Most Asian low-income countries (LICs) and Pacific Island economies (PICs) continued to experience healthy economic growth in the second half of 2010. Strong exports of commodities and garments, a pickup in investment, especially in commodity sectors, and a rebound in tourism have benefited the region, while greater political stability and macroeconomic policy credibility continue to pay off. Nevertheless, slower remittances have added to balance of payments pressures in some cases, while inflationary pressures from food and commodity prices have increased economic and social vulnerabilities. Looking ahead, many Asian LICs and PICs will share with the emerging market economies of the region the challenges of managing the social impact of higher commodity prices and of maintaining sound financial systems in the face of rising and volatile capital inflows. Indeed, section A shows that even though remittances and aid remain the main sources of foreign funding for Asian LICs, gross capital flows have accelerated after the global crisis in a number of these economies. Healthy banking systems will be key to absorbing these flows in an orderly manner. Section B shows that while banks in Asian LICs have emerged relatively unscathed from the global crisis, they are also exposed to risks and vulnerabilities, including from sudden drying up of cross-border liquidity. Turning to the opportunities and challenges from higher commodity prices, section C looks at the experience of Timor-Leste in restoring political stability and reducing poverty on the back of windfall gains from oil and gas, and section D highlights the vulnerability of PICs to commodity price shocks and offers policy options to address them.
A. Capital Flows, Aid, and Remittances to Asian LICs
Capital flows into Asian LICs weathered the global financial crisis relatively unscathed.1 Starting from a low base, gross capital flows into Asian LICs tripled from US$3.5 billion (2.9 percent of GDP) in 2005 to US$10 billion (4.7 percent of GDP) in 2009 (Figure 4.1). The upward trend in capital inflows was merely halted in 2008 during the global crisis, before picking up again in 2009.
Asian LICs: Gross Total Inflows
(In percent of GDP)
Sources: IMF, Balance of Payments Statistics; WEO database; and staff calculations.Moreover, the structure of capital flows to Asian LICs has changed since the start of the crisis. For the first time in this century, a few Asian LICs have experienced portfolio inflows starting from early 2000, in particular Sri Lanka, but also Bangladesh and Mongolia. At the same time, the share of foreign direct investment (FDI) in total inflows declined in 2009.
Compared with emerging Asian economies, capital flows to LICs are generally smaller, and these economies are still heavily dependent on aid flows and remittances. Gross capital inflows in LICs have averaged less than 3 percent of GDP over the past five years, compared with an average of 3.7 percent of GDP in Asian emerging economies. Remittances and aid have accounted for 86 percent of total foreign flows to Asian LICs in 2009, compared with 32 percent in emerging Asian economies (Figure 4.2).
Selected Asia: Structure of Capital and Capital-like Inflows, 2009
(In percent of total)
Sources: IMF, International Financial Statistics and staff calculations.Aid and remittances provided a stable flow of funds to Asian LICs during the global financial crisis. Aid inflows to Asian LICs rose from 13 percent of GDP in 2007 to more than 15 percent in 2009, creating some space for countercyclical macroeconomic policies. Traditional development partners have kept their share of GDP devoted to aid relatively constant, despite the need for fiscal consolidation in some of those countries. At the same time, new development partners, such as China, increased aid to the region, particularly to commodity exporters. International financial institutions have also increased their aid to Asian LICs, in order to help them maintain macroeconomic stability during the recent crisis. Remittances have been resilient, although experience has varied across countries depending on migration patterns.
The outlook for private capital flows is improving, although it is more mixed for remittances.
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Portfolio inflows to Asian LICs are likely to continue, given the ample global liquidity and the increased attractiveness of these economies’ assets, thanks to their progress in improving governance, reducing discrimination between foreign and domestic investors, and developing financial markets. For example, a stock exchange was recently opened in Lao P.D.R., with a successful initial public offering of an electricity company; and Bangladesh received its first credit rating in 2010. In addition, currently high commodity prices are likely to provide additional impetus for investment into the commodity-exporter LICs.
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Meanwhile, the strong growth of remittances observed in the past few years may soften. The numbers of migrant workers from Asian LICs has stabilized in 2010 (and declined sharply in Bangladesh; Figure 4.3), and it is unlikely to pick up in the near future as unemployment in advanced economies and the oil-producing Middle East countries (a key destination of Asian migrants so far) remains high and the migration flows to Asian emerging economies remain still relatively low, although increasing at a fast rate.
Selected Asia: Workers Moving Abroad, January 2006–January 2011
(In thousands; 3-month moving average)
Sources: CEIC Data Company Ltd.; and IMF staff calculations.B. Impact of the Global Crisis on Asian LIC Banks
Asian LICs such as Cambodia, Lao P.D.R., and Sri Lanka that are experiencing a pickup in capital flows may need a commensurate buildup in banking system capacity to absorb these flows in an orderly manner. Moreover, as LICs recover from the impact of the global financial crisis, their growth prospects will depend, among other things, on the state of their banking systems. Vulnerable banking sectors would make economic growth more susceptible to new shocks, particularly as countries are emerging from the crisis with substantially reduced policy space. Banking fragility may also delay adjustments in countries where monetary tightening is needed to deal with rising inflationary pressure (such as Bangladesh, Lao P.D.R., and Nepal). This section assesses how banks in Asian LICs were affected by the global financial crisis and lessons to be taken from this experience.2
Bank-level data across a number of Asian LICs and emerging economies suggest the following:3
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Funding: Growth of customer deposits declined sharply in LIC banks in 2008, but bounced back subsequently, closely mirroring the pattern in emerging Asian banks (Figure 4.4). The decline in deposit growth involved both larger and smaller banks. Growth in wholesale funding for banks in LICs followed a similar pattern, with a sharp decline in 2008 followed by a rapid rebound in 2009. This contrasts with large emerging Asian banks, for which wholesale funding growth remained relatively flat in 2009. The rapid recovery of wholesale funding for the LIC banks likely reflects their greater reliance on intraregional, interoffice flows rather than on international money markets.
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Lending: In 2008, growth of bank lending moderated in Asian LICs more than in emerging Asia (Figure 4.5) although there was little impact on nonperforming loan (NPL) ratios. In the four years leading to the crisis, banks in both Asian LICs and emerging markets made substantial progress in reducing NPL ratios, cutting them on average from about 9 percent to about 4½ percent of gross loans. The trend continued after the crisis, as the median NPL ratio of Asian LIC banks was about 3 percent in 2009, compared with about 4 percent for Asian emerging market banks. That said, there is a nonnegligible cross-country difference among the Asian LICs, with NPL ratios relatively high in Sri Lanka (about 9 percent of loans) and Mongolia (about 7 percent of loans).
Selected Asia: Customer Deposit Growth
(Year over year; in percent)
Source: IMF staff calculations.Selected Asia: Gross Loan Growth
(Year over year; in percent)
Source: IMF staff calculations.What explains the greater decline in bank lending growth in Asian LICs relative to emerging Asian economies? An important reason is that large banks in LICs entered the crisis with significantly high customer loan-to-deposit ratios (Figure 4.6). When the crisis occurred, and both deposits and cross-border bank flows declined, these banks cut lending sharply to build up liquidity cushions. In contrast, large banks in emerging Asia entered the crisis with significantly higher liquidity positions, as witnessed by the lower loan-to-deposit ratios in 2007 relative to 2004, partly the result of a shift of corporate financing toward capital markets. As they used this buffer in the crisis, banks in emerging Asia were able to cut lending growth by much less than their counterparts in Asian LICs.
Selected Asia: Customer Loan-to-Deposit Ratio
(In percent)
Source: IMF staff calculations.Overall, banking systems in Asian LICs are emerging from the crisis with limited damage to their balance sheets. At the same time, the crisis showed that banks in Asian LICs are also exposed to the risk of cross-border liquidity drying up, and that their liquidity management can amplify the cyclical dynamics of credit. Moreover, banking systems in these economies continue to suffer from structural weaknesses in banking supervision, the absence of financial safety nets, and an inappropriate judicial system for loan and collateral enforcement. Efforts should therefore continue toward strengthening macroprudential frameworks in these economies, particularly to firm up banking supervision and NPL resolution.
C. Timor-Leste: The Transition from Conflict to Development
After emerging from a long independence struggle and internal conflicts in 1999 and 2006, Timor-Leste authorities have made substantial progress toward restoring stability and rebuilding the country. Authorities are now finalizing an ambitious development strategy aimed at reducing poverty further and developing the non-oil economy to provide employment.
Timor-Leste became formally independent in 2002, making the territory the first new country of the twenty-first century. The outcome of the 1999 referendum to determine the territory’s future status triggered a violent reaction by anti-independence forces, resulting in extensive loss of life and destruction of the majority of the country’s infrastructure (including homes, the electric grid, irrigation and water supply systems, and schools). Moreover, more than three-fourths of the population was displaced. In 2006, tensions resurfaced when a military strike led to social disruption.
Despite the political tensions, the first decade of Timor-Leste’s independence saw a significant rise in national income, thanks to petroleum. Petroleum income accounts for about 340 percent of non-oil GDP, as of 2010. Real gross national income grew at an annual average of 27 percent, but was volatile because of swings in global oil prices. Non-oil GDP expanded over the decade at an annual average rate of 5 percent with large volatility, reflecting Timor-Leste’s post-conflict status (Figure 4.7). High oil-financed government spending and a rebound in agriculture have supported strong non-oil GDP growth since 2007, averaging about 10 percent, but inflation has remained in single digits (Figure 4.8).
Timor-Leste: Real Non-oil GDP Growth
(Year over year; in percent)
Sources: Country authorities; and IMF staff calculations.Selected Asia: Consumer Price Inflation
(Year over year; in percent)
Sources: Country authorities; CEIC Data Company Ltd.; and IMF staff calculations.With the strong economic performance in the last few years, Timor-Leste has made substantial progress with poverty reduction and other social indicators for its population of 1 million. For example, a recent World Bank study (World Bank, 2009) indicates a sharp decline in poverty incidence from 50 percent in 2007 to 41 percent in 2009 owing to increased government spending on social protection programs and infrastructure projects. Moreover, the United Nations Development Programme 2010 Human Development Report ranks Timor-Leste at 120 out of 169 countries, compared with a ranking of 162 out of 182 countries in 2007. Despite these achievements, Timor-Leste remains one of the 48 least-developed countries.
The government has resolved to step up development. To rebuild basic infrastructure, such as electricity and roads, and promote private sector growth by scaling up public investment, the authorities are finalizing a Strategic Development Plan for 2011–30. The plan aims at growth of the non-oil economy at an average rate of 12 percent a year during 2011–20, and 10 percent a year during 2020–30. To improve the quality and prioritization of public investment, the government is planning to establish a new agency that will be responsible for project appraisal, design, and monitoring.
The outlook for the Timorese economy is promising. The economy stands to benefit enormously from its oil and gas wealth in the coming years, which is currently estimated at US$24 billion or US$22,000 per capita, and is expected to increase further in light of additional reserves that have been discovered recently. Using this wealth for economic development will present some challenges, despite a transparent framework for the governance of the petroleum sector in place together with a well-managed Petroleum Fund.
The government is aware of the need to improve its institutional capacities and human resources to strengthen fiscal management (including public investment), taking into account the absorptive capacity of a small non-oil sector. These efforts, and other reforms, should be able to steer the economy to a path of sustainable, high growth with low inflation and improving living standards for the population of Timor-Leste. The IMF, together with other development partners, will continue to provide policy advice and technical assistance to help the authorities’ efforts to rebuild the country. Since late 1999, Timor-Leste has been one of the largest recipients of IMF technical assistance.
D. Pacific Island Countries: Vulnerabilities to Commodity Price Shocks
Recent developments in commodity markets are again drawing attention to how vulnerable PICs are to external price shocks. This section highlights why PICs are so vulnerable, notes the macroeconomic impact of commodity price shocks, and discusses measures to address the immediate impact of rising prices and reduce the vulnerability of PICs to price shocks in the long term.
Vulnerability to Shocks
The vulnerability of PICs to commodity price fluctuations stems from their small and open economies, remote locations, and high dependence on food and fuel imports. A narrow export base, reliance on tourism and workers’ remittances for foreign exchange earnings, and gaps in social protection all serve to exacerbate this vulnerability.
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PICs are among the most vulnerable countries when it comes to the impact of oil price fluctuations (Asian Development Bank, 2009). Fuel imports are worth on average close to 10 percent of GDP, and oil makes up a greater share of the import bill and export proceeds than in low-income Asian countries that face similar challenges. Several PICs—Kiribati, Solomon Islands, and Tonga—rely almost entirely on imported oil for their commercial energy requirement and all others (except oil-producing Papua New Guinea) are heavily reliant on fuel imports. Dependence on oil is likely to remain high in the medium to long term as most non-oil-producing PICs have limited prospects for alternative energy sources.
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PICs are net importers of staple foods and depend heavily on imports of cereals and processed foods. Food comprises approximately 45 percent of their consumer price index baskets, placing them overall in a position similar to Asian LICs and well above the average for emerging market economies.
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These factors imply a high pass-through of oil and food prices to domestic inflation. In addition, fuel prices have a significant indirect impact on food prices owing to high transportation costs. Moreover, social protection systems in PICs are not well developed and the impact of commodity price increases on the more vulnerable members of society is potentially severe.
Macroeconomic Impact of Commodity Price Shocks
Because PICs are either dollarized or operate de jure or de facto pegged exchange rate regimes, there is limited scope for the exchange rate to act as a buffer for shocks. This means that the economic fallout of commodity price shocks generally consists of deteriorating current account balances, loss of reserves, higher domestic inflation rates, and a decline in household welfare. There are also potential impacts on the fiscal accounts, although these can counteract each other and depend largely on the policy response.
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The primary impact of high fuel and food prices is on the import bill (except for oil-producing Papua New Guinea). There is, nonetheless, evidence to suggest that oil import volumes decline in the face of higher prices. Although it is likely that the decline in Fiji partially reflects the slowdown in the domestic economy, Fiji’s oil imports include a significant reexport component and can be taken to suggest a falloff in demand throughout the region.
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With PICs’ narrow export bases and limited prospects to diversify their economies, a sustained widening of their trade and current account deficits can be anticipated if oil and food prices remain high. Higher fuel prices may reduce the competitiveness of the tourism sector (for example, through flight costs) and this could worsen the deterioration in the current account through lower service receipts. Average PICs’ current account deficits have widened to 8 percent of GDP since 2008 compared with an average of 6 percent of GDP between 2000 and 2007. The scope for PICs to finance large current account deficits on a sustained basis is limited as their reserves generally hover close to three to four months of imports—a level that is low for small and very open economies.
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Rising domestic inflation is another important consequence of higher international fuel and food prices. Inflation in PICs increased to an average of about 12 percent following the surges in food and fuel prices in 2007–08, up from an average of 4 percent from 2000 through 2007. The pass-through in PICs of international fuel prices to inflation was almost complete, with the average retail price of fuel closely tracking world prices (Figure 4.9). Food price inflation peaked in 2008, reaching more than 15 percent in Solomon Islands and Papua New Guinea. There was, however, less than full pass-through of higher food prices, in part because a number of PICs lowered tariffs on food (Marshall Islands and Solomon Islands) and introduced price controls (Fiji and Kiribati) (Figure 4.10).
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The fiscal impact varies across the PICs but, overall, government budgets have been under pressure. Higher prices, particularly for fuel, increase the cost of providing government services and may raise subsidies to, and contingent liabilities emanating from, state-owned enterprises (Marshall Islands and Micronesia). Although there can be some offsetting revenue gains, during the last price spike, policy decisions reduced this gain. Samoa and the Marshall Islands reduced tax rates on petroleum products, and Tonga removed excise duties on oil for sea and air transport operators. In many parts of the world, fuel subsidies put pressure on expenditure, but this impact was not as severe in the PICs owing to the almost complete pass-through of international oil prices.
PICs: Pass-Through of Oil Prices to Inflation
(In percent)
Source: IMF staff calculations.Policy Implications
Policymakers in the PICs face tension between mitigating the short-term impacts of commodity price shocks and laying the groundwork to reduce vulnerability. PICs’ reliance on imported food and fuels, the cost efficiency of energy supply, and agricultural diversification have clear implications for macroeconomic management, but the scope for solutions to these challenges is limited and time frames are likely to be long. Economic policy will therefore have to continue to manage the impacts of price movements. It can also contribute to management of supply and demand of energy and supply of food, and to mitigating the impact of price shocks on households and businesses. Key issues for macroeconomic managers in the PICs to consider are:
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Price signals are vital for macroeconomic stability, the success of any viable energy policy, and investment and growth (including agricultural diversification). Many of the PICs responded to the 2007–08 surges in food and fuel prices by introducing or increasing subsidies, lowering tariffs or sales taxes, and imposing price controls. These measures can help alleviate the impact of volatile prices on households but are often poorly targeted, place pressure on budgets, and can lead to lasting distortions. By suppressing price signals, they prevent demand from adjusting to supply conditions, dampen the volume response to higher import prices, exacerbate the negative impact on the external accounts, and discourage energy and investment efficiency. They can also have serious fiscal consequences through rising subsidies and contingent liabilities.
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Social protection is best achieved through transfers targeted to the neediest. General budget subsidies arising from controls on retail prices of fuel, electricity, and food generally benefit the rich far more than the poor. Better targeted transfers can provide more effective social protection at a lower fiscal cost and help reduce the pressure on the current account.
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Tax policy should balance the needs of consumers and the government budget. Reductions in consumption taxes (for example, value-added tax (VAT)) on selected goods to moderate the impact on consumers of high prices should be avoided as they distort relative prices, complicate VAT administration, and have a similar impact on demand as price controls. Moderations in import duties create fewer distortions and are consistent with trade policy objectives. Increases in taxation to discourage consumption, perhaps to take account of environmental consequences, are best achieved through specific excises. Governments in PICs need not, however, rely too heavily on taxation of oil products for financing expenditure. Because demand for oil products in the PICs is quite inelastic, taxes designed to discourage consumption could have stark effects on the domestic private sector.
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Monetary and exchange rate policy should be used to control inflation.4 The immediate pass-through of a price shock (the “first-round” effect) can be accommodated, but monetary policy needs to remain vigilant against “second-round” effects. Price shocks will therefore often need to be followed by increases in interest rates to contain domestic demand, decrease inflation pressures, and help protect external reserves. In the medium term, appropriate exchange rate policies that avoid an overvalued exchange rate will contain the demand for imported fuels and help export performance.
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Long-term vulnerability can be partially addressed through the removal of price controls and subsidies, and the implementation of structural measures. Removing price controls and subsidies will encourage efficient use of imported fuels and greater self-sufficiency in both food and energy. The Asian Development Bank (2008) identifies a number of PICs as having potential for large increases in the production of staples (Fiji, Micronesia, Papua New Guinea, Samoa, Solomon Islands, Tonga, and Vanuatu). Currently, Fiji, Samoa, and Papua New Guinea meet approximately one-third to one-half of their electricity needs from hydroelectric systems, and further exploration of alternative energy sources could help reduce dependence on imported oil for electricity needs. In Fiji, increases in electricity tariffs during the past year should allow the Fiji Electricity Authority to attract renewable energy investment to feed the power grid. Other growth-supporting structural measures such as land reform, investment in internal transportation infrastructure (so that domestic produce can be brought to urban markets), competitive bidding for gasoline distribution (as, for example, in Samoa), the removal of import monopolies (such as for rice by the Solomon Islands in 2009), and simplifying procedures for the establishment and operation of private enterprises can also reduce the vulnerability of the PICs to international commodity price shocks.
Note: The main authors of this chapter are Jonathan Dunn, Byung Kang Jang, Joedianna Mohammed, Svitlana Maslova, Erdembileg Ochirkhuu, Jookyung Ree, Niamh Sheridan, and Jie Yang.
Capital flow data of Asian LICs (Bangladesh, Cambodia, Lao P.D.R., Mongolia, Myanmar, Nepal, Papua New Guinea, and Sri Lanka) have to be interpreted with some caution, given gaps in quality, coverage, and timeliness.
Bank-level data from Bankscope were examined for five Asian LIC countries: Bangladesh, Cambodia, Lao P.D.R., Mongolia, and Sri Lanka. Emerging Asian economies include Indonesia, Malaysia, the Philippines, and Thailand.
These and other results are from Ree (forthcoming).
Capital flows are limited in the PICs; thus monetary policy retains a certain degree of freedom even in those countries that have their own currency and a pegged exchange rate regime.
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