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Bouyant in South Asia but inflation and fiscal debt are growing concerns

Global Macroeconomics Team's picture

The World Bank’s latest outlook (Global Economic Prospects: June 2011) projects that after growing 9.3% during calendar year 2010, activity in the South Asia Region will slow down and moderate to a still buoyant 7.5% in 2011. The slowdown partly reflects macroeconomic policy tightening aimed at curbing stubbornly high inflation and reducing large fiscal deficits. Tighter financing conditions and rising food and fuel prices have contributed to a weakening in consumption and investment growth, factors that have been partially offset by strong export growth and resilient remittances. Growth is projected to pick up in 2012-13, reaching 7.9% in 2013, led by robust investment expenditures in India, Sri Lanka, and Bangladesh. Pakistan and Nepal are projected to lag, given continued political challenges and associated difficulties with macro-policy implementation.

Inflationary pressures are elevated across South Asia reflecting various factors, including higher international food and fuel prices, tight capacity utilization, and past macroeconomic loosening, which have led to elevated inflation expectations and higher core prices (figure 1). High international fuel and food prices are key factors in South Asia because of its heavy reliance on imports of oil and some staples, such as edible oils. Additionally, food represents a large share (about 40%) of the regional household consumption basket, a key concern from a poverty perspective. The strength of the recovery in South Asia partly explains the persistence of inflation in the region, as little spare capacity remains. A series of local one-off factors have contributed to price pressures including: the economic disruptions from flooding in Pakistan (during the second half of 2010) and Sri Lanka (early-2011); the partial liberalization of petroleum prices in India (mid-2010); and the raising of administered petrol prices elsewhere in the region (including Bhutan, the Maldives, and Pakistan).

To rein-in domestic demand and inflationary pressures, monetary authorities have initiated policy rate hikes in Bangladesh, India, and Pakistan.  Despite these measures, real policy interest rates are negative—or remain looser than they were prior to the crisis. Unfortunately, bringing inflation back down will be complicated by the trend rise in inflation over the past decade, which has contributed to an increase in inflationary expectations in recent years. Household surveys in India, for example, indicate that consumers’ inflation expectations have increased over the last four years.

While some countries (India, Maldives and Sri Lanka) made progress toward fiscal consolidation in 2010, general government deficits remain very high, at 8.8% of GDP in India for FY2010/11, 20.7% in the Maldives for CY2010, and 7.9% in Sri Lanka for CY2010. Large outlays for interest payments are hampering achievement of greater fiscal consolidation, and—while improving in some countries (Afghanistan, Maldives, Nepal and Sri Lanka)—the region’s low tax base makes consolidation particularly challenging. Fiscal balances have deteriorated in Pakistan—after rising to 6.3% of GDP in FY2009/10—the deficit continued to expand in the first half of FY2010/11 tied to flood-related outlays, high power-sector subsidies and increased defense spending. In Bhutan, the fiscal deficit rose to an estimated 4.4% of GDP in FY2010/11, as the government continues to plow money into development and infrastructure projects. In Bangladesh, the deficit rose to 4.9% in 2010/11, due to large outlays for investment in power generation and higher subsidies. Sizeable foreign aid inflows and improved revenue performance helped contain Nepal’s deficit to a relatively modest 2.8% of GDP and helped Afghanistan retain a surplus of 0.6% of GDP.

Government debt is elevated across the region—reflecting the impact of long-term structural fiscal deficits—and exceeds the average for developing countries in aggregate (except for Afghanistan) (figure 2). As of FY2009-10, debt as a share of GDP in the Maldives (96%), Sri Lanka (82%) and India (73%), sharply exceeded the average for developing countries (37%). Indeed, South Asia’s government debt is more closely in line with that of high-income countries (91%).

Inflation remains a key downside risk to growth, as policymakers face numerous challenges in reducing price pressures. If inflation remains elevated, it is likely hamper the region’s international competitiveness and foreign investment—creating headwinds to gains in productivity. Higher monetary policy interest rates aimed at crimping price pressures, however, could also prompt a rise in capital inflows and complicate monetary policy—emphasizing the need for fiscal consolidation. Persistently large budget deficits also pose important downside risks to growth, by crowding out private investment and contributing to excess demand. Fiscal slippage is contributing to inflationary pressures and limits policy options in the event of future crises through limited fiscal space. Regional deficit (and debt) problems will need to be resolved by simultaneous reforms on both revenues and expenditures along with reforms to support expansion of the private sector, including deepening financial markets.

Key external downside risks are tied to uncertainty in the Middle East and North Africa. A spreading of turmoil to GCC countries could undermine confidence and economic growth in the Middle East and North Africa, and result in a decline in remittances. Expansion of the sovereign-debt crisis in Europe represents another important downside risk, particularly if the crisis were to spread to larger Euro Area economies, which are key export markets for South Asia and could, in particular, negatively impact the tourism sectors among the smaller South Asian economies, such as the Maldives and Sri Lanka.