3 Growth Outlook and Macroeconomic Challenges in Emerging Economies and Developing Countries
- International Monetary Fund
- Published Date:
- April 2010
The recovery of the global economy has been more robust than expected. Driven by strong internal demand in many emerging economies and the recovery of global trade, GDP growth in emerging and developing countries is projected to accelerate to 6.3 percent in 2010, from 2.4 percent in 2009. Supporting the economic recovery are expansionary macroeconomic and, especially, fiscal policies. Fiscal deficits in emerging and developing countries, up by almost 3 percent of GDP in 2009, are projected to remain high in 2010. More than in previous crises, many countries sustained spending plans and raised social spending to mitigate the effects of the downturn on the poorest people, although the differences among countries are wide. While financial market conditions for emerging and developing countries are improving and capital flows are returning, international bank financing and foreign direct investment are projected to remain weak in 2010.
Although the short- and medium-term growth prospects for most emerging and developing countries are positive, the question arises: to what extent does the current shock have longer-run implications that could knock countries off their track of solid growth? The question is especially important for low-income countries because poverty is so much more pressing there than in countries with higher incomes. History does not suggest that low-income countries can uniformly escape global shocks without absorbing long-lasting damage to both growth and welfare. In past crises, it has often taken several years for low-income countries to bring growth rates back into positive territory. Even so, the turnaround in low-income countries this time is projected to be faster than in previous crises, thanks to countercyclical fiscal policies and better macroeconomic fundamentals in place at the beginning of the crisis. Commodity exporters are helped by the fairly quick recovery of commodity prices. And financial systems in low-income countries have been less affected by turmoil than those in advanced economies.
The recovery is still vulnerable, however, and the rapid expansion of fiscal deficits and the greater reliance on domestic sources of financing in many countries may not be sustainable. External debt ratios in low-income countries, deteriorating in the short run, should be watched.
Optimal exit policies from policy support should depend on country circumstances.
- Countries where private demand is still weak should continue supporting activity if policy space is available.
- Some countries, however, are facing financing constraints—they cannot delay adjustment. Donors should assist them by following up on commitments to increase aid.
- All countries should adopt credible medium-term fiscal adjustment plans to bolster confidence in macroeconomic policies and undertake policy reforms to secure long-term growth.
The economic recovery
Global economic activity is recovering from the deepest recession since the Second World War, albeit at a moderate pace. According to the International Monetary Fund’s (IMF) World Economic Outlook, growth of global output will increase to 4.2 percent in 2010, from a decline of 0.6 percent in 2009 (table 3.1). The recovery, supported by improving financial conditions and rising world trade (figure 3.1), is led by emerging economies in Asia, where growth rates now exceed precrisis levels. The prospects for developing countries, including the poorest, are improving as well, although growth rates have not yet recovered to the levels seen in the years before the crisis.1
|Emerging and developing economies||8.3||6.1||2.4||6.3||6.6|
|Central and Eastern Europe||5.5||3.0||-3.7||2.8||3.8|
|Commonwealth of Independent States||8.6||5.5||-6.6||4.0||4.1|
|Middle East and North Africa||5.6||5.1||2.4||4.5||4.8|
|Western Hemisphere||5.8||4.3||-1.8||4.0||4.2|FIGURE 3.1Short-term indicators of production and trade are recovering
Source: IMF International Financial Statistics; Bloomberg; Haver Analytics; central banks.
Note: Data are weighted by PPP-GDP, 2006.
The underlying factors driving the expansion differ from country to country. While economies in Asia and Latin America are bolstered by a recovery of private consumption and investment, private demand growth in emerging Europe is expected to remain sluggish, and several countries remain dependent on exceptional policy stimulus. Commodity exporters are benefiting from firmer global demand for raw materials and higher commodity prices. Even so, the recovery remains vulnerable, most notably in advanced countries and the economies of Eastern Europe, where high unemployment, moderate income growth, and weaker household balances are dampening consumption growth, posing risks for the global outlook. In addition, in the medium–term, growth rates in some groups of countries, especially low-income countries, are not expected to reach the high levels recorded before 2008.
Because the recovery is in an early stage and unemployment rates are still elevated, global inflation has remained low, although some economies, especially in Asia, are showing the first signs of price pressures. Inflation risks are rising in Latin America as well, where output gaps in some countries are closing rapidly.
Commodity prices are recovering
Following the sharp drop in commodity prices in late 2008, prices for most commodities rebounded sharply in 2009 and are continuing their upward trend in 2010 as the global recovery gains momentum (figure 3.2). The increases are helping to mitigate the impact of the crisis on commodity exporters. Food prices are the exception, because good harvests in Sub-Saharan Africa and elsewhere have given an opportunity to rebuild stocks. But food and commodity prices, relatively high by historical standards, are projected to remain so, given the prospects for further medium-term demand growth and continuing supply constraints in many sectors.
FIGURE 3.2Commodity price indexes rebounded strongly in 2009
Note: Indexes are in U.S. dollars.
Financial conditions are improving, but financial flows remain below precrisis levels
Financial market conditions for emerging and developing countries have improved considerably since the onset of the crisis. Bond spreads have declined, stock markets in both emerging and developing countries have recovered sharply, and exchange rate volatility has come down considerably (figure 3.3–3.5). Some borrowers—sovereigns and prime corporations in particular—quickly regained market access following a brief interruption at the end of 2008. Financial market access for sub-investment-grade borrowers in emerging and developing countries has also improved. But access to international bank financing remains limited as banks in advanced economies continue deleveraging.
FIGURE 3.3Bond spreads have declined in emerging markets and developing countries
Source: Dealogic; Bloomberg.
Note: Bond issues and spreads as of end-March 2010..
FIGURE 3.4Share prices have recovered sharply
Source: IMF International Financial Statistics.
Note: Prices are in the local currency.
Financial policies, such as improved financial sector regulation and crisis measures, have contributed to avoidance of widespread banking crises in emerging and developing countries. The public response to the financial crisis has been broad, covering several instruments, such as liquidity support, deposit insurance, bank interventions, and recapitalizations. Banking sectors in many emerging economies have also benefited from higher financial market resilience, including less volatility in exchange and interest rates,2 and therefore have avoided negative dynamics from balance sheet effects.
Even so, concerns about systemic risks to the solvency of banks and corporations linger. The cost of external debt financing remains elevated in some emerging and developing countries, where spreads on high-yield external corporate bonds are still substantially above those before the collapse of Lehman Brothers in September 2008 (figure 3.6). In addition, some countries in Eastern Europe and the Commonwealth of Independent States (CIS) continue to face uncertainties as a result of high external debt refinancing needs and private sector foreign currency debt. The fallout from the crisis has also affected bank loan portfolios in many countries, as evidenced by the rising shares of nonperforming loans (figure 3.7).
FIGURE 3.5Exchange rates have been less volatile: Daily spot exchange rates
Note: Exchange rates are in national currency per U.S. dollars.
FIGURE 3.6The cost of external debt financing has come down
FIGURE 3.7The share of nonperforming loans to total loans has been rising
Source: IMF 2009b.
Despite the general improvement in market conditions, financial flows to emerging and developing countries have not recovered to those seen in the years preceding the financial crisis (table 3.2). In emerging economies, net inflows of foreign financial resources (capital flows and transfers) are not expected to exceed 8.2 percent of GDP this year, down from an average of about 12 percent in 2007-08, mainly because of the sharp drop in bank financing (figure 3.8), especially in Asia and Latin America, and foreign direct investment. Developing countries are facing weak foreign direct investment activity as well, because overcapacity in extractive industries remains considerable despite rising global demand for commodities. Overall, net financial flows are projected to decline to 13.9 percent of GDP in 2010, from 15.9 percent in 2007-08.
|Emerging market economies||12.6||11.4||8.7||8.2|
|Private capital flows, net||8.0||7.0||3.2||3.1|
|of which: private direct investment||5.4||5.1||3.3||3.3|
|Private portfolio flows||0.8||-0.5||-0.3||0.1|
|Private current transfers||4.1||3.7||3.8||3.6|
|Official capital flows and transfers, net||0.4||0.7||1.7||1.6|
|Private capital flows, net||6.6||7.7||5.2||5.3|
|of which private direct investment||6.6||6.2||4.8||4.7|
|Private portfolio flows||-0.7||-0.6||-0.4||-0.2|
|Private current transfers||5.6||5.8||5.2||5.1|
|Official capital flows and transfers, net||1.8||4.2||3.6||3.5|
|Reserve assets||-4.0||-2.3||-1.6||-1.0|FIGURE 3.8Bank financing to emerging markets dropped sharply in 2009
Source: Bank for International Settlements (BIS).
Note: Adjusted for exchange rate changes. Changes are calculated as flow adjusted for exchange rate changes as a share of the stock in the previous quarter.
The drop in foreign direct investment in developing countries is partly offset by the recovery of workers’ remittances (table 3.3). Although remittances to countries in Latin America, North Africa, and the Middle East were weaker than expected in 2009, they appear to have reached a bottom toward the end of the year. At the same time, remittance flows to South and East Asia, largely originating in the Gulf countries, surprised on the upside in 2009, with particularly strong increases in Bangladesh and Pakistan. Overall, remittances to emerging and developing countries are projected to increase by 2 percent in 2010, following a 6 percent decline in 2009.
|Emerging market economies||58.9||177.2||283.3||266.0||271.7||279.1|
Remittances include workers’ remittances, compensation of employees, and migrant transfers.
Forecast base case scenario.
Remittances include workers’ remittances, compensation of employees, and migrant transfers.
Forecast base case scenario.
Current account imbalances in emerging and developing countries have been shifting in recent years, mainly as the result of the sharp swings in world trade and terms of trade since late 2008 (figure 3.9). Fuel-exporting countries have been most hit by fluctuations in the external accounts, a reflection of the high volatility of oil prices and insufficient export diversification. Nonfuel primary product exporters face strong fluctuations as well, but less so than fuel-exporting countries. Despite these fluctuations, there have been reductions in external imbalances in the past two years within the group of emerging and developing countries. The number of emerging economies with high balance of payments deficits and the number of high surplus emerging economies and developing countries declined in 2009 (figure 3.10).
FIGURE 3.9Changes in terms of trade have swung sharply since 2008
Source: IMF staff calculations.
Note: Quintile groups are based on the average of terms-of-trade changes in 2008-09 and 2009-10.
FIGURE 3.10External imbalances have come down in emerging and developing countries
Source: World Economic Outlook.
Even with the large differences in external conditions among emerging and developing countries, there has been a remarkable similarity in international reserve developments across groups of countries and regions. Helped by the recovery in international trade and capital flows, and the allocation of IMF special drawing rights, almost all countries rebuilt international reserves (as measured by reserve coverage in months of imports) in 2009, after a decline in 2008 (figure 3.11). At the end of 2009, 80 percent of emerging markets and 75 percent of developing countries had reserves that could be considered adequate (equivalent to three months of imports of goods and services). For emerging economies, reserves as a share of short-term debt also increased, and at the end of 2009 about 70 percent of emerging economies had reserves that exceeded the stock of short-term debt.3
FIGURE 3.11Almost all countries rebuilt their international reserves in 2009
Source: World Economic Outlook.
Note: The median ratio is shown. “Stock of the external short-term debt” = outstanding (on remaining maturity basis) plus amortization scheduled on medium- and long-term debt.
Thanks to good policies, the recovery is stronger than in past crises
Overall, emerging and developing countries weathered this global crisis better than past ones. Their financial markets and exchange rates have not shown the sharp fluctuations of past crises, and the rebound in economic activity is stronger than expected. Healthier fiscal accounts, reduced debt, better debt maturity structures, low inflation, and higher international reserves gave many countries room for countercyclical policies that were often not an option in previous crises. Further, stronger balance sheets and continued access to financing, especially for prime borrowers, helped private corporations in emerging and developing countries to deal better with adverse conditions than they had in the past. Local bond markets have also benefited some of these countries, with larger enterprises in Asia and Latin America able to rely on local markets for their refinancing needs.
Nonetheless, the crisis has depressed disposable incomes in many countries
The crisis and the pace of recovery have deeply affected disposable incomes in many countries, where a contraction in real activity was sometimes reinforced by a deterioration in the terms of trade (figure 3.12). In 2008-10, about a third of emerging and developing countries were experiencing declines in disposable incomes, with potentially serious adverse effects on poverty. Central and Eastern Europe has been particularly hard hit, with nine countries facing cumulative income declines, in total averaging more than 8 percent.
FIGURE 3.12Deteriorating terms of trade sometimes reinforce contraction in economic activity
Source: IMF Staff calculations.
Note: The figure shows, by region average, real per capita GDP growth rates adjusted for the per capita value of net terms-of-trade changes. The numbers above and below the bars show the number of countries.
Macroeconomic policy trends
Reflecting cross-country differences in initial conditions and the international transmission of the crisis, macroeconomic policy responses have differed. In general, most emerging and developing countries first focused on addressing weakening confidence and containing the impact of the financial market crisis on the real economy. In a second stage, these policies have been followed by comprehensive efforts to support domestic demand and growth in the medium term—mainly through expansionary macroeconomic policies. In most countries these policies are still in place, and the start of the third stage—exiting from extraordinary policy support—has been gradual thus far.
Monetary policy provided support in most countries
Aided by moderate inflation trends and less volatile exchange rates, central banks in most emerging and developing countries reduced policy interest rates in 2009. About 70 percent of emerging economies and close to 60 percent of developing countries followed a path toward lower rates last year. In some countries, higher policy interest rates were initially needed to preserve market confidence. These increases were more modest than in previous crises, however, and in many cases were quickly reversed. In most countries, lower interest rates were associated with depreciations of nominal effective exchange rates. As a result, monetary conditions in most emerging and developing countries—as measured by a simple summary indicator incorporating nominal interest rates and nominal effective exchange rates4—appear to have become more accommodating in 2009 (figure 3.13).5
FIGURE 3.13Monetary policy conditions became more accommodating in 2009
Source: IMF International Financial Statistics.
Note: Monetary policy loosening is based on Monetary Conditions Index (MCI) calculations.
The financial crisis resulted in a sharp decline in money growth in emerging and developing countries (figure 3.14). The decline was largest in countries that had seen the strongest growth in the precrisis years. But as a result of the even stronger decline in nominal GDP growth rates, measures of excess liquidity, such as the nominal money gap, increased. This suggests that despite the fall in money growth, additional liquidity remained available to support corporations and households during the crisis period.
FIGURE 3.14Average year-on-year growth in money and the money gap in emerging markets
Source: IMF International Financial Statistics; Haver Analytics.
Note: The money gap is the difference between year-on-year growth rates of the M2 money supply and nominal GDP. The sample includes emerging-market countries that have data on both for the whole sample period shown.
Expansionary fiscal policies support the recovery
Measured by the median general government balance, fiscal deficits in emerging and developing countries expanded by almost 3 percent of GDP in 2009 (figure 3.15) and are projected to increase further in 2010 in more than one-third of the countries, despite some decline in the median balance. Some countries, especially emerging economies, have put stimulus plans in place. But in most countries the widening deficit is the result of weakening revenue, including the disproportionate impact of the crisis on trade—and thus on revenues from import tariffs—and on consumption taxes. Some countries have also lost corporate tax revenue as the contribution of key sectors in the economy (such as natural resources and other export sectors) declined. Moreover, tax administrations may be facing bigger enforcement challenges during the crisis and its aftermath as tax planning becomes more aggressive. Many countries are more exposed to such challenges because of their weak administrative capacity, large informal sectors, and the constrained cash positions of taxpayers.
FIGURE 3.15Fiscal deficits expanded in 2009
Source: World Economic Outlook.
Despite falling revenues, emerging and developing countries as a group have allowed automatic stabilizers to work and have maintained previous spending plans during the financial crisis. To some extent they have increased social spending related to the crisis, supporting domestic demand and sustaining the recovery. But the overall numbers on spending conceal wide differences in policy stances and conditions. About half of emerging and developing countries cut spending in 2009 in reaction to the crisis, a pattern likely to be repeated to some extent in 2010 (figure 3.16). The steepest spending cuts were in fuel-exporting countries that faced sharp terms-of-trade deteriorations after the collapse of oil prices in the second half of 2008. Expenditures were less affected in other emerging and developing countries, especially nonfuel commodity exporters. Thanks to higher oil prices, many fuel-exporting countries will be able to reverse these policies in 2010.
FIGURE 3.16Growth in real primary spending, 2010 projections
Source: World Economic Outlook.
But many countries are not on a sustainable fiscal path
Widening government deficits pose financing challenges for many countries, especially those with limited access to capital markets. Emerging markets rapidly regained access to sovereign debt markets following the collapse of Lehman Brothers in September 2008, but developing countries with limited or no market access are more constrained in their options. A country-by-country analysis of budget financing shows that most countries in this group were able to finance rising deficits with increased domestic and foreign financing. On average, budget financing needs of developing countries increased by about 3 percentage points of GDP in 2009, about half from domestic sources (mainly domestic bank loans and the drawing down of government deposits in the banking system) and the rest from foreign sources (mainly aid). In some countries, however, governments could not mobilize significant additional foreign resources despite pressing needs. As budget deficits remain elevated in 2010, many governments will continue to borrow heavily in domestic markets.
MAP 3.1How the crisis undermined GDP growth in 2009
Source: World Economic Outlook.
This is not sustainable. While fiscal stimulus in many developing countries has supported the recovery, there are risks of crowding out through higher interest rates. Recent International Monetary Fund (IMF) research shows significant effects of fiscal deficits on interest rates, which could dampen private investment and force governments to spend more on debt service payments and less on social programs.6 These effects will be stronger when initial deficits or debts are high. Expansionary fiscal policies may also become counterproductive if the positive demand effects are more than offset by higher private saving or reduced investment. That may occur if consumers and investors adapt their behavior to take into account higher future tax liabilities.
The macroeconomic policy mix
Most emerging and developing countries as a group appear to have supported economic activity in 2009 with a combination of expansionary fiscal and monetary policies (figure 3.17 and box 3.1). In some countries, expansionary fiscal policies were combined with less accommodating monetary conditions. Such a policy mix is not necessarily incoherent. In fact, it may be useful in countries facing large capital outflows and pressures on the exchange rate. In such a situation, rising interest rates may be appropriate to avoid excessive exchange rate volatility and ensure that sufficient external financing remains available for the economy. On average, growth in countries with this policy mix in 2009 was not weaker than in countries that had expansionary policies on both the monetary and fiscal front.
FIGURE 3.17Most countries responded with expansionary fiscal and monetary policy
Source: IMF International Financial Statistics.
Note: Fiscal conditions are defined based on the change in government balance as a percent of GDP in 2008-09. Monetary conditions are based on the change in the MCI from 2008Q4 to 2009Q3.
Adapting monetary and fiscal policies to changing circumstances
As the recovery in emerging and developing countries takes hold, questions arise about the best approach to exit from policy stimulus.7 The appropriate timing and nature of exit policies depend on individual country circumstances. In many countries, where private demand components are still cyclically weak and sufficient policy space is available, monetary and fiscal policy should remain geared toward supporting activity. Governments in these countries should lay out a credible exit strategy to maintain confidence in the authorities’ commitment to macroeconomic stability. Monetary and fiscal support should be gradually removed when private demand is sufficiently strong to sustain growth. In addition, to support fiscal consolidation, reforms to strengthen fiscal institutions could be initiated now.
A number of countries, however, are not in a position to delay adjustment and should act in 2010 to reduce fiscal deficits. In some cases, this reduction should be accompanied by a gradual tightening of the monetary policy stance. Three broad groups of countries can be distinguished.
Most developing countries financed widening budget deficits in 2009 by increasing reliance on domestic sources of financing. This financing policy, while appropriate when the global economy was facing the risks of a further sharp downturn, cannot be continued for very long, especially in countries with weak external payments positions, low reserves, or rapidly rising debt. Without higher aid inflows, financing constraints and the need to maintain fiscal sustainability will compel many countries to move to more prudent policies in 2010.
Some developing economies with fiscal sustainability problems may still be able to finance deficits in the current environment. But they could rapidly face external financing pressures if the perception takes hold that fiscal discipline is not a priority. If there are no signs of rising inflation, accommodating monetary policies can be maintained for some time to support domestic demand, unless strong downward pressures on the exchange rate (flexible regime) or reserves (fixed regime) emerge.
Several countries, mainly emerging economies, face high or rising rates of inflation. The economic dynamics underlying these phenomena differ from country to country. In several countries, the first signs of rising inflationary expectations are becoming visible in the context of exceptional macroeconomic policy support. In some other countries, inflation rates remained stubbornly high in 2009, notwithstanding depressed demand conditions, usually reflecting a lack of confidence in monetary policy. In both categories of countries, a move toward a more restrictive monetary and fiscal policy stance would be warranted.
Maintaining confidence in macroeconomic stability remains a priority for all countries. Credible medium-term fiscal adjustment plans are important to manage expectations by reducing the risks of crowding out and unsustainable debt dynamics. To maintain the ability of fiscal policy to respond to future crises, a preferable strategy would aim to reduce debt ratios to their precrisis levels in the medium term. In addition to phasing out temporary stimulus measures, this approach will require some emerging economies to make improvements in their structural primary balance.8 To enhance confidence that future fiscal adjustment will not lead to an appreciable increase in the tax burden, the medium-term adjustment plans could emphasize the following elements.
BOX 3.1Quality of macroeconomic policies in low-income countries
As in previous years, IMF staff conducted surveys among mission chiefs to gauge their assessments of the quality of macroeconomic policies in low-income countries. In 2009 low-income countries made good progress in the quality of monetary policies, a reflection of the rapid response to the global crisis in many countries and governance in the public sector. At the same time, governance in monetary and financial institutions showed deterioration, while little change was recorded in other areas.
- Phasing out temporary stimulus measures while strengthening well-targeted social safety nets. A large number of emerging and developing countries are supporting domestic activity with ad hoc measures, such as increased spending on public works or reductions in tax rates. Medium-term fiscal consolidation plans should envisage public investment at levels consistent with fiscal sustainability and available financing, and phase out tax reductions presented as temporary stimulus measures. At the same time, temporary social programs should be replaced with cost-effective, well-targeted, permanent social safety nets.
- Structural cuts in nonpriority spending. Governments should continue their efforts to reduce nonpriority spending, through further improvements in public financial management and by eliminating expenditure categories such as badly targeted fuel and food subsidies. Although the decline in food and fuel prices since mid-2008 has allowed some countries to reduce spending on inefficient general subsidies, further progress could be made in replacing general subsidies with programs better targeted to the poor.
- Improving revenue performance. Many emerging and developing countries have room for further improvements in tax systems and revenue administration, including measures aimed at widening the tax base to include informal sectors, further shifts away from trade taxes to domestic taxes, and addressing governance problems. Well-functioning revenue administrations, in combination with tax systems that minimize distortions, lay the basis for better revenue performance and create a more stable investment climate (box 3.2).
Countries with strong fiscal policies in the period leading to the global crisis have been better able to deal with its effects than countries with weak policies. They regained faster access to international financing on more favorable terms—and were better able to offset the effects of falling world demand with countercyclical fiscal policies in 2009 and 2010. This experience argues in favor of a countercyclical, medium-term fiscal rule that aims to generate savings during good years and create room for countercyclical policies during crisis periods. Although almost 60 emerging and developing countries have had some type of fiscal rule since the 1990s,9 helping to maintain fiscal discipline, only some of these are designed to smooth out the effects of fluctuations in commodity export prices and other external shocks. Chile and Nigeria are countries where a countercyclical fiscal rule on the basis of prudent projections of commodity export prices has helped to stabilize the macroeconomic effects of the crisis (box 3.3).
Strengthening international policy cooperation
The global crisis of confidence that eventually caused the collapse in world trade in 2008 required a global response: a simultaneous fiscal and monetary policy stimulus in countries with sufficient room to maneuver for such policies. The prospects of sustaining the current economic recovery will be enhanced if advanced, emerging, and developing countries continue to cooperate in the implementation of exit strategies and policies aimed at increasing growth. The agreement among the Group of Twenty (G-20) leaders at Pittsburgh to create a new process for mutual policy assessments is an important step in the right direction, but policy cooperation cannot be limited to those countries. Enhanced policy cooperation will be necessary in the following areas.
Avoiding protectionism. Restrictions on international trade and services, government subsidies for domestic industries, distortions to foreign direct investment, informal pressures on banks to give preference to domestic borrowers—all constitute serious threats to the economic recovery. Political pressures to maintain financial support to domestic industries indefinitely and to take more far-reaching protective measures could rise if unemployment remains relatively high in the coming years, in line with current expectations. Governments should eschew such protectionist policies and make strong efforts to reinvigorate the Doha Round. An ambitious Doha Round would constitute a major step toward a higher growth path for the world economy: a recent study puts potential annual GDP gains from multilateral trade liberalization at $300 billion to $700 billion.10
Increasing aid levels and aid effectiveness. Insufficient progress has been made in enhancing aid effectiveness, and aid still falls well short of the 2005 Gleneagles commitments, in particular for Africa. In addition, many donor countries have reduced their aid budgets, while others face pressures to reduce aid in light of tighter domestic fiscal constraints. These pressures must be resisted. A substantial increase in aid, at least in line with existing international commitments, is essential to allow developing countries, especially those in vulnerable debt situations and with limited alternative sources of finance, to generate resources for higher growth, improve social protection for the most vulnerable, and enhance food security.
BOX 3.2Mobilizing additional revenue in developing countries: key issues for tax policy and revenue administration
The international financial crisis and its consequences for economic activity have put additional pressure on an already fragile revenue situation in many developing countries. Although the revenue situation in most countries is expected to improve as the effects of the crisis dissipate and temporary stimulus measures are phased out, some policy changes made in response to the crisis, and during the precrisis period that saw substantial increases in food and fuel prices, may have longer-term effects on revenues. An example is the proposed change to the value added tax (VAT) directive of the West African Economic and Monetary Union to allow for broader exemptions and a second (lower) rate on selected items. In addition, taxpayer compliance may have declined in many countries, posing challenges for revenue administration.
The policy tools that developing countries can mobilize to deal with the potential revenue loss stemming from the crisis and other ongoing challenges may be more limited today than in the 1980s and 1990s, and those that are left may involve stronger political commitments. The vast majority of countries have already implemented broad-based consumption taxes (typically VATs) at rates that are not particularly low in general and with bases that are generally narrow. Moreover, corporate tax rates have fallen dramatically since the early 1990s (by about one-quarter on average), and countries have intensified the use of tax incentives, further narrowing the tax base.
Country experiences in addressing these challenges differ, sometimes significantly, but common areas for reform exist.
Tax bases can be broadened, especially for VAT and profit taxes. This is not an issue of improving tax administration to better handle the informal sector (which is a separate and ongoing challenge); it primarily means rationalizing the use of income tax incentives (such as tax holidays) and reducing significantly the reliance on VAT exemptions as a (costly and largely ineffective) social policy tool.
The taxation of individuals is, in many countries, limited to the taxation of wages of the public sector and large enterprises. The taxation of unincorporated small and midsize enterprises remains largely elusive—both for technical and for political economy reasons. Addressing these issues is key to improving the equity of tax systems.
Some tax sources remain underexploited in many countries—excise taxes on alcohol and tobacco, and environmental taxes (fuel and car taxes, for example) are important examples.
The institutional framework for policy making, including coordination at the country level between the various government entities with responsibility for tax policy, is deficient in many developing countries and often leads to fragmentation of policy decisions with negative consequences for revenues—for example, between trade and tax policy, industrial and tax policy, and central and local taxation. Countries should better integrate tax policy making into macro-economic management, and strengthen the coordination mechanisms across government entities.
Taxes on real property have historically yielded very little revenue for a number of reasons, including the lack of a proper framework for sharing taxation powers between central and regional levels of government. This revenue source remains underexploited in many developing countries.
Tax agencies should also develop a strategy to enhance revenue administration. The primary objective of the strategy should be to contain the rise in noncompliance often observed during periods of crisis. If left unchecked, rising noncompliance could lead to substantial forgone revenue and provide unfair competitive advantages to noncompliant businesses.
To achieve this objective, the following four sets of measures could be considered.
- Assistance to taxpayers could be expanded by adjusting advance payments, accelerating tax refunds, and making greater use of payment extensions.
- Communication with the taxpayer population could be improved. An effective communication program for taxpayers and other key stakeholders in the tax system should aim at clearly conveying to stakeholders and the public the various elements of the tax agency’s compliance strategy.
- Legislative reforms that facilitate revenue administration could be enacted. Needed reforms vary from country to country; they could include measures such as the strengthening of transfer-pricing rules or the introduction of default assessments and indirect audit methods.
Enforcement could be strengthened, including the reassessment of controls over the largest taxpayers, the intensification of arrears collection, securing tax withholding, giving greater attention to loss-reporting businesses, and enhancing the scrutiny of cross-border transactions and offshore evasion.
Early warning for shifts in taxpayer compliance is crucial for prevention. The sooner a tax agency can identify an increase in noncompliance, the faster it can respond. Few tax agencies, however, have the capacity to estimate the precise level of the overall tax gap. In this situation, tax agencies should identify and track compliance indicators that can be more easily measured, such as increases in late filing of tax returns and growth in tax arrears.
Government support for tax administration is critical. Like all government agencies, tax agencies face the prospect of declining budget allocations in an economic downturn as governments seek to create fiscal room for high-priority social expenditures. However, it should be recognized that the task of tax administration becomes more demanding during difficult economic times. In this situation, substantial cuts in tax agencies’ budgets are likely to reduce the effectiveness of tax collection and further aggravate a decline in revenue.
Tax agencies should align their near-term compliance strategies and medium-term modernization plans. Sustaining revenue collection over the medium term will require tax agencies to address their most fundamental weaknesses (such as poor organizational and staffing arrangements, weak taxpayer services and enforcement programs, and outdated information systems). By their nature, such problems can be addressed only over the medium term, but in developing a compliance strategy for the economic crisis, tax agencies should not neglect their medium-term goals.
The medium- and long-term economic effects of the crisis in low-income countries
Over the past few decades, a low-income country’s growth rate in one decade has generally been a poor predictor of its growth rate in the next decade, while many policies and country characteristics are more stable. An emerging and vibrant empirical literature points to growth nonlinearities—accelerations (periods of high growth) and growth decelerations (periods of abrupt and severe growth slowdowns)—as an important development fact that until recently has not been in the spotlight.11 Moreover, an extensive theoretical literature explores the possibility of low-income countries falling into prolonged periods of underdevelopment, commonly known as poverty traps.12 Finally, crises can result in sharp declines in investment in education and health, declines that potentially can have long-lasting effects.13
This section thus puts the current crisis in historical perspective and examines the prospects for growth in the medium to long run. Although the uncertainties are enormous, and the light that recent history can shed is limited, some preliminary and conditional answers are possible.
Transmission mechanisms from the global crisis seem to vary considerably across countries. While advanced economies have primarily suffered a financial and banking crisis, most developing countries primarily were hit by an external demand effect, although some, notably fuel exporters, were also hit by a terms-of-trade and, perhaps to a lesser extent, a capital flows effect. From a methodological point of view, this difference is quite important because these types of external shocks are more familiar to low-income countries than the financial shock is to advanced countries, therefore permitting a more credible historical analysis of the effects in low-income countries.
BOX 3.3A fiscal rule for commodity exporters: The cases of Chile and Nigeria
Several commodity exporters have in recent years adopted medium-term frameworks for fiscal policy aimed at reducing the impact of commodity price fluctuations on the domestic economy. These frameworks allowed countries to build up sizable reserves during the commodity price boom of 2007-08, helped to stabilize expenditures, and created additional space for countercyclical policies in 2009. Chile and Nigeria illustrate the benefits of such a fiscal rule.
Since the beginning of the decade, fiscal policies in Chile have been based on a structural fiscal surplus rule aimed at mitigating the effects of fluctuations in prices for copper and molybdenum, the country’s main commodity exports. Each year, the authorities make a calculation of structural revenue, consistent with potential GDP and long-term projections of copper and molybdenum prices. The annual spending budget is set on the basis of total structural tax and nontax (mainly mining) revenue minus a structural surplus. Fiscal surpluses are used to feed two sovereign wealth funds established under the 2006 Fiscal Responsibility Law: the Pension Reserve Fund to cover the government’s long-term pension liabilities; and the Economic and Social Stabilization Fund, established to smooth fiscal expenditure and finance regular or extraordinary public debt amortization. The consistent implementation of the fiscal rule, which has received broad public support, and the sovereign wealth funds have served Chile well in recent years. Rising copper prices since the middle of the decade have allowed Chile to accumulate substantial reserves in the Economic and Social Stabilization Fund, creating a comfortable buffer to offset the sharp revenue declines in 2009.
Nigeria introduced an oil-price-based fiscal rule in 2004 as a framework for the annual budget process, which was subsequently formalized in the 2007 Fiscal Responsibility Act. In the annual Medium-Term Fiscal Strategy presented to parliament, expenditures are set on the basis of relatively prudent projections for oil prices and production. If actual oil revenues exceed the budgeted levels, the surpluses are transferred to accounts held by the federal, state, and local governments at the central bank according to a preset intergovernmental sharing formula. Balances accumulated in the accounts can be used as a source of budget financing at the various levels of government if the actual oil price falls below the reference price for three consecutive months.
The fiscal rule is supported by a limit on the federal government’s fiscal deficit of 3 percent of GDP, enshrined in the Fiscal Responsibility Act. The fiscal rule helped Nigeria stabilize expenditures and accumulate sizable reserves during the oil price boom of 2007-08. Although the political backing for the new approach does not seem to be as strong as in Chile, and lower levels of government are not bound by the Fiscal Responsibility Act, the fiscal rule has served Nigeria well thus far. Notwithstanding extraordinary distributions from the central bank accounts in response to political pressures during the oil price boom, Nigeria accumulated sufficient resources to avoid a contraction of public spending in 2009, reducing the effects of the global economic downturn.
Source: World Economic Outlook.
MAP 3.2Across the world 884 million people lack access to safe water—84 percent of them in rural areas
Source: World Economic Indicators.
The historical analysis that follows focuses on external demand, terms of trade, and capital flows as the three main transmission mechanisms of the crisis affecting low-income countries.14 The analysis consists of four exercises, each tackling the importance of external shocks from a slightly different angle. The first is a simple event study that illustrates the growth paths of past crises and compares these to the current crisis. The second and third exercises focus on the medium-run effects of the crisis. Specifically, an impulse response analysis (a time-series analysis) is employed to estimate the effects over time, complemented with five-year growth panel regressions. The last exercise is concerned with the longer-run implications of the crisis using recently developed methods to capture possible sharp and very persistent drops in growth rates.
In past global crises, growth declined sharply leading toward the crisis year, but low-income countries experienced the worst of the crises about a year after the global low point was reached (figure 3.18). In addition, recovery seemed to be faster in the world economy than in low-income countries. More precisely, while recovery in the world began almost immediately after the crisis year, it took about three years for a turnaround to take place in low-income countries in previous global crises. The good news is that low-income countries have tended to recover fully in the sense that they have reached or surpassed their precrisis growth rate after about five years.
FIGURE 3.18After previous crises, low-income countries recovered more slowly than the world economy
Source: IMF staff calculations.
Note: The figure plots the average per capita GDP growth in the world and in low-income countries five years before and five years after the global crises (centered at zero on the horizontal axis) of 1975, 1982, and 1991, and the current crisis. Also shown in dashed lines are IMF projections until 2013.
The current crisis is distinguished by more synchronization between low-income countries and global cyclical growth movement. Also, IMF forecasts imply a more rapid V-shape recovery path out of the recession than in previous crises.
Unlike previous crises in which terms-of-trade growth suffered a sharp downturn relative to external demand growth, the current crisis is characterized by a sharp decline in export demand, with terms-of-trade growth on average moving around historical averages (figure 3.19).15
FIGURE 3.19Growth of terms of trade and external demand in low-income countries in past and current crises
Source: IMF staff calculations.
Note: The figure plots the terms of trade and external demand growth in low-income countries five years before and five years after the global crises (centered at zero on the horizontal axis) of 1975, 1982, and 1991, and the current crisis. Also shown in dashed lines are IMF projections until 2013.
Persistence of output loss over time using time series or impulse response analysis
An impulse response function analysis, as in Cerra and Saxena (2008), examines whether terms of trade and external demand have historically been associated with severe output losses and whether such output losses have been permanent in low-income countries.16figure 3.20 presents impulse responses of output losses, measured as the percentage change from a linear growth trend to a terms-of-trade shock and an external demand shock, respectively.17 The solid orange line is the mean of output loss, and the dashed lines reflect one standard deviation from the mean. A key assumption is that countries will eventually return to the growth rate existing before the shock. This assumption is quite reasonable because most of the low-income countries considered in these exercises tend to revert to their preexisting growth trend in the five years following the shock.
FIGURE 3.20Output losses are highly persistent, especially under external demand shocks
Source: IMF staff calculations.
Note: Impulse response of output loss in low-income countries to terms-of-trade and external demand shocks. Dashed lines are 1 standard deviation from the mean output loss.
The main message is that the impact on output is negative and highly persistent under both types of shock, but especially under external demand shocks. Output losses continue to rise without a sign of a reversal even 10 years after an external demand shock, mounting to a cumulative loss of over 6 percent of GDP. This result may stem from interactions of external demand shocks with private and public investment decisions or policy responses. The output loss path eventually becomes flat as growth reaches its precrisis rate. But after a decade, lower growth and a substantial loss of output is likely to have detrimental effects on tax revenues, income, and certainly welfare.
The impulse response analysis is replicated for Sub-Saharan Africa (figure 3.21). One notable difference is that terms-of-trade shocks seem to have had a larger and more persistent effect than external demand shocks in the rest of low-income countries. Many Sub-Saharan countries are commodity exporters, particularly fuel exporters, and are thus more prone to terms-of-trade shocks. This issue is explained further below regarding growth downbreak.
FIGURE 3.21In Sub-Saharan Africa terms-of-trade shocks have larger and more persistent effects
Source: IMF staff calculations.
Note: Impulse response of output loss in Sub-Saharan Africa countries to terms-of-trade and external demand shocks. Dashed lines are 1 standard deviation from the mean output loss.
A third exercise employs five-year panel growth regressions as an alternative approach to investigating the impact of terms-of-trade, external demand, and foreign direct investment (FDI) shocks on medium-term per capita GDP growth.18 In particular, the estimation results are based on panel regressions that combine time-series and cross-country information,19 and the sample is restricted to nonfuel exporters. Fuel exporters are excluded from the baseline sample because these countries’ growth experience has been heavily influenced by external demand for fuel. In the baseline specification, per capita growth is regressed on lagged per capita GDP growth, and the three shock variables (growth in terms of trade and external demand and the lag of the difference in FDI-to-GDP ratio) are all measured in five-year averages.20 Columns 1-3 in table 3.4 present results for “All” nonadvanced nonfuel countries, nonfuel low-income countries, and nonfuel non-low-income countries. The comparison between low-income countries and non-low-income countries is intended to provide some insights into the differential effects of these shocks to the two income groups.
|Entire time period||Before 1989||After 1989|
|Growth in terms of trade||0.123||***||0.115||*||0.111||**||0.031||0.030||0.023||0.156||**||0.131||*||0.182||***|
|Growth in external demand||2.603||***||1.960||***||3.419||***||1.332||**||0.617||2.599||**||1.727||***||1.665||*||1.769||**|
|Lagged change in (FDI / GDP)||0.631||***||0.221||1.010||***||0.599||-0.404||1.773||***||0.783||***||0.517||*||0.953||***|
|Number of countries||88||48||40||86||47||39||88||48||40|
For low-income countries, terms-of-trade growth and external demand growth obtain positive and significant coefficient estimates, indicating a positive impact on medium-term growth (column 2 of table 3.4). While the coefficient estimate on FDI for low-income countries using the entire time period in the sample is insignificant, it is highly significant for “All” and non-low-income countries along with the coefficient estimates for terms of trade and external demand (columns 1 and 3, respectively). Columns (4-9) present results from splitting the sample in the periods before and after 1989 (the median year in the sample). Coincidentally, “after 1989” is the period when growth increased dramatically in most low-income countries. Note that most of the effect of terms-of-trade and external demand growth for low-income countries has been driven by variation in the period after 1989 (columns 5 and 8). Even more notable is that in the post-1989 sample the FDI coefficient becomes positive and significant. That may not be surprising given that FDI in low-income countries has been plentiful only in the past decade or so.21 The broad message of this exercise is that regression results seem to reinforce the impulse response findings showing economically significant effects of the shocks in the medium run.
The analysis shows that external demand shocks, such as those faced by low-income countries in 2009, cause growth to slow down not just immediately but for several years. An even greater concern, though, is the risk that the global crisis may cause an essentially permanent decline in growth in many low-income countries—that is, a growth “downbreak.” Many low-income countries have enjoyed relatively strong growth over the past 10-15 years, when a favorable external environment prevailed. The concern is that, with the global shock, this could change. Underlying this concern is the observation that, whereas output paths in the advanced countries tend to be reasonably steady, in developing countries they are often characterized by “mountains, cliffs, and plains.”22 This exercise employs the methodology by Berg, Ostry, and Zettelmeyer (2008) to obtain growth downbreaks (sustained declines in the rate of growth) in low-income countries and to explore whether terms-of-trade and external demand shocks are correlated with such “cliffs.”
One pattern emerging from figure 3.22 is that persistent negative terms-of-trade shocks have often coincided with growth downbreaks in the past. However, persistent negative partner-country demand shocks have shown no association with growth downbreaks. This phenomenon may be related to the fact that terms-of-trade changes are usually strongest in commodity sectors, and that these sectors often find it more difficult to adjust to the new environment than do, for instance, industrial sectors. The supply factors that produce the commodities in question cannot easily switch to other uses, such as satisfying domestic demand or finding other export markets. The resulting decline in foreign income could squeeze imports and activity persistently, thus impeding productive activities throughout the economy.
FIGURE 3.22In low-income countries, growth downbreaks are more associated with terms-of-trade shocks, giving hope for smoother recovery
Source: Berg and others forthcoming.
Note: The left panel plots the number of GDP growth downbreaks in a large sample of low-income countries during the periods leading up to and following a large persistent terms-of-trade shock (year 0 on the horizontal axis). A large persistent terms-of-trade shock is defined as the worst 10 percent of the distribution of all terms-of-trade shocks, measured as the difference of the average three-year terms-of-trade growth before and after a year of shock. The right panel is the same, except that the shock is to external demand, measured as partner-country real growth weighted by export shares.
This remarkable observation suggests that if indeed the current crisis has affected primarily low-income countries through external demand and not through terms of trade, there may be more reason for hope for a smoother recovery.23
In this chapter, the group of developing countries includes mainly low-income countries and some middle-income countries that are not considered emerging economies. High-income oil-exporting countries are excluded from this category.
IMF 2009g, box 1.2; IMF 2009d.
The adequacy of reserves depends on many factors, including the volatility of exports and imports, fluctuations in the terms of trade, the level and maturity structure of external debt, and the vulnerability to sudden shifts in international capital movements. While reserve adequacy should be assessed country by country, a level equivalent to three months of imports is often used as a rule of thumb, especially for low-income countries. For a discussion on optimal reserve determination, with a focus on low-income countries, see Drummond and Dhasmana (2008).
The evolution of monetary policy stance is approximated by the Monetary Conditions Index (MCI), a summary indicator of the impact of policy rates and exchange rates on domestic demand. The MCI combines nominal short-term interest rates and the nominal effective exchange rate (with a one-third weight for the latter) in a single index. The change in the indicator is calculated up to 2009Q3, except for Vietnam and Rwanda, which have data only until 2009Q1. The MCI is a useful indicator of direction in the monetary policy stance: it is simple to calculate and based on data readily available. However, it also suffers from various caveats (including, for example, the use of common weights across diverse countries), so detailed country results need to be interpreted with some caution.
In many countries that reduced rates in 2009, inflation came down faster than nominal rates, propping up real interest rates. Temporary factors, such as commodity price movements, may have contributed to the fall in inflation, however, mitigating the impact of higher real rates on spending and investment decisions.
See IMF 2009e and Baldacci and Kumar, forthcoming. An increase in fiscal deficits of 1 percent of GDP is found to increase 10-year nominal bond yields by about 20 basis points in the medium term, and an increase in the debt-to-GDP ratio of 1 percent increases rates by approximately 5 basis points. Although the econometric analysis is based on a sample of advanced and emerging economies, it is plausible that low-income countries show similar relations between deficits, debt, and interest rates.
For a detailed discussion of exit strategies see IMF 2010a.
Data are from IMF. External demand is partner-country real GDP growth, 2000 = 100, weighted by trade exports to all partner countries (APR 2009 Global Economic Environment). Terms of trade are for goods (World Economic Outlook [WEO] latest update). Capital flows are proxied by direct investment in reporting economy in billions of U.S. dollars.
Data on foreign direct investment were not available to produce a similar plot. This observation is also shown in more formal growth regression analysis in Berg and others (work in progress).
The shock dummy variable for both terms of trade and external demand was constructed as follows: A restricted sample was constructed in which values below and above the 1st and 99th percentiles were excluded to mitigate the effects from extreme values. The crisis periods belong to the left tail of the moving-average growth (based in two periods) distribution, where the left tail is based on one standard deviation of the restricted sample defined above. Results are qualitatively similar to two alternative shock definitions considered.
Using a statistical estimation method called generalized method of moments (GMM).
An alternative growth regression specification would be the Barro-Solow type regression. This alternative was not considered, because it suffers from the well-documented endogeneity and omitted variable problems, which the specification used here is less subject to.
The robustness of these results to alternative specifications and subsamples has been checked.
The definitions of “persistent” and “large” can be found in the note to figure 3.22. It turns out that large negative external demand shocks such as those experienced by many countries in 2009 are not unprecedented for many low-income countries. In the sample used for figure 3.22, there were 68 instances in which countries faced external demand shocks larger than they faced in 2009 (assuming IMF projections for the out-years).
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