Chapter 3: Growth and Macroeconomic Adjustment in Developing Countries

International Monetary Fund
Published Date:
April 2012
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Summary and Main Messages

The global recovery shows signs of stalling amid deteriorating financial conditions. Global growth slowed to 3.9 percent in 2011 and is projected to decline further to 3.5 percent in 2012. The strongest slowdown is being felt in advanced economies, but the worsening external environment and some weakening in internal demand is expected to lead to lower growth in emerging and developing countries as well. This outlook is subject to downside risks, such as a much larger and more protracted bank deleveraging in the Euro Area or a hard landing among key emerging market countries. Against these broad developments, food, fuel, and other commodity prices have eased somewhat from their peaks in mid-2011; where high commodity prices had become a concern for broader price stability, this price decline has provided policy makers with greater flexibility to ease monetary policy.

Strengthening the recovery will require sustained policy adjustment at a measured pace that depends heavily on a country’s individual circumstances. There are risks in some places of inadequate medium-term fiscal adjustment, and in some of overaggressive short-term fiscal adjustment. In the advanced economies, while fiscal policy consolidation proceeds, monetary policy should continue to support growth as long as unemployment remains high and inflation expectations are anchored. This should be accompanied by steady progress toward repairing and reforming financial systems and by steps to avoid excessively rapid bank deleveraging.

The weaker global economic environment has implications for the emerging and developing countries as they progress toward the Millennium Development Goals (MDGs). Among the low-income countries, despite a solid recovery, a concern is that macroeconomic policy buffers have not been rebuilt to levels before the crisis. Should downside risks such as a sharp global slowdown or another surge in food or fuel prices materialize, these countries will have to confront the situation with weaker buffers than in 2009. In addition to eroded macroeconomic policy buffers, still-high food prices complicate policy making and make progress toward achieving the MDGs more difficult. Accelerated progress toward achieving the MDGs in low-income countries will require adequate and effective international development cooperation and the continued strengthening of policy frameworks in individual countries. Fragile states require special attention.

A weaker global economic environment may impede progress toward the MDGs

Growth slowed in 2011

Global economic growth slowed considerably in 2011 to 3.9 percent, from 5.3 percent in 2010, as the economic recovery continued along two tracks (Table 3.1 and map 3.1). In the advanced economies, growth slipped to 1.6 percent, half the rate in 2010 and well below the rate foreseen in the 2011 Global Monitoring Report (GMR), owing to lower than expected growth in the United States and Japan.1 Modest growth rates were accompanied by relatively high unemployment and low inflation.

Table 3.1Global outputAnnual percentage change
Advanced economies0.0−
Emerging and Developing Countries6.
Central and Eastern Europe3.2−
Commonwealth of Independent States5.4−
Developing Asia7.
Middle East and North Africa4.
Sub-Saharan Africa5.
Western Hemisphere4.2−
Low-Income Countriesa5.
Emerging Market Countriesb6.
Fragile Statesc6.
Source: World Economic Outlook.

MAP 3.1As global growth slows, growth outcomes across countries converge

In the emerging and developing economies, growth slowed to 6.2 percent, about the level foreseen in the 2011 GMR. Growth in the developing world was led by Asian developing countries, while growth in the Middle East and North Africa was dampened by ongoing political turmoil. Growth in Sub-Saharan Africa continued at around 5 percent, notwithstanding slower export growth to the Euro Area and drought in the Horn of Africa. Despite an overall weaker global performance, per capita incomes rose in most countries (Figure 3.1).

Figure 3.1.GDP per capita growth

Source: World Economic Outlook.

The World Economic Outlook of the International Monetary Fund (IMF) foresees a further moderation of global growth in 2012, to 3.5 percent. The Euro Area is expected to be in a recession because of high sovereign borrowing costs, fiscal consolidation, and the impact of bank deleveraging on the real economy. Growth in other advanced economies would slow, in part, because of trade and financial spillover effects from the Euro Area, but is expected to remain positive. In the United States and a few other countries, modest growth momentum would be maintained and underlying domestic demand would broadly offset the impact of these spillovers. Overall, advanced economies are projected to grow by just over 1 percent.

In the emerging and developing economies, a weaker and more uncertain external environment, compounded by softer internal demand, is expected to further dampen activity in 2012. Nonetheless, strong growth is expected to continue in developing Asia, in particular China and India. Growth is expected to accelerate in the Middle East and North Africa, led by oil exporters such as Libya, where recovery from the political turmoil of 2011 is expected; nonetheless, many countries in the region face muted prospects as political transitions draw out. Countries in central and eastern Europe may be severely affected by trade and financial spillovers from the Euro Area, and recovery there would lag. In contrast, Sub-Saharan African countries should see continued strong growth, except in southern Africa, which is more exposed to weak demand conditions in Europe. Overall, emerging and developing countries are projected to grow by 5.7 percent.

Global current account imbalances remain below those experienced in the run-up to the global financial and economic crisis, and narrowed somewhat in 2011 (Figure 3.2). Net financial flows to emerging and developing countries, while fairly robust, are also below pre-crisis levels (Table 3.2). Average net financial flows were broadly unchanged in 2011 from 2010 and 2009, and the expectation is for similar levels in 2012. Relative to gross domestic product (GDP), low-income countries continue to receive higher net financial flows than do emerging market countries—mainly reflecting significantly higher official loans and grants inflows. Fragile states received substantially higher foreign direct investment (FDI), official capital flows, and official transfers in 2011, and the expectation is that these high levels will be maintained in 2012. While private current transfers remain below the pre-crisis levels, international remittances (in nominal dollars terms) fully recovered from the decrease in 2009.

Figure 3.2.Global current account imbalances

Source: World Economic Outlook.

Note: The global statistical discrepancy is not shown.

Table 3.2Net financial flowsPercent of GDP, equally weighted
Economy20082009201020112012 projection
Emerging Market Countries9.
Private capital flows, net5.
Of which: private direct investment5.
private portfolio flows–1.2–
Private current transfers3.
Official capital flows and transfers (net)
Memorandum item:
Change in reserve assets (–, accumulation)–1.7–2.8–2.1–1.5–1.0
Low-Income Countries15.413.513.214.713.8
Private capital flows, net4.
Of which: private direct investment6.
private portfolio flows–1.2–1.2–1.3–0.9–0.9
Private current transfers5.
Official capital flows and transfers (net)
Memorandum item:
Change in reserve assets (–, accumulation)–2.1–2.0–1.7–2.0–1.2
Fragile Statesa15.211.410.319.018.8
Private capital flows, net5.
Of which: private direct investment4.
private portfolio flows–1.0–1.0–1.4–1.6–1.6
Private current transfers6.
Official capital flows and transfers (net)
Memorandum item:
Change in reserve assets (–, accumulation)–1.6–2.0–2.0–1.7–1.9
Source: World Economic Outlook.

Emerging and developing countries were part of the continued brisk expansion in global trade in 2011. Their exports have recovered fully from the drop in 2009 and grew by 22 percent in 2011. Current account deficits (net of inward FDI), in low-income countries widened somewhat in 2011 (Figure 3.3). Since 2009 (when reserves were boosted by SDR allocations), official reserves have not kept pace with growing trade; however, most emerging and developing countries maintain reserves in excess of three months of imports—one of several measures of reserve adequacy (Figure 3.4).

Figure 3.3.Low-income countries: imports, exports, and current account balance, including FDI

Source: World Economic Outlook.

Figure 3.4.Official reserves

Source: World Economic Outlook.

Note: Bars represent the range between the 25th and 75 percentiles.

Macroeconomic policies

In advanced economies, ample economic slack and well-anchored inflation expectations continued to provide room for supportive monetary policy. There was much less room for maneuver regarding fiscal policy in 2011, however, given large debt levels and concerns in financial markets over governments’ debt sustainability. In emerging and developing countries, increasing prices for food and other commodities through mid-2011 prompted higher headline inflation rates (Figure 3.5). Some easing in non-fuel commodity prices since mid-2011 has reduced these pressures, but in many countries commodity price volatility continues to complicate macroeconomic policy making.

Figure 3.5.Commodity price indexes

Source: World Economic Outlook.

Note: Indexes are in U.S. dollars. Data for 2012 Q2, Q3, and Q4 are projections.

After the unprecedented countercyclical fiscal response to the 2009 crisis, emerging and developing countries had begun to reduce fiscal deficits in 2010 and 2011 (albeit rather timidly) (Figure 3.6). Although real GDP growth among developing countries in 2011 was similar to that in 2008, fiscal deficits on average (unweighted) remained 2 percentage points of GDP higher than before the crisis.

Figure 3.6.Fiscal deficits in emerging and low-income economies

Source: World Economic Outlook.

Note: General government balances as defined in IMF Government Finance Statistics Manual 2001.

Among emerging and developing countries that loosened monetary policy in 2011, looser monetary conditions mostly took the form of a nominal depreciation of the currency, rather than a lowering of nominal short-term interest rates (Figure 3.7). Against this background, monetary aggregates continued to expand broadly in line with the increase in nominal GDP in emerging market countries (Figure 3.8).

Figure 3.7.Monetary policy loosening in emerging market and low-income countries

Source: World Economic Outlook.

Note: Monetary policy loosening is based on Monetary Conditions Index (MCI) calculations. The MCI is a linear combination of nominal short-term interest rates and the nominal effective exchange rate (with a one-third weight for the latter).

Figure 3.8.Average year-on-year growth in money and the money gap in emerging market countries

Source: International Financial Statistics.

Note: The money gap is the difference between year-on-year growth rates of M2 and nominal GDP. The sample includes emerging market economies that have data on both for the whole sample period shown.

The direction of macroeconomic policy adjustments varied considerably in 2011. Among the 62 percent of emerging market countries that tightened fiscal policy, more than half complemented that with monetary tightening (Figure 3.9). In contrast, among the 55 percent of low-income countries that tightened monetary policy, half loosened fiscal policy. The variety of policy responses contrasts with 2009, when 90 percent of emerging market economies and 80 percent of low-income countries loosened fiscal policy in response to a major global economic shock. Most policy adjustments seem to be driven by country-specific considerations—including available policy space.

Figure 3.9.Macroeconomic policy mix

Source: International Financial Statistics.

Note: Fiscal conditions are defined based on annual change in government balance as a percent of GDP in 2008, 2009, 2010, and 2011. Monetary conditions are based on the change in the Monetary Conditions Index; changes are calculated Q4 over Q4, subject to availability (see also Figure 3.7’s note).

Quality of macroeconomic policies in low-income countries

Monetary policy, access to foreign exchange, and the consistency of macroeconomic policies were judged by IMF country desks to be relatively strong areas of policy implementation in low-income countries in 2011 (Figure 3.10). Governance in the public sector, fiscal transparency, and the composition of public spending were assessed as areas of relative weakness. Lower ratings for fiscal policy in 2011 suggest a sense that a return to pre-crisis fiscal positions has progressed too slowly, given the continued strong economic growth rates. Country desks also perceive that the quality of monetary policy slipped in some countries in 2011; although assessments remained fairly positive overall, more than 10 percent of country desks considered the monetary policy stance unsatisfactory—similar to that of fiscal policy, but noticeably higher than in recent years.

Figure 3.10.Quality of macroeconomic policies in low-income countries, 2005 and 2009-11

Source: IMF staff estimates.

Food price developments and their macroeconomic impact on developing countries

As discussed in chapter 1, food prices have been volatile over the past several years.

Global food prices rose by more than 50 percent during 2007 and the first half of 2008, before plummeting by 30 percent in late 2008. By early 2011, however, food prices exceeded the peak level of mid-2008. Although prices have since moderated, average levels in 2011 exceeded those in 2008. While some weakening of prices is projected for 2012 and beyond, the prospects are for relatively high food prices to remain.

An increase in food prices represents a shift of real income away from net-food-importing countries toward net-food-exporting countries. The shift in income takes place through changes in the terms of trade, which affect the purchasing power of domestic firms and households. Countries that are broadly self-sufficient in food will not experience any terms-of-trade losses, but may nonetheless be affected as higher prices trigger a shift of real income from net-food-consuming households to net-food-producing households.

The balance of payments is also directly affected by higher prices for food and other commodities, because changes in terms of trade may trigger payments imbalances. For a typical net-food-importing country, higher food prices will lead to a widening of the external trade deficit. Initially, the larger deficit may be financed by increased donors’ assistance (for example, in the form of food aid) or a drawdown of the central bank’s foreign currency reserves. A flexible exchange rate may also work to cushion the balance of payments impact of a higher food import bill (although at higher social costs for vulnerable groups), which over time may be lowered by increases in domestic food production.

While the social implications may be different, and typically less urgent, changes in other commodity prices affect macroeconomic aggregates similarly to changes in food prices. As food, fuel, and other commodity prices often move in tandem, it can be difficult to isolate the effect of food prices alone. The 2007–08 food price surge coincided with even larger increases in fuel prices (Figure 3.11). For some oil-exporting developing countries, higher prices for food imports were more than offset by higher prices for oil, while many poorer countries had to confront the challenge of concurrently financing more expensive imports of both food and fuel.

Figure 3.11.Commodity prices and macroeconomic developments, 2007–12

Source: World Economic Outlook.

Note: Indexes are in U.S. dollars.

Source: World Economic Outlook

Note: Bars represent range between 25th and 75th percentiles.

In contrast to the 2007–08 food price shock, the 2010–11 food price shock was part of a broader-based commodity price surge. For many net-food-importing developing countries, the terms-of-trade effects (though not the social implications) of higher food prices were thus mitigated to the extent that these countries export other types of commodities. For example, whereas Sub-Saharan African oil exporters benefited from higher oil prices during both food price shocks, Latin American metal exporters only benefited during the latter episode. In both episodes, robust underlying growth in developing countries cushioned the negative impact on real income in affected countries.

Volatility in food and other commodity prices also has indirect or “second-round” effects. Risk and uncertainty complicate the planning and execution of new investments, dampening investment. These effects can be especially important along the food production chain, where food price volatility makes investment programs less “bankable” and credit more difficult to obtain. Long-lasting price changes may even render part of the country’s capital stock prematurely obsolete (a risk in particular when fuel prices rise together with food prices). Such second-order effects affect developing countries’ growth prospects both immediately and over the longer run.

To help deal with future negative shocks, developing countries can seek to strengthen their risk management frameworks and can consider securing financial resources on a contingent basis (Box 3.1). Contingent financing instruments include commodity-price-hedging instruments, contingent debt instruments (indexed bonds, deferred repayment of loans) or natural disaster insurance (for instance, in the case of a drought). Developing-country demand for these products has been rather limited so far, but examples include oil-importing developing countries that hedge their oil import bill. A few countries have also hedged volatile export proceeds, such as by selling crops in forward markets.

Box 3.1Dealing with shocks: Risk management and contingent financing instruments

Adverse external shocks, even when temporary, can have prolonged negative effects on income and poverty in developing countries. Natural disasters or sharp swings in commodity prices or export volumes, for example, can disrupt growth and affect the fiscal and balance of payments positions, which in turn may threaten core public spending on health, education, and infrastructure.

To mitigate the impact of these shocks, countries require an appropriate risk management framework and access to a range of risk management tools. Since the types of shocks and the degree of risk are specific to each economy, a risk management framework begins by assessing the country’s principal fiscal risks and debt sustainability vulnerabilities, including by analyzing fiscal flows, the government balance sheet, and contingent liabilities. The World Bank assists developing countries in creating effective risk management frameworks; the International Monetary Fund also provides support in key areas such as fiscal risks and asset and liability management.

Risk management tools are of three broad types: self-insurance; ex post financing arranged after a shock hits; and ex ante financing arranged before a shock hits. Countries self-insure against shocks by building up official reserves and other macroeconomic policy buffers. But there are limitations. For example, public investment and other development needs imply a high opportunity cost to holding excessively large reserves.

External finance can complement self-insurance. Particularly for low-income countries, which often require grants or low-interest loans, an effective architecture for the financing of shocks should provide predictability while still delivering scarce con-cessional resources in amounts tailored to countries’ needs stemming from a shock. Financing arranged after a shock can be better tailored and can limit moral hazard, but its volume and timing is not assured in advance; complementing it with the possibility of ex ante support could give greater confidence to policymakers in low-income countries that at least part of their needs would be met promptly in the face of shocks.

This ex ante support can be provided by contingent financing instruments such as insurance, market hedging, contingent credit lines, and contingent debt instruments. The historically low use of contingent financing instruments by low-income countries partly reflects factors such as affordability, political economy concerns, and technical capacity. The international community can help in addressing some of these constraints to the use of contingent financing instruments.

Source: IMF 2011c.

Within a country, higher food prices decrease the real incomes of urban and many rural workers. In poor, vulnerable developing countries, the weight of food in the consumption basket is close to 50 percent and households have limited opportunities to smooth consumption (given their low savings and limited access to credit). Insofar as higher food prices lead poor households to substitute toward less nutritious food items, increased undernourishment may lower health outcomes and cognitive development of children, as discussed in chapter 2. Thus, higher food prices may bring not only immediate economic hardship, but also sustained effects on growth and development. Recent experience underscores how high food prices can also prompt social and political instability that may disrupt economies and weaken economic management, adversely affecting poverty reduction and growth.

As food and fuel prices rose in 2010 and the first half of 2011, consumer prices rose in tandem in many countries (map 3.2). In emerging and developing countries, the median inflation rate rose from 4 percent in 2009 to 6 percent in 2011, but experiences were mixed. In about one-third of all countries, inflation abated over this period, while the share of countries containing inflation in the low, single digits fell from 60 percent in 2009 to 40 percent in 2011. Nonetheless, the share having double-digit inflation remained steady at about 20 percent; in at least some cases, excessively accommodating macroeconomic policies, rather than cost-push pressures, may have been responsible.

MAP 3.2With higher commodity prices, few countries are able to maintain price stability

Still, high food and fuel prices noticeably affected inflation levels in several low-income countries. In Burundi inflation more than tripled from 4½ percent in 2009 to 15 percent in 2011 as the monetary authorities sought to contain the second-round effects of the imported inflation. Inflation doubled in Bangladesh from 5½ percent to 11 percent over the same period. Other examples of sharp increases in consumer prices during this period that were associated with international food and fuel prices include the Kyrgyz Republic (from 7 to 17 percent), Maldives (from 4 to 12 percent), and Mozambique (from 3 to 11 percent).

The food price shocks of 2007–08 and 2010–11 constituted adverse shocks in many emerging and developing countries. These shocks, however, were partly offset by relatively buoyant economic conditions. As global growth faltered in 2009, the developing world was negatively affected, but at the same time lower food prices provided a respite. A similar scenario of moderating growth in the context of lower food prices could occur in 2012.

Managing macroeconomic risks in developing countries

Risks to the baseline outlook

There are important downside risks to the global baseline outlook explored here.

Perhaps the most immediate is the possibility of a larger, more protracted bank deleveraging in the Euro Area. Tightening credit would deepen the recession and further strain fiscal positions, with additional spillovers. Deleveraging could also affect emerging and developing countries more directly: Euro Area banks account for large shares of global trade finance, an area where the impact of deleveraging was already evident by late 2011. Another key risk is that medium-term fiscal consolidation plans and rising medium-term public debt levels could leave Japan and the United States vulnerable in the event of turmoil in global bond and currency markets. In key emerging market countries, where growth has benefited from buoyant credit markets and asset price increases, a hard landing that triggers a loss of confidence and an unwinding of credit and real estate markets could slow growth significantly.

Food and other commodity price projections are also subject to risks. For example, increased geopolitical tensions may push up fuel prices with knock-on effects on other commodity prices (through higher transportation and other production costs). Higher fuel prices may also lead to a further expansion of biofuel production at the expense of food production, thus placing further pressures on food prices. If global growth is higher than expected, demand pressures could also lead to higher commodity prices, at least in the short run. Although food prices are expected to continue to ease in the period ahead, a broad range of alternative scenarios could well lead to a retesting of the peak food prices of 2008 and mid-2011.

The low-income countries may be particularly vulnerable to these risks

Most low-income countries recovered swiftly from the global crisis and growth has been strong since early 2010, helped by past macroeconomic and structural reforms that had enhanced the resilience of their economies. Nonetheless, with their macroeconomic buffers still well below pre-crisis levels, most low-income countries are now less prepared to cope with further external shocks. As analyzed by IMF staff in the fall of 2011, adverse shocks to global growth and commodity prices could thus have severe economic and social consequences.2 At the peak of the global crisis in 2009, many low-income countries used strong pre-crisis macroeconomic buffers to pursue countercyclical fiscal responses: despite falling revenues, they maintained and often even increased spending. While growth recovered swiftly from the global crisis, most low-income countries have since made little progress in rebuilding those buffers. Fiscal adjustment began in 2010 as revenues rebounded, but has since halted—in part because of measures taken in response to the commodity price shock of early 2011.

Current account deficits (net of FDI) have widened, especially for net oil importers. And reserve coverage has declined since the 2009 IMF special drawing rights allocation, in particular for many low-income countries with pegged exchange rates. Consequently, most low-income countries are now less prepared to cope with further external shocks than they were in 2008 (Figure 3.12). In the event that downside risks materialize, for most low-income countries the scope for fiscal stimulus would be more limited than in 2009, given weaker fiscal buffers and constrained aid envelopes.

Figure 3.12.Selected macroeconomic indicators for low-income countries, 2007-12

Source: World Economic Outlook.

To provide a more structured assessment of these vulnerabilities, an analytical framework was used to simulate two (mutually exclusive) tail-risk scenarios for all low-income countries (Figure 3.13):

  • A sharp downturn in global growth scenario, in which shocks to financial conditions in advanced economies reduce global growth by 1.3 percentage points in the first year and by 1.6 percentage points in the second year, relative to the World Economic Outlook baseline.

  • A spike in global commodity prices scenario, involving surges in prices for food (25 percent in the first year and 31 percent in the second year), fuel (21 percent and 48 percent), and metals (21 percent and 36 percent), relative to the World Economic Outlook baseline.

Figure 3.13.Tail-risk scenarios for low-income countries

Source: IMF 2011b.

Note: The illustrative fiscal space measure (top panel) is calculated as the difference between the baseline primary balance and the constant primary balance that is needed to achieve a target public debt-to-GDP ratio of 40 percent in 2030. The bottom panel shows a simulation of the reserve coverage ratio after an increase in global food, metals (except gold and uranium), and fuel prices (by 31, 36, and 48 percent respectively) and a slowdown in global growth (by 1.6 percentage points) relative to the World Economic Outlook baseline.

The adverse global growth shock is estimated to cut about 1 percentage point off low-income country growth in each of two years, because these countries are negatively affected through channels such as global export demand, commodity prices, remittances, and FDI. The severity of the impact would vary, with more than a quarter of low-income countries experiencing a growth slowdown exceeding 2 percentage points. A downturn in global growth would severely erode external and fiscal buffers, causing fiscal deficits to increase (by about 1 percentage point of GDP for the median low-income country) and, for most low-income countries, current account deficits to widen and official reserve coverage to fall.

The price spike scenario recognizes that commodity price shocks tend to create winners and losers both within and across countries, depending on the terms of trade, sectoral employment, and consumption patterns. However, its repercussions on inflation, poverty, and social pressures would be felt more symmetrically, because of high shares of food in the consumption baskets of low-income countries. While the growth impact of this scenario would likely be modest, inflation could more than double, assuming that the pass-through from global to domestic prices follows historical patterns and that any monetary policy response is mild.

The external impact of a commodity price spike would differ significantly across low-income countries depending on their trade structure. A large majority would be adversely affected, however, with the median trade balance deteriorating by almost 3 percent of GDP. For commodity exporters, a negative median impact from food and fuel prices would be more than offset by the gain from higher prices of other commodities. About one-fifth of low-income countries would stand to gain from higher prices. Among those hurt by the shock, about half would have adequate international reserves to absorb the shock and the others would face additional financing needs.

In many low-income countries, increased global commodity prices would put pressure on fiscal positions, assuming that countries maintain existing policies (such as fuel subsidies) and that they reintroduce transfers and subsidies similar to those used in 2007–08. A sharp increase in commodity prices that was sustained for long periods would also worsen debt dynamics in a number of low-income countries with existing debt vulnerabilities.

Policy responses in the event of adverse external developments

A key policy challenge for many low-income countries is to build resilience while supporting economic development. This requires balancing pressing spending needs, including public investment and social protection, against the rebuilding of macroeconomic buffers to prepare for future shocks.

Many low-income countries could still benefit from a further strengthening of their fiscal buffers. Scenario analysis indicates that a large number of low-income countries can only partially absorb large tail-risk shocks. This group could consider a mix of gradual fiscal adjustment combined with realignment of priorities, for example by shifting spending in favor of investment and social programs, and building a stronger revenue base. Those countries that already have no fiscal space under the baseline would have limited room for maneuver in the event of a tail-risk shock. For this group, rebuilding fiscal buffers and strong concessional support from development partners will be particularly important. Some low-income countries already have adequate fiscal buffers, and may even be able to expand their fiscal deficits in the baseline, for instance to step up critical spending, without compromising their ability to absorb large shocks.

While many low-income countries have built up sufficient reserves to absorb the impact of either shock fully without the need for adjustment (and import compression), others would benefit from building additional reserve buffers. These buffers could be achieved through a mix of monetary and fiscal tightening, combined with greater exchange rate flexibility where appropriate. A quarter of these countries already have import coverage of less than three months under the baseline. For this group, rebuilding external buffers should be a high priority. These countries are most in need of help from the international community.

To reduce their exposure or create space to prepare for future shocks, low-income countries can also take steps ex ante. Besides building policy buffers during good times, they can, for example, make their budgets more structurally robust (IMF 2011d); put in place more flexible and robust social safety net systems; pursue reforms to encourage domestic savings and deepen their financial sectors; and explore policies to encourage greater diversification in an economy’s production and exports. A specific example in this regard would be to lower domestic fuel subsidies. This step would directly strengthen the fiscal buffer, while also giving the private sector incentives to pursue a more rational use of energy. Another example would be to lower import tariffs—at a pace that acknowledges the potential revenue implications—to better align domestic and international prices of traded commodities.

Macroeconomic policies in the event of a sharp global downturn

The appropriate macroeconomic policy response to a sharp global downturn would depend in part on available policy buffers. During the global downturn in 2009, low-income countries with more comfortable buffers were able to mount a strong countercyclical fiscal response that cushioned the impact on spending and growth. In the event of another sharp downturn, the scope for fiscal stimulus would be more limited for most low-income countries, given weaker fiscal buffers and constrained aid envelopes, but those with sufficient fiscal room should aim to protect spending. For countries lacking fiscal room, key challenges will be to limit the decline in domestic revenue to the extent possible through strengthening tax and customs administration, and to prioritize spending. If fiscal space allows, low-income countries should seek to soften the economic and social impact of a global downturn by preserving—and where feasible increasing—real fiscal spending in priority areas.

In the event of another global downturn and related softening in commodity prices, more active monetary easing may be appropriate in low-income countries with moderate inflation. Greater exchange rate flexibility could also help to weather another downturn, and would be particularly important for those countries with low reserve cushions.

Macroeconomic policies in the event of global commodity price spikes

Global commodity price spikes present low-income countries with difficult tradeoffs between price stability, external goals, and social objectives. A pragmatic response could include targeted measures to protect the poor and a monetary policy response that may largely accommodate the first-round impact on inflation, although those countries with limited reserves may need to tighten policies in support of external and price stability. The scope to use tax and expenditure measures to mitigate the social impact of higher commodity prices depends considerably on the country-specific fiscal space.

The illustrative tail-risk scenario indicates that many low-income countries appear to have adequate fiscal space to absorb the effect of a large, but temporary, global commodity price shock. By contrast, those lacking fiscal space even under the baseline would need to adjust over the medium term to preserve fiscal sustainability after such a shock. A “first-best” policy response to global price shocks would consist of fully passing on price increases while relying on an effective, well-targeted social safety net—in combination, these measures would ensure fiscal affordability and avoid economic distortions, while protecting the most vulnerable. However, institutional capacity and political constraints often make the first-best infeasible, particularly in the shorter term. These constraints may imply a need to resort to pragmatic policy responses—a challenge then being to make the measures as cost-effective and targeted as possible. A number of “second-best” policy approaches have been used—some effectively, and others less so (Box 3.2).

Box 3.2Fiscal policy responses to food price shocks

In designing policies to respond to food price and related shocks, national authorities consider the effectiveness of various tax and expenditure policies and the fiscal space available to implement these policies without endangering macroeconomic objectives. The scope for mitigating the impact of higher food prices depends considerably on earlier policies and how those have affected the country’s fiscal and debt positions. The appropriate fiscal response also depends on the nature of shock and its expected duration.

Even for countries with ample fiscal space that face a spike in food prices, measures aimed at limiting the price increase for all consumers, such as a general price subsidy, are typically not optimal. First, by providing relief to the general population, large shares of the cost of these schemes are incurred in subsidizing consumers that may not require assistance. Second, because broad-based subsidies are more expensive, if the shock persists their cost becomes a greater concern very quickly. Third, political economy considerations can make it difficult to eliminate price subsidies once they are in place. Finally, subsidies create a substantial wedge between world market and domestic prices; incentives for smuggling could lead to the budget subsidizing consumption in neighboring countries.

Developing countries’ experiences dealing with recent years’ high and volatile oil prices are illustrative in this regard (Granado et al). After oil prices began to rise at the end of 2003, most developing countries limited the full pass-through of international prices to domestic consumers (the median pass-through was lowest in the Middle East and highest in Africa). When oil prices did not subsequently reverse, the cost of maintaining the subsidies mounted and by mid-2008 reached about 1 percent of GDP in affected countries, with most of the associated benefits on household welfare accruing to the better off segments of the populations. Pass-through of international to domestic food prices varies across regions and countries; as discussed in chapter 1, in countries open to trade the pass-through is faster and relatively larger.

While a well-targeted social safety net aimed at the most vulnerable households is preferable to general price subsidies, such safety nets are difficult to design and implement. Until they can be put in place, in some cases policy makers may subsidize particular products predominantly consumed by the poor (such as coarse grains) while recognizing that some non-poor households may also benefit from the scheme.

Export taxes and restrictions have also been used in an attempt to dampen domestic price increases, but these have considerable drawbacks, including exacerbating the volatility of global prices (chapter 4). Reductions in import tariffs—if only temporary—carry similar drawbacks. Measures to address supply constraints such as agricultural input subsidies—may have a role if implemented within a broader strategy focused on increasing agricultural productivity. However, the experience with input subsidies is mixed (chapter 2).

During both the 2007–08 and 2010–11 food price shocks, countries implemented a broad variety of measures to counteract the effects of higher international prices. Examples of targeted measures include the provision of food vouchers to the lowest quintile households in the two largest urban areas in Burkina Faso, an expansion of school feeding programs in Sierra Leone, and a conditional cash transfer program targeting orphans and vulnerable children in Kenya. Broader across the board measures included a suspension of customs duties on rice, wheat, and powdered milk in Senegal and a suspension of taxes on food products and the introduction of fuel subsidies in Burkina Faso. In Guinea, a reduction in retail prices on fuel turned out to be very costly and spurred illegal reexports to neighboring countries. Vietnam temporarily banned rice exports for a few months until it was clear that the new harvest was sufficiently large. In the meantime, world market prices had started to fall rapidly and Vietnamese exporters experienced larger drops in their earnings than did their Thai counterparts.

During the recent commodity price shock, most low-income countries adopted countervailing fiscal measures to mitigate the impact of higher food and fuel prices. In several cases, the fiscal costs exceeded the measures introduced during the 2007–08 episode. An often-used measure was fuel subsidies. These subsidies helped lower transportation costs, and thus indirectly food prices. The median (annual) fiscal cost is estimated to exceed 1 percent of GDP for those countries adopting the measures. Most fuel or food subsidies were universal, and few were explicitly targeted to the poor. While these fiscal measures helped address urgent economic and social concerns, they also prevented low income countries from making further progress toward restoring their fiscal deficits to levels prevailing before the 2009 crisis.

The appropriate monetary policy response to a food price shock depends on the inflation outlook, the share of food prices in household consumption baskets, the pass-through from food prices to other prices, and the country’s external balance, debt, and reserves situation. When inflation is at low to moderate levels, the standard monetary policy advice is to accommodate the direct impact of the food price shock, while guarding against any second-round effects. (For food importers, adjustment will often require some degree of exchange rate depreciation, amplifying the inflationary impact.) This allows the monetary authorities to avoid an undue policy tightening that would exacerbate the impact of the price shock on output, while preventing a persistent effect on inflation and inflation expectations (Box 3.3). However, food-importing (and other commodity-importing) low-income countries with high inflation or weak external buffers such as high current account deficits, low reserves, or vulnerable debt positions) may require policy tightening.3 Striking the proper balance can be particularly complex for low-income countries, where products that exhibit considerable price volatility, such as food and fuel, may constitute half of the consumption basket (Figure 3.14). On the other hand, because wage indexation and other contract mechanisms that foster inflation inertia are less prevalent in many low-income countries, a temporary surge in commodity prices will have milder second round effects on inflation.

Box 3.3Food price volatility and monetary policy

Recent research done for the International Monetary Fund’s World Economic Outlook suggests that central banks faced with high and volatile food prices set and communicate monetary policy based on developments in underlying inflation (IMF 2011e).

This finding hinges on the observation that, when food prices are volatile and the share of food in the consumption basket is high, it can be very difficult to control headline inflation. Food price shocks often stem from weather disruptions and other shocks that are generally temporary and outside the control of the central bank. Consequently, when a food price shock hits, a central bank targeting headline inflation will be faced with either a loss of credibility if it accommodates the shock, or collateral economic volatility if it attempts to dampen the inflationary effects of the shock. Conversely, if a central bank has established and communicated a clear focus on underlying inflation that is embedded in people’s expectations, it can successfully accommodate the first-round effects without undermining credibility or risking higher future inflation. A striking consequence is that a central bank can achieve lower headline inflation and output volatility than if it had focused on headline inflation. The key channel for this result is the preservation of the central bank’s credibility and the anchoring of inflation expectations when food price shocks hit.

While an emphasis on underlying inflation can deliver superior outcomes, there are challenges in establishing such a regime. A common objection to the use of underlying inflation targets is that they do not necessarily reflect the day-to-day prices faced by consumers. However, even headline inflation is not an accurate measure of the prices faced by any given consumer. For example, consumption patterns of households with many children will be very different from those made up of young adults, and neither consumption pattern will match the basket used for the headline inflation measure. Furthermore, underlying inflation measures are generally constructed so that over the medium run, if not the short run, they show the same average level of inflation as headline inflation. The research argues that the central bank, thus, has some choice over the target used, a finding that is supported by the successful experiences of inflation-targeting central banks that established their regimes around underlying inflation measures through the use of sustained and ultimately successful communications strategies.

Volatile food prices present a significant challenge to central banks trying to control inflation. This challenge is magnified in countries with high shares of food in their consumption baskets seeking to establish a credible policy regime. The research suggests that these central banks would do better to target what they can hit (that is underlying inflation) than valiantly trying to control headline inflation in the face of food price shocks that are outside their control.

Figure 3.14.Composition of the Consumer Price index basket in low-income and OECD countries

Source: World Economic Outlook.

A note on fragile states

Fragile states are characterized by weak public institutions, lack of timely and reliable statistics on the basis of which policies can be formulated, skills shortages, slow rates of GDP growth, and greater macroeconomic instability. Peace- and state-building takes priority over formulating and implementing consistent medium-term macroeconomic policy frameworks. Conflict and other major shocks not only bring great hardship but also

set back years of investment in public institutions and public infrastructure, perpetuating a cycle of underdevelopment.

In the face of a slowdown in global growth, the structural problem of unemployment, particularly among the young, would become starker. In the face of food price shocks, fragile states lack many of the policy options available to other developing economies. Because available policy space is strictly limited, these countries often turn to the international community for assistance. To engage most effectively, international organizations and development partners are increasingly recognizing the limited capacity and large financing needs of fragile states, and developing longer-term strategies to benefit them.


The classification of countries is the one used in the IMF’s World Economic Outlook. Emerging and developing countries are those countries that are not designated as advanced countries. Countries that are eligible for financial assistance under the IMF’s Poverty Reduction and Growth Trust constitute a subset of emerging and developing countries; these countries are denoted low-income countries although eligibility is based on other considerations in addition to income levels. Emerging and developing countries that are not eligible for financial assistance under the Poverty Reduction and Growth Trust are designated as emerging market countries.

This section draws from IMF 2011b.

Food and other commodity exporters should generally rely on exchange rate appreciation to mitigate inflation pressures from a food price spike.


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