SOUTH ASIA ECONOMIC FOCUS FALL 2018

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2 2 SOUTH ASIA ECONOMIC FOCUS FALL International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington DC 2433 Telephone: ; Internet: Some rights reserved 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. IGO license (CC BY 3. 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 Budget Crunch. South Asia Economic Focus (October), Washington, DC: World Bank. Doi: / License: Creative Commons Attribution CC BY 3. 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. Views and opinions expressed in the adaptation are the sole responsibility of 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 World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 2433, USA; pubrights@worldbank.org. ISBN (electronic): DOI: / Cover photo: World Bank and JohnnyGreig/istock Design: Alejandro Espinosa/sonideas

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5 5 This report is a joint product of the Office of the Chief Economist for the South Asia Region (SARCE) and the Macroeconomics, Trade and Investment Global Practice (MTI). Its preparation was led by Robert Beyer (Economist) under the oversight of Martin Rama (Chief Economist, South Asia Region) in close collaboration with Manuela Francisco (Practice Manager, MTI). Substantive contributions were made by Milagros Chocce, Ishita Dugar, Lazar Milivojevic and Rucheta Singh (in alphabetical order, all SARCE). The report greatly benefitted from inputs from Temel Taskin and other colleagues in the Development Economics Prospects Group (DECPG) under the supervision of Ayhan Kose (Director DECPG). We are very grateful for comments and suggestions provided by Enrique Blanco Armas, Poonam Gupta, Zahid Hussain, Fernando Gabriel Im, Taehyun Lee, Mona Prasad, Aurelien Kruse, Florian Blum, and Adnan Ashraf Ghumman (all MTI), as well as to Prof. Ila Patnaik (National Institute of Public Finance and Policy, Delhi), Martin Melecky (Finance, Competitiveness and Innovation Global Practice), and to Fan Zhang (SARCE). Colleagues providing information for country briefs include Mona Prasad, Tobias Akhtar Haque, Taehyun Lee, Zahid Hussain, Shegufta Shahriar, Afroza Alam, Nazmus Sadat Khan, Yoichiro Ishihara, Aurelien Kruse, Rangeet Ghosh, Fernando Gabriel Im, Kishan Abeygunawardana, Roshan Darshan Bajracharya, Kene Ezemenari, Enrique Blanco Armas, Adnan Ashraf Ghumman under supervision of Manuela Francisco (Practice Manager, MTI). Alejandro Espinosa at Sonideas signed responsible for the layout, design and typesetting, Alexander Ferguson (Senior Manager, South Asia External Communications) and Yann Doignon coordinated the dissemination, Gonzalo Alberto Villamizar De La Rosa created accompanying videos, and Neelam Chowdhry provided valuable administrative support. South Asia as used in this report includes Afghanistan, Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka. The cutoff date for this report was October 1, 218. South Asia Chief Economist Office Macroeconomics, Trade and Investment Global Practice

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7 7 Table of Contents Recent economic developments 8 A generally positive picture 1 Five tensions to watch 12 A turbulent external environment 19 South Asia economic outlook 24 Budget crunch 32 Limited room for maneuver 34 Amplification of boom-and-bust cycles 37 A build-up of liabilities 4 A fiscal reading of development challenges 43 Summing up 48 South Asia country briefs 52 South Asia at a glance 72

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10 1 SOUTH ASIA ECONOMIC FOCUS FALL 218 Recent economic developments South Asia remains the fastest-growing region in the world and its performance has strengthened further, with growth rates exceeding 7 percent in Bangladesh, India and Maldives. Inflation remains near or below targets, but it has picked up in some countries. The external environment, while remaining conducive, has become more turbulent. Monetary policy is being adjusted accordingly, but fiscal policy is not equally responsive and fiscal deficits remain large. Despite strong demand from advanced economies and considerable depreciation of domestic currencies, imports are still growing stronger than exports in most countries. International reserves remain comfortable in most cases, but they are generally declining. Rising oil prices add further pressure on South Asia s high current account deficits. A generally positive picture Global growth has stabilized at a relatively high level and is particularly strong in the United States, a key export destination for the region. The world has been growing above 3 percent since the second quarter of 217. Growth in the United States accelerated to 2.6 percent in the first quarter of this year and further to 2.9 in the second quarter, roughly twice the growth rate of two years ago. In other OECD countries, on the other hand, growth has been decelerating since the third quarter of 217 and was only 2 percent in the second quarter of 218. Developing countries grew by 5 percent during the first half of this year. In a positive development for the region, remittances are holding well or are even increasing. Remittances are an important source of foreign reserves and a key contributor to domestic demand and poverty reduction in several South Asian countries. With many South Asian migrants working in Gulf countries, remittances are Figure 1: Growth has plateaued at the global level but is accelerating in the US. Real GDP growth Percent change, y-o-y Q3 216 Q4 217 Q1 217 Q2 217 Q3 217 Q4 218 Q1 218 Q2 Developing countries United States World OECD (excluding United States) Source: World Bank and staff calculations.

11 Recent economic developments 11 Figure 2: Remittances are holding well or are even increasing. Remittance flows Percent change, y-o-y Q3 216 Q4 217 Q1 217 Q2 217 Q3 217 Q4 218 Q1 218 Q2 Source: Haver Analytics and staff calculations. Bangladesh India Nepal Pakistan Sri Lanka sensitive to international oil prices. Their amount had decreased substantially after oil prices dropped in 215 and remained low throughout 216, but it is now recovering. Over the last year, the flow of remittances has increased strongly in Bangladesh and India. In the second quarter of this year, remittances to these two countries were 18 percent and 28 percent higher than a year earlier, respectively. In Pakistan and Sri Lanka, on the other hand, remittances are nearly at the same level as one year ago. In this conducive environment, South Asia remains the fastest-growing region in the world, and the gap with East Asia has even widened. Growth in South Asia increased for five consecutive quarters from 5.5 percent in the second quarter of 217 to 8.1 percent in the second quarter of 218. Meanwhile, growth in East Asia and the Pacific the other leading region slightly decreased in the second quarter of 218, to 6.4 percent. Elsewhere the moderation is sharper. Growth in Sub-Saharan Africa decreased from 2.6 percent in the last quarter of 217 to 1.7 percent in the second quarter of 218. Growth in Latin America and the Caribbean decreased to 1.8 percent and 1.6 percent in the last two quarters. In the Middle East and North Africa, growth decreased from 5.1 percent in the third quarter of 217 to 2.4 percent in the second quarter of this year. Figure 3: South Asia is consolidating its position as the fastest-growing region. Regional real GDP growth Percent change, y-o-y Q3 216 Q4 217 Q1 217 Q2 217 Q3 217 Q4 218 Q1 218 Q2 East Asia and Pacific Europe and Central Asia Middle East and North Africa Sub-Saharan Africa Latin America and the Caribbean South Asia Source: World Bank and staff calculations.

12 12 Recent economic developments Figure 4: Except for Afghanistan, growth rates are relatively strong and stable. Real GDP growth Percent Afghanistan (CY) Bangladesh (FY) Bhutan (FY) India (FY) Maldives (CY) Nepal (FY) Pakistan (FY, factor prices) (f) Sri Lanka (CY) Note: (f) = forecast, CY = calendar year, FY = fiscal year. Afghanistan, Maldives and Sri Lanka are in calendar years. For Bangladesh, Nepal and Pakistan, year 216 refers to fiscal year 215/16. For Bhutan and India, year 216 refers to fiscal year 216/17. Source: World Bank. Growth rates differ across South Asian countries, but they are substantial in most cases and have been quite stable over time. Due to its size, India drives regional performance. Its growth rate has been steadily increasing since the second quarter of 217, offsetting a decline that had lasted for five quarters. From 5.6 percent back then, the growth rate has climbed to 8.2 percent in the second quarter of this year. Growth performance improved in other South Asian countries as well. In Bangladesh, the growth rate is officially reported to have reached 7.9 percent in FY 217/18, driven by consumption and public investment. In Maldives, growth is projected to reach 8. percent this year thanks to strong dynamism in tourism and construction. In Pakistan growth accelerated to 5.8 percent during FY 217/18, and in Sri Lanka it is projected to reach 3.9 percent this year. Elsewhere, economic growth has slowed down. In Nepal it had been exceptionally strong in FY 216/17, due to reconstruction efforts after the 215 earthquakes, and moderated to 6.3 percent last fiscal year. In Bhutan, growth is decelerating as the investment into hydropower construction is decreasing due to major projects nearing completion. Growth in Afghanistan remains the lowest in South Asia, by far, and is projected to decrease to 2.4 percent this year. Stock markets have been relatively stable across South Asia, and especially strong in India. Across the developing world, the appreciation of the US dollar and concerns about the normalization of monetary policy in advanced economies took a toll on share prices. But despite the growing turbulence in international markets, declines have been more muted in South Asia. The stock market in Bangladesh peaked at the beginning of 218, and since then has decreased by over 1 percent. Similarly, in Sri Lanka, the stock market index fell by 1 percent from January to September. In both cases the stock market is below the level of one year ago, closer to the level of Spring 217. But in Pakistan the Karachi Stock Exchange has been hovering around 4, over the last year, despite concerns about the country s macroeconomic situation. And in India, the stock market declined somewhat at the beginning of the year but started increasing again around April and remains higher than one year ago. Five tensions to watch Growth is strong, but not driven by exports or manufacturing Domestic consumption has been the main contributor to economic growth across the region, with exports or investment being remarkably subdued. In Bangladesh, private and government consumption contributed 8.5 percentage points to growth in FY 217/18, compared to only 3.2 percentage points contributed by investment. The net effect of exports and imports decreased growth by over 4 percentage points. Similarly, in Pakistan growth was overwhelmingly driven by domestic consumption last fiscal year. In India and Sri Lanka, the contribution of investment is projected to be relatively more important in 218, but even there the main driver remains domestic consumption. In both countries exports contribute relatively little to growth. Industrial production is holding well, but it grows slower than GDP in most countries. South Asia s industrial production grew by only 5.4 percent in the second quarter of 218, slightly lower than a quarter before. In India it grew by 5 percent, in Pakistan by 4.5 percent, and in Sri Lanka by only.6 percent. In Bangladesh industrial

13 Recent economic developments 13 Figure 5: Stock markets are performing relatively well. Index Bangladesh, Dhaka Stock Exchange DSEX Index India, Bombay Stock Exchange SENSEX Jul-16 Aug-16 Sep-16 Nov-16 Dec-16 Jan-17 Mar-17 Apr-17 Jun-17 Jul-17 Aug-17 Oct-17 Nov-17 Dec-17 Feb-18 Mar-18 May-18 Jun-18 Jul-18 Sep-18 Index Pakistan, Karachi Stock Exchange Jul-16 Aug-16 Sep-16 Nov-16 Dec-16 Jan-17 Mar-17 Apr-17 Jun-17 Jul-17 Aug-17 Oct-17 Nov-17 Dec-17 Feb-18 Mar-18 May-18 Jun-18 Jul-18 Sep-18 Jul-16 Aug-16 Sep-16 Nov-16 Dec-16 Jan-17 Mar-17 Apr-17 Jun-17 Jul-17 Aug-17 Oct-17 Nov-17 Dec-17 Feb-18 Mar-18 May-18 Jun-18 Jul-18 Sep-18 Index Sri Lanka, Colombo Stock Exchange ASPI Jul-16 Aug-16 Sep-16 Nov-16 Dec-16 Jan-17 Mar-17 Apr-17 Jun-17 Jul-17 Aug-17 Oct-17 Nov-17 Dec-17 Feb-18 Mar-18 May-18 Jun-18 Jul-18 Sep-18 Source: Haver Analytics.

14 14 Recent economic developments Figure 6: Strong growth, but not driven by exports Contributions to growth forecasts in 218 Percentage points Bangladesh (FY) India (FY) Pakistan (FY) Sri Lanka (CY) Government consumption Private consumption Imports Gross fixed investment Exports Real GDP growth (percent) Source: World Bank and staff calculations. Figure 7: while industrial production is generally lagging aggregate growth. Industrial production growth Percent, y-o-y Q3 216 Q4 217 Q1 217 Q2 217 Q3 217 Q4 218 Q1 218 Q2 Source: World Bank and staff calculations. South Asia Bangladesh India Sri Lanka Pakistan production growth moderated for three consecutive quarters but is at over 1 percent still very strong. Admittedly, industrial production is a volatile indicator and changes need to be interpreted with caution, especially for individual countries. But it is safe to say that the region is not experiencing a broad-based manufacturing boom, as could be hoped for given its development level. Inflation is close to target, but it is accelerating in some countries The strong growth performance of the region has not been accompanied by inflationary pressures so far. A benchmark to assess inflationary pressures is to compare actual inflation rates with inflation targets. This comparison reveals whether policy makers are confronting unexpected developments on the price front and allows assessing how successful stabilization policies have been. In this respect, it is reassuring that inflation rates remain in line with the explicit or implicit inflation targets of the authorities in most South Asian countries. Across South Asia, actual inflation has been minimally below the target in September. In some countries, however, consumer prices are increasing faster than in previous years. Consumer prices in the region as a whole grew by 3.7 percent in March 218,

15 Recent economic developments 15 Figure 8: Headline inflation is generally close to target Inflation and distance to policy target Percentage points Bangladesh India Pakistan Sri Lanka China Japan Euro Area US Difference from inflation target Inflation (Sept 218) Note: Sri Lanka has not yet moved to explicit inflation targeting; the target used is the center point of the Monetary Policy Consultation Clause (MPCC) of 4.7 percent. For Bangladesh inflation is from August 218. Sources: Inflation target data is from Haver Analytics (National Authorities). Current inflation data is from Trading Economics. Distance to inflation is based on staff calculations. Figure 9: but headline inflation has picked up in the largest countries in the region. South Asia consumer price inflation Percent change, y-o-y Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 South Asia Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka Source: World Bank and staff calculations. 1.2 percentage points less than a year earlier. Regional inflation rates mask the trend because they give equal weight to all countries, and the smaller ones have been on a different trajectory. Since May 217, the inflation rate has fallen considerably in Afghanistan and the Maldives, with both countries experiencing deflation lately. But the acceleration is visible in some of the larger countries. In Sri Lanka and Pakistan, inflation rates went up from below 4 percent in April to 5.9 percent in August. In September, however, inflation in Sri Lanka fell back to 4.3 percent driven by slower growth in food prices. And in India, inflation reached 4.9 percent in May and June but then decreased again to 3.7 percent in August and September. External demand has improved, but trade balances remain weak Import demand in South Asia s key markets has been strong, and South Asian currencies have generally depreciated, even more than those of other emerging economies. Total imports in the US grew by 4. percent last year and import growth is projected to strengthen to 5.3 percent this year. In the Euro Area, imports grew by 5.4 percent last year and are expected to continue on the same trend this year. The potential boost to South Asian exports has been amplified by currency depreciation. Over the course of 218, all South Asian currencies

16 16 Recent economic developments Figure 1: South Asian currencies are depreciating US Dollar per national currency Percent change, January to September Pakistan Bhutan India Nepal Afghanistan Sri Lanka Bangladesh Indonesia China Thailand Vietnam From January to July 218 Sources: Haver Analytics and staff calculations. Figure 11: but the growth of exports remains lower than the growth of imports. Growth of exports Percent, y-o-y Growth of imports Percent, y-o-y Q3 216 Q4 217 Q1 217 Q2 217 Q3 217 Q4 218 Q1 218 Q Q3 216 Q4 217 Q1 217 Q2 217 Q3 217 Q4 218 Q1 218 Q2 Bangladesh India Pakistan Sri Lanka Bangladesh India Pakistan Sri Lanka Note: The figures refer to merchandise exports and imports only. Source: World Bank and staff calculations. lost ground against the USD. The trend was especially pronounced in India. The Indian Rupee fell by 14 percent since the beginning of the year. The Reserve Bank of India has smoothed out the trend, but it has not fundamentally opposed it. After a period of strong foreign exchange intervention, also Pakistan has allowed its currency to depreciate substantially. The lowest value was reached by end-july, at 129 Rupees per USD. Despite a modest rebound subsequently, there was a 1 percent depreciation compared to the beginning of the year and a 14 percent depreciation compared to one year before. Despite strong import demand and currency depreciation, export performance remains disappointing while imports are still growing rapidly. In Bangladesh and Sri Lanka, import growth accelerated in the second quarter of 218, relative to the same period a year before. The 1.1 percent growth in imports experienced by Sri Lanka stands in sharp contrast with its 2.4 percent growth in exports. In India and Pakistan recent nominal exchange rate depreciations have led to a depreciation of the real effective exchange rates. And indeed, in Pakistan import growth came down quite dramatically from its peak of over 3 percent in the first quarter of last year. But at 9.1 percent it is only marginally lower than the 1.4 percent growth in exports. In India, import growth moderated from over 3 percent a year ago to 6.9 percent now, and exports are growing faster than imports. But overall, South Asia does not look like an export powerhouse at this point. External buffers are generally solid, but current account deficits are large With a few exceptions, the level of international reserves is relatively high in the region. Reserves in India and Bangladesh are at comfortable level and can cover 9.3 and 7.6 months of imports respectively. Compared to the beginning of the year, this is.8 months lower

17 Recent economic developments 17 Figure 12: The level of international reserves is comfortable in most cases Foreign exchange reserves Months of imports Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Bangladesh India Maldives Pakistan Sri Lanka Source: World Bank. Figure 13: but current account deficits are sizeable. Current account balance Percent of GDP Q3 216 Q4 217 Q1 217 Q2 217 Q3 217 Q4 218 Q1 218 Q2 Bangladesh India Nepal Pakistan Sri Lanka Note: Quarterly GDP for Bangladesh, Pakistan, Nepal, Afghanistan is derived from annual GDP and assumed to be constant for all four quarters. Sources: Quarterly current account data is from Trading Economics. Quarterly GDP data for India and Sri Lanka is from Haver Analytics. for India and.5 months higher for Bangladesh. In Sri Lanka reserves increased by over USD 1 billion due to the issuance of a USD 2.5 billion bond that marked the country s return to the US capital market. With a coverage of 5. months of imports, the level of reserves is now prudent. Not all countries have such substantial buffers, however. In Maldives reserves are increasing but cover less than 3 months of imports. And in Pakistan a weaker macroeconomic situation and a delayed adjustment of the exchange rate led to considerable loss of reserves, bringing coverage down to 1.5 months of imports by end-september 218.

18 18 Recent economic developments However, current account deficits have been growing across most of South Asia and buffers are being eroded in some cases. In Sri Lanka, the deficit bottomed out at the end of 216, but the balance has remained negative since then and was still 1.9 percent of GDP in the third quarter of 217. In India, the current account has been in a deficit since 24 and amounted to 2.2 percent of GDP in the second quarter of this year. In Bangladesh, the current account was in surplus during most of 216, but it declined from plus 1. percent of GDP in the third quarter of 216 to minus 3.9 percent of GDP in the second quarter of 218. The sharpest deterioration was in Pakistan, with the current account deficit worsening from USD 22 million the first quarter of 216 to USD 5.8 billion in the second quarter of 218. The growth of imports is partly the result of capital goods imports for the China Pakistan Economic Corridor (CPEC), but it is also the consequence of growing macroeconomic imbalances. Monetary policy is responsive, but fiscal policy less so Monetary authorities are responding to the inflationary signs, as well as to growing exchange rate pressures. Nepal is the only South Asian country that has left the policy rate unchanged for the last couple of years, at 7 percent. Pakistan began to raise its Figure 14: Monetary policy is adjusting to rising inflation and external pressure Official interest rate (policy instrument/base rate) Repo rate (EOP, percent) Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 Bangladesh India Nepal Pakistan Sri Lanka Sources: Haver Analytics and Reuters. Figure 15: but fiscal policy is not being equally responsive. Fiscal balance Percent of GDP (f) Afghanistan (CY) Bangladesh (FY) Bhutan (FY) India (FY) Maldives (CY) Nepal (FY) Pakistan (FY) Sri Lanka (CY) Note: (f) = forecast, CY = calendar year, FY = fiscal year. Afghanistan, Maldives and Sri Lanka are in calendar years. For Bangladesh, Nepal and Pakistan, year 216 refers to fiscal year 215/16. For Bhutan and India, year 216 refers to fiscal year 216/17. Source: World Bank.

19 Recent economic developments 19 policy rate in January and India in June of this year. The policy rate in Pakistan was increased from 6.3 percent in January to 8.5 percent in September to contain pressures on the exchange rate. In India, the policy rate increased from 6. percent in May 218 to 6.5 percent in August 218, in response to a pick-up in inflation. The Central Bank of Sri Lanka has left the policy rate unchanged due to the fragility of economic growth but injected liquidity in the domestic market and intervened in the foreign exchange market during September. In contrast with the responsiveness of monetary policy, fiscal policy remains expansionary across most of the region. Fiscal deficits have been traditionally large in South Asia, especially when considering the deficits of sub-national levels of government. In recent years, public expenditures grew much faster than revenue generation in several of the countries. While some countries used to display a positive budget balance, all of them have been running deficits since 217. In Sri Lanka, the fiscal deficit is projected to reach 5.2 percent of GDP in 218, despite a primary surplus, due to heavy interest payments. Maldives saw substantial fiscal consolidation, but its deficit is still expected to stand at 5.3 percent of GDP this year. In Nepal and Bangladesh, the fiscal deficit rose to 5.8 percent and an estimated 4.1 percent respectively in FY 217/18. In Pakistan it reached 6.5 percent, up from 5.8 percent in the previous fiscal year. And in India it attained 6.6 percent, with state deficits improving slightly to 3.1 percent of GDP from 3.5 percent of GDP a year earlier and the deficit of the center being stable at 3.5 percent of GDP. Fiscal discipline is not equally strong across all Indian states. A turbulent external environment The international price of oil has been on an upward trend, and this matters to South Asia because the region is a net oil importer. Oil prices started increasing again since January 216, after having reached a low of 28 USD per barrel. At the beginning of this year, the price stood at 67 USD per barrel and it went up further to above 85 USD in the beginning of October. This is still much lower than before the oil price collapse of 214 the average price of oil during the first half of 214 was 19 USD per barrel. Nevertheless, the upward trend puts further pressure on South Asian economies. Higher oil prices put further pressure on current accounts but may also have an indirect impact on fiscal deficits. On the positive side, with many South Asian migrants working in Gulf countries, higher oil prices raise the prospect of a sustained growth in remittances. But all countries in the region are oil importers, raising the prospect that trade balances may deteriorate further. In the past, the impacts of higher oil prices on economic activity have been relatively muted, mainly because Figure 16: International oil prices are increasing again. Crude oil prices: Brent - Europe USD/Bbl Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar-18 May-18 Jul-18 Sep-18 Source: Haver Analytics.

20 2 SOUTH ASIA ECONOMIC FOCUS FALL 218 Recent economic developments Figure 17: Emerging markets have become more vulnerable External vulnerability 5 Nominal exchange rate depreciation (local currency vis-a-vis the USD) ARG TUR BR ZAF 1 RUS MEX IND ARG BR CHN ARG MEX Current account deficit (percent of GDP) TUR IND RUS CHN 6 CHN ZAF IND TUR ZAF -1 MEX BR -2 RUS 216 Q1 217 Q1 218 Q1 Note: ARG=Argentina, BR=Brazil, CHN=China, IND=India, MEX=Mexico, TUR=Turkey, ZAF=South Africa. Sources: Haver Analytics, national central banks, World Bank, and staff calculations. Figure 18: and capital flows may not differentiate sufficiently across markets. Total portfolio flows of India and Turkey USD billion, 3-month moving average Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar-18 May-18 Jul-18 Sep-18 India Turkey Source: International Institute of Finance. of limited pass-through to consumers. But limited passthrough leads to a loss of government revenue, either through subsidies or through lower taxation. Fiscal deficits could therefore increase even further. Contagion is another source of risk, as external vulnerabilities have increased in important emerging markets across the world. The economic situation of Argentina, Turkey, and South Africa has deteriorated considerably in recent months. In the first quarter of this year, the Argentinian Peso depreciated by over 4 percent compared to six months earlier, while the current account deficit widened to 7.3 percent of GDP. In Turkey, the Lira depreciated by over 2 percent over the same period, and the current account widened to 5.5 percent of GDP. At 1 percent, currency depreciation was more modest in South Africa, but the current account deficit widened to 18 percent of GDP. Commentators have at times linked these developments to those in India, where the Rupee depreciated by 6 percent during this period and the current account deficit reached 2.8 percent of GDP in the first quarter of this year. The comparison is far-fetched, but the fact that it is being made highlights the risks from international turbulence.

21 Recent economic developments 21 Figure 19: Economic shocks abroad increase bond spreads in South Asia Change in emerging market bond spreads after Taper Tantrum and latest market correction Basis points change Days EMDEs after latest market correction South Asia after latest market correction EMDEs after Taper Tantrum South Asia after Taper Tantrum Note: = April 15, 218 for latest market correction and = May 23, 213 for Taper Tantrum. The average for South Asia includes only India, Pakistan and Sri Lanka. Source: JP Morgan and staff calculations. Figure 2: lead to considerable capital outflows in India... Change in EMDE and India portfolio flows after Taper Tantrum and latest market correction USD, billion Days EMDEs after latest market correction India after latest market correction EMDEs after Taper Tantrum Note: = April 15, 218 for latest market correction and = May 23, 213 for Taper Tantrum. Source: International Institute of Finance and staff calculations. Figure 21: and to weaker currencies in the region. Change in currencies after Taper Tantrum and latest market correction Percent change India after Taper Tantrum Days EMDEs after latest market correction South Asia after latest market correction EMDEs after Taper Tantrum South Asia after Taper Tantrum Note: = April 15, 218 for latest market correction and = May 23, 213 for Taper Tantrum. The average for South Asia includes Bangladesh, India, Pakistan and Sri Lanka. Sources: Bloomberg, Haver Analytics, and staff calculations.

22 22 Recent economic developments Short-term capital flows to emerging economies tend to be synchronized, because they are affected by market sentiment. For example, the domestic economic situation has been different in Turkey and India, and yet the correlation coefficient between the capital flows to these two economies from 213 onwards is a sizeable.64. If international investors do not differentiate sufficiently across emerging markets, an external event leading to a change of investor sentiment may result in broad-based impacts. Countries with substantial stocks of foreign portfolio investments and large current account deficits may be more vulnerable to contagion. Experience shows that economic shocks abroad can increase bond spreads in South Asia, lead to capital outflows and cause currency depreciation. In May 213, the Federal Reserve announced that it would start reducing the quantitative easing program established after the Global Financial Crisis. This tapering talk led to a broad-based surge in bond spreads across emerging markets. Bond spreads increased more in South Asia than in other regions. Similarly, in April 218 the expectation that interest rates would start increasing in advanced economies led to a widespread stock market correction. In India, the only South Asian country for which daily data on portfolio flows is available, the capital outflow 4 days after the tapering talk of May 213 amounted to USD 7.6 billion. It reached USD 6.9 billion 4 days after the stock market correction of April 218. Outflows of this sort exert considerable pressure on exchange rates. Box 1: Views from the South Asia Economic Policy Network The South Asia Economic Policy Network, launched by the office of the regional Chief Economist at the World Bank in 217, represents an attempt to engage more strongly with thinkers and practitioners across South Asia. The objective is to nurture the exchange of ideas and to learn more systematically from local colleagues and counterparts. The network focuses broadly on macroeconomics and includes over 35 members from seven South Asian countries. Members stand out in terms of peer recognition, participation in professional conferences and research outputs. Many of them are academics at renowned universities, others are researchers in central banks and think tanks, and some are affiliated with policy-making units. Figure 22: We asked over 35 economists from seven countries about their views. Survey among South Asia Economic Policy Network Number of experts India Bangladesh Pakistan Nepal Sri Lanka Bhutan Undisclosed country Source: World Bank South Asia Economic Policy Network. As for the last two editions of this report, a short opinion survey was conducted among the members of the network for this edition of South Asia Economic Focus. The objective was to take the pulse of informed and influential experts about economic developments in their countries. The response rate exceeded 2 percent, with 84 filled-in questionnaires from 7 countries. Nearly all respondents identified themselves as academics and as macroeconomists. Three quarters of the respondents are involved in policy advising and a quarter in policy making. The expectations of network members regarding economic developments over the next six months are summarized in a single number, using so-called diffusion indices. For every indicator, a value of the diffusion index above 5 indicates that an increase is expected, whereas a value below 5 corresponds to an expected decrease. The farther away the number is from 5, the greater the consensus among network members that an important change is under way.

23 Recent economic developments 23 Based on the responses, network members do not anticipate much change in economic growth in their countries. The exception is Pakistan, where there is a strong consensus that the growth rate will decline. Network members also expect that inflation and interest rates will pick-up across all countries. In Bangladesh, imports are expected to increase strongly, while exports are expected to remain stable. In Pakistan, imports are on the contrary expected to decrease, while an increase in exports is anticipated. In all countries except Pakistan, network members foresee an increase in the fiscal deficit. Finally, there are strong views across South Asia that exchange rates will depreciate, and that financial sector stress will rise. Figure 23: Network members expect higher inflation, interest rates and financial stress. What do you expect to happen in your country within the next six months? Diffusion index Decrease Increase Real GDP growth Headline inflation Interest rates Imports Exports Fiscal deficit Exchange rate Financial sector stress India Pakistan Bangladesh Others Note: The index is calculated as follows: Index=(P1*1) + (P2*5) + (P3*), where P1 is the proportion of responses that report that the variable is too large/overvalued/too high, P2 is the proportion of responses that report that the variable is stable, and P3 is the proportion of responses that report that the variable is too low/undervalued/too small. For the exchange rate, a value smaller than 5 signals and expected depreciation of the currency against the USD. Source: World Bank South Asia Economic Policy Network and staff calculations. There are two stark differences between these responses and those to the last survey, conducted six months ago. First, inflationary expectations have gone up across South Asia, despite the increase of policy rates by some central banks. Second, views on Pakistan s economic prospects have changed substantially. While in the last survey respondents still anticipated faster economic growth and larger fiscal deficits, there now is a strong majority expecting fiscal consolidation, lower current account deficits, and slower economic growth.

24 24 SOUTH ASIA ECONOMIC FOCUS FALL 218 South Asia economic outlook

25 By singh lens / Shutterstock

26 26 Economic outlook South Asia is expected to remain the fastest-growing region in the world and its performance could strengthen even further. But economic growth will mainly be driven by domestic demand, not by exports. This inward orientation may sound justified at a time when there are concerns about trade wars, and financial markets have become more jittery. But import demand in the traditional destination markets for South Asian exports the United States and Europe will remain robust. And so far, the region has been subject only to minimal trade barriers. Therefore, South Asia s export opportunity has not gone away. Instead of seizing it by reorienting resources towards foreign markets, especially through fiscal consolidation, countries in the region seem to be drifting toward more traditional protectionist policies. The international environment will remain conducive on the real side of the economy, but somewhat more turbulent on the financial side. Global growth is projected to reach 3. percent in 219, only a slight decline from 3.1 percent in 218. Global merchandise trade growth is expected to reach 3.9 percent in 218, and 3.7 percent the next year. Both figures are higher than the corresponding GDP growth rates. This marks a difference with the period after the global financial crisis and suggests that there are opportunities to increase exports. But the international price of oil may remain high for a while, exerting pressure on the current accounts of oil importers, including South Asian countries. And the continued appreciation of the US dollar, together with greater nervousness in financial markets, may exert pressure on many economies. South Asia is projected to remain the fastest-growing region in the world and its lead could consolidate further in the coming years. Mainly due to a stronger performance in India, growth in South Asia is estimated to accelerate to 6.9 percent in 218 and to strengthen to 7.1 percent from next year onwards. Consequently, South Asia will maintain its position as the fastest-growing region. It will even extend its lead over East Asia and the Pacific, which is projected to grow at 6.1 percent next year and at 6. percent in 22. Growth in the rest of the region, excluding India, is expected to remain stable at 5.6 percent next year, and to accelerate to 5.8 percent the following year. These growth forecasts are broadly in line with the expectations in June 218. Growth rates will be robust across most countries in South Asia, with the exception of Afghanistan. More specifically: Afghanistan. Growth is projected to pick up, but only to 3.2 percent by 22. Importantly, this projection presumes a recovery of confidence after a temporary weakening due to security challenges and political uncertainty in the context of the upcoming parliamentary and presidential elections. Bangladesh. Growth will be strong, driven by consumption and public investment, but it is expected to slow to an average of 6.9 percent over the forecast horizon. This is due to a projected slowdown of private investment and an increase of imports. Bhutan. Growth will accelerate with the commissioning of two major hydropower projects, Mangdechhu and Punatsangchhu-II. The growth rate is projected to jump from 4.6 percent in this fiscal year to 7.6 percent in FY 219/2, before moderating again to 6.4 percent in FY 22/21.

27 Economic outlook 27 Figure 24: Growth in South Asia is projected to accelerate slightly... Real GDP growth Percent Latin America and Caribbean Middle East and North Africa Sub Saharan Africa Europe and Central Asia East Asia and Pacific South Asia (f) 219 (f) 22 (f) Note: (f) = forecast. Source: World Bank. India. Prompted by the adoption of the Goods and Services Tax and the recapitalization of banks, growth in India is firming up and it is projected to accelerate further. Growth is expected to rise to 7.3 percent in FY 218/19, and to 7.5 percent in the following two years, with stronger private spending and export growth as the key drivers. Maldives. Growth is projected at a very strong 8. percent this year, based on the dynamism of the construction and tourism sectors. But it is projected to decelerate in the next two years as new capital investment projects gradually begin to taper off. Nepal. Economic activity is set to grow on average 6 percent over the medium term. However, performance could be less impressive if the challenging transition to a federalist system affects infrastructure provision and service delivery. Pakistan. Macroeconomic stabilization policies will take a toll on growth this fiscal year. GDP growth is expected to lower to 4.8 percent in FY 218/19, reflecting a tighter fiscal and monetary policy. However, with improved macroeconomic conditions, growth could reach 5.2 percent in FY 219/2. Sri Lanka. Economic growth is projected to recover from the effects of last year s weather disruptions, which negatively impacted agriculture, and to remain around 4 percent in the next two years. Table 1: and changes in growth rate across countries will be minor (f) 219 (f) 22 (f) Afghanistan (CY) Bangladesh (FY) Bhutan (FY) India (FY) Maldives (CY) Nepal (FY) Pakistan (FY, factor prices) Sri Lanka (CY) Note: (f) = forecast, CY = calendar year, FY = fiscal year. For Bangladesh, Nepal and Pakistan, year 216 refers to fiscal year 215/16. For Bhutan and India, year 216 refers to fiscal year 216/17. The numbers for 218 are either estimates or forecasts. Source: World Bank. This solid growth performance will be anchored not on private investment or exports, but rather on domestic consumption. Private consumption is expected to slightly firm and to offset the moderation in public consumption that a gradual fiscal tightening would bring about. Similarly, private investment is expected to accelerate and offset moderating public investment. The contribution of private consumption to growth is projected to rise from 4.1 this year to 4.2 percent in the next year. With an annual

28 28 Economic outlook Figure 25: Private consumption will remain the main contributor to growth. Contributions to growth in South Asia Percentage points (f) 219 (f) 22 (f) Private consumption Government consumption Gross fixed investment Exports Imports Real GDP growth (percent) Source: World Bank. growth over 7.5 percent over the forecast horizon, investment is projected to remain strong. Its contribution to growth is projected to increase from 2.4 percent this year to 2.5 percent next year. Import growth is set to decline to 6.5 percent in 219, and to moderate further to 6. percent in the following year. Export growth is expected to remain at around 6 percent over the next years. Uncertainty about the external policy environment is rising and the promise of a strong South Asian trade performance is becoming elusive. Trade forecasts have proven overly optimistic over the last few years. In January 217, the growth of imports for the full year was forecasted at 5.1 percent, and that of exports at 5.6 percent. Over time, the projection for import growth increased, while the projected export growth decreased. Actual growth of imports in 217 turned out to be above 6 percent, while export growth was only 4.5 percent. For this year, revisions to the January trade forecasts follow the same pattern: upwards for imports and downwards for exports. For 219, the new projections now entail Figure 26: The external policy environment is becoming more uncertain... US trade and global policy uncertainty Index, 3-month moving average Q1 215 Q3 216 Q1 216 Q3 217 Q1 217 Q3 218 Q1 218 Q3 US trade uncertainty Global policy uncertainty Note: The policy uncertainty is computed by Baker, Bloom, and Davis (216). They are based on the frequency of articles in domestic newspapers mentioning economic policy uncertainty and terms related to trade policy uncertainty. Source: Bake, Bloom, and Davis (216). Updated results are available at

29 Economic outlook 29 Figure 27: and trade forecasts are becoming more pessimistic. Change in export forecasts for South Asia over the years Percent Change in import forecasts for South Asia over the years Percent Jan-17 Jun-17 Jan-18 Jun-18 Oct-18 Source: World Bank. Box 2: The implications of US-China trade tensions for South Asia Since the beginning of this year, the US has imposed tariffs on a set of imports from China whose combined value is close to USD 25 billion. An initial round of tariffs affected USD 5 billion worth of imports from China, including solar panels, aircraft parts, and batteries. China retaliated with tariffs on an equal value of imports from the US, covering goods like fuel, steel products, autos, and medical equipment. In the latest development, the US government imposed an additional round of US tariffs on USD 2 billion worth of imports from China, with a near immediate reaction from China, imposing duties on USD 6 billion worth of US imports. Both countries have announced that additional tariffs are possible. South Asia has not been affected to a large extent by tariff increases. One exception is a new US tariff on certain steel and aluminum products from India. The corresponding tariff rates are 25 and 1 percent respectively. In response, India proposed to raise import duties on 3 US products ranging from motorcycles to apples and almonds. These tariffs would amount to over USD 24 million, equivalent to the steel and aluminum tariffs imposed by the US on India. However, India has deferred its plan to impose retaliatory tariffs on the US until the end of the year, in the expectation that trade talks may lead to an exception for India s steel and aluminum products from tariffs imposed by the US. Figure 28: Proposed and imposed tariffs restrictive trade measures do not target the region Imports subject to new tariffs in 218 Percent of 217 imports Imposed Additionally proposed Imposed Additionally proposed Imposed Additionally proposed US imports from China Chinese imports from US US imports from India Sources: United States Census Bureau, National Bureau of Statistics of China, Peterson Institute of International Economics, and staff calculations. While India has not been substantially impacted by tariff increases so far, it could be affected by two other measures by the US government. First, the US sanctions on Iran may result in higher oil prices for India, which used to be the second largest importer of oil from Iran. Crude oil imports from Iran declined sharply, from 787, barrels/day in July to only 5, barrels/day in mid-august, and they are set to decline further. Since Iran offered extremely competitive terms, India is facing a higher oil import bill in the future. Second, the US government tightened its visa regime, which may make it more difficult for Indian companies to send employees to work temporarily to the US.

30 3 SOUTH ASIA ECONOMIC FOCUS FALL 218 Economic outlook South Asian countries export mainly to the US and Europe, and therefore a key question is how a potential trade war may affect import demand in these two markets. Current projections suggest that effects will be quite muted. Despite increasing tariffs, US imports are growing faster than in the last two years, and the growth of imports by the Euro Area remains stable. From this perspective, the export prospects of South Asian countries have improved, not deteriorated. Figure 29: Import demand by advanced economies will remain strong. Import growth in advanced economies Percent United States (f) Euro Area Note: (f) = forecast. Euro Area values do not include Malta and Cyprus due to data unavailability. Source: OECD. South Asia could even benefit from the current trade dispute between the US and China through trade diversion. As the US and China increase their tariffs on each other, the prices of mutual imports increase and the demand for substitutes from other exporting economies including South Asian countries - grows. But it will not be easy for South Asian countries to reap the benefits and currently other countries seem better prepared, especially to replace imports from the US (Freund et al. 218). The Spring 217 edition of this report argued that South Asia s benefits from trade diversion may be small indeed but that they increase with the elasticity of domestic supply and the extent of export diversification (World Bank 217). To benefit from the opportunities offered by strong import demand in the US and Europe, South Asian countries need to improve logistics, reduce red tape, and enhance competitiveness. Unfortunately, some of the policy measures recently adopted in the region to address widening current account deficits go in the opposite direction. Regulatory duties have been increased in Pakistan; import tariffs on vehicles have been raised in Sri Lanka; and India did the same on 19 products worth 13 USD billions in imports. References: Freund, C., Ferrantino M., Maliszewska, M., Ruta, M. (218). Impacts on Global Trade and Income of Current Trade Disputes (Number 2). MTI Practice Notes. Washington DC: The World Bank. World Bank. (217). South Asia Economic Focus, Spring Globalization Backlash. Washington DC: The World Bank. stable export growth and a strong decrease of import growth. Risks to the forecasts remain tilted towards the downside. On the domestic side, vulnerabilities are being exacerbated by rising inflation and fiscal slippages. Structural reforms to address the balance sheet issues faced by the banking sector and non-financial corporates may be delayed. In addition, the region is vulnerable to political uncertainty, which may increase with upcoming elections in some countries. Also on the downside, the security environment remains fragile in Afghanistan, while adverse weather conditions and natural disasters are frequent across the region. On the external side, the risks to watch are a further deterioration in current accounts due to higher global oil prices and increased turbulence in international capital markets. But perhaps the biggest uncertainty concerns the escalation of tariff measures between the US and China, and their possible impacts on value chains and investor sentiment.

31 CRStudio / Shutterstock

32 32 SOUTH ASIA ECONOMIC FOCUS FALL 218 Budget crunch

33 DeMenace / istock

34 34 Budget Crunch Widening current account deficits and increased turbulence in international markets call for prudent economic policy, and fiscal discipline is at the core of prudent management. However, most South Asian countries generate low tax revenue. They also run large fiscal deficits, often amplified by economic shocks and political cycles, which limits their room to maneuver. Tax revenue increases with economic growth, but so does government expenditure. Since spending multipliers are positive, the procyclicality of spending amplifies boom-and-bust cycles instead of smoothening them. In several countries debt levels are high and hidden liabilities are a concern. Not all these patterns are present in all countries, but they combine into a specific set of challenges in each, putting fiscal matters at the core of development policy. Limited room for maneuver Tax revenue in South Asia is generally lower than could be anticipated given the region s level of economic development. South Asian countries are not different from other developing countries in terms of the tax instruments they use. But their tax bases are small, tax exemptions are common, and tax evasion is widespread. Some countries in the region have been making progress on these fronts. In India, the introduction of the Goods and Services Tax and the drive towards electronic payments have fostered the formalization of transactions, which should increase tax revenue in the future. By broadening the base, encouraging compliance, and fighting evasion, Nepal managed to boost its tax revenue from 8 percent of GDP in 2 to over 2 percent today. In Sri Lanka, tighter macroeconomic management increased tax revenue by 2 percent of GDP over a short period of time. But overall, for the period 21-17, tax revenue in the region remained below that of other developing countries with a similar income per capita, in some cases by a vast margin. Government spending is not as low as tax revenue however, and as a result fiscal deficits are larger than in most other regions. Substantial government spending is understandable, given South Asia s enormous development needs. But spending needs to be financed, and the alternatives to taxation from artificially low borrowing rates to excessively high money printing are costly too. At 4.4 percent of GDP, South Asia s fiscal deficit is projected to be the second largest in the world this year. The only region with an even higher deficit is the Middle East and North Africa, which is still suffering from the relatively low oil prices over the last years. Fiscal deficits in several South Asian countries have been large for quite some time. The average deficit over the last three years has been around 5.5 percent in Pakistan and above 6 percent in Maldives, India, and Sri Lanka. The level of fiscal deficits is often affected by developments beyond the control of policy makers, including economic shocks. Between 198 and 217, South Asian countries experienced over 1 downturns in five key global and domestic variables. These key variables

35 Budget Crunch 35 Figure 3: Tax revenue is generally low... Tax revenue Percent of GDP IND AFG NPL BGD PAK BTN LKA MDV GDP per capita (in logs, PPP adjusted) South Asian countries OECD countries Non-OECD countries Note: Values are averages from 2 to 217 (216, 215, or 214 for some countries). The red line is a linear trend line between tax revenues and the logarithm of the per capita GDP (PPP adjusted). Source: World Bank. Figure 31: and fiscal deficits remain uncomfortably large. Fiscal balance forecasts for 218 Percent of GDP Europe and Central Asia Sub-Saharan Africa East Asia and Pacific Latin America and Caribbean Source: IMF and staff calculations. South Asia Middle East and North Africa include global GDP growth, the growth of world trade, the international oil price, the level of remittances, and the country s terms of trade. The downturns in these variables can be combined to construct an aggregate measure of the economic conditions faced by a country. During the troughs of this aggregate measure, fiscal deficits were on average.75 percentage points of GDP larger than two years earlier and.85 percentage points higher than two years later. Not surprisingly, fiscal deficits in South Asia are also amplified in times of intense political competition. Between 199 and 215, 39 national elections took place in Bangladesh, India, Pakistan, and Sri Lanka. Of these contests, 2 were parliamentary elections and 19 were presidential elections. In the year before elections, the fiscal deficit rose on average by.5 percent of GDP. The average fiscal deficit remained high during the election year, to decrease only in subsequent years. While the pattern holds both for presidential and parliamentary elections, it is stronger for the latter. Fiscal deficits rose on average from 5.5 percent of GDP two years before a parliamentary election to 6.3 percent one year before and further to 6.4 percent in the year when the election took place. Regional experts are well aware of the influence economic and political cycles have on their countries

36 36 Budget Crunch Figure 32: Fiscal deficits increase with adverse economic shocks. Average fiscal deficits over downturns Percent of GDP Trough of the downturn Global and national shocks Global shocks Note: The bars show the average fiscal deficit computed from 14 cycles in world GDP growth, world trade, oil prices, countries received remittances, and terms of trade. The cycle is defined as follows: the value of the respective variable is smaller than mean - one standard deviation in trough, the value which precedes is smaller than the respective mean and the value which follows is bigger than the value in the trough period. The figure shows average five-year periods for all South Asian countries. Sources: Federal Reserve Bank of St. Louis, World Bank, and staff calculations. Figure 33: Fiscal deficits increase in times of national elections. Average fiscal deficit before and after elections Percent of GDP Election year Presidential and parliamentary elections Parliamentary elections Note: The bars show the average fiscal deficit computed from 39 national elections between 199 and 215 in Bangladesh, India, Pakistan, and Sri Lanka. Of these, 19 were presidential and 2 were parliamentary elections. Sources: World Bank, National Election Commissions, and staff calculations. Figure 34: Regional experts see deficits increasing with external shocks and national elections. How does the budget deficit in your country react to a negative external shock? Number of responses How does the budget deficit in your country evolve when national elections approach? Number of responses Increases Increases Stays the same Stays the same Decreases Decreases Source: South Asia Economic Policy Network. Survey conducted for this report. fiscal stance. In a survey conducted for this report among researchers and practitioners affiliated with the South Asia Economic Policy Network, a strong majority of respondents reported a relationship between negative external shocks and fiscal deficits in their countries. Similarly, almost 9 percent said that fiscal deficits in their countries increased when national elections approached.

37 Budget Crunch 37 Figure 35: Tax revenue responds positively to economic growth... Correlation between cyclical components of tax revenues and GDP India Maldives Nepal Bhutan Pakistan Sri Lanka Bangladesh Since Global Financial Crisis Note: Based on annual data from 199 to 217. Data for Maldives starts in Cyclical components are calculated as the deviation of the actual data from a trend computed using the Hedrick-Prescott filter with the standard smoothing parameter for annual data (6.25). Filled bars refer to values significant at 1 percent level. Sources: ADB, IMF, World Bank, and staff calculations. Figure 36: and so does the level of public expenditures. Correlation between cyclical components of government expenditures and GDP Bhutan Nepal Bangladesh Pakistan India Maldives Sri Lanka Since Global Financial Crisis Note: Based on annual data from 199 to 217. Data for Maldives starts in Cyclical components are calculated as the deviation of the actual data from a trend computed using the Hedrick-Prescott filter with the standard smoothing parameter for annual data (6.25). Filled bars refer to values significant at 1 percent level. Sources: ADB, IMF, World Bank, and staff calculations. Amplification of boomand-bust cycles From the point of view of macroeconomic stability, it would be desirable if fiscal deficits increased during economic downturns and shrank during growth accelerations. Higher public spending and lower taxes can stimulate economic activity, and therefore can be used to mitigate a downturn. In economic parlance, a countercyclical fiscal policy is desirable, because it can contribute to macroeconomic stability. By contrast, a procyclical fiscal policy may amplify boom-and-bust cycles. Across South Asia, faster economic growth leads to higher tax revenue. Studies on the relationship between the fiscal stance and economic growth in advanced economies focus on changes in revenue and expenditures before and after recessions. But in a region where rapid growth is the norm, it makes more sense to compare revenue and expenditures when growth is above or below its trend. Fluctuations around a trend are also known as cyclical components. In most countries in the region, the cyclical components of tax revenue and GDP move closely together. In India and the Maldives, for example, the correlation between the two variables is above.6. The conclusion is similar when analyzing the growth rates of tax revenue and GDP. The correlation between these two growth rates is statistically significant in India, Maldives, Nepal and Bhutan. The correlation between tax revenue and growth is also positive in Sri Lanka and Pakistan, but at around.2 it is not statistically significant. When GDP growth accelerates, most governments in South Asia also tend to spend more. The cyclical components of public spending and GDP move strongly together in Bhutan, Nepal, Bangladesh, and Pakistan. Analyzing the correlation between growth rates, rather than cyclical components, yields similar results. But

38 38 Budget Crunch Box 3: A statistical budget crunch Short-term tax buoyancy and spending cyclicality can be assessed by regressing the growth rate of tax revenues or government expenditure on the growth rate of GDP (Lane 23): In this expression, indicates the change between two consecutive years, X it is the tax revenue or the government expenditure of country i in year t, a i is the change when growth remains on trend, and is the estimated short-term tax buoyancy or spending cyclicality. Rather than estimating this expression for every country separately, we construct a data panel for all South Asian countries and allow for the trend change a i to vary across countries (we do this by using fixed effects in the estimation). Where necessary, the estimated models include a correction for first-order serial correlation in the error term. The simple expression above concerns the short-term, not taking into consideration the possible long-run relationship between the two variables. If a cointegration relationship exists between the change in X it and the change in GDP it, the estimation of this expression yields distorted results. To address this concern, we also employ an error-correction model, which allows a distinction between the short- and long-term relationships between fiscal variables and output. The panel error-correction model with fixed effects is estimated in the following form (Akitoby et al. 26; Belinga et al. 214): where θ refers to the short-run effect, b to the long-term relationship between the variables, and g represents the rate of adjustment to the gap between the actual level of the fiscal variable considered and the level predicted by the long-term relationship. To estimate fiscal multipliers, we use a three-dimensional panel vector auto-regression (VAR) model with fixed effects. The model includes the first differences of the logarithmic values of real government expenditure ( g it ), GDP ( y it ), and tax revenues ( t it ). This specification turns out to be proper, given that all the variables are unit-root processes and the hypothesis of panel cointegration between them is rejected. The estimated model has the following reduced-form: where ( Z it ) and are matrices of the VAR model parameters. We estimate the model with the optimal lag length determined in accordance with standard information criteria. After ensuring the stability of the model, structural shocks are identified following broadly the identification approach proposed Blanchard and Perotti (22). The approach relies on the assumption that governments cannot change expenditures in reaction to changes in economic growth and tax revenue within the same period. Economic growth, on the other hand, is affected by changes in government expenditure and taxes contemporaneously. Originally, this approach was applied to advanced economies with quarterly data. Due to limited data availability, we implement it here with annual data. Stronger assumptions are needed for the results to be valid in this case (Beetsma et al. 214). But it can be argued that the approach is justified, because lags in implementing fiscal policies are longer in developing countries (Diop and Ben Abdallah 29). The contemporaneous effect of changes in economic activity on tax revenues (tax elasticity) is not estimated but is instead added exogenously from other empirical estimations. We use a tax elasticity of one, but results are robust to slightly smaller and larger elasticities. The estimation of the structural VAR model provides impulse response functions and consequently the values of fiscal multipliers. We rely mostly on World Bank data for the estimations. This is the case for GDP data for all the countries and for most of the tax revenue data. For some countries, ADB tax data goes back in time longer than World Bank data. When the correlation of the two series is very high, we use ADB tax data to extend the World Bank series backwards. For India, we compute consolidated tax revenue from IMF and Reserve Bank of India data and for Bangladesh we rely on tax revenue information from the ADB. Data on government expenditure is from the IMF. The breakdown for capital and current expenditure is from the ADB. by this metric Pakistan s government spending is the most procyclical in the region. A further refinement is to break down public spending into recurrent expenditures and capital expenditures. Results are similar for both components across most countries, but capital spending is much more procyclical than current spending in Pakistan. Except for Sri Lanka, the procyclicality of public spending has increased since 28 across South Asia. For the region as a whole, tax revenue increases proportionally with economic activity, but public spending increases more than proportionally. Statistically, a one

39 Budget Crunch 39 Table 2: Tax buoyancy is around one, but spending is strongly procyclical. South Asia Observations Simple regression Error correction model Short-term tax buoyancy *** 1.6*** Spending cylicality *** 1.28** Note: Panel regression models with fixed effects are estimated using the annual data from 199 to 217 for six South Asian countries - Bangladesh, Bhutan, India, Nepal, Pakistan, and Sri Lanka. Three stars mean significant at the 1 percent level, two starts at the five percent level. Sources: ADB, IMF, World Bank, and staff calculations. Figure 37: The tax multiplier is negative but insignificant Impulse response to an unexpected one USD increase in tax revenues Note: Unbalanced panel VAR model with four lags and fixed effects is estimated using the annual data from 1987 to 217 for six South Asian countries - Bangladesh, Bhutan, India, Nepal, Pakistan, and Sri Lanka. Sources: ADB, IMF, World Bank, and staff calculations. Figure 38: while the expenditure multiplier is positive and significant. Impulse response to an unexpected one USD increase in government expenditure Note: Unbalanced panel VAR model with four lags and fixed effects is estimated using the annual data from 1987 to 217 for six South Asian countries - Bangladesh, Bhutan, India, Nepal, Pakistan, and Sri Lanka. Sources: ADB, IMF, World Bank, and staff calculations. percent increase in GDP growth translates into a one percent increase in tax revenue. In economic parlance, tax buoyancy is around one. However, for every additional percentage point of growth, public spending increases by 1.3 percentage points. Such a more-than-proportionate increase in expenditures is referred to as a voracity effect. Considering the inverse relationship, from fiscal variables to economic activity, the tax multiplier in South Asia is insignificant but the expenditure multiplier is large. In a panel of six South Asian countries, an additional USD in tax revenue for the government, reduces growth initially by.3 USD. The largest negative effect is

40 4 SOUTH ASIA ECONOMIC FOCUS FALL 218 Budget Crunch Figure 39: The expenditure multiplier is driven by public investment. Current and capital expenditure multipliers Impact Peak Cumulative (4 years) Current expenditure Capital expenditure Note: Both models are balanced panel VAR models with variables current and capital expenditure respectively, instead of the total expenditure. The model with 3 lags is estimated using the annual data from 199 to 217 for six South Asian countries - Bangladesh, Bhutan, India, Nepal, Pakistan, and Sri Lanka. Sources: ADB, IMF, World Bank, and staff calculations. found after four years, before the effect recedes again. After seven years, the cumulative effect on growth is minimal and not significant. The effect of public spending on economic activity, on the other hand, is positive and significant. An additional USD of government spending leads to an immediate increase in GDP of.3 USD. Over time, the effect builds-up and each USD of additional spending results in.7 USD additional GDP in the third year. In the long-run, the cumulative effect settles at.6 USD. The expenditure multiplier is statistically significant at the five percent level in all years. The positive impact of public spending on economic activity comes entirely from capital expenditures. The expenditure multiplier of current government spending is very small and not statistically significant. The expenditure multiplier of public investment, on the other hand, is very large and always statistically significant. On impact, an additional USD of capital expenditure by the government results in an increase of GDP by.6 USD. Over time, additional benefits drive up the cumulative effect close to 1 USD. The statistical estimates of the relationship between fiscal variables and growth coincide with the views of regional experts. Among the respondents to the survey conducted for this report, only around 2 percent expect an additional USD of public spending to have a negative impact on economic activity, or no impact at all. Around 4 percent expect a positive impact, but smaller than.3 USD. In line with the estimation results, a quarter expects an effect between.3 USD and 1 USD and a few expect an even stronger effect. Three quarters of the respondents expect capital expenditure multipliers to be larger than current account multipliers. Procyclical public spending and a positive expenditure multiplier imply that fiscal policy in South Asia amplifies boom-and-bust cycles. When growth accelerates, both tax revenue and government spending increase, but spending increases more strongly than revenue. The impact of larger tax revenue on subsequent economic activity is not significant but that of larger public spending is, which further accelerates economic growth. And the reverse is true in economic downturns, with the deceleration of economic activity being amplified by fiscal policy. The analyses above, on a country-by-country basis, suggest that the amplification of boom-and-bust cycles may be severe in Pakistan and Bangladesh, and sizeable in Bhutan and Sri Lanka. A build-up of liabilities Public debt levels are low in some South Asian countries, but remarkably high in others. Public debt in South Asia is projected to be above 55 percent of GDP this year. This average figure masks a strong heterogeneity within the region. With 7 percent of GDP, debt is extremely low in Afghanistan, where the vast majority of foreign aid is provided on grant terms. At the other end, public debt stands at very high 94 percent of GDP in Bhutan, but it is mostly driven by borrowing for commercially viable hydropower projects whose returns will bring the debt level down strongly over the next years. The debt levels of other countries lie somewhere

41 Budget Crunch 41 Figure 4: Regional experts report that there is both tax buoyancy and procyclical spending How do the following fiscal variables react to a change in economic growth in your country? Distribution of responses Tax revenue Current public spending Capital public spending Opposite direction Stays the same Same direction Source: South Asia Economic Policy Network. Survey conducted for this report. Figure 41:... they believe that the expenditure multiplier is substantial If public expenditure in your country grows by one USD, by how much do you think output changes? Number of responses Output decreases Output growth is negligible Output grows but by less than.3 USD Output grows between.3 and 1 USD Output grows by more than 1 USD Source: South Asia Economic Policy Network. Survey conducted for this report. Figure 42:... and they attribute the multiplier effect entirely to capital expenditures. What kind of spending has a larger effect on output? Number of responses Capital expenditure Current expenditure Both the same Source: South Asia Economic Policy Network. Survey conducted for this report. in between these extremes. In Nepal and Bangladesh, debt is relatively low, at 23 percent of GDP and 31 percent of GDP respectively. In the Maldives and India, debt is around 65 percent of GDP. In Pakistan it reaches 74 percent of GDP and in Sri Lanka it is close to 8 percent of GDP. These debt levels are high in international perspective. Debt sustainability requires prudent borrowing and smaller fiscal deficits. Debt sustainability analysis jointly conducted by the World Bank and the IMF project that the public debt of most South Asian countries measured as a fraction of GDP will decline in the coming years. In Sri Lanka, for example, public debt is expected to fall by nearly ten percentage points by 222. In

42 42 Budget Crunch Box 4: Research on spending procyclicality and multiplier effect in South Asia A vast empirical literature suggests that developing countries tend to follow procyclical fiscal policy: they increase spending (or curb taxes) in good times and cut spending (or raise taxes) during periods of recession (Gavin and Perotti 1997; Kaminsky, Reinhart and Végh 24; Frankel, Végh and Vuletin 213). Procyclical fiscal policy reinforces business cycles by exacerbating booms and aggravating busts. The procyclical bias in fiscal policy is arguably a reflection of two fundamental challenges faced by developing countries. These are the inability to access external finance timely and weak institutions that cannot contain overspending when growth is high. Hussain and Siddiqi (213) analyze the cyclicality of government expenditure in six South Asian countries using data from 198 to 21. While they find evidence that fiscal policy was procyclical in these countries, they find no evidence that the strength or quality of political systems or institutions affects this outcome. Zakaria and Junyang (215) discuss the cyclical properties of fiscal policy in seven South Asian economies and explore the factors responsible for fiscal cyclicality. They find strong procyclicality of government expenditure and argue that limited access to domestic and international borrowing, as well as a wider dispersion of political power, are factors contributing to procyclicality. The empirical evidence on the size of multipliers in developing countries is relatively scarce, but it suggests that multipliers are quite small. Using a Panel VAR model and quarterly data for 44 developing countries, Ilzezki, Mendoza and Végh (212) argue that the government spending multiplier is around.3. They find that multipliers tend to be larger in advanced economies, in countries with fixed exchange rates, in more closed economies, and in economies with lower levels of public debt. Similarly, Huidrom et al. (216), using an Interactive Panel VAR model and a large sample of advanced economies and developing countries, conclude that fiscal multipliers depend on fiscal positions. They find that multipliers tend to be larger when government debt and deficits are low. Using a large sample of developing countries, Kraay (212, 214) obtains an average government spending multiplier somewhere between.4 and.5. Hayat and Qadeer (216) estimate fiscal multipliers for Bangladesh, India, Pakistan and Sri Lanka over the period using a Panel VAR model. They find an initial impact close to.4 and a surprisingly large long-run effect. Tax multipliers, on the other hand, are statistically insignificant. Yadav et al. (212) estimate the impact of fiscal shocks on the Indian economy using quarterly data from 1997 Q1 to 29 Q2. They find that, on impact, unexpected changes in tax revenue have a much larger effect on GDP than unexpected changes in government spending. Jain and Kumar (213) estimate the size of the expenditure multiplier in India at the center and state levels using annual data for the period from 198 to 211. The size of the multiplier for all categories of expenditure by state governments is estimated to be larger than that of the central government. Furthermore, capital spending has a higher multiplier than current spending. Depending on the model specification, the aggregate tax multiplier is found to be between.1 to.5, lower than the expenditure multiplier. Finally, Bose and Bhanumurthy (215) present a structural macroeconomic model for the estimation of fiscal multipliers in India. Based on annual data from 1991 to 212, they find a large capital expenditure multiplier of 2.5, a transfer payment and current spending multiplier of 1, and a tax multiplier of -1. India, public debt is expected to decline to 63 percent by 223. Only in Bangladesh and Maldives is the debt ratio projected to increase, but the anticipated increases are small. And without exception, the primary balance (the fiscal balance without counting interest payments) is projected to be more favorable than it is today. Debt sustainability is thus closely associated with smaller budget deficits. Some countries face substantial repayments of obligations in the coming years, and currency depreciation will increase debt service payments associated with foreign debt. In Maldives, rising debt levels are reflecting the large infrastructure investments of recent years. These investments were aimed at facilitating population consolidation around the main island and at developing the airport. Major creditors of Maldives include China, Saudi Arabia, Abu Dhabi, and the OPEC Fund. Total external disbursements to service these debts are estimated to be USD 1.4 billion until 221. In Pakistan, external financing needs reached USD 21.5 billion in FY 216/17, or 7.1 percent of GDP. They are expected to increase further over the next few years, partly due to loan repayments and profit repatriation related to projects in the China-Pakistan Economic Corridor (CPEC). In Sri Lanka, more than half of the central government s external debt stock is denominated in USD, making Sri Lanka especially vulnerable. Financing needs are projected to be around 18.6 percent of GDP in 218 and substantial international bond repayments will fall due over the coming years. In addition to explicit public debt, the growth of hidden liabilities is an important concern. Hidden liabilities are

43 Budget Crunch 43 Figure 43: Public debt is reaching high levels in some countries. Government debt forcasts for 218 in South Asia Percent of GDP Bhutan (FY) Sri Lanka (CY) Pakistan (FY) India (FY) Maldives (CY) Bangladesh (FY) Nepal (FY) Afghanistan (CY) Source: World Bank. Table 3: Debt sustainability requires prudent borrowing. Country First-year Last-year First-year government debt (percent of GDP) Last-year government debt (percent of GDP) First-year primary balance (percent of GDP) Last-year primary balance (percent of GDP) Annual debt space (percent) Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka Note: Initial projection years range from fiscal years 216/17 or 217/18, depending on available DSAs. Space refers to the annual increase in nominal debt over the next four/five projection years under the baseline scenario as a share of first-year GDP. Sources: World Bank-IMF debt sustainability analysis (DSA) and staff calculations. obligations that may end up in the government s books not due to a deliberate borrowing decision, but rather because of a default on debt obligations outside of the government. Important sources of hidden liabilities include borrowing by state-owned enterprises and the failure of infrastructure projects involving the private sector. In South Asia, one of the main sources of hidden liabilities is the circular debt of distribution companies in the power sector. Other unplanned government obligations arise from overly optimistic or poorly designed Public-Private-Partnerships. Liabilities can also be hidden in the banking sector in the form of non-performing loans. The recapitalization of banks in India, for example, was already accompanied by considerable capital infusions by the Indian government. A fiscal reading of development challenges The nature of fiscal issues in South Asia is intrinsically linked to the development challenges the countries in the region face. Not all the fiscal patterns described above are present in all countries in the region. Nevertheless, these patterns combine into a distinctive set of fiscal issues in each case. And these fiscal issues are very telling about the constraints each of the countries faces in its quest for greater prosperity. Afghanistan. Foreign aid, aimed at increasing security and fostering development, is very large relative to the size of the economy. Security spending is huge, and despite great efforts a large fraction of

44 44 Budget Crunch Figure 44: In Afghanistan, the level of aid-dependence is unsustainable in the long run. External/core budget and domestic revenue in Afghanistan Percent of GDP Domestic revenue Aid on-budget Aid off-budget Source: Islamic Republic of Afghanistan National Statistics and Information Authority. Figure 45: In Bangladesh, the cost of energy is increasing while electricity demand is surging. Wholesale subsidies in Bangladesh Tk/kWh /1 21/11 211/12 212/13 213/14 214/15 215/16 Wholesale purchase costs Price paid by distributors Source: International Energy Agency. aid remains off-budget. There is a limit to how much domestic revenue can increase and there is also a limit to how much more aid donors will be willing to provide in the future. Hence, without peace bringing down security spending substantially, the fiscal situation of Afghanistan could become unsustainable. Bangladesh. The energy mix is becoming increasingly expensive, at a time when the demand for electricity is surging. Distortions in the natural gas sector are getting on the way of further exploration and exploitation and are leading to a growing reliance on more expensive fuels. Generation costs are amplified by a dispatch that does not follow merit order and by poorly designed contracts with private electricity generating companies. Passing on the high costs to consumers is politically difficult, which results in a growing subsidy burden for the budget. Bhutan. Exports of electricity from large hydropower projects are an important source of government revenue, but they are lumpy. When Tala, a large dam,

45 Budget Crunch 45 Figure 46: In Bhutan, revenue from hydropower exports is lumpy and creates instability. Domestic revenue and total expenditure in Bhutan Percent of GDP 45 Tala Percent of GDP /6 26/7 27/8 28/9 29/1 21/11 211/12 212/13 213/14 214/15 215/16 216/17 217/18 Rupee crisis Total expenditure less energy capital spending Non-tax revenue (rhs) Note: Vertical line refers to the Tala hydropower plant getting commissioned. Source: Ministry of Finance of Bhutan. Figure 47: In India, competitive federalism requires strong discipline in the states. Fiscal deficit and resource transfer in India Percent of total reciepts 6 Percent of GDP /12 212/13 213/14 214/15 215/16 216/17 217/18 Resource transfer from center to states Fiscal deficit of center (rhs) Fiscal deficit of states (rhs) Source: Reserve Bank of India. became operational in FY 26/7, non-tax revenue surged, which created strong pressure for larger current public spending. Higher government spending fueled domestic demand and imports of consumer goods, leading to the so-called Rupee crisis a couple of years later. Without a mechanism to smooth out public spending, similar turbulence could arise as other large dams start operation. India. In the drive towards competitive federalism, spending decisions by state governments have become increasingly important. But fiscal discipline is stronger at the center than it is in the states. The fiscal deficit of the center decreased from 3.9 percent of GDP in FY 215/16 to 3.5 percent in FY 216/17 and FY 217/18, while that of the states increased for four consecutive years to 3.5 percent in FY 216/17 before moderating to 3.1 percent last fiscal year. In addition, states could be a source of contingent liabilities, for example due to borrowing by unreformed utilities and due to waivers of bank debts for specific groups.

46 46 Budget Crunch Figure 48: In Maldives, service delivery is costly but bringing it down is expensive too. General government expenditure Percent of GDP 7 6 Predicted given GDP per capita, population, and being an archipelago 5 4 Maldives 3 2 Predicted given GDP per capita only GDP per capita (in logs, PPP adjusted) Note: All data is for 216. Sources: IMF and World Bank, and staff calculations. Figure 49: In Nepal, decentralization may make budget execution even more challenging. Actual expenditure relative to budget in Nepal Percent /9 29/1 21/11 211/12 212/13 213/14 214/15 215/16 216/17 Current expenditure Capital expenditure Sources: Ministry of Finance of Nepal, Finance General and Comptroller Office, and staff calculations. Maldives. Providing universal public services is costly when the population is scattered among remote islands with a few thousand inhabitants each. From that perspective, consolidating the population around the capital city could reduce public spending in the long run. It could also contribute to job creation and thus increase government revenue. But population consolidation requires huge infrastructure investments, hence large borrowing, in the short term. Managing this borrowing in a way that does not compromise debt sustainability will be challenging. Nepal. Low capacity even at the federal government level prevents full spending of the budget, especially of the capital budget. In 216/17, for example, current spending was 16 percent lower than budgeted and capital spending was 33 percent lower than budgeted. Capacity is even lower in the provinces and local

47 Budget Crunch 47 Figure 5: In Pakistan, a procyclical budget deficit reinforces the boom-and-bust. GDP growth and fiscal deficit in Pakistan Percent 1 Percent of GDP /1 22/3 24/5 26/7 28/9 21/11 212/13 214/15 216/17 Procyclical fiscal policy GDP growth Fiscal balance (rhs) -1 Note: Grey shaded areas indicate years when the fiscal deficit widens as GDP growth accelerates, or narrows down as GDP growth decelerates. Source: World Bank. Figure 51: In Sri Lanka, population aging will put pressure on public spending. Population 6 years and above and tax revenue in Sri Lanka Percent of GDP Percent of total Tax revenue Population 6 years and above (rhs) Sources: UN Population Database and World Bank governments. The welcome move to fiscal federalism may hence result in even stronger underspending and could end up affecting the delivery of public services in a country that really needs them. Pakistan. The recent economic history of Pakistan is one of slow growth punctuated by recurrent macroeconomic adjustments, often supported by International Monetary Fund programs. Adjustment programs brought in macroeconomic stability, but often at the cost of a temporary (and often substantial) deceleration in economic activity. And once the economy was back on track, fiscal pressures mounted again, triggering the next boom-and-bust cycle. Fiscal policy has thus amplified macroeconomic fluctuations. Sri Lanka. Population aging could make the country s generous social programs unaffordable in a not-so-distant future. Sri Lanka is the only aging society in South Asia. With older populations come higher health care costs and larger spending on public pensions. Furthermore, much job creation has been in the public sector, which puts additional pressure on expenditures. Sri Lanka thus needs to keep social programs affordable. It also needs to increase tax revenues, which until recently were steadily declining relative to GDP.

48 48 Budget Crunch Summing up The region s fiscal patterns affect countries differently, but all of them face fiscal challenges. The precise nature of these challenges is related to deeper development issues that are specific to each country. But all of them face at least one of the three fiscal patterns identified, namely limited room for maneuver, the amplification of boom-and-bust cycles and the build-up of liabilities. Some of them face two of these patterns, and all three are present in Pakistan s case. The most important reason for limited room to maneuver across the region is low revenue generation, but in some countries inadequate spending is a concern too. This challenge is shared among most countries in the region and the only exceptions may be India and Bhutan. The amplification of boom-and-bust cycles is caused by procyclical public spending which is strong in Bangladesh, Bhutan, Nepal, and Pakistan. The build-up of liabilities is a concern across South Asia but especially in India, the Maldives, Pakistan, and Sri Lanka. South Asian experts see limited room for maneuver as the biggest fiscal challenge faced by the region. In the survey conducted for this report, members of the South Asia Economic Policy Network were asked whether the fiscal patterns identified for the region as a whole were relevant in their own countries. More than 6 percent of respondents, and nearly all respondents from Pakistan and Bangladesh, saw low revenue generation as a major issue in their countries. Around a third considered that inadequate spending was a major challenge, and Table 4: The region s fiscal patterns affect countries differently. Country Afghanistan Limited room for maneuver Fiscal patterns Amplification of boom-and-bust cycles Bangladesh Bhutan India A build-up of liabilities Maldives another third was somewhat concerned about it. A majority saw the procyclicality of spending as somewhat of a challenge, but less than a quarter answered that it matters a lot. Not surprisingly, respondents from Pakistan are the most concerned about the procyclicality of public spending. Responses were similar, if somewhat weaker, for the build-up of liabilities. Nepal Pakistan Sri Lanka Figure 52: Limited room for maneuver is seen as South Asia s biggest fiscal challenge. Do you think your country faces the following challenges? Distribution of responses Limited room for maneuver Low revenue generation Inadequate spending Amplification of boom-and-bust cycles Procyclicality of public spending A build-up of liabilities Liability build up A lot Somewhat No Source: South Asia Economic Policy Network. Survey conducted for this report.

49 Budget Crunch 49 References Akitoby, B., Clements, B., Gupta, S. and Inchauste, G. (26). Public spending, voracity, and Wagner s law in developing countries. European Journal of Political Economy, 22(4), Belinga, V., Benedek, M.D., de Mooij, R.A. and Norregaard, M.J. (214). Tax buoyancy in OECD countries (No ). International Monetary Fund Working Paper. Beetsma, R., Giuliodori, M. and Klaassen, F. (28). The effects of public spending shocks on trade balances and budget deficits in the European Union. Journal of the European Economic Association, 6(2-3), Blanchard, O. and Perotti, R. (22). An empirical characterization of the dynamic effects of changes in government spending and taxes on output. Quarterly Journal of Economics, 117(4), Diop, N., and Ben Abdallah, N. (29). The dynamic effects of countercyclical fiscal stimulus on output in Tunisia (587). World Bank Policy Research Working Paper 587. Lane, P. R. (23). The cyclical behaviour of fiscal policy: evidence from the OECD. Journal of Public Economics, 87(12), Bose, S., and Bhanumurthy, N. R. (215). Fiscal multipliers for India. Margin: The Journal of Applied Economic Research, 9(4), Frankel, J. A., Vegh, C. A., and Vuletin, G. (213). On graduation from fiscal procyclicality. Journal of Development Economics, 1(1), Gavin, M., and Perotti, R. (1997). Fiscal policy in Latin America. NBER Macroeconomics Annual, 12, Hayat, M. A., and Qadeer, H. (216). Size and impact of fiscal multipliers: an analysis of selected South Asian countries. Pakistan Economic and Social Review, 54(2), 25. Huidrom, R., Kose, M. A., Lim, J. J., and Ohnsorge, F. L. (216). Do fiscal multipliers depend on fiscal positions?. World Bank Policy Research Working Paper Hussain, T., and Siddiqi, M. W. (213). Fiscal policy, institutions and governance in selected South Asian countries. Pakistan Journal of Commerce & Social Sciences, 7(2). Ilzetzki, E., Mendoza, E. G., and Végh, C. A. (213). How big (small?) are fiscal multipliers?. Journal of Monetary Economics, 6(2), Jain, R., and Kumar, P. (213). Size of government expenditure multipliers in India: a structural VAR analysis. Reserve Bank of India Working Paper Series, 7. Kaminsky, G., Reinhart, C., and Végh, C. (24). When it rains, it pours: procyclical macropolicies and capital flows. NBER Macroeconomics Annual, 24, Kraay, A. (212). How large is the government spending multiplier? Evidence from World Bank lending. The Quarterly Journal of Economics, 127(2), Kraay, A. (214). Government spending multipliers in developing countries: evidence from lending by official creditors. American Economic Journal: Macroeconomics, 6(4), Yadav, S., Upadhyay, V., and Sharma, S. (212). Impact of fiscal policy shocks on the Indian economy. Margin: The Journal of Applied Economic Research, 6(4), Zakaria, M., and Junyang, X. (215). The cyclicality of fiscal policy in South Asia. Argumenta Oeconomica, (1 (34)), 33-6.

50 5 SOUTH ASIA ECONOMIC FOCUS FALL 218 Budget Crunch Box 5 Views from the region on fiscal policy In preparation for a new edition of this report, we convene a technical workshop with experts from the region. This time a two-day Regional Workshop on Fiscal Policy in South Asia was held in Kathmandu, Nepal. Following a broadly disseminated call for papers, this event brought together researchers and practitioners from most countries across the region. Over 6 papers were submitted, and ten of them were selected for discussion at the workshop. The selection process was run by experts from the South Asia Network on Economic Modelling (SANEM, Bangladesh), the National Institute for Public Finance and Policy (NIPFP, India), the Sustainable Development Policy Institute (SDPI, Pakistan), and the Institute of Policy Studies (IPS, Sri Lanka). The discussants of the papers included authors of related papers participating in the workshop, as well as economists from the ADB, IMF, and the World Bank. Prof. Ila Patnaik (NIPFP), a renowned expert on fiscal policy in South Asia, delivered a special lecture on fiscal cyclicality. She discussed the role of business cycles and how to measure them in emerging markets, before analyzing the procyclicality of public spending in South Asia. She argued that the high costs of postponing public spending may potentially be a defensible justification for the procyclicality of fiscal policy in developing countries. Some of the papers focused on the impacts of public spending on economic and social outcomes. Priyatharsiny Selvarasa and Sangaran Vijesandiran (both with the University of Peradeniya, Sri Lanka) analyzed the relationship between fiscal policies and social indicators. They did so by assessing the impact of public spending and taxation on the provision of infrastructure, education, and health services in Sri Lanka. Impacts of public spending on economic activity deserved special attention. Pawan Gopalakrishnan (Reserve Bank of India), Chetan Ghate (Indian Statistical Institute), Chetan Dave (New York University) and Suchismita Tarafdar (Shiv Nadar University, India) evaluated the consequences of fiscal shocks for growth using a real business cycle model of a small open economy calibrated for India. They concluded that when tax rates on capital and labor income are low, a contractionary fiscal shock has an expansionary effect on GDP. Not surprisingly, this finding was intensely debated. In a less controversial way, Iffat Anjum and Selim Raihan (both with SANEM, Bangladesh) concluded that fiscal policy has been effective in stimulating economic growth. In their paper they establish that there is bi-directional causality between economic growth and government consumption in Bangladesh. A similar relationship is found with tax revenue. Other papers dealt with the reasons for low tax revenue generation in South Asia. Vaqar Ahmed and Ahad Nazir (both with SDPI, Pakistan) identified the fragmented structure of revenue mobilization and weak capacity in the provinces as key reasons in Pakistan s case. They presented a public-private dialogue approach that in their view has helped push tax reform on the country s political agenda. In India, the newly adopted GST broadens the tax base, harmonizes tax rates across states, and encourages formalization, but this is not without implementation costs. Bornali Bhandari (National Council of Applied Economic Research, India) and Astha Sen (Sonoma State University, USA) used detailed taxpayer surveys to gauge these costs, finding that they were high in the initial phases but decline later. According to the surveys, GST led to reduced corruption due to the digitization of the reporting system. In some South Asian countries state-owned enterprises and public utilities can indirectly affect fiscal discipline. Priti Dubey and Rishika Shankar (both with University of Delhi, India) point out that the poor performance of Central Public-Sector

51 Budget Crunch 51 Enterprises in India can lead to a build-up of contingent liabilities and may cause a drain on public resources if they are bailed out at the expense of taxpayers. The discussion centered on the interpretation of aggregate data, and the insights detailed enterprise data can provide. Monzur Hossain, Mahbubur Rahman and Atiqur Rahman (all from Bangladesh Institute for Development Studies) used a large macro-econometric model to analyze the consequences of energy price adjustments in Bangladesh. The results suggest that price increases are inflationary and cause a decline in GDP growth. There was debate on whether a model with microeconomic foundations, with firms and consumers changing their behavior after the adjustment, would yield the same conclusion. Due to their large fiscal deficits over time, many countries in South Asia have high levels of public debt. Sima Rani Dey and Mohammed Tareque (both with the Bangladesh Institute of Governance and Management) argued that the accumulation of external debt has a negative effect on GDP growth, but that better macroeconomic policies can neutralize this effect. Ranjan Kumar Mohanty (NIPFP, India) and Sidheshwar Panda (Indian Institute for Technology) reached a similar conclusion. The workshop concluded with a public session graced by a keynote speech by Nepal s Finance Minister, Dr. Yuba Raj Khatiwada. Minister Khatiwada offered a thorough review of the challenges posed by the transition to federalism in his Nepal and explained the steps the government is taking to address them. His talk was followed by a panel discussion attended by over one hundred guests, including representatives from think tanks, donors, civil society and the media. Papers presented Ahad Nazir (SDPI, Pakistan) and Vaqar Ahmed (SDPI, Pakistan): National and Sub-National Tax Reforms in Pakistan: A Public- Private Dialogue (PPD) Approach. Astha Sen (Sonoma State University, USA) and Bornali Bhandari (NCAER, India): Lost in Transition? Case Studies Based Approach of Firm s Compliance cost of India s GST. Iffat Anjum (SANEM, Bangladesh) and Selim Raihan (SANEM, Bangladesh): The effectiveness of fiscal policy in stimulating private investment and growth: An Empirical Study on Bangladesh. Monzur Hossain (BIDS, Dhaka), Mahbubur Rahman (BIDS, Dhaka) and Atiqur Rahman (BIDS, Dhaka): Impact of energy price adjustments on Bangladesh economy: A macro-econometric modeling approach. Pawan Gopalakrishnan (Reserve Bank of India), Chetan Ghate (ISI, Delhi), Chetan Dave (NYU, Abu Dhabi) and Suchismita Tarafdar (Shiv Nadar University, India): Fiscal austerity in emerging market economies. Ranjan Kumar Mohanty (NIPFP, India) and Sidheswar Panda (IIT, India): How Does Public Debt affect the Indian Macro-economy? A Structural VAR Approach. Rishika Shankar (University of Delhi, India) and Priti Dubey (University of Delhi, India): Loss making public sector undertakings and their impact on fiscal deficit. Sangaran Vijesandiran (University of Peredeniya, Sri Lanka) and Priyatharsiny Selvarasa (University of Peredeniya, Sri Lanka): An Empirical Analysis of the Impact of Fiscal Policy on Human Development in Sri Lanka. Sima Rani Dey (Bangladesh Institute of Governance and Management) and Mohammed Tareque (Bangladesh Institute of Governance and Management): Debt and Growth: Role of Stable Macroeconomic Policy.

52 52 SOUTH ASIA ECONOMIC FOCUS FALL 218 South Asia country briefs

53 Afghanistan 54 Bangladesh 56 Bhutan 59 India 61 Maldives 63 Nepal 65 Pakistan 67 Sri Lanka 69 CRS PHOTO / Shutterstock.com

54 54 Country briefs Afghanistan Although economic activity remains subdued, growth has accelerated gradually over 216 and 217 reflecting slowly recovering confidence and reform progress. Building momentum now appears to be at some risk, with declining business confidence in the context of upcoming parliamentary and presidential elections (scheduled for October 218 and April 219, respectively), worsening drought conditions, and an ongoing displacement crisis. Over the medium-term, Afghanistan needs to mobilize new sources of growth in the context of declining aid and stubbornly-high poverty. 217 Population, million 35.5 GDP, current USD billion 19.6 GDP per capita, current USD 55 Source: World Bank. Contributions to real GDP growth Percentage points (f) 219 (f) 22 (f) 221 (f) Note: (f) = forecast. Afghanistan s fiscal year is the calendar year. Source: World Bank. Agriculture Industry Services Real GDP growth (percent) Recent economic developments Afghanistan has experienced a slight recovery in growth since 215, with growth accelerating slightly to 2.3 percent in 216 and reaching 2.7 percent in 217. Growth in 217 was driven mostly by the services sector, which expanded by 2.6 percent in the context of recovering confidence and investment. The agricultural sector grew by 3.8 percent, with strong growth in fruit and vegetables offsetting declining wheat production in the context of an ongoing drought impacting Northern and Eastern areas. Inflation remained moderate through 217 and has declined through 218. Period-average inflation for 217 was 4.7 percent, with declining domestic food prices (fruit and vegetables) and weakening prices for imported grains offsetting increased energy prices. Low inflation through 218 (reaching -1 percent y-o-y in June) has been driven by declining food prices, with strong local production of fruit and vegetables, and steady international grain prices. Exports grew strongly in 217 and into 218. In 217 exports were 28 percent higher than in 216, while Q1 218 exports were up nearly 5 percent on Q1 217 levels. Export growth has been driven by the establishment of new air corridors to India, the resolution of border issues that constrained trade with Pakistan during 216 and continued gradual depreciation of the Afghani relative to major trading currencies. Imports also increased, however, driven by higher energy prices and increased grain imports in the context of drought-related disruption to domestic wheat production. Consequently, the merchandise trade balance widened further, from 31.6 percent of GDP to 33.6 percent of GDP. The wide trade deficit is financed by aid inflows, and the current account remains in surplus (1.6 percent of GDP at end-217). Driven by the current account surplus, foreign exchange reserves continued to accumulate (8.2 USD billion at end-217, more than one year of merchandise import cover). The Afghani depreciated steadily by around 4 percent against the USD during 217 (end period) and into 218 (6 percent depreciation against the USD in the first half of 218), driven mostly by the general strengthening

55 Country briefs 55 of the USD but possibly reflecting capital flight in the context of election-related uncertainties. Revenues continued to grow strongly in 217, increasing by around 15 percent in nominal terms and exceeding budgeted levels by 5.5 percent, driven by administrative and compliance improvements. However, donor grants fell well short of budgeted levels, leading to a fiscal deficit of around.5 percent of GDP, even despite a 2.5 percentage decline in overall expenditure. Revenue growth has ceased in the first half of 218, reflecting slowing economic activity and potential deterioration in governance around upcoming elections. With the population growing faster than the economy, poverty has increased significantly. A quarter of the labor force is unemployed, and 8 percent of employment is vulnerable and insecure, comprising self- or own-account employment, day labor, or unpaid work. With almost half the population below the age of 15, each year, 483, to 6, Afghans enter the working age population, most with little education and few productive employment opportunities. The impact of slow growth on poverty and livelihoods is compounded by growing insecurity, internal displacement, refugee repatriation, and declining aid. In the past, there has been little relationship between economic growth and poverty. Economic growth in Afghanistan has translated to changes in welfare to the top 2 percent of the distribution, whose consumption has increased and fallen with GDP per capita. Outlook Recent recovery appears increasingly vulnerable. Growth is expected to slow to 2.4 percent in 218, in the context of election-related uncertainties and weak business confidence. Growth is expected to accelerate gradually to over 3 percent by 22, as confidence is projected to recover. In the context of gradually declining aid, the current account surplus is expected to narrow to.2 percent of GDP in 218 before moving into a slight deficit from 219 (1.2 percent of GDP) onwards. Foreign exchange reserves are expected to remain at comfortable levels, however, at around 11 months of import cover by 22, reflecting very large current reserves. Inflation is expected to remain moderate, with higher energy prices offset by low domestic fruit and vegetable prices. Drought is not expected to have a major impact on food prices given stable international grain prices. With flattening of recent revenue growth, a fiscal deficit of around.4 percent of GDP is expected in 218. Risks and challenges Afghanistan faces substantial risks in the short-term arising from the possibility of political instability and violence in the context of upcoming elections. The contested 214 presidential elections had a negative impact on confidence, investment, and governance, feeding into lower growth and revenues. A similarly disruptive election period could have a major negative impact on revenues, investment, and growth over 218, 219, and beyond. On the other hand, progress with a negotiated peace settlement with the Taliban could have a major positive impact on investment confidence, potentially spurring accelerated growth and improved government revenues. Over the medium-term, and in the context of expected declines in aid, economic development progress will depend on mobilizing the sectors with greatest capacity to support increased growth, job creation, exports, and government revenues. This is likely to require a balanced growth strategy, including increased investment in agricultural productivity (including through expanded irrigation), increased investment in human capital, and the realization of Afghanistan s substantial extractives potential. Afghanistan macroeconomic outlook (f) 219 (f) 22 (f) Real GDP growth, at constant market prices Real GDP growth, at constant factor prices Agriculture Industry Services Inflation (Consumer Price Index) Current account balance (percent of GDP) Financial and capital account (percent of GDP) Net foreign direct investment (percent of GDP) Fiscal balance (percent of GDP) Debt (percent of GDP) Primary balance (percent of GDP) Note: (f) = forecast. Source: World Bank.

56 56 Country briefs Bangladesh Strong growth, driven by consumption and public investment, is expected to continue to support poverty reduction. Macroeconomic stability is increasingly stressed by the widening current account deficit because of a surge in imports, and accelerating inflation. Downside risks include fiscal slippages, delays in banking reforms, loss of monetary policy predictability due to diminished central bank independence and weakening reform momentum in the run-up to the elections. 218 Population, million GDP, current USD billion GDP per capita, current USD 1653 Source: World Bank. Contributions to real GDP growth Percentage points Final consumption Gross fixed investment Net exports Statistical discrepancy Note: Bangladesh s fiscal year runs from July 1st to June 3th. Source: Bangladesh Bureau of Statistics and staff calculations. Real GDP growth (percent) Recent economic developments GDP growth in FY18 remained strong, underpinned by private consumption, public investment, and a recovery in ready-made garment exports. Remittances posted 17 percent increase after declining for two consecutive years. Capital machinery imports have been buoyant. Growth in agriculture was limited in the beginning of the year due to above-normal flooding, but harvests recovered subsequently. Real private investment flows increased by 9 percent over its level the previous year, notwithstanding cumbersome business regulations, substantial infrastructure deficits and mounting policy uncertainties. The competitiveness ranking improved marginally, but the Logistics Performance Index ranking slipped 13 places in 218 relative to 216. Progress in reducing poverty has been notable. However, recent GDP growth delivered less poverty reduction than in the past. Close to a million Rohingya people have crossed over into Bangladesh since August 217. Without aid, 76 percent of these displaced people would be unable to meet basic needs. The localized effects are estimated to have significantly reduced wages. Supply shocks accelerated food inflation from 6 percent in FY17 to 7.1 percent in FY18, pushing headline inflation to 5.8 percent in FY18, from 5.4 percent in FY17. Monetary growth has been below nominal GDP growth, contributing to a decline in non-food inflation. However, non-food inflation increased from its recent low of 3.5 percent in December to 4.9 percent (y-o-y) in June due to spillovers from higher commodity prices and exchange rate depreciation. Interest rates came under pressure as excess liquidity shrank due to credit growth exceeding deposit growth, tightening of the Advance-Deposit Ratio by Bangladesh Bank (BB) and high non-performing loans in the banking

57 Country briefs 57 system. In March, ceding to pressures from the Bankers Association of Bangladesh, BB reduced the Cash Reserve Ratio from 6.5 percent to 5.5 percent; the repo rate from 6.75 percent to 6.25 percent; and increased the cap on government holding of deposits in private domestic banks from 25 percent to 5 percent. With the administered rates on the National Savings Certificates unchanged at double digit levels, the deposit and lending rates remained downwardly rigid. Subsequently, the government directed commercial banks to cap the deposit rates at 6 percent and the lending rates at 9 percent. The banks are yet to comply. These developments indicate that BB autonomy has substantially eroded. The overall balance of payments swung into the largest deficit in recent memory, driven by a surge in consumer and capital machinery imports. Despite a recovery in exports, the current account deficit jumped from.5 percent of GDP in FY17 to 3.5 percent in FY18, driven by 25.2 percent growth in merchandize imports. BB managed the resulting pressure on the exchange rate through a combination of direct sales of foreign exchange and directing foreign exchange dealers to keep their buying and selling rates stable. The nominal taka-us dollar rate depreciated by 1.8 percent in July-August 218 following 4 percent depreciation in FY18. Fiscal underperformance has continued. The fiscal outcomes in FY18 differed markedly from what was envisaged in the original budget. Underperformance in development spending relative to the original budget offset a revenue shortfall, thus containing the deficit at around 4 percent of GDP. Public debt increased modestly to 31.2 percent of GDP and continues at low risk of debt distress. Excessive reliance on the more expensive nonbank sources of domestic financing has continued. Consequently, interest expenditures remained high. Outlook Output growth in FY19 is projected at 7 percent, driven by industry and services on the supply side and private consumption and investment on the demand side. Public investment will remain strong as the implementation of mega projects gains further momentum. Private investment growth will remain subdued due to structural constraints. Continued strength in imports is projected to keep net exports negative despite healthy export growth. Increased investment in manufacturing will re-energize job creation and contribute further to poverty reduction. Inflation is projected to increase as global commodity prices pick up and an expansionary fiscal policy coupled with election-induced rise in private expenditures overheat the economy. Adherence to a tight monetary policy, announced in July, will help contain excess demand. The current account deficit is projected to narrow moderately due to sustained strong imports, owing partly to large import payments associated with foreign debt financed mega projects. The payment obligations will largely be funded by foreign debt accumulation. A large shortfall in government revenue is expected due to reduced taxes on garments and banks and lack of revenue enhancing administrative measures. Also, additional pressures on expenditures are likely due to expanded export subsidies after the budget was announced, as well as inadequate provisions for bank recapitalizations and spending associated with the Rohingya crisis. These together may widen the budget deficit. Risks and challenges With elections approaching, a major domestic risk is the weakening of ongoing efforts to improve economic governance. Donor fatigue in providing resources to meet the needs of the Rohingya could increase pressure on the budget, while the quasi-fiscal deficit could rise with increasing international oil prices. Unfavorable weather could further slow poverty reduction among households in agriculture. Rising food inflation may dampen gains made through increased investment in industry, while exacerbating the situation for food-deficit households in agriculture. However, export demand and remittances could surprise on the upside. External imbalances and tight liquidity need to be handled urgently. Exchange rate flexibility can help BB maintain sufficient foreign exchange reserves. Timely resolution of external imbalances will also contribute to expanding liquidity in the banking system. However, efforts to reduce interest rates without reducing the NSC rates may be futile. Allowing the BB to function independently, avoiding regulatory forbearance, and strengthening banking supervision is a high priority. The potential for export-led manufacturing growth remains significant as productivity levels lag the global technological frontier. Apart from structural reforms to foster diversification of the economy, this requires putting ever-increasing emphasis on education, skills, and adaptability to rapidly changing technology.

58 58 Country briefs Bangladesh macroeconomic outlook (f) 22 (f) Real GDP growth, at constant market prices Private consumption Government consumption Gross fixed capital investment Exports, goods and services Imports, goods and services Real GDP growth, at constant factor prices Agriculture Industry Services Inflation (Consumer Price Index) Current account balance (percent of GDP) Net foreign direct investment (percent of GDP) Fiscal balance (percent of GDP) 1/ Debt (percent of GDP) Primary balance (percent of GDP) 1/ Note: (f) = forecast; 1/ Including grants Source: World Bank.

59 Country briefs 59 Bhutan Delays in hydropower construction lowered Bhutan s growth rate in 217/18 and the trend is likely to persist over the medium term. The fiscal deficit is projected to decline because of lower public capital expenditures during the initial years of the 12th five-year plan (218-23). As hydropower projects contribute little to job creation, the direct impact of growth on poverty reduction is modest. 217 Population, million.8 GDP, current USD billion 2.7 GDP per capita, current USD 3276 Source: World Bank. Contributions to real GDP growth Percentage points /16 216/17 217/18 218/19 219/2 22/21 Agriculture Industry Services Real GDP growth (percent) Sources: National Statistics Bureau, Royal Monetary Authority, Ministry of Finance, World Bank, and staff calculations. Recent economic developments GDP growth in 217/18 is estimated at 5.8 percent. On the supply side, growth was driven by hydropower construction and the services sector (especially financial services, hotels and restaurants, and transportation). On the demand side, gross fixed capital formation, primarily in hydropower and government-financed infrastructure projects, supported output expansion. The Consumer Price Index remained under 3 percent in the first half of 218, mainly due to stable non-food prices, although the Ngultrum pegged to the Indian Rupee depreciated slightly against the USD. The financial sector remained sound with a risk-weighted capital adequacy ratio of 14.5 percent in March 218, above the minimum requirement of 12.5 percent. However, the gross non-performing loans (NPLs) increased to 14.6 percent in March 218, up from 12.4 percent a year earlier. NPLs are especially high in the services sector. To boost financial resources to strategic sectors such as cottage and small industries and agriculture, the central bank introduced the Priority Sector Lending program in early 218. High imports due to increased government spending as well as construction of hydropower projects kept current account deficit elevated at 21.7 percent of GDP in 217/18. The deficit was almost fully financed by loans from India. As a result, as of May 218, gross international reserves remained comfortable at 1.1 USD billion, equivalent to 11 months of imports of goods and services. To support the last year of implementation of the 11th FYP, government spending increased. The fiscal deficit was at 4.1 percent of GDP despite an increase in tax collections to 14.3 percent of GDP in 217/18 from 13.6 percent a year before. Public debt, including hydropower debt, remained at about 1 percent of GDP in 217/18.

60 6 SOUTH ASIA ECONOMIC FOCUS FALL 218 Country briefs Outlook Economic growth is projected to average 6 percent a year over the medium term, largely supported by on-going hydropower projects and the services sector, especially tourism. However, downside risks to growth remain, particularly from the delay in the completion of two mega hydropower projects. With the completion of the Mangdechhu hydro project in late 218, exports are likely to increase while imports will decline because of lower public capital spending. This will help narrow the current account deficit to 12 percent of GDP by 22/21 and reduce external debt to 87 percent. Lower capital spending during the first few years of the new 12th FYP is expected to bring the fiscal deficit to below 3 percent of GDP during the forecast period. As the hydropower projects contribute little to direct job creation, the impact of growth on poverty reduction is expected to be modest. Low-productivity agricultural activities still account for nearly 6 percent of employment and with limited private sector development, the transition out of farming into more productive jobs will likely happen at a slow pace. Risks and challenges There are four key risks facing the Bhutanese economy: (a) given the size of hydropower projects relative to the size of the economy, any further delays in hydropower construction will negatively affect the economy through lower exports and revenues; (b) donor financing in Bhutan is getting scarce while domestic debt markets are not yet developed (limited financing sources could constrain government spending and negatively affect future growth and development); (c) the ongoing 218 general election could lead to policy uncertainty which could impact growth and investment; and (d) adverse weather events could negatively impact the economy through lower electricity generation from existing hydropower plants and lower tourist traffic. Longer-term challenges center on boosting dynamism and job creation in the private sector. Bhutan macroeconomic outlook (e) 219 (f) 22 (f) Real GDP growth, at constant market prices Private consumption Government consumption Gross fixed capital investment Exports, goods and services Imports, goods and services Real GDP growth, at constant factor prices Agriculture Industry Services Inflation (Consumer Price Index) Current account balance (percent of GDP) Net foreign direct investment (percent of GDP) Fiscal balance (percent of GDP) Debt (percent of GDP) Primary balance (percent of GDP) Note: (e) = estimate; (f) = forecast. Source: World Bank.

61 Country briefs 61 India The economy appears to have recovered from the temporary disruptions caused by demonetization and the introduction of the GST: growth reached 6.7 percent in FY17/18, with a significant acceleration in recent months. However, domestic risks and a less benign external environment impact the macroeconomic outlook. 217 Population, million GDP, current USD billion 26.8 GDP per capita, current USD 1938 Source: World Bank. Contributions to real GDP growth Percentage points (e) Final consumption Gross fixed capital formation Net exports Other Real GDP growth (percent) Note: (e) = estimate; India s fiscal year runs from April 1st to March 31st. Source: Indian Central Statistics office and staff calculations. Recent economic developments The economy has recovered from the twin shocks of demonetization and GST introduction. GDP growth is estimated at 6.7 for FY17/18, with an acceleration to 7.4 percent in the second half. On the production side, the turnaround in the second half was led by manufacturing (that grew at 8.8 percent vs. 2.7 percent in the first half). Agriculture growth improved, and services growth held steady at 7.7 percent. On the demand side, the pick-up in growth was reflected in a sharp acceleration in gross fixed capital formation to 11.7 percent in the second half, from 3.4 percent in the first. Consumption, growing at 7 percent in the second half, remained the major driver of growth. Meanwhile, some inflationary pressures have emerged due to the convergence of price effects (higher oil prices and exchange rate depreciation) and growth dynamics (closing output gap). Inflation reached 4.2 percent in July 218, exceeding the central parity of 4 percent, though remaining within the policy band. As a result, RBI has raised policy rates twice by a cumulative 5 basis points since April 218 (from 6. percent to 6.5 percent). The external situation has become less favorable and the current account balance has deteriorated. A worsening trade deficit has led the current account deficit to widen (on the back of strong import demand, higher oil prices and exchange rate depreciation) from a benign.7 percent of GDP in FY16/17 to 1.9 percent in FY17/18. External headwinds - monetary policy normalization in the US coupled with recent stress in some EMDEs - have triggered portfolio outflows from April 218 onwards. As a result, the nominal exchange rate depreciated by about 12 percent from January to September 218, and foreign reserves declined by over 5 percent since March, while remaining comfortable at about 9 months of imports. Public finances have broadly remained on a gradual consolidation path. In FY17/18 the fiscal deficit of the central government remained at 3.5 percent (unchanged from FY16/17). At the sub-national level, the gross fiscal

62 62 Country briefs deficit of states declined from 3.5 to 3.1 percent of GDP (y-o-y), mostly on account of lower capital outlays (as a share of GDP). General government debt remained stable and sustainable at around 67 percent of GDP; however, questions remain as to the magnitude of contingent liabilities at the state level. Outlook Growth is projected to firm-up gradually over It is projected to rise to 7.3 percent in FY18/19, on the back of a recovery in investment and continued support from consumption. On the production side, industry is projected to make a more significant contribution. From FY19-2 onwards, growth is projected to rise further to 7.5 percent and possibly higher, in line with potential growth. India faces continued internal and external risks. High oil prices and an uncertain global trade environment may pose challenges for the current account. A widening trade deficit is likely to lead to a current account deficit of around 2.6 percent of GDP in FY18/19, and tighter global financing conditions will put added emphasis on India s ability to attract FDI. Fiscal consolidation is expected to resume in FY18/19, but slippages could happen on both the revenue side (as the GST is still stabilizing) and the expenditure side (ahead of state and federal elections). Elevated oil prices, a recent hike in agricultural support prices, and further exchange rate depreciation, could keep the inflation outlook challenging, possibly resulting in further monetary policy actions. Risks and challenges The higher degree of uncertainty in the global environment and remaining sources of domestic fragility imply that the risks to the outlook are tilted to the down side. This puts a premium on prudent macroeconomic management, including in containing spending pressures ahead of elections and continuing to address the twin balance sheet problems of banks and corporates. With little room for fiscal and monetary levers to support aggregate demand, structural reforms will determine the prospects of economic growth in the medium term; namely addressing bottlenecks to private credit growth and wider issues related to the banking sector, alleviating supply side bottlenecks, and adopting other competitiveness enhancing measures. Policies to improve competitiveness will also be needed to support export growth and address external imbalances. While the recent real depreciation of the Rupee helps ceteris paribus tightening global financing conditions can bring challenges in financing the current account deficit. Preventing fiscal slippage will be key to signal commitment to macroeconomic stability. Broad-based poverty reduction remains a big challenge. India needs to accelerate the responsiveness of poverty reduction to growth, including for presently excluded groups (such as women and scheduled tribes), and to extend gains to a broader range of human development outcomes, where it continues to rank poorly. The persistent negative impact of uneven monsoons on agricultural growth, amplified by low uptake of crop insurance, underlines the medium-term risk of climate change on the rural poor. India macroeconomic outlook (e) 219 (f) 22 (f) Real GDP growth, at constant market prices Private consumption Government consumption Gross fixed capital investment Exports, goods and services Imports, goods and services Real GDP growth, at constant factor prices Agriculture Industry Services Inflation (Consumer Price Index) Current account balance (percent of GDP) Net foreign direct investment (percent of GDP) Fiscal balance (percent of GDP) Debt (percent of GDP) Primary balance (percent of GDP) Note: (e) = estimate; (f) = forecast. Source: World Bank.

63 Country briefs 63 Maldives Growth is expected to continue to be driven by construction and tourism, supported by the opening of 13 new resorts in 217. Real GDP growth is expected at 8. percent in 218, and to gradually decline to 5.6 percent over the forecast period. Efforts to contain recurrent spending to accommodate the increase in capital spending have been effective, yet the level of public debt is projected to rise further, and foreign exchange reserves are low. 217 Population, million.4 GDP, current USD billion 4.7 GDP per capita, current USD 1675 Source: World Bank. Contributions to real GDP growth Percentage points Taxes less subsidies Construction Tourism Real GDP growth (percent) Transport Transport Other Note: Maldives fiscal year is the calendar year. Source: National Bureau of Statistics. Recent economic developments Real GDP grew by 7.1 percent in 217, on the back of strong performance of the tourism sector, an acceleration of construction, transportation and communication, and fisheries. These sectors contributed about 5 percentage points to headline growth (or over 7 percent). Preliminary estimates for 218 indicate that GDP growth accelerated to 12 percent (y-o-y) in the first quarter of 218 against 6 percent in Q1 217, driven by strong outings from tourism (4.1 percentage points), the construction sector (2.1 percentage points), trade (1.1 percentage points), and the transportation and communication (1.1 percentage points) sectors. Headline inflation averaged 2.8 percent in 217, driven by the increases in prices of food and housing and utilities, reflecting the partial removal of food subsidies and the pass-through of rising electricity prices. Over the first half of 218, major components of the CPI basket receded, with the overall consumer price index falling by.4 percent. This decline in prices was more pronounced in the atolls, given the relatively higher weight of food items compared to Malé. Limited uptake of the cash transfer to compensate for the partial removal of food subsidies may have impacted on the poor households purchasing power. Growth in goods exports outpaced that of imports, narrowing the trade deficit by 2.7 percentage points of GDP in 217. Strong performance of services exports against the backdrop of strong tourism receipts was more than offset by growing services imports, rendering the balance of goods and services virtually unchanged. The current account deficit is estimated to have narrowed to 18.8 percent of GDP in 217 (from 24.4 percent in 216), mainly supported by significant improvements in the secondary income account balance. The financing of the current account was mainly through direct investment and, to a lesser extent, portfolio flows. Gross official reserves recovered from 467 USD million at end-216 to 586 USD million at end-217 (26 USD million after netting out short-term foreign currency liabilities to domestic banks, representing 1.1 month of goods imports). The government made progress in rebalancing fiscal expenditure to accommodate increased capital expenditure.

64 64 Country briefs The fiscal deficit narrowed from a 1.6 percent of GDP in 216 to a 2.5 percent in 217, driven mainly by a reduction in public investment from 1.9 percent of GDP in 216 to 8.2 percent in 217, and a reduction in spending on food subsidies and on the Aasandha unlimited health care system. Excluding the Public Sector Investment Program, the underlying current fiscal balance went from a deficit of 2. percent of GDP in 215 to an estimated surplus of 5.7 percent of GDP in 217, reflecting revenue increases and current expenditure reforms. Public debt is estimated to have reached 61.2 percent of GDP in 217, an increase from 59.7 percent of GDP in 216, driven by external project-related borrowing and the 2 USD million Eurobond issuance, while domestic T-bills were redeemed. The construction and tourism sectors, the main drivers of recent growth, have not generated sufficient jobs for Maldivians since they rely mostly on foreign labor and male employment. Youth and female unemployment are high. More than a quarter of women are either unemployed or not looking for a job. Almost a quarter of Maldivian youth are not employed, in education, or training (NEET). The driver for the high NEET rate among females is inactivity, whereas for males it is unemployment. Outlook Real GDP growth is expected at 8. percent in 218, and to gradually fall to 5.6 percent at the end of the forecast period, as growth in the tourism sector returns to historical levels and capital investment projects are gradually tapering off. The current account is projected to narrow over the forecast period, as investment-related imports gradually subside. The outlook assumes no major fiscal slippages related to current expenditure or the realization of contingent liabilities through guarantees. The overall fiscal deficit is projected to narrow over the forecast period. Public debt is projected to rise to 22 and peak soon after. Maldives risk of external debt distress is assessed as high. Risks and challenges Risks to the outlook are tilted to the downside. A downturn in the global economy could impact Maldives tourism industry. Increases in global commodity prices could impact external sector performance given the heavy reliance on diesel imports. In the domestic front, the challenging political environment along with major elections due in the coming months could adversely impact the reform momentum, including measures to improve budget credibility. One key challenge for the Maldives is to find the appropriate balancing act between, on the one hand, the ongoing large infrastructure projects to close some of the existing infrastructure gaps that potentially would allow to boost tourism, reduce the impact of climate change and ease constraints in the delivery of key public services, and on the other, the rapid accumulation of public debt, the widening current account deficits and the limited fiscal space available. Vulnerability of the overall debt portfolio, with indebtedness levels at over 6 percent of GDP, is heightened by the short maturity of domestic debt and low reserve coverage. Large volume of external loans and guarantees on non-concessional terms to finance infrastructure projects represent significant risks to the downside. The government is still the top employer among Maldivians, and about two thirds of Maldivians are employed in jobs not related to tourism, suggesting a misalignment between the drivers of growth and aspirations of jobseekers. Measures that foster private sector job creation can help reduce pressure on the public sector to create jobs for an expanding working age population. The consolidation of population from vulnerable islands and atolls into Greater Malé, while also reducing pressure on Malé, may eventually allow for new forms of economic activity, create employment, improve quality of public service delivery, and increase resilience to climate change. Maldives macroeconomic outlook (e) 219 (f) 22 (f) Real GDP growth, at constant market prices Real GDP growth, at constant factor prices Agriculture Industry Services Inflation (Consumer Price Index) Current account balance (percent of GDP) Fiscal balance (percent of GDP) Debt (percent of GDP) Primary balance (percent of GDP) Notes: (e) = estimate; (f) = forecast. Source: World Bank.

65 Country briefs 65 Nepal At 6.3 percent, economic growth remained strong in FY218, driven mainly by investment in earthquake reconstruction. To sustain investment and maintain high levels of growth, additional private sector resources and engagement - including foreign direct investment (FDI) - are needed. This necessitates timely implementation of reforms to support an enabling environment for the private sector and to increase foreign investment. As Federalism proceeds, it will be particularly important to enhance implementation capacity and revenue potential at subnational levels of government. 217 Population, million 29.3 GDP, current USD billion 249. GDP per capita, current USD 849 Source: World Bank Contributions to real GDP growth Percentage points Note: Nepal s fiscal year runs from July 16th to July 15th. Source: Central Bureau of Statistics and staff calculations. Recent economic developments Growth in FY218 remained strong at 6.3 percent despite less favorable monsoons and the easing of rapid growth that ensued following the 215 earthquake. Services were the main driver contributing 3.6 percentage points, over 6 percent of which came from trade and hotels. For industry, over 9 percent of growth came from construction and manufacturing. On the demand side, investment and private consumption were the main drivers of growth. Inflation was 4 percent driven by non-food items whose prices grew at 5.5 percent, compared to food prices which grew at 3.1 percent. Consumption fueled by remittances continued to drive private sector credit growth which contributed 17.2 percentage points to money (M2) growth of 19.4 percent. Saving deposits growth increased to 18.8 percent in July but credit grew faster at 22.5 percent, causing the weighted average lending rates of commercial banks to remain high at 12.5 percent in July. All banks met the minimum capital adequacy ratio of 1 percent with an NPL ratio of 1.7 percent in Q3 FY218. A higher trade deficit and slower remittances growth widened the current account deficit, which was offset by errors and omissions, government borrowing, and trade credit. The trade deficit surged to 37.7 percent of GDP (from 33.9 percent in FY217), primarily from imports to build government subnational offices, construction and reconstruction materials, as well as higher fuel prices. Remittances grew by 1 percent, but as a share of GDP declined from 26.3 percent in FY217 to 25.1 percent in FY218. In addition, the USD-Rupee exchange rate depreciated 6.2 percent. Gross official reserves declined slightly but remained adequate to cover 8.3 months of imports (compared to 9 months in FY217). Poor execution of the budget continued with overall execution of 82.4 percent (71.2 percent for capital expenditure). In FY218, 37.5 percent of total spending (or 54.6 percent of capital expenditure) was spent in the last

66 66 Country briefs quarter of the fiscal year. Revenue growth was strong due to higher taxes from high imports (which constitute just under half of all revenue) coupled with collection rates that were close to planned targets. The fiscal deficit increased in FY218, primarily driven by higher spending to establish sub-national governments and to finance the transition to Federalism. This was financed by government deposits and higher public debt. Outlook GDP growth is projected to average 6 percent over the medium term, driven primarily by total investment. The FY219 budget includes investments to promote improved inputs and storage facilities for farmers, including for irrigation. These investments focus on modernization, commercialization, mechanization and the expansion of value chains. As these programs ramp up, the agriculture sector growth is expected to increase from 2.8 to 4.5 in FY22. Also, the Visit Nepal 22 program aims to bring in two million foreign tourists annually by 22. This will be supported by key infrastructure projects and includes linking completed hydro projects to the transmission grid. A new large private cement factory is expected to boost construction activities, while the agreement to build a second cement factory with Chinese investment will likely enhance FDI in the next fiscal year. Growth in industry and services is projected to average 8 and 6 percent respectively, as infrastructure constraints are eased, and capacity utilization expanded. Inflation is projected to reach 5 percent over the medium term, assuming oil prices increase, and the exchange rate depreciates. The current account deficit will gradually improve as import growth moderates. The government is shifting from consumption to investment-based growth, with emphasis on engaging the private sector and raising the very low levels of FDI. In addition to infrastructure investments, key reforms will include establishing public private partnerships (PPPs), one-stop investor services, and e-government services for citizens. Consolidated spending of government is expected to reach 34 percent of GDP over the medium term (versus 28 percent in FY217), with 3 to 4 percent of the increase from Federalism alone. Transfers to sub-nationals are expected to increase by 4 percentage points to reach 6 percent of GDP by 221. Raising revenue potential of subnational governments will be critical as will be their capacity to implement their projects and programs. Overall, taxes on rising imports, luxury items and incomes of wealthier households, including a broadening of the tax base, will help increase revenue to 29 percent of GDP over the medium term. Public debt as a share of GDP will increase but remain sustainable. Risks and challenges Risks to the outlook include: (i) slow implementation of reforms needed to increase private investment, particularly foreign investment; (ii) low implementation capacity at decentralized levels that worsens budget execution and the quality of expenditure; (iii) external shocks to outmigration and remittances leading to deterioration of the balance of payments, a reduction in growth of financial deposits, a shortage of loanable funds and credit, lower consumption and increased poverty; and (vi) natural disasters. Each of the above factors individually would seriously undermine growth. A combined occurrence could lead to growth below the average 4.4 percent per annum that was observed in previous decades. Nepal macroeconomic outlook (e) 219 (f) 22 (f) Real GDP growth, at constant market prices Private consumption Government consumption Gross fixed capital investment Exports, goods and services Imports, goods and services Real GDP growth, at constant factor prices Agriculture Industry Services Inflation (Consumer Price Index) Current account balance (percent of GDP) Fiscal balance (percent of GDP) Debt (percent of GDP) Primary balance (percent of GDP) Note: (e) = estimate; (f) = forecast. Source: World Bank.

67 Country briefs 67 Pakistan Pakistan s macroeconomic situation remains fragile. Consumption led growth is expected to slow down due to fiscal and possibly monetary tightening. However, short term measures for fiscal consolidation and export growth need to be complemented with implementation of medium term structural reforms to uplift the economy out of frequent boom-and-bust cycles. 218 Population, million 2.4 GDP, current USD billion GDP per capita, current USD 156 Source: World Bank. Trade deficit and import coverage Percent 6 Months of imports Note: Pakistan s fiscal year runs from July 1st to June 3th. Sources: Ministry of Finance and State Bank of Pakistan. Current account balance Import coverage (rhs) Recent economic developments Pakistan s macroeconomic imbalances are increasing. Economic growth reached 5.8 percent in FY18,.4 percentage points higher than in FY17. On the demand side, growth was driven by consumption which contributed seven percentage points towards GDP growth. On the supply side, recovery in the agricultural and industrial sectors and consistent acceleration in the services sector contributed to the GDP growth. Although headline inflation remained benign and was recorded at 3.9 percent in FY18, core inflation rose indicating underlying inflationary pressures. Therefore, the State Bank of Pakistan increased the policy interest rate by 175 bps to 7.5 percent between January 218 and July 218. The current account deficit increased to 5.8 percent of GDP in FY18, up from 4.1 percent in FY17. The widening current account deficit reflects the growing trade deficit as exports are not growing as fast as imports. Imports are growing fast due to high domestic demand and import-intensive investments related to the China Pakistan Economic Corridor (CPEC). The State Bank of Pakistan intervened heavily in the foreign exchange market in the first half of FY18 to maintain the value of the Pakistani Rupee, resulting in a large decline in international reserves from 16.1 USD billion (2.9 months of imports) at end-june 217 to 1.2 USD billion (or 1.7 months of imports) by August 24th, 218. Under intense market pressure, the currency depreciated by almost 18 percent between 1st December 217 and 25th of July 218. Post-election, with emerging political certainty, the Pakistani Rupee recovered 3 percentage points against the USD and was trading at Pakistani Rupees per USD on 7th September 218. The fiscal deficit has widened over the past two years reversing fiscal consolidation efforts in previous years and raising public debt levels. The FY18 fiscal deficit (including grants) reached 6.5 percent of GDP a slippage of 2.5 percentage points compared to the budget target. This was due to limited revenue growth and large increases in recurrent spending at both the federal and provincial levels. Consequently, Pakistan s public debt reached 73.5 percent of GDP by end-june 218, significantly raising debt-related risks. The newly elected

68 68 Country briefs government recognizes the need for macroeconomic adjustments to overcome these challenges and has already announced its plans to cut expenditures, improve the management of State Owned Enterprises, and undertake revenue mobilization reforms. Outlook GDP growth is projected to decelerate to 4.8 percent in FY19 as authorities are expected to tighten fiscal policy to correct imbalances. However, growth is expected to recover in FY2 and reach 5.2 percent as macroeconomic conditions improve. This recovery is conditional upon the restoration of macroeconomic stability, a supportive external environment, including relatively stable international oil prices, and a strong recovery in exports. Inflation is expected to rise to 8 percent (average) in FY19 and remain high in FY2, driven by exchange rate pass through to domestic prices and a moderate increase in international oil prices. The pressure on the current account is expected to persist and the trade deficit is projected to remain elevated during FY19 and FY2. Remittances will continue to partly finance the current account deficit, although slower growth in the Gulf Cooperation Council (GCC) countries will affect remittances. FDI, multilateral, bilateral, and private debt-creating flows are expected to be the main financing sources in the near to medium term. The fiscal deficit is projected to narrow in FY19 due to post-election adjustments and some fiscal measures. It is expected that there will be some scaling down of public investment spending at the federal and provincial levels, and increase in revenue collection through tax base expansion and other administrative measures. Fiscal consolidation would improve debt dynamics, but the public debt to GDP ratio is expected to stay around 7 percent of GDP during FY19 and FY2 - the debt burden benchmark for high-risk in case of Emerging Markets (as per the IMF Market-Access Countries public debt sustainability analysis). Growth deceleration and higher inflation are expected to slow-down poverty reduction in FY19 though overall poverty decline is projected to continue reflecting GDP growth. The presence of safety net programs will mitigate the negative impact of inflation on poverty. Risks and challenges Immediate macroeconomic adjustments are required to correct the large twin deficits. Rising global interest rates and tighter liquidity situation will pose challenges to Pakistan given the high gross external financing requirements. With declining reserves and elevated debt ratios, Pakistan s ability to withstand external shocks is diminished and risks will remain predominantly on the downside. Appropriate policy responses to correct these imbalances and increased buffers to absorb future shocks will reduce these risks and support a positive growth outlook. Such responses would entail increased flexibility of the exchange rate, strengthening the fiscal position through renewed efforts to improve revenue collection and better coordination between federal and provincial governments to reduce public spending. Pakistan macroeconomic outlook (e) 219 (f) 22 (f) Real GDP growth, at constant market prices Private consumption Government consumption Gross fixed capital investment Exports, goods and services Imports, goods and services Real GDP growth, at constant factor prices Agriculture Industry Services Inflation (consumer price index) Current account balance (% of GDP) Net Foreign Direct Investment (% of GDP) Fiscal balance (% of GDP) Debt (% of GDP) Primary balance (% of GDP) Notes: e = estimate; f = forecast. Source: World Bank.

69 Country briefs 69 Sri Lanka The recent fiscal and monetary policy measures have broadly contributed to stability amid continued natural calamities. Growth is projected to be around 4. percent in the medium-term and the outlook remains stable. Poverty is projected to further decline as growth recovers. However, risks are downward tilted. The country is vulnerable to global financial conditions due to large external refinancing requirements starting from 219. Although some vital reforms were carried out, the process has slowed down in a challenging political environment. The impending election cycle elevates the uncertainty. 217 Population, million 21.4 GDP, current USD billion 87.3 GDP per capita, current USD 473 Source: World Bank. Real GDP growth Percent Average Real GDP growth Average of the period Note: Sri Lanka s fiscal year is the calendar year. Source: Department of Census and Statistics and staff calculations. Recent economic developments The country-wide drought conditions continue to take a toll on macroeconomic performance. The economy is estimated to have grown by 3.6 percent in the first half of 218, following a 16-year low growth of 3.3 percent in 217. Agriculture and related industry sectors are expected to have recovered in the first half of 218 with relatively benign weather. However, the ongoing episode of drought, which has been more pronounced from the beginning of the third quarter of 218, has already impacted more than 9, people in 18 districts. Increased agriculture output led to benign inflation in the first quarter of 218. Favorable inflation outlook prompted the central bank to marginally relax policy rates in April, as the growth in monetary aggregates decelerated in response to a tight monetary policy. However, subsequent currency depreciation and spill-over effects of increasing fuel prices increased inflation to 5.6 percent by August 218. On the external front, exports rebounded thanks to the reinstatement of GSP+ preferential access to the European Union. Nevertheless, the gradually rising fuel bill and increased imports of vehicles and gold widened the trade deficit. External liquidity received a boost from the proceeds of sovereign bonds and increased FDI compared to the previous year. While reserve cover of imports has improved from 217, external vulnerability remains elevated with relatively high short-term liabilities. Amid tightening global financial conditions, the Sri Lankan Rupee depreciated by 5.6 percent against the USD by end-august 218. Albeit lower than expected, the government recorded a primary surplus for the first quarter of 218; however, the higher than budgeted interest costs masked the

70 7 SOUTH ASIA ECONOMIC FOCUS FALL 218 Country briefs improvement. The debt portfolio of the central government is subject to important risks with over 5 percent being denominated in foreign currencies, of which around 3 percent is expected to mature in the next five years. While implementation of the cost-reflective fuel pricing will enhance fiscal sustainability, the flip side will be the need for targeted measures to protect the poor and vulnerable who may be affected more. The gradual rebound of growth from last year s record-low rate is expected to have helped improve the incomes of the poor. However, droughts continue to disrupt livelihoods and agricultural activities, and may have contributed to the recent notable drop in employment, especially among women in rural areas. In addition, inflation reached 6.5 percent in 217, its highest levels since 214, which likely offset some of the gains. Outlook The outlook remains stable, conditional on reforms to improve competitiveness, governance and public financial management. Together with the IMF program, these reforms will add to confidence and lead to sustained growth and development. Growth is projected to rebound in 218 from a low base and continue to be marginally above 4. percent in the medium term, driven by private consumption and investment. Inflation will hover around mid-single digit level, although currency depreciation and rising oil prices may exert some upward pressure. Despite global uncertainties, exports will benefit from spill-over effects of the reinstatement of GSP+, while tourism and remittances support the external balances. With improved hydropower generation, the growth in imports will normalize in the medium-term. External reserves are expected to improve, thanks to debt inflows to the government, providing a buffer for debt redemptions. The Liability Management Act, passed in early 218, will provide the flexibility for managing some important risks of the debt portfolio. The overall fiscal deficit is projected to fall in the medium term, supported by the implementation of revenue measures. Risks and challenges A further slowdown in reform implementation, in a challenging political environment, remains the key domestic risk to the baseline. Impending election cycle exacerbates this risk. External risks include steeper than expected global financial conditions that would increase the cost of debt and make rolling over the maturing Eurobonds from 219 more difficult; disappointing growth in key countries that generate foreign exchange inflows to Sri Lanka through exports, tourism, remittances, FDI, and other financing flows; faster than expected rises in commodity prices that would increase pressure on the balance of payments; and capital outflows that would further increase currency pressure. On the fiscal and debt management front, risks include the delay in implementing revenue measures, and slower than expected improvement in tax administration. The increasing occurrence and impact of natural disasters could have an adverse impact on growth, the fiscal budget, the external sector and poverty reduction. Sri Lanka needs to address several challenges that increasingly put its economic growth and stability at risk, through macroeconomic and structural reforms: (1) continue fiscal consolidation by broadening the tax base and aligning spending with priorities: this is important given high public debt, contingent liabilities and large gross financing needs; (2) shift towards a private investment-tradable sector-led growth model by improving trade, investment, innovation and the business environment; (3) improve governance and accountability and improve SOE performance; and (4) reduce vulnerability and risks by enhancing disaster preparedness and mitigating the impact of reforms on the poor and vulnerable with well-targeted spending. The government recently announced plans to expand coverage of the main social protection program (Samurdhi), but details remain unclear.

71 Country briefs 71 Sri Lanka macroeconomic outlook (e) 219 (f) 22 (f) Real GDP growth, at constant market prices Private consumption Government consumption Gross fixed capital investment Exports, goods and services Imports, goods and services Real GDP growth, at constant factor prices Agriculture Industry Services Inflation (Consumer Price Index) Current account balance (percent of GDP) Net foreign direct investment (percent of GDP) Fiscal balance (percent of GDP) Debt (percent of GDP) Primary balance (percent of GDP) Note: (e) = estimate; (f) = forecast. Source: World Bank.

72 72 South Asia at a GLANCE South Asia at a glance Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka South Asia OUTPUT and PRICES BALANCE of PAYMENTS Real GDP growth Inflation (Consumer Price Index) REER (CY) Current account balance (percent of GDP) Trade balance (percent of GDP) Import growth (percent, y-o-y) Export growth (percent, y-o-y) Foreign reserves (months of goods import cover, CY) (f) Q1 (CY) Q2 (CY) (f) July August (f) August September (f) (f) May June (f) April May January February

73 South Asia at a GLANCE 73 Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka South Asia BALANCE of PAYMENTS GOVERNMENT FINANCES CONSUMPTION and INVESTMENT Personal remittances received (USD million, CY) Fiscal balance (percent of GDP) Public debt (percent of GDP) Private consumption growth (percent, y-o-y) Gross fixed capital investment growth (percent, y-o-y) Net foreign direct investment (percent of GDP) Net foreign portfolio investment (USD million, CY) , ,91 4 6,73 19,36 7, 117, , , ,612 19,88 7,262 11, , , ,928 19,689 7,19 116, Q1.. 3, , ,862 1, Q2.. 4, , ,16 1, (f) (f) (f) (f) (f) , , , ,2-1, Q ,

74 74 South Asia at a GLANCE Notes (f) CY FY Real GDP growth Inflation (Consumer Price Index) REER (CY) Current account balance (percent of GDP) Trade balance (percent of GDP) Import growth (percent, y-o-y) Forecast Series for calendar year Series for fiscal year Afghanistan s fiscal year is the calendar year. Bangladesh s fiscal year runs from July 1st to June 3th. Bhutan s fiscal year runs from July 1st to June 3th. India s fiscal year runs from April 1st to March 31st. Maldives s fiscal year is the calendar year. Nepal s fiscal year runs from July 16th to July 15th. Pakistan s fiscal year runs from July 1st to June 3th. Sri Lanka s fiscal year is the calendar year. Real GDP growth rates (percent change, y-o-y) at market prices; Pakistan is in factor costs. Source: Central Statistics Office of India, Sri Lanka Department of Census and Survey, World Bank DEC GEP, and World Bank MTI. Period average percent change in CPI inflation. Source: World Bank DEC GEM and World Bank MTI. Real effective exchange rate is the nominal effective exchange rate (a measure of the value of a currency against a weighted average of several foreign currencies) divided by a price deflator or index of costs. An increase in REER implies that exports become more expensive and imports become cheaper. Source: World Bank DEC GEM. Does not include grants unless otherwise stated. Source: World Bank MTI. Trade balance in goods and services is derived by substracting imports of goods and services from exports of goods and services as ratio to GDP. Source: World Bank WDI. Annual trade change is in (respective) fiscal year and covers goods and non-factor services (GNFS) imports. Monthly trade change is in calender year and covers only merchandise. Source: World Bank DEC GEM, World Bank DEC GEP, World Bank MTI, and staff calculations.

75 South Asia at a GLANCE 75 Export growth (percent, y-o-y) Foreign reserves, months of import cover (CY) Remittances (USD million, CY) Fiscal balance (percent of GDP) Public debt (percent of GDP) Private consumption growth (percent, y-o-y) Gross fixed capital investment growth (percent, y-o-y) Net foreign direct investment (percent of GDP) Portfolio investment (USD million) Annual trade change is in (respective) fiscal year and covers goods and non-factor services (GNFS) exports. Monthly trade change is in calender year and covers only merchandise. Source: World Bank DEC GEM, World Bank DEC GEP, World Bank MTI, and staff calculations. Source: World Bank DEC GEM. Personal remittances including personal transfers and compensation of employees in current USD. Source: Haver Analytics, World Bank WDI, and staff calculations. Does not include grants unless otherwise stated. Source: IMF, World Bank MTI, and staff calculations. Gross public debt stock including domestic and foreign liabilities, end of Period. Source: IMF, World Bank MTI, and staff calculations. Annual (respective) fiscal year percent change in gross consumption expenditure. Source: World Bank DEC GEP and World Bank MTI. Annual (respective) fiscal year percent change in gross fixed capital expenditure. Source: World Bank DEC GEP and World Bank MTI. Net balance of Foreign Direct Investment assets and liabilities as ratio to GDP. Source: Haver Analytics and World Bank MTI. Portfolio investment covers transactions in equity securities and debt securities. Balances are calculated as net assets minus net liabilities. Data is in current USD. Source: Haver Analytics and staff calculations.

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