Annex: Low-Income Countries and Pacific Island Countries
Asian Low-Income Countries: Recovery Prospects and Policy Challenges1
After a moderate slowdown in early 2009, growth in Asian low-income countries (LICs) started to pick up in the second half of 2009. The recovery was supported by improvements in external demand, resilient foreign direct investment (FDI) inflows and private remittances, and accommodative monetary and fiscal policy.
The recovery in Asian LICs, however, has proceeded at a slower pace than in emerging Asia, though with some variation. Countries that are more export dependent, and hence more severely affected by the global crisis, are now enjoying stronger recoveries. Among the relatively open Asian LICs, those with a more diversified economy and greater reliance on domestic demand have maintained relatively high and stable growth (Papua New Guinea and Vietnam); while those with a narrow export base were hit the most during the crisis, but are expected to rebound more strongly in 2010 (Cambodia and Mongolia), on account of improved external demand and higher commodity prices.
Real GDP Growth in Comparison with Pre-crisis Growth1
(In percent)
Sources: IMF, WEO database; and staff calculations.1 Pre-crisis growth is defined as the average growth of 2000-07.2 See footnote 1 of the text for the countries included in the low-income-countries (LICs).Export Dependence and Impact on Real GDP Growth
(In percent)
Sources: IMF, WEO database; and staff calculations.The economic recovery in LICs in 2010 is expected to be slow, for a number of reasons:
While Asian LICs’ commodity exports have been robust, supported by strong demand from China, the recovery of garment exports has been relatively anemic, mainly reflecting weak demand for garments and little sign of garment inventory rebuilding in the United States, which has affected all the large garment-exporting Asian LICs.
FDI flows to Asian LICs generally have declined (in percent of GDP), although less so in resource-based economies (Lao People’s Democratic Republic, Mongolia, and Papua New Guinea). And they may remain low even as the global recovery becomes more established, especially if emerging Asia economies retain their recent gains in competitiveness (including through continued improvements in business environments). This is what happened after the Asian financial crisis at the end of the 1990s—FDI flows gyrated from Asian LICs toward emerging Asia economies, reflecting the latter’s improved competitiveness (through significant devaluations).
While remittances remained an important source of income in several Asian LICs, they are expected to slow down in many economies in the region (Bangladesh, Nepal, and Sri Lanka), as the effect of the hiring surge in the Gulf region through mid-2008 is gradually tapering off.
Finally, while expansionary policies helped to cushion the impact of the crisis, they also have heightened macroeconomic risks. The fiscal stimulus packages implemented in Bangladesh, Sri Lanka, and Vietnam, for example, have not been very extensive in general, mainly due to capacity constraints. However, policy rates were reduced substantially as the adverse spillover effects became more apparent, especially since the first quarter of 2009 (Mongolia and Sri Lanka). This has helped support growth, but also has fueled rapid credit growth and increased inflation pressures, the latter exacerbated by the rebound in global commodity prices. In addition, overly accommodative policies have resulted in a significant deterioration in the external position of some countries, such as Nepal and Vietnam.
Looking ahead, a key priority for Asian LICs is to restore macroeconomic stability. For most countries, tighter monetary and fiscal policy would help keep credit growth and inflation under control, while reducing pressures on the balance of payments. Moreover, while fiscal balances are expected to improve slightly for most countries, deficits are likely to remain high, raising concerns about debt sustainability.
Illustrative Medium-Term Growth Paths
(Per capita GDP in 2000 U.S. dollars)
Sources: IMF, WEO database; and staff calculations.Over the medium term, real GDP growth in Asian LICs is expected to reach 6–7 percent on average, allowing a gradual convergence with income levels of their emerging Asia peers. But Asian LICs will need to grow even faster than their pre-crisis growth rates (about 6 percent), in order to substantially narrow the income gap with the ASEAN-4 group within the next two decades. Recent studies have shown that following a global shock to their terms of trade or external demand, LICs tend to recover more slowly than other countries, and to only fully return to their historical growth trend after about five years. With an estimated cumulative output loss in Asian LICs of about 3 percent of GDP during the current crisis, the catching-up process for Asian LICs may have been slowed down significantly.
Competitiveness Index of Selected Asian Countries, 2009–20101
Source: World Economic Forum, Global Competitiveness Report, 2009-20101 Each factor is scored in the 1-7 scale with 1 being the poorest quality and 7 being the best.2 Including Bangladesh, Cambodia, Mongolia, Nepal, Sri Lanka, and Vietnam.To realize their growth potential Asian LICs cannot rely solely on a rapid recovery in external demand and capital inflows. They also need to make significant progress in a series of structural reforms needed to raise their competitiveness, including:
Improving the business environment, to attract more private investment and FDI. Based on the World Bank Doing Business 2010, Asian LICs continue to lag behind emerging Asia in this area, with only Bangladesh making progress in facilitating new businesses among Asian LICs.
Addressing infrastructure bottlenecks, particularly in transportation and utilities, as well as shortages of skilled labor, which are the weakest areas of Asian LICs compared with ASEAN-4 (World Economic Forum Global Competitiveness Report 2009–2010). This will require higher capital and social spending, but within a fiscal framework that ensure medium-term fiscal sustainability. To achieve this, Asian LICs may need substantial reforms of tax policy and administration, and where relevant, in effectively managing the large resource revenues. Several Asian LICs (Bangladesh, Lao People’s Democratic Republic, Papua New Guinea, Sri Lanka, and Vietnam) have begun reforms on this front, but more will be needed in this area.
Increasing the domestic value added of production. The Asian LICs with large endowments of natural resources should expand the role of processing industries (e.g., Vietnam is developing domestic oil refineries). More generally, Asian LICs would benefit from diversifying their production base, to be less vulnerable to commodity price shocks.
Safeguarding banking sector soundness. Sustained periods of excessive credit growth, and property busts in a few countries, have led to increasing concerns about asset quality, particularly in Cambodia, Lao People’s Democratic Republic, Mongolia, Nepal, and Vietnam, underscoring the need to further enhance bank regulation and supervision capacity in these economies.
Impact of the Global Crisis on the Pacific Island Countries
Growth fell sharply in 2009 in almost all of the Pacific Island countries (PICs) as the full impact of the global economic crisis hit the Pacific. The deterioration in growth was driven by a fall in tourist arrivals, loss of key export markets and a fall-off in remittances from workers in Australia, New Zealand, and the United States. Fiji’s growth also suffered from structural problems that have driven sugar exports to historical lows and Samoa was negatively affected by a tsunami that damaged its tourism sector. Palau faced a contraction in FDI as foreign firms lost access to financing and investment may have been negatively affected by protracted Compact negotiations with the United States. The Solomon Islands was affected by a reduction in timber production, in part related to overlogging. In contrast, growth held up in Papua New Guinea due to its insulated financial sector, still-strong terms of trade, and an increase in public spending; and in Vanuatu due to tourism and construction.
Real GDP Growth
(In percent)
Source: IMF, APDLISC database.Consumer Price Inflation
(In percent)
Source: IMF, APDLISC database.Current Account Balance
(In percent of GDP)
Source: IMF, APDLISC database.Inflation eased substantially during 2009 in many PICs, from the high rates associated with the pass-through of international food and fuel prices in 2008. The decline in inflation was driven partly by the reversal in the prices of international commodities on which the PICs are heavily dependent. Other key factors were the sharp contraction in domestic credit growth that resulted from the cautious behavior of international banks from Australia and the United States that dominate the PICs’ financial sectors and the general slump in economic activity (although in Vanuatu credit growth remained robust). In Kiribati, the fall in inflation to zero at end-2009 also reflected the strong appreciation of the Australian dollar (national currency) in the second part of the year. In Fiji, domestic liquidity was further reduced in the first half of 2009 as Fiji’s international reserves dwindled to less than two months of import cover. Reserves and liquidity in Fiji recovered following the 20 percent devaluation of the Fiji dollar in April 2009, and the devaluation pushed inflation slightly higher, though credit growth did not rebound. In Tonga, a rise in NPLs also constrained bank lending
Current account deficits improved in most PICs in 2009 due to sharp shifts in the trade balance as commodity prices fell and the demand for imports eased. This was the case in Fiji even though sugar exports fell substantially. However, the current account deteriorated in several countries. In the Solomon Islands this was due to declining log exports and larger repatriated profits by foreign companies. Papua New Guinea continued to import, given strong domestic demand while lower commodity prices reduced nominal exports shifting the current account into deficit. Tonga faced reduced investment income and a substantial decline in remittances.
Tax Revenue1
(In percent of GDP)
Source: IMF, APDLISC database.1 Total domestic revenue.Fiscal sectors were hit hard in most PICs during 2009. In some countries with large trust funds (Tuvalu and the Compact countries of the North Pacific), the funds’ value lost 10–20 percent due to poor investment performance; this constrained these countries’ ability to support their economies through fiscal stimulus. In Kiribati, after declining by 12 percent in 2008, the value of the trust fund increased marginally in 2009. All PICs faced substantial declines in tax revenue as imports, consumption and profits fell, although for some this was partially offset by increased donor support, or by an increase in nontax revenues, as in the case of Kiribati. In the Solomon Islands, despite spending constraints, this was insufficient to cover revenue shortfalls, putting further pressure on an already fragile cash situation. Poor revenue performance (and rapidly falling international reserves) in Fiji constrained needed spending following severe floods early in the year and forced the government to freeze civil service wages. In Fiji and the Marshall Islands, high public debt limited governments’ options to support domestic demand during the economic crisis. In contrast, accumulated windfall mineral revenue allowed for significant fiscal stimulus in Papua New Guinea.
Export Growth
(In percent; U.S. dollar basis)
Source: IMF, APDLISC database.Public Debt, 2009
(In percent of GDP)
Source: IMF, APDLISC database.Growth in the Pacific is projected to rebound marginally during 2010–11 due to stronger growth in Asia, including Australia and New Zealand, though the recovery is likely to be uneven across the PICs. Australian tourist departures to the Cook Islands, Fiji, and Vanuatu picked up by 23 percent, 9½ percent and 15 percent, respectively, for the 12 months through January 2010 (compared to the previous 12 months). However, growth of tourist departures to other PICs from Australia and New Zealand, was, still marginally negative. Furthermore, there is a risk that Pacific travel will decline as source-country tourists return to long-haul travel as the economic recovery gains pace. PIC exports are projected to pick up due to the recovery in destination markets, although Samoa’s exports will remain suppressed as it gradually rebuilds its tourism sector following the tsunami; and the Solomon Islands’ logging exports are expected to continue to fall. In Kiribati, recovery in regional economies is expected to spill over, lifting near-term prospects, and private sector activity appears to have picked up, especially in the construction and retail sectors. Unemployment is projected to remain high for 2010 in the major destination countries (New Zealand and the United States) for PIC labor, and this is likely to weigh on remittances to, and growth in the PICs. In Papua New Guinea, the construction phase of liquefied natural gas projects and recovery in export incomes will stimulate domestic demand and generate robust growth. With international commodity prices projected to rise, inflationary pressure also is likely to build in the PICs over the coming months.
Note: The main author of this box is Jonathan Dunn.Restoring Macroeconomic Sustainability in Maldives
The 2008–09 global economic crisis hit Maldives hard and exacerbated the effects of an unsustainable fiscal expansion, leading to large external and fiscal imbalances. The Maldivian authorities responded with an ambitious policy package supported by external financing, including an IMF program. This helped stabilize the economy and move it back from the brink of a macroeconomic crisis, but major challenges remain.
After the 2004 tsunami, government expenditure almost doubled as a share of GDP. A key driver was the public wage bill, which rose fourfold between 2004 and 2009, coming to absorb almost 90 percent of the government’s total revenue in 2009. The fiscal expansion, compounded in 2008 by rising commodity prices, led to a rapid growth in imports and a widening of the current account deficit.
Tourism
(Year–on–year percent change)
Source: IMF staff calculations.From mid-2008, the global crisis significantly exacerbated the existing imbalances. Tourism receipts were affected badly by the global downturn, driving this tourism-based economy into recession. The decline in tourism receipts also hurt foreign exchange earnings and fiscal revenues which also fell on account of slower imports (customs duties are a key source of revenue) and postponed lease payments from embattled tourist resort projects. The fiscal deficit rose to 17 percent of GDP in 2008, and without corrective action, was on course to reach more than 30 percent of GDP in 2009. To finance the ballooning deficit, the government increasingly resorted to central bank credit. The global crisis also prompted a significant setback in foreign investment inflows into tourism-related activity, and a key bank had difficulty rolling over external credit lines, falling into severe dollar liquidity shortages. With a large exposure to the tourism sector, banks experienced a sharp increase in NPLs.
Public Debt
(In percent of GDP)
Source: IMF staff calculations.By mid-2009, the situation became critical. Supporting the fixed exchange rate—pegged to the U.S. dollar at 12.8 rufiyaas per dollar since 2001—in the face of a lax fiscal policy, deficit monetization, and negative external shocks led to significant reserve losses. This forced the Maldives Monetary Authority (MMA) to ration foreign exchange, and a parallel foreign exchange market emerged with a considerable premium.
In response, a comprehensive, IMF-supported program of bold policy measures was put together to restore macroeconomic stability and fiscal sustainability. In December 2009, the IMF Board approved a blended financial arrangement, combining a Stand-By Arrangement and the Exogenous Shocks Facility, for a combined total of about US$92 million (700 percent of quota). At the core of the program is a strong effort to reduce the fiscal deficit, while protecting social spending. The program also aims to absorb excess rufiyaa liquidity, shore up reserves, and strengthen the financial sector.
On the fiscal front, authorities have taken bold measures to cut the fiscal deficit. They temporarily cut public sector wages by an average of 14 percent, began an ambitious process of public sector downsizing, and raised electricity tariffs significantly to reduce the associated subsidies. They also have committed to introducing new tax measures to boost revenue and broaden the tax base, including a business profit tax and a goods and services tax on tourism and other industries. To protect the poor, the authorities maintained social spending in the budget, and are improving the targeting of subsidies.
The program also aims to rebuild international reserves to prudent levels while preserving the current exchange rate peg to the U.S. dollar. Monetary policy is supporting the fiscal adjustment effort through a tightening of domestic currency liquidity. The authorities have taken key steps to regain control of the money supply: they halted the monetization of the deficit, converted the government’s debt stock with the MMA into tradable securities, and introduced open market operations using these securities as collateral. The authorities also are strengthening the financial sector’s supervision and regulation framework, including by introducing regulations on loan loss provisioning and asset classification, single borrower limits, and net open positions.
Reserve Money and Gross International Reserves
Source: IMF staff calculations.This strong policy effort was supported by substantial multilateral and external financing. The IMF program helped catalyze support from other multilateral sources, including the World Bank and the Asian Development Bank (AsDB). India also provided significant financing, and a donor conference organized by the World Bank and the United Nations (UN) at end-March 2010 yielded significant commitments from other bilateral donors.
The authorities’ strong policies under the program and external financial support have succeeded in stabilizing the economy and restoring confidence. Pressures on the exchange rate have eased, international reserves have increased, money growth has slowed, and conditions in the banking sector have stabilized. The tourism industry is bouncing back, along with the global economy, helping growth to recover.
Looking ahead, significant challenges and risks remain. Progress on public sector reform has been slower than envisaged; the authorities are facing strong opposition to the public sector wage cuts, which could be reversed earlier than expected; and passage of the needed tax reforms may prove difficult, given the government’s lack of a parliamentary majority. With a high level of public debt, projected to reach 97 percent of GDP this year, any significant fiscal slippages may compromise debt sustainability. However, the authorities remain strongly committed to the program’s objectives and numerical targets.
Note: The main author of this box is Rodrigo Cubero.References
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