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CHAPTER 3 How Are LICs Affected?

Author(s):
Stefania Fabrizio
Published Date:
March 2010
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For many LICs the crisis is expected to have a severe impact on economic growth this year, but a V-shaped recovery is expected for 2010.

An Overview

LIC economies are being hit hard by the global crisis (see Figure 3.1), reflecting the sharp contraction in trade, rising unemployment, and weak internal demand in many advanced and emerging economies (Figure 3.2 and Appendix 2). As a consequence of this major economic slowdown, the World Bank (2009a) estimates that an additional 89 million people will be pushed into extreme poverty (below US$1.25 a day) by end-2010.

Figure 3.1.Low-Income Country GDP Growth

(In percent)

Sources: WEO database, and Fund staff calculations.

Figure 3.2.Projections for 2009 and 2010

Sources: WEO database, and Fund staff calculations.

1Excludes the Fund SDR allocation provided in August 2009.

Growth projections have been revised down significantly since March. In 2009, growth is forecast at an average 2.4 percent (down from precrisis rates in the 5–7 percent range), mainly on account of lower trade flows, reduced remittances, and lower FDI. Economic growth is expected to recover to 4.2 percent in 2010, as increased openness to trade and foreign capital should enable the private sector to take better advantage of rising world demand, while short-term domestic policies continue to support growth. However, the speed of recovery is expected to vary significantly across regions—while Asia should witness a quick recovery, the rebound in economic activity in Latin America is expected to be much more modest.

Despite the sharper-than-expected drop in export growth, trade and current account balance projections have remained broadly unchanged in 2009, and no further deterioration is expected for 2010. The outlook for LIC exports has worsened markedly for 2009, mainly reflecting lower export volumes (the overall terms of trade have improved instead; see below), with some regions experiencing a contraction in 2009. However, this is expected to be more than compensated for by lower imports, reflecting the decline in food and fuel prices, reduced FDI-related imports, and, in some countries, financing constraints.

The forecast for LIC reserves in 2009 has remained broadly unchanged, although with some regional differences. Reserve coverage is projected at an average 4.2 months of imports in 2009, remaining broadly unchanged in 2010, provided countries’ financing needs are met (see Chapter 5).2

Inflation is expected to drop sharply in 2009 from the peaks seen in 2008, and to ease further in 2010. The declines in food and fuel prices from their 2008 hikes, together with falling demand in the wake of the global crisis, are expected to lower inflation in 2009 to a median 5.9 percent in current projections as the subdued external environment prevents any significant inflation pass-through to wages or other prices from recent upward pressures on commodity prices.

LICs’ overall fiscal balances are projected to deteriorate on average by about 2.8 percent of GDP in 2009 (Figure 3.3). The deterioration in the deficit projection reflects primarily the worsening deficits of commodity exporters. Revenues will decline with GDP but, in addition, two-thirds of LICs are projected to see revenues fall relative to GDP, due to the disproportionate impact of the crisis on trade and commodity tax revenues as well as lower compliance. The revenue loss for commodity exporters is expected to be more than twice the average of all LICs (Figure 3.4).

Figure 3.3.Change in Average Overall Fiscal Balance in 2009 Relative to 2008, by Country Groups1

(In percent of GDP)

Sources: Fund staff estimates and projections.

1Including grants.

Figure 3.4.Impact of the Crisis on LIC Revenues, 2008–09

Source: Fund staff estimates and projections.

1Including grants.

Source: Fund staff calculations.

Increases in public expenditure are also contributing to the fiscal expansion. On average, expenditure is expected to increase as a share of GDP by almost 1.8 percentage points in 2009 as planned spending increases are maintained in the face of the crisis and one-third of countries implement discretionary fiscal stimulus. The largest average increases are in capital expenditures, but the civil service wage bill in LICs is also forecast to grow, as civil servants are shielded, relative to other workers, from the decline in output.3

LICs are projected to begin consolidating their fiscal positions, with overall balances expected to improve on average by around 1¼ percent of GDP in 2010, with commodity exporters adjusting their fiscal balances by about 2 percent of GDP.4 For some countries, at least part of this reduction can be achieved by winding down their fiscal stimulus. However, especially for countries in debt distress, the adjustment will require implementation of structural reforms, such as tax policy and revenue administration measures to augment the low revenue ratios, together with expenditure rationalization and enhanced public financial management to improve the efficiency of public spending.

The Channels

The crisis is significantly impacting LICs through reduced demand for their exports, lower FDI, and reduced remittances. Prospective aid flows fall short of donors’ commitments. At the same time, the direct impact of the financial crisis has been limited. However, risks to the financial sector from a domestic economic slowdown are a serious concern and must be closely monitored.

Spillovers from the Global Recession

Trade

The external environment for LIC exports has deteriorated substantially. Global trade volumes are estimated to have fallen by 12 percent in 2009, driven largely by a sharp decline in trade in advanced economies but also in emerging and developing countries.

LICs have seen a strong decline in merchandise exports (Figure 3.5). Following an initial period of resilience, LIC exports started to fall in October 2008, about three months after exports began to decline in advanced and emerging market economies. The onset of the decline in imports appears to have slightly lagged that of exports. Exports of services, mainly tourism, have also declined, but by much less than goods exports, as is the case globally.5 Overall exports of goods and services are expected to fall by 16 percent this year.

Figure 3.5.Merchandise Export Growth

(Quarter to same quarter previous year)

Sources: WEO database, International Financial Statistics database, and Fund staff calculations.

LICs have seen a slight improvement in their terms of trade this year (Figure 3.6), reflecting the decline in oil prices from their peaks in 2008 as well as lower manufactured goods prices. On average, LICs’ export prices fell by 12 percent, while import prices declined slightly more, due to lower oil prices and lower prices of manufactured goods (Figure 3.7). On average, oil importers have seen a moderate terms-of-trade improvement, while oil exporters suffered a pronounced terms-of-trade deterioration.

Figure 3.6.LIC Terms of Trade

(Change in percent per year)

Sources: WEO database, and Fund staff calculations.

Figure 3.7.Export and Import Indices

(2007 = 100)

Sources: WEO database, and Fund staff calculations.

In 2010, LIC trade volumes are expected to recover moderately, reflecting projections for renewed demand in the global economy. LIC terms of trade are projected to change only slightly.

Remittances

Remittances to LICs are projected to fall substantially in 2009 and to recover modestly in 2010. The projected decline in remittances by 10 percent in 2009 is a decisive break from the recent past, when remittances were growing at double-digit rates, becoming the second largest flow to LICs (Figure 3.8; see also World Bank, 2009b). In 2010, remittances are projected to recover somewhat but remain below precrisis levels.

Figure 3.8.LIC Aid, Remittances, and FDI Flows

Sources: OECD for ODA through 2007, World Bank for remittances; WEO database for FDI, and Fund staff calculations

Sources: WEO database, and Fund staff calculations.

The impact of the global recession on remittances will vary from region to region depending on developments in key source countries. Remittances to sub-Saharan Africa are likely to be affected strongly. Western Europe and the United States are the largest sources of remittances for many African countries (in 2008, over three-quarters of Africa’s remittances came from these two regions), and both regions are currently experiencing significantly larger declines in economic output than the rest of the world. Remittances to Latin America are likely to be affected strongly as well, given the severity of the downturn in the United States. Similarly, some Commonwealth of Independent States countries are likely to be severely affected by the sharp contraction of the Russian economy and the depreciation of the ruble. In contrast, remittances to most Asian countries are likely to be more resilient because of their more diverse sources, and in particular their greater reliance on the Middle East, where economic activity remains relatively strong.

Foreign Direct Investment

The global economic crisis likely affects FDI to LICs mainly through changes in economic conditions in advanced economies. Empirical evidence suggests that both weak GDP growth in advanced countries and unfavorable global financial market conditions tend to reduce FDI flows (see Levy-Yeyati, Panizza, and Stein, 2007).

Gross FDI flows to LICs are expected to fall by 25 percent this year, hurting growth prospects in recipient countries.6 A survey of investors suggests that countries in Asia could be affected the most, and countries in sub-Saharan Africa the least, by downward revisions in FDI plans (UNCTAD, 2009). This suggests that natural-resource-oriented FDI may be affected only to a limited extent. The decline in FDI is likely to have a significant impact in many LICs, given its importance as a source of external financing for investment as well as a driver of growth (accounting for one-fourth of gross fixed capital formation in LICs). The outlook for FDI in 2010 shows only a slight recovery, reflecting mainly the expectation of still sluggish growth in advanced economies (Figure 3.9).

Figure 3.9.Foreign Direct Investment to LICs

Sources: WEO database, and Fund staff calculations.

Aid

Notwithstanding international commitments to scale up aid, overall aid flows to LICs are expected to grow only marginally in 2009 and remain broadly stable in 2010. To meet Gleneagles commitments, aid flows would need to grow by 11 percent in real terms per year during both 2009 and 2010, and current indications are that donor plans fall well short of this.7

Direct Financial Channels

Developments in the Banking Sector

As anticipated in an earlier report (see International Monetary Fund, 2009a), the direct impact of the global financial crisis on the banking system in LICs has been limited, but funding for bank operations has come under pressure in some countries. The lack of exposure to subprime mortgage loans and complex derivative instruments insulated LIC banking systems from direct effects of the crisis. Nevertheless, although some larger banks have succeeded in securing long-term funding from international financial institutions, the deterioration in global market liquidity has put strains on foreign branches and subsidiaries that relied on credit lines from parent institutions.8 Moreover, the effectiveness of policy responses in easing domestic liquidity conditions has been impeded by shallow domestic financial markets and limited collateral.

Pressures on banks’ loan portfolios have begun to emerge in some countries, reflecting second-round effects of the crisis. Although the available data are limited, there are indications that nonperforming loans (NPLs) have increased in 2009 as macroeconomic risks have begun to materialize (Figure 3.10). This deterioration is particularly acute in countries with limited sectoral diversity in loans. Because many NPLs are relatively new, and therefore not yet fully provisioned, bank earnings are likely to deteriorate going forward. Some banks have, however, started the process of rescheduling and restructuring their credit portfolios.9

Figure 3.10.Bank Nonperforming Loans to Total Loans

(In percent)

Sources: Global Financial Stability Report, October 2009, and Fund staff estimates.

Note: 2009 reflects the latest data available.

In several countries, asset quality has also deteriorated as a consequence of the impact of falling equity prices on loans for share purchase, or collateral in the form of shares. Rising equity markets prior to the crisis encouraged borrowing for stock market investment, frequently in the form of margin loans. Not only have such loans become nonperforming, but the steep decline in share prices also revealed weaknesses in the regulatory framework for domestic capital markets as well as gaps in the regulation of credit risk and bank reporting, since banks were able to delay booking losses on these loans. The Nigerian central bank’s intervention in five banks in August is the most illustrative example.

Falling international interest rates have reduced earnings from foreign placements.10 Most LIC banks have placed part of their deposits (up to 10 percent of total assets in some cases) in banks abroad. These portfolios have been adversely impacted by falling interest rates and higher counterparty risk. In response, there are signs that, in some countries, banks are repatriating funds or reallocating these foreign deposits to other countries where interest rates are higher or deposit guarantee schemes are fuller.11

As capital inflows and remittances declined, bank earnings from foreign exchange operations have also been hit. Earnings from foreign operations have declined in the West African Economic and Monetary Union (WAEMU) region, Armenia, the Kyrgyz Republic, Ghana, Tanzania, and Zambia as a result of reduced foreign inflows. Lower capital flows and remittances have also reduced the value of bank collateral by contributing to declines in real estate prices, and, in countries such as Tajikistan, have been important enough to have reduced system deposits.

Domestic bank lending has been curbed as a result of banks’ deteriorating positions. In response to the increase in NPLs, lower profitability, and higher funding costs, many banks have increased lending rates and tightened credit conditions. In almost all LICs, bank credit to the private sector slowed sharply in the year to June 2009 (Figure 3.11), albeit from exceptionally rapid growth rates in some countries.12 In some countries, particularly in sub-Saharan African, the supply of credit to specific sectors, such as real estate, has been particularly constrained. Although some countries have worked out rescue plans to relieve the pressure on banks’ balance sheets, these strategies are likely to be reserved for systemically important financial institutions.

Figure 3.11.Bank Credit to the Private Sector in LICs

Annual growth in percent)

Source: International Financial Statistics database.

Sovereign Access to Financing

The potential for LIC sovereigns to access commercial external financing appears to have improved somewhat. Credit ratings on LICs have held up well,13 and the public sector has been active in the external syndicated loan market (Figure 3.12), with the flow of new loans to LIC sovereigns up 11 percent in the first half of 2009 compared to the second half of 2008, with, for example, Angola and Ghana tapping this market.

Conditions in international bond markets have also eased. Nevertheless, despite the marked improvement in spreads since late 2008, spreads remain significantly elevated.

Figure 3.12.Syndicated Loan Issuance, 2008–09

Source: Dealogic.

This improvement in external conditions is reflected in increased activity by foreign investors in LIC debt securities (Figure 3.13). In the six months to March 2009, activity by foreign investors increased in all regions, barring Latin America, with the most significant gains in Asia, the Middle East, and Europe. This activity is mostly concentrated in local markets.

Figure 3.13.Evolution of Selected Stock Market Indices

Source: Emerging Markets Trading Association.

1Figures reflect both purchases and sales of assets in the secondary trading market.

Source: Bloomberg.

1As of September 11, 2009.

Developments in domestic financing conditions have been more uneven. For instance, in Asia, domestic financing conditions appear to have improved significantly, with yields falling across the curves quite sharply; however, as discussed above, tighter domestic liquidity conditions have seen yields increase substantially at the short end in several sub-Saharan African LICs (Figure 3.14).

Figure 3.14.Evolution of the Yield Curve

Sources: Bloomberg, and central banks.

Corporate Access to Financing

Corporate entities continue to face challenging financing conditions both in external and domestic markets. The flow of externally sourced syndicated loans to corporate sectors in LICs declined by about 8 percent in the first half of 2009 compared to the second half of 2008 (for example, Angola and Liberia). This is a particular concern given the extent of the refinancing needs facing the corporate sector (Figure 3.15). Corporate access to domestic bank financing tracks the general picture discussed above.

Figure 3.15.Maturities Falling Due on Syndicated Loans

(In billions of USD)

Source: Dealogic.

Nevertheless, in line with broader global developments, conditions in equity markets show some improvement (Figure 3.16). Having reached a low around the turn of the year, the Merrill Lynch Africa Lions Index rose by close to 60 percent in the period January–June 2009. Though not universal, this pattern is also repeated in other LICs (e.g., Sri Lanka and Vietnam), suggesting that some corporate entities might have scope to access capital through the stock market.

Figure 3.16.Equity Markets and Selected Asian LICs

Source: Bloomberg.

1As of September 11, 2009.

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