86812 South Asia Economic Focus Spring 2014 Time to Refocus © 2014 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Some rights reserved 1 2 3 4 17 16 15 14 This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Nothing herein shall constitute or be considered to be a limitation upon or waiver of the privileges and immunities of The World Bank, all of which are specifically reserved. Rights and Permissions This work is available under the Creative Commons Attribution 3.0 IGO license (CC BY 3.0 IGO) http://creativecommons.org/licenses/by/3.0/ igo. Under the Creative Commons Attribution license, you are free to copy, distribute, transmit, and adapt this work, including for commercial purposes, under the following conditions: Attribution—Please cite the work as follows: World Bank. 2014. South Asia Economic Focus, Spring 2014. Washington, DC: World Bank. Doi: 978-1-4648-0273-7 License: Creative Commons Attribution CC BY 3.0 License: Creative Commons Attribution CC BY 3.0 IGO Translations—If you create a translation of this work, please add the following disclaimer along with the attribution: This translation was not created by The World Bank and should not be considered an official World Bank translation. The World Bank shall not be liable for any content or error in this translation. Adaptations—If you create an adaptation of this work, please add the following disclaimer along with the attribution: This is an adaptation of an original work by The World Bank. Responsibility for the views and opinions expressed in the adaptation rests solely with the author or authors of the adaptation and are not endorsed by The World Bank. Third-party content—The World Bank does not necessarily own each component of the content contained within the work. The World Bank therefore does not warrant that the use of any third-party-owned individual component or part contained in the work will not infringe on the rights of those third parties. The risk of claims resulting from such infringement rests solely with you. If you wish to re-use a component of the work, it is your responsibility to determine whether permission is needed for that re-use and to obtain permission from the copyright owner. Examples of components can include, but are not limited to, tables, figures, or images. All queries on rights and licenses should be addressed to the Publishing and Knowledge Division, The World Bank, 1818 H Street NW, Washing- ton, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights@worldbank.org. ISBN (electronic): 978-1-4648-0273-7 DOI: 10.1596/ 978-1-4648-0273-7 Cover photo: © Simone D. McCourtie / World Bank; Design: Alejandro Espinosa/Sonideas South Asia Economic Focus Spring 2014 Time to Refocus SOUTH ASIA ECONOMIC FOCUS SPRING 2014 TIME TO REFOCUS 5 This report is a product of the Office of the Chief Economist for the South Asia Region. Its preparation was led by Markus Kitzmuller (Economist, SARCE) under the oversight of Martin Rama (Chief Economist, South Asia Region). Substantive contributions to the focus section were made by Gabi Afram, Gunjan Gulati, Yuki Ikeda, Aurelien Kruse and Denis Medvedev. The report greatly benefitted from inputs and continued advice by Sanket Mohapatra and col- leagues in the Development Economics Prospects Group (DECPG) under the supervision of Andrew Burns (Acting Director, DECPG). Colleagues providing information for country briefs include Kishan Abeygunawardana, Deepak Bhattasali, Genevieve Boyreau, Roshan Darshan, Daminda Fonseka, Camilo Gomez Osorio, Zahid Hussain, Omar Joya, Faruk Khan, Aurelien Kruse, Chandana Kularatne, Jose Lopez Calix, Jaba Misra, Saurav Shamsher Rana, Saadia Refaqat, Nadeem Rizwan, Adiba Sanjana, Smriti Seth, Saurabh Shome, Muhammad Waheed, and Salman Zaidi, under the guidance of Vinaya Swaroop (Sector Manager, Poverty Reduction and Economic Management, South Asia Region) and Ernesto May (Sector Director, Poverty Reduction and Economic management, South Asia Region). Valuable research assistance was provided by Bilgehan Gokcen and Ayesha Raheem. Gabriela Aguilar signed responsible for the layout, design and typesetting, and Neelam Chowdhry provided administrative support. South Asia as used in this report includes Afghanistan, Bangladesh, Bhutan, India, Mal- dives, Nepal, Pakistan and Sri Lanka. The cutoff date for this report was April 6, 2014. 6 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 Table of Contents Recent economic developments·························································································································································································································· 9 Advanced economies recover while developing country growth remains weak ·························································································9 Some emerging markets including India have turned around the wheel and reduced external vulnerabilities ······ 10 Pressures on external balances across South Asia have eased····································································································································· 11 Nonetheless, recent output growth in South Asia remains sluggish······················································································································ 15 Main risks and vulnerabilities are gradually shifting from external to domestic ······················································································· 18 Inflation remains high across South Asia but shows signs of losing momentum······················································································ 18 Fiscal deficits and sovereign debt continue to constrain many South Asian countries······································································· 20 Outlook and policy··············································································································································································································································································25 The overall outlook for South Asia remains on the upside··············································································································································· 25 Domestic vulnerabilities are increasingly becoming the main source of risk································································································ 27 Focus: From external to domestic risk·······························································································································································································29 What to learn from the “tapering talk surprise”··········································································································································································· 29 External risk factors are likely to give way to domestic ones·········································································································································· 32 India’s public banks and private (corporate) debt····································································································································································· 34 Pakistan’s private banks and public debt··························································································································································································· 39 Nepal’s banks and the question of liquidity···················································································································································································· 41 South Asia Country Briefs··················································································································································································································································45 Afghanistan······································································································································································································································································································46 Recent Economic Developments··············································································································································································································· 46 Outlook and Policy··················································································································································································································································· 47 TIME TO REFOCUS 7 Bangladesh········································································································································································································································································································49 Recent Economic Developments··············································································································································································································· 49 Outlook and Policy··················································································································································································································································· 50 Bhutan·························································································································································································································································································································53 Recent Economic Developments··············································································································································································································· 53 Outlook and Policy··················································································································································································································································· 54 India·································································································································································································································································································································55 Recent Economic Developments··············································································································································································································· 55 Outlook and Risks····················································································································································································································································· 57 Maldives···················································································································································································································································································································60 Recent Economic Developments··············································································································································································································· 60 Nepal······························································································································································································································································································································62 Recent Economic Developments··············································································································································································································· 62 Outlook and Policy··················································································································································································································································· 64 Pakistan····················································································································································································································································································································65 Recent Economic Developments··············································································································································································································· 65 Outlook and Policy··················································································································································································································································· 66 Sri Lanka··················································································································································································································································································································68 Recent Economic Developments··············································································································································································································· 68 Outlook and Policy··················································································································································································································································· 69 South Asia at a glance··································································································································································································································································71 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 TIME TO REFOCUS 9 Recent economic developments G radual removal of stimulus policies con- Advanced economies recover tinues as developed economies follow while developing country their expected path of slow but sustained growth remains weak recovery. After suffering from interna- tional portfolio rebalancing triggered by gradual removal of quantitative easing in the US an- As advanced countries such as the US, Japan and even nounced in May 2013, India in particular and South the Eurozone show signs of slow but sustained recov- Asia more broadly have managed to reduce external ery, developing economies continue to exhibit slow vulnerability. However, growth across the region and flat growth. In light of labor market improvements, continues to falter while formidable domestic chal- and in spite of slowing growth in the last two quarters, lenges remain to be tackled. the US Federal Reserve Bank decided to further cut monthly quantitative easing to US$ 55 billion starting April 2014. While there is little signs of inflation at this point, US interest rates may well be rising soon after QE ends. The Eurozone is also building momentum with market optimism increasing as sovereign credit FIGURE 1: Real GDP growth shows signs of sustained but slow recovery in advanced economies 6.5 Percent change, q-o-q saar 5.5 4.5 3.5 2.5 1.5 0.5 -0.5 -1.5 -2.5 2012Q2 2012Q3 2012Q4 2013Q1 2013Q2 2013Q3 2013Q4 Developing countries Eurozone Japan United States Source: World Bank DECPG 10 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 FIGURE 2: South Asia featured a strong cyclical rebound in 2013Q3 Percent change, q-o-q, saar 9 8 7 6 5 4 3 2 1 0 2012Q2 2012Q3 2012Q4 2013Q1 2013Q2 2013Q3 2013Q4 -1 East Asia and Paci c Europe and Central Asia Latin America and Caribbean Middle East and North Africa Sub Saharan Africa South Asia Source: The World Bank DEC Data Note: DEC data is updated as of 03-13-2014 default swaps (e.g. for Portugal, Spain, Italy or Ireland) Some emerging markets further tightened in March 2014; however, deflation including India have turned risks and unemployment concerns remain. around the wheel and reduced South Asia experienced a strong cyclical rebound external vulnerabilities in 2013Q3 growth but has since slowed again. The strong regional growth performance between July and Since the large impact of global portfolio rebalancing September 2013 can be largely attributed to a tempo- in May 2103, Emerging Markets have separated into rary pick up in export growth, investment activity as a diverse group ranging from continuously fragile to well as stronger agricultural output. Annual regional resilient vis-à-vis external pressures. With the pros- real GDP growth in 2013 is estimated at 4.8 percent, pect of interest rates increasing gradually in advanced below East Asia and Pacific at 7.2 percent, but well economies, developing countries find themselves in a above Middle East and North Africa, Latin America brave new world characterized by a permanently more and Caribbean, and Europe and Central Asia. competitive environment for attracting international capital flows. Between May and August 2013, many FIGURE 3: Capital flows to South Asia increased slightly in February 2014 against the trend for developing countries overall US$ millions 70000 7000 60000 6000 50000 5000 40000 4000 30000 3000 20000 2000 10000 1000 0 0 2013M1 2013M2 2013M3 2013M4 2013M5 2013M6 2013M7 2013M8 2013M9 2013M10 2013M11 2013M12 2014M1 2014M2 Developing countries bank loans Developing countries bond issue Developing countries equity issue Gross capital ows to DEV (right axis) TIME TO REFOCUS 11 emerging markets have been hit hard by international Pressures on external balances portfolio rebalancing and capital outflows have put across South Asia have eased pressure on external financing of current account deficits across the board. However, during the second half of 2013, some countries managed to take profit Current account deficits are getting easier to finance of the short window of opportunity to reduce external in most of the region. Most notably, India managed vulnerabilities. to significantly shrink its current account deficit (CAD) to pre-crisis levels, from 4.9 percent of GDP India has managed to turn around the wheel and in 2013Q2 down to 0.9 percent in 2013Q4 (2.2 per- minimize exposure to further tapering in 2014. Weak cent annual for FY2014 to date). India’s annual CAD growth and exchange rate depreciation have charac- further is expected to stay between 2 and 3 percent terized India for some time. A wide current account of GDP in the short to middle run (1.8 percent deficit (CAD), at 4.8 percent of GDP for FY2013, for FY2014 with a possibility of some widening in which had been increasingly financed through volatile FY2015). At the same time, Pakistan maintains a portfolio flows, left the economy vulnerable to the first small current account deficit - at 0.9 percent of GDP announcement of US tapering on May 22, 2013. How- during the first seven months of FY2014 with solid ever, since the period of sharp depreciation of the In- remittance inflows. Afghanistan features an estimated dian rupee vis-à-vis the US$ between May and August CAD (excluding grants) of 39.8 percent of GDP as 2013, increased export growth and restrictions on gold opposed to a surplus of 3.6 percent once accounting imports have helped to recover the trade balance and for grants in 2013. In Bangladesh, the external bal- reduce the CAD. In addition, continuous tightening of ance remained in a comfortable zone with a declining monetary policy has signaled credibility regarding Re- trade deficit more than offsetting slower remittance serve Bank of India’s mission to address high inflation, growth. Nepal continues to accumulate a current ac- thereby calming investors and further increase confi- count surplus on the back of a stunning increase in dence into its economy. Hence, capital flows bounced remittance flows (at 34.4 percent since the beginning back in 2013H2 and proved quite resilient in January of FY2014 as compared to also high 22 percent over and February 2014. India was joined by countries such the same period in FY2013) while solid export growth as Indonesia or Mexico, while other emerging markets (with exports being on significantly smaller scale than (most notably South Africa and Turkey) remained imports) do not slow trade deficit increases. On an- vulnerable and suffered repeated exchange rate effects other positive note, Sri Lanka’s CAD is estimated to in 2014. have decreased to around 4 percent of GDP in 2013, down from 6.6 percent in 2012. FIGURE 4: India has managed a remarkable turn around and its nominal exchange rate proved highly resilient in early 2014 Current account de cit (Percent of GDP) India -2 -12 -10 -8 -6 -4 -2 0 2 0 Indonesia 2 Mexico 4 Russian Federation Brazil 6 Mexico 8 South Africa South Africa 10 Turkey 12 Turkey Brazil 14 16 Indonesia Nominal exchange rate * Source: World Bank Sta calculations 18 depreciation (local India currency vis-a-vis the 20 US$) 2013 Q2 (Q3) 2013 Q4 (2014 Q1) 12 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 FIGURE 5: Current account balances (by fiscal year) are slowly shrinking, with the exception of Bhutan and Maldives Percent of GDP 6 0 Bhutan (right axis) Maldives (right axis) 4 -5.0 Afghanistan 2 Bangladesh -10.0 India 0 Nepal -15.0 Pakistan -2 Sri Lanka -20.0 -4 -6 -25.0 -8 -30.0 2012 2013 2014 Source: World Bank and national authorities Bhutan and Maldives constitute two outliers with and August, 2013, with bank loans, as well as equity very different implications. Both countries run large and bond issues all dipping, January 2014 saw a rela- CADs, the former estimated at around 20 percent and tively smaller and qualitatively different dip in response the latter at 28 percent of GDP in 2013, however, with to further tapering. While bonds remained a significant very different implications for external stability. While share of total flows through February, it is bank loans Bhutan’s deficit is largely hydropower driven and well that mainly drive capital flows to the region since Oc- financed, Maldives’ external balance is in a much more tober 2013 - with the point exception of January 2014. precarious state with continuous pressures on reserves to be expected. Many South Asian economies saw little change in their capital inflows. Pakistan continues its ongoing Capital inflows into South Asia have regained some struggle on the capital and financial account, where momentum and proved more resilient in January Foreign Direct (FDI) and Portfolio Investment (FPI) 2014 as opposed to May 2013. While regional gross flows remain at very low levels. Furthermore, higher capital inflows declined by 70 percent between May debt service repayments as well as net repayments to FIGURE 6: Capital flows (in US$ millions) to South Asia are more robust; however their primary composition has changed US$ million 7000 6000 5000 4000 3000 2000 1000 0 2013M1 2013M2 2013M3 2013M4 2013M5 2013M6 2013M7 2013M8 2013M9 2013M10 2013M11 2013M12 2014M1 2014M2 South Asia bank loans South Asia bond issue South Asia equity issue Source: World Bank DECPG TIME TO REFOCUS 13 FIGURE 7: India has recently financed its current account deficit mainly through increased Non Resident Indian deposits 100 80 60 Others 40 Change in Reserve Assets Non-Resident Indian Deposits Percent 20 Foreign Institutional Investment 0 Foreign Direct Investment -20 -40 -60 2009/10Q3 2009/10Q4 2010/11Q1 2010/11Q2 2010/11Q3 2010/11Q4 2011/12Q1 2011/12Q2 2011/12Q3 2011/12Q4 2012/13Q1 2012/13Q2 2012/13Q3 2012/13Q4 2013/14Q1 2013/14Q2 2013/14Q3 Source: Reserve Bank of India the IMF during the first seven months of FY2014 put India’s capital inflows remain more than sufficient pressure on Pakistan’s financial accounts and foreign ex- to finance its current account deficit. However, their change (FX) reserves. Also Bangladesh remains below composition has recently changed away from volatile its potential, attracting only a slightly higher US$ 840 portfolio flows to more stable flows. With FDI inflows million in stable FDI flows over FY2014H1 as com- remaining constant at 1.5 percent of GDP during Q1- pared to US$ 797 million in FY2013H1. Overall, the Q3 FY2014, Non-Resident Indian deposits soared by financial and capital account surplus is shrinking due more than 700 percent y-o-y in 2013Q4 to a total level to trade credit (net). Sri Lanka saw relatively healthy of 2.6 percent of GDP over Q1-Q3 FY2014. However, inflows, largely in the form of remittances and tourism also portfolio flows have started to return to India, earnings on the current account side, but also flows to where inflows of US$5.5 billion in December and government securities and an increase in FDI, although January begin to make up for an outflow of US$15.7 on a modest absolute level, on the capital account side. billion over the preceding 6 months (May to November 2013). FIGURE 8: India’s real effective exchange rate (REER) has been depreciating for a while, but experienced an accelerated rate during summer 2013 REER Index 130 120 110 100 90 80 70 2010M01 2010M07 2011M01 2011M07 2012M01 2012M07 2013M01 2013M07v 2014M01 China India Eurozone USA Source: The World Bank DECPG and ECB 14 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 India also has been the major regional beneficiary to 6.3 percent. Ultimately, Bhutan’s export revenues from tapering induced increases in competitiveness. (mainly from electricity sales to India) got boosted by While the reversal of capital flows in summer 2013 favorable hydro flows due to better monsoon rains in has put pressure on the nominal rupee US$ exchange 2013 without any exchange rate effects due to the peg rate, it also has accelerated a longer-term trend towards with the Indian rupee and the fact that 90 percent of its real exchange rate depreciation, which has made India energy exports go to India. and South Asia overall more competitive (through the direct exchange rate and more broad business cycle With the exception of Pakistan and Maldives, South transmission channels). Hence, export growth is esti- Asian countries maintain solid reserve levels. Since mated to have picked up to 15.7 percent for calendar the State Bank of Pakistan has begun to rebuild its year 2013. However, the recent loss of momentum in external position through US$ purchases on the spot, Indian export performance in early 2014 suggests that net official reserves arrived at 1.1 months of import the FY2014Q2 hike may have been a level adjustment coverage as of March 12, 2014, after a bumpy ride rather than a permanent acceleration of growth. from 1.3 months at the end of June 2013 to a stag- gering 0.6 month at the end of November 2013. But also Bangladesh, Bhutan, Nepal and Sri Lanka Recent alleviation has come from unexpected inflows experienced a significant boost in export growth. received bilaterally under the umbrella of the Pakistan Bangladesh’s trade deficit decreased due to strong Development Fund, and further easing is expected to exports with readymade garments (RMG) growing at come from CSF monies, 3G and 4G license as well as 17.7 percent over the first seven months of FY2014 Eurobond issuance (US$ 0.5 to 1 billion in Q4). On and total exports expanding by 14 percent over the first the other hand, the stabilization of the rupee and the eight months of FY2014. In a slightly different manner, shift from volatile portfolio investments to more stable Nepal’s pegged rupee significantly boosted exports, par- flows helped increase foreign reserves in India by US$8 ticularly to India, due to substitution by Indian import- billion during Q1-Q3 FY2014 to a current level of ers. The increase in exports to India from 3.8 percent US$294 billion. Sri Lanka saw its gross international (over the first six months of FY2013) to 18.45 percent reserves increase to 5.3 months of imports by the end of over the same period in FY2014 ultimately led to an January 2014, while Bangladesh’s current and capital/fi- overall growth in exports of 16 percent (FY2014H1) as nancial account surplus continued a buildup of reserves compared to 10.2 percent (FY2013H1). Sri Lankan ex- in February 2014 to US$ 19 billion or 5.7 months of ports – mainly textiles and garments - also rebounded prospective FY2014 merchandise imports. As a result strongly in the second half of 2013, growing at 17 of a large balance of payments surplus, Nepal saw its percent y-o-y to bring annual export growth for 2013 reserves increase to 10.2 months of imports by January FIGURE 9: A tapering induced competitiveness dividend began to materialize in the form of increased export growth in 2013 (here growth rates of total annual value in US$) Percent Change 20 15 10 5 0 -5 Bangladesh Vietnam India China Sri Lanka Pakistan Thailand Indonesia Malaysia Source: World Bank and National Authorities TIME TO REFOCUS 15 FIGURE 10: Foreign exchange reserves are broadly solidifying, except for Pakistan and Maldives Months of imports 12.0 10.0 8.0 6.0 4.0 2.0 0.0 2013M01 2013M03 2013M05 2013M07 2013M09 2013M11 2014M01 Bangladesh India Maldives Pakistan Sri Lanka Nepal Source: World Bank and national authorities 2014, while Sri Lanka’s import coverage is estimated and leather sub sectors. Bangladesh is subject to high at 4.2 months for 2013 and projected to stay around 4 volatility due to recent political turmoil (and partly ir- in 2014. While Bhutan’s reserves have built up to over reversible output, employment and asset losses), where US$ 900 million by the end of November 2013, which manufacturing growth paid a substantial toll in spite of is the equivalent of 13 months of merchandise imports, stronger export growth, and industrial growth is pro- Maldives foreign exchange reserves are very low at 2.3 jected to have slowed down to 7.9 percent for FY2014 months of imports at the end of 2013 of which only compared to FY2013’s 9 percent. 3 weeks were usable. Ultimately, Afghanistan’s foreign reserves closed 2013 at almost the same level as for The overall South Asian growth motor continues 2012, namely around 7 months of imports.a to sputter, mainly due to India’s subdued growth performance. While regional growth is estimated at 4.8 percent for calendar year 2013, many South Asian economies experienced slowing or flat Nonetheless, recent growth. On the back of weak performance in the output growth in South mining, construction and manufacturing sectors, Asia remains sluggish India’s overall real sector activity moderated in FY2014Q3 with real GDP growth (at factor costs) coming down to 4.7 percent y-o-y from 4.8 percent Industrial production continues to be lackluster in FY2014Q2. Also Bangladesh’s estimated growth across South Asia. With the exception of Pakistan, of 5.4 percent for FY2014, down from 6 percent all major South Asian economies continue to see slow in FY2013, shows a continuation of the downward and in some cases highly volatile growth in industrial trend observed since FY2011, reflecting political production (IP) during the second half of 2013. While uncertainties, supply side constraints, a suffering India saw IP growth (3m/3m) turn negative in October service sector and lower private investment. Also 2013, its recent IP has trended upwards and actually in large parts due to a marked fall in private in- registered small but positive growth in February 2014 vestment, Pakistan’s real GDP growth in FY2013 (at 0.5 percent 3m/3m crawl). Sri Lanka faced a steep was subdued at 3.6 percent. However, industry and increase in IP growth between July and September services growth, estimated at 5.2 and 5.7 percent 2013, as did Pakistan slightly thereafter. In the latter, respectively for FY2014Q1, are expected to open up large scale manufacturing recorded an increase of 6.7 an opportunity for faster annual FY2014 growth, percent in the first half of FY2014, compared to 2.2 projected at between 3.6 and 4 percent. Nepal, as percent in the first half of FY2013, mainly driven by opposed to its solid performance on the external strong performance in the fertilizer, food, electronics side, continued its low growth path in FY2013 at 3.6 16 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 FIGURE 11: Industrial production growth remains weak and volatile across South Asian economies with the exception of Pakistan Percentage change, 3m/3m 5 4 3 2 1 0 -1 -2 -3 -4 2013M1 2013M2 2013M3 2013M4 2013M5 2013M6 2013M7 2013M8 2013M9 2013M10 2013M11 2013M12 2014M1 South Asia Bangladesh India Sri Lanka Pakistan Source: World Bank DECPG percent down from 4.9 percent in FY2012. How- and Afghanistan continue at the tail of the regional ever, as agricultural output is expected to recover growth distribution at 3.7 percent and 3.6 percent due to a good monsoon and services sector growth in 2013, respectively. However, while Maldives ex- to continue at a healthy pace fuelled by remittances, pects a pick up to 4.5 percent in 2014 with tourism growth should eventually bounce back to 4.5 per- and its spillover effects to do the heavy lifting, real cent in FY2014. On the upside, Sri Lanka shows GDP growth in Afghanistan is projected to further faster growth at 7.3 percent in 2013, up from 6.4 slow to 3.2 percent, in spite of robust agricultural percent in 2012, mainly driven by industry and ser- production and mainly due to uncertainties sur- vices, and is expecting a stabilizing trajectory with rounding security and the April 2014 elections. a projected 2014 growth rate of 7.3 percent. Also Bhutan expects a growth rebound in 2013, driven India’s output growth has been cyclically rebounding by good rainfall increasing (hydropower) electricity in 2013Q3 but the momentum could not be carried generation and agricultural performance. Maldives forward into Q4. From a sectorial perspective, agricul- ture spurred by a good monsoon as well as improved FIGURE 12: Real GDP growth (fiscal years) paints a industrial production in manufacturing, utilities and mixed picture for South Asia construction contributed significantly to the strong 2013Q3 growth performance, thereby complement- Percent, y-o-y ing India’s growth engine, the service sector, whose 14.0 13.0 acceleration was led by finance and business services. 12.0 In detail, agricultural growth increased to 3.7 percent 11.0 for FY2014 to date, y-o-y, while industrial growth 10.0 has expanded a mere 0.6 percent in FY2014 to date, 9.0 again y-o-y (with output growth having dropped back 8.0 into the negative at -0.7 percent in 2013Q4). Services, 7.0 on the other hand, not only contribute 55 percent to 6.0 total output, but also grew 7.6 percent in FY2014Q3, 5.0 4.0 based on strong net export growth in financial, business 3.0 and software services. On the expenditure side, while 2012 2013 growth in public consumption supported aggregate Afghanistan Bangladesh Bhutan India demand, private consumption and investment lost Maldives Nepal Pakistan Sri Lanka speed in FY2014Q3, after they had featured a strong acceleration in FY2014Q2 with private expenditure Source: World Bank and national authorities increasing from 0.3 to 0.9 percent q-o-q, saar and TIME TO REFOCUS 17 FIGURE 13: Real GDP growth (at market prices) bounced back strongly in India vis-à-vis other emerging markets in 2013Q3 but lost momentum in Q4 Percent, q-o-q, saar 10 8 6 4 2 0 2013Q1 2013Q2 2013Q3 2013Q4 -2 -4 Brazil Russia India China Turkey Mexico Source: World Bank DECPG investment growing at 3.2 percent q-o-q, saar, up from optimism. While business expectations – as measured a negative 3.6 percent. by the RBI business expectation index - in India con- tinue to stay below the 100 level that separates contrac- However, India’s growth performance vis-à-vis tion from expansion in FY2014Q3, the Manufacturing Emerging Market peers remains relatively strong. Purchasing Managers’ Index (PMI) places India above India comes out as the second fastest growing emerging the 50 mark, thereby pointing to expectations of a bet- market in 2013, only outperformed by China’s continu- ter future. Interestingly, the absolute level of the PMI ously high but slightly decelerating expansion. Turkey positively separates India from many of its emerging and Brazil continue to struggle with the effects of US market peers. From a dynamic perspective, sentiment tapering, however, exports and industrial production in India has been improving between January and begin to show signs of strengthening. February 2014, from 51.4 to 52.5. This rather positive expectation has received support from an actual pick up Expectations for India lacked confidence in the in industrial production in January 2014 breaking into past but most recently have started to show signs of positive territory at 0.1 percent y-o-y, largely driven by FIGURE 14: India’s Purchasing Managers’ Index ranks well below many developed countries but clearly above its BRIC peers, and suggests better times ahead February 2014 58 UK 57 US 56 Japan 55 Germany PM Index 54 Eurozone 53 India 52 Italy 51 50 France Brazil 49 Russia China 48 48 49 50 51 52 53 54 55 56 57 58 January 2014 Source: Markit 18 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 FIGURE 15: Policy rates reflect broad tightening of monetary policy, with the exception of Sri Lanka repo rate, percent 11.5 11.0 10.5 10.0 9.5 9.0 8.5 8.0 7.5 7.0 6.5 2013 Jan 2013 Feb 2013 Mar 2013 Apr 2013 May 2013 Jun 2013 Jul 2013 Aug 2013 Sep 2013 Oct 2013 Nov 2013 Dec 2014 Jan 2014 Feb Bangladesh Nepal India Pakistan Sri Lanka Source: National central banks a pickup in manufacturing with a monthly growth rate Inflation remains high across of 25.5 percent saar up from 5.7 percent the previous South Asia but shows signs month. This trend may be further spilling over into the of losing momentum region more broadly given India’s importance for South Asian business cycles. Regional inflation in South Asia remains the highest among developing regions, even as monetary policy has been broadly tightened. Although almost all ma- Main risks and vulnerabilities jor regional central banks, with the notable exception are gradually shifting from of Sri Lanka’s accommodative stance (where the mon- external to domestic etary authorities have given sustaining faster economic growth a top priority), have recently followed a path of monetary tightening through increasing their main While further (disorderly) adjustment of long term policy (repo) rates, CPI inflation has remained rela- interest rates remains as a tail risk for macroeconomic tively high across South Asia and still dominates all stability and growth, the weight is shifting towards other regions. Notably, Nepal Rastra Bank has chosen domestic challenges. Vulnerabilities exist along the to keep its policy rate at eight percent and not attempt whole spectrum of potential domestic risk factors, from to sterilize the double speed growth of broad money political risk and uncertainty due to social unrest and (M2) fuelled by extraordinarily high remittance flows turmoil to fiscal stress related to persistent weaknesses in FY2014H1. Overall, the tight monetary policy in revenue generation and collection. Notably, partly stance across South Asia has certainly helped to build fueled by recent global events, financial sector risk and confidence and send a strong signal to international exposure, e.g. to corporate debt in India, government investors. debt in Pakistan or excess liquidity in Nepal, has been on the rise (see this edition’s Focus section for a more Favorable food price developments have contributed detailed discussion). to headline inflation losing momentum. Food Prices in South Asia continue to be the main driver of CPI inflation. Recently, two key determinants have strongly supported a decline in food price inflation: Favorable weather (monsoon rains) eased pressure on the supply side while India has stopped increasing prices through its support price mechanism. Therefore, a reduction in food prices by 2.7 percentage points, particularly TIME TO REFOCUS 19 FIGURE 16: South Asian CPI inflation remains high but upward pressures have recently begun to ease Percent change, y-o-y 10 9 8 7 6 5 4 3 2 1 0 2013M1 2013M2 2013M3 2013M4 2013M5 2013M6 2013M7 2013M8 2013M9 2013M10 2013M11 2013M12 2014M1 2014M2 East Asia and Paci c Europe and Central Asia Latin America and Caribbean Middle East and North Africa South Asia Sub-Saharan Africa Source:World Bank DECPG FIGURE 17: The recent downward trend in CPI is quite common across major South Asian countries Percent change, y-o-y 12.0 10.0 8.0 6.0 4.0 2013M1 2013M2 2013M3 2013M4 2013M5 2013M6 2013M7 2013M8 2013M9 2013M10 2013M11 2013M12 2014M1 Bangladesh India Nepal Pakistan Afghanistan Maldives Source: The World Bank and national authorities in December 2013 and January 2014, helped achieve expectations. Sri Lanka saw headline inflation decreas- an overall reduction in CPI inflation to 9.8 percent ing from 7.6 to 6.9 percent in 2013, also helped by in FY2014 to date as compared to 10.2 percent in lower food prices. Bangladesh constitutes a special FY2013. The other commonly used headline inflation case due to increased inflationary pressures because of index, WPI, moderated to 6 percent in FY2014 to date supply side disruptions, particularly for food, and wage (with a February y-o-y inflation rate of 4.7 percent increases. In sum, food price inflation accelerated from only), down from 7.3 percent in FY2013. In Pakistan, 8.1 percent in July 2013 to 8.8 percent in February favorable weather helped to dampen food prices and, 2014, while headline inflation continues to move in a together with a sharp reduction in administered prices band between 7-7.5 percent in the first half of FY2014. brought headline inflation back into the single digits, As an exception to the rule, Nepal saw its inflation up averaging 8.6 percent over the first eight months of at 9.7 percent (y-o-y) in January 2014, actually also FY2014. On the downside, upward revisions of VAT driven by food prices which have started to slightly (+2 percent) levied on selected manufacturing items as drop recently tracking India. Along the same lines, well as energy prices helped cement higher inflationary food price increases in Afghanistan led to upward 20 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 FIGURE 18: Food price inflation continues to be a major determinant of CPI movements across South Asian economies Percent change 16 14 12 10 8 6 4 2 0 2013M1 2013M3 2013M5 2013M7 2013M9 2013M11 2014M1 Bangladesh India Nepal Pakistan Sri Lanka Afghanistan Source: World Bank and ILO pressure in CPI inflation in the second half of 2013, estimated to be 6.7 percent of GDP in 2013, down however, remaining below double digits and averaging from 7.5 percent in 2012. This puts South Asia 7.7 percent over 2013 (up from 6.3 percent in 2012). second only to Middle East and North Africa (at 7.2 percent) across all developing regions. At the same time, public debt keeps on resisting downward pressures. The regional estimate for 2013 puts South Fiscal deficits and sovereign Asian public debt at slightly below 67 percent of debt continue to constrain GDP, the highest debt level across all regions. How- many South Asian countries ever, as a large share of public debt is held domesti- cally, sustainability is less endangered by exchange rate movements directly, but subject to domestic Fiscal deficits and public debt in the region remain sources of risk, e.g. in the banking sector depend- large, thereby constraining policy space. The aver- ing on relative exposure and hedging strategies of age fiscal deficit across South Asian countries was domestic financial institutions. FIGURE 19: Despite fiscal consolidation budget deficits remain large in South Asia Percent of GDP 0 -1 -2 -3 -4 -5 -6 -7 -8 2012 2013 2014 Middle East and North Africa South Asia Latin America and Caribbean Sub Saharan Africa East Asia and Paci c Europe and Central Asia Source: The World Bank DECPG TIME TO REFOCUS 21 Although many countries in South Asia continue Across the region expenditure compression remains their struggle to bring down fiscal deficits, some difficult while revenue generation and collection falls progress can be observed. India’s central govern- short of compensation. Many countries need to con- ment FY2014 fiscal deficit is expected to be con- tinuously compress expenditure to reach fiscal targets, tained at 4.6 percent of GDP, a reduction from the while revenues broadly fall short of budgeted amounts. 5.1 percent in FY2013. Fiscal deficit among Indian On the one hand, India compressed expenditures (for states registered at 2.3 percent of GDP in FY2013, example in rural development, health and education) above the budget estimate of 2.1 percent. Together to 14 percent of GDP or 0.6 percent below budget in with state deficits, the overall Indian fiscal deficit order to contain its fiscal deficit. Of course subsidies for FY2014 is projected at 6.3 percent of GDP. Also remain a large item with more than 2 percent of GDP Pakistan, the second largest South Asian economy, per annum. On the other hand, FY2014 tax revenues shows some signs of progress in fiscal consolidation. currently are expected to fall short of the budget, bring- In Bangladesh, fiscal outcomes are expected to suffer ing the total revenue shortfall to date to 0.5 percent of from severe revenue shortfalls and, unless expendi- GDP and implying that Q4 revenues will have to grow ture is cut further, its deficit may come in at around by an ambitious 33.5 percent of the budget estimate to 5.1 percent of GDP for FY2014, significantly above reach their budgeted amount. In Pakistan, the overall the budgeted 4.6 percent. With expenditure staying fiscal deficit is expected to fall from 8 percent of GDP flat and revenues continuously weakening, Afghani- in FY2013 to 5.8 percent in FY2014, with revenue stan’s dependence on aid financing remains salient. collection on its way to recovery from a poor FY2013 Its financing gap increased from 13.5 percent of performance and recurrent expenditure projected to GDP in 2012 to 14.9 percent in 2013, while its fiscal remain below last year’s level. Also Bangladesh fits in sustainability ratio decreased in 2013. Bhutan expe- this picture, with revenue growth being severely off rienced a fiscal deficit of 1 percent in FY2012, and track and falling short of budget by about Tk. 82 bil- expects a widening to 4.5 percent for FY2013 due lion between July 2013 and January 2014. At the same to lower domestic revenues. As opposed to FY2013, time, public expenditure remained below target in the Nepal adopted a full budget on day 1 of FY2014, beginning of FY2014 with the help of a lower subsidy and runs a comfortable surplus on account of low bill. Sri Lanka experienced a shortfall in revenues due expenditure and robust revenue growth. Last but to sluggish tax collection (mainly due to lower imports) not least, Maldives found itself with an approximate where total revenue collection rose by 1.2 percent over fiscal deficit of around 13 percent of GDP (includ- the first nine months of 2013 as opposed to an annual ing unpaid commitments through arrears), leaving target rate of 20 percent, casting doubts over reliability the cash constrained country in a difficult situation of revenue estimates underlying targets. After a decade regarding deficit financing. of strong revenue growth, also Afghanistan continued FIGURE 20: Overall fiscal deficits (by fiscal year) remain sizeable in many South Asian countries Percent of GDP 4 2 0 -2 -4 -6 -8 -10 -12 -14 -16 2012 2013 2014 Maldives India Pakistan Sri Lanka Bangladesh Nepal Afghanistan Bhutan Source: The World Bank and national authorities 22 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 FIGURE 21: South Asian public debt stays stubbornly high and occupies the number one spot across regions in 2013 Percent of GDP 80 70 60 50 40 30 20 10 0 2012 2013 2014 Europe and Central Asia Sub Saharan Africa Middle East and North Africa Latin America and Caribbean East Asia and Paci c South Asia Source: IMF World Economic Outlook & World Bank sta calculations Percent of GDP 110 100 90 80 70 60 50 40 30 20 2012 2013 2014 Nepal Bangladesh Pakistan India Sri Lanka Maldives Bhutan Source: The World Bank and national authorities to experience a weakening of revenue collection in 2013 Public debt remains broadly sustainable but con- with a decline to 9.5 percent of GDP vis-à-vis 10.3 tinues to resist reduction. In light of continued fiscal percent in 2012. Bhutan projects a drop in its domestic deficits and following the trend of FY2012 and 13, revenues for FY2013 to 19.5 percent (down from 20.8 also FY2014 saw India’s total central government debt percent of GDP in FY2012), mainly driven by non- slightly increase to 51.5 percent of GDP, while state hydro items such as business income taxes, excise duties level debt to GDP is also likely to inch up a bit, leaving and non-tax revenue. general government debt at an estimated 67.4 percent of GDP. Pakistan’s debt to GDP ratio also remained Nepal and Maldives constitute interesting outliers. above 60 percent over the past two fiscal years (FY2012 In Nepal, revenue streams are solid and likely to achieve and 13), and exhibits a similar tendency during the first targets in FY2014 while public capital expenditure lags half of FY2014, standing at 58.9 percent, but with the its plan due to continued budget under-execution and expectation of again breaching the 60 percent ceiling absorptive bottlenecks. Maldives is spending beyond its by end of the FY. Sri Lanka’s government debt is esti- means (with public expenditure at 42 percent of GDP) mated to have decreased in 2013 to 75 percent of GDP, in spite of solid revenue collection – actually the high- down from 79.1 percent in 2012. Bhutan’s public debt est of all South Asian countries at 32.8 percent of GDP. remains high, at around 90 percent of GDP at the end of FY2013, and concentrated in external hydropower TIME TO REFOCUS 23 sector debt, which as long as commercially viable, keeps risks of debt distress at moderate levels. Following the dire fiscal situation and the choice of domestic (short term) financing, Maldives faces unsustainable interest rates at 10 percent (for T-bills) and sustained fiscal risks through arrears. Hence, the country is at high risk of debt distress where the current debt to GDP ratio of 86 percent of GDP is expected to deteriorate further in 2014 and 15. A large part of public debt in South Asia is domestic, which reduces exposure to exchange rate related risks and adds to sustainability but may entail its own set of vulnerabilities. In India, the lion’s share of total debt – 47.7 percent of GDP out of a total of 51.65 percent - is internal liabilities. Also Sri Lanka contin- ues to hold a large majority of debt domestically, while other economies such as Bangladesh feature a more (internal-external) balanced debt portfolio. However, also domestic debt can imply vulnerabilities to stability and growth. In Pakistan, domestic debt in the amount of about Rs 6 trillion – a whopping 64.2 percent of the whole domestic debt portfolio - is short term and maturing in FY2014. Hence, refinancing risk is quite elevated. Also around 67 percent of domestic debt in Pakistan is exposed to interest rate changes within one year, as opposed to only 22 percent of external debt. Estimates suggest that in this environment, a 1 percent increase in domestic interest rates would boost interest payments by RS 63 billion while the same change in interest on external debt would lead only to an Rs 8.4 billion increase. SOUTH ASIA ECONOMIC FOCUS SPRING 2014 TIME TO REFOCUS 25 Outlook and policy T he overall short and medium term outlook The overall outlook for South for South Asia remains cautiously positive. Asia remains on the upside External vulnerabilities are gradually giving way to domestic downside risks as primary concern for growth and macroeconomic In line with the overall outlook on developing coun- stability. Hence, as previous regional economic updates tries, regional growth in South Asia is projected to have argued, any positive development in growth will gradually increase. As higher import demand and depend on progress isolating domestic threats to and economic growth in developed countries is expected to building buffers for macroeconomic stability, strength- outweigh adverse effects from potentially lower capital ening the investment climate, and removing infrastruc- inflows, regional real GDP growth in South Asia is ex- ture bottlenecks. pected to gradually increase from 4.8 percent in 2013 to 5.2 percent in 2014. The main pillars of this growth pro- jection are a solid pick up in gross fixed investment as well as continued solid export growth. The regional current account deficit is down from its 2012 peak of 4.2 percent and expected to stay around 2 percent of GDP over the coming calendar year, hence reflecting the significant FIGURE 22: South Asia’s growth outlook remains moderately positive Percent change 9 7 5 3 1 -1 2012 2013 2014 2015 -3 -5 Private Consumption Government Consumption Gross Fixed Investment Exports, GNFS Imports, GNFS South Asia market price GDP (calendar year) January 2014 South Asia current account balance (Percent of GDP, calendar year) Source: World Bank DECPG Note: Forecasts are subject to constant revisions 26 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 TABLE 1: South Asia’s growth performance will depend on continued export strength and strong investment growth Percent change 2012 2013 2014 2015 SAR market price GDP (calendar year) March 2014 4.9 4.8 5.2 5.8 Private Consumption 5.7 4.4 5.2 5.9 Government Consumption 6.3 5.6 5.7 6.0 Gross Fixed Investment 4.7 1.2 3.7 6.4 Exports, GNFS 6.9 7.0 6.3 6.5 Imports, GNFS 8.6 1.0 5.3 7.3 Statistical Discrepancy 0.3 -0.6 -0.4 -0.1 Change in inventories 0.8 -0.3 0.0 0.0 SAR Current a/c balance (Percent of GDP, calendar year) -4.2 -2.5 -2.0 -2.2 reduction in India’s CAD – mainly due to favorable export at around 4.5 percent with strong remittances addition- growth and restricted gold imports - but also a broader ally boosting consumption and service sector growth. Sri regional trend towards more balanced current accounts. Lankan real GDP growth is forecast to benefit from an increase in potential capacity from new infrastructure A strengthening of economic activity across most South investments and rebuilding, hence potentially continuing Asian countries can be expected in the short term. Bol- to grow at 7.3 percent of GDP in 2014. Two exceptions stered by a permanently more competitive exchange rate stick out: Afghanistan is expected to suffer from con- (hence solid export growth) and progress towards clear- tinued uncertainty regarding transition as well as lower ance of important investment projects (hence continuing agricultural output, hence, only projected to grow at 3.2 investment recovery), India may see an acceleration of percent in 2014. However, in the medium term, post tran- growth (in factor costs) in FY2014 to 4.8 percent, further sition growth may reach around 5 percent during 2015 to increase to 5.7 percent in FY2015 (or an equivalent and 2016, conditional upon a relatively stable security of 5.6 percent in calendar year 2014, at market prices). environment and agriculture as well as mining driving the Pakistan is also expected to build further momentum to acceleration. Bangladesh is set to pay the bill of political projected FY2014 growth of 4 percent supported by less turmoil in terms of stagnating private investment paired load shedding, resilient remittance flows, manufacturing with lower consumption due to decreasing remittance export performance and a dynamic service sector. Nepal flows. Ultimately this leads to subdued service sector and will recover from a bad year (FY2013) in terms of ag- industrial activity, with real GDP growth projected to ricultural growth and budget execution, and likely grow come down to 5.4 percent in FY2014. FIGURE 23: Growth is likely to pick up across most South Asian economies (by fiscal year) Percent change 8.0 16 Bangladesh 7.0 14 Bhutan 6.0 12 India 5.0 10 Maldives 4.0 8 Nepal 3.0 6 2.0 4 Pakistan 1.0 2 Sri Lanka 0.0 0 Afghanistan (right axis) 2012 2013 2014 Source: World Bank and national authorities TIME TO REFOCUS 27 Domestic vulnerabilities increase access to finance and foster financial stabil- are increasingly becoming ity, notably including the easing of FDI restrictions the main source of risk in selected sectors, putting forward a proposal to strengthen the monetary policy framework and restructure bad loans, as well as steps to improve While external (and exogenous) downside risks public financial management. In order to reinvigorate remain, reducing domestic vulnerabilities becomes broad based private sector led growth in Pakistan, the more central to achieving macroeconomic stability government is pursuing a comprehensive program of while following an accelerating growth path. Sustain- economic and social reforms, with macroeconomic ing sufficient momentum in export growth is clearly stability through fiscal consolidation being the first dependent on further recovery and growth in South priority target. In addition, Pakistan has started to Asia’s most important export destinations, namely implement crucial structural reforms in the energy the Eurozone and the US. However, the current pace sector (mainly targeting tariffs and subsidies as well of removal of Quantitative Easing in the US suggests as sector performance and accountability), pushed no major disruptions to the expected recovery in the ahead with the privatization of State Owned Enter- short term, while recent Eurozone statistics including prises, and has begun to remove distortions from the sovereign bond spreads as well as output growth esti- financial sector and the broader business environment mates also point towards a slow but sustained recovery. (e.g. enacting the Credit Bureau law or the rolling out Hence, the ability to realize the necessary increase in of an electronic platform for business registration). investment in South Asia gains even more importance Also Bangladesh maintains an active reform agenda, in the medium term, highlighting domestic risk fac- spanning from revised minimum wage levels in the tors ranging from inflation and debt (mostly domestic) garment sector to increased power tariffs or macro- sustainability to financial sector instability and the per- prudential regulation in the banking sector, however sistent structural (infrastructure) deficiencies in energy being significantly slowed down by recent political and transport across the region. turmoil. Overall, these reforms constitute important first steps towards a more comprehensive and perma- Political change bears great potential for growth and nent effort to solidify macroeconomic stability and development while some uncertainty remains as a move towards an attractive investment and business potential downside risk. Pakistan is a recent example environment needed to solve the region’s main struc- of how peaceful elections yielding a strong and de- tural problems. termined government can actually support economic performance and market perception. In India there However, formidable domestic challenges in the exists consensus by now that whoever wins the 2014 form of financial sector vulnerabilities and continued elections - a colossal endeavor with over 800 million weakness in revenue collection will need to be tack- Indians allowed to vote - will put increasing emphasis led in order to mobilize resources for investment. In on growth. Other South Asian economies face chal- other words, to provide incentives for efficient invest- lenges related to political uncertainties. Afghanistan’s ment – both private and public – remains a necessary growth slowed considerably in 2013 based on inves- condition for achieving faster and sustained growth in tor and consumer concerns while its future hangs in South Asia. As the effects from external tapering grad- the balance with elections to determine the country’s ually wear off, potential pressures that have built up in transition towards self-sufficiency. Bangladesh, on the the financial sectors in the recent past may threaten fi- other hand, will have to sort out sources of turmoil re- nancial sector stability or prevent banks from efficiently lated to the modality of political transition that caused intermediating and boosting private investment and considerable unrest, worried investors and trading growth. As far as public investment is concerned, most partners, and ultimately dampened economic activity South Asian countries are operating under tight fiscal and growth. conditions and are subject to weak revenue collection, which puts pressures on fiscal balances in the short term Reform momentum in important South Asian and constrains the mobilization of resources towards economies has been accelerating recently, under- much needed infrastructure investment. In addition, as lining rising awareness of the urgent need to start inflation remains high, although with a likely easing of tackling key challenges to structure and stability. In pressures in the medium term, monetary policy space India, RBI led a broader effort to control inflation, remains constrained. SOUTH ASIA ECONOMIC FOCUS SPRING 2014 TIME TO REFOCUS 29 Focus: From external to domestic risk A fter the 2013 experience of tapering talk shocks into the region, directly through exchange rate inducing massive portfolio rebalancing linkages or broader business cycle transmission1. Both away from Emerging Markets, the ques- Bhutan and Nepal are directly linked to the rupee tion remains as to what will happen as exchange rate through a peg, but fluctuations in India stimulus policies come to an end. There- do spill over more generally through a variety of other fore, in order to analyze what impact future tapering channels transmitting business cycles across the region may have on South Asia two key questions need to including trade or cross border investment. be answered. First, what determinants do explain the sharp rupee US$ exchange rate depreciation between May and September 2013? And second, will these same factors continue to transmit pressures from US What to learn from the tapering to South Asia? “tapering talk surprise” Overall, the end of stimulus in advanced countries is good news for South Asia. It signals sustained recov- The rapid rupee depreciation of 2013 earned India to ery and growth translating into stronger demand for be perceived as one of the worst performers among imports from South Asia, a region that traditionally emerging market economies. More precisely, the exports to industrialized countries while having limited Indian rupee came under heavy pressure after the US capital expenses. And as outlined above, many countries Federal Reserve signaled the possibility of tapering its across the region have indeed witnessed significant Quantitative Easing (QE) program in May 2013. In increases in export growth since summer 2013. the months to follow, the rupee depreciated sharply and fell by more than 20 percent vis-à-vis the US dollar Nonetheless, India showed vulnerability to taper- (from 55 rupees to record low 68 rupees per dollar) as ing in 2013 as it does have exposure through deeper investors withdrew their funds from emerging markets. financial and capital markets. India is not only the Over the same period, the 10-year Treasury note yields “deepest” financial market in South Asia but also the rose by 100 basis points from 1.93 percent. While other most important regional destination of foreign invest- emerging-market currencies also came under stress ment and international capital flows. Hence, it was around the same time, the Indian rupee was one of the significantly affected by the first tapering talk in May most severely affected currencies between May and 2013, experiencing on of the sharpest nominal exchange September 2013. Massive capital outflows from emerg- rate depreciations of all emerging market economies. ing markets were observed, with India experiencing a And what happens in India also affects other South Asian economies. India plays an important role as it 1 See the Focus on business cycle transmission in South Asia in the Fall 2013 edition “A is a major gateway and transmission channel for global Wake-Up Call” of the South Asia Economic Focus (World Bank) 30 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 sharp decline in foreign portfolio investment. Net economies. Large external or internal imbalances may foreign portfolio investment inflows plunged from have acted as an amplifier of capital outflows. Hence, US$6,783 million to -US$8,627 million between May apart from the current account balance, other factors and June 2013. such as the growth of industrial production and global investors’ risk appetite are also expected to play key However, a rapid depreciation of the rupee had hap- roles. pened in previous occasions, and it had always been related to external events. In fact, the Indian rupee has A variety of intuitive and conceptually valid factors experienced several sharp depreciations since 2007, and driving exchange rates as a result of the 2013 tapering neither of the massive depreciations in 2008-09 and surprise has been proposed. First, the relative openness 2011-12 was associated with the rise of the Treasury of a countries’ capital account has been put forward. In note yields. This simple observation is consistent with this respect, Eichengreen and Gupta (2014)2 study the the statistical insignificance of the yields in the entire role of financial market depth and find that the size of sample period. The depreciation during the global fi- the financial market ex ante positively correlates with nancial crisis can be mostly explained by the slowdown the size of portfolio outflows ex post because investors in the US (and Europe) as well as a flight to safe invest- seeking to rebalance their portfolios concentrated on ments, while the one starting in July 2011 was strongly countries with relatively deep financial systems. This has affected by the weak economic conditions in the Euro likely contributed to India experiencing such a severe area, high inflation and sluggish growth in industrial decline in portfolio investment in June 2013. Second, production in India. US long term interest rates could have incentivized investors to reallocate their funds towards higher yields A quick look into the past may shed some light on as tapering talk sent a strong signal of increasing inter- the heterogeneity of factors that interact at different est. A third potential (co)determinant of exchange rate points in time (and lay dormant or submissive in oth- movements following the 2013 tapering signal was the ers) to drive investor sentiment and ultimately ac- current account balance. This suggestion is based upon tion. As investors base their choice of portfolio balance an observed negative correlation between the share of on a variety of factors that determine expected return current account in GDP and the rate of currency de- – most notably growth expectations and related (mac- preciation among emerging-market economies in 2013 roeconomic or political) risk factors that may dampen growth prospects in a country – such considerations help explain relative differences in capital outflows 2 Eichengreen, B. and P. Gupta, 2014, “Tapering Talk: The Impact of Expectations of Reduced Federal Reserve Security Purchases on Emerging Markets,” World Bank Policy and exchange rate movements across emerging market Research Working Paper No.6754. FIGURE 24: In various episodes rupee depreciation was driven by factors other than US interest rates Exchange rate (USD/INR) A: Capital ight to safety B: Euro zone crisis and sluggish Share price index (2010 = 10) IP (billion constant 2005 USD) during the crisis growth in IP in India Yield (%) 60 16 14 50 12 C: Tapering talk 10 40 8 30 6 4 20 2 10 0 2007M01 2007M05 2007M09 2008M01 2008M05 2008M09 2009M01 2009M05 2009M09 2010M01 2010M05 2010M09 2011M01 2011M05 2011M09 2012M01 2012M05 2012M09 2013M01 2013M05 2013M09 2014M01 Industrial production in India (left, billion constant 2005 USD, 3-month rolling average, sa) Nominal USD/INR exhange rate (left) Share price index for the Euro area (right, index 2010 =10) 10-year T-note yields (right, %) Source: Reserve Bank of India, Federal Reserve Economic Data and World Bank DECPG TIME TO REFOCUS 31 FIGURE 25: India Nominal Exchange Rate and the US FIGURE 26: Net Foreign Portfolio Investment Outflows 10-year Treasury Note Yields move together between have been highly volatile in 2013 (Monthly data) May-October 2013( Weekly data) 68.0000 3.1 10000 US$ million 66.0000 2.9 8000 Net foreign portfolio investment 64.0000 out ow, monthly 2.7 6000 62.0000 2.5 4000 60.0000 2.3 2000 58.0000 2.1 0 56.0000 2011m7 2011m9 2011m11 2012m1 2012m3 2012m5 2012m7 2012m9 2012m11 2013m1 2013m3 2013m5 2013m7 2013m9 2013m11 1.9 -2000 54.0000 52.0000 1.7 -4000 50.0000 1.5 -6000 5-May-13 19-May-13 2-Jun-13 16-Jun-13 30-Jun-13 14-Jul-13 28-Jul-13 11-Aug-13 25-Aug-13 8-Sep-13 22-Sep-13 6-Oct-13 20-Oct-13 -8000 -10000 Nominal EXR (left) US 10-year T-note yields (right) Source: Federal Reserve Economic Data Source: Reserve Bank of India Q2-Q4 and 2014 Q1. It suggests that the Indian rupee sheet sizes of the central banks. Also yields of the 10- was most severely affected by the tapering in 2013 Q2 year US Treasury note and the net portfolio investment and Q3 because of its widening current account deficit inflow are included as short-run explanatory variables. in 2013 Q2. Eichengreen and Gupta (2014) also pro- vide evidence in favor of a larger impact of tapering in countries that allowed the current account deficit to widen relatively more during the earlier period of The following main insights emerge: quantitative easing. Even after controlling for a comprehensive set of ex- In order to quantify the impact of the tapering an- change rate determinants, the 10-year US T-bill yield nouncement on the nominal rupee US$ exchange emerges as the main driver of the drastic nominal rate and to disentangle the relative effects of the rupee US$ exchange rate depreciation between May proposed factors a dynamic model is developed. To and September of 2013. The size of portfolio flows evaluate the relative importance of the changes of fi- and trade deficit are also confirmed as significant but nancial and macroeconomic variables in the long run, quantitatively small co-determinants, thereby support- as a first step the error-correction model using monthly ing large and open capital accounts rather than mac- data over the entire sample period between January roeconomic fundamentals as drivers of exchange rate 2004 and November 2013 is estimated. As a second movements across emerging markets. In other words, step, the estimated coefficients are applied to the period global (and truly external) rather than domestic factors between April and September 2013, the peak of the were central to this particular episode of Indian rupee response, to decompose the change in the nominal depreciation. exchange rate into various factors over the specified short run. More precisely, the error-correction model For this particular short run episode, nearly 70 per- is built around a long-run co-integrating relationship cent (11 percent out of 16.3 percent) of the change between the nominal exchange rate, the wholesale price in the nominal exchange rate between April and index (WPI) in India, the producer price index (PPI) September 2013 can be explained by the rise in the in the US, the industrial production indices in the two 10-year US Treasury note yields. Using the estimated countries, and the lagged share of trade deficit in GDP coefficients, the relative effects of different factors on the in India. Short-run dynamics, on the other hand, are rupee depreciation in summer 2013 can be quantified. mainly captured by monetary and financial market Then it is found that the change in the yields on the 10- variables, such as stock market indices and the balance year US Treasury note constitutes the most important 32 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 FIGURE 27: Decomposition of the Nominal Exchange Rate Change between April-September 2013 shows T-bill yields as the major driving force 20% 16.3% 15.1% 15% 11.0% (Numbers in parentheses are the changes of the variables between April-September 2013.) 10% 5% 3.6% 2.0% 0.9% 0.7% 0.5% 0.2% 0.1% -0.1% -0.1% -0.8% -2.7% 0% Actual depreciation rate Predicted depreciation rate T-note after tapering (+105 basis points) India WPI (+5.3%) RBI total asset (+7.6%) Fed total asset (+12%) Portfolio inv. (-4.9%) India IIP (-1.2%) "Trade de cit (% GDP, +1.5%)" "T-note yield (+105 basis points)" US PPI (+0.2%) US IIP (+0.7%) "Stock price in Euro area (+8.9%)" Other 5% * Source: World Bank Sta calculations determinant of the respective change in the nominal past episodes other factors may have been at the fore- exchange by 16.3 percent over the period of interest. front of determining investment decisions. In contrast, the sharp decline in portfolio investment and a modest rise in the trade deficit have only limited impacts on the rupee depreciation, although both have significant depreciation effects on the exchange rate in External risk factors are likely the long-run. to give way to domestic ones Intuitively, what happened in summer 2013 can be explained by simple adjustment of investor ex- The results indicate that a rise in the 10-year US pectations regarding i) interest rate spreads and ii) Treasury note yields significantly contributed to the the relative exposure of emerging markets to large depreciation of the Indian rupee, however only for portfolio rebalancing towards the US. Investors were the period May to November 2013. A hypothetical surprised by the tapering announcement and immedi- 100 basis/1 percentage point(s) increase in the Trea- ately factored in the implied increase in the US long sury note yields after the announcement, for instance, term interest rates. This pushed up T-bill yields and would have implied an increase in the depreciation prompted investors to reallocate flexible funds towards rate of the rupee by 10 percent. However, the Treasury the US. Large and open capital accounts (portfolio note yields were statistically insignificant for the entire positions) allowed investors to withdraw money faster sample period, hence it can be concluded that a statis- while perceived risk premia for those markets increased, tically significant relation between the yields and the thereby adding a notion of self-fulfillment to investor exchange rate is confined strictly to the short run, here expectation regarding emerging markets. the 7 months following May 2013. However, the strong causal relationship between US When estimated over the entire sample period (2004- long terms interest rates and the rupee US$ nominal 2013), the 10-year US Treasury note yields do not exchange rate disappears over the longer run. More appear as relevant determinants of the movements of precisely, the significant effect of US T-bill yields is the nominal exchange rate. The quantitative analysis found to be restricted to the specific “short run” time confirms that the lagged trade deficit and portfolio frame – here May to November 2013 – while it is investment inflow had depreciation and appreciation absent over the long run – here the full sample period implications for the exchange rate, respectively, over the from 2004 to 2013. This strongly suggests that during entire sample period. In contrast, while an outflow of TIME TO REFOCUS 33 BOX 1: Estimation Results of the Short-Run Error Correction Model Dependent variable: Δln(Nominal EXR) With tapering dummy With T-note Increase = depreciation of the rupee and T-note (Benchmark) Δ(yields of the 10-year T-note) 0.007 0.001 Tapering dummy x ΔT-note yields 0.104*** Δln(Net foreign portfolio inv.) -0.138*** -0.133*** Δln(India WPI) # 0.798*** 0.668*** Δln(US PPI) # -0.514*** -0.455*** Δtrade deficit, lagged (% in GDP) # 0.135** 0.110* Δln(Indian industrial production), seasonally adj. # -0.461*** -0.366** Δln(US industrial production), seasonally adj. # -0.174 -0.190 Δln(Share prices in the Euro area) -0.088** -0.087** Δln(FED balance sheet size) 0.072** 0.073** Δln(RBI balance sheet size) 0.270*** 0.262*** Observations 117 117 Adjusted R-squared 0.559 0.596 #: variables included in the long-run equation Standard errors in parentheses Significant depreciation factors *** p<0.01, ** p<0.05, * p<0.1 Significant appreciation factors foreign portfolio investment and a rise in the share of long-term interest rate solely, while some countries in- trade deficit in GDP led to a significant depreciation in cluding India could also reduce risk perceptions due to the rupee throughout the sample period, they had only strengthened external positions. Hence, India remains limited impacts on the behavior of the rupee after the a relatively attractive investment destination even after tapering shock. accounting for the US recovery, as witnessed by port- folio investment inflows being back to pre-shock levels In light of these findings and recent developments, by December 2013. expected future increases in US interest rates due to tapering are unlikely to transmit comparable Considering that markets have permanently updated pressures and South Asia in the near term. In India, their expectations and priced in the lion’s share of external vulnerabilities decreased drastically as the future tapering, a further rise in the US long term current account deficit shrank (due to higher export interest rates is unlikely3 to cause a severe deprecia- growth and import restrictions) and monetary policy tion of the Indian rupee in the near future. India has tightened to keep inflationary expectations in check. significantly reduced its external vulnerability and its As a result, also portfolio and capital flows to the re- growth outlook remains positive and hence attractive gion recovered, leaving the capital accounts in ample for investors. In 2013 Q3 current account deficit nar- shape to finance smaller current account deficits. Then, rowed sharply to 1.2 percent and fell to less than one in the first quarter of 2014, when tapering gradually proceeded, the stronger macroeconomic position paired with the early “pricing in” of tapering in US markets 3 The World Bank Global Economic Prospects Volume 8 (January 2014) presents evidence put little additional pressure on the Indian rupee. In in Chapter 3 that the pace of QE withdrawal significantly affects probability of distress in developing countries with currently unexpected rapid adjustment in interest rates bear- the long run, investors are unlikely to focus on the ing the highest risk. 34 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 percent in the following quarter, greatly helped by a fall for distressed but systemically important banks. On the in gold imports and export growth gaining momentum. other hand, Pakistan is subject to dynamics of opposite Associated with the improvements in current account, direction, where private banks (and the economy) may the rupee exchange rate was stable during 2013 Q4 and suffer from a large exposure to short term government 2014 Q1. In terms of reducing external vulnerability, debt. Finally, Nepal provides interesting insights into India outperformed other emerging-market peers in questions related to excess liquidity, where we analyze recent months. the potential incentives for banks and central banks to maintain excess liquidity in more depth. Going forward, South Asian economies will need to refocus and shift attention towards rising domestic risks that have been fueled by recent events and may but need not challenge financial stability and India’s public banks and economic growth in the future. Along those lines, po- private (corporate) debt tential pressures emanating from the banking sectors in India, Pakistan and Nepal are identified and analyzed in more depth. Although tapering induced effects may Disproportionately faster growth of credit and capi- have contributed to the building up of vulnerabilities tal inflows, compared to the rate of fixed investment in the private and public sector in the past, the above growth, especially in infrastructure, has raised the derived conclusions strongly motivate a refocus on a leverage of domestic Indian corporates. As an im- more domestic agenda. Hence, we look at the banking mediate result of the tapering induced rupee deprecia- sector due to its increasing importance for South Asia’s tion, the financial health of many Indian corporations future stability and growth. has increasingly come under pressure. Availability of cheap funds aided by loose monetary policy of the Banking sectors across South Asia constitute a key global central banks together with easing in some of part of the financial system and are at the cutting the Asian economies lowered domestic interest rates, edge between private sector activity, growth and consequently prompting corporations to leverage up. macroeconomic and financial stability. We focus on However, the Fed’s announcement of tapering in May three countries – India, Pakistan and Nepal – that last year tightened global liquidity, exerting pressure constitute a fairly representative sample of potential on most of the EM currencies and prompting central risks and vulnerabilities emanating from South Asian banks to raise interest rates again. This raises concerns banks. On the one hand, India’s banks are increas- about a spike in corporate default risk and its potential ingly exposed to risks inherent to corporate debt, which spillover effects to the banking sector in India. may ultimately affect the government’s balance sheet through state banks and potential lending of last resort Corporate leverage in India has increased beyond FIGURE 28: Movement of key interest rates 10.5 10.0 9.5 9.0 per cent 8.5 8.0 7.5 7.0 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 Policy Repo Rate Call Money Rate (Weighted Average) 10-Year Government Securities Yield TIME TO REFOCUS 35 FIGURE 29: Domestic debt composition shows an increasing share of corporate debt while it increased disproportionately compared to fixed investment growth 160 80 140 70 120 60 Total corporate debt* 100 Corporate 50 % of GDP % of GDP 80 40 Households 60 30 40 20 Fixed capital formation Government 20 10 0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: Reserve Bank of India levels seen in 2008, with bank lending making up FIGURE 30: Bank lending and overseas borrowing the lion’s share of corporate debt. Domestic corporate account for majority of corporate debt debt-to-GDP likely increased a sharp 16 percentage points during FY2004-FY2008, to 52 percent. How- 80 ever, during the last five years, the share is estimated to 70 have marginally increased to 56 percent in FY13. Large part of leveraging happened in an environment of ro- 60 bust economic growth with expectations of sustained 50 economic momentum. Real GDP expanded an average % of GDP 8.7 percent per year during FY2004-08, but moder- 40 ated to 7.1 percent during FY2009-13. In context of 30 the Indian corporate sector, bank lending makes up 20 majority of the domestic corporate debt. Corporate bonds—though growing briskly—still constitutes 10 mere 3 percent of GDP. The share of bank lending to 0 the private sector has significantly increased between 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 the early 2000s and 2013 but remains lower than the Others External borrowing Bank lending regional average. Ultimately, disproportionately faster growth of credit and capital inflows, compared to the Source: CEIC rate of fixed investment growth, raised the leverage of domestic corporates. correct capital structures, sponsors are also considering stake/asset sales, examples being Lanco, Adani, GVK, The sharp depreciation of the rupee in 2013 and slow- GMR, Tata Power, Ramky Infrastructure. Second, even down in output growth has substantially increased though the rupee has appreciated around 12 percent the cost of servicing existing debt, especially of from its all-time lows in August last year, it is still nearly India’s infrastructure companies. Although pressures 10 percent weaker than that at the beginning of 2013. have eased recently, external vulnerability has increased Thus, to the extent that some part of the borrowing in the private sector. First, a significant part of corpo- remains unhedged, it could pose risks to the corporate rate debt was in the form of external commercial bor- balance sheets. rowings – which usually have a 3-4 year tenure – and are near maturity. Anecdotal evidence indicates that Pressures on Indian banks have been increasing as heavily indebted firms are struggling to renegotiate witnessed by an increase in NPAs. Cash flow pres- debt repayment schedules. To bridge funding gaps or sures from a weak operating environment have been 36 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 BOX 2: Economic development and leverage: While the total debt burden has increased in the region over the last decade; in most of the South Asian economies, including India, the debt-to-GDP ratios have remained well below those in advanced economies. This can partially be explained by the fact that better developed economies can be expected to have higher capacity to carry debt burden. As an economy matures, its financial market develops, helping to allocate capital efficiently – providing the corporates and households with wider and sophisticated tools to increase leverage. Growth in the share of bank lending maps economic expansion of a country quite well 200 Japan 180 160 Thailand Dom credit to pvt sector (% of GDP) S.Africa Korea 140 China Malaysia 120 Singapore 100 80 Brazil 60 India 40 Turkey Russia 20 Indonesia 0 0 10000 20000 30000 40000 50000 60000 GDP per capita, nominal US$ Source: CEIC Data and World Development Indicators The chart above indicates that economies with higher per capita income – Singapore, Japan, Korea—have significantly higher credit-to-GDP ratios as compared to the emerging economies of Brazil, Turkey, South Africa, Thailand, Malaysia and Indonesia. Despite having grown sharply over the last few years, India’s private sector credit-to-GDP is well below most of its EM peers. India is likely to be less vulnerable with relatively lower debt burden when compared to EM peers 70 Singapore Japan 60 50 Brazil Thailand Change bw 2007 and 2013, pp 40 Turkey 30 20 Russia Korea 10 S.Africa Malaysia 0 India -10 Indonesia -20 0 50 100 150 200 250 300 350 400 450 Total Debt to GDP (%), 2013 Source: CEIC Data and World Development Indicators The figure above plots the change in total debt to GDP ratio since 2007 against its current level. Economies in the top right hand corner are expected to be more vulnerable as they have witnessed a sharp rise in leverage and carry a relatively large debt burden. Solely using this lens suggests that India is less likely to be at risk than some of the peers. However, a significant share of the corporate debt in India is funded externally, thus making the balance in the external account vulnerable to external financing. TIME TO REFOCUS 37 FIGURE 31: Growth in NPAs far exceeds that in advances (left) and sector contributions to stressed advances (right) 50 35 60 40 30 50 Share in Stressed Advances (%) Share in stressed advances (%) Gross Advances 25 30 40 % Growth 20 20 30 Gross NPAs 15 10 20 10 0 10 5 -10 0 FY09 FY10 FY11 FY12 FY13 Sep-13 0 -20 Infrastructure Iron & Steel Textiles 2002 2004 2006 2008 2010 2012 Aviation Mining Total of these Sectors Source: Reserve Bank of India aggravated by high leverage of firms, making them of live CDR cases, and the ratio rises to over 60 percent more vulnerable to sustained periods of slowdown, if iron & steel, construction, and ship building are also delays in projects, or external shocks. Gross NPLs have included. About 16 percent of infrastructure loans were risen to 4.1 percent as of December 31, 2013 from 3.6 restructured till March 2013. Performance in the sector percent in FY2013 and 2.5 percent in the previous two continues to be affected by unresolved issues on fuel years. The picture looks worse if restructured assets are linkages (despite Coal India Fuel Supply Agreements), also included – estimated at 9.2 percent as of March increasing dependence on imported coal, offtake risks 2013. There has been a steep rise in the number and on account weak discoms and regulatory/political risks value of the restructuring of loans, particularly of big in effecting tariff increases. Having said that, ultimate ticket loans under the corporate debt restructuring losses are expected to be low as these projects remain (CDR) mechanism. CRISIL estimates that as much viable, expected to generate cash flow over the opera- as 5.7 percent of advances as of March 2014 could be tional life. NPA (including slippages from restructured assets). 4 RBI stress tests indicate that GNPA ratio is expected to Public-sector banks (PSBs) are most affected by peak by September 2014 and improve thereafter. Under growth in stressed assets. In India, PSBs are the larg- severe stress conditions, RBI estimates the GNPA ratio est contributor to stressed advances with 75 percent of could reach 7 percent by March 2015. advances generating 86 percent of stressed assets till September 2013. Some of the mid-sized public sector Infrastructure and related sectors are the largest banks remain vulnerable to the elevated single-name contributors to bank NPAs and corporate debt re- / sector concentrations. PSBs approach to NPA man- structuring cases. Infrastructure, iron & steel, aviation, agement differs from other banks, as they retain a high and mining – which together contribute 20 percent to proportion of restructured assets on their books. On the bank advances – accounted for around 44 percent of contrary, new private sector and foreign banks choose total stressed assets as of September 2013. These sectors to write off rather than hold delinquent assets demon- were hit by operational challenges—such as lack of fuel strating more agility to act on the part of management. availability and poor cash flow generations relative to those made at the time of conception of these proj- Bank capitalization as required by Basel III may ects—which have had a marked effect upon their credit also pose a challenge for PSBs unless being spread quality. As of end-December 2013, infrastructure (in- out over the transition period. Funding challenges cluding power and telecoms) accounted for 37 percent for the banking sector moderated as the loan growth slowed down in FY2014, however the imbalance could resurface once the demand for credit gathers pace with 4 H1 2013-14 Ratings Roundup overall economic activity. Further, in line with the 38 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 FIGURE 32: Stressed assets continue to grow 6 5 Gross NPSAs to Gross Advances (%) 4 3 2 1 1 All Banks Foreign Banks New Pvt Banks Old Pvt Banks PSBs Mar-12 Dec-12 Mar-13 Sep-13 Source: Reserve Bank of India state-owned banks which have weak credit profiles BOX 3: The Transition to Basel III in India and are unable to sufficiently tap the capital markets. If raising capital is managed effectively by spreading An estimated Rs 5 trillion11 is the capital requirement of out over the transition period, together with sustained banks over 2013-2018 for Basel II and III purposes, of which improved performance, the impact of equity injections non-equity capital is of the order of Rs3.25 trillion while on government finances is unlikely to be burdensome. equity capital is of the order of Rs1.75 trillion. Government of India would need to infuse between Rs 700-900 billion, Hence, unless mismanaged, the increase in corporate depending on where it wants to maintain its shareholding leverage and distressed assets will put some pressure leaving the balance to be funded through minority on PSBs but overall is unlikely to pose systemic risks shareholders and capital markets. Whether markets have for the banking sector. The current corporate situa- the appetite for common equity, debt or additional Tier tion is unlikely to place insurmountable stress on the I instruments (Basel III compliant) remains a risk factor. economy, but it does offer an opportunity to undertake Also, capital assumptions assume a certain proportion of reforms, including broader banking/financial sector retained earnings to be ploughed back which under current reforms. Viability of the banking system appears ad- conditions of stress may be an overestimate. Even assuming equate although profitability of some banks remains back ended requirements, the FY2015 requirement of Rs112 vulnerable to elevated sector/single borrower concen- billion while manageable from the Government perspective, trations. Stressed assets of the banking system can be is a reduction from Rs140 billion of FY2014 and therefore contained should the current growth prospects mate- warrants a question as to its adequacy given current asset rialize and the investment cycle pick up as expected; quality stresses. as this would improve corporate cash flows and reduce default risk. However, delay in growth revival and an event of aggravated macro risks could worsen the credit 1 Approximately 80 percent of this would be for public sector banks. pressures. However, the funding imbalance may surface with increased capital demand to meet the Basel III requirements and a pickup in credit growth. Basel III requirements, the demand for Tier I capital is expected to increase from FY2015 onwards, increasing Continued strengthening of the regulatory frame- substantially in subsequent years till FY2018. Private work governing banking in India as well as a stable sector banks, with better access to equity markets and and committed government will be key factors for currently healthy capital levels, are unlikely to face financial sector stability. Regulatory measures forcing challenges in maintaining the required capitalization banks to improve loan loss reserves (on restructured level. However, the situation could be challenging for loans and exposures to corporates with large unhedged TIME TO REFOCUS 39 FIGURE 33: Financial Sector Asset Composition FIGURE 34: Asset Structure of Banking Sector Share of Assets Share of Assets NBFIs, 5% Foreign banks, 18% Insurance, 4% Specialized banks, 2% National Savings Schemes 77% Banks MFIs, 0.2% 19% Public sector banks 74% 74% 17% 17% Source: State Bank of Pakistan Financial Sector Review 2011 and Quarterly Statistics of the Banking System December 2013 forex liabilities) and common equity injections will Pakistan’s private banks likely help the banking sector maintain adequate and public debt defenses. Further, the systemic support to the sector remains strong, as evidenced by recently announced allocations of government funds to bolster capital at Pakistan has a largely private financial sector, with public sector banks. It is also worth noting that Indian private commercial banks constituting the largest banks continue to have sound liquidity metrics, under- share of assets. The financial sector has over US$ 130 pinned by a sizable domestic deposit base and minimal billion in assets, 74 percent of which are in the banking reliance on wholesale funding. And in light of upcom- sector. Within the banking sector, private commercial ing elections, a stable government will help reviving banks make up 77 percent of assets, 79 percent of de- both foreign as well as domestic investment needed to posits and 75 percent of loans. These banks contribute underpin growth and lift credit quality of Indian banks. to overall market efficiency, comprising 77 percent of income and 84 percent of profits before taxes. Stability and performance of the banking sector has been strong over the last decade, reflected in solid assets growth, adequate liquidity, and grow- ing profitability, while maintaining solvency and capital adequacy thresholds. The sector is largely FIGURE 35: Banking Sector Growth FIGURE 36: Banking Sector Performance 10000 25% 8000 20% PRs billion 6000 15% 4000 10% 2000 5% 0% 0 2008 2009 2010 2011 2012 2013 2009 2010 2011 2012 2013 Capital Adequacy Ratio Gross NPLs Net NPLs to Loans to Loans Advances Investments Deposits Spread ROA (before tax) ROE (before tax) Source: State Bank of Pakistan Financial Sector Review 2011 and Quarterly Statistics of the Banking System December 2013 40 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 compliant with the Basel Core Principles. State Bank Further, the sector showed resilience to domestic shocks of Pakistan’s banking sector supervision has remained in the form of the economic slowdown in the past five relatively strong and independent over the past, and it years. Gross non-performing loans (NPLs) increased has conducted regular financial stability reviews as well significantly from 7.6 percent of total portfolio in 2007 as stress tests. In August 2013, SBP decided to imple- to 15.7 percent in 2011. However, adequate provision- ment Basel III standards (issued by the Basel Com- ing kept net NPLs in check, and banks persisted with mittee on Banking Supervision) to further strengthen a risk-aversion to private sector credit despite strong capital related rules.5 The minimum capital adequacy liquidity positions. The Government of Pakistan has ratio requirement is 10% of risk-weighted assets while been dealing with BOP and fiscal imbalances that have the statutory minimum capital requirement is high at intensified in recent years. An economic slowdown, PRs 9 billion (US$ 90 million) which is considerably weak external inflows, low revenue collection and high higher than in other South Asian economies such as subsidies to support an unsustainable energy mix have India, Sri Lanka and Bangladesh.6 Advances, invest- all contributed to a significantly deteriorating balance ments and deposits have grown at compounded annual sheet. To manage these pressures, the government has growth rates of 5 percent, 32 percent and 15 percent been relying heavily on domestic sources of funding respectively in the five year period 2008-2013 (Figure (Figure 5). Annual borrowing from domestic banks was 3). Return on equity and Return on assets peaked in PRs 952 billion in FY13 compared to PRs 186 billion 2011 at 23.0 percent and 2.2 percent respectively, and in FY09. Moreover, direct borrowing from SBP of PRs continue to be strong. 505 billion in FY12 and another PRs 506 billion in FY13 has mopped up liquidity from the market. The banking system has very limited exposure to external shocks and has showed resilience amidst do- The banking system now holds a substantial portion mestic shocks, but may now be vulnerable to reverse of the government’s debt. The government’s domestic shock transmissions from the Government of Paki- debt has increased from PRs 3.9 trillion (30.3 percent stan. The sector was not heavily impacted by the global of GDP) in FY09 to PRs 10.3 trillion (41.8 percent financial crisis mainly because of limited inter-linkages of GDP) in FY13. The domestic banking sector holds with international financial and securities markets. approximately 35 percent of this domestic debt. Finally, assets of the banking sector in recent years have contin- ued to expand in the form of investments in govern- 5 According to State Bank of Pakistan, BPRD Circular No. 06 of 2013, the instructions will ment securities. As a result, banks now hold about 77.4 become effective in a phased manner with full implementation intended by December 31, 2019. percent of government securities outstanding. Over 6 There are four undercapitalized banks in the sector which are being closely monitored by SBP as part of the financial sector benchmarks set under Pakistan’s current three-year 90 percent of these holdings are in short term (less IMF EFF arrangement. than 1 year) market treasury bills, and profitability is FIGURE 37: Government Debt Profile FIGURE 38: Bank Holdings of Government Securities 2500 70% 4500 90% 60% 4000 80% 2000 3500 70% 50% 3000 60% % share of toral 1500 PRs billion PRs billion 40% % of GDP 2500 50% 30% 2000 40% 1000 1500 30% 20% 500 1000 20% 10% 500 10% 0 0% 0 0% FY09 FY10 FY11 FY12 FY13 H1 FY14 Q1 FY10 Q3 FY10 Q1 FY11 Q3 FY11 Q1 FY12 Q3 FY12 Q1 FY13 Q3 FY13 Q1 FY14 State Bank of Pakistan Commercial banks Non-bank sources Holdings % Share Govt external debt Govt domestic debt Govt total debt Source: State Bank of Pakistan Financial Sector Review 2013 (State of the Economy) and Monetary Statistics March 2014 TIME TO REFOCUS 41 linked to an accommodating interest rate environment. Nepal’s banks and the However, with debt levels of the government reaching question of liquidity unsustainable levels, and limited expansion of private sector credit, banks remain exposed to significant risk on government, which in turn is exposed to significant Since severe liquidity constraints had contributed to external account and fiscal shocks. an “almost financial sector crisis” in mid-2011, excess liquidity has been building up in Nepal’s financial While the banking system has adequate absorption system. Fuelled by remittance growth, Nepal’s banking capacity for shocks transmitted through the govern- sector appears to be increasingly holding liquid assets ment, the risk of such exposure is not adequately rather than supporting productive investment through reflected. First, liquidity implications are not fully lending. Deposit mobilization increased by 8% in reflected because these large holdings of short term the first half of the year vs. 5.3% at the same time in government securities are essentially being refinanced FY2013; by contrast domestic credit growth slowed to and rolled-over through new and larger auctions of 7.3% over the first 6 months of the fiscal year under the market treasury bills. At the same time, these securities influence of both lower levels of government borrowing are traded only between designated banks - a secondary and slower growth of claims on the private sector (9% in market through the stock exchange has been launched the review period vs. 12.3% in the first half of FY2013). but has not yet been implemented. Second, there may As a result, the loans-to-deposits ratio has been declin- be impacts on solvency and capital adequacy which are ing over time. Three commercial banks (8.8% market not being covered. Capital adequacy and risk weight of share) recorded Credit to Deposit Ratio (in LCY) in assets treat short term government securities as risk- excess of 90% in the second quarter of FY2014 com- free, thus increased government borrowing from banks pared to five commercial banks (9% market share) in has actually increased banks’ capital adequacy ratios. the previous quarter and eleven banks (30percent of the Banks’ overexposure to government debt, the govern- market) in the previous year. At the same time, treasury ment’s vulnerable external account and fiscal positions, bills accounts of commercial banks increased signifi- and the existence of a reverse shock transmission cantly, almost doubling between FY2011 and FY2013. mechanism are proving to be a new source of systemic Reflecting these trends the interest rate spread between risk to the banking sector. risky assets (private sector loans) and low risk assets (T-Bills) widened significantly. Banks appear to be withholding credit by maintain- ing high lending rates despite slower credit growth. In other words, prices may not be efficiently clearing FIGURE 39: Liquid assets of commercial banks are increasing 250000 200000 150000 100000 50000 0 Liquid funds Cash in hand Balance with NRB Balance held abroad 2008 2009 2010 2011 2012 2013 Source: NRB 42 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 FIGURE 40: Interest rates may not effectively clear markets 10 8.5 8.1 8 6.8 Interest Rates (%) 6 6.6 5.1 4 3.0 3.6 3.7 2 2.8 1.2 1.2 0.9 0.9 0 FY07 FY08 FY09 FY10 FY11 FY12 FY13 T-Bills (91 days) Interbank Rate the credit market at this point. While credit to the private sector remains high, the rate of credit growth BOX 4: Effects of excess liquidity has decreased significantly from FY2013. Also, the large interest spread between risky assets (credit to the -On growth: as the bias toward liquidity implies a higher cost private sector) and low risk assets (T-bills, deposits at of borrowing (or credit rationing) leading businesses and NRB) is significant, indicating reluctance from banks households to defer investments or current expenditure and to use the price mechanisms to attract greater demand possibly to sectoral shifts in the composition of lending at the for loanable funds. That is not because of involuntary expense of smaller and less well established clients (flight to rationing (although the NRB has imposed some limits quality) to real estate related lending) but rather appears to be -On inflation: to the extent that it increases the capacity of the a voluntary behavior, possibly linked to psychological banking sector to boost credit in response to demand shocks, factors and/or a reassessment by banks of default risk inflationary pressures could quickly become difficult to contain and balance sheet weaknesses. -On financial sector stability: the effect is ambiguous: to the extent that banks can have access to cheap money, high levels Excess liquidity may be costly in terms of growth of liquidity provide a boon to the banks’ ability to rebuild their effects and inflationary pressures. Excessive liquidity balance sheets; at the same time, if adequate safeguards are can be a source of concern for growth to the extent not in place and banks remain exposed to liquidity risks (as is that it amounts, de facto, to a tightening of the money the case in Nepal) banks could be tempted to engage in overly supply. Ceteris paribus, excessive liquidity means less risky lending practices lending to support non-government productive invest- -On monetary policy effectiveness: by affecting the ability of ment –for a given money base- and therefore slower monetary authorities to stimulate demand and stabilize the overall economic growth. However, at the same time, economy during downturns: with banks already highly liquid it is potentially a source of inflationary pressure. Abun- (i) further attempts by the monetary authorities to stimulate dant liquidity comes at a cost for commercial banks demand would likely prove futile and (ii) the ability to regulate (in the form of deposit) who will only hold it if they the money supply via reserve requirements and the money need to improve their balance sheets and/or consider multiplier are also proportionately weaker. the risk profile of borrowers to be too high. But such liquidity can be rapidly mobilized for lending if these parameters change and can translate in asset bubbles fueling inflation. an unnecessary slowdown in growth on one hand and controlling inflation on the other hand. Maintain- Choosing a monetary policy stance, therefore, in- ing a relatively lose monetary policy and allowing the volves a tradeoff between the objectives of avoiding excess liquidity to remain is consistent with emphasis TIME TO REFOCUS 43 on the growth objective. Draining off excess liquidity relatively favorable macroeconomic outlook, Nepal is is consistent with a priority on the inflation objective. in the fortunate position to be able to afford a relatively In other words, if sound demand for credit exists in conservative monetary policy stance. Third, the interest the economy but does not materialize either because cap needs reconsideration as it adversely affects both of reluctant investors and/or excessively risk-averse the ability of banks to rebuild balance sheet strength banks, then maintaining a relatively loose monetary and to use price mechanisms to discriminate between policy may be justified. On the other hand, if banks are good and bad loans, and it may compromise the ob- worried about balance sheet weaknesses and/or assess jective of restoring balance sheet health and allowing the existing demand for credit as too risky, then a loose sound demand for credit to be met. policy stance combined with policy directives to expand lending could exacerbate financial sector woes and feed In the medium run, monetary policy objectives need asset bubbles and inflation. NRB has identified two ad- to be clarified and the available monetary policy tool ditional policy objectives namely, financial development kit empowered to strategically deal with structural and stability. Loose monetary policy is consistent with excess liquidity. While excess liquidity can result from both, however its combination with policy directives to temporary shocks, in Nepal this is increasingly a fix the spread that banks can maintain between deposit structural feature of the economy. The phenomenal and and lending rates is not and possibly counterproductive. sustained rise in inward remittances and corresponding buildup of net foreign assets –other things equal- is Ultimately, understanding the drivers of the credit steadily growing the money base. At the same time this slowdown is crucial. On the one hand political uncer- overall steady rise is combined with short term fluctua- tainty, especially since the dissolution of the first Con- tions driven by remittances and asset bubbles (and their stituent Assembly and in the run-up to the elections, bursting), which discourage investors from making may have led private operators to postpone investment long term investments (due to the un-predictability of decisions; likewise the depreciation of the Nepali rupee funding) and bank lending (due to the unpredictability may have led importers to reduce their demand for let- of supply of credit). NRB, however, has acted with in- ters of credit. On the other hand however, the supply creasing frequency in FY2014 to absorb excess liquidity of credit may also have fallen (for any given level of in the system via reverse repo and open market opera- interest rate –i.e. leftward shift of the supply curve) due tions (outright sale auctions) but these are short term to balance sheet weaknesses of banks and/or height- fixes, in fact more typically used for fine tuning pur- ened perception of default risk. The banks’ continued poses -to smooth the interest rate fluctuations caused exposure to real estate – whose valuation is particularly by temporary variations in liquidity- than for long term hard and where the market remains subdued– adds to management. As such they are different from so called the constraints that banks face in assessing the true structural operations that are used to adjust a central extent of their exposure and need for additional protec- bank’s long term position vis-à-vis the financial sector. tion beyond those imposed by regulation. Perceptions Therefore, it will be important to develop a toolkit to could also be playing a part including the experience of deal with excess liquidity in a strategic way providing crisis (an impaired loan portfolio) and/or heightened clarity and stability with respect to goals (inflation uncertainty (leading to regard previously normal loans and growth) and adopt corresponding targets for bank as having now excessive risk). These two dynamics liquidity and interest rates. Given the cost of steriliza- maybe re-enforcing each other since the most typical tion, the best option is to tackle the inefficiencies that form of collateral is real-estate. are at the source of involuntary or ‘excessive’ of liquidity. This implies that the GoN should continuously carry In the short run, NRB should closely monitor the out structural reforms to improve the overall credit evolution of bank balance sheets, stand ready to environment and the investment climate to make sure tighten monetary policy, and reconsider the proposed that banks can expand lending in a sustainable and safe cap on interest rate margins between deposit and manner to viable investments. lending rates. First, the NRB should carry out an in depth review of weaknesses of BFIs and build capacity to provide effective supervision, as there is still uncer- tainty about the true health of Nepal’s financial sector (e.g. the amount of ever green loans in the system) and a better diagnostic is needed. Second, given the SOUTH ASIA ECONOMIC FOCUS SPRING 2014 TIME TO REFOCUS 45 South Asia Country Briefs In alphabetical order: AFGHANISTAN BANGLADESH BHUTAN INDIA MALDIVES NEPAL PAKISTAN SRI LANKA 46 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 Afghanistan 30.0 GDP Growth & Sectors, 2005-2013 20.0 10.0 Recent Economic Developments Percent Economic growth fell dramatically in 2013, to an 0.0 estimated 3.6 percent of GDP from 14.4 percent in 2012, as heightened uncertainty about the political -10.0 and security transition led to a slump in investor and 2013p 2012 2005 2006 2007 2008 2009 2010 2011 consumer confidence. It was the second successive year of robust agricultural output – cereals production rose Agriculture Industries Services 2.7 percent above the bumper harvest of 2012 – but the bounty could not make up for the falloff in private investment and tepid growth of non-agricultural sec- Public expenditures rose only modestly in 2013, tors – construction, manufacturing and services. The with total budget spending just 24.2 percent of number of new firm registrations fell sharply in 2013 GDP (US$5 billion) from 23.8 percent (US$4.9 bil- to its lowest level in five years, with a reduction in both lion) in 2012. Spending on sectors such as education, local and foreign new fixed investments. health, and agriculture & rural development increased modestly or held steady, while lower spending on in- The slide in confidence is rooted in concerns about frastructure and economic governance accounted for national security and stability after most interna- most of the decline in civilian expenditures in the year. tional forces withdraw in 2014 and doubts that a It was considerably lower than the previously projected cohesive, broadly accepted government will take 2013 budget spending of 26.7 percent of GDP, and is a hold within a reasonable period after the April 2014 result of austerity measures put in place to address the elections. Growth is projected to remain weak in 2014, weak revenue collection and overall lower discretionary although a smooth political and security transition resources. would help bolster confidence and enable economic growth to pick up in 2015. The Ministry of Finance introduced a variety of measures in 2013 to stabilize revenues, reduce leak- Revenue collection weakened in 2013, while Af- ages, and improve administration. These measures ghanistan’s large security expenditure obligations included the implementation of a computerized risk and high aid dependence threaten to crowd out important civilian operating and development Financing Gap: spending. After a decade of strong revenue growth, Domestic vs. Total Core Expenditures domestic revenues declined to 9.5 percent of GDP in 30.0 2013, from 10.3 percent in 2012 and a peak of 11.6 Percent of GDP percent in 2011. Nominal revenues amounted to Afs 109 billion in 2013, almost level with the pro-rated 20.0 figure for 2012. The decline in revenue collections is a result of the economic slowdown as well as weaknesses in enforcement in both tax and customs administration. 10.0 Meanwhile, with more security spending moving into the budget, on-budget security expenditures increased to 11.5 percent of GDP in 2013 from 10.4 percent in 2012. Civilian expenditures, on the other hand, - 2012-12 2006 2007 2008 2009 2010 2011 2013 declined to 12.8 percent of GDP in 2013 from 13.4 percent in 2012, as the government tightened public Financing gap Domestically- nanced expenditures spending following the mid-year budget review. TIME TO REFOCUS 47 management module, improved procedures for ran- expanded by 36 percent to 209,000 hectares (after a dom post-verification of examination, introduction of decline in 2012 due to adverse weather and disease). post-clearance audits, salary incentives for detection of Despite substantial financial flows from opium pro- non-compliance, and an increase in fuel valuation at duction, analysis suggests that opium’s contribution customs. While the immediate effects of these measures to Afghanistan’s economic growth in the past 10 years have been modest to date, they have likely prevented an has been minimal, although it is probably an impor- accelerated decline. tant source of livelihood for a segment of the rural population. Consumer price inflation remained below 10 percent throughout the year. Period-average headline inflation increased slightly to 7.7 percent in 2013, up from 6.3 percent the previous year, but remained in single digits Outlook and Policy throughout the year. Furthermore, Afghanistan has enjoyed a period of relative price stability in the last two Economic growth is projected to remain weak at 3.2 years compared to the fluctuations and acute swings in percent in 2014 due to heightened uncertainty and prices which occurred during and after the 2008 world lower agriculture output. Uncertainty surrounding the commodity price crises. political and security transition is expected to persist through most of 2014, resulting in continued weakness Food price increases exceeded non-food increases in in private investment and growth in the non-agricul- the second half of 2013, in contrast to the first half tural sectors. A smooth political and security transition of the year. The increase in food prices (year-on-year) would help restore confidence in the economy. At the was 9.8 percent in December 2013, from 4.4 percent same time, lower agriculture output is anticipated in in December 2012. On the other hand, the increase 2014 as the winter precipitation has been assessed as in non-food prices moderated to 4.8 percent from 7.4 less favorable. Taking into account the bumper harvest percent over the same period. in 2013, agricultural output in 2014 is expected to be lower than in 2013, thus placing a further drag on Foreign aid inflows continue to finance the large growth prospects for 2014, explaining the lowered pro- trade deficit and sustain foreign exchange reserves. jection of 3.2 percent of GDP. In this context, public The trade deficit remained large but declined slightly in investment expenditures on essential infrastructure can 2013 as slower economic growth and demand led to a provide an important prop for economic activity during moderation of imports. Total estimated imports –both this period of heightened uncertainty and also contrib- official and smuggling – declined by an estimated 4 ute to Afghanistan’s medium-term growth prospects. percent, reducing the trade deficit from -42.4 percent of GDP in 2012 to -39.9 percent in 2013. Because In the medium term, post-transition growth is of an exceptionally high level of unofficial trade in projected at about 5 percent per year during 2015 Afghanistan, official recorded exports are estimated to to 2016. This is less than the average growth of 9.4 represent only one-fifth of total exports. Total exports percent per year during 2003-12 that was fueled by in 2013 were estimated at US$2.6 billion, of which the surge in international aid and security spending. about US$500 million were recorded by official sources. The post-transition growth outlook is contingent (The large difference between total estimated and of- upon a relatively stable security environment, with ficially recorded exports is explained not by opium but agriculture and extractive industries likely to be by unofficial non-opium exports.) On the other hand, among the significant sectors driving growth. Agri- official imports were US$9.3 billion for 2013, while culture accounts for about a quarter of GDP and is total imports were an estimated US$10.9 billion. also linked closely to other parts of the economy, such as food and beverages (which account for almost all Illicit opium production and the area under poppy of manufacturing), and parts of transport and retail. cultivation rebounded even more impressively than Afghanistan has the potential to build on this founda- official agriculture in 2013. Though opium production tion by reviving its historical position as an important is not reflected in official GDP growth figures, the exporter of fruits, nuts, vegetables, and other higher UN Office on Drugs and Crime reports that opium value-added products. This will require investments in production increased by almost 50 percent to 5,500 irrigation and extension services to improve capacity, tons in 2013 and the total area under poppy cultivation as well as efforts to build and improve downstream 48 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 agro-processing activities. On the other hand, the ex- Total Budgetary Expenditures, 2006-2013 tractive industries sector currently accounts for a very small share of GDP, but has significant potential in 6.0 light of Afghanistan’s deposits of copper, iron ore, and hydrocarbons. Unlocking this potential will require 5.0 Non- progress on the legislative framework, securing financ- discretionary 4.0 development ing for the necessary infrastructure and, by adopting a Billion US$ “resource corridor” approach, enhancing the value of 3.0 Discretionary these resources for Afghan communities. development 2.0 The medium-term growth outlook is subject to seri- Recurrent- 1.0 ous risks which will need to be carefully managed. civilian Significant uncertainty surrounds the outcomes of the - Recurrent- political and security transition in 2014. Continued 2006 2008 2010 2012-12 security violence, economic crime and systemic corruption also have often undermined progress in Afghanistan’s gov- ernance and state-building agenda. Much will depend, therefore, on Afghanistan’s success in achieving peace, just under one percentage point of GDP per year). In stability and reconciliation. light of recent weaknesses in collections, the increase in revenues will require a concerted effort on the part Given the recent weakness in fiscal revenue perfor- of the Afghan authorities to (i) reduce leakages and mance, a concerted effort will be required from the strengthen customs administration; and (ii) expedite authorities to improve revenue mobilization. Donors the introduction and implementation of the planned have committed to cover the budget financing gap, al- value-added tax (VAT). The natural resources sector though these funds are contingent on satisfactory prog- also has the potential to contribute to revenues in the ress in the Tokyo Mutual Accountability Framework medium term, but the timeline for this has become (TMAF), of which an important indicator is increas- more uncertain in light of recent developments in the ing domestic revenue. The July 2012 donor meeting sector. in Tokyo pledged US$16 billion in development aid for Afghanistan over 2012-16. Together with earlier Budget expenditures are expected to continue to pledges on the security side, this means annual aid of rise, from about 24 percent of GDP in 2013 to about about US$8 billion – roughly equally divided between 30 percent of GDP by 2016. The increase in budget civil and security aid. expenditures is largely a reflection of more spending moving on-budget from previously being undertaken The medium-term fiscal framework calls for an in- directly by donors. There appears to be limited space to crease in revenues from 9.5 percent of GDP in 2013 adjust expenditures without adversely affecting growth to 11.1 percent in 2015 and 13.8 percent in 2018 (or prospects and social outcomes. TIME TO REFOCUS 49 Bangladesh disturbances obstructed food distribution channels, throttled supplies, and drove up food prices. Stability in international commodity prices, weak domestic de- mand, and appreciation in the nominal exchange rate combined with a restrained monetary policy to moder- ate the increase in inflation. Recent Economic Developments External balances have remained comfortable due to strong export growth and weak imports which The falling growth trajectory of the last three years more than offset the decline in the level of workers’ looks set to stay course in FY14 as political turmoil, remittance. A large surplus in the overall balance of stagnating private investment, and declining remit- payments, driven primarily by an increased surplus in tance continue to exact a toll on the Bangladesh the current account, and the Bangladesh Bank (BB)’s economy. GDP growth is projected to fade to 5.4 frequent interventions to prevent appreciation of the percent in FY14, from 6 percent last year, but an export nominal exchange rate led to further accumulation of growth revival and uptick in public spending could yet official reserves to over five months of GNFS import stem the slide. cover. The political turmoil inflicted a value-added loss Monetary policy was restrained, achieving broadly of about US$1.4 billion, of which 86 percent was in the targets for the first half of FY14. Implementa- services, 11 percent in industry and the remaining tion of monetary policy benefited from a slowdown in 3 percent in agriculture. Growth performance in all private credit growth. This contributed to an increase major sectors is expected to be weakened by general in excess liquidity despite the BB stepping up steriliza- strikes (hartals) and blockades. Business and consumer tion operations to counter above-target growth in net confidence in general was undermined by domestic and foreign assets. foreign investors’ perceptions of declining rates of re- turn on investment, and by reduced remittance and de- The financial sector has been stressed by deteriorat- mand for Bangladeshi labor. Progress in the twin goals ing fundamentals of the banking sector in step with of eliminating poverty and boosting shared prosperity a rise in default risk across the board due to losses is likely to have slowed from the rate of the last three inflicted by prolonged disruptions in production and years because of slower growth and loss of employment. trade. The state-owned banks were already negatively impacted by the earlier financial scams. The growing Inflation may rise to 7.5 percent this year, from 6.8 nonperforming loans of private commercial banks are percent in FY13, due to the cost push from sup- also a matter of concern. Capital market turnover has ply disruptions and wage increases. The political been increasing in the post-election period. GDP Growth and Sector Growth Rates (%) 20 6.2 6.5 6.0 15 5.7 5.3 8.2 10 6.5 8.9 9.0 7.9 5 6.1 6.7 6.2 6.0 5.4 0 FY10 FY11 FY12 FY13 FY14(P) Services Industry Agriculture Overall GDP Growth Source: Bangladesh Bureau of Statistics 50 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 In ation (2005-06, y-o-y,%) 20 15 10 5 0 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 General Food Non-food Source: Bangladesh Bureau of Statistics Fiscal management faces serious challenges from Bangladesh has made good progress in addressing a large, growing shortfall in NBR tax revenue, the electricity shortage. The liquid fuel-based, high- demand for fiscal support from sectors adversely cost generation plants brought much-needed breathing affected by the political turmoil, and slower uti- space. A multi-pronged strategy is needed to address lization of the annual development program. Tax the remaining demand-supply imbalance and to ensure revenue growth in the first seven months of FY14 the sustainability of adequate and reliable power. The was barely 10 percent. The usual shortfalls in public policy priorities are to boost base-load supply, promote investment spending will probably not be sufficient efficiency across the value chain, diversify fuel mix, and to prevent the government overshooting the FY14 reduce the fiscal burden through better alignment of budget deficit target. Government bank borrowing retail prices with unit costs. so far has been contained, while net nonbank bor- rowing has increased. The structural reform agenda came to a near standstill Outlook and Policy during the political crisis and has yet to regain nor- mal momentum. The IMF’s ECF program remained The world economy is showing signs of rebound, on track, however, and all end-June 2013 performance which is critical to Bangladesh’s recovery. Global criteria and structural benchmarks were met. Bangla- GDP is projected to grow from 2.4 percent in 2013 desh is well positioned to take advantage of the current to 3.2 percent this year, stabilizing at 3.4 percent and favorable external environment to advance structural 3.5 percent in the next two years. The recovery is most reforms and consolidate macroeconomic stability. advanced in the United States, which is projected to grow by 2.8 percent this year (from 1.8 percent GDP growth lost momentum in recent years because in 2013), firming to 2.9 and 3.0 percent in the next of lingering uncertainties over the modalities of the two years. Growth in the Euro Area, after two years political transition, slow pace of structural reforms, of contraction, is projected to be 1.1 percent this year, and the country’s inability to firmly establish a and 1.4 and 1.5 percent in the succeeding years. This transformative infrastructure. Bangladesh needs im- is bound to stimulate import demand in high- mediately to tackle three formidable sets of challenges: income economies, leading to a rebound in exports (i) resolve the remaining political uncertainties while from developing countries like Bangladesh. Global maintaining stability, boosting investment in transfor- trade volumes rose at a 12.1 percent annualized pace mative infrastructure, especially in power and roads, (3m/3m saar) in December, from a low of -1.4 percent and streamlining trade and investment regulations; (ii) last August, with developing country exports expand- conduct a successful transformation of the readymade ing at a 21.1 percent pace, the fastest in nine months. garment (RMG) industry; and (iii) reverse the decline in remittance. The slide in Bangladesh’s growth has undermined TIME TO REFOCUS 51 140 Quaterly Growth Rate of LC Opening for Intermediate Inputs (%) 120 100 80 60 40 20 0 -20 FY11Q3 FY11Q4 FY12Q1 FY12Q2 FY12Q3 FY12Q4 FY13Q1 FY13Q2 FY13Q3 FY13Q4 FY14Q1 -40 Source: Bangladesh Bank 70 Quarterly Growth Rate of LC Opening for Industrial Raw Materials (%) 60 50 40 30 20 10 0 FY11Q3 FY11Q4 FY12Q1 FY12Q2 FY12Q3 FY12Q4 FY13Q1 FY13Q2 FY13Q3 FY13Q4 FY14Q1 FY14Q2 -10 Source: Bangladesh Bank 50 Quaterly Growth Rate of LC Opening for Capital Machinery (%) 40 30 20 10 0 -10 -20 FY11Q3 FY11Q4 FY12Q1 FY12Q2 FY12Q3 FY12Q4 FY13Q1 FY13Q2 FY13Q3 FY13Q4 FY14Q1 FY14Q2 Source: Bangladesh Bank 52 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 the country’s progress on the twin goals to elimi- because of a stronger inflow of FDI and public external nate extreme poverty and boost shared prosperity. borrowing for infrastructure. Achievement of these goals is critical to the country’s ambition to graduate from LDC status and become Adhering to the macroeconomic policy stance envis- a middle-income country. Hopes for a rebound in aged in the government’s Medium-Term Macroeco- growth lie especially in manufacturing and services. nomic Policy Framework underpinning the FY14 While manufacturing will likely benefit from stronger budget will contribute to external and internal eco- demand in high-income countries, the services sec- nomic stability. Monetary aggregates should remain tor will probably suffer, especially in FY14, from a restrained while providing room for a recovery in private decline in domestic demand due to employment losses credit growth to support the likely increase in private in- and decreased remittance flows. If stability prevails, vestment. Fiscal policy should allow a continued rise in growth could rise to potential capacity (to around 6.5 public investment spending while restraining growth in percent) within a couple of years. But it is unlikely to recurrent expenditures, particularly untargeted subsidies accelerate much further without hitting capacity con- and non-ADP capital spending. In the medium term, a straints and generating overheating pressures in the moderate consolidation path anchored by a stronger tax absence of continuing structural reforms and upgraded collection effort should be continued. infrastructure. If prudent macroeconomic management is sus- The external balance may erode from the current tained, inflation should approach a more normal 6 comfortable level, but not too far beyond comfort. percent in the medium term. This assumes, of course, As the RMG industry upgrades factory and labor stan- that international commodity prices are stable. In the dards, export growth will likely recover after moderat- case of a sustained trade shock the exchange rate could ing in FY15. Remittance is expected to normalize from be allowed to adjust with a pass-through to inflation FY15, on the assumption that intensive international contained by monetary tightening and ensuring an ad- diplomacy succeeds persuading Saudi Arabia, the UAE, equate supply of liquidity to the markets. At the same and Kuwait to relax restrictions on Bangladeshi labor time, some fiscal easing in the form of additional public and so reinvigorate migration and remittance. Import investment and expansion of well-targeted safety nets growth can be expected to rise with an uptick in private to protect the poor and the vulnerable will help sustain investment demand. However, reserves may still rise growth without risking price stability. TIME TO REFOCUS 53 Bhutan Pressure remains, despite a slight easing in India at year-end; any upward motion in Indian subsidies (fuel, power, fertilizer) or a monsoon shock could ramp the rate. The government continues to rely heavily on foreign – mainly Indian – grants to finance expenditure. Recent Economic Developments The FY2014 budget projected a decline of nearly 9 percent in nominal spending from the revised budget Economic growth rebounded to about 6.5 percent for the previous year. The persistent shortage of rupees in 2013 from a multi-year low of 4.6 percent in 2012. prompted the government to tighten expenditures to Hydropower construction, good rainfall (raising elec- match available resources. A slow start to the budget tricity generation by 10.7 percent), and improved agri- year due to elections and a change of leadership, and cultural output led the recovery. Non-hydro construc- delays in foreign grant disbursements also slowed tion, however, is still stagnant because of housing loan spending. restrictions and other government measures brought in 2012 to curb a rupee liquidity bubble. Tourism, which Public and publicly guaranteed external debt contributes one-fifth of non-hydro export revenues, increased to 85  percent of GDP at end-FY2013, grew at a low 10 percent in 2013 but raised convertible driven mainly by hydro-related external borrowing currency revenues by only 1 percent. The tight liquidity (52 percent of GDP). But the risk of external debt of the banking system has eased slightly, but the finan- distress remains moderate because of the commercial cial sector still shows signs of vulnerability, with limited viability of the hydropower projects, the risk-sharing supervision. agreement with India for hydropower loans, Bhutan’s strong track record of project implementation, rapid Bhutan runs a large and growing current account growth in Indian energy demand, committed donor deficit. Public and publicly guaranteed external debt support, and Bhutan’s high level of international increased to 85  percent of GDP by end-FY2013, up reserves. 14 percentage points from FY2012. This was driven largely part by hydro sector-related external borrowing, The pace of poverty reduction in Bhutan has been mostly from India in a mix of loans (70 percent) and rapid, broad-based and inclusive between 2007 and grants (30 percent) in Indian rupees. Grants financed 2012. But rural vulnerability remains, magnified by around 36 percent of total spending in fiscal 2013. out-migration. Officially, unemployment is relatively low and declining, though the statistical methodol- Consumer price inflation – tied to India’s by import ogy needs fine-tuning to better reflect factors such as dependency – will reach about 10 percent in 2013. under-employment. 20 20 GDP Growth - A hydropower story 18 18 16 16 14 14 12 12 10 10 8 8 6 6 4 4 2 2 0 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Services Industry Agriculture GDP 54 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 Outlook and Policy FY2013 due to lower non-hydro revenues such as business income tax, excise duties, and non-tax rev- The 2014 outlook is positive but macroeconomic enue. Hydro revenue remains stable at 3.7 percent in pressures on domestic demand need to be managed. FY2014, with no new projects starting generation. The Growth is set to reach 7.3 percent supported by ongo- deficit in FY2015 should ease to 0.7 percent of GDP, as ing hydro and industrial construction and commission- more revenues will kick in with commissioning of more ing, possible lifting of the bans on imports and housing hydro and industrial capacity. credit, disbursements from India to finance the 11th Five-Year-Plan, which will bring higher public capital Inflation in 2014 and beyond will be affected by a spending, economic stimulus, increased public wages, scheduled rise in electricity tariffs of up to 30 percent, and tourism expansion. But these developments carry while the impact on poverty should be modest, given a risk of resumed overheating and macro imbalances; the progressive nature of tariffs. monetary and fiscal policies must be tightened. Grants should more than halve from 15 percent of Domestic revenue is projected to decline to 19.5 GDP in FY2013 to about 6.6 percent, due to the slow percent of GDP in FY2014 from 20.8 percent in implementation of the 11th FYP. TIME TO REFOCUS 55 India not return to expansion territory in Q3, the accelera- tion was not sustained: growth in private consumption slowed and investment contracted in the third quarter (both on a q-o-q and y-o-y basis). Inflation remains high despite the slowdown in GDP growth. Even though core inflation came down in early Recent Economic Developments FY14 as output lagged below its long-term trend, pres- sure from food and fuel prices kept overall consumer India’s economic recovery remains tentative follow- inflation above 9 percent. Moreover, the stickiness in ing a slowdown in growth in FY13. Revised national core inflation in the second half of the current fiscal accounts estimates show that India’s GDP growth fell year has been interpreted by some observers as indica- to a decade-low 4.5 percent in FY13. Since then, the tive of high inflationary expectations feeding into over- recovery has remained tentative, picking up pace in all inflation; this prompted the Reserve Bank of India Q2 FY14 but losing some of the momentum in Q3. (RBI) to adopt a tighter monetary stance and signal While agricultural growth has picked up due to good greater commitment to inflation targeting. monsoon rains and service sector activity has remained strong, manufacturing has thus far been unable to stage Deepening financial sector stress reflects persistent a recovery. Net exports, buttressed by an improvement challenges in the real sector. Cash flow pressures due in exchange rate competitiveness over the summer, have to a slower pace of economic activity have been ag- supported growth on the demand side, but persistent gravated by high leverage of firms, making them more weakness in consumer and business confidence has kept vulnerable to sustained periods of slowdown, delays investment below its long-term average of 30 percent in projects, or external shocks. As a result, NPAs have of GDP and has dampened consumer spending. risen to 4.1 percent as of December 31, 2013, from 3.4 percent at the beginning of the fiscal year. Although Private consumption and investment momentum bank capital is sufficient by regulatory standards and waned in Q3 as business and consumer sentiment the NPA situation is not an immediate threat to the remained subdued. Q2 FY14 registered a significant soundness of the financial system, it is a source of worry pick-up in growth of private consumption expenditure and is adding stress to bank balance sheets. Public sec- (from 0.3 to 0.9 percent, q-o-q, saar) and a major re- tor banks have been hit hardest by the deterioration in bound in investment (from -3.6 percent to 3.2 percent, asset quality, largely because they tend to retain a high q-o-q, saar). However, this pick-up was not reflected in proportion of restructured assets on their books rather consumer and business confidence, which in Q2 FY14 than writing them off. The increasing concern is that fell below the threshold level of 100 that separates capital for sustaining good quality credit growth may contraction from expansion. As confidence levels did be getting constrained. To carefully balance trade-offs Economic growth remained subdued 11 (percent y-o-y growth) 9 7 5 3 1 -1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 2008-09 2009-10 2009-10 2010-11 2010-11 2011-12 2011-12 2012-13 2012-13 2013-14 2013-14 Agriculture Industry Services Source: Central Statistics O ce and World Bank Sta estimates 56 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 120 Business expectations and consumer sentiment 14 contined their downward trend 115 12 110 10 105 8 100 6 95 4 90 2 85 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 2011-12 2011-12 2011-12 2011-12 2012-13 2012-13 2012-13 2012-13 2013-14 2013-14 2013-14 Private Consumption Expenditure (saar growth: Tramo Seats) (Right axis) RBI: Business Expectation Index (Left axis) 6.0 Stressed assests continue to grow 5.0 4.0 3.0 2.0 1.0 0.0 All Banks Foreing Banks New Pvt Banks Old Pvt Banks PSBs Mar-12 Dec-12 Mar-13 Sep-13 Source: Reserce Bank of India between credit growth and risk, banks could consider vulnerabilities such as inflation and the fiscal deficit. adopting superior credit underwriting standards, en- Since the summer and even as tapering began, India suring early detection and timely resolution of problem has substantially reduced its vulnerability to global assets, and improving the balance sheet strength to market turmoil by containing the current account attract capital. Not taking these steps could run the risk deficit (from 4.9 percent of GDP in Q1 to 0.9 percent of financial sector development getting crowded out by of GDP in Q3 FY14), shoring up reserves (to US$294 immediate concerns of asset quality. billion, equivalent to more than six months of imports), and tightening monetary policy. India also experienced Benefitting from the US tapering-induced depre- resurgence in capital inflows, with the important dis- ciation in the rupee, the current account deficit has tinction that volatile portfolio flows are being replaced returned to pre-global crisis levels. Between May and by more stable deposits by non-resident Indians. August 2013, the Indian rupee lost more than 18 per- Overall, tapering-driven depreciation last summer has cent in value against the US dollar as global investors likely had a net positive effect as it stimulated exports, withdrew US$15 billion in portfolio flows from the contained import demand, and incentivized long-term country on fears of tapering in the US Federal Reserve’s investors to come back looking for bargains. quantitative easing program. Similar concerns affected other emerging markets’ currencies, and evidence sug- Fiscal consolidation has continued despite pres- gests that outflows were linked more to India’s large sures from lower tax revenue and high spending on exposure to international markets than country-specific subsidies. The authorities expect the FY14 central TIME TO REFOCUS 57 Current account de cit narrowed markedly in Q2-Q3 FY2014 7 35 6 30 5 25 4 20 3 15 2 10 1 5 0 0 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 2009-10 2009-10 2010-11 2010-11 2011-12 2011-12 2012-13 2012-13 2013-14 Percent of GDP USD Billion (RHS) government deficit to be contained at 4.6 percent of Outlook and Risks GDP, a reduction of 0.3 percentage points from a year ago and nearly 2 percentage points from the peak of Supported by a favorable global environment, India’s FY10. On the revenue side, the improvement was economic recovery is expected to gain strength in the driven by windfall receipts from the telecom spec- last quarter of FY14. Although the growth momentum trum auction and larger transfers from public sector waned somewhat in Q3 FY14, the pace of economic enterprises, while tax revenue came in below budget activity is expected to accelerate in Q4. Agricultural estimates. Expenditure was controlled primarily by production is expected to pick up momentum as high spending compression in rural development, health, soil moisture levels and increased rabi (winter crop) and education, while the subsidy bill rose above the sowings are likely to translate into an increase in output. budgeted amount as this summer’s rupee depreciation Four consecutive months of manufacturing PMI read- largely wiped out the gains from diesel subsidy reform. ings above the expansion threshold of 50 and a pick-up Despite the reduction in fiscal deficit, the decline in in industrial production in January suggest that the the central government’s debt-to-GDP ratio – which industrial sector may finally be on a path to recovery. fell by more than 15 percentage points in the second Activity in the services sector is likely to remain strong, half of the 2000s – has come to a halt in FY13 and the although the scope for significant further acceleration debt ratio was expected to inch up marginally to 51.5 in Q4 is limited due to some compression in govern- percent of GDP by the end of FY14 (March 31) due to ment spending as part of fiscal consolidation efforts. the slowdown in GDP growth. Overall, these developments could raise GDP growth in Q4 to around 5 percent y-o-y, pushing growth for The reform momentum accelerated in the first half of the entire fiscal up to 4.8 percent. FY14. Reforms were led mostly by the RBI, anchored around the central bank’s renewed focus on controlling India’s potential growth remains high, but returning inflation, accelerating financial inclusion, and fostering to potential will require a sustained improvement financial stability. The central and state governments in manufacturing performance. Currently, estimates complemented the RBI’s efforts with regulations to place India’s potential GDP growth in the 6.3-6.9 per- improve public financial management and ease food cent range. Three consecutive years of below-potential supply bottlenecks. Major reforms of FY14 include a growth have opened up a negative output gap and new RBI proposal to strengthen the monetary policy created space for acceleration in growth without a framework and restructure bad loans, raising the ceil- build-up of inflationary pressures. Under the baseline ings and/or easing of FDI norms in a number of sec- scenario of this report, recent progress on accelerat- tors, and steps to improve public finance management. ing clearances of investment projects is expected to translate into an increase in the investment-to-GDP ratio, while exporters are expected to continue to take advantage of the more competitive exchange rate and 58 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 strengthening global demand. These developments Government debt is likely to remain on a sustainable are expected to support a substantial strengthening of trajectory. Most of the decline in the debt-to-GDP manufacturing growth in FY15 and FY16, which could ratio over the past decade can be attributed to a fa- in turn lead to acceleration in GDP growth to 5.7 and vorable macroeconomic environment and particularly 6.5 percent, respectively. rapid GDP growth. Under the baseline path growth, inflation, and fiscal deficit delineated in the previous Inflation is likely to continue to moderate, while discussion, the debt-to-GDP ratio is likely to rise in the current account deficit is expected to remain in FY14 to 67.4 percent of GDP from 66.6 percent in the range of 2 percent of GDP. As output remains the previous year. Thereafter, under the assumption that below potential throughout the forecast period, growth accelerates, the central government continues momentum in core prices is likely to wane. Further its fiscal consolidation efforts, and state governments reductions in core inflation are likely to be supported remain on the adjustment path recommended by the by the RBI’s renewed focus on inflation, particularly 13th Finance Commission, the debt-to-GDP ratio in light of the recommendations of the Patel Com- could resume its earlier downward trend. The debt ratio mittee report, which could bring down inflationary could fall to 66.5 percent of GDP in FY16, though at expectations. As Indian exporters continue to benefit a slower pace than before. Even if real interest rates from a more competitive exchange rate following this rise, a recovery in growth and continued commitment summer’s bout of depreciation in the rupee while de- to fiscal discipline are expected to offset any potential mand for imports remains subdued, the merchandise adverse effects on debt sustainability. On the other trade deficit in FY14 is likely to contract to below hand, risks to the primary balance or growth could have 8 percent of GDP from 10.6 percent of GDP in negative implications for the debt-to-GDP trajectory: the previous year and the current account deficit is if economic growth were to fall below the baseline expected to decline to 1.8 percent of GDP in FY14. projections in each of forecasting years by one standard However, the deficit could widen somewhat in FY15 deviation of the historical distribution, the general and FY16 as import growth picks up in line with ac- government’s debt-to-GDP ratio could instead rise to celerating demand and particularly rising imports of 76 percent of GDP by FY16. capital goods, which have been on the decline for the past two years. Decomposition of General Government Debt Fiscal consolidation is expected to continue, but (percent) 2013/14f 2014/15f 2015/16f achievement of fiscal targets could become more Debt-GDP Ratio (baseline) 67.4% 67.3% 66.5% challenging. The expected acceleration in growth in FY15 could help in achieving revenue targets, al- Change in Public Debt 0.8% -0.1% -0.8% though demand multipliers would need to be strong Identified flows 0.4% -0.1% -0.8% to translate a reduction in excise tax rates into higher revenues. Furthermore, additional policy efforts are Real Interest Rate 0.6% 0.9% 1.0% likely to be required to contain oil subsidy spending Primary Balance 2.9% 2.7% 2.3% around the budgeted amount. While the authorities Real GDP Growth -3.1% -3.6% -4.1% have demonstrated a commitment to fiscal con- solidation in previous years by limiting expenditure Residual 0.4% 0.0% 0.0% growth, sustained improvements over the long term Effects of shocks on debt-GDP ratio are likely to require further efforts to strengthen the revenue base. Under these assumptions, together with Fall in Real GDP growth 70.4% 73.4% 75.7% continued fiscal consolidation at the state level, the Fall in Inflation rate 69.9% 72.4% 74.3% general government deficit is expected to decline to Rise in Interest Rates 67.9% 68.3% 68.0% 6.8 percent of GDP in FY14, and to fall further to 6.3 percent in FY15 and 5.9 percent in FY16. Delivering Rise in Primary Balance 68.9% 70.3% 70.9% on the Finance Minister’s objective of bringing the fiscal deficit down to 3 percent of GDP by FY17 will Normally distributed shocks (drawn from history FY2002-FY2013) were introduced to real GDP growth, inflation rate and interest rate. be critical to maintaining debt ratios on a sustainable One standard deviation negative shock to the primary balance (taking the reference period as FY2002 - FY2013). downward trajectory, particularly as growth recovers to its high potential only gradually. TIME TO REFOCUS 59 Less orderly market reactions could lead to an 15.0 abrupt deceleration of in ows 10.0 5.0 0.0 Percent of GDP -5.0 00Q1 03Q1 06Q1 09Q1 12Q1 15Q1 Fast normalization Source: World Bank. Risks to the outlook are primarily on the downside. outlook is predicated on a recovery in investment and a The baseline scenario in this report assumes a gradual strong pick-up in manufacturing growth. Should these improvement in the global environment and no signifi- conditions fail to materialize, growth in FY14 could fall cant adverse external shocks over the forecast period. to around 4.6 percent and remain below 5.5 percent in External shocks, including slower global growth, higher FY15 and FY16. The findings of the 7th Pay Commis- oil prices due to heightened tensions in Eastern Europe, sion, charged with revising the salaries and pensions of and further volatility in global financial markets due to more than 800,000 central government employees and disorderly unwinding of monetary policy stimulus in retirees, could have significant effects on public sector the high income countries, could have adverse conse- finances when it releases its report in about 18 months quences for the baseline trajectory. Domestically, the from now. 60 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 Maldives seem to lie on the expenditure side, as revenue collec- tion has been strong at above 32% of GDP in 2013. Inflation moderated to 6 percent in 2013, although food inflation remained high. Recent Economic Developments Outlook and Policy Real GDP growth stood at 3.7 percent in 2013 and the Political stability, or lack thereof, will be a key deter- outlook is positive, at 4.5 percent for 2014. Tourism minant of economic growth. Though politics appear demand is slowly picking up having a positive impact relatively stable after the March parliamentary elec- on growth in the non- tourism sectors. Chinese tour- tions, the longer-term prospects are harder to gauge ists continue to compensate for weaker arrivals from as political groups still jostle for advantage. President Europe, but overall the length of stay has declined, as Abdulla Yameen took office in November promising to has spending per tourist. end the fractiousness and instability that roiled Mal- dives for two years. Growth, though dynamic, was less inclusive, as the tourism industry operates on an enclave model for The positive outlook for growth this year is based on development. The share of GDP from the primary an expectation of stability and strong tourist arrivals, sector, agriculture, mining, and fisheries that employs driven especially by the Chinese tourist segment. the largest share of Maldivians in the outer atolls was The MMA projects tourism to grow at 5.2 percent in less than 0.3 percent of GDP in 2013. 2014. Recovery of the European market would extend those tourists’ visits, which were on the decline, and Loose fiscal policy at a time of moderating economic raise tourism receipts. Non-tourism sectors, too, will growth magnified macroeconomic imbalances. Mal- contribute to growth through demand for services, dives is spending beyond its means. Its revenue-expen- telecom and construction. The construction sector will diture gap has widened over five years, financed with be particularly dynamic with ongoing new resort devel- unsustainable public debt at increasing interest rates. opments and the leasing of 12 new islands. The fiscal deficit closed 2013 at close to 10% of GDP and was financed through: (i) short-term commercial Reserves will remain under pressure in 2014, and at borrowing from the banking, private sector, and high critical levels. A record MVR 17.95 billion budget net worth individuals, (ii) monetization of the deficit, for 2014 (about 50 percent of GDP) and 3.2 percent and (iii) build-up of payment arrears, which risks af- financing gap leave scant fiscal space to accumulate fecting the real economy. Public finance imbalances reserves. Such high spending could boost the demand Tourist Arrivals and Receipts 100% 2,500 6% 6% 6% 6% 8% 8% 15% 14% 15% 15% 14% 15% 80% 2,300 6% 9% 15% 60% 21% 2,100 24% 29% 40% 1,900 73% 70% 64% 58% 54% 20% 47% 1,700 0% 1,500 2008 2009 2010 2011 2012 2013 Rest of the world China Receipts/tourist (RHS) (USD) Other Asian countries Europe TIME TO REFOCUS 61 for imports and fuel the need for foreign exchange, putting pressure on reserves. Cash management will be tight. Higher tourism receipts, however, could contain pressure on the exchange and sustain the parallel dollar market at the current 10-15 percent premium level. The airport concession arbitration, to be decided in 2014, would put big pressure on reserves if a large payment is due. Achieving fiscal sustainability will require short- term measures to address the cash crunch, and long- term structural measures that could entail political and social costs. Spending is under pressure from the civil service wage bill, subsidies and social contribu- tions, transfers to state-owned enterprises, and capital spending in the outer atolls. An array of measures could be combined in a policy package accompanied with a communication strategy to sensitize the public on the need for reforms. Any delay in expenditure cuts would stretch resources and harm government’s ability to pay salaries. 62 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 Nepal Nepal’s internal and external balances are sound, but not for the right reasons. During the first half of FY14, the government has maintained a sizeable surplus – partly through continued revenue mobilization growth, but also low levels of spending. The slow mobilization of resources earmarked for capital projects is especially worrying. While much of the blame for low rates of Recent Economic Developments budget execution and important bunching had been blamed previously on delayed budget approval, this was Prospects for more coherent economic policy-mak- not the case in FY14 when a full budget was unveiled ing, in step with vibrant private-sector activity, have on day one of the fiscal year. In other words Nepal has been enhanced by the successful election of a new as- yet to come to grips with the deep structural inefficien- sembly and formation of a popularly mandated gov- cies in budget planning, formulation and execution. ernment. The uncertainties of the country’s prolonged This is crucial for not only short-term growth but also political transition and electoral period had stifled because infrastructure development is key to expanding private sector investment and diverted attention of the the long-term growth potential of the economy and bureaucracy away from difficult but crucial reforms. It stimulating essential complementary private finance. is now incumbent on the new government to signal its On the external side, Nepal has benefited from the intention to use the relative political stability as an op- depreciation of the rupee and also –much more signifi- portunity to tackle the country’s formidable challenges. cantly– from a sharp increase in inward remittance. This will require a bold and skillful balancing act to ensure that the arduous process of constitutional draft- Inflationary pressures have not subsided and the risk ing is carried out in tandem with regular and improved of second round effects is present. Inflation stood at governmental operations. 9.7 percent, y-o-y, in January 2014, driven by rising food prices. This contrasts with FY13 when non-food After weathering a difficult year, the economy is items were the inflationary driver. At the end of the poised for a modest recovery. Nepal achieved only second quarter of FY14, the index for food and bever- modest growth of 3.6 percent in FY13. This was due age prices had registered a 12.9 percent increase, y-o-y, largely to poor performance of the agricultural sector while that for non-food items had grown by only 6.9 and very modest levels of industrial activity. The only percent. Within the food and beverage category, cereal source of relief came from the services sector. Agricul- grains and their products, vegetables, and meat and fish ture is expected to make the biggest difference in FY14, had experienced sharp price rises. Causes included a with expanded production on the back of a good har- meat shortage due to an import quarantine because of vest. Strong remittance inflows will continue to drive avian flu fears, consumer stockpiling during the pre- services sector expansion. election period, and higher import prices from India. 60 Mid-year status of recurrent expenditure 50 NRs in billions 40 30 20 10 0 Comp. of Goods and Interest, Services Subsidies Grants Social Security Employees Services & Comm. FY13 FY14 Source: FCGO TIME TO REFOCUS 63 Growth in Foreign Trade (mid-year) 40 30 20 10 Percent Change 0 -10 FY11 FY12 FY13R FY14P -20 -30 -40 Ex. To Other Countries Im. From Other Countries Ex. To India Im. From India Source: MoF and NRB Monetary policy has sought to achieve a delicate confidence, Nepal’s new government will need to define equilibrium between controlling inflation and clear priorities and selectively invest its energy in cata- supporting economic activity, but the optimum bal- lytic interventions. Given Nepal’s critical infrastructure ance may evolve naturally and require corrections. gaps it would make sense for public policy to focus Significant inflation, close to double digits, appears to first and foremost on unlocking public investment and have become a feature of the Nepali economy. While focusing policy initiatives and project implementation some factors may contribute to dampen inflationary on the energy and transportation sectors. pressure – most notably expanded agricultural output – significant growth in the money supply may eventually Since remittance has become a defining feature of the generate inflationary expectations and second-round Nepali economy the country must develop systems to effects that translate into higher imports (serving to manage excess liquidity and interest rate volatility. lower reserves). From that viewpoint, the evolution of The significant buildup of liquidity in the financial the quantity and quality of credit to the private sector sector reflects both strong push factors (remittance will be important to monitor. inflows translating into a build-up of net foreign as- sets) and weak pull factors (slowing credit growth and Structural reforms will be necessary to put Nepal on loose monetary policy). In the short term, the central a more permanent path of higher growth. In order Nepal Rastra Bank (NRB) will need to strike a balance to achieve tangible gains and restore private sector between encouraging sound credit growth – so as not 16.0 In ation Comparison – Nepal and India 14.0 12.0 10.0 8.0 Percent 6.0 4.0 2.0 0.0 May May Aug Aug Mar Mar Nov Nov Sep Sep Dec Dec Feb Feb Apr Apr Jun Jun Jan Jan Jan Oct Oct Jul Jul 2012 2013 2014 India CPI Nepal CPI India Food NepalFood Source: NRB + CSO, India 64 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 to compromise economic activity objectives – and con- developing country status by 2022, but have not taining inflation. At present this balance is particularly articulated the vision for development that would difficult to achieve because of uncertainties over the underpin that achievement, nor have they identi- true health of the banking sector, weak risk manage- fied those policies and reforms that are the most ment systems, and market failures. The NRB may also important and urgent. In the absence of such clear need to expand its toolset to deal with excess liquidity. priority setting, the process of development plan- In the medium term, resolving structural bottlenecks to ning is unlikely to follow a strategic path. achieve efficient credit-market function is a precondi- tion for monetary policy to operate more smoothly and • Boosting public investment and infrastructure efficiently and to lower the risk of financial crisis. development. Nepal is caught in a paradoxical situation. It is the only country in South Asia to record a budget surplus (helped by buoyant rev- enue growth), its level of indebtedness is modest, Outlook and Policy it is flush with liquidity (thanks to large remittance inflows), and yet it struggles to attract investment The outlook is cautiously optimistic for FY14. Our growth above its current low levels. However, in- previous half-yearly assessment of Nepal’s economic vestment growth is really the only means by which outlook, in October 2013, estimated that growth would it can substantially and durably accelerate the pace reach 4.0-4.5 percent this year, driven mainly by in- of economic activity. The public sector has a key creased agricultural output and improved execution of role to play in (i) providing a friendlier environ- the budget. This has to some extent proved true. While ment for the private sector to operate in, and (ii) the pace of capital expenditure may be below initial developing the essential public infrastructure expectations, inward remittance inflows have been needed for firms to thrive and private funds to significantly above projected levels and should provide crowd in. This, in turn, requires maintaining a safe an additional boost to the services sector. On balance and stable macroeconomic environment. therefore, growth is projected to reach 4.5 percent, es- pecially if capital spending picks up in the second half • Tackling enduring financial sector risks and of the year. managing excess liquidity. Uncertainty over the true health of the financial sector remains the single The government of Nepal should take advantage of most important macroeconomic risk for Nepal. A the calmer political waters to set a firm policy course financial sector crisis – though highly unlikely at and tackle emerging risks. The appointment of a new this juncture – would have devastating effects on Finance Minister with deep experience and reformist public finances and economic growth. Further- credentials is a positive sign, and Minister Ram Sharan more, the ability of the financial sector to provide Mahat’s initial commitment to “take forward the sec- adequate credit to deserving borrowers is cur- ond round of reforms…in partnership with the private rently hampered by factors such as (i) distortionary sector” is encouraging. policies, (ii) low levels of effective access to finance, (iii) poor risk management practices by monetary The key policy priorities include: authorities and banks amplified by deficient infor- mation, and (iv) limited recourse for banks to find • Developing and formulating a growth promo- protection from delinquent borrowers. As a result tion vision or agenda. Because Nepal’s challenges the financial sector is operating sub-optimum, and are so numerous, it is particularly difficult to set the current excess liquidity in the system is largely out clear policy goals and priorities. The Nepalese a reflection of this state of affairs. authorities have formulated the goal to graduate to TIME TO REFOCUS 65 Pakistan Estimates for first half of FY14 show growth im- proved in wholesale and retail trade, finance, and insurance. Acceleration in growth of large-scale manufacturing came from a strong performance of agro-based industries, iron and steel, construc- tion, and external demand-driven cotton yarn- and fabrics-based textiles. Agriculture appears slightly Recent Economic Developments below target because of underperformance of cot- ton, major kharif crop, due to shortage of water Pakistan’s economy, though still weak (or below po- availability at the time of sowing. On the demand tential), has begun to show signs of improvement. side, growth continues to be driven by private con- Real GDP is projected to grow at 3.6-4.0 percent in sumption. Credit to the private sector has started FY14 – driven by dynamic manufacturing and service to rebound and had posted nominal growth of 4.6 sectors, better energy availability, and early revival percent, y-o-y, at mid-March 2014. However, private of investor confidence (Table 1). Nascent optimism, investment recovery is mild; much of it inherited however, contrasts markedly with the slump in private from the crowding out of private-sector credit by investment last fiscal year, the lowest level in two government domestic borrowing, which grew at decades. close to nil in FY13. Estimates of Economic Growth (%) Corrective measures are being implemented to tight- en the fiscal stance and ensure sustainability. Pakistan Q1-FY14E Q1-FY13P FY13 is on track to meet a fiscal deficit target of 5.8 percent of Real GDP 5.0 2.9 3.6 GDP in FY14. FBR collection is slightly below target Agriculture 2.5 2.7 3.3 but improving. On the expenditure side, energy-related Industry 5.2 3.1 3.5 subsidies have been reduced with tariff adjustments. Services 5.7 2.9 3.7 However, although the government reduced the stock E Estimated; P Projected of circular debt, which led to reduced load-shedding Source: Pakistan Bureau of Statistics in the first months of the year, the circular debt is re- emerging. Public investment – constrained by lack of fiscal space and any commitment to reduce the fiscal Inflation remains steady at 7.9 percent, y-o-y. The fis- deficit – remains contained. Public debt remains above cal deficit is contained at around 6 percent of GDP due the 60 percent of GDP allowed by the Fiscal Respon- to improved tax collection and reduced expenditures. sibility Law, and justified by security reasons. As large The current account deficit remains modest, at around fiscal deficits have been financed increasingly through 1 percent of GDP, supported by strong remittances and domestic borrowing, rollover risk has increased. Exter- export dynamism, and the external position is slowly nal financing available to the government during the improving since monetary and exchange rate policies first half of the year remained scarce, but is expected to switched gear toward rebuilding reserves past Novem- improve significantly in the last two quarters. ber. Performance under the IMF program remains satisfactory, with the 2nd Review concluded on March The external position is fragile but strengthening. 24. Domestic and external risks remain high, however, The current account deficit is small, at around 1 per- but are declining. cent of GDP by end-FY13. In contrast, net official foreign exchange reserves declined to the equivalent Thus far, the impulse to growth stems mainly from in- of 1.3 months of imports at the end of June 2013 dustry and services, while agriculture is estimated to (bottoming out at 0.6 month of imports by the end of slightly miss its annual target. An improved industrial November 2013), though they had risen to above 1.1 sector performance can be attributed to better energy month of imports as of March 26. This is partly due availability and post-election investor confidence. Even to the fact that since the second quarter of FY14, the with this uptick in local industry, better performance State Bank of Pakistan (SBP) increased its policy rate by the telecom sector, and improved volumes of inter- and has started to purchase dollars on the spot mar- national wholesale and retail trade, the services sector ket, turning decisively toward rebuilding the external appears to have stolen the limelight. position. 66 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 Real Policy and Weighted Average Lending Rates 6.0 4.0 2.0 0.0 -2.0 -4.0 May-11 May-12 May-13 Mar-11 Mar-12 Mar-13 Nov-10 Nov-11 Nov-12 Nov-13 Sep-10 Sep-11 Sep-12 Sep-13 Jan-10 Jan-12 Jan-13 Jan-14 Jul-10 Jul-11 Jul-12 Jul-13 Real WALR Real Policy Rate Monetary tightening has been underway since end- low risk weightages. Meanwhile, the microfinance sub- 2013. The SBP increased the policy rate by 50 basis sector continues to expand. points successively in September and November 2013 (Figure 1) to deal with two concerns: a continued de- Non-Performing Loans (NPLs) showed a slight terioration in the balance of payments position, and a decline. NPLs decreased slightly, from 14.5 percent worsening of the inflation outlook during Q1-FY14. in December 2012 to 13.0 percent in December 2013. Real weighted average lending rates have been only Adequate provisioning also kept net NPLs ratio in marginally positive in recent months. check at 3.1 percent in December 2013. NPLs in small and medium enterprises (SMEs) remain high, A temporary rise in the inflation rate was predictable representing 32.3 percent of loans, followed by the in early FY14. The fiscal year started with the govern- agricultural sector (14 percent) and consumer sector ment revising the general sales tax rate upward from (13.6 percent). The largest share of the portfolio is the 16 percent to 17 percent. Furthermore, by October, the corporate sector (66.8 percent of loans) where the NPL government levied an additional 2 percent value-added ratio is 13.4 percent. tax on selected manufacturing items. More significant were the several rounds of upward adjustments in the prices of energy items. The percentage of CPI non- food items registering double-digit inflation increased Outlook and Policy from 28 percent to 36 percent by December 2013. Nevertheless, non-food, non-energy core inflation has Given the modest international recovery, Pakistan’s significantly declined, 8.3 percent July-February, or 190 medium-term outlook presents moderate downside bps lower than the same period last year, indicating that risks. The external environment is expected to starting the risk of demand-driven inflation remains low. improving gradually with global GDP growth rising from 3.2 percent in 2014 to 3.5 in 2016. Banking sector profitability was steady, declining only slightly in calendar year 2013. The benchmark Three sources of risk remain worrisome: Pakistan interest rate (6-month KIBOR) increased from 9.4 imports more than it exports (the latter being con- percent in December 2012 to 10.2 percent in Decem- strained by low productivity and under-competitive- ber 2013. Return on assets and return on equity during ness); access to reliable energy remains uncertain; and the last quarter of 2013 was at 1.7 percent and 18.4 unwieldy business regulation continues to constrain percent, compared to 2 percent and 21.4 percent dur- enterprise. Investors’ concerns over governance issues, ing the same period last year. The sector’s liquidity and energy and prevailing security issues keep FDI flows solvency positions remain strong backed by sluggish and private investment low, which also affects foreign growth in advances and sizeable concentration of the reserves. The troubled domestic energy sector continues asset portfolio in government securities which carry to labor under a complex inheritance from its circular TIME TO REFOCUS 67 debt which might affect the magnitude of fiscal adjust- a significant reduction in federal government “other” ment. On the other hand, Pakistan’s Emerging Markets recurrent spending, while better financial health of Bonds Index Plus (EMBI+) risk spread keeps declin- SOEs would imply smaller demand on federal grants ing from the high levels shown at the start of the new to support these enterprises. Interest payments would administration. Market confidence in the government’s be higher due to higher accumulated debt, increase in program and its steady implementation is bearing fruit, interest rate by SBP and depreciation of rupee. Devel- as the EMBI has almost halved from 1,011 basis points opment spending of the government (inclusive of net in March 2013 to around 468 basis points as of March lending to the public corporate sector) is projected to 26, 2014. The government intends to benefit from this decline from 5 percent of GDP in FY13 to 4.1 percent and return to the international markets with the place- in FY14 but only because of a sharp fall in net lending. ment of a US$500 million-US$1 billion Eurobond in the fourth quarter of the current fiscal year. Overall, the fiscal deficit is expected to fall to 5.8 percent in FY14 of GDP, from 8 percent last year. Revenue collection is expected to be close to the About half of the effort is expected to come from rev- revised target of Rs 2,345 billion. On the basis of enue increases and the other half from the reduction performance during the first half of the year, the sea- of untargeted power subsidies and recurrent spending. sonality in fiscal transactions and the expected impact Provinces are also expected to generate small fiscal of government’s policy actions, it is projected that surpluses. Taking into account the additional fiscal FBR tax collection would not only recover from the space, along with increased development spending, exceptionally poor performance of FY13, but its tax- the fiscal deficit is expected to reach 4.5 percent of to-GDP ratio would much exceed the level achieved GDP in FY16. Expected budget support from mul- in FY12 and be quite close to its annual revised target tilateral donor agencies (i.e., the World Bank and (10.3 percent of GDP – Figure 2). ADB) should also improve external financing for the budget, but repayments, especially to the IMF, will Tax Collection also be higher. In net terms, the external financing 0.6 position in FY14 is expected to be substantially better Federal excise 0.5 than in FY13. 0.6 1.3 Other 1.1 In the medium term, Pakistan’s real GDP growth 0.7 is projected to regain momentum slowly, to reach 1.1 Customs 1.0 4.4 percent by FY16. At the sector level, the initial 1.1 economic expansion will be supported by less load- 3.4 shedding and resilient remittance complemented on Direct taxes 3.2 3.6 the supply side by manufacturing exports and dynamic 3.9 services. Official figures place inflation in single digits 3.7 Sales tax 4.0 by end-2013, but some pressures related to hikes in ad- 0.0 1.0 2.0 3.0 4.0 5.0 ministered prices for provisions such as oil, electricity, Percent of GDP and gas, might put pressure by end-fiscal year toward a 2013/14 (Proj.) 2012/13 2011/12 9-10 percent rate. As fiscal consolidation and monetary tightening proceed, average inflation should approach its medium-term target 84 percent over medium-term. Collection of all federal taxes is projected to be significantly higher than last year while owing to The current account deficit is projected to approach a a positive trend in collection of provincial tax, es- modest 1 percent of GDP by end-FY14, and remain pecially services general sales tax, some increase is so during the projection period. Higher financial in- expected to come from the collection of provincial flows are expected to be attracted by lower country risk, revenue. privatizations, new trade relations with neighbors and the opening of special economic zones and multilateral Recurrent expenditure is expected to remain below flows. Official foreign exchange reserves are expected the level achieved last year. Current expenditure of to build from US$6.0 billion by the end of FY13 to the federal government is projected to decline. The about US$16 billion by end-FY16 (equivalent to three government’s austerity measures are responsible for months of imports). 68 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 Sri Lanka Inflation remained subdued, with headline inflation moderating to 6.9 percent in 2013 from 7.6 percent in 2012. The outlook for inflation remains favorable sup- ported by subdued international commodity prices, im- proved domestic supply conditions, and well-contained demand-driven inflationary pressures. Lower inflation- ary expectations are evident in the sharp reduction in Recent Economic Developments treasury yields. Over the past 16 months (from 12.85 percent in November 2012 to 7.07 percent in February Economic growth looks to have risen to 7.3 percent in 2014) 12-month treasury-bond yields in primary auc- 2013, from the 6.3 percent registered the previous year, tions have declined by 578 basis points, while longer- driven by the services and industry sectors. The bounce- term T-bonds (1-4 years) have seen a yield decrease of back began in the second quarter of 2013, and is expected 100 basis points. to continue through the last quarter and beyond. Private sector credit growth has been sluggish The services sector, accounting for nearly 60 percent through most of 2013. The overall policy stance of GDP, grew by an average 6.4 percent for the year, remains accommodative because the monetary underpinned by strong performance in wholesale and authorities have prioritized high economic growth, retail trade (another 23 percent of the economy), ho- targeting 8 percent. Therefore, the two main rea- tels and restaurants, transport and communications, sons to justify monetary easing are declining core- as well as the banking and finance sub-sectors. While inflation and the availability of space for monetary industrial-sector growth moderated in the third quarter easing – lower credit growth and lower imports of 2013, it remained buoyant at 9.9 percent, from 10.3 growth. percent in 2012, propelled mainly by the construction and manufacturing subsectors. By contrast, public sector borrowing continued to rise, by 24 percent for the central government and The agricultural sector bounced back strongly in the 25 percent for state-owned enterprises (SOEs), second-half of 2013 to record a growth of 4.2 percent during the year. The increases were due mainly to for the year. This was especially impressive since flood- the government placing higher budgetary emphasis ing had ravaged the country’s main maha season and on domestic sources for financing, the lower interest contracted output by 0.4 percent in the first half of the rates making domestic borrowings more attractive, year. The rebound was due largely to impressive paddy and the private sector’s aversion to credit in the cli- production in the secondary yala season; one-third of mate of monetary accommodation, which prompted total paddy production originates in the formerly war- banks to place their excess funds in government affected North and East provinces. securities. 9.0 percent, y-o-y Sectoral Contributions to Real GDP, % y-o-y 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 2006 2007 2008 2009 2010 2011 2012 2013E Services Manufacturing Construction Industry others Agriculture Source: CBLS and Department of Census and Statistics Sri Lanka TIME TO REFOCUS 69 12% Sectoral Contributions to In ation 10% 8% 6% 4% 2% 0% -2% Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 -4% Food Housing, Water, Electric, Gas & Fuel Transport Others Overall In ation The government curtailed expenditures during the two weeks of liabilities rather than one week, in order first nine months of 2013 in an attempt to meet the to provide the banks greater flexibility in managing fiscal deficit target of 5.8 percent of GDP. This was in liquidity. In line with monetary policy easing, between response to poor revenue performance from the short- November 2012 and February 2014, money market fall in trade-related taxes, and followed a trend towards interest rates have responded accordingly, with the T- stricter management of fiscal spending in recent years. bill yield and Average Prime Lending Rate (APLR) dropping by 578 basis points and 486 basis points. External finances were poor during the first nine months of 2013. The external financing during the In January 2014, the Central Bank released a master period was LKR 95 billion but authorities expect this plan for consolidation of the financial sector. Bank- to reach LKR 149 billion by year-end. In the absence ing and non-bank financial institutions (NBFIs) will be of a Euro bond issue for the first time in four years, consolidated by mergers and absorption of businesses. domestic bank funding will finance the bulk of the fis- The Central Bank also prohibited the institutions in- cal deficit in 2013. volved in the consolidation from retrenching staff or reducing wages after the fact. The Central Bank has The current account deficit is estimated to decline to made the move in order to strengthen capital buffers 4.0 percent of GDP in 2013, from 6.6 percent in 2012 for the financial sector. It is expected that the project on the back of lower imports and continued healthy will leave at least five Sri Lankan banks with assets of inflows of workers’ remittance and tourism receipts. LKR 1 trillion or more each, and about 20 NBFIs with an asset base of over LKR 20 billion each. The Central The Central Bank has cut policy rates three times for Bank expected completion of the NBFI consolidation a combined 125 basis points since December 2012. In by end-March 2014, and the entire process to be final- December 2013, the Central Bank established a Stand- ized by the end of the year. ing Rate Corridor (SRC) in place of the current Policy Rate Corridor. The Monetary Board also decided to reduce the Standing Lending Facility Rate of the Cen- tral Bank by 50 basis points to 8.00 per cent, thereby Outlook and Policy compressing the Standing Rate Corridor to 150 basis points from 200 basis points. It is expected that this GDP growth is expected to accelerate further, to 7.3 compression will facilitate the reduction of the inter- percent in 2014. The stronger momentum of activity est spread of banks without affecting the deposit rates projected for the second half of 2013 will also lead to offered by banks to their customers. In June 2013, the stronger carry-over into 2014. This growth is supported Central Bank removed the credit ceiling for commercial by an increase in capacity from new infrastructure banks and amended regulations to permit commercial investments and rebuilding. But a relatively protracted banks to hold required reserves against an average of recovery in high-income countries and tightening 70 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 of international financial conditions will constrain a impact and reduce overall consumption expenditure. more robust rebound for Sri Lanka within the forecast horizon. Weathering global commodity prices. Rising global oil prices and depreciation of the Sri Lanka rupee could Risks to the outlook include: put pressure on prices. Oil prices could rise due to geo- political tensions in Middle-East, particularly Syria. Maintaining fiscal consolidation. Recent efforts at fiscal consolidation could go off track if the authorities Declining exports-to-GDP. Given that the growth are unable to collect the budgeted tax revenue and/or in the two key export sectors – i.e., tea and apparel – rising interest costs should the currency depreciate. In remains stagnant, there is a risk that there will be a such an event, the central government may resort to continued decline in the exports-to-GDP ratio. There increased borrowing from the domestic banking sector, needs to be a new thrust towards diversification of both possibly crowding out private sector credit. product and export markets to ensure that the trade balance remains manageable. The precarious financial position of two of the larg- est state-owned corporations, the Ceylon Electricity Managing the economic fundamentals in the face Board (CEB) and the Ceylon Petroleum Corpora- of currency fluctuations of major trading partners. tion (CPC). A drought in 2014 would increase the Further depreciation of the Indian rupee could reduce already-substantial losses of the CEB. Inadequate rain- FDI inflows and tourist arrivals from India, and inhibit fall increases the cost of electricity generation because Sri Lankan exports to India. India represents the single it is produced by furnace oil rather than hydropower. largest trading partner and the single largest source of The unresponsiveness of electricity tariffs to changing tourist arrivals. Furthermore, since India is the single conditions has already undermined the viability of the largest source of imported goods to Sri Lanka (19 CEB. As a result of its higher dependence on thermal percent of total imports in 2012), a deprecation of the power, the CEB’s operating loss would increase. This Indian rupee would likely drive up imports from India, would trigger further below-cost provisions of furnace thereby inflicting further deterioration in the trade oil by the CPC to the CEB increasing the CPC’s losses balance. as well. The greater the losses of the CEB the more it undermines private-sector credit growth and, by exten- The three primary challenges to foreign direct in- sion, investment and GDP growth. The situation could vestment in Sri Lanka are (i) policy uncertainty and be aggravated by the government having to transfer ad- inconsistency with respect to macroeconomic and ditional resources to bolster the balance sheets of these trade and industrial policy, (ii) administrative, bu- two state-owned corporations – a substantial fiscal cost. reaucratic, and organizational constraints, and (iii) Increased administered prices to cover the losses of relatively high production costs. the CPC and CEB could have temporary inflationary TIME TO REFOCUS 71 South Asia at a glance AFG (1) BGD (5) BTN (9) IND (12) MDV (15) NPL (19) PAK (22) LKA (25) SAR (28) 2010 8.4 6.1 10.0 10.3 (13) 7.1 4.8 3.7 8.0 9.9 2011 6.1 6.7 8.1 6.6 7.0 3.4 4.4 8.2 7.2 2012 14.4 6.2 5.6 (prov) 4.7 3.4 4.9 3.6 6.3 4.2 Real GDP 2013 3.6 6.0 6.8 (p) 4.8 (p) 3.7 (e) 3.6 (e) 3.6 7.3 (prov) 4.8 Growth Q4 .. .. .. 4.7 .. .. .. 8.2 .. 2014 3.2 (p) 5.4 (p) 7.1 (p) 5.7 (p) 4.5 (p) 4.5 (p) 4 (p) 7.3 (p) 5.2 (f ) Q1 .. .. .. .. .. .. 5.0 (e) .. .. 2010 7.7 6.8 8.3 10.4 6.2 9.5 13.7 6.2 7.6 2011 10.2 10.9 13.5 8.4 11.3 9.6 11.0 6.7 8.5 2012 6.4 8.7 5.5 (prov) 10.4 10.9 8.3 7.4 7.6 8.6 Inflation 2013 7.7 6.8 8 (p) 10.2 6 (e) 9.9 (e) 10.0 6.9 (prov) 7.6 (y-o-y) Dec 7.3 7.3 11.86 9.9 3.2 10.3 9.2 4.7 8.2 OUTPUT and PRICES 2014 6.1 (p) 7 (p) .. 9.8 2.0 9.8 (p) 4.7 7.5 (p) 4.1 Jan .. 7.5 .. 8.8 3.2 9.7 7.9 4.4 7.3 Feb .. 7.4 .. 8.1 .. .. 7.9 4.3 7.6 2010 9.8 (2) 4.8 .. 5.0 .. 5.8 9.3 7 (26) .. 2011 14.6 6.8 .. 7.3 .. 6.4 9.9 6.9 .. 2012 6.6 11.5 .. 5.4 .. 10.7 10.6 5.8 .. Core Inflation 2013 7.0 7.5 (6) .. 4.9 .. 9.9 (20) 9.8 (23) 4.4 .. 2014 6 (p) .. .. .. .. .. .. .. .. Jan .. .. .. .. .. .. 8.1 .. .. 2010 -1.4 10.1 10 (Q4) 14.2 12.4 15.1 .. 6.9 11.4 2011 12.1 12.8 9 (Q4) 7.9 12.0 14.7 11 9.0 11.4 2012 4.6 7.5 11.8 (Q4) 8.1 -8.0 7.6 9 5.0 4.9 2013 .. 7.8 9.41 (Q3) 9.3 -2.0 9.7 8 12.0 .. Food Inflation Dec 9.8 9 .. 12.3 .. 14.4 3.2 1.6 .. 2014 .. .. .. .. .. .. .. .. .. Jan .. 8.8 .. 10.0 .. 12.9 2.5 0.6 .. Feb .. 8.8 .. 8.6 .. .. .. .. .. 2010 2.8 (3) 3.7 (7) -24.1 -2.7 -9.2 -2.4 0.1 -2.2 -2.6 Current 2011 3.1 0.8 -25.6 -4.2 -21.4 -0.9 -2.1 -7.8 -3.1 Account (% 2012 3.9 -0.4 -21.2 -4.7 -27.1 4.8 -1.0 -6.6 -4.1 of GDP) 2013 3.6 1.9 -18.6 -1.8 (p) -27.9 (e) 3.3 (e) -1 -4.0 (prov) -2.5 2014 3.9 (p) 0.2 (p) -25.0 -2.8 (p) -26.02 (p) -0.8 (p) -0.8 (p) -4.4 (p) -2 (e) 15.1 (e) BALANCE of PAYMENTS 2010 -45.9 -5.2 (8) -25 (10) -7.5 -26.2 -0.5 -9.7 -5 (16) Trade Balance 2011 -42 -6.9 -20.3 -8.8 3 (e) -25.8 -8 -16.5 -6 (% of GDP) -18.1 2012 -41.9 -7.8 -10.5 -3.1 (e) -24.3 -7.4 (p) -15.9 .. (prov) 2013 -39.9 -5.0 -16.4 (p) .. -6 (p) -27.1 .. -13.3 (p) .. 2010 5.1 21.3 -13.3 28.8 -6.5 35.7 4.7 15.4 19.0 2011 2.7 41.8 36.9 24.2 24.0 9.2 19.2 23.9 10.2 2012 11.2 9.9 39.4 1.1 20.4 3.9 0.2 0.0 4.2 Import Growth 2013 -4 0.8 -3.3 -7.7 (p) 1.1 (e) 11.1 4.2 6.2 1 (e) Nov .. .. .. -12.2 .. .. .. .. 2014 -1.8 (p) 14.2 (p) 2.4 5.5 -2.6 (e) 3.7 (e) 9.4 (e) 5.30 € 72 SOUTH ASIA ECONOMIC FOCUS SPRING 2014 AFG (1) BGD (5) BTN (9) IND (12) MDV (15) NPL (19) PAK (22) LKA (25) SAR (28) 2010 4.7 10.8 19.1 37.5 -18.6 -7.3 7.2 10.3 22.8 2011 1.5 41.5 11.4 17.9 55.1 9.1 6.8 20.4 18.8 2012 2.6 5.9 -5.8 0.3 22.6 3 1.3 -5.9 1 BALANCE of PAYMENTS 2013 -5.1 11.2 0.5 2.2 (p) -1.8 (e) -4.6 3.3 6.3 (H2) 7 (e) Export Growth Nov/Dec .. 16.6 .. 6.7 (Dec) .. .. .. .. 13.8 (Nov) 2014 -8.0 (p) 11 (p) 11.2 7.8 (e) -2 (e) .. 7.3 (e) 7.3 (e) 6.3 (e) Jan .. 15.1 .. 4.8 .. .. .. .. .. Feb .. 14.0 .. -2.6 .. .. .. .. .. 2010 -0.02 10.84 -0.06 49.65 -0.19 3.44 9.68 3.60 82 (29) Remittances 2011 0.01 12.06 -0.08 58.42 -0.21 4.18 12.24 4.57 97 (US$ billion) 2012 0.11 14.07 -0.06 63.86 -0.25 4.74 13.98 5.32 109 (e) 2013 .. .. .. .. .. 0.49 (Dec) 13.90 6.80 .. AFG (1) BGD (5) BTN (9) IND (12) MDV (15) NPL (19) PAK (22) LKA (25) SAR (28) 2010 1.9 (4) -3.7 3.4 -6.9 -15.7 -0.8 -6.5 (24) -8 -8 2011 -0.4 -4.0 3.9 -7.6 -11.3 -0.9 -8.8 -6.9 -7.9 Fiscal Deficit 2012 -0.4 -4.1 2.3 (e) -7.2 -13.4 -0.6 -8.0 -6.4 -7.5 (% of GDP) -9.8 (e) 2013 2.2 -4.3 2.7 (b) -6.8 (p) 2 (e) -5.8 -5.8 (prov) -6.7 (17) 2014 -0.4 (p) -5.1 (p) -0.7 -6.3 (p) -23.6 (p) 0.2 (p) -5.1 (p) -5.2 (p) -6.8 2010 13.8 42.9 69.0 67.4 65.7 35.4 59.4 81.9 .. 2011 13.2 44.2 72.0 66.8 72.4 33.0 63.7 78.5 .. GOVERNMENT FINANCES and MACRO POLICIES Public Debt 2012 11 (e) 42.8 90.0 66.6 81.0 34.1 63.0 79.1 .. to GDP (%) 75.0 2013 .. 39.3 86.2 67.4 (p) 86.2 (e) 31.0 (e) 64.2 .. (prov) 2014 .. .. 100.2 67.3 (p) 121.9 (p) 30.0 (p) 63.2 (p) 71.1 (p) .. 2010 6.7 5.4 10.5 7.1 3.9 5.4 3.7 5.9 7 25.4 2011 6.9 3.9 6.8 (14) 2.7 5.8 2.9 3.5 .. (prov) 2012 7.7 3.3 27.8 (p) 6.6 2.4 7.2 .. 4.3 .. Reserves in 2013 7.3 4.6 23 (p) .. 2.6 (e) 7.6 (e) .. 4.2 (prov) .. Months of 2.3-2.4 Import Nov/Dec 7 (Dec) 5.4 (Dec) .. 7.6 (Nov) 10.1 (Dec) 0.6 (Nov) 3.8 (Nov) 6.8 (Dec) 2014 7.5(p) 4.4(p) .. .. .. 7.8(p) .. 4.4(p) .. Jan .. 5.4 .. 7.8 .. 9.9 0.9 .. .. Feb .. 5.7 .. 8 .. 10 1.4 .. .. 2010 114.4 108.3 97.4 (11) 100.0 124.5 (18) 54.1 (21) 100.0 81.9 (27) 100 2011 126.2 108.9 98.6 (p) 97.5 135.0 46.0 102.8 57.34 98.0 2012 127 105.2 .. 91.5 120.3 40.3 104.3 47.8 92.7 REER 2013 125.3 111.6 .. 86.8 .. .. 102.2 .. 88.2 Q4 .. .. .. 82.4 .. .. 99.7 .. 84.0 2014 .. .. .. 83.4 .. .. 103.9 .. 85.3 Q1 .. .. .. 83.4 .. .. 103.9 .. 85.3 TIME TO REFOCUS 73 AFG (1) BGD (5) BTN (9) IND (12) MDV (15) NPL (19) PAK (22) LKA (25) SAR (28) 2010 120 82 66.3 (e) 69.9 .. 88 90 66 .. Consumption 2011 120 84 64.1 (e) 72.7 .. 91 92 70 .. (% of GDP) 2012 .. .. 63.2 (e) 74.7 .. 80 .. 69 (e) .. 2013 .. .. 60.7 (p) 73.1 (p) .. 88 .. .. .. CONSUMPTION and INVESTMENT 2010 27 19.4 51.6 (e) 30.9 .. 32.5 16 28 28 Investment 2011 25 19.5 59.4 (e) 31.8 .. 32.8 12.5 30 27 (% of GDP) 2012 .. 20.0 61.8 (e) 30.4 .. .. 11 28 (e) .. 2013 .. 19 65 (p) 29 (p) .. .. .. .. .. 2010 .. 0.9 0.03 9.4 0. 22 (e) 0.1 1.6 0.9 30.4 2011 .. 0.8 0.02 22.1 0. 28 (e) 0.1 0.7 1.5 35.7 FDI (US$ billion) 2012 .. 1.0 0.02 (pro) 19.8 0.16 (e) 0.1 1.2 1.3 29.7 (e) 2013 .. .. 0.01 (p) 22 (p) 0.22 (p) 0.01 (H1) 1.3 2.1 (p) 36.9 (e) 2010 .. -0.07 .. 28.2 .. 0.0 0.3 -0.46 29.9 Portfolio 2011 .. 0.01 .. 16.6 .. 0.0 -0.14 -0.29 -4.8 Investment 2012 .. 0.06 .. 26.7 .. 0.0 0.03 0.5 11.5 (e) (US$ billion) 2013 .. .. .. 2 (p) .. .. 0 .. 16.4 (f ) e Estimate f Forecast p Projections prov Provisional Afghanistan 1 2013 onwards is calender year, preceding years correspond to solar year (Apr-Mar) 2 Core inflation (exc. Fuel and cereal, %) 3 Including grants 4 Including grants Bangladesh 5 These numbers are for fiscal year unless otherwise mentioned. For example; for 2012 numbers, 2012-2013 values are used. 6 (Avg of Jan-Feb) 7 Including transfers 8 WB Staff Calculations Bhutan 9 These numbers are for fiscal year unless otherwise mentioned. For example; for 2010 numbers, 2010-2011 values are used. 10 WB Staff Calculations 11 WB Staff Calculations India 12 These numbers are for fiscal year unless otherwise mentioned. For example; for 2012 numbers, 2012-2013 values are used. 13 Real GDP Growth ( at market prices) 14 Calendar year for 2011 and 2012 Maldives 15 These numbers are for calendar year unless otherwise mentioned. 16 WB Staff Calculations 17 2013 is est at around 3% of GDP 18 WB Staff Calculations Nepal 19 These numbers are for calendar year unless otherwise mentioned. 20 (Avg of Jan-Feb) 21 WB Staff Calculations Pakistan 22 These numbers are for fiscal year unless otherwise mentioned. For example; for 2012 numbers, 2012-2013 values are used. 23 (Avg of Jan-Feb) 24 Excluding grants Sri Lanka 25 These numbers are for calendar year unless otherwise mentioned. 26 (Avg of Jan-Feb for 2010-2012) 27 WB Staff Calculations SAR 28 These numbers are for calendar year unless otherwise mentioned. 29 Remittances numbers are taken from GEP 2013 Jan report and they are calendar year numbers (US$ billions) 1818 H Street, N.W. Washington, DC 20433