is to be expected. Structurally, new LNG expenditure occurs at historical rates for the projects risk selling at weaker prices as new remainder of the year, the deficit would be closer to conventional and unconventional supply becomes 6 percent of GDP , although there also is some risk available from elsewhere in the region and globally. that the deficit may be higher, with receipts weaker Meanwhile, the agricultural sector has witnessed REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 110  |  Country Pages and Key Indicators a decline in cash crop production in recent years. Complementary investments in extension and marketing services required to improve farmers’ incentives and productivity have been lagging. Macroeconomic risks could emerge on the fiscal front. PNG’s headline public debt ratio provides a strong anchor for fiscal policy, but is weakened by the various debts and contingent liabilities held off- budget by parastatals. PNG can deliver better public services and goods even with slower spending growth, by tackling the weaknesses in funding chains for health and education or procurement which have been highlighted in recent work by the National Economic and Fiscal Commission, the Office of the Auditor General, and the National Research Institute. Efforts are being made to better manage the state’s enterprises and mineral and oil and gas assets, notably through consolidation into a proposed “Kumul” holdings. This is a challenging task and outcomes will likely hinge on the quality of governance and transparency arrangements that are implemented. The government has also passed legislation taking ownership of the major Ok Tedi mine from the PNG Sustainable Development Program, with uncertain implications for SDP’s ongoing social investment programs. These unfolding policy changes are likely to be followed closely by national and international investors aiming to make long-term commitments to sustainable and inclusive growth in PNG. Separately, the government is making efforts to address years of underinvestment in public sector capabilities, through restaffing the public service—again, a task that many governments have found challenging. Finally, recent announcements around spatial development, focusing on PNG’s main towns, are consistent with the successful international experience of building on economic momentum by supporting development in existing core urban areas, while ensuring all citizens across the country are able to access the benefits and opportunities created by these centers. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  111 Key Indicators Papua New Guinea:  2011 2012e 2013f 2014f 2015f Year Year Year Year Year Output, Employment, and Prices Real GDP (% change yoy) 10.7 8.7 4.5 10.0 20.0 Real nonmineral GDP (% change yoy) 13.0 9.0 3.8 0.0 3.0 Formal employment (BPNG index, % change yoy) 6.3 5.8 2.0 -2.0 1.0 Consumer Price Index (% change yoy) 6.9 1.6 6.0 6.0 5.5 Public Sector Government revenues & grants (% GDP) 30.4 29.6 28.4 26.3 23.5 Government expenditures (% GDP) 28.7 32.8 34.0 32.2 28.0 Government balance (% GDP) 1.7 -3.2 -6.5 -5.8 -4.5 Nonmineral government balance (% GDP) -5.7 -6.7 -9.3 -7.6 -9.7 Public and publicly guaranteed debt (% GDP) 1/ 22.3 26.7 31.6 32.0 29.0 Foreign Trade, BOP , and External Debt Trade balance (millions US$) 1,093 -162 1,271 2,047 6,687 Exports of goods (millions US$) 6,954 6,249 5,977 6,694 11,945 (% change yoy) 19.0 -10.1 -4.4 12.0 78.4 Key export (% change yoy) 2/ 9.2 -6.2 -1.8 12.5 102.8 Imports of goods (millions US$) 5,861 6,411 4,706 4,647 5,258 (% change yoy) 36.3 9.4 -26.6 -1.3 13.1 Current account balance (millions US$) -2,303 -4,411 -2,017 -1,349 3,291 (% GDP) -17.9 -29.1 -12.5 -7.6 13.7 Foreign direct investment (millions US$) 1,750 1,200 800 500 800 Total external debt (billions US$) 12.6 23.1 21.4 21.0 19.7 (% GDP) 97.8 152.8 132.8 118.6 81.7 Public debt service ratio (% exports of g&s) 1.3 0.7 1.4 1.2 0.8 Foreign exchange reserves, gross (millions US$) 4,126 3,804 3,000 3,500 4,000 (months of imports of nonmining g&s) 14.5 12.7 9.0 9.0 10.5 Financial Markets Domestic credit to private sector (% change yoy) 7.3 15.0 12.0 6.0 10.0 Short-term interest rate (% p.a.) 6.8 7.0 6.3 6.8 7.5 Exchange rate (K/US$, eop) 2.15 2.06 2.25 2.34 2.43 Real effective exchange rate (2005=100) 127 .5 147 .0 145.0 145.0 145.0 (% change yoy) 12.7 15.3 -1.4 0.0 0.0 Memo: Nominal GDP (billions US$) 12.9 15.1 16.1 17.7 24.1 Sources: National data sources; IMF; and World Bank staff estimates. e = estimate. f = forecast. 1/ Not including debts of state-owned enterprises, or assets of the Bank of Papua New Guinea. 2/ Mineral exports.   REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 112  |  Country Pages and Key Indicators PHILIPPINES in the second quarter of 2013 (Q2 2013), following the revised 7.7 percent growth in Q1 2013. Growth in H1 2013 surpassed China’s 7 .5 percent and was the highest among the ASEAN-5 economies.5 The country’s strong macroeconomic fundamentals, characterized by low and stable inflation, healthy external balance, and stronger government finances, have continued to shield the economy from the persistent weaknesses of the global economy. GDP growth in H1 2013 was driven by the robust performance of private consumption and Population 96.7 million construction, and higher government spending. Population growth 1.7 percent As in the previous quarters, the sustained inflow GDP (PPP , int’l US$) 426.7 billion of remittances fueled private consumption, which GDP per capita (PPP , int’l US$) 4,413 Surface area 300,000 sq. km. grew by 5.3 percent and contributed 3.7 percentage Capital Manila points (ppt) to overall growth. Private construction Source: World Development Indicators. increased by 22.1 percent, supported by the low interest rate environment and the robust demand for office and residential space by the booming business Summary processing outsourcing (BPO) industry and its 800,000-strong workforce, which now constitutes a The Philippines continues to exceed most new middle class. Aside from the improved efficiency expectations, with first-half growth of 7 .6 percent. in government spending, the strong growth of public Growth was underpinned by consumption and construction and government consumption reflected services, with investment and manufacturing election spending, which historically contributed up giving the extra boost. Amid the challenging global to 2 ppt to H1 domestic demand growth. Exports, environment, the Philippines is expected to sustain however, continued to decline and subtracted high growth in the medium term. Full-year growth 4 ppt from overall growth given slack demand for is projected at 7 percent, while growth in 2014 electronic products in key trading partners, such as would remain robust at 6.7 percent. Going forward, China and the United States. the government needs to focus its attention on generating higher, sustained, and more inclusive On the production side, the services sector growth—the type that creates more and better jobs continued to be the main engine of growth, while and reduces poverty. These can be achieved with manufacturing also provided a boost. The services reforms to enhance competition, protect property sector benefited from the resilient growth of trade, rights, simplify regulations, and increase investment financial intermediation, and real estate and other in infrastructure, education, and health. business activities. It expanded by 7.1 percent and contributed 4.1 ppt to overall growth. Despite the fall in exports, manufacturing grew by 10 percent Recent Economic Developments and was driven by strong domestic demand for food, household appliances, chemical products, and The Philippine economy grew remarkably by industrial machineries and equipment. Growth in 7.6 percent in the first half of 2013 (H1 2013), outperforming major economies in the region. Growth momentum was maintained at 7 .5 percent 5 Indonesia, Malaysia, the Philippines, Singapore, and Thailand. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  113 agriculture slowed to 1.4 percent from 3.6 percent the magnitude of narrow money [M1]), could pose in 2012 due to lower production of major crops, such significant upside risk to inflation. as rice, coconut, sugarcane, and banana, largely offsetting the increase in fish harvests. Government finances continued to improve, with a fiscal deficit of 1 percent in H1 2013, below the Despite weaker exports, sustained growth in government’s target of 2 percent. Efforts to improve remittances kept the country’s external position the efficiency and pace of government disbursements healthy. Remittances remained largely unaffected continued to pay off as reflected in the 12 percent by slower growth in advanced economies. It grew growth of public spending. In terms of budget items, by 5.6 percent in H1 2013, on account of sustained higher growth rates were seen in maintenance and deployment of skilled overseas Filipino workers other operating expenditures, which include social (OFWs) mostly to Taiwan, Hong Kong, and the services spending, and infrastructure and other Middle East. And despite weaker exports, the capital outlays. Revenue collection, however, grew contraction in imports resulted in a narrower trade by 13.7 percent, and is expected to further increase deficit in H1 2013. by 0.3 ppt of GDP due to incremental revenues from the “sin tax law. ” Further public finance reforms In recent months, financial markets experienced are underway. These include rationalizing fiscal significant volatility as investors responded to the incentives, improving customs administration to planned tapering of the U.S. stimulus program. The minimize smuggling, and enhancing accountability Philippine Stock Exchange index, which hit a record and transparency of the budget through the reform high of 7 ,350 points in May, lost almost 30 percent of the Priority Development Assistance Fund. of its value by August before recovering half of its losses in mid-September. The interest rate spreads between the 2-year and 10-year bonds jumped to Outlook and Emerging Challenges 250 basis points (bp) in July from a three-year low of 58 bp in March, before settling at 115 bp in August. Amid the challenging global environment, the Following the strong appreciation of the peso in Philippines is expected to sustain high growth in 2012 and through June 2013, the peso depreciated the medium term. Baseline growth projections by around 7 percent against the U.S. dollar. are revised upward from 6.2 percent to 7 percent for 2013, and from 6.4 percent to 6.7 percent for Monetary policy stance remained accommodating, 2014. Private consumption, which comprises given the low inflation environment, but upside over 70 percent of GDP , would continue to drive risks could arise from funds exiting the special overall growth on the back of sustained growth deposit accounts. CPI inflation eased to an average of remittances and growth of the BPO industry. A of 2.8 percent through July, below the central doubling of infrastructure spending from 2.5 percent bank’s low-end target of 3 percent. Following three to 5 percent of GDP by 2016, as announced by consecutive cuts in the rate of the special deposit the President in his State of the Nation Address, accounts (SDA) in the first semester by a total of would drive growth of government consumption, 150 bps, the Monetary Board tightened rules on and both public and private investments. Further the SDA facility by limiting access only to banks’ improvements in the investment climate would trust accounts starting November 2013. With also contribute to higher foreign direct investment money supply growth reaching a six-year high of (FDI) inflows, which so far have manifested in an around 20 percent (yoy) in June, the outflow of SDA 87 percent increase in FDI pledges. funds, which currently has placements of around Philippine peso (P) 1.7 trillion (almost equivalent to Downside risks to growth include a slower global recovery, uncertainties in advanced economies as REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 114  |  Country Pages and Key Indicators stimulus programs taper, potential asset bubbles in the real estate sector, and domestic reform lags. Protracted economic slowdown and financial market volatility in high-income countries could slow growth through weaker external demand and large capital outflows. Unchecked growth of the real estate sector, in particular shadow financing for real estate, is also a major source of risk. Finally, domestic reform lags, in particular reforms to raise tax revenues, could pull down infrastructure spending and, hence, overall growth. Going forward, the government needs to focus its attention on generating higher, sustained, and more inclusive growth—the type that creates more and better jobs and reduces poverty. The challenge of sustaining growth and creating more and better jobs will have to focus on raising the productivity of the majority of the country’s workers, which requires increasing overall investments in human and physical capital. Increased investment levels and fiscal sustainability are possible only with efficient government spending financed by increased revenues through a combination of tax policy and administrative measures and improvement in the investment management process. In addition, opening up the economy to new entrants from within and outside the country to create more competition is an equally essential part of the policy reform agenda. With reforms that secure property rights, open competition, simplify business regulations, and increase investments in health, education, and infrastructure, the private sector will have the incentive to invest more and create jobs, and the country can attract more investments when, for instance, a rebalancing in the region takes place. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  115 Key Indicators Philippines:  2011 2012 2013f 2014f 2015f 2012 2013 2013 Year Year Year Year Year Q3 Q4 Q1 Q2 May Jun Jul Aug Output, Employment, and Prices Real GDP (% change yoy) 1/ 3.6 6.8 7.0 6.7 6.8 7.3 7.1 7.7 7.5 Industrial Production Index 93.0 100.2 101.1 106.2 101.9 n/a (1994 = 100) (% change yoy) 1.1 7.2 4.9 12.5 4.7 n/a Unemployment (%) 2/ 7 .1 7.0 7.0 6.8 7.1 7.5 Nominal wages (% change yoy) 3/ 4.6 4.9 4.7 7.0 7.0 2.2 Real wages (% change yoy) 3/ 0.6 2.0 1.0 4.1 5.0 0.5 Consumer Price Index 4.6 3.2 3.5 4.0 4.0 3.5 2.9 3.2 2.6 (% change yoy) Public Sector Government revenues (% GDP) 14.0 14.5 15.2 15.8 16.5 14.0 14.0 13.8 16.7 Government expenditures (% GDP) 16.0 16.8 17.4 18.0 18.8 16.7 18.7 16.3 16.2 Government balance (% GDP) 4/ -2.1 -2.4 -2.3 -2.3 -2.4 -0.7 -1.3 -2.6 0.4 Domestic public sector debt 49.2 53.5 (% GDP) 5/ Foreign Trade, BOP , and External Debt Trade balance (billions US$) 6/ -15.7 -14.8 -2.0 -3.7 -2.3 -1.8 -0.4 -0.4 -0.6 Exports of goods (billions US$) 6/ 47 .6 51.6 54.2 58.5 63.8 13.3 11.9 12.1 13.5 4.9 4.5 4.8 (% change yoy) -6.8 8.5 5.0 8.0 9.0 6.6 10.1 -6.0 -2.7 -0.8 4.1 2.3 Key export (% change yoy) 7/ -22.5 -1.0 -7.8 5.6 -28.1 -2.1 -10.6 5.8 8.7 Imports of goods (billions US$) 6/ 63.2 66.4 69.1 73.6 79.5 15.3 15.6 14.4 15.3 5.3 4.9 5.5 (% change yoy) 2.6 5.1 4.0 6.5 8.0 1.9 6.5 -7.4 0.1 -2.4 -4.8 8.7 Current account balance 9.5 7.3 5.4 6.1 6.2 2.2 2.2 3.1 2.5 0.9 1.0 (billions US$) 6/ (% GDP) 4.2 2.9 2.0 2.0 1.8 3.7 3.1 4.8 3.6 Foreign direct investment 1.9 2.0 3.5 4.0 5.0 0.4 0.5 2.1 0.1 0.1 -0.1 (billions US$) External debt (billions US$) 9/ 60.4 60.3 61.7 60.3 59.0 58.0 (% GDP) 27 .0 24.1 24.7 24.1 n/a n/a Short-term debt (billions US$) 9/ 7.0 8.5 8.0 8.5 9.8 9.5 Debt service ratio 8.9 (% exports of g&s) Foreign exchange reserves, gross 75.3 83.8 85.0 87.0 91.2 82.0 83.8 84.0 81.3 82.0 81.3 83.2 82.9 (billions US$) 9/ (months of imports of g&s) 10/ 11.1 11.9 10.8 10.4 10.0 12.1 11.9 12.2 11.8 11.9 11.8 12.0 12.0 Financial Markets Domestic credit (% change yoy) 11/ 14.7 7.8 12.0 7.8 15.6 11.5 13.4 11.4 12.5 Short-term interest rate 4.6 4.0 3.9 3.6 2.8 2.2 2.2 2.2 2.0 (% p.a.) 12/ Exchange rate (P/US$, ave) 43.3 42.2 41.9 41.2 40.7 41.7 41.3 42.9 43.4 43.9 Real effective exchange rate 126.7 132.8 134.7 136.3 141.4 140.4 141.9 142.5 136.8 136.4 (2000=100) (% change yoy) 13/ 0.7 4.8 6.9 7.3 11.6 11.1 11.8 12.7 8.8 8.0 Stock market index 4,189 5,168 5,249 5,538 6,418 6,850 7,216 6,402 6,575 6,334 (Jan. 2, 1985=100) 14/ Memo: Nominal GDP (billions US$) 224.1 250.2 272.1 306.9 343.4 61.0 72.1 65.0 68.2 Source: National data sources. f = forecast. 1/ The GDP series has a break in 2000.  2/ Figures are from the Labor Force Survey.  3/ Nonagriculture minimum wage, National Capital Region. 4/ IMF Government Financial Statistics basis.  5/ Total public sector domestic debt. Latest available data for 2012 is Q3.  6/ Central bank data, balance-of-payments BPM6 format. 7/ Electronic products and other electronics.  8/ Estimates.  9/ Central bank data, % of annual GDP for quarterly figures.  10/ Based on end-of-period gross international reserves. 11/ Based on Depository Corporations Survey.  12/ Interbank call rate.  13/ World Bank staff estimates.  14/ PSEi Composite, period average for annual figures. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 116  |  Country Pages and Key Indicators SMALL PACIFIC ISLAND COUNTRIES Summary Growth in the small Pacific Island economies (Kiribati, Samoa, Tonga, Tuvalu, and Vanuatu) continues to be quite volatile, in response to economic conditions in remittance-sending countries and tourist markets, natural disasters, and the project cycles of donor- funded infrastructure investments. Governments are working to consolidate public expenditure and strengthen revenue in order to expand their fiscal space to respond to future shocks. Kiribati Population 100,786 Recent Economic Developments Population growth 1.5 percent GDP (PPP , int’l US$) 248.0 million GDP per capita (PPP , int’l US$) 2,461 Economic growth in Kiribati was 2.8 percent in Surface area 810 sq. km. 2012, driven largely by donor-funded infrastructure Capital South Tawara projects. Growth of around 3 percent is expected Samoa during 2013, as construction activity associated with Population 188,889 infrastructure projects continues. Inflation remained Population growth 0.8 percent GDP (PPP , int’l US$) 853.3 million negative in 2012, due to lower prices for major GDP per capita (PPP , int’l US$) 4,517 imports, including rice, but is expected to average Surface area 2,840 sq. km. 2.5 percent during 2013, due to stabilizing import Capital Apia prices and pressure on some domestic services, Tonga including transport, from increased infrastructure Population 104,941 Population growth 0.4 percent spending. GDP (PPP , int’l US$) 527.4 million GDP per capita (PPP , int’l US$) 5,026 The current account deficit widened to 31.4 percent Surface area 750 sq. km. of GDP during 2012, despite higher-than-average Capital Nuku'alofa fishing license revenues, due to a surge in Tuvalu Population 9,860 machinery and equipment imports associated Population growth 0.2 with infrastructure projects. Remittances, which GDP (PPP , int’l US$) are dominated by transfers from seafarers, also GDP per capita (PPP , int’l US$) dropped, due to the slowdown in world shipping Surface area 30 sq. km. activity. The current account deficit is expected to Capital Funafuti Vanuatu widen further to 43 percent of GDP during 2013, Population 247,262 as imports increase and fisheries license revenues Population growth 2.2 percent decline. GDP (PPP , int’l US$) 1.1 billion GDP per capita (PPP , int’l US$) 4,606 The Government of Kiribati continues to face Surface area 12, 190 sq. km. Capital Port Vila major challenges to fiscal sustainability. Following Source: World Development Indicators. a fiscal deficit of more than 21 percent of GDP in 2011, strong fishing license revenues in 2012 narrowed the fiscal deficit to 6.8 percent of GDP , while the government also cleared accumulated overdrafts with a commercial bank equal to around WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  117 7 percent of GDP . Prospects for maintaining the stress on the Government of Samoa’s fiscal position. fiscal deficit and drawdowns from the Revenue Budget deficits averaged 6.5 percent of GDP in the Equalization and Reserve Fund6 at sustainable levels three years to FY2012, and recovery expenditure are heavily dependent on future fishing license in FY2013 has pushed the expected deficit up revenue performance, successful implementation to 6.9 percent from a pre-cyclone projection of of planned revenue reforms, and continued 4.8 percent. This fiscal pressure, combined with expenditure restraint. A deficit of 21 percent of GDP other borrowing, has seen the rapid accumulation of was projected for 2013, but a smaller deficit is likely public debt, and Samoa is now at high risk of debt given better-than-expected fishing license revenues distress. Development partners have responded during the year to date and expected budget support by increasing grant assistance for recovery and grants. rebuilding. Samoa’s economy has been hit hard by Cyclone Tonga’s economy grew by about 0.5 percent Evan, which swept across the country in December during FY2013, as a result of low remittances, 2012. After only just recovering from the full effect of subdued tourism activity, and the withdrawal of the tsunami in FY2010, economic growth in Samoa fiscal stimulus following the completion of major declined to 0.9 percent in FY2013 (relative to the infrastructure projects financed by China’s EXIM pre-cyclone projection of 2 percent). The recovery Bank. Remittances were approximately 14 percent is expected to be prolonged because the cyclone of GDP in FY2013, compared to nearly 30 percent damaged productive capacity across all sectors on in FY2009, reflecting demographic shifts and weak the main island. Repeated, major natural disasters economic conditions in the main remittance-sending have constrained growth in Samoa over the last economies of the United States, Australia, and decade, but a loss of competitiveness has also New Zealand. Weak external conditions also held played a role. back Tonga’s tourism sector, as did disruptions to domestic air services associated with the exit of Largely as a result of the cyclone, the current account the primary airline operator following the launch of a deficit is expected to have expanded to 13.1 percent new locally owned airline. of GDP in FY2013, up from 10 percent in FY2012. In the wake of the cyclone, exports of goods and Private credit growth remains negative, as tourism services have fallen, while recovery and commercial banks reduce loan books and repair rebuilding efforts have increased imports. Samoa balance sheets damaged by the unwinding of a secured rapid assistance from the IMF to ease speculative lending bubble in 2008. Recent data pressure on the balance of payments. Inflation has suggest that deleveraging may soon be complete, dropped from an average of 6.2 percent in FY2012 with the equity-to-asset ratio now reaching to an average of 2 percent in FY2013, reflecting an 20 percent and loan loss provisioning stabilizing. easing of drought-induced food shortages in FY2012. Inflation remained moderate at 3 percent in FY2013, reflecting softening import prices for food and fuel. Expenditure on recovery and rebuilding efforts The National Reserve Bank of Tonga is maintaining from repeated natural disasters has combined with an accommodative policy stance. subdued economic growth to place considerable The current account deficit narrowed to 6 percent of GDP in FY2013, with declining imports associated 6 The Revenue Equalization and Reserve Fund, established with proceeds from phosphate mining prior to independence, is intended to serve with the completion of infrastructure projects a dual role as saving vehicle and source of ongoing budget support. Due to successive large deficits, however, drawdowns have exceeded offsetting the reduction in remittances. Foreign sustainable levels. Due to unsustainable drawdowns and declines in asset exchange reserves are equal to nearly eight months values during the Global Economic Crisis, the real per capita value of the fund has declined by 18 percent since 2009. of import cover and are now 45 percent higher than REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 118  |  Country Pages and Key Indicators in 2010, largely due to grant inflows. The fiscal deficit year, largely due to higher tourism receipts, and is for FY2013 was around 1 percent of GDP , compared expected to narrow further in 2013. Foreign direct to a forecast small surplus. The deficit was driven investment contributed to an overall balance-of- by additional expenditure under a supplementary payments surplus in 2012, with foreign exchange budget and shortfalls in donor budget support. reserves rising to a comfortable seven months of These were partly offset by reductions in recurrent import cover. expenditure. The Government of Vanuatu has maintained a Economic growth in Tuvalu was an estimated conservative fiscal stance, with small budget deficits 1.2 percent in 2012, and is expected to be somewhat and low levels of public debt. The fiscal deficit in 2012 higher in 2013 as a result of donor-funded airport was 1.6 percent of GDP , down from 2.2 percent in and road upgrading projects. Inflation in the first 2011. Tax revenue, however, is relatively low against quarter of 2013 was 2 percent year-on-year, driven regional comparators, standing at 16.5 percent of largely by higher transport costs. The Government GDP in 2012. Efforts to increase tax revenue are of Tuvalu is expected to achieve a balanced budget required if Vanuatu is to boost capital spending to in 2013, with higher recurrent spending offset by adequate levels and expand public service delivery higher-than-expected fishing license revenues (see to meet the needs of its rapidly growing population. box). With the moderate recovery of global financial markets, the national Trust Fund is expected to make distributions to rebuild government reserves, an Outlook and Emerging Challenges important buffer given Tuvalu’s extreme vulnerability to external shocks. The current account deficit is Risks to growth in the small Pacific Island economies expected to narrow in 2013, from nearly 30 percent are tilted to the downside. Construction activity in of GDP in 2012, largely as a result of high fishing each country is contingent on donor-funded projects license revenues. Remittances from seafarers proceeding according to schedule. Remittance continue to decline, from their peak over a decade flows and tourism activity in Samoa, Tonga, and ago. Grants play an important role in narrowing the Vanuatu are vulnerable to economic slowdowns in current account deficit. Australia, New Zealand, and the United States, while remittance flows in Kiribati and Tuvalu are vulnerable Following subdued economic activity in 2010 and to any decline in global shipping, which would affect 2011, growth in Vanuatu increased to 2.3 percent in demand for their seafarers. In Kiribati, Tonga, and 2012, driven by increasing tourist arrivals. Continued Tuvalu, fiscal sustainability is heavily dependent on tourism growth together with new donor-financed continued consolidation. Tonga’s strong efforts to infrastructure projects are expected to see growth date at fiscal consolidation could be undermined increase to 3.3 percent in 2013. by increased expenditure in the lead-up to the 2014 elections, especially in the context of a planned civil The Reserve Bank of Vanuatu reduced its rediscount service remuneration review. In Kiribati and Tuvalu, rate by 50 basis points to 5.5 percent in April 2012, fiscal consolidation is in part dependent on the in response to slowing financial activity. Following strength of fishing license revenues. rapid credit growth in 2007 , in part spurred by the entry of a new bank, private sector credit growth For Samoa, the challenge is to rebuild fiscal and moderated from 9.4 percent in 2011 to 6.9 percent external buffers in the wake of the succession in 2012. Inflation was low, at 1.4 percent in 2012, of major natural disasters it has suffered. Policy and is expected to remain at that level in 2013. The priorities in Kiribati, Tonga, Tuvalu, and Vanuatu current account deficit narrowed to 6.3 percent include continued progress with revenue policy and of GDP in 2012 from 8.1 percent the previous administration reforms to strengthen tax revenues. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  119 For Kiribati and Tuvalu, effective implementation of regional fisheries agreements is also critical, to support increased and more stable fisheries revenues through the trading of quota permits (see box). For all of the small Pacific Island economies, continued investment in human capital is vital to facilitate labor mobility. In Tonga, this investment could reap additional dividends from the exploitation of emerging online work opportunities arising from its new broadband cable connection. Box. An Opportunity for Growth and Resilience: The Vessel Day Scheme for Fisheries Management Fisheries resources are the most valuable resources available to several Pacific Island economies, including the archipelagos of Kiribati and Tuvalu. Their small size, dispersed populations, and remoteness from major markets constrain their ability to sustain economic growth based on globally competitive manufacturing and service industries. Instead, their growth potential depends largely on securing rents from natural-resource- based industries. For several decades, Pacific Island countries have been working on ways to conserve their fish stocks and increase their fishing license revenues through the coordinated control of access by distant water fleets to their fisheries resources. Substantial progress has been achieved in recent years through the establishment of a Vessel Day Scheme (VDS) by the eight countries with the most significant tuna resources (the Federated States of Micronesia, Kiribati, the Marshall Islands, Nauru, Palau, Papua New Guinea, the Solomon Islands, and Tuvalu). Fully implemented in 2012, the VDS allocates a fixed number of “vessel days” to participating countries, through which each country can sell rights to purse seiner fishing vessels to undertake fishing activity in its exclusive economic zone (EEZ) on a 24-hour-period basis. Vessel days can be traded among participating countries, allowing them to mitigate the volatility of revenue from highly variable catch through the sale of vessel days when their allocations exceed the available catch within their EEZs. At present, the total number of vessel days issued under the VDS is equivalent to the total fishing effort in 2008. Through imposing coordinated controls on access, the implementation of the VDS has allowed participating countries to generate significantly higher license fees, increase control of overall levels of fishing effort, and improve data collection, strengthening prospects for sustainable management of the resource. Some estimates based on limited data suggest the value of a fishing day may have increased from around US$1,350 in 2004 to more than US$5,000 in 2012, reflecting the impact of the VDS. As long as the limit on total vessel days is set at a sustainable level and the VDS is properly implemented, it promises to provide Kiribati and Tuvalu with a more valuable and more stable flow of revenues from their fisheries than they have enjoyed in the past. Part of these higher revenues can be used to fund expenditure on essential public goods and services, including infrastructure. Importantly, these revenues can also be used to reinvest in the national trust funds that—if adequately capitalized—provide Kiribati and Tuvalu with vital fiscal buffers to respond to external shocks, thereby enhancing their resilience. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 120  |  Country Pages and Key Indicators THE SOLOMON ISLANDS lower foreign and domestically financed investment. Meanwhile forestry and gold mining activity, key drivers of the surge in growth from 2010 through the first half of 2012, slowed in H1-2013, partly due to unusually wet weather temporarily disrupting output. The number of foreign investment applications fell in early 2013, as did the value of investment, although bank lending to the private sector rose, largely for personal loans. Manufacturing production was the outstanding exception to the general weaker trends. The central bank’s manufacturing output index was 42 percent higher in the March quarter 2013 than Population 549,598 a year earlier, both for domestic and external (tuna Population growth 2.1 percent canning) sales. Reflecting all these trends, formal GDP (PPP , int’l US$) 1.7 billion sector employment growth slowed to 3 percent year- GDP per capita (PPP , int’l US$) 3,127 Surface area 28,900 sq. km. on-year to March 2013 and fell in comparison with Capital Honiara December 2012. The relative strength in government Source: World Development Indicators. spending may be supporting consumption spending. Summary The international prices of Solomon Islands exports continued to retreat over H1-2013. The Solomon The moderation in the Solomon Islands’ economic Islands’ average export prices peaked in mid-2011, conditions evident in the second half of 2012 then fell by 20 percent over the following 18 months continued into mid-2013. The slowdown has been (in Solomon Islands dollar terms). Over the first half associated with a drop in the Solomon Islands’ of 2013, they fell by a further 12 percent, returning export prices to more normal levels, a return to them to the average levels of mid-2008 to mid-2010. trade deficits, declining investment, and slower Most notable in the first half of 2013 was the one- government revenue growth. The moderation of the quarter fall in gold prices, from a peak of US$1,746 past year contrasts with the very rapid growth from per ounce in October 2012, to below US$1,300 per 2010 through the first half of 2012, although that ounce in July 2013. Cash crop farmers continue to period of rapid growth may prove to be exceptional respond to the retreat in prices by cutting production, and the recent moderation a return to more normal amplifying the impact on rural incomes—copra conditions. The withdrawal of the military component production in the first half of 2013 was 5,925 tons, a of the regional assistance mission in mid-2013 little over one-third of the level a year earlier. The gold appears to have proceeded smoothly. The extent mine also reduced production compared with 2012, to which recent strong growth has translated into to an annual rate around 55,000 ounces. The fish broad-based improvements in living standards will catch in the first half of 2013 was 30 percent below be revealed by the results of the first comprehensive the equivalent level of 2012, although the temporary household welfare survey since 2006, which is reopening of bêche-de-mer exports provided some scheduled to be released in 2014. support to export values. Imports slowed around the turn of 2013, before Recent Economic Developments accelerating somewhat in the second quarter. Import values (in Solomon Island dollar [SI$] terms) Weakening economic activity is linked to declining increased by 15 percent in the year to the second international prices and production of cash crops, and quarter of 2013. Fuel imports, which constitute WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  121 one-quarter of imports, rose by one-quarter over above budgeted levels by the second quarter of this period, despite stable international prices. 2013, largely due to higher payroll spending with the Machinery and transport equipment imports fell “relevelling” of teachers’ salaries to incorporate a from historically high levels of the turn of 2013, but long-delayed pay adjustment. After the usual, very still made up almost one-quarter of total imports. slow start, development spending, including capital spending, accelerated in May. Notable shifts in The exchange rate remained around SI$7 .1 per spending plans over the first half of 2013 included U.S. dollar, notwithstanding the central bank’s a rapid growth in payments for scholarships for shift to peg the exchange rate against a basket overseas tertiary study, and in various streams of of currencies rather than the U.S. dollar alone. funds directly administered by individual members Despite the deterioration in external flows, foreign of parliament (loosely termed “constituency exchange reserves remained at historical peaks, development funds”), which were partly funded by just below US$480 million in May 2013, compared redirecting funds allocated to development projects. with US$470 million at the end of 2012, or over 11 months of forward imports, a solid buffer to protect the Solomon Islands from potential external Outlook and Emerging Challenges shocks. The central bank attributed the strength in reserves in 2012 to inflows of budget support and The trends of the first half of 2013 of slower the external trade position, and their maintenance in output and revenue growth and tighter investment 2013 to weaker imports. conditions are expected to continue into the medium term under baseline projections. Inflation moderated in Q2 2013, after a surge at the Projected growth rates are only modestly above start of the year that was mostly due to adjustments population growth, increasing the importance of the in administered prices and factors impacting government raising the effectiveness with which it domestic food prices. Honiara consumer prices turns its scarce resources into services delivered rose by 6.5 percent in the year to June 2013. Food to the public. Recent trends show the imperative prices rose by 6 percent over this period, largely due of providing public goods effectively, for example to higher domestic food prices due to temporary through delivering extension services to support factors. Administered prices (especially water farmers and help reverse recent falls in cash crop tariffs) continued to contribute to inflation as these production. Significant risks continue to be centered were further adjusted to reflect the cost of supplying on the outlook for logging, and have emerged around these goods and services. the outlook for production at the small gold mine given the retreat in international gold prices. Some The fiscal balance deteriorated over the first five upside risks emanate from potential investments in months of 2013 to a small deficit of SI$22 million. tuna canneries and a modest hydroelectric facility Government deposits rose to SI$1.55 billion in advancing to more advanced project preparation June 2013, from SI$1.2 billion at the start of the stages. Significant potential nickel mining year, which was their level in most months through investments have been delayed, however, due to 2012. Government revenues rose marginally from uncertainty around the mining regulatory and tax the same period in 2012, but this increase was less regimes. than had been budgeted. These shortfalls occurred across most revenue categories, including payments of pay as you earn (PAYE) tax receipts, customs and excise collections (due to weaker export values for logs and gold), and nontax revenues (due to the fall in the fish catch). In contrast, expenditures rose to REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 122  |  Country Pages and Key Indicators  ey Indicators Solomon Islands: K 2011 2012e 2013f 2014f 2015f Year Year Year Year Year Output and Prices 1/ Real GDP (% change yoy) 10.7 4.8 4.0 3.5 3.7 Real GDP , excl. logging and mineral sectors (% change yoy) 7.3 3.5 5.5 3.8 4.0 Consumer Price Index (% change, period average) 7.4 5.9 6.0 5.0 4.7 Public Sector Revenues and grants (% GDP) 60.3 54.2 53.3 50.8 50.0 Expenditures (% GDP) 51.2 50.3 52.5 50.2 49.6 Recurrent (% GDP) 25.6 28.5 28.2 26.8 26.6 Development (% GDP) 25.5 21.8 24.3 23.4 23.0 Government budget balance (% GDP)3/ 9.0 3.9 0.8 0.6 0.4 Noncommodity primary balance (% GDP) -1.4 -4.3 -4.0 -3.7 -2.8 Public sector debt (% GDP) 22.2 17.9 16.0 13.9 13.8 Foreign Trade, BOP , and External Debt Current account balance (millions US$) -59 -1 -22 -77 -66 (% GDP) -6.7 -0.1 2.0 -6.5 -5.3 Goods trade balance (millions US$) -5 47 0 -7 -18 Exports (millions US$) 418 493 489 526 536 o/w Logging (millions US$) 191 180 176 164 150 Imports (millions US$) 423 446 488 533 554 Services balance, net (millions US$) -49 -58 -66 -95 -83 Income balance, net (millions US$) -178 -111 -123 -150 -154 Current transfers, net (millions US$) 173 120 167 175 188 Foreign direct investment (millions US$) 141 67 27 34 36 (% GDP) 16.2 6.7 2.4 2.9 2.9 Foreign exchange reserves (millions US$) 412 480 530 560 590 (months of forward imports) 7.6 8.5 8.4 8.6 8.6 Financial Markets 5/ Domestic credit to private sector (% change yoy) 4.7 4.0 8.0 8.0 8.0 Lending rate (%) 11.5 11.4 11.0 10.0 10.0 Exchange rate (SI$/US$, eop) 7.25 7.3 7.3 7.52 7.72 Real effective exchange rate Index (2005=100) 124.5 125.4 125.4 125.4 125.4 (% change yoy) 11.2 0.7 0.0 0.0 0.0 Sources: National data sources and World Bank staff estimates. e = estimate. f = forecast. 1/ Data and projections are from the Ministry of Finance and Treasury (MoFT); the National Statistics Office; IMF Country Report No. 11/359; and World Bank staff. 2/ Data for 2009 are from the 2011 Approved Recurrent Budget Estimates. Estimates for 2010 to 2012 are from the MoFT. The presentation of the data differs from the IMF Government Financial Statistics methodology largely in the treatment of donor-funded and donor-provided public services. The presentation differs from the Solomon Island Government’s in 2012 by including among revenues and grants accountable cash grants from the Regional Assistance Mission to Solomoin Islands. Forecasts are by World Bank staff. 3/ Balances are shown before drawdown of SI$32 million in National Transport Fund resources in 2012. 4/ Data and projections through 2014 are from IMF Country Report No. 11/359 and World Bank staff. 5/ Data are from the Central Bank of Solomon Islands; IMF Country Report No. 11/359; and World Bank and IMF staff projections.   WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  123 THAILAND consumers took advantage of the government’s subsidy for first-time car buyers in the first quarter of the year.7 Exports of services, primarily driven by tourism receipts, have reached record high this year, growing by more than 20 percent year-on-year (yoy) in the first half of this year. However, exports of goods (in US dollar terms) performed below expectations, rising by only 1.2 percent in the first half of the year, while imports grew by 3.2 percent yoy, in line with high growth in manufacturing of cars and pickup trucks for domestic sales. Population 66.8 million Manufacturing growth in the first half of the year was Population growth 0.3 percent driven mainly by vehicle production. Manufacturing GDP (PPP , int’l US$) 655.5 billion grew by 2 percent yoy. Manufacturing of vehicles GDP per capita (PPP , int’l US$) 9,815 Surface area 513,120 sq. km. grew by 47 percent and 12 percent yoy in the first Capital Bangkok and second quarters of this year, respectively. This Source: World Development Indicators. is primarily driven by growth in domestic purchases of cars and pickup trucks. However, manufacturing of other key products such as food, hard disk drives, Summary and integrated circuits and semiconductors have contracted. This is in line with the exports contraction The Thai economy is projected to grow by 4 percent of these products. for the entire year. Real GDP growth in the first half of 2013 was supported mainly by household Household consumption grew in the first half of consumption, which was stimulated by the the year, supported by the government’s first-car government’s subsidy for first-time car buyers. In the subsidy program and growth in consumer loans. second half of the year, exports, which have slumped Household consumption grew by 3.4 percent driven in the first half, are expected to slowly recover, while by car purchases in the first quarter, which increased growth of household consumption will slow. The by 97 percent yoy. Household consumption was also economy is expected to grow at a higher rate next supported by the increase of household loans by year as the global economy continues to recover. banks. Since last year, household loans have grown Large public investments are also expected to come by more than 15 percent yoy, only to decelerate to online next year, supporting growth. However, there 13.6 percent in July this year. As a result, household remains the risk of disbursement delays in these debt has reached a record high of close to 80 percent investments. Other external risks include the pace of GDP . of recovery of the global economy and the volatility of capital inflows. Exports of goods have underperformed while that of services have done very well. In light of the global economic slowdown, goods export growth (in U.S. Recent Economic Developments dollar terms) in the first eight months of this year grew by only 1 percent yoy. Beginning in the second In the first half of the year, real GDP grew by 4.1 percent year-on-year, driven mainly by domestic demand. Household consumption was the major 7 Registration for this subsidy program, known as the First Car Program, ended in December 2012, but half of the cars and pickup trucks were driver of growth in the first half of this year as delivered and paid for in the first half of 2013. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 124  |  Country Pages and Key Indicators quarter, exports contracted in major export products quarter of 2012 and was reduced to 2.5 percent in such as electronics, electrical appliances, and May this year when capital inflows peaked and there agromanufacturing products. As a result, exports were signs of slowdown in domestic demand going of goods in the second quarter contracted by forward. Inflation has been low at 2.7 percent yoy 1.9 percent yoy. However, exports of services have in the first seven months of this year. Low inflation risen with the inflows of tourists. Tourist arrivals in was also supported by the decline in import prices the first half of the year have increased by 20 percent by an average of 2.4 percent in the same period. yoy. Tourism receipts have contributed to the rise of export of services in real GDP by 24 percent yoy. The implementation of the government’s water management project has been delayed, but the Capital flows have been volatile and are reflected by government has been able to raise its on-budget the exchange rate. Net Capital inflows into Thailand investment. The B 3.5 billion water management have been high starting the third quarter of last year project that was approved as an off-budget fund and continued into the first half of this year. Net under the Emergency Decree after the 2011 capital inflows into Thailand swung from US$3 billion floods have been delayed due to Constitutional in the first half of last year to US$7 billion in the Court ruling that consultations and environmental second half. In the first half of this year, another impact assessments have to be completed prior US$7 billion have flowed into the country, with the to implementation. As a result, its implementation, bulk in the form of foreign loans by the banking and which was planned for this year, has been delayed. private sectors. By June, the trend had reversed as However, the government was able to disburse there was a net outflow of US$1.9 billion followed its on-budget funds of public investments, thus by another US$0.4 billion of net outflow in July. In increasing public investments by 16.6 percent yoy in August, the outflows were reinforced by news that real terms in the first half of this year. Quantitative Easing in the United States will be tapered. The exchange rate also fluctuated with the The government has continued its paddy-pledging net inflows despite intervention by the Central Bank scheme into this year. The government has so far in its attempt to smooth the baht volatility. The baht implemented this program for four rice-growing went from 31.7 to the U.S. dollar in June 2012 to seasons over two years. The scheme has to date B 29.10 in April 2013 to B 31.60 to the U.S. dollar in cost the government B 660 billion (US$22 billion). August. Our estimates of the losses are around B 2 billion per year (a little short of 2 percent of GDP per year). The current account was in deficit while the capital The government has announced that it will continue account was in surplus in the first half of this year. the program into the next two growing seasons The current account was in a US$1.3 billion surplus (October 2012–September 2013) at the same in the first quarter but was in a US$5.1 billion deficit pledging price as last year, but will impose some in the second quarter. The capital account has limits and conditions to restrict the quantity. registered positive net inflows for both quarters, however. Taking into account errors and omissions, there was a small overall balance of US$0.2 billion Outlook and Emerging Challenges in the first half of the year. At the end of July, international reserves were at US$195.3 billion, Real GDP growth for 2013 is projected at 4 percent which is 2.6 times of external debt. with a slight year-on-year slowdown in the second half of the year as household consumption slows while Monetary policy has been accommodative to exports pick up slowly. Household consumption growth in an environment of low inflation. The has shown signs of slowing, with the private policy rate has been at 2.75 percent since the last consumption index contracting by 0.7 percent yoy WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  125 in July. With the recovery in the global economy, however, export growth in the second half of the year is expected to grow by more than that of the first half—1.2 percent yoy (in U.S. dollar terms). At the same time, exports of services (mainly tourism) are expected to remain buoyant, continuing to grow at double digits. The economy is expected to grow at a higher rate next year as the global economy continues to recover and large public investments are implemented. The government has plans to implement large infrastructure projects in 2014. These include the delayed water management project and the upcoming seven-year B 2 trillion transport infrastructure investments. The B 2 trillion investments will be mainly in roads and rail; the latter includes dual rail tracking, high-speed trains, and mass transit in Bangkok. However, the investments will not be large next year since implementation would have just begun. Nevertheless, they will contribute to growth next year. Major foreseeable challenges to Thailand’s future growth are the pace of recovery of the global economy, the volatility of capital inflows, slowdown in household consumption, and the delays in public investments. A slower-than-expected recovery in the global economy and a faster slowdown in the Chinese economy will have a negative impact on Thai exports. The volatility of capital inflows will have implications on the exchange rate, which affects export revenues and import costs. The high leverage of households and car purchases that has been brought forward this year as a result of the First Car Program may dampen future growth of household consumption next year. Finally, delays in the long-awaited large public infrastructure projects will affect growth not only next year but also in the long run, since better water management and logistics improvements are crucial for Thailand’s future growth. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 126  |  Country Pages and Key Indicators Key Indicators Thailand:  2011 2012 2013f 2014f 2015f 2012 2013 2013 Year Year Year Year Year Q3 Q4 Q1 Q2 May Jun Jul Aug Output, Employment, and Prices Real GDP (% change yoy) 0.1 6.5 4.0 4.5 5.0 3.1 19.1 5.4 2.8 Domestic demand (% change yoy) 1.0 9.4 3.3 4.7 4.4 4.6 16.2 5.0 3.6 Industrial Production Index 177 .7 181.6 180.0 183.6 184.8 174.4 179.3 181.0 174.3 173.3 (2000=100) (% change yoy) -8.5 2.2 -11.1 43.4 2.9 -4.9 -7.5 -3.2 -4.9 -3.1 Unemployment (%) 0.7 0.7 0.6 0.5 0.7 0.7 0.8 0.5 0.9 Real wages (% change yoy) 1/ 7.2 19.6 16.6 17.2 13.7 10.4 Consumer price index 3.8 3.0 2.6 2.8 3.0 2.9 3.2 3.1 2.3 2.3 2.3 2.0 1.6 (% change yoy) Public Sector Government revenues (% GDP) 18.0 18.3 17.4 19.2 16.9 15.9 21.9 17.3 35.0 Government expenditures 21.0 21.5 19.9 20.2 26.8 19.8 16.6 14.0 17.2 (% GDP) 2/ Government balance (% GDP) 2/ -2.9 -3.3 -2.5 -1.0 -9.8 -3.9 5.3 3.4 17.9 Total public sector debt (% GDP) 40.8 43.6 45.0 43.4 43.6 43.7 44.6 44.2 44.6 Foreign Trade, BOP , and External Debt Trade balance (billions US$) 3/ 17 .0 6.0 1.8 0.7 -1.7 4.5 0.1 -0.3 -0.5 0.5 0.6 0.3 Exports of goods (billions US$) 219.1 225.9 231.5 243.1 265.0 59.0 56.4 56.2 55.6 19.5 18.8 18.8 (% change yoy) 14.3 3.1 2.5 5.0 9.0 -3.4 18.2 4.5 -1.9 -5.1 -3.5 -1.6 Key export (% change yoy) 4/ -7.3 3.4 -10.6 34.3 0.0 -13.8 -18.6 -13.5 0.5 Imports of goods (billions US$) 202.1 219.9 229.8 242.4 266.6 54.5 56.3 56.5 56.1 19.0 18.2 18.6 (% change yoy) 24.9 8.8 4.5 5.5 10.0 -2.1 16.4 6.4 0.2 -6.3 0.9 0.0 Current account balance 5.9 0.2 -6.2 -7.3 -8.7 2.2 0.2 1.3 -5.1 -1.1 -0.7 -0.7 (billions US$) (% GDP) 1.7 0.0 -1.6 -1.7 -1.9 2.5 0.2 1.3 -5.1 -3.3 -2.1 -2.2 Foreign direct investment 7.8 7.2 2.0 1.0 1.4 0.6 0.9 -1.9 (billions US$) 5/ External debt (billions US$) 434.0 363.6 126.1 133.2 140.4 140.7 (% GDP) 125.5 99.2 34.4 36.4 36.4 14.2 Short-term debt (billions US$) 214.1 174.0 57.5 60.6 62.1 62.3 Debt service ratio 3.5 3.2 4.4 4.0 4.8 (% exports of g&s) Foreign exchange reserves, gross 165.2 171.1 172.7 171.1 167.7 162.5 166.2 162.5 163.5 159.7 (billions US$) (months of imports of g&s) 7.8 7.5 7.7 7.3 Financial Markets Domestic credit (% change yoy) 6/ 11.6 15.3 12.4 15.3 15.8 15.3 14.3 15.3 12.7 Short-term interest rate (% p.a.) 7/ 2.98 2.94 3.00 2.75 2.75 2.58 2.50 2.50 2.50 2.50 Exchange rate 30.47 31.05 30.50 30.50 30.20 31.32 30.66 29.78 29.88 29.76 30.82 31.13 31.61 (B/US$, monthly average) Real effective exchange rate 102.0 102.3 102.3 103.8 108.9 111.1 112.33 107.79 107.22 (2007=100) 8/ (% change yoy) -0.8 0.3 0.3 2.5 7.7 8.7 9.9 5.5 5.0 Stock market index 1,025 1,392 1,299 1,392 1,561 1,452 1,562 1,452 1,423 1,294 (January 1, 1975=100) 9/ Memo: Nominal GDP (billions US$) 345.9 366.4 395.0 421.0 457.5 89.5 96.7 100.7 98.8 Sources: CEIC, World Bank staff estimates. f = forecast. 1/ Average monthly wage.  2/ Cash balance of central government, including off-budget expenditure.  3/ Balance of goods.  4/ Electronics.  5/ Nonbank FDI. 6/ Bank of Thailand (BoT), end-of-period.  7/ Policy rate, average.  8/ Trade-weighted broad index (23 major trading partners), average (Source: BoT).  9/ Stock Exchange of Thailand (SET) index, end-of-period. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  127 TIMOR-LESTE the 2012 and 2013 estimated real growth in nonoil GDP from 10.6 and 10.4 percent, respectively. An International Finance Corporation (IFC)-supported one-stop shop for business registration, and the possible demonstration effect from the planned airport and port public-private partnerships, have the potential to lift private sector activity, but will only partially offset the decline in public sector activity, given its dominance in the economy. Despite falling global food prices, and an appreciation of the U.S. dollar (Timor’s currency), inflation has risen rapidly again to 13 percent year-on-year in June, Population 1.2 million reflecting continued demand pressures and supply Population growth 2.9 percent bottlenecks. GDP (PPP , int’l US$) 1/ 2.1 billion GDP per capita (PPP , int’l US$) 1,709 2/ In June, the government’s first estimate of 2012 Surface area 14,870 sq. km. nominal nonoil GDP (Timor-Leste’s preferred measure Capital Dili of economic activity) was US$1.293 million, up from Source: World Development Indicators. 1/ The equivalent in 2011 nonoil GDP at current market prices is US$1.128 billion. actual US$1.128 million in 2011, published in the May 2/ The equivalent in 2011 nonoil GDP at current market prices is US$1,007. 2000–2011 National Accounts. The 2012 actual, and hence the real growth estimate of 10.6 percent, is, Summary however, likely to be revised lower, as 2012 budget Timor-Leste’s nonoil economy continues to grow execution and agricultural sector growth appear at pace. Slowing growth in public spending and slower than initially estimated. This lowers the base a gradual pickup in private sector activity may against which 2013 real growth occurs, and the moderate medium-term forecasts. Inflation remains strong rise in proxies such as electricity consumption in the double digits in relation to last year, likely and vehicle purchases in Q1 2013 also provide some due to continued demand pressures against supply upside opportunities. However, downside risks bottlenecks. Despite unseasonally high coffee around falling budget execution rates and a long exports, the first-half trade balance is significantly wet season affecting agricultural production, may wider than last year. But petroleum revenues lead to a downward revision in the 2013 real growth support a large current account surplus. Structural estimate of 10.4 percent. reforms continue, including a recent one-stop shop for business registration, a draft mining law, and The FY13 budget was passed in February, later than progress on the land and procurement laws. usual due to the June 2012 elections and related changes to the structure of government. The budget was significant in several ways. First, the proposal to Recent Economic Developments Parliament was flat in nominal terms in relation to the US$1.8 billion 2012 budget, following three years of The government first proposed an FY14 fiscal roughly 40 percent annual nominal budget growth. envelope of US$1.3 billion, following an FY13 Second, Parliament cut it by a further US$150 million budget of US$1.65 billion, in an attempt to ease as infrastructure projects were scaled back. Third, aggregate demand pressures and inflation and the government plans after several years to return improve budget credibility. Despite smaller budgets, to its de facto fiscal anchor (Estimated Sustainable budget execution has slowed. Lower-than-budgeted Income from the Petroleum Fund, or ESI) and expenditure will likely lead to downward revisions of finance the budget without excess withdrawals, REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 128  |  Country Pages and Key Indicators instead fully using large unspent cash balances from due to higher-than-forecast petroleum prices, could 2012. Finally, the budget was supported by both lift the fiscal surplus (including petroleum revenues), government and the opposition. above the 54 percent of nonoil GDP forecast for 2013. Budget execution is slow relative to 2012, both in nominal terms and as a share of the budget, In a decisive move aimed at lowering inflation, despite a smaller budget this year. Only 28 percent greater fiscal sustainability, and enhancing budget of the 2013 budget had been executed (not credibility, the government in May proposed an FY14 including obligations) at end-August compared with fiscal envelope of US$1.3 billion although there has 39 percent at the same time in 2012, weighed down since been pressure to increase it. This represents a by low execution rates of capital and development 29 percent reduction in relation to the FY13 budget and minor capital of just 18 percent and 9 percent, and only around US$100 million more than was respectively. With the exception of salaries and spent in FY12—effectively representing a reduction wages, recurrent spending rates have also fallen. in real terms on current inflation estimates. Reasons for overall lower spending may include the late budget approval, a settling-in period for the End-2012 inflation was 11.7 percent (headline inflation new government, a change in the profile of capital is year-on-year CPI in Dili), bringing the 2012 annual expenditure from lumpy investments like electricity average to 10.9 percent. The government’s 2013 generation and transmission to smaller critical headline inflation target is 7 .6 percent. However, infrastructure investments, thin capacity across the inflation has risen quickly this year to over 13 percent project cycle, and tightening of public investment in June (year-on-year) largely driven by food prices, management systems. The latter includes a new notably rice and meat. This has occurred despite Supreme Audit Institution that at inception reviewed global rice prices, notably from Vietnam and Thailand all contracts above US$500,000, though the where Timor-Leste sources, falling by roughly threshold is now being raised to US$5 million. 4 percent to June. Global meat prices, with the exception of chicken, have also fallen significantly in The 2013 budget was in part reduced to bring it into the first half of this year. Following an analysis of line with absorptive capacity. However, at current spending patterns, both the CPI basket and item rates, there may be, for the first time, a year-on- weights were adjusted in January 2013. This has, year nominal decline in spending. Close attention for instance, raised the share of food slightly to just will need to be paid to the quality of spending in the over 60 percent. remainder of the year, when spending traditionally picks up. In a welcome development, the price of communications fell by over 12 percent in February The 2013 budget includes US$146 million of domestic relative to last year, and in a few months thereafter revenues, representing 10 percent of estimated to June. This can be attributed to the opening of nonoil GDP and 9 percent of the budget. By the the monopoly telecoms market to two additional end of July, 47 percent of this had been collected providers. Overall inflation should dampen, albeit compared with 49 percent in 2012, suggesting that with a lag, as the U.S. dollar, the official currency the 2013 projected nonoil fiscal deficit (domestic of Timor-Leste, appreciated over the period, relative revenues less total spending) of US$1.5 billion, to the currencies of Timor-Leste’s major trading or 100 percent of nonoil GDP , can be met. The partners (Australia, Singapore, and Indonesia). An government made its first modest withdrawal from explanation for persistent inflation could therefore the petroleum fund in July, reflecting slow spending lie in continued rapid growth in aggregate demand, rates and the commitment to first use 2012 cash combined with supply bottlenecks, including at the balances. Overperformance on petroleum revenues WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  129 ports and border, and a prolonged rainy season that the Fund to the Treasury in July. Revenue inflows to has dampened local rice production. the Fund were US$1.7 billion, on track to meet the full-year estimate of US$2.3 billion. At the end of Net credit to the private sector grew by nearly July, official reserves were US$620 million, or nearly 4 percent in the first half of 2013 to US$165.6 million, eight months of imports. Import cover fell from or 12.8 percent of estimated 2012 nonoil GDP . nearly 15 months at end 2012, as average monthly Agriculture (only 1 percent of overall credit), tourism imports picked up. and services (5 percent of overall credit), and trade and finance (25 percent of overall credit) grew the fastest, with loans to individuals (39 percent of Outlook and Emerging Challenges overall credit) registering 3 percent growth. Timor-Leste and Australia have entered into Spreads widened, as lending rates rose from arbitration over the maritime treaty governing the 12.13 percent in January 2013 to 12.59 percent Greater Sunrise gas and condensate field, increasing in August, while deposit rates remained flat at uncertainty around revenue potential from oil and 0.56 percent. The share of nonperforming loans, a gas fields not currently under development. This legacy from the period around the 2006/7 security may also have implications for the next exploration crisis, continues to decline, to 28 percent at end- licensing round, due to be launched soon. June 2013 from 31 percent at end-2012. Loan loss provisions were US$59.7 million, or 131 percent The public sector has been the key contributor to of the value of nonperforming loans, effectively growth—accounting for up to three-quarters of nonoil mitigating the risk to the banking system. growth in recent years. Private sector contributions are low and slowing, however, with contractions in Official trade data showed first-half 2013 imports agriculture and manufacturing. jumping to US$491 million—more than double the same period last year, due to unusually high imports Should projected public spending slow, and settle of products related to the printing industry. Coffee, in the medium term at levels indicated by the Timor-Leste’s only significant nonoil export, was 2014 fiscal envelope, then nonoil growth rates US$2.6 million, which is high compared to the value are likely to fall below double digits for a period. of US$300,000 exported last year in January–June, Much will depend on the prospects for an uptick in the low season, and given that global Arabica prices private sector activity that is not directly linked to declined over 10 percent in the first half of the year. government contracts. Recent progress has been Despite this increase in coffee exports, the first-half made in this regard through a business registration trade deficit was more than twice the previous first- one-stop-shop, preparation of the land law, and the half high. However, first-half petroleum revenues recent public consultation on the mining law. of nearly US$1.7 billion, recorded as income on the current account, help transform the first-half trade deficit into a current account surplus of nearly Timor-Leste: Key Indicators US$1.2 billion, or roughly 100 percent of estimated 2012 nonoil GDP . No table accompanies the Timor-Leste entry because data were unavailable at time of publication. The Petroleum Fund, Timor-Leste’s Sovereign Wealth Fund, reached US$14 billion in value at the end of July 2013, over 10 times estimated 2012 nonoil GDP , and up from US$11.8 billion at end 2012. The government made its first 2013 drawdown (US$180 million) from REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 130  |  Country Pages and Key Indicators VIETNAM account in 2012 for the first time since 1992. The improved trade and current account balances have helped the State Bank of Vietnam to shore up foreign exchange reserves—from 1.6 months of import cover at end 2011 to about 2.8 months in the first quarter of 2013. Headline inflation has been falling in the last 24 months. In July 2013, headline inflation had fallen to 7 .3 percent—largely attributed to the easing of food price and stabilization measures. Greater macroeconomic stability has helped Vietnam to regain confidence among investors. Population 88.8 million Vietnam’s stock market rose nearly 18 percent in Population growth 1.1 percent 2012 and about 19 percent in the first seven months GDP (PPP , int’l US$) 322.7 billion of 2013 after declining two consecutive years in 2010 GDP per capita (PPP , int’l US$) 3,635 Surface area 330,957 sq. km. and 2011. Vietnam’s sovereign spreads and country Capital Hanoi default swaps are hovering at their lowest levels Source: World Development Indicators. since the onset of the global economic crisis. At the same time, sluggish global growth and Summary the slow pace of structural reforms has led to an economic slowdown. Vietnam’s economy is While macroeconomic performance improved in the experiencing its longest spell of modest growth since last two years, growth slowed in the face of structural the onset of economic reforms in the late 1980s. problems in the state-owned enterprise (SOE) and GDP growth slowed to 5.2 percent in 2012 from banking sectors. Headline inflation declined from 6.2 percent in 2011 and 6.4 percent in 2010. Nearly more than 23 percent (year-on-year) in August 2011 29,000 businesses are reported to have closed, to 7.3 in July 2013. The current account was in surplus liquidated, or temporarily suspended their operations with strong export growth. The exchange rate during the first half of 2013—a 10.5 percent increase was stable and the level of international reserves compared to the same period of 2012, while newly increased. Growth is estimated at 5.2 percent registered enterprises amounted to around 39,000. in 2012—the lowest level since 1999. Growth is likely to remain moderate in the medium term in Recognizing the current economic difficulties, the the absence of visible progress in addressing the government introduced a number of measures to problems confronting the financial and SOE sectors. support GDP growth. The State Bank of Vietnam has aggressively cut interest rates in response to the slowdown in growth and falling inflation. Key policy Recent Economic Developments rates were cut by 600 basis points between March and December 2012, and by a further 200 basis Vietnam’s macroeconomic conditions continue to points in March–April 2013. The Ministry of Finance improve as its economy enters the third year of also introduced several fiscal measures including relative stability. Stabilization measures implemented reductions in tax rates and tax payment delays to in 2011 and 2012 helped Vietnam reduce inflation, assist struggling enterprises. strengthen fiscal and external accounts, and stabilize the exchange rate. Exports continue to grow rapidly, Despite the efforts of the government, the economy enabling Vietnam to post a surplus on its trade extended its slow growth into the first half of 2013, WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  131 registering a growth rate of 4.9 percent in the Booming exports, a sustained flow of external first quarter and 5 percent in the second quarter. capital and remittances, and lackluster import Despite the lower borrowing cost, total credit to performance have all helped Vietnam to turn around the economy from the banking system is estimated its external balances. In 2012, Vietnam posted its to have grown by only 5 percent (year-to-date) largest ever trade and current account surpluses. as of July 2013 compared to the annual target The trade balance (based on the balance-of- of 12 percent. Credit activity remains subdued payments definition) was estimated to yield a record as banks have become more reluctant to lend on surplus of 6.5 percent of GDP in 2012. Similarly, account of impaired balance sheets, poor financial the current account balance turned from a huge health of the SOEs, weak monitoring and reporting deficit of 11 percent of GDP in 2008 to a minor systems, and general lack of transparency in the surplus of 0.2 percent of GDP in 2011 and a record policy-making process. At the same time, demand surplus of about 5.9 percent in 2012. However, this for credit has waned in light of weaker business performance may not last forever, because imports prospects. Efforts to stimulate the economy through are expected to pick up once the economy regains accommodative monetary policy and tax breaks strength. appear to have reached their limits, while raising fiscal deficits and creating new contingent liabilities. Vietnam’s public finances have come under stress Under such circumstances, further monetary easing during the last few years on account of slower is likely to have only limited impact on growth, but growth, lower revenue buoyancy, and increased could add to concerns surrounding credit quality stimulus spending. During 2012, the fiscal deficit and negative consequences on macroeconomic increased to 4.8 percent of GDP (under the instability. Authorities would do well by extending the Government Financial Statistics [GFS] definition) as measured approach of macroeconomic stabilization the ratio of revenue collection to GDP fell to a record and deepening structural reforms, with a special low of 22.8 percent and despite the government’s focus on the SOE and banking sectors. effort to consolidate capital spending. As a result of higher deficits, government debt increased from Vietnam’s growth pessimism stands in sharp 48 percent of GDP in 2011 to 52 percent in 2012. contrast with its strong export performance in Despite the fact that Vietnam’s public and external recent years. Total export value (in nominal U.S. debt sustainability indicators are projected to dollars) is estimated to have grown by 14 percent remain below their applicable debt thresholds, the during the first seven months of 2013 after achieving government will need to maintain its ongoing control a growth rate of 18 percent in 2012 and 34 percent over spending growth to ensure medium-term fiscal in 2011. While earnings from commodity exports sustainability. are declining due to falling global prices, Vietnam’s traditional labor-intensive manufacturing exports such as garments, footwear, and furniture continue Outlook and Emerging Challenges to sustain rapid growth. A noteworthy addition to the export composition has been the exports of hi-tech Vietnam’s economy is projected to grow at a and high-value products (for example, cell phones moderate pace of around 5.3 percent during 2013. and parts, computers, electronics and accessories, The trade and current accounts are expected automobile parts), that have emerged as the largest to remain in surplus in 2013, though by a smaller and fastest-growing export items in 2013. The solid amount than in 2012. Some consolidation of the export performance is largely attributed to the fiscal balance, and inflation remaining in the high foreign-invested sector, which now accounts for two single digits, could be expected during 2013. third of Vietnam’s total exports. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH 132  |  Country Pages and Key Indicators Vietnam’s gains on the macroeconomic front are, however, still fragile and face several downside risks. First, slower growth may intensify demand for further loosening of monetary and fiscal policies, with the risk of stoking inflationary pressures and reversing the recent gains in macroeconomic stability. Second, if the implementation of structural reforms is delayed further, investor confidence would be undermined, further worsening growth prospects. WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Country Pages and Key Indicators  |  133 Vietnam: Key Indicators 2011 2012e 2013f 2014f 2015f Year Year Year Year Year Output, Employment, and Prices Real GDP (% change yoy) 6.2 5.2 5.3 5.4 5.4 Domestic demand (% change yoy) 0.7 4.3 4.5 5.2 5.5 Industrial Production Index 1/ (% change yoy) 7.3 4.7 4.8 5.5 5.8 Unemployment (%) 2/ 3.6 3.3 3.5 3.5 3.5 Consumer Price Index (% change yoy, period average) 18.6 9.1 8.8 7.4 7.7 Public Sector Government revenues (% GDP) 25.2 22.9 22.2 21.7 21.7 Government expenditures (% GDP) 28.1 27.7 26.2 25.7 25.1 Government balance, official (% GDP) 3/ -1.3 -3.2 -2.6 -2.6 -2.2 Government balance, general (% GDP) 4/ -2.9 -4.8 -4.0 -4.0 -3.4 Public sector debt (% GDP) 5/ 47 .9 51.3 50.4 50.5 49.8 Foreign Trade, BOP , and External Debt Trade balance (billions US$, BOP definition) -0.5 9.9 11.8 7.9 4.8 Exports of goods (billions US$, fob) 97 115 132 146 160 (% change yoy) 34.2 18.2 15.6 9.9 10.2 Key export (% change yoy) 6/ 45.9 13.6 -5.0 2.0 2.0 Imports of goods (billions US$, cif) 107 114 131 150 169 (% change yoy) 25.9 6.6 15.3 14.0 13.1 Current account balance (billions US$) 0.2 9.1 9.6 6.2 2.0 (% GDP) 0.2 5.9 5.6 3.3 1.0 Foreign direct investment (billions US$, net) 6.5 7.2 7.4 7.6 7.7 External debt (billions US$)/5 36.6 43.6 48.5 51.7 55.2 (% GDP) 27 .2 28.5 28.5 27 .6 27 .0 Debt service ratio (% exports of g&s) 3.7 3.3 3.3 3.4 3.5 Foreign exchange reserves, gross (billions US$) 13.5 25.4 (months of imports of g&s) 1.5 2.3 Financial Markets Domestic credit (% change yoy) 14.3 8.9 10.0 15.0 15.0 Short-term interest rate (% p.a.) 7/ 14.9 8.0 7.5 Exchange rate (D/US$, eop) 8/ 20,828 20,828 21,036 Real effective exchange rate (2000=100) 122.7 122.0 (% change yoy) 4.5 -0.6 Stock market index (July 2000=100) /9 351.6 413.7 491.3 Memo: Nominal GDP (billions US$) 134.6 152.8 170.0 187.0 204.6 Sources: General Statistics Office; State Bank of Vietnam; IMF; and World Bank staff estimates. e = estimate. f = forecast. ” 1/ The Industrial Production Index (IPI) is a new series replacing previous “industrial production value in constant 1994 prices. 2/ Urban areas. 3/ Excludes off-budgetary items. 4/ Includes off-budgetary items. 5/ Public and publicly guaranteed debt. Forecast by Debt Sustainability Analysis 2013. 6/ Crude oil (value). 7/ Three-month deposit, end-of-period. 8/ Central Bank’s interbank exchange rate as of August 27 , 2013. 9/ Ho Chi Minh Stock Index as of August 27 , 2013. REBUILDING POLICY BUFFERS, REINVIGORATING GROWTH WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE OCTOBER 2013 Rebuilding Policy Buffers, Reinvigorating Growth