Emerging from the Global Crisis - Macroeconomic Challenges Facing Low-Income Countries
Author: International Monetary Fund
Publication Date:
10 May 2010
eISBN:
9781498336734
Language:
English
Keywords:
PP; fiscal policy; baseline LIC inflation; a number of LICs; economic recovery; LICs in Latin America; LIC growth; program LICs; revenue-to-GDP ratio; LIC recovery; macroeconomic position
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While the impact of the global crisis has been severe, real per capita GDP growth stayed positive in two-thirds of low-income countries (LICs), unlike in previous global downturns, and in contrast to richer countries. The crisis affected LICs not so much through the terms of trade or global interest rates, but rather through a sharp contraction in export demand, foreign direct investment, and remittances (oil exporters also suffered from a sharp fall in oil prices). LICs saw the sharpest decline in their economic growth rate over the last four decades. However, this slowdown followed a period of strong expansion, and real per capita GDP growth has generally held up in LICs, remaining well above growth in richer countries.

Abstract

While the impact of the global crisis has been severe, real per capita GDP growth stayed positive in two-thirds of low-income countries (LICs), unlike in previous global downturns, and in contrast to richer countries. The crisis affected LICs not so much through the terms of trade or global interest rates, but rather through a sharp contraction in export demand, foreign direct investment, and remittances (oil exporters also suffered from a sharp fall in oil prices). LICs saw the sharpest decline in their economic growth rate over the last four decades. However, this slowdown followed a period of strong expansion, and real per capita GDP growth has generally held up in LICs, remaining well above growth in richer countries.

I. How Have LICs Coped with the Crisis?

  • Unlike in previous downturns, when terms of trade shocks and high interest rates played a key role, this crisis affected LICs mainly through a sharp contraction in export demand, foreign direct investment (FDI), and remittances, hitting LICs harder than in the past.

  • Most LICs reacted, for the first time, with a domestic countercyclical policy response, preserving vital spending and cushioning the impact of the crisis on growth, which has held up better than in most emerging markets (EMs) and advanced market economies (AMs).

  • The countercyclical policy response has been possible thanks in part to macroeconomic policy buffers LICs have built over the past decade, in particular lower fiscal and current account deficits, reduced debt levels, lower inflation, and comfortable reserves.

A. Impact of the Crisis

1. Although the global crisis has hit LICs hard, growth has remained positive in most countries—unlike in previous downturns and in contrast to much of the rest of the world.1 The global crisis caused a dramatic collapse in world growth and the most severe global recession since the 1930s. The crisis severely affected LICs, which saw the sharpest decline in economic growth rate over the last four decades (Appendix II). This slowdown followed a period of exceptionally strong expansion, however, with the result that real per capita GDP growth in 2009 still remained close to the average of the last 30 years, and positive in two-thirds of LICs. Across regions, LICs in Latin America and the Caribbean, and those in the Middle East and Europe were relatively more affected, while growth in Asian and sub-Saharan African LICs held up reasonably well, broadly mirroring how the crisis impacted richer countries in these regions.

uA01fig01

LICs per capita growth has remained positive, in contrast to most EMs and AMs, and…

(Real per capita growth; percent, median)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.
uA01fig02

… unlike in previous crises.

(Real per capita growth; percent, median)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

1/ Previous crises are 1975, 1982, and 1991.
uA01fig03

During the crisis, fiscal and current accounts deteriorated while inflation pressures eased and reserves held up well. Unlike in richer countries, debt increased only slightly.

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.

2. Along with the drop in growth, fiscal and current account deficits widened, whereas inflation pressures eased and reserves held up well in 2009 (Appendix III). The impact on the fiscal and current account was felt most by oil-exporting LICs that were affected by the sharp decline in oil prices. Inflation declined in most LICs as the impact of the fuel and food crises waned, with less than one-fourth of LICs still seeing double-digit inflation in 2009, compared to nearly two-thirds in 2008. Reserves held up well during the crisis, in part reflecting the IMF’s general SDR allocation.2

3. Unlike in more advanced economies, for which debt dynamics have become a concern, public debt has deteriorated only slightly in most LICs. In fact, public debt-to-GDP ratios across LICs have been on a downward trajectory, in part because a number of countries benefited from debt relief under Heavily Indebted Poor Countries (HIPC) Initiative and Multilateral Debt Relief Initiative (MDRI). For LICs reaching the Decision Point or Completion Point under the HIPC initiative in 2008–10, the median public debt ratio fell from 76 percent of GDP to 57 percent over 2007–09.3 Most non- and post-HIPC LICs saw their gross debt ratios rise during the crisis, although this build-up—by a median 6 percentage points of GDP—was much smaller than in advanced countries, reflecting LICs’ significantly higher nominal GDP growth rates, the limited impact of the crisis on their financial sector, and the fact that their deficits were financed partly by drawing down government deposits.

4. In contrast to past global downturns, this crisis affected LICs not so much through the terms of trade or global interest rates, but rather through a sharp contraction in demand for their exports, FDI, and remittances. The histogram below shows that the one-percent decline in real GDP growth of LICs’ trading partners in 2009, which was a key transmission channel to LICs, was an unprecedented (“tail”) event. The decline in private transfers and FDI was unusually strong. By contrast, the terms-of-trade impact was positive for most LICs, with the exception of oil exporters who saw a significant fall in prices from the heights in 2008. Aid flows held up well, which matches the experience during most previous crises when official transfers did not exhibit a decline during the crisis year itself.

5. The combination of shocks associated with the crisis is estimated to have had a severe impact on poverty and employment. World Bank simulations suggest that the crisis will leave an additional 64 million people in extreme poverty by the end of 2010.4 This effect is likely to persist and by 2015 the global poverty rate is projected to be 15 percent, compared to the 14.1 percent it would have been without the crisis. While the labor market data needed to assess the employment effects is limited, the International Labor Organization (ILO) estimates that the most severe impact has been in Latin America and the Caribbean region, where the average unemployment rate is estimated to have risen by 1.2 percent in 2009.5 The crisis had a particularly severe impact on the mining, garment, maquila, and tourism industries.6

uA01fig04

The 2009 shocks were more severe (“tail events”) than in previous downturns

(Distribution of Median of Shocks to LICs by Year, 1971–2009)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff calculations.Note: For each year, the median level of change in the variable was calculated and the histogram of the distribution of those medians was plotted. The red curve represents a smoothed estimate of the probability density function.

6. As anticipated in previous studies,7 the direct impact of the global crisis on LICs’ banking sectors has been limited. Many banks in LICs were characterized by low reliance on capital inflows and wholesale funding. They had generally limited leverage and also maintained relatively high pre-crisis capital adequacy ratios. As a result, banking sectors were shielded from the initial impact of the crisis, more so than banks in the rest of the world (Appendix IV). However, as the macroeconomic environment continued to deteriorate, banks’ portfolios were adversely affected by an increasing volume of non-performing loans (NPLs) and decreasing profitability.8 Banks responded by tightening credit standards and curtailing lending to the private sector. A number of countries therefore implemented policy measures that mitigated the impact of the crisis on the banking sector,9 and credit growth appeared to pick up somewhat in the second half of 2009.10 Nevertheless, higher loan-loss provisions and stronger competition for new deposits appear to have been exerting pressure on banks’ earnings.

uA01fig05

While private-sector borrowing slowed, there are signs of a gradual recovery. Non performing loans increased during the crisis and lower earnings have strained bank profits.

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Source: Country authorities.

7. The small number of LICs with access to capital markets were affected by the turmoil in global markets in 2008/09, but have since benefited somewhat from renewed investors’ interest in EM bonds. International capital markets reopened for LICs with Senegal’s debut issuance in December 2009 (US$200 million) and Vietnam’s issuance in January 2010 (US$1 billion), the first issuances of significant size since the crisis broke. In line with improved cost conditions in international markets, the cost of domestic bond financing has generally declined, although the size and structure of these markets remains limited in LICs. In equity markets, Asian LICs, including Bangladesh and Mongolia, have performed relatively well.

B. LICs’ Pre-Crisis Position

8. LICs entered this crisis with much stronger macroeconomic positions than in the past. Compared with previous downturns (1975, 1982, and 1991), LICs had far smaller fiscal and current account deficits, lower inflation, stronger international reserve coverage, and—thanks in part to debt relief—lower debt burdens. These “policy buffers” were built up mostly during the last decade—supported by sound macroeconomic policies, an enabling global environment, and in some case debt relief—as shown by an overall policy buffer index constructed for this paper.11

uA01fig06

LICs’ pre-crisis macroeconomic policy buffers were stronger than in the past.

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.Note: Previous-crisis periods: 1972–74; 1979–81; 1988–90.

9. However, the strength of LICs’ pre-crisis policy buffers differed across regions, and was generally greater in commodity exporters and countries with Fund programs. LICs in Latin America and the Caribbean appeared generally less well-prepared for the crisis than others. By contrast, commodity exporters benefited from global price trends since 2004 and on average had more reserves, lower public debt, smaller fiscal deficits, and stronger current account balances than non-commodity exporters, though their inflation was still higher. Countries that had a long-term program engagement with the IMF tended to build up reserves, reduce debt, and contain fiscal and current account deficits more significantly than other LICs.12

Policy Buffer Components by LIC Groups, 2000 and 2007 1/

article image
Source: IMF staff calculations.

The 2000 and 2007 values for the flow variables are calculated as the average over 1998–2000 and 2005–07 respectively.

Defined as having a Fund program for at least six years during 1995–2007.

uA01fig07

Policy buffers were built up during the last decade, though with differences across countries.

(Composite Policy Buffer Index, all LICs)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.Note: the number of countries differs between the two periods (1993–99 and 2000–07) due to data availability. The 1993 and 1999 buffers were calculated using external public debt rather than total public debt, which was also due to data availability.

10. In spite of significant progress made through 2007, LICs approached the crisis with somewhat lower policy buffers than EMs and AMs, in part reflecting their very weak initial conditions. As of end-2007, EMs had higher international reserves coverage, lower public debt in percent of GDP, and a more comfortable current account position than LICs—somewhat expected given their greater economic development. Fiscal deficits in AMs and EMs were also smaller than those in LICs.

C. Domestic Policy Responses to the Crisis

Fiscal policy

11. Unlike in previous downturns, most LICs could afford to adopt a countercyclical fiscal policy response, and most did so. As in past downturns, fiscal revenue declined as a result of the crisis, but this time around, most LICs did not curtail spending; indeed, in about half of LICs, the growth rate of real primary expenditures accelerated. As a result, the median fiscal overall deficit widened by about 2.7 percent of GDP (and the median primary deficit by 1.9 percent of GDP). This countercyclical fiscal policy response was a first for LICs, and was made possible by much stronger pre-crisis macroeconomic policy buffers (in particular stronger fiscal positions) and greater availability of domestic and external financing.13

uA01fig08

LICs used a countercyclical fiscal response…

(Fiscal Indicators; in percent of GDP)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.
uA01fig09

… unlike in previous crises.

(Fiscal balance; in percent of GDP)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

12. Most LICs let fiscal automatic stabilizers work and increased real primary spending. The median decline in revenue in LICs amounted to 0.3 percent of GDP. In about half of LICs, the cyclical drop in revenue was partly offset by revenue-boosting measures reflecting ongoing reforms to strengthen medium- and long-term revenue performance. Commodity exporters were hit hardest, with a median revenue loss of 2.1 percent of GDP. Notwithstanding the lower revenue, real spending grew in LICs during the crisis, with a median increase of 7.4 percent in 2009 in comparison with 7.6 percent over the previous five years.

uA01fig10

Automatic stabilizers in LICs worked on the revenue side during the crisis.

(Median change in revenues, 2006–09; in percent of GDP)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.

13. Pre-crisis policy buffers were the key factor determining the scope for fiscal accommodation in 2009. Regression analysis suggests that LICs with stronger pre-crisis buffers14 could better afford widening primary fiscal deficits and responded more forcefully to weakening growth (Appendix VI).15 While LICs with stronger buffers could afford to increase real spending in 2009, many low-buffer countries were unable to do so.16 17 All told, 81 percent of LICs increased expenditures, compared with 88 percent of AMs and less than 69 percent of EMs.

Determinants of Change in Primary Balance to GDP in 2009 1/

article image

Real GDP growth in 2009 is instrumented by real GDP growth in trading partners, change in remittances scaled by GDP in 2008, and change in export deflator. t-statistics are in parenthesis. ***, **, and * denote significance at 1, 5, and 10 percent level, respectively.

An increase in index corresponds to an improvement in performance.

uA01fig11

Stronger policy buffers provided scope for higher spending during the crisis.

(Real primary expenditure, median, 2007 = 100)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.
uA01fig12

LICs increased real spending more rapidly in 2009 than AMs and EMs.

(Real primary expenditure, median, 2007 = 100)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

14. The composition of spending improved in favor of public investment and social sectors.18 Public investment in 2009 increased by 17 percent in real terms. Health and education spending increased in real terms by 10 percent in 2009, while real growth in spending on goods and services slowed during the crisis. The growth in health and education spending was higher in countries with IMF-supported programs. In addition, although LICs’ social safety net systems are, in general, not well developed, many countries took steps to strengthen social protection, enhancing or introducing cash transfer programs, with the dual purpose to protect nutrition of young children and provide cash to poor families. A number of LICs also implemented labor-intensive public works programs.19

uA01fig13

The composition of spending improved in favor of public investment and social sectors.

(Real growth rate of primary expenditure, median, 2006-09; in percent)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.

15. Countries supported by a Fund program were able to increase real spending more than non-program countries. Almost 90 percent of countries with Fund-supported programs (“program LICs”) increased real primary expenditures in 2009, compared with 67 percent of countries without Fund-supported programs, as Fund financing reduced liquidity constraints and helped catalyze donors’ support. Median real expenditures among program LICs increased by about 8 percent, as compared with 7 percent among non-program LICs.

16. LICs relied heavily on domestic sources to finance the rising fiscal deficits. More than half of the additional deficit was financed by domestic sources, which includes borrowing in domestic debt markets, central bank financing, or drawing down government deposits. External loans accounted for much of the remainder, with IMF financing a significant component. Grants increased slightly in 2009.

17. Empirical evidence suggests that this countercyclical fiscal response also helped cushion the impact of the global crisis on growth. Loosening fiscal policy can support growth, in particular, when the economy is sluggish and inflationary pressures are low. The effectiveness of fiscal stimulus would also depend critically on the quality of the fiscal measures and whether debt sustainability is adversely affected. Econometric analysis of the determinants of short-run growth during economic downturns based on the last three crisis periods, including the last one, suggests that loosening fiscal policy has tended to support growth in the short run (see text table and Appendix VII). This suggests that, in many LICs, countercyclical fiscal policy in 2009 helped cushion the adverse growth impact of the crisis, in addition to sustaining adequate spending on social and infrastructure sectors. The latter, in turn, may have helped speed the recovery in 2010 and beyond, though this remains to be seen.

uA01fig14

Domestic sources financed much of the additional fiscal deficits.

(Sources of financing; median, 2007–09; in percent of GDP)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.

Short-term Determinants of Growth during Crisis Episodes 1/

article image

Panel instrumental variable regressions are estimated by Limited Information Maximum Likelihood (LIML). Sample includes downturns (1981–82; 1989–90; 2008–09). Change in primary balance to GDP is instrumented for by lagged values of macroeconomic stability indicator and the current account balance to GDP. t-statistics are in parenthesis. ***, **, and * denote significance at 1, 5, and 10 percent level, respectively.

The combined effect of contemporaneous external shocks to trade, remittances, FDI, and services exports in percent of previous year’s GDP. Negative value indicates adverse shocks.

Monetary, exchange rate, and financial sector policies

18. As in the past, monetary policy remained somewhat passive during the crisis in most LICs. While almost two-thirds of the 39 LICs for which data are available lowered the nominal policy rate, this decrease was less than the globally-driven fall in inflation could have allowed, resulting in an increase in real rates at the peak of the crisis. Constraints on monetary policy effectiveness, such as weak monetary transmission channels and inefficient monetary policy frameworks, are likely reasons for this muted monetary policy response. Regarding financial sector policies, a number of countries sought to mitigate the impact of the crisis on their banking sectors through measures ranging from enhanced surveillance to intervention and capital injection. Some banks have also benefited from financial support to other sectors (Box 1).

uA01fig15

While many LICs lowered policy rates when the crisis hit…

(Number of countries changing the nominal discount rate)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.
uA01fig16

…monetary policy did not respond to the full extent.

(Nominal and real discount rate, 2007–2009; in percent)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Examples of Crisis Mitigating Measures in the Banking Sector, 2008–09

  • Direct assistance in the form of capital injection or intervention (Kenya, Nigeria, and Uzbekistan).

  • Targeted assistance to affected sectors considered key for economic growth, which was to some extent channeled via affected banks (Nigeria, Tanzania, and Uganda). In Tanzania and Uganda, NPLs were concentrated in loans to these sectors. Tightened supervision of banks through, for example, enhanced monitoring of NPLs, and imposing stricter prudential limits (Moldova, Sierra Leone, and Zambia); and strengthened coordination between home/host supervisors and the regulations on cross-border financial flows (WAEMU countries).

  • Establishment of special monitoring units (e.g., Tanzania) to identify emerging risks in the financial sector and formulate a coordinated policy response. In Nigeria, a high-level committee was launched (Presidential Steering Committee on the Global Economic Crisis).

  • Tightening of exchange rate controls (Nigeria imposed temporary foreign exchange controls to prevent depreciation of the Naira, including: (i) allowing purchases of foreign exchange from the central bank window that could be used only for the purpose of transactions with corporate clients; and (ii) tightening requirements on net open position limits); these controls were removed in July 2009.

  • Blanket restructuring of past-due loans and increasing size and flexibility of credit lines to banks (Nicaragua).

  • Lowering the costs of the Lombard facility (Tanzania).

  • Expanding the mandate of deposit insurance by broadening on-site monitoring function (Tanzania) and exploring the establishment of a deposit insurance fund to boost confidence in the banking sector (Ghana and Malawi).

19. By contrast, LICs used exchange rate flexibility much more than in previous crises to respond to exchange rate pressures. Indeed, unlike in previous crises, LICs reacted to downward exchange rate pressures mostly by letting the exchange rate depreciate rather than allowing losses in reserves as in the past (see Appendix VIII). There were, however, some significant differences among sub-groups. Also, although both commodity exporters—including the hardest hit oil exporters—and non-commodity exporters responded to the downward exchange rate pressures primarily by depreciation, commodity exporters incurred reserve losses as well. The real exchange rate for countries experiencing an adverse terms-of-trade shock in 2009 depreciated relatively more than for countries with an improvement in the terms of trade, and the effect was stronger among floating-exchange rate countries.

uA01fig17

LICs have used exchange rate flexibility more than in previous downturns.

Floating Exchange Rate Regimes

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.Note: The EMPI combines movements in the exchange rate and international reserves. Negative (positive) values suggest downward (upward) pressure on the exchange rate, to which countries could respond by either letting the exchange rate depreciate (appreciate) or by selling (accumulating) reserves (Appendix VIII).
uA01fig18

The real exchange rate reacted more in countries that experienced an adverse terms-of-trade shock, and more among those with a floating exchange rate.

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.

II. Emerging from the Crisis—Prospects and Macroeconomic Challenges

  • LICs’ economic recovery is projected to be faster and more aligned with the rest of the world than in previous crises, although the pace of recovery will vary across regions.

  • There are significant downside risks due to uncertain global economic prospects and somewhat weakened policy buffers.

  • Countries are expected to rebuild their macroeconomic policy buffers as the recovery takes hold, in particular by consolidating fiscal and external positions, but real spending is projected to continue to grow for almost all LICs.

  • The appropriate pace and extent of rebuilding buffers depends critically on country-specific vulnerabilities and resilience to further shocks.

  • To rebuild buffers, many LICs should aim to (i) strengthen domestic revenues; (ii) boost priority spending and improve the efficiency and allocation of spending; (iii) pursue cautious external and domestic borrowing strategies, supported by measures to boost domestic savings, develop domestic financial sectors, and prepare debt management frameworks; and (iv) advance structural reforms, in particular to boost growth and manage volatility in an increasingly integrated global environment.

A. Growth Prospects

20. Unlike during previous global downturns, the economic recovery in LICs is projected to mirror the growth pick up in more advanced countries. WEO baseline projections envisage a sharp V-shaped recovery for world growth. The recovery in LIC growth is projected to follow more closely that of the rest of the world, in contrast to the experience in previous global downturns when LICs’ recovery dragged on over several years.

uA01fig19

LIC recovery is expected to mirror that of the rest of the world.

(Real per capita growth; percent, median)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.1/ Previous crises are 1975, 1982, and 1991.

21. The more synchronized recovery of LICs reflects their increased integration in world trade and finance, as well as their more robust domestic policy response during the crisis. Unlike in previous crises, trade and financial openness is playing a crucial role in the current recovery, which is driven significantly by the pick-up of global demand, FDI, and remittances. As shown in an IMF study, since 1990 global demand and financial flows have become important engines of growth in LICs, and are expected to drive LICs’ growth in the future, as globalization continues to increase.20 Indeed, in 38 percent of LICs for which data are available, the contribution from exports would account for more than half of total real GDP growth in 2010. Nevertheless, in many LICs domestic demand would continue to be a significant factor driving growth as well, in part reflecting the robust domestic policy response that has sustained investment throughout the crisis.21

uA01fig20

Trade and financial openness have increased and are expected to be drivers of growth recovery.

(Exports, FDI, and remittances prior to crises for LIC regions; median; in percent of GDP)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.

22. The pace of recovery is projected to vary across regions, mirroring growth in LICs’ trading partners. Economic growth in 2010/11 is projected to be fastest in Asian LICs, benefiting from strong regional growth, whereas LICs in Latin America and the Caribbean are facing a much weaker recovery. The “V-shaped” nature of the recovery is generally less pronounced in LICs than in their richer trading partners, with the exception of LICs in the Middle East and Central Asia, the latter partly reflecting idiosyncratic factors.

uA01fig21

The recovery is projected to vary across regions, mirroring growth in trading partners.

(Real GDP growth in LICs and their trading partners; in percent)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.

23. Risks to LICs’ overall favorable recovery prospects are weighted to the downside, in particular in the event of a slower-than-expected global recovery. A slower recovery in advanced and emerging economies could arise for example from a renewed drop in confidence in advanced economies’ fiscal sustainability, policy responses, and growth prospects. Such a drop was observed temporarily in mid-summer 2010, casting a cloud over the growth outlook in advanced economies. Risks related to donor support are also on the downside, as advanced countries need to tighten their fiscal positions and may find difficult to meet their aid commitments. Renewed pressure could emerge if the recovery in advanced economies were to be slower than expected. See Section II.C for an illustrative downside scenario.

B. Macroeconomic Outlook: Realigning Policies and Rebuilding Buffers

24. LICs are poised to emerge from the crisis with somewhat less comfortable buffers, albeit with significant variation across countries. The baseline WEO projections envisage a gradual consolidation of LICs’ macroeconomic positions, with improving fiscal and current account balances, low to moderate inflation, generally adequate reserve positions, and declining debt paths. Almost three-fourths of LICs are projected to improve their macroeconomic policy buffers over the medium term. This rebuilding is most rapid for commodity exporters and Asian LICs, and is least pronounced for those in Latin America and the Caribbean. Reassuringly, countries that had comparatively low buffers in 2009 are, in general, slated to improve their buffers by more than the average, with the result that the number of countries in the “low buffer” category drops from 25 in 2009 to only 11 by 2015.

uA01fig22

Policy buffers have been used during the crisis—LICs are emerging in a somewhat weaker position, especially with regard to fiscal and current account balances.

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.

25. The baseline WEO outlook suggests that inflation pressures appear to be contained for now, although there are upside risks related to global food and fuel prices. The forecast is for median LIC inflation to continue to fall from its 2008 peak to about 5 percent over the medium term, reflecting moderate food and fuel price increases and low global inflation. Average inflation among countries with floating exchange rates and commodity exporters would be somewhat higher than that of other LICs. There is also heterogeneity among countries, with 11 out of 64 countries experiencing double-digit inflation in 2010 and another nine near-double digits. Risks to the baseline LIC inflation forecast are on the upside given possible increases in world food and fuel prices (see below).

26. Unlike in advanced economies, medium-term debt dynamics are not problematic for most LICs as they rebuild fiscal buffers along the recovery path. The median improvement in the primary balance is projected at 1.3 percentage points of GDP over five years. The share of countries with fiscal deficits in excess of 5 percent of GDP is projected to drop from almost one-half in 2009 to one-tenth by 2014, while at the other end of the spectrum, almost half of the countries are expected to have fiscal deficits below 2 percent of GDP by 2014, up from one-fourth of countries in 2009. With the projected recovery in growth and the gradual improvement in the fiscal balance, the median public debt ratios in LICs will return to a declining trend, unlike in advanced countries, where, on average, debt ratios are projected to increase over the medium term.22 By 2015, public debt would be less than 40 percent of GDP in half of LICs, and a fifth would have debt in excess of 65 percent of GDP.

uA01fig23

The overall debt outlook seems favorable as fiscal buffers are being rebuilt along with the recovery.

(Fiscal balances and debt, median, 2006–15; in percent of GDP)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.

27. The expected fiscal realignment is partly driven by automatic stabilizers, as the pick-up in growth generates higher revenues. About one-third of the projected improvement in the primary balance is expected to come from the cyclical recovery in revenues. The remaining two-thirds comes mainly from measures to boost underlying revenue performance and trim non-priority spending, some of which are part of longer term reform efforts initiated prior to the crisis. In sub-Saharan African LICs, the projected structural fiscal adjustment is estimated at a median just over ½ percent of GDP over five years. In countries with larger projected adjustment, the rebuilding of fiscal buffers would be made easier if additional donor support were forthcoming.

uA01fig24

Much of the projected fiscal realignment should come from building stronger revenues, leaving room for real spending growth.

(Projected change in the fiscal primary balance, median, 2010–15; in percent of GDP)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.

28. Real spending is expected to continue to grow, though with important differences across countries. Median real spending is projected to increase by 4.6 percent annually during 2010–15, somewhat lower than in the pre-crisis period, reflecting the need to rebuild buffers by reducing reliance on domestic financing. The slowdown in spending is lowest in sub-Saharan African LICs. In fact, in one-fourth of the countries in sub-Saharan Africa the medium-term projections incorporate a significant fiscal expansion. By contrast, five countries are expected to cut real spending over this period, mainly reflecting their highly vulnerable fiscal and debt positions coming out of the crisis and the related need to rebuild policy buffers (see below). Further progress in tax policy and revenue administration reforms would also support rebuilding of buffers and higher spending in priority areas.

uA01fig25

Real spending is expected to increase significantly in most LICs

(Real primary spending in LICs; 2010 = 100)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.
uA01fig26

Countries projected to cut real spending tend to have high deficits and debt.

(Average, 2010, percent of GDP)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.

29. The global recovery is projected to boost demand for LICs’ exports and strengthen current account balances, which in turn will help bolster reserve cushions. After a significant drop in 2009, exports are projected to rebound in the near term, helping to narrow current account deficits, especially among oil producers. Over the medium term, eight LICs would have current account deficits (incl. FDI) in excess of 8 percent of GDP, compared to 16 at the end of 2009. The projected improvement in the external environment would help maintain median reserve coverage at around 4–4¼ months of imports over the medium term, though with significant heterogeneity across countries. In particular, at one end of the spectrum, one-seventh of LICs would have more than six months of import coverage, while on the other end, about one-twentieth of the countries would have less than two months. Also, countries that had relatively low reserve coverage in 2009 (below three months of imports), are expected to improve their coverage somewhat over the medium term, but their median coverage would still be only 2.7 months of imports.

uA01fig27

The current account balance is projected to improve gradually as exports rebound…

(Exports of goods and services, and current account balance + FDI, average, 2007–12; in percent of GDP)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.
uA01fig28

… but reserve cushions would not improve much among LICs with relatively low reserves.

(Reserve coverage by initial coverage in 2009, median, 2007–12; in months of prospective imports of goods and services)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Note: “Low” is defined as having less than 3 months of reserves coverage; “Medium” as having more than three but less than four months of reserves coverage.Sources: WEO, and Fund staff estimates.

30. As current account deficits narrow, LICs’ external financing needs are projected to decline gradually in relation to GDP over the medium term. On average, FDI, grants, and borrowing (largely sovereign borrowing for most LICs) are each expected to fill around a fourth of that financing need, with the balance coming from private transfers and other capital flows. Though grants are projected to increase slightly from around US$30 billion in 2010 to US$32 billion by 2014, their contribution to external financing needs is expected to decline. In contrast, external borrowing is expected to increase both in nominal terms (from around US$38 billion in 2010 to US$48 billion in 2014) and as a share of total financing.

uA01fig29

The composition of external financing is projected to shift slightly from grants to loans in the medium term.

(in percent of total external financing)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staf f estimates.

31. To summarize, most LICs are projected to improve their fiscal and current account balances, keep debt manageable, reduce inflation, and maintain relatively comfortable reserve cushions; however, policy buffers will remain weak in a few countries over the medium term, absent additional policy adjustment. Almost half of LICs are projected to have relatively comfortable fiscal and external buffers by 2014. At the other end of the spectrum, almost one-quarter of LICs will have significant fiscal or external vulnerabilities, or both. Cutting across regions, Latin American and Caribbean LICs, which entered the crisis already in a vulnerable position and are particularly exposed to shocks as five out of nine countries are small islands, stand out as the most vulnerable group, as they will continue to have relatively high debt, low reserve coverage, and large current account deficits over the medium term.

C. How LICs Would Cope With Renewed Stress: An Illustrative Scenario

32. The appropriate pace and extent of rebuilding macroeconomic policy buffers depends on country-specific vulnerabilities and cyclical factors. Although the projected outlook for global growth suggests a fast economic recovery, there are significant risks to the outlook, which on balance are on the downside. If economic activity in the rest of the world did not pick up as expected and LICs, in turn, were to face protracted lower economic growth, how would they cope with such renewed stress? Would they have the policy space to respond to a further shock?

33. The purpose of this section is to “stress-test” LICs’ exposure to further shocks, based on an illustrative exercise, to inform policy choices with respect to the rebuilding of macroeconomic buffers as LICs emerge from the crisis. It is intended to bring out some broad policy conclusions about where the main macro vulnerabilities lie, in the wake of the crisis, to provide a sense of how much policy space might remain, and signal what kinds of policy choices LICs will face as a result. What it does not do is provide a blueprint for policy settings in individual countries—hence, the paper does not offer country-specific policy recommendations.

34. For this purpose, we simulate a “downside” scenario that is based on a much slower global recovery, under which per capita real GDP growth in LICs would be lower than in the baseline by about 1 percentage point in 2011. This result was obtained by assuming a hypothetical shock to growth in advanced and emerging economies, and then estimating the spillover effects on LICs’ growth, drawing on recent IMF research into the short-run determinants of LIC growth (see Box 2). This shock would widen fiscal and current account deficits of LICs, reduce reserve coverage, and increase public debt.

A “Downside” Recovery Scenario for LICs

The downside scenario for advanced and emerging economies (accounting for about 87.5 percent of world GDP) is based on the IMF’s Global Projection Model (GPM). It assumes shocks to financial conditions and domestic demand in advanced economies as large as those experienced in 2008, and contagion of these shocks to other financial markets where reductions in equity prices dampen private consumption. Given negative financial and trade spillovers, growth is suppressed in other regions as well. As a result, growth in advanced and emerging economies is reduced relative to the baseline by 0.3 percentage points in 2010, 1.4 percentage points in 2011, and 0.2 percentage points in 2012.1

Using these projections of growth differences relative to the baseline for advanced and emerging economies as a starting point, the downside scenario for LICs was developed in three steps, applied to each LIC:

  • In a first step, the downside growth scenario for advanced and emerging economies was used to calculate by how much GDP growth in LICs’ trading partners would be lower relative to the baseline. This calculation made use of information on trading patterns taken from the IMF’s Direction of Trade statistics.

  • In a second step, the difference in trading partners’ growth calculated in step one was multiplied by the estimated coefficient on partner country growth from a panel regression that relates growth in LICs to a number of its short-run determinants.2

  • In a third step, the result of step two was subtracted from the baseline growth forecast.

A limitation of the method used to derive the downside scenario for LICs is that it considers only the impact of slower growth in advanced and emerging markets and ignores possible associated effects, such as changes in commodity prices, interest rates, and capital flows. This limitation appears to be acceptable as growth in trading partners has been found to be the most important short-run determinant of growth in LICs.

uA01fig30

Baseline and downside projections of per capita growth in LICs Groups

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

uA01fig31

Baseline and downside projections of per capita growth in LICs

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.
1 This downside scenario was presented in the July 2010 World Economic Outlook Update, available at http://www.imf.org/external/pubs/ft/weo/2010/update/02/index.htm.2 Berg, Andrew, Chris Papageorgiou, Catherine Pattillo, Martin Schindler, Nikola Spatafora, and Hans Weisfeld (2010). “Global Shocks and their Impact on Low–Income Countries: Lessons from the Global Financial Crisis”, IMF Working Paper (forthcoming).
uA01fig32

Current account balance (incl. FDI) would widen, and reserve coverage decline in the downside scenario.

(Reserves, median, months of prospective imports of goods and services; and current account balance incl. FD, median, in percent of GDP.)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.
uA01fig33

Fiscal consolidation would slow down, and public debt higher in the downside scenario.

(Public debt, median, in percent of GDP; and fiscal balance, median, in percent of GDP.)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

35. To assess the shock’s impact across different countries, an illustrative assessment of buffers is conducted with a focus on fiscal and external positions. As described in Appendix IX, the relative strength of the fiscal position is based on an assessment of public debt and the fiscal deficit. Similarly, the relative strength of the external position is based on an assessment of the current account balance plus FDI and reserves.23

uA01fig34

A slower-than-projected recovery would leave some LICs in a vulnerable fiscal position.

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.

36. Although the downside scenario would lead to weaker fiscal positions and higher debt, almost half of LICs would have sufficient policy space to absorb the impact on their fiscal balances. The downside scenario would worsen the median structural primary deficit of LICs by about 0.5 percent of GDP and increase the public debt-to-GDP ratio by 3 percentage points by 2015 (excluding those countries with expected debt relief). There would be a wide variation across countries in their ability to respond to such a shock (Appendix X).

37. Almost half of LICs would emerge from such a shock with still low or moderate debt and deficit levels. However, a third of LICs would face high debt and/or fiscal deficits. Half of the countries had fiscal vulnerabilities already prior to the current global crisis. Countries with low buffers in 2009 (over a third of LICs) would need to respond to the shock with some fiscal adjustment, while those with medium and high buffers in 2009, including commodity exporters, would generally be able to absorb most of the shock without additional policy adjustment. Across regions, while sub-Saharan African LICs, in general, largely have policy space to accommodate the shock, Latin American and Caribbean LICs would be in a relatively weaker situation. Clearly, if aid commitments, including budget support, were not fully realized, further risks would emerge for most LICs.

uA01fig35

There are significant differences in LICs’ ability to absorb further shocks.

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.1/ Appendix X describes the methodology to calculate the fiscal space available to absorb shocks.

38. Regarding the external position, many LICs would still have adequate buffers after the shock, whereas some would face significant external vulnerabilities. Over a third of LICs would emerge from a shock with relatively comfortable external positions, with broadly adequate reserve coverage and low or moderate current account deficits. Conversely, about a third of countries would face either low reserves or large current account deficits or both. However, more than a third of the countries in this second group had external vulnerabilities already prior to the current global crisis. A closer look at reserve coverage shows that median LIC reserve coverage could fall by almost one month of imports by 2012, leaving about a quarter of LICs with less than two months of import coverage. Countries with a floating exchange rate regime and with fixed exchange rates would each end up with median reserve coverage of about three months of imports, even though countries with fixed exchange rates would normally be expected to hold more reserves than those with floating exchange rates. Latin American and Caribbean LICs would end up particularly vulnerable, with a median of less than two months of reserve coverage and double-digit current account deficits as a share of GDP.

uA01fig36

A slower-than-projected recovery would leave some LICs in a vulnerable external position.

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.

D. Realigning Policies and Rebuilding Buffers: Policy Recommendations

39. The appropriate macroeconomic policy mix in the recovery phase depends critically on a country’s exposure to potential future shocks. A variety of combinations of fiscal, monetary, and exchange rate realignment could help countries rebuild their buffers against future volatility. At a general level, a gradual reduction in fiscal deficits, supported by both the cyclical rebound and continued structural measures, could help keep public debt at manageable levels and allow a supportive or countercyclical response in the event of another shock. At the same time, fiscal adjustment can also support rebuilding external buffers, including a narrowing of current account deficits and the reconstitution of reserves if needed. Similarly, monetary policy could be used to reduce inflation if needed, while also supporting a buildup in reserves and narrowing of the current account deficit.

40. The above analysis can provide some general guidance on the choice of the macroeconomic policy mix. As shown above, some countries are already in a comfortable position to absorb the impact of a further shock, while many others should realign their policies to some extent, as many are expected to do under baseline projections. The illustrative downside scenario above can provide an indication of vulnerabilities to future shocks across countries, and inform the appropriate policy mix as countries exit from the global crisis. In particular:

  • About one quarter of LICs could comfortably absorb another sizeable economic shock and can therefore maintain accommodative fiscal and monetary policies, with some scope for additional increases in spending and absorption beyond baseline projections.

  • Another quarter of LICs would face moderate vulnerabilities after another shock, and some adjustment may be needed in the event of such a shock, although country specific factors would be critical in determining the appropriate degree and mix of adjustment policies.

  • Of the remaining half of LICs, about a third has more comfortable external positions, but relatively large fiscal deficits and/or high public debt, suggesting that more efforts may be needed on medium-term fiscal realignment. Another third of this group has more comfortable fiscal positions, but faces relatively low reserves or large current account deficits (or both), suggesting the need to focus on monetary and/or exchange rate realignment, depending on the exchange rate regime. The final third of this group (eleven countries) faces both significant external and fiscal vulnerabilities, suggesting the need for both monetary and fiscal adjustment. As their policy options are generally very limited, these countries should focus on addressing their most significant vulnerabilities and would benefit most from additional concessional support.

  • Inflation appears mostly benign for now, at single digits, suggesting that monetary policy could be accommodative. However, risks to future food and fuel prices are on the upside, and policymakers should be prepared to act against possible second-round effects on inflation should another global price shock occur.

  • Across regions, LICs in Latin America and the Caribbean stand out as comparatively vulnerable, with less rosy prospects for growth and weaker policy buffers, suggesting the need to step up the rebuilding of buffers and reinforce growth-oriented policies.

  • Many LICs with fixed exchange rate regimes could benefit from somewhat faster macroeconomic consolidation to rebuild reserves. Conversely, some LICs with floating rates appear to have built more than adequate reserves and could raise spending and absorption.

Fiscal policy

41. The challenge for fiscal policy will be to continue to increase real spending in priority areas, while enhancing the resilience of the budget to volatility. The direct fiscal impact of the crisis in the form of larger deficits and higher debt was manageable in most LICs. However, the crisis exposed vulnerabilities among LICs to future growth shocks and uncertain aid prospects. The fiscal strategy going forward will require strengthening revenue collections, improving the efficiency of spending, and pursuing a careful debt management strategy.

42. LICs should aim for a sustained increase in fiscal revenues over the medium term. LICs’ revenue-to-GDP ratios are below their potential. Strengthening domestic resource mobilization would not only help countries improve their fiscal positions after the crisis, but will also create fiscal space to meet critical spending needs. While LICs’ low revenue ratios are due in part to structural constraints, including the large share of small-scale agricultural and informal sectors that are hard to tax, most countries can improve their revenue collections by improving tax policy and administration. Estimates prepared in recent years by the Commission on Macroeconomics and Health and the Millennium Task Force point to potential revenue increases in the range of 2–4 percent of GDP. In these countries, the tax bases can be broadened by rationalizing income tax incentives and VAT exemptions. There is also some scope to increase excise taxes on alcohol, tobacco, and fuel, while tapping revenue from property taxes. To improve tax administration, efforts should center on securing revenue from large and medium enterprises, and tackling tax evasion and abuses of tax privileges through risk-based audits and compliance checks.

43. Most LICs have the space to continue raising fiscal expenditures in real terms, and are expected to do so; these increases should be targeted to priority sectors, including health, education, and infrastructure. The cyclical rebound in revenues, combined with structural revenue measures should generate enough resources to allow for both a consolidation of the fiscal deficits post crisis and continued increases in spending in real terms. Sustained increases in infrastructure and social spending—in some countries introduced in response to the crisis—should help alleviate growth bottlenecks going forward.

44. The crisis has also highlighted the desirability of strengthening automatic fiscal stabilizers. These are weaker in LICs than in advanced economies, mainly reflecting the smaller size of government. This is unlikely to change in the near term. However, in some countries there is scope to strengthen stabilizers by developing the capacity to provide targeted temporary income support—for example, by labor intensive public works programs or cash transfer programs. But most importantly, stronger fiscal buffers would allow countries to let the fiscal position weaken in response to a short-term downturn rather than having to counteract the automatic stabilizers.

45. Improving the efficiency of spending can create additional fiscal space for priority spending areas. Many countries have room to improve the quality and efficiency of expenditures while protecting priority areas. There is significant scope for improving education and health outcomes, for example, at existing levels of expenditure.24 In addition, subsidies are often costly and poorly targeted, disproportionally benefiting more well-off households. More than one-third of LICs have fuel price subsidies, with these subsidies projected for 2010 to exceed 1 percent of GDP in 6 countries.25 Strengthening public financial management and promoting transparency also would contribute to improving expenditure efficiency. Key measures include: bolstering treasury management, improving budget preparation and implementation, strengthening the appraisal and selection of infrastructure projects, and moving to medium-term budget frameworks, with recurrent cost of capital investment activities fully reflected in the budget. For some LICs, multiyear fiscal frameworks built around fiscal anchors or rules could help balance a rebuilding of buffers with allocating sufficient budget resources for priority needs.

46. A key challenge will be to balance the use of nonconcessional external borrowing against domestic sources of financing and concessional support. Given the larger post-crisis fiscal deficits and the large infrastructure gap experienced by most LICs, many will be tempted to rely to some extent on nonconcessional external borrowing by the state or public enterprises. Those countries with stronger capacity for effective project selection and debt management may have scope to tap this source, as long as debt vulnerabilities are moderate and carefully monitored. However, the above analysis suggests that most LICs are still vulnerable to shocks, and some have elevated debt levels. Highly concessional donor support will thus continue to be critical in many LICs. Moreover, all LICs face the challenge of raising the currently low level of domestic savings and developing their financial sectors (see below) to avoid an overreliance on capital inflows. As LICs increase their use of market based financing, strengthening capacity to effectively manage the resultant portfolio risks will become a policy priority.

Monetary and exchange rate policies

47. Monetary policy could be accommodative in most countries from an inflation perspective, but may need to be used proactively in countries with weak external and reserve positions and in the event that global food or fuel prices spike. A fan chart analysis of median LIC inflation, taking into account uncertainty regarding future oil and food prices, indicates a 25 percent probability that half of LICs could experience inflation that is higher than in the baseline by at least 2 percentage points. This would imply that the number of countries experiencing double-digit inflation could rise from 14 in 2009 to 19 in 2010 and 16 in 2011. This would still leave two-thirds of countries with space to loosen monetary policies somewhat if the external position allows. However, should higher food and fuel prices materialize, monetary and interest rate policies should accommodate the direct impact on the price level, but should counter any second-round effects on inflation and external positions.

uA01fig37

Baseline inflation remains moderate, but there are upside risks related to food and fuel prices.

(Inflation forecast for LICs, median, 2010–11; in percent)

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Sources: WEO, and Fund staff estimates.

48. Exchange rate policies should continue to be used to cushion the effect of future volatility where possible. The above analysis showed that countries with floating exchange rate regimes largely avoided reserve losses during the crisis, as they let their exchange rates adjust to the shock, whereas countries with pegged exchange rates drew on their reserve buffers. In general, countries with low reserve buffers will need to allow their exchange rates to adjust more flexibly. Conversely, countries with floating rate regimes and high reserve levels should consider whether a somewhat lower level of reserves may have net economic benefits, in light of the cost of holding these reserves.

Financial sector

49. The crisis has underscored the importance of adequate financial regulatory frameworks, effective supervision, and sound financial institutions. Supervisory authorities will need to ensure that credit standards do not deteriorate during times of strong credit growth. Regulatory frameworks should focus on the risks assumed by banks and sources of their business growth to ensure that these are sustainable. Closer supervision to ascertain whether banks are complying with prudential regulations is required, and prompt supervisory actions taken if they are found to be noncompliant. In banks where financial strains have been significant, the balance sheet clean-up should proceed quickly; this would require that losses be recognized and that shareholders inject additional capital as needed.

50. Other risk-mitigation reforms that LICs should consider include:

  • Strengthening crisis management arrangements: typical measures might include (i) establishing a special regime for bank resolution, (ii) strengthening arrangements for emergency liquidity assistance, and (iii) establishing crisis contingency plans. Stronger financial safety nets should also be considered, including cautious introduction of deposit insurance schemes, with effective public information.

  • Enhancing information-sharing: information-sharing between home and host supervisors would help to improve the consolidated supervision of foreign financial entities and ensure that banks being considered for licensing are operating in a sound manner in the home country.

  • Continuing with financial sector reforms: for example, the establishment of credit reference bureaux, as announced by a number of countries, would help to mitigate credit risk and lower the cost of credit.

51. Developing domestic debt markets would help to mobilize national savings and increase policy buffers in LICs. The 2009 crisis showed that domestic financing can help to cushion the impact of the crisis and thus create countercyclical policy space. LICs also have enormous investment needs that are in search of financing. While external financing necessarily ought to remain part of the financing mix, policies to mobilize domestic savings and develop domestic debt markets would broaden the range of available options.

52. As LICs strengthen the broader macroeconomic policy framework, a sound debt management framework can catalyze domestic market development (Box 3). LICs have generally been prudent in limiting their use of domestic debt where costs and rollover risks are relatively high. Countries should continue to actively develop the domestic financial system, including strengthening the local institutional investor base, to facilitate an extension of maturities on domestic debt issuance while containing costs.26 A robust debt management framework would also help mitigate the risks associated with greater domestic and external financial integration.

Developing Debt Markets: Lessons from Emerging Markets (EMs)

The lessons on debt management and debt market development in EMs are instructive for many LICs. While sustained improvements in macroeconomic conditions are critical, the experience of some EMs (e.g., Brazil and Turkey) illustrates how a sustained plan for market development can help increase the resilience of debt stock to various shocks (rollover, interest, and exchange rate) while containing costs.

After the 2000–02 crisis, and in parallel with a strong macroeconomic program, Turkey adopted debt management strategies targeted at reducing rollover and currency risks. The authorities actively sought opportunities to extend maturities, initially requiring a reliance on floating rate notes, and reduce the share of foreign currency debt. In parallel, the authorities strengthened their primary dealer framework1 and actively cultivated the domestic institutional investor base. As macroeconomic fundamentals improved, long-term fixed rate instruments were introduced. The improved portfolio resilience helped the authorities weather foreign exchange shocks during the recent global crisis.

The Brazilian experience also emphasizes the importance of sound debt management for market development and policy resiliency.2 Over the past decade, the authorities have focused their debt management strategy on reducing vulnerability to interest rate and exchange rate shocks. Again, in parallel with a sustained period of sound macroeconomic policies, the authorities focused on increasing the proportion of domestic currency debt, while increasing its average maturity and the share of fixed rate instruments. In this instance, inflation-linked bonds played a significant role in meeting these objectives. A strong domestic institutional investor base (e.g., pension funds) also proved critical in helping weather the impact of foreign investor exit at the height of the crisis. Overall, the improved debt structure provided significant resilience in the face of crisis-related market volatility.

1 See Undersecretariat of Treasury (Turkey) (2009). “Public Debt Management Report.”2 See National Treasury (Brazil) and World Bank (2010). “Public Debt: The Brazilian Experience.”

Other structural reforms

53. Reforms that promote economic diversification also have an important role to play in managing macroeconomic volatility and fostering durable economic growth. This is a broad topic that goes beyond the scope of this paper, but it would need to be considered as part of any comprehensive country development strategy. Promoting economic diversification is likely to involve, in particular, further trade integration, which will require both LICs and their trading partners to undertake further reforms of their trade regimes. Benefiting from new trade opportunities would require, in turn, continuing improvements in the business environment, as well as reforms to improve education, financial depth, labor market flexibility, and firm entry flexibility (see Appendix XI). To the extent that transformation in economic structures leads to social dislocation, it would be important to ensure that effective social safety nets are established to protect vulnerable groups.

Appendix I. List of LICs

The group of LICs analyzed in this work is formed by the 64 Poverty Reduction and Growth Trust (PRGT)-eligible countries for which data were available,27 which include, by region:

Sub-Saharan Africa:

Benin, Burkina Faso, Burundi, Cameroon, Cape Verde, Central African Republic, Chad, Comoros, Democratic Republic of Congo, Republic of Congo, Côte d’Ivoire, Eritrea, Ethiopia, The Gambia, Ghana, Guinea, Guinea-Bissau, Kenya, Lesotho, Liberia, Madagascar, Malawi, Mali, Mauritania, Mozambique, Niger, Nigeria, Rwanda, São Tomé and Príncipe, Senegal, Sierra Leone, Tanzania, Togo, Uganda, and Zambia.

Middle East and Europe:

Armenia, Djibouti, Georgia, Kyrgyz Republic, Moldova, Sudan, Tajikistan, Uzbekistan, and Republic of Yemen.

Asia:

Afghanistan, Bangladesh, Bhutan, Cambodia, Lao People’s Democratic Republic, Maldives, Mongolia, Myanmar, Nepal, Papua New Guinea, and Vietnam.

Latin America and Caribbean:

Bolivia, Dominica, Grenada, Guyana, Haiti, Honduras, Nicaragua, St. Lucia, and St. Vincent and the Grenadines.

Appendix II. Distribution of Median Real GDP Growth and Change in Real GDP Growth by Year, 1971–2009

uA01fig38

Unlike previous global downturns and in contrast to EMs and AMs, LICs’ real growth in 2009 remained positive and was close to the average of the last 39 years.

Citation: Policy Papers 2010, 040; 10.5089/9781498336734.007.A001

Note: Considering the period 1971–2009, for each year the median level of / change in growth are calculated and the histograms of those medians are plotted to illustrate the distribution over the sample period.

Methodology

Histograms are plotted to illustrate the distribution of each variable over 1971–2009, covering four global recessions including the global crisis in 2009. For each year the median of variable medXt is calculated over N countries for which data is available as follows:
medX1971=median(X)forcountry=1,…,NmedX1972=median(X)forcountry=1,…,N⋮medX2008=median(X)forcountry=1,…,NmedX2009=median(X)forcountry=1,…,N

While LICs are subject to frequent idiosyncratic adverse shocks, examining medians for each year essentially captures the common shocks affecting the majority of LICs. Simple averages are not preferred since they are not robust to outliers. The histograms of medians, medXt, provide a convenient visual illustration of how frequently a certain range for that variable is observed over the sample of 39 years. The objective is to compare the significance of the common shock in 2009 with those in previous global recessions in 1975, 1982, and 1991 as well as over the full sample period of 1971–2009.

These points could be illustrated in the histograms above. For the change in growth in LICs, the range of -1½ to -2 percent is a fat-tail event that includes the medians for two global downturns in 2009 and 1991. Density is plotted in y-axis so that the total area under bars adds up to one. Therefore, with a histogram bin width of 0.5 percent about 13 percent of observations, i.e., about 5 years out of 38, recorded median change in growth in this range. This rather high frequency indicates that LICs were subject to significant common adverse shocks over the sample period. On the other hand, for emerging market countries and advanced economies, the drop in growth rate in 2009 is unprecedented, being the only year in that tail range for emerging market economies and one of the two years out of 38 for advanced economies.

Appendix III. Selected Economic Indicators

Selected Economic Indicators

article image
Sources: WEO database, and Fund staff calculations.

Next year’s imports of goods and services.