102968 JANUARY 2016 © 2016 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington, DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Some rights reserved 1 2 3 4 19 18 17 16 This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. 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Table of contents Foreword .................................................................................................................................... xv Acknowledgments ..................................................................................................................... xvii Executive Summary .................................................................................................................... xix Abbreviations ............................................................................................................................. xxi Chapter 1 Global Outlook: Disappointments, Risks, and Spillovers ........................................1 Summary and key messages ................................................................................... 3 Major economies ................................................................................................... 6 Global trends and spillovers ............................................................................... 12 Developing countries ........................................................................................... 17 Risks to the outlook ............................................................................................. 24 Policy challenges .................................................................................................. 31 References ............................................................................................................ 39 Special Focus From Commodity Discovery to Production: Vulnerabilities and Policies in LICs ..45 Introduction......................................................................................................... 47 Lead times between discovery and production ........................................................ 48 Evolution from commodity discovery to production. .............................................. 49 Determinants of the lead time ............................................................................... 51 Policy implications ............................................................................................... 52 Recent developments and near-term outlook in low-income countries ..................... 53 Annex SF.1 .......................................................................................................... 57 References ........................................................................................................... 59 Chapter 2 Regional Outlooks ...............................................................................................61 East Asia and Pacific ...........................................................................................63 Recent developments ......................................................................................... 63 Outlook ............................................................................................................ 65 Risks ................................................................................................................ 67 Policy challenges ................................................................................................ 69 Box 2.1.1 Regional integration and spillovers: East Asia and Pacific ...................... 73 v Europe and Central Asia ....................................................................................... 83 Recent developments........................................................................................... 83 Outlook ............................................................................................................. 87 Risks ................................................................................................................. 88 Policy challenges ................................................................................................. 89 Box 2.2.1 Regional integration and spillovers: Europe and Central Asia ................. 93 Latin America and the Caribbean ......................................................................... 101 Recent developments......................................................................................... 101 Outlook ........................................................................................................... 106 Risks ................................................................................................................ 107 Policy challenges ............................................................................................... 108 Box 2.3.1 Regional integration and spillovers: Latin America and the Caribbean .. 112 Middle East and North Africa ............................................................................. 123 Recent developments......................................................................................... 123 Outlook ........................................................................................................... 126 Risks ................................................................................................................ 127 Policy challenges ............................................................................................... 128 Box 2.4.1 Regional integration and spillovers: Middle East and North Africa ....... 132 South Asia........................................................................................................... 139 Recent developments......................................................................................... 139 Outlook ........................................................................................................... 141 Risks ................................................................................................................ 143 Policy challenges ............................................................................................... 143 Box 2.5.1 Regional integration and spillovers: South Asia ................................... 147 Sub-Saharan Africa .............................................................................................. 153 Recent developments......................................................................................... 153 Outlook ........................................................................................................... 156 Risks ................................................................................................................ 157 Policy challenges ............................................................................................... 158 Box 2.6.1 Regional integration and spillovers: Sub-Saharan Africa ...................... 162 References ........................................................................................................... 169 vi Chapter 3 Who Catches a Cold When Emerging Markets Sneeze?........................................ 177 Introduction........................................................................................................ 179 What are the key channels of spillovers from the major emerging markets?.............. 184 Do business cycles in BRICS move in tandem with those in other emerging markets and frontier markets?............................................................................... 187 How large are the spillovers from the major emerging markets? .............................. 190 What are the policy implications? ......................................................................... 195 Conclusion.......................................................................................................... 202 Box 3.1 Sources of the growth slowdown in BRICS............................................... 182 Box 3.2 Understanding cross-border growth spillovers ........................................... 188 Box 3.3 Within-region spillovers .......................................................................... 198 Annex 3.1 Data ................................................................................................... 204 Annex 3.2 Methodology....................................................................................... 205 Annex 3.3 Empirical estimates of spillovers from emerging markets. ....................... 210 References ........................................................................................................... 212 Chapter 4 Two Topical Issues. ............................................................................................217 Potential Macroeconomic Implications of the Trans-Pacific Partnership....................... 219 Introduction ..................................................................................................... 219 How do new generation trade agreements differ from traditional FTAs? ............... 220 What are the main features of the Trans-Pacific Partnership? ............................... 222 What are the potential macroeconomic implications of the TPP? ......................... 225 Conclusion ....................................................................................................... 229 Box 4.1.1 Regulatory convergence in mega-regional trade agreements ................ 230 Annex 4.1 Methodology .................................................................................... 234 Peg and Control? The Links between Exchange Rate Regimes and Capital Account Policies ................................................................................................................. 237 Introduction ..................................................................................................... 237 What does economic theory say about the choice of ERRs and CFMs?................. 238 What do the data say about ERRs and CFMs? .................................................... 240 What are the main empirical linkages between the choices of ERR and CFM? ...... 243 Conclusion ................................................................................................. ......244 Annex 4.2 Data and methodology..........................................................................245 References ........................................................................................................ 249 vii Statistical Appendix .................................................................................................................... ..257 Figures 1.1 Global and developing-country growth prospects ............................................ 5 1.2 Global trade, finance, and risks ...................................................................... 6 1.3 United States ................................................................................................ 7 1.4 Euro Area ..................................................................................................... 8 1.5 Japan.......................................................................................................... 10 1.6 China ......................................................................................................... 11 1.7 Financial volatility and asset valuations......................................................... 12 1.8 Capital flows............................................................................................... 13 1.9 Commodity markets ................................................................................... 15 1.10 Global trade slowdown ................................................................................ 16 1.11 Growth in emerging and developing economies ............................................ 17 1.12 Domestic demand conditions in developing countries ................................... 19 1.13 Macro-financial vulnerabilities ..................................................................... 20 1.14 Monetary and fiscal policy space .................................................................. 21 1.15 Developing-country outlook ........................................................................ 21 1.16 Regional outlook......................................................................................... 22 1.17 Slowdown in China .................................................................................... 24 1.18 Spillovers from slowing growth in BRICS .................................................... 26 1.19 Rising borrowing costs and balance sheet pressures ....................................... 27 1.20 Deteriorating capital flows and sudden stops ................................................ 28 1.21 Growth slowdown in BRICS combined with financial stress.......................... 29 1.22 Weakening potential growth........................................................................ 29 1.23 Terrorism and geopolitical tensions .............................................................. 30 1.24 Unrealized gains due to low oil prices ........................................................... 31 1.25 Policy challenges in the United States........................................................... 32 1.26 Policy challenges in Euro Area and Japan .................................................... 33 1.27 Policy challenges in China ........................................................................... 34 1.28 Monetary policy challenges in developing countries ..................................... 35 1.29 Fiscal frameworks and financial stability ....................................................... 36 1.30 Fiscal policy challenges in developing countries............................................. 37 1.31 Structural reform needs ............................................................................... 38 viii SF.1 Prospects and risks from resource investment.............................................. 48 SF.2 The mining project cycle ........................................................................... 49 SF.3 Developments during lead times between resource discovery and extraction . 50 SF.4 Lead times between resource discovery and extraction ................................. 51 SF.5 Growth prospects in LICs ......................................................................... 53 2.1.1 Activity in East Asia and Pacific ................................................................. 64 2.1.2 Internal rebalancing in China .................................................................... 65 2.1.3 External rebalancing in China.................................................................... 66 2.1.4 Trade ....................................................................................................... 67 2.1.5 Financial markets ...................................................................................... 68 2.1.6 Policy rates, credit growth, inflation, and fiscal balances .............................. 69 2.1.7 Regional vulnerabilities ............................................................................. 70 2.1.8 Policy issues .............................................................................................. 71 2.1.1.1 Cross-region comparisons .......................................................................... 73 2.1.1.2 Regional integration .................................................................................. 74 2.1.1.3 Main spillover channels ............................................................................. 75 2.1.1.4 Trade and finance with China and Japan ................................................... 76 2.1.1.5 Portfolio liabilities and capital account restrictions ...................................... 78 2.1.1.6 Intra-regional spillovers ............................................................................. 78 2.1.1.7 Spillovers from G7 excluding Japan ........................................................... 79 2.2.1 Key indicators ........................................................................................... 84 2.2.2 Inflation and exchange rates for selected countries....................................... 85 2.2.3 Monetary and fiscal policy ......................................................................... 85 2.2.4 Remittances ............................................................................................. 86 2.2.5 Exposure to spillovers through trade and foreign direct investment ............. 86 2.2.6 Recent developments at the country level .................................................. 87 2.2.7 External financing .................................................................................... 89 2.2.1.1 Cross-region comparison .......................................................................... 93 2.2.1.2 Main features of the ECA region .............................................................. 94 2.2.1.3 Trade, remittances, and foreign direct investment ....................................... 95 2.2.1.4 Main export markets ................................................................................ 96 2.2.1.5 Tourism and remittances ........................................................................... 97 2.2.1.6 Regional spillovers .................................................................................... 98 ix 2.2.1.7 Spillovers from G7 ..................................................................................... 99 2.3.1 GDP growth, 2014-2015 ......................................................................... 102 2.3.2 Commodity prices.................................................................................... 102 2.3.3 Exchange rates ......................................................................................... 103 2.3.4 Exports .................................................................................................... 103 2.3.5 Inflation rates........................................................................................... 103 2.3.6 Central bank policy rates, 2014-2015 ........................................................ 104 2.3.7 Fiscal indicators ....................................................................................... 104 2.3.8 Current account balances.......................................................................... 105 2.3.9 Gross capital flows.................................................................................... 105 2.3.10 Regional outlook ...................................................................................... 106 2.3.11 Remittance flows...................................................................................... 106 2.3.1.1 International linkages: Cross-region comparison ....................................... 113 2.3.1.2 Evolution of openness .............................................................................. 114 2.3.1.3 Sources of trade and financial flows ........................................................... 115 2.3.1.4 LAC exports ........................................................................................... 116 2.3.1.5 LAC commodity exports .......................................................................... 117 2.3.1.6 Within-region trade and FDI .................................................................... 118 2.3.1.7 The role of the largest economies in LAC ................................................. 119 2.3.1.8 Correlations with Brazil and Mexico ........................................................ 119 2.3.1.9 Spillovers from Brazil, Mexico, G7 and China ........................................... 120 2.3.1.10 Ease of trading across borders.................................................................... 121 2.4.1 Oil production and fiscal balance .............................................................. 125 2.4.2 Exchange rates, inflation, and current account balances ............................. 125 2.4.3 Trade ...................................................................................................... 128 2.4.4 Labor market conditions........................................................................... 128 2.4.5 Perception of standard of living................................................................. 129 2.4.1.1 Cross-region comparison .......................................................................... 132 2.4.1.2 Trade, FDI, and remittances ..................................................................... 133 2.4.1.3 Openness inside and outside the region ..................................................... 134 2.4.1.4 Spillovers from Egypt and Turkey ............................................................. 137 2.5.1 Recent developments ................................................................................ 140 2.5.2 Risks and challenges ................................................................................. 141 x 2.5.3 Demographic challenges........................................................................... 144 2.5.1.1 Cross-region comparison .......................................................................... 147 2.5.1.2 Regional and global integration in South Asian countries ........................... 148 2.5.1.3 Financial flows to SAR ............................................................................. 150 2.5.1.4 Global and regional growth spillovers........................................................ 151 2.6.1 Commodity market developments ............................................................ 154 2.6.2 Capital market developments ................................................................... 155 2.6.3 Domestic constraints................................................................................ 156 2.6.4 Fiscal deficits and government debt........................................................... 157 2.6.5 Exchange rates and inflation ..................................................................... 158 2.6.6 Outlook .................................................................................................. 159 2.6.1.1 Cross-region comparison .......................................................................... 163 2.6.1.2 Linkages between Sub-Saharan Africa and the rest of the world .................. 164 2.6.1.3 Intra-regional linkages .............................................................................. 165 2.6.1.4 Linkages between South Africa and the rest of Sub-Saharan Africa .............. 166 2.6.1.5 Linkages between Nigeria and the rest of Sub-Saharan Africa ..................... 167 2.6.1.6 Regional spillovers in SSA ........................................................................ 168 3.1 Emerging market growth slowdown .......................................................... 180 3.2 Rising economic significance of emerging markets ..................................... 181 3.1.1 Sources of the growth slowdown in BRICS ............................................... 183 3.3 BRICS in EM and FM trade ................................................................... 185 3.4 Commodity demand and supply............................................................... 186 3.5 BRICS in regional trade and remittances ................................................... 187 3.6 Emergence of emerging and frontier market business cycle ......................... 191 3.7 Role of BRICS in business cycle synchronization ....................................... 191 3.8 Growth slowdown in BRICS .................................................................... 192 3.9 Spillovers from BRICS ............................................................................. 193 3.10 Spillovers from BRICS and advanced markets ........................................... 194 3.11 Spillovers from individual BRICS ............................................................. 195 3.12 Channels of spillovers .............................................................................. 196 3.13 Spillovers from a synchronous slowdown in BRICS ................................... 196 3.14 Growth slowdown in BRICS combined with financial stress ...................... 197 3.3.1 Openness ................................................................................................ 198 xi 3.3.2 Within-region integration ........................................................................ 199 3.3.3 Spillovers from large emerging markets in each region ............................... 200 3.15 Fiscal policy and fiscal space..................................................................... 201 3.16 Monetary policy room ............................................................................. 202 3.17 Growth slowdown and structural reforms ................................................. 202 4.1.1 Growth in world trade ............................................................................. 220 4.1.2 Importance of regional trade agreements................................................... 221 4.1.3 RTAs: Tariffs and membership ................................................................ 221 4.1.4 The main features of the TPP .................................................................. 223 4.1.5 Aggregate impact of TPP: GDP and trade by 2030 ................................... 226 4.1.6 Country specific impact of TPP: GDP and trade by 2030 ......................... 227 4.1.7 Impact of TPP on sectoral output by 2030 ............................................... 228 4.1.8 Comparing TPP to other trade agreements ............................................... 228 4.1.1.1 Implications of a common regulatory approach ......................................... 233 A.4.1.1 Modeling assumptions ............................................................................ 236 4.2.1 Exchange rate regime categories by country grouping ................................ 239 4.2.2 Capital control categories by country grouping ......................................... 240 4.2.3 Trade and exchange rate regimes: Frequency distributions ........................ 241 4.2.4 Trade and capital controls: Frequency distributions.................................. 241 4.2.5 Financial development and capital controls: Frequency distributions .......... 242 4.2.6 Pegged regimes and capital controls .......................................................... 242 4.2.7 Pegged regimes and capital controls across per capita income levels ............ 243 Tables 1.1 Global growth ....................................................................................... 4 SF.1 Low Income country forecasts ............................................................. 56 Annex SF.1 Duration regression of lead times.......................................................... 58 2.1.1 East Asia and Pacific forecast summary ................................................. 72 2.1.2 East Asia and Pacific country forecasts ................................................. 72 2.1.1.1 Membership of major actual and potential free trade agreements ........... 80 2.1.1.2 Literature review.................................................................................. 81 2.2.1 Europe and Central Asia forecast summary ........................................... 91 2.2.2 Europe and Central Asia country forecasts ............................................ 92 2.2.1.1 Summary of the literature .................................................................. 100 xii 2.3.1 Latin America and the Caribbean forecast summary ................................... 110 2.3.2 Latin America and the Caribbean country forecasts ................................... 111 2.4.1 Middle East and North Africa forecast summary ........................................ 130 2.4.2 Middle East and North Africa country forecasts ......................................... 131 2.5.1 South Asia forecast summary .................................................................... 145 2.5.2 South Asia country forecasts ..................................................................... 146 2.6.1 Sub-Saharan Africa forecast summary ........................................................ 160 2.6.2 Sub-Saharan Africa country forecasts ......................................................... 161 xiii Foreword Emerging market economies have been an engine of This outlook is expected to be buttressed by recovery global growth during the 2000s, especially after the in major high-income economies, stabilizing 2007-08 global financial crisis. However, times are commodity prices, and a continuation of low interest changing. Growth rates in several emerging market rates. All this does not rule out the fact that there is a economies have been declining since 2010. The low-probability risk of disorderly slowdown in major global economy will need to adapt to a new period of emerging markets, as U.S. interest rates rise after a more modest growth in large emerging markets, long break and the US dollar strengthens, and as a characterized by lower commodity prices and result of geopolitical concerns. diminished flows of trade and capital. This is the message that underlies this issue of the World Bank The simultaneous slowing of four of the largest Group’s Global Economic Prospects . emerging markets—Brazil, Russia, China, and South Africa—poses the risk of spillover effects for the rest The report offers a detailed outlook for the global of the world economy. Global ripples from China’s economy and each of the world’s emerging market slowdown are expected to be greatest but weak regions. It analyzes themes vital to policy makers in growth in Russia sets back activity in other countries emerging markets and elsewhere. These include how in the region. Disappointing growth again in the the slowdown in major emerging markets affects the largest emerging markets, if combined with new rest of the world, including their regions and their financial stress, could sharply reduce global growth in neighbors; the potentially far-ranging macro- 2016. economic implications of the Trans-Pacific Partnership trade accord; and risks and opportunities Meanwhile, the Trans-Pacific Partnership could offered by low commodity prices for low-income potentially provide a boost to growth and trade in its countries with recent discoveries of natural gas, oil, member countries. The detrimental effects on non- metals, and other natural resources. The report also members as trade is diverted could be mitigated by examines capital controls and other strategies that beneficial effects from greater regulatory countries with different exchange rate regimes can harmonization, streamlining and transparency. use to better shield themselves from financial turmoil. In the current environment, developing countries Looking ahead, global growth is poised to recover need to brace for possible shocks by building modestly, by 2.9 percent in 2016, after (once again) resilience to risks to growth. Where they are able to falling short of expectations at 2.4 percent in 2015, boost government spending or lower interest rates, held back by weak capital flows to emerging and they can provide support to economic activity. They developing countries, weak trade and low commodity can further encourage investor confidence with prices. Under the baseline scenario, it is expected that reforms to governance, labor market functioning, and China will steer its economy to a more consumption- business environments. Measures to absorb young and services-led growth and the monetary policy workers or to increase workforce participation will tightening cycle in the United States will proceed relieve demographic pressures in many countries. without undue turbulence; as a consequence, global growth will see a modest upturn. Kaushik Basu Chief Economist and Senior Vice President e World Bank xv Acknowledgments is World Bank Group Flagship Report is a product of the Prospects Group in the Development Economics Vice Presidency. e project was managed by Ayhan Kose and Franziska Ohnsorge, under the general guidance of Kaushik Basu. Many people contributed substantively to the report. contributions from Jose Luis Diaz Sanchez, Lei Sandy Chapter 1 (Global Outlook) was prepared Carlos Ye, Jaime de Jesus Filho, Xiaodan Ding, Sergio Kurlat, Arteta and Marc Stocker with contributions from John and Qian Li. Box 3.1 (Sources of the growth slowdown Baffes, Tehmina Khan, Eung Ju Kim, Ekaterine in BRICS) was prepared by Lei Sandy Ye; Box 3.2 Vashakmadze and Dana Vorisek. The Special Focus (Understanding cross-border growth spillovers) was was prepared by Tehmina Khan, Trang Nguyen, prepared by Raju Huidrom; and Box 3.3 (Within- Franziska Ohnsorge and Richard Schodde. region spillovers) was prepared by Jesper Hanson, Raju Huidrom, and Franziska Ohnsorge. Chapter 2 (Regional Outlooks) was coordinated by Carlos Arteta and Franziska Ohnsorge. The authors Chapter 4 (Two Topical Issues) has two essays. The were Ekaterine Vashakmadze (East Asia and Pacific), first essay (Potential Macroeconomic Implications of Christian Eigen-Zucchi and Ekaterine Vashakmadze the Trans-Pacific Partnership) was prepared by Csilla (Europe and Central Asia), Derek Chen (Latin America Lakatos, Maryla Maliszewska, Franziska Ohnsorge, and the Caribbean), Dana Vorisek (Middle East and Peter Petri, and Michael Plummer. The second essay North Africa), Tehmina Khan (South Asia), and (Peg and Control? The Links between Exchange Rate Gerard Kambou (Sub-Saharan Africa). Box 2.1 Regimes and Capital Account Policies) was prepared by (Regional integration and spillovers: East Asia and Carlos Arteta, Michael Klein, and Jay Shambaugh. Pacific) was prepared by Ekaterine Vashakmadze, Aaditya Mattoo was the author of Box 4.1.1 Nikola Spatafora, and Duygu Guven; modeling work (Regulatory convergence in mega-regional trade was done by Raju Huidrom and Jesper Hanson. Box agreements). 2.2 (Regional integration and spillovers: Europe and Central Asia) was prepared by Ekaterine Vashakmadze Modeling and data work were produced by Jungjin and Duygu Guven with contributions from Raju Lee, assisted by Mai Anh Bui, Xinghao Gong, Xiaodan Huidrom and Jesper Hanson. Box 2.3 (Regional Ding, Qian Li, and Trang Thi Thuy Nguyen. integration and spillovers: Latin America and the Caribbean) was prepared by Derek Chen with The online publication was produced by a team contributions from Raju Huidrom, Duygu Guven, including Graeme Littler, Praveen Penmetsa, Mikael Jesper Hanson, and Mai Anh Bui. Box 2.4 (Regional Reventar, and Katherine Rollins, with technical support integration and spillovers: Middle East and North from Marjorie Patricia Bennington. Phillip Hay and Africa) was prepared by Ergys Islamaj and Jesper Mark Felsenthal managed media relations and the Hanson. Box 2.5 (Regional integration and spillovers: dissemination. The print publication was produced by South Asia) was prepared by Tehmina Khan, Jesper Jose Maria Lopez Martin-Duarte, Maria Hazel Hanson and Raju Huidrom. Box 2.6 (Regional Macadangdang, Adriana Maximiliano, and Quinn integration and spillovers: Sub-Saharan Africa) was Sutton. prepared by Gerard Kambou and Jesper Hanson with contributions from Raju Huidrom. Many reviewers offered extensive advice and comments. These included: Ahmad Ahsan, Ibrahim Al-Ghelaiqah, Chapter 3 (Who Catches a Cold When Emerging Enrique Aldaz-Carroll, Kassia Antoine, Enrique Blanco Markets Sneeze) was prepared by Raju Huidrom, Arma, Marina Bakanova, Ulrich Bartsch, Davaadalai Ayhan Kose and Franziska Ohnsorge with Batsuuri, William Battaile, Hans Anand Beck, Fabio xvii Sola Bittar, Rogier J. E. Van Den Brink, César Tae Hyun Lee, Joseph Louie C. Limkin, Julio Ricardo Calderón, Jose R. Lopez Calix, Jasmin Chakeri, Loayza, Rohan Longmore, Sodeth Ly, Dorsati Madani, Shubham Chaudhury, Jean-Pierre Chauffour, Rodrigo Sanja Madzarevic-Sujster, Sandeep Mahajan, Paul A. Chaves, Menzie Chinn, Marcel Chistruga, Ajai Mariano, Miguel Eduardo Sanchez Martin, Martin Chopra, Karl Kendrick Tiu Chua, Punam Chuhan- Melecky, Elitza Mileva, Shabih Ali Mohib, Rafael Pole, Roland Clarke, Kevin Clinton, Andrea Coppola, Munoz Moreno, Lili Mottaghi, Ranjana Mukherjee, Tito Cordella, Barbara Cunha, Stefano Curto, Zafer Mustafaoglu, Pierre Nadji, Evgenij Najdov, Raj Somneuk Davading, Simon Davies, Agim Demukaj, Nallari, Khwima Nthara, Antonio Nucifora, Rei Shantayanan Devarajan, Tatiana Didier, Viet Tuan Odawara, Lucy Pan, John Panzer, Marcelo Echague Dinh, Ndiame Diop, Calvin Zebaze Djiofack, Doerte Pastore, Catalin Pauna, Suzana Petrovic, Keomanivone Doemeland, Mariam Dolidze, Ralph van Doorn, Jozef Phimmahasay, Samuel Pienknagura, Miria Pigato, Draaisma, Franz R. Drees-Gross, Bakyt Dubashov, Ruslan Piontkivsky, Juan Pradelli, Catriona Mary Sebastian Eckardt, Nur Nasser Eddin, Kim Alan Purfield, Rong Qian, Habib Rab, Martin Raiser, Edwards, Olga Emelyanova, Wilfried Engelke, Michael Martin Rama, Nadir Ramazanov, Elliot Joseph Ferrantino, Erik Feyen, Fitria Fitrani, Cornelius Riordan, David Robinson, Daniel Francisco Barco Fleischhaker, Caroline Freund, Laura Sofia Olivera Rondan, David Rosenblatt, Michele Ruta, Pablo Garrido, Michael Geiger, Anastasia Golovach, Anabel Saavedra, Seynabou Sakho, Ilyas Sarsenov, Cristina Gonzalez, David Gould, Poonam Gupta, Gohar Savescu, Marc Tobias Schiffbauer, Sergio Schmukler, Gyulumyah, Faris H. Hadad-Zervos, Kiryl Haiduk, Lea Luis Servén, Lazar Sestovic, Radwan Shaban, Rashmi Hakim, Birgit Hansl, Marek Hanusch, Wissam Shankar, Sudhir Shetty, Altantsetseg Shiilegmaa, Bojan Harake, Leonardo F. Hernandez, Marco Hernandez, Shimbov, Maryna Sidarenka, Alex Sienaert, Emilia Yumeka Hirano, Sandra Hlivnjak, Bert Hofman, Skrok, Gregory Smith, Karlis Smits, Ravshan Paulina Ewa Holda, Shantae Holland, Zahid Hussain, Sobirzoda, Nikola Spatafora, Abdoulaye Sy, Ashley Stella Illieva, Fernando Gabriel Im, Alain Ize, Ivailo V. Taylor, Theo David Thomas, Hans Timmer, Augusto Izvorski, Evans Jadotte, Steen Jorgensen, Satu Kristiina de la Torre, Eskender Trushin, Sergei Ulatov, Ekaterina Kahkonen, Leszek Pawel Kasek, Michelle Keane, Ushakova, Boris Enrique Utria, Robert Utz, Sona Mizuho Kida, Markus Kitzmuller, David Knight, Fritzi Varma, Julio Velasco, Mathew Verghis, Gallina Koehler-Geib, Naoko C. Kojo, Ewa Joanna Korczyc, Andronova Vincelette, Jan Walliser, Ayberk Yilmaz, Tigran Kostanyan, Christos Kostopoulos, Auguste Pui Shen Yoong, Albert Zeufack, and Luan Zhao. Tano Kouame, Ahmed Kouchouk, Aart Kraay, Regional Projections and write-ups were produced in Aurelien Kruse, Megumi Kubota, Sibel Kulaksiz, coordination with country teams, country directors, Chandana Kularatne, Matija Laco, Daniel Lederman, and the offices of the regional chief economists. xviii Executive Summary Global growth again fell short of expectations in 2015. Growth is projected to edge up in 2016-18 but the forecast is subject to substantial downside risks. In addition to discussing global and regional economic developments and outlook, this edition of the Global Economic Prospects also includes analysis of key challenges and opportunities currently confronting emerging and developing countries: spillovers from a slowdown in major emerging markets; the potential macroeconomic implications of the Trans-Pacific Partnership; and the links between exchange rate regimes and capital controls in emerging and developing countries. It also includes a study on vulnerabilities accumulating between commodity discovery and production in low-income countries. Global Outlook: Disappointments, Risks, and integration of the largest emerging markets— Spillovers. Global growth again fell short of Brazil, the Russian Federation, India, China, and expectations in 2015, decelerating to 2.4 percent South Africa (BRICS)—the simultaneous from 2.6 percent in 2014 (Chapter 1). The slowdown underway in all but one of them could disappointing performance mainly reflected a have significant spillovers to the rest of the world continued growth deceleration in emerging and (Chapter 3). Specifically, a 1 percentage point developing economies amid post-crisis lows in decline in growth in BRICS is associated with a commodity prices, weaker capital flows and reduction in growth over the following two years subdued global trade. Global growth is projected by 0.8 percentage points in other emerging to edge up in the coming years, but at a slower markets, 1.5 percentage points in frontier markets, pace than envisioned in June 2015, reaching 2.9 and 0.4 percentage points in the global economy. percent in 2016 and 3.1 percent in 2017-18. This Spillovers could be considerably larger if the pickup is predicated on continued gains in major growth slowdown in BRICS were combined with high-income countries, a gradual tightening of financial market turbulence. financing conditions, a stabilization of commodity prices, and a gradual rebalancing in China. The Within-Region Spillovers. Within-region forecast is subject to substantial downside risks, spillovers from BRICS and other major emerging including a disorderly slowdown in major markets are discussed in Boxes 2.1-2.6 of Chapter emerging market economies, financial market 2. Since most BRICS are the largest and most turmoil arising from sudden shifts in borrowing integrated economies in their respective regions, costs amid deteriorating fundamentals, lingering they tend to generate larger spillovers than other vulnerabilities in some countries, and heightened major emerging markets. Strong within-region geopolitical tensions. Weakening growth and trade and remittance links are reflected in sizeable sharply lower commodity prices have narrowed spillovers in Europe and Central Asia from a the room for policy makers to respond, especially growth decline in Russia, and in East Asia and in commodity-exporting countries, should risks Pacific from a growth decline in China (Boxes 2.1 materialize. and 2.2). In other regions, measured within-region spillovers are typically small (Boxes 2.3-2.6), partly Who Catches a Cold When Emerging Markets reflecting the lesser openness of major regional Sneeze? Given the size and global economic emerging markets or the prevalence of integration xix with major advanced economies. Many emerging degree of monetary policy control. The second market and developing countries are still most essay in Chapter 4 explores how emerging markets susceptible to growth spillovers from major and developing countries manage these competing advanced markets. pressures. The results suggest that developing countries with fixed exchange rate regimes appear Potential Macroeconomic Implications of the to be more likely to have capital flow restrictions. Trans-Pacific Partnership. On October 4, 12 This effect is particularly pronounced for lower- Pacific Rim countries concluded negotiations on income countries. the Trans-Pacific Partnership. The first essay in Chapter 4 shows that, if ratified by all, the From Commodity Discovery to Production: agreement could raise GDP in member countries Vulnerabilities and Policies in Low-Income by an average of 1.1 percent by 2030. It could also Countries. Major natural resource discoveries increase member countries’ trade by 11 percent by have transformed growth prospects for many low- 2030. A common regulatory approach could buoy income countries (LICs), though the sharp post- trade provided it is not associated with excessively crisis downturn in commodity prices may delay restrictive requirements on rules of origin and development of these discoveries into production. standards. As long as regulatory reforms benefit During the pre-production period, non-members, the detrimental effects of the macroeconomic vulnerabilities in these economies agreement due to trade diversion and preference may rise as a result of large-scale investment needs. erosion on non-members would be limited. This heightens the importance of reducing lead times between discovery and production. The Peg and Control? The Links between Exchange Special Focus finds that such lead times can be Rate Regimes and Capital Account Policies. As shortened by several years through improvements emerging and developing countries prepare to in business environments that benefit resource and shield themselves from risks to the global outlook, non-resource sectors alike. Separately, while they need to consider policy responses to adjust to growth in LICs eased in 2015, it continued to be external shocks. Among these, some countries robust at about 5 percent, sustained by investment might rely on exchange rate flexibility as a buffer, (both public and private, including in mining) and some might aim to minimize currency rising farm output. For 2016-17, strengthening fluctuations, and some might consider measures to import demand in advanced economies should limit capital flows as they seek to keep some help support activity in these countries. xx Abbreviations ASEAN Association of Southeast Asian Nations bbl barrel BRICS Brazil, Russian Federation, India, China, and South Africa BVAR Bayesian Vector Autoregression CFM capital ow measures DEV developing countries EAP East Asia and Paci c ECA Europe and Central Asia ECB European Central Bank EM emerging market economies EMBI Emerging Markets Bond Index ERR exchange rate regime EU European Union FDI foreign direct investment FM frontier markets FTA free trade agreements FY scal year GCC Gulf Cooperation Council GDP gross domestic product GEP Global Economic Prospects HIC high-income country HIY high-income country IMF International Monetary Fund LAC Latin America and Caribbean LDC least developed country LIC low-income country MNA Middle East and North Africa MIMT Mexico, Indonesia, Malaysia, and Turkey MRTA mega-regional trade agreements NAFTA North America Free Trade Agreement NTM non-tari measures ODA o cial development assistance OECD Organisation for Economic Co-operation and Development OPEC Organization of the Petroleum Exporting Countries PPP purchasing power parity REER real e ective exchange rate RHS right-hand side (in gures) xxi RTA Regional Trade Agreements SAR South Asia region SSA Sub-Saharan Africa TFP total factor productivity TPP Trans-Paci c Partnership T-TIP Transatlantic Trade and Investment Partnership VAR vector autoregression VAT value-added tax WDI World Development Indicators WEO World Economic Outlook WTO World Trade Organization xxii G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 3 Global growth again fell short of expectations in 2015, slowing to 2.4 percent from 2.6 percent in 2014. The disappointing performance was mainly due to a continued deceleration of economic activity in emerging and developing economies amid weakening commodity prices, global trade, and capital flows. Going forward, global growth is projected to edge up, but at a slower pace than envisioned in the June 2015 forecast, reaching 2.9 percent in 2016 and 3.1 percent in 2017-18. The forecast is subject to substantial downside risks, including a sharper-than-expected slowdown in major emerging and developing economies or financial market turmoil arising from a sudden increase in borrowing costs that could combine with deteriorating fundamentals and lingering vulnerabilities in some countries. Summary and key Notable exceptions in an otherwise gloomy outlook for developing countries include South messages Asia (reflecting reduced macroeconomic vulner- abilities and domestic policy reforms in India), as A further deceleration of activity in key emerging well as some commodity-importing countries in and developing economies overshadowed a modest East Asia. Growth in low-income countries recovery in major high-income countries in 2015. generally remained robust in 2015, albeit slowing This deceleration was accompanied by further to 5.1 percent from 6.1 percent in 2014. Some declines in commodity prices, subdued global low-income economies showed continued strength trade, bouts of financial market volatility, and (Ethiopia, Rwanda, Tanzania), supported by large- weakening capital flows. Global growth continued scale infrastructure investment, ongoing mine to disappoint, and is now estimated at a slower- development, and consumer spending. However, than-expected 2.4 percent in 2015, 0.4 percentage fiscal risks have increased in several countries in point below June 2015 Global Economic East Africa because of sharp increases in public Prospects projections. debt and contingent liabilities. In developing countries, growth in 2015 is These scattered bright spots aside, the widespread estimated at a post-crisis low of 4.3 percent, down slowdown across emerging and developing from 4.9 percent in 2014 and 0.4 percentage economies is a source of concern for the global point lower than projected in June (Figure 1.1). In economy and poses a threat to hard-won a development unprecedented since the 1980s, achievements in poverty reduction: more than 40 most of the largest emerging economies in each percent of the world’s poor live in the developing region have been slowing simultaneously for three countries where growth slowed in 2015. consecutive years. The economic rebalancing in China is continuing and accompanied by slowing Worsening prospects for developing countries growth. Brazil and Russia have been going have coincided with a sharp slowdown in global through severe adjustments in the face of external trade, a rise in financial market volatility, and a and domestic challenges. On average, activity in substantial decrease in capital inflows (Figure 1.2). emerging and developing commodity exporters In anticipation of tighter U.S. monetary policy, stagnated in 2015, as they continued to be hard currency pressures have intensified and borrowing hit by declining commodity prices. As a result, the costs have increased, particularly for a number of contribution to global growth from these commodity exporters. Significant nominal economies has declined substantially. More currency depreciations against the U.S. dollar are generally, 2015 growth estimates for more than straining balance sheets in countries with elevated half of developing countries were further dollar-denominated liabilities. In an environment downgraded. Disappointments are concentrated in of weak global trade, exports are likely to languish. Latin America and, to a lesser degree, Sub-Saharan On the domestic front, a trend deceleration in Africa, where a number of commodity exporters productivity growth, rising private sector leverage, are struggling to maintain growth. depleted fiscal buffers, and heightened policy uncertainty are major headwinds. 4 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 TABLE 1.1 Global real GDP growth1 (Percent) (Percentage point difference from June 2015 projections) 2013 2014 2015e 2016f 2017f 2018f 2015e 2016f 2017f World 2.4 2.6 2.4 2.9 3.1 3.1 - 0.4 - 0.4 - 0.1 High income2 1.2 1.7 1.6 2.1 2.1 2.1 - 0.3 - 0.2 - 0.1 United States 1.5 2.4 2.5 2.7 2.4 2.2 -0.2 -0.1 0.0 Euro Area -0.2 0.9 1.5 1.7 1.7 1.6 0.0 -0.1 0.1 Japan 1.6 -0.1 0.8 1.3 0.9 1.3 -0.3 -0.4 -0.3 United Kingdom 2.2 2.9 2.4 2.4 2.2 2.1 -0.2 -0.2 0.0 Russia 1.3 0.6 -3.8 -0.7 1.3 1.5 -1.1 -1.4 -1.2 Developing countries2 5.3 4.9 4.3 4.8 5.3 5.3 - 0.4 - 0.6 - 0.2 East Asia and Pacific 7.1 6.8 6.4 6.3 6.2 6.2 -0.3 -0.4 -0.4 China 7.7 7.3 6.9 6.7 6.5 6.5 -0.2 -0.3 -0.4 Indonesia 5.6 5.0 4.7 5.3 5.5 5.5 0.0 -0.2 0.0 Thailand 2.8 0.9 2.5 2.0 2.4 2.7 -1.0 -2.0 -1.6 Europe and Central Asia2 3.9 2.3 2.1 3.0 3.5 3.5 0.3 -0.4 -0.2 Kazakhstan 6.0 4.4 0.9 1.1 3.3 3.4 -0.8 -1.8 -0.8 Turkey 4.2 2.9 4.2 3.5 3.5 3.4 1.2 -0.4 -0.2 Romania 3.5 2.8 3.6 3.9 4.1 4.0 0.6 0.7 0.6 Latin America and the Caribbean2 3.0 1.5 -0.7 0.1 2.3 2.5 -1.5 -2.3 -0.6 Brazil 3.0 0.1 -3.7 -2.5 1.4 1.5 -2.4 -3.6 -0.6 Mexico 1.4 2.3 2.5 2.8 3.0 3.2 -0.1 -0.4 -0.5 Colombia 4.9 4.6 3.1 3.0 3.3 3.5 -0.4 -0.9 -0.9 Middle East and North Africa 0.6 2.5 2.5 5.1 5.8 5.1 0.1 1.4 2.0 Egypt, Arab Rep.3 2.1 2.2 4.2 3.8 4.4 4.8 0.0 -0.7 -0.4 Iran, Islamic Rep. -1.9 4.3 1.9 5.8 6.7 6.0 0.9 3.8 4.7 Algeria 2.8 3.8 2.8 3.9 4.0 3.8 0.2 0.0 0.0 South Asia 6.2 6.8 7.0 7.3 7.5 7.5 -0.1 0.0 0.0 India3 6.9 7.3 7.3 7.8 7.9 7.9 -0.2 -0.1 -0.1 Pakistan3 4 4.4 4.7 5.5 5.5 5.4 5.4 -0.5 1.8 0.9 Bangladesh3 6.1 6.5 6.5 6.7 6.8 6.8 0.2 0.0 0.1 Sub-Saharan Africa2 4.9 4.6 3.4 4.2 4.7 4.7 -0.8 -0.3 -0.3 South Africa 2.2 1.5 1.3 1.4 1.6 1.6 -0.7 -0.7 -0.8 Nigeria 5.4 6.3 3.3 4.6 5.3 5.3 -1.2 -0.4 -0.2 Angola 6.8 3.9 3.0 3.3 3.8 3.8 -1.5 -0.6 -1.3 MEMORANDUM ITEMS Real GDP growth World (2010 PPP weights) 3.2 3.4 3.1 3.6 3.8 3.9 -0.3 -0.4 -0.2 BRICS 5.7 5.1 3.9 4.6 5.3 5.4 -0.6 -0.8 -0.5 Low-income countries 6.4 6.1 5.1 6.2 6.6 6.6 -0.7 -0.1 0.1 Emerging markets (EME)5 4.9 4.5 3.7 4.2 4.8 4.9 -0.5 -0.7 -0.4 Frontier markets (FME)6 3.7 2.2 1.1 2.3 3.4 3.8 -0.7 -0.9 -0.6 Commodity-exporting EME & FME7 3.3 1.9 -0.4 0.9 2.6 2.9 -1.3 -1.7 -0.8 Other EME & FME 5.6 5.7 5.7 5.7 5.7 5.8 -0.1 -0.2 -0.3 World trade volume growth8 3.3 3.6 3.6 3.8 4.3 4.5 -0.8 -1.1 -0.6 Oil price growth9 -0.9 -7.5 -46.5 -8.5 7.2 7.2 -6.8 -18.1 1.6 Non-energy commodity price growth -7.2 -4.6 -14.8 -1.8 1.9 1.9 -3.8 -3.0 0.6 International capital flows to developing countries (percent of GDP)10 Developing countries 5.9 5.3 3.1 3.7 4.2 4.5 -2.0 -1.3 -0.6 East Asia and Pacific 6.2 5.3 2.0 3.0 3.8 4.3 -3.1 -1.9 -0.8 Europe and Central Asia 6.8 4.6 2.7 3.1 3.6 4.1 -2.3 -2.7 -2.9 Latin America and the Caribbean 6.9 6.7 5.5 5.4 5.3 5.3 0.1 -0.1 0.1 Middle East and North Africa 2.4 2.3 3.1 3.2 3.3 3.5 0.9 1.1 1.1 South Asia 4.3 4.9 5.0 5.1 5.2 5.2 -0.8 -0.5 -0.3 Sub-Saharan Africa 5.0 5.1 4.0 4.0 4.1 4.3 -0.2 0.0 0.2 Source: World Bank. Notes: PPP = purchasing power parity; e = estimate; f = forecast. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not differ at any given moment in time. 1. Aggregate growth rates calculated using constant 2010 U.S. dollars GDP weights. 2. Since July 2015, Argentina, Hungary, Seychelles, and Venezuela, RB have been classified as high income, and have been removed from respective developing regions. Percentage differences from previous Global Economic Prospects projections are calculated after modifying previous numbers to this new classification. 3. In keeping with national practice, data for Bangladesh, Arab Republic of Egypt, India, and Pakistan are reported on a fiscal year basis in Table 1.1. Aggregates that depend on these countries are calculated using data compiled on a calendar year basis. 4. GDP data for Pakistan are based on market prices. 5. Includes Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Rep., Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Qatar, Russian Federation, Saudi Arabia, South Africa, Thailand, Turkey, and United Arab Emirates. 6. Includes Argentina, Azerbaijan, Bahrain, Bangladesh, Bolivia, Botswana, Bulgaria, Costa Rica, Côte d'Ivoire, Croatia, Ecuador, El Salvador, Gabon, Georgia, Ghana, Guatemala, Honduras, Jamaica, Jordan, Kazakhstan, Kenya, Kuwait, Lebanon, Mauritius, Mongolia, Namibia, Nigeria, Oman, Panama, Paraguay, Romania, Senegal, Serbia, Sri Lanka, Tunisia, Ukraine, Uruguay, Venezuela, RB, Vietnam, and Zambia. 7. Includes Argentina, Azerbaijan, Bahrain, Bolivia, Botswana, Brazil, Chile, Colombia, Costa Rica, Côte d'Ivoire, Ecuador, Gabon, Ghana, Guatemala, Honduras, Indonesia, Jamaica, Kazakhstan, Kenya, Kuwait, Malaysia, Mongolia, Namibia, Nigeria, Oman, Panama, Paraguay, Peru, Qatar, Russian Federation, Saudi Arabia, Senegal, South Africa, Sri Lanka, Ukraine, United Arab Emirates, Uruguay, Venezuela, RB, and Zambia. 8. World trade volume for goods and non-factor services. 9. Simple average of Dubai, Brent, and West Texas Intermediate. 10. Balance of payments data for capital inflows of foreign direct investment, portfolio investment, and other investment (BPM6). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 5 In contrast to developing countries, the recovery FIGURE 1.1 Global and developing-country growth in major high-income countries gained traction in prospects 2015 and has been increasingly driven by stronger Despite a modest recovery in high-income countries, global growth slowed domestic demand as labor markets heal and credit in 2015, as developing-country growth dipped to a post-crisis low. The conditions improve. However, 2016 growth upturn in 2016 and 2017 is projected to be shallower than previously anticipated. Weakening prospects are most visible among key commodity forecasts for high-income countries have been exporters, pointing to a significantly lower contribution to global growth marked down in light of the effect on the United than in the past. China’s gradual slowdown and rebalancing continued. Low-income countries continued to show some resilience, but a rising States of dollar appreciation and the impact on share of the world’s extreme poor live in countries with slowing growth. Japan of slowing trade in Asia. Conditions for a continued but fragile upturn in the Euro Area still A. GDP growth, actual and projected B. Global GDP growth forecasts over time appear in place, despite soft external demand and rising geopolitical concerns. Albeit gradually dissipating, legacies from the global financial crisis continue to be felt across high-income countries, limiting both aggregate demand and the underlying growth potential of these economies. Going forward, global growth should pick up, albeit at an appreciably slower pace than previously projected, reaching 2.9 percent in 2016 C. Contribution to global growth D. Contribution to global growth and 3.1 percent in 2017-18. Global inflation is revisions expected to increase moderately in 2016 as commodity prices level off, but will remain low by historical standards. A modest upturn in global activity in 2016 and beyond is predicated on a continued recovery in major high-income countries, a gradual slowdown and rebalancing in China, a stabilization of commodity prices, and an increase in global interest rates that is gradual and stays well contained. All of these projections, E. Share of developing countries with F. Share of world’s poor living in however, are subject to substantial downside risks. slower growth than 1990-2008 average countries with slowing growth Although it is still a low-probability scenario, a faster-than-expected slowdown in China combined with a more protracted deceleration in other large emerging markets is a risk. Empirical estimates suggest that a sustained 1 percentage point decline in growth in the BRICS (Brazil, the Russian Federation, India, China, and South Africa) would reduce growth in other emerging Sources: Haver Analytics; CPB Netherlands Bureau for Economic Policy Analysis; World Bank. and developing economies by around 0.8 A. Shaded areas indicate forecasts. B. Global GDP growth forecasts for a given year over subsequent Global Economic Prospects percentage point and global growth by 0.4 projection exercises. C. Contribution to global growth revisions measured in constant 2010 U.S. dollars. “Other Com. Exp.” percentage point. This suggests a substantial risk stands for other commodity exporters, and excludes Russia and Brazil; “Other Com. Imp.” stands for other commodity importers, and excludes China and G3 (Euro Area, Japan, and United States). of contagion through other emerging markets, Cumulative contributions from individual country growth revisions can differ from global growth with potential adverse effects for some advanced revisions reported in Table 1.1 due to decimal rounding. D. Contributions to global growth measured in constant 2010 U.S. dollars. “Other Com. Exp.” stands economies as well. Compounding this risk is the for other commodity exporters, and excludes Russia, Brazil and South Africa; “Other Com. Imp.” stands for other commodity importers, and excludes China, India and G3 (Euro Area, Japan, and possibility of a protracted decline in potential United States). E. For each year, the fraction of middle- and low-income countries in which growth is slower than its growth throughout emerging and developing historical average for 1990-2008. F. Share of extreme poor ($1.90/day) living in developing countries that grew more slowly in the economies, persistently subdued growth in major current year than in the previous year. EAP= East Asia and Pacific, ECA = Europe and Central Asia, LAC = Latin America and the Caribbean, MNA = Middle East and North Africa, SAR = South Asia, high-income countries, and an escalation of SSA = Sub-Saharan Africa. 6 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 1.2 Global trade, finance, and risks geopolitical tensions. In addition, baseline forecasts of a smooth monetary policy tightening Deteriorating growth prospects for developing countries have been accompanied by weakening global trade, capital flows, and commodity cycle in the United States are subject to prices. Currency pressures have increased, particularly for some considerable uncertainty. A sudden readjustment commodity exporters. Domestic challenges have intensified as well, with elevated private sector debt, slowing credit, and weaker productivity of expectations about the future trajectory of U.S. growth. Prospects of rising borrowing costs combined with lingering interest rates could combine with domestic vulnerabilities in some countries could heighten the risk of financial market fragilities and policy uncertainties in some turbulence. Further growth disappointments in major emerging economies could disproportionately affect other developing countries. developing countries to generate financial stress. Given the weak outlook and lingering A. Global merchandise trade growth B. Capital flows in emerging and vulnerabilities in many developing countries, these developing countries risks have the potential to be a source of damaging sudden stops in capital flows in the most fragile economies. Policies can play an important role in mitigating risks and supporting growth. A combination of cyclical and structural policies could be mutually reinforcing. In the near term, policy actions need to be focused on building the ability to withstand C. Exchange rates D. Credit growth and private debt financial market turbulence. Cyclical policies need to be supplemented with structural reform measures that boost investors’ confidence in the short term and enhance growth prospects in the long term. Major economies The recovery in major high-income countries gained E. Productivity growth in BRICS F. Impact of a 1 percentage point traction last year. This has been increasingly driven decline in BRICS on growth by stronger domestic demand, particularly in the United States, where employment conditions are robust. In the Euro Area, credit growth is picking up and unemployment is declining. The recovery remains fragile in Japan despite substantial policy stimulus. With external demand negatively affected by a slowdown in large emerging market economies, growth forecasts across major high-income economies in 2016 have been shaded down, but growth should Sources: Haver Analytics; World Bank; CPB Netherlands Bureau for Economic Policy Analysis; Bank still show some improvement from 2015. The for International Settlements. A. Global merchandise trade is the average of global imports and exports. Volumes are computed by tightening cycle of the U.S. Federal Reserve is deflating nominal trade flows by unit value indexes. Latest observation is October, 2015. B. Based on quarterly balance of payment data for the largest 23 emerging and developing projected to be very gradual, while policy economies. Includes foreign direct investment, portfolio, short-term debt, and other investment flows. Countries are classified as either emerging or frontier markets when they have either full or partial accommodation will likely continue in the Euro Area access to international financial markets. C. Median effective exchange range of developing countries classified as either commodity exporters and Japan. China’s gradual slowdown and or commodity importers. An increase denotes appreciation. Latest observation is November 2015. rebalancing continued in 2015, as further D. GDP-weighted average of credit growth to and debt-to-GDP ratios of households and non-financial corporations in BRICS and MIMT (BRICS are Brazil, Russia, India, China, and South Africa; MIMTs deceleration in sectors with excess capacity was are Mexico, Indonesia, Malaysia, and Turkey). Latest observation is 2015 Q2. E. Unweighted average of total factor productivity growth in BRICS using 2010 USD GDP weights. partially offset by robust growth in services. F. Weighted average of the responses of other emerging market and global GDP to a 1 percentage point decline in growth of BRICS countries’ GDP, according to a vector-autoregression models presented in Chapter 3. Confidence bands span the 16th-84th percentiles. EM (excluding BRICS) comprises Chile, Colombia, Czech Republic, Egypt, Hungary, Indonesia, Korea, Morocco, Mexico, Malaysia, Pakistan, Peru, Philippines, Poland, Qatar, Saudi Arabia, Thailand, Turkey, United Arab Emirates. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 7 United States FIGURE 1.3 United States Domestic demand in 2015 was supported by Robust consumer spending and investment in the non-oil private sector supported above-trend growth in 2015, and should continue to be the main robust consumption and dynamic investment drivers of growth in 2016. The unemployment rate has dropped to lows outside the oil sector. In contrast, net exports seen during previous recoveries, but labor participation and growth in remained a drag on growth and industrial activity productivity have been declining, constraining potential output. A strength- ening U.S. dollar and weakening external demand are weighing on exports continued to be subdued in the second half of and manufacturing activity. This points to a very gradual tightening cycle 2015 (Figure 1.3). For 2015 as a whole, growth is by the U.S. Federal Reserve. estimated at 2.5 percent—the highest annual rate A. GDP and demand components B. Growth and inflation in the post-crisis period. Solid labor market conditions continued to support a consumption- led recovery, with job creation averaging more than 200,000 per month in 2015 and the unemployment rate falling to 5 percent in the final quarter of 2015. However, labor participation has continued to trend down, and is unlikely to recover much as the number of baby- boomers approaching retirement age increases. Labor productivity has moved downward in recent years, constraining potential output growth C. Unemployment rate from cyclical D. Labor participation and productivity troughs growth (Gordon 2014, Hall 2014, Fernald and Wang 2015). Household real disposable income has been boosted by employment gains, declining oil prices and moderate wage growth. This led to rising personal consumption growth in 2015, despite an increase in the savings ratio. A recovery in housing markets and prospects of strengthening wage growth amid tight labor market conditions support a positive outlook in 2016. The decline in net exports is a principal factor E. U.S. dollar exchange rate and real F. U.S. policy interest rate exports expectations dampening growth at present. This is the result of the strength of the dollar and the softness in external demand, particularly from large emerging markets. Reflecting in part asynchronous monetary policy stances among major central banks, the dollar has appreciated more than 20 percent in nominal effective terms—and 18 percent in real effective terms—since mid-2014. Empirical studies suggest that an appreciation around this size may reduce GDP growth by one Sources: Haver Analytics; World Bank; Federal Reserve Economic Data (FRED). percentage point after two years (Laporte and B. Inflation is the year-on-year percent change of the overall Consumer Price Index. C. Based on the last three cyclical troughs identified by the NBER's Business Cycle Dating Commit- Roberts 2014; Brayton, Laubach, and tee: March 1991, November 2001, and June 2009. D. Productivity growth is measured as annual change in real output per hour worked of all persons in Reifschneider 2014). the non-farm business sector. The civilian labor force participation rate is the ratio of people either employed or actively looking for work to the active age population. The thick lines show the trend measured by a Hodrick-Prescott filter. Latest observation is 2015 Q3. Headline inflation continued to hover around zero E. REER: real effective exchange rate based on relative CPI inflation. An increase denotes apprecia- tion. Latest observation is October 2015 for real exports and November, 2015 for exchange rates. in the second half of 2015, with the renewed fall F. Past tightening cycles refer to average of Fed fund rate hikes during previous tightening cycles (December 1986, March 1988, February 1994, March 1997, June 1999, and June 2004). in oil prices during the summer of 2015 and the strengthening dollar exerting downward pressures. Excluding food and energy, inflation stayed below 2 percent and is projected to rise only gradually in 8 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 1.4 Euro Area further to 2.8 percent of GDP in 2015, the result of stronger growth and consolidation efforts. The recovery in the Euro Area in 2015 has been supported by both strengthening domestic demand and exports. Pickups in credit and intra- Fiscal policy has eased to a broadly growth-neutral European trade growth point to a broadening recovery. Deflation concerns stance in 2014-15, having weighed on activity in have receded, but core inflation and wage growth remain subdued among previous years. economies with high long-term unemployment rates. Robust employment growth, still-accommodative A. GDP and demand components B. Growth and inflation financing conditions, and low oil prices should continue to support domestic demand in the period ahead. Growth is projected to average 2.7 percent in 2016, above potential but somewhat lower than predicted in June, reflecting a larger drag from net exports. Growth is expected to stabilize around 2.3 percent in 2017-18, with the output gap closing in 2017. Monetary policy tightening is likely to be very gradual throughout the forecast period. C. Private loan growth and credit D. Extra and intra-EU export growth standards (nominal) Euro Area Growth picked up in 2015, as domestic demand strengthened and exports accelerated, partly due to the lagged effect of a euro depreciation (Figure 1.4). For the year as a whole, Euro Area growth is estimated at 1.5 percent, in line with previous expectations, with activity firming in Spain, somewhat disappointing in Germany, and still E. Wage growth and core inflation F. Long-term unemployment and core lagging (albeit gradually recovering) in France and inflation, 2015 Italy. Low oil prices and favorable financing conditions are supporting consumer spending and investment. In the absence of further escalation, security concerns following the terrorist attacks in Paris are not expected to have lasting effects on confidence and activity. Diminishing fiscal consolidation and healing labor markets are underpinning domestic demand, although conditions vary across countries. Since Sources: Haver Analytics; World Bank; Eurostat; European Central Bank, Bank Lending Survey. B. Inflation is the year-on-year percent change of the Harmonized Index of Consumer Prices. the start of the European Central Bank’s (ECB) C. Credit standard is calculated as the difference (net percentage) between the share of banks reporting that credit standards have been easing and the share of banks reporting that they have quantitative easing program, credit conditions been tightened. A positive net percentage indicates that a larger proportion of banks have eased credit standards. Latest observation is 2015 Q3. have improved and credit growth has resumed D. Six month moving average. Latest observation is September, 2015. E. Wage growth is measured as percentage change, year-over-year, in negotiated wage rates. Latest following several years of contraction. However, observation is 2015 Q3 for wage growth and November, 2015 for core inflation. credit remains tight in some countries because of F. Standard ISO country codes. Long-term unemployment rate refers to people who are actively seeking for employment for at least a year in percent of total unemployment. Long-term unemploy- elevated non-performing loans and impaired bank ment is 2015 Q3 for most countries. Core inflation is the average of January to November 2015. Core Inflation is Harmonized Consumer Price Index excluding energy, foods, and tobacco. balance sheets. Despite the monetary policy easing, the euro appreciated about 7 percent in 2016. Market-based inflation expectations trade-weighted terms since reaching a low in April remained somewhat below the Federal Reserve’s 2 2015, mainly reflecting the broad-based percent inflation target in the second half of 2015, depreciation of emerging-market currencies. This pointing towards a gradual normalization of policy may reduce somewhat the momentum of export rates. The fiscal deficit is estimated to have fallen growth and delay a pick-up in inflation. Although G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 9 the impact may vary depending on the underlying consumption.1 Over the medium term, the influx factors driving currency movements, results from a may also help to meet labor shortages in the face number of macroeconomic models indicate that a of an ageing population. However, the ultimate 7 percent euro appreciation reduces Euro Area effect on growth and public finances remains GDP growth by between 0.2-0.4 percentage highly uncertain, depending on the performance point, and inflation by 0.1-0.5 percentage point of migrants in the labor market (Münz et al. 2006, (ECB 2015a, European Commission 2015a). OECD 2014) as well as the coherence of national and EU policy responses. Peripheral economies have been little affected by contagion from the Greece crisis. A third bailout Japan program was agreed to with European partners in August 2015, amounting to €86 billion ($95 Japan experienced a soft growth patch in mid- billion), in exchange for pension, tax, and other 2015, confirming a weak underlying trend despite reforms. The weakening of the Greek economy rising corporate profits and continued policy following the implementation of capital controls stimulus. Private consumption contracted in 2015 in June 2015 will make program implementation and investment was stagnant, which was only challenging, but the disbursement of bailout funds partially offset by positive but relatively subdued and the agreed bank recapitalization plan have export growth (Figure 1.5). Overall, GDP growth reduced immediate funding pressures. is estimated at 0.8 percent for 2015, 0.3 percentage point lower than projected in June. Deflation concerns have receded since the start of 2015 but have not disappeared, with core inflation Despite the low value of the yen since 2013, the and wage growth remaining subdued, particularly export response has been modest. This among economies with high long-term disappointment partly owes to past offshoring of unemployment rates. Headline inflation remained production to the rest of Asia, which helped close to zero in 2015. Market-based inflation develop regional value chains and shifted sales to expectations have bottomed out but remain below overseas subsidiaries. The transition to foreign the 2 percent target. This situation led the ECB to plants was led by the more productive enterprises ease monetary policy further in December 2015. (Wakasugi et al. 2014). This offshoring trend appears to have lowered Japan’s gross export Conditions should continue to improve in 2016, elasticity. Weakening external demand from the with growth reaching 1.7 percent, a bit slower rest of Asia also played a dampening role on than expected in June, reflecting a weakening exports, as value-added trade between Japan and external environment. Growth should average 1.6 other Asian countries intensified during the 2000s percent in 2017-18, slightly above potential. (Ito and Wakasugi 2015). However, concerns persist about low potential growth, high unemployment, and large public The Bank of Japan maintained its commitment to debt. While population ageing limits growth quantitative easing, and a further expansion of potential (Jimeno 2015), labor mobility and asset purchases is likely as inflation is not expected migration can help alleviate some of these to reach the central bank’s target before 2017. constraints (World Bank 2015b) and help Tax revenues have increased following the rise in adjustments to country-specific shocks in the consumption tax in April 2014 and the growth monetary union (Beyer and Smets 2015). in corporate profits, but achieving primary balance by 2020-21 will be challenging, as spending The recent acceleration in the number of asylum pressures on social security and defense remain seekers is creating important absorption and significant. Skill shortages in key services sectors policy challenges that could strain public services and government finances in exposed countries, but is expected to provide some marginal support 1 e European Commission predicts that the in ux of 3 million migrants over the next three years would provide a net gain of up to to Euro Area-wide growth in the short-term ¼ of percentage point to EU growth by 2017 (European Commis- through rising public expenditure and private sion 2015b). 10 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 1.5 Japan Sustained policy accommodation, and the Growth in Japan remains fragile, with private consumption and investment prospect of higher earnings and record low failing to pick up in 2015. Growth is expected to recover moderately to 1.3 unemployment, are positives for the outlook. percent in 2016, from 0.8 percent in 2015. Past offshore investments have Going forward, growth is expected to recover to helped raise sales and profit by overseas subsidiaries, but restrained exports. Skill shortages continued to increase, raising prospects of a 1.3 percent in 2016, less than expected in June gradual acceleration in wage growth. Rising female participation has due to a downward revision to both domestic boosted employment rates and is helping to offset demographic pressures. Long-term inflation expectations remain below the 2 percent inflation demand and exports. The recovery remains fragile target, despite further policy easing by the Bank of Japan. and dominated by downside risks. A. GDP and demand components B. Growth and inflation China Sectoral rebalancing in China became more pronounced in 2015. It was accompanied by bouts of volatility in financial markets and additional government stimulus measures. Growth in 2015 is estimated at 6.9 percent, down from 7.3 percent the previous year. The deceleration reflects an ongoing correction in the property sector, weakness in industrial activity, and slower growth C. Exports and sales of overseas D. Employment shortages by industry in non-traditional credit. The robust expansion of subsidiaries consumer spending and services has helped boost the economy, and is in line with the rebalancing sought by policymakers. Even so, forecasts for 2016-17 have been downgraded, with growth expected to reach 6.5 percent by 2017. In line with rebalancing efforts, the deceleration in activity during 2015 has been most visible in industry and real estate—sectors with considerable E. Female and overall employment rate F. Inflation expectations and central overcapacity and, in the case of industry, a high bank balance sheet presence of state-owned enterprises (Figure 1.6). These sectors saw the sharpest increase in investment and leverage in 2009-13, resulting in a significant concentration of debt among a small number of large firms (Chivakul and Lam 2015). Balance sheets and credit quality have deteriorated in sectors with excess capacity. Policy efforts to reduce supply mismatches in the real estate sector, and to tighten nonbank credit flows, continued to Sources: Haver Analytics; World Bank; Bank of Japan. B. Inflation is the year-on-year percent change of the Consumer Price Index. weigh on non-traditional credit growth, which C. Latest observation is 2015 Q2. slowed notably during 2015. Weaker activity in D. Percent of reporting companies based on the Bank of Japan’s Tankan survey data on labor market shortages is a diffusion index taking a negative value when companies report perceived labor manufacturing and construction have significantly shortages (as factor hampering production). Latest observation is 2015 Q3. E. Percent of the active age population. Latest observation is October, 2015. impacted import demand, which contracted in the F. Inflation expectations extracted from 5-year swap rates. Central Bank’s balance sheet is total assets held. Latest observation is November, 2015. first half of 2015. continued to increase, as reforms that have The service sector has seen its share of encouraged female labor force participation have employment increasing in recent years, and only partially offset demographic pressures on accounted for the majority of new urban jobs labor supply. The tight labor market in the created in 2015 (World Bank 2015a). This helped services sector raises the prospect of a gradual offset stagnant hiring in shrinking industrial acceleration in wage growth. sectors, and kept urban labor markets tight. Wages G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 11 and real incomes have continued to increase, albeit FIGURE 1.6 China at lower rates, contributing to sustained growth of The growth slowdown in China has been most noticeable among private consumption. A continued rebalancing enterprises operating in the manufacturing and real estate sectors. Growth from industry to services should support the shift forecasts have been revised down to 6.9 percent in 2015 and 6.7 percent in 2016. In evidence of the rebalancing of China’s economy, the share of from investment to consumption, whose share in services employment has increased, supporting real incomes and GDP is gradually recovering from a post-crisis dip. contributing to robust private consumption. A drop in equity prices and a change in exchange rate policy led to market turbulence, but foreign Policies became more supportive throughout the reserves remain plentiful and the current account is in surplus, reducing risks associated with capital outflows. course of 2015, in order to counter slowing activity. The People’s Bank of China (PBOC) A. Value-added by type of B. Growth and inflation companies continued to lower benchmark interest rates and required reserve ratios, while implementing new collateral policies to facilitate refinancing for commercial banks. The central bank also continued to inject liquidity into the financial system, especially during the June stock market correction. The fiscal deficit widened to a six-year high of 2.3 percent of GDP in 2015, reflecting accelerated infrastructure investment by the central government in the second half of the year. The increase in central government spending more C. GDP share of services and D. Employment by sector industry than offset cutbacks at the local government level resulting from lower revenues due to falling land sales, restrictions imposed on borrowing through Local Government Financing Vehicles (LGFV), and other off-budget transactions. To foster greater exchange rate flexibility, the PBOC introduced a change in the calculation of the renminbi reference rate on August 10. This led to an almost 3 percent depreciation against the E. Stock market index and exchange F. Current account balance and U.S. dollar, the largest three-day drop since the rate reserves mid-1990s. The change was implemented against a backdrop of accelerated capital outflows and slowing growth. While it sparked some market volatility in the short term, the decision was fully aligned with the objective of allowing market forces to play a greater role in the economy. With this exception, the renminbi has been stable throughout 2015, and has continued to appreciate in real effective terms despite strong capital outflows. Sources: Haver Analytics; World Bank. A. 2015 is the average of January to October. B. Inflation is the year-on-year percent change of the Consumer Price Index. Private capital outflows have increased as capital E. Stock market index is the Shanghai Stock Exchange Composite Index (SHCOMP). Latest observa- tion is December 16, 2015. controls have been loosened. The net outflow F. Foreign currency reserves is the foreign exchange holdings of the People’s Bank of China. Latest observation is 2015Q3. reflects corporate efforts to reduce net foreign currency exposures and foreign short-term debt. Currency interventions to reduce the resulting percent off their peak level). The drop in reserves downward pressure on the renminbi contributed in August 2015, US$94 billion, was the sharpest to an estimated US$443 billion decline in foreign drop on record, and partly reflected valuation currency reserves since September 2014 (11.5 effects, as well as an effort to diversify foreign 12 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 1.7 Financial volatility and asset valuations Global trends and spillovers Concerns about prospects in emerging markets, combined with China’s stock-market correction in the summer of 2015 and uncertainty about the Concerns about the growth outlook and prospects of impact of a normalization in U.S. monetary policy, contributed to greater financial market volatility. Equity and currency markets were particularly rising U.S. interest rates led to a tightening in affected, with the most significant currency depreciations among key financing conditions for many developing countries commodity exporters and in countries with lingering vulnerabilities. and contributed to a significant slowdown in capital Borrowing costs also rose in line with heightened risk-aversion. inflows in 2015. Commodity exporters, and countries A. Global volatility index B. Emerging market volatility with heightened domestic challenges, are especially indexes affected. The widespread slowdown in emerging market economies contributed to a contraction in global trade in the first half of the year, adding headwinds to the global recovery. The broad weakness in commodity prices in 2015 is expected to persist in 2016, maintaining pressure on commodity exporters while supporting real income gains among importers. Increasingly difficult financial conditions C. Currency changes against the U.S. D. Nominal effective exchange rate dollar Global financial market volatility rose noticeably in 2015 against the backdrop of slowing activity in large emerging economies, diverging monetary policies of major central banks, continued declines in commodity prices, and fragile liquidity conditions. In this context, market adjustments to adverse or unexpected news have been abrupt. Following a correction from overvalued equity prices in China and an unforeseen change in its E. Emerging market bond spreads F. Equity price indexes exchange rate regime during the summer of 2015, the VIX index of stock-market volatility, often considered a proxy of global risk aversion, briefly surged to levels last seen during the 2011-12 Euro Area crisis (Figure 1.7)2. While there was no unusual stress in short-term funding markets, nor a credit crunch in any large emerging markets, the summer market turmoil led to a sharp sell-off in developing country assets and a drop in capital inflows to those economies. Sources: World Bank; Haver Analytics; Bloomberg. A. Implied stock-market volatility derived from option pricing on the U.S. S&P 500 Index (VIX index). Half of the 20 largest developing-country stock Latest observation is December 15, 2015. B. EM currency and stock market volatility computed by Bloomberg. Latest observation is December markets saw plunges of 20 percent or more from 15, 2015. C. An increase denotes appreciation. Latest observation is December 15, 2015. their 2015 peaks. Currencies of key commodity D. Median effective exchange range of developing countries classified as either commodity exporters or commodity importers. A decline denotes depreciation. Latest observation is November 2015. exporters (including Brazil, Indonesia, Malaysia, E. EMBI Global bond spreads measured from emerging market U.S.dollar-denominated Brady bonds, loans, and Eurobonds with an outstanding face value of at least $500 million. Latest observation is the Russian Federation, and South Africa), and December 15, 2015. F. Latest observation is December, 2015. developing countries subject to heightened political risk (including Brazil and Turkey) fell to assets through the purchase of gold. multi-year lows both against the U.S. dollar as Notwithstanding this decline, China’s foreign 2 In contrast, currencies in high-income Eastern European countries exchange reserves remain substantial, at about appreciated in nominal e ective terms, alongside the euro, which US$3.5 trillion (or 32.8 percent of GDP). strengthened during the turmoil on safe-haven ows. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 13 well as in trade-weighted terms (Figure 1.7). Since FIGURE 1.8 Capital flows July 2015, sovereign debt spreads have widened by Capital flows decelerated to their weakest level since the global financial 45 basis points and emerging market corporate crisis, particularly in China. Foreign direct investment has shown greater debt spreads by 80 basis points, with the largest resilience, while short-term debt and portfolio inflows have decelerated increases occurring among commodity exporters significantly. Weakening capital flows have exacerbated currency and equity market pressures in many countries, particularly among commodity in Africa, Latin America, and East Asia. Since exporters. Borrowing costs also rose in line with heightened risk-aversion, October, equity markets have rebounded, and and corporate bond issuance slowed significantly, particularly from sovereign bond spreads have narrowed, although construction, oil and financial companies. remaining elevated in many countries. Several A. Outflows from emerging market B. Capital flows in and out of emerging emerging market currencies also retraced some of funds and frontier market economies their losses against the U.S. dollar, led by the Malaysian ringgit and the Indonesian rupiah. Global investors pulled about $52 billion from emerging market equity and bond funds in the third quarter of 2015, the largest quarterly outflow on record (Figure 1.8). This was mostly driven by institutional investors reducing their exposure in a sign of deteriorating confidence about long-term prospects. Net short-term debt and bank outflows C. Capital flows in emerging and D. Emerging market corporate bond developing countries issuance by sector from China, combined with a broad-based retrenchment in the Russian Federation, accounted for the bulk of the outflow from emerging markets, but portfolio and short-term capital inflows also dried up elsewhere in the third quarter of 2015. Meanwhile, FDI inflows remained generally steady, although they decelerated in some economies. Sources: World Bank; EPFR Global; Bloomberg; Dealogic; JP Morgan; U.S. Federal Open Market International bond issuance by emerging market Committee. A. Figure shows cumulative EPFR weekly flows. “Global Financial Crisis “ refers to June 11, 2008 to corporates slowed significantly, particularly in the October 28, 2009. “Taper Tantrum” refers to May 29 to September 4, 2013. “Summer 2015 Turmoil” oil and gas sector. This has partially reversed the refers to July 17 to September 16, 2015. B. C. Based on quarterly balance of payment data for the largest 23 emerging and developing econo- post-crisis doubling of bond issuance by mies. Includes foreign direct investment, portfolio, short-term debt, and other investment flows. Last observation is 2015Q2. Four-quarter moving sum. developing country corporates, especially in D. Last observation is December, 2015. commodities-related sectors. Since 2010, bonds have been issued more often to refinance debt gradual and notably slower than in previous than for investment purposes (Rodrigues Bastos, tightening cycles, reflecting in part low Kamil, and Sutton 2015). In consequence, some inflation expectations and U.S. dollar commodity firms have become highly leveraged, appreciation. Legacies from the crisis, such as and are now vulnerable to a combination of rising elevated household debt and weak borrowing costs and declining commodity prices. productivity growth, also point towards a protracted period of low interest rates. Since Looking ahead, the diverging monetary policy the tightening cycle has been widely stances of major economies will continue to be a anticipated, baseline projections assume a key determinant of financial conditions in benign impact on capital inflows to emerging developing countries. and developing economies. However, as financial market expectations are susceptible • United States. Following a first hike in to scares, risks of volatility during the Fed December 2015, the pace of interest rate tightening cycle remain significant (Arteta et increases in the United States is expected to be al. 2015). 14 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 • Euro Area and Japan. Continued quantitative dropped below $40 per barrel towards the end easing by the ECB and the Bank of Japan of 2015. Prices have been driven lower by should help shore up global liquidity. high stocks in OECD economies, ample Negative interest rates in Europe and global supplies, and expectations of slower increasing yield differentials with the United global demand (particularly from large States could contribute to a further emerging markets). U.S. crude oil production appreciation of the U.S. dollar and have has begun to decline due to lower investment mixed effects for developing countries. On the and drilling but was resilient for most of one hand, the increase in cross-border lending 2015. OPEC production increased further, from European banks and Eurobond issuance reaching a three year high, with much of the during 2015 is likely to continue as the Euro increase coming from Saudi Arabia and Iraq. Area recovery becomes more firmly A removal of sanctions following the entrenched and as bank balance sheets implementation of the Iran nuclear agreement improve. On the other hand, continued could increase Iranian oil exports by 0.5-0.7 strengthening of the dollar could contribute to million barrels per day by 2016, nearing the refinancing pressures in countries with pre-sanctions level of 4 percent of global significant dollar-denominated liabilities. consumption. Since other energy prices are at least partially linked to oil prices, prices for Capital inflows to developing countries dipped to other energy products, including natural gas, a post-crisis low relative to GDP in 2015 (Table have also fallen. 1.1). They are expected to recover slowly in 2016- 17 as developing-country growth stabilizes. A • Metals. The slump in metal prices, which gradual shift from portfolio to cross-border bank reached their lowest levels in more than 6 lending flows is likely to continue, supported in years in November, reflects well-supplied particular by a healing European banking sector markets as well as weaker growth in major and ongoing policy accommodation by the ECB. emerging markets. New mining capacity came A gradual rise in global interest rates and into operation in several countries, especially continued weakness in commodity prices could Australia, adding to already abundant affect FDI decisions, particularly in mining and supplies. exploration, while the cost of infrastructure financing is expected to rise. Renewed bouts of • Agricultural commodities. Grain and oilseed volatility, or heightened concerns about prices dipped in 2015, mostly in response to developing country growth prospects, represent well-supplied markets, with the agricultural downside risks to this benign scenario. price index standing 33 percent below its early -2011 high as of November. The stocks-to-use Renewed decline in commodity prices ratio (a measure of how well supplied markets are) for key grains remains well above its 5- Commodity prices fell further in the second half and 10-year average levels. Ample supplies and of 2015. By November, the three industrial the weak influence of global food prices on commodity price indexes—energy, metals, and most local prices, suggest that the El Niño agricultural raw materials—were down, on weather pattern, which some forecasts say may average, 45 percent from their 2011 peaks (Figure be the strongest since 1997-98, is unlikely to 1.9). Abundant supplies, due in part to investment raise global food commodity prices in a during the decade-long price boom, and softening significant way (World Bank 2015c). demand are the main factors behind the continued weakness. The appreciation of the U.S. dollar, the Conditions remain in place for a protracted period currency in which most commodities are traded, of low commodity prices in coming years. Oil has also contributed to the price weakness. prices are projected to average $49 per barrel in 2016, and then rise only gradually. Metal and • Oil. The price of oil (simple average of Brent, agricultural prices are likely to edge up in the Dubai, and West Texas Intermediate) range of 1-2 percent. While geopolitical risks and G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 15 adverse weather conditions could lead to a more FIGURE 1.9 Commodity markets rapid recovery in prices, risks are on the downside. By end-2015, the three World Bank industrial commodity price indexes— In the case of oil, prices may come under renewed energy, metals, and agricultural raw materials—were down, on average, downward pressure if weakness in emerging and 45 percent from their 2011 peaks. Oil prices declined further in the second half of 2015, despite large reductions in investment and drilling in U.S. developing economies persists or if the Islamic shale oil. The agreement with the Islamic Republic of Iran over its nuclear Republic of Iran receives substantial foreign program could provide a boost to its oil exports. Metal prices continued to investment to expand capacity quickly (Iran has reflect well-supplied markets and weaker demand from major emerging markets. The strong El Niño weather pattern may affect numerous local the world’s largest proven natural gas reserves, and markets but it is unlikely to have major effects on global food prices given fourth largest oil reserves). These developments well-supplied markets. suggest continued significant headwinds for the A. Commodity prices B. Islamic Republic of Iran’s oil outlook for growth, fiscal positions, and trade of production commodity-exporting countries, emphasizing the need to accelerate the diversification of their economies. Global trade weakness Global merchandise trade contracted in the first half of 2015, for the first time since 2009 (Figure 1.10). This was largely driven by a drop in import demand from emerging and developing C. Oil consumption growth D. Refined metal consumption growth economies, including in East Asia and the Pacific, Europe and Central Asia, and Latin America and the Caribbean. Growing import demand from the United States and the Euro Area did not offset the drop in developing countries’ import demand, which now accounts for half of global trade. The contraction in import demand from emerging and developing economies reflected four trends: E. El Niño index F. Stock-to-use ratios • GDP contractions in Brazil and the Russian Federation. Recessions in these two countries sharply reduced import demand. Sanctions against the Russian Federation further restricted trade. More generally, sharp declines in commodity prices reduced export revenues and demand across commodity exporters, leading to a significant slowdown in imports from these countries. Sources: Baker Hughes; BP Statistical Review of World Energy; World Bank; World Bureau of Metal • Rebalancing in China. As a result of an Statistics. A. Last observation is 2015Q4. increasingly pronounced shift in sources of B. Last observation is 2015. C. D. Last observation is 2015Q2. growth from trade-intensive investment and E. The ENSO (El Niño Southern Oscillation) index represents a centered three-month mean SST (Sea Surface Temperature) anomaly for the Niño 3.4 region. Latest historical observation is October exports toward less trade-intensive 2015. November 2015 through June 2016 are forecasts. F. The stocks-to-use ratio indicates the level of stocks for any given commodity as a percentage of consumption and services, import growth has consumption. Latest observation is November 2015. slowed. have thus far shown limited benefits for exports. This • Currency depreciations. Real effective exchange may partly reflect changes in global value chains that may rate depreciations have been accompanied by be reducing the elasticity of exports to real effective a decline in imports in several countries, but appreciation (Ahmed, Appendino, and Ruta 2015). 16 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 1.10 Global trade slowdown However, conventional trade, which still Global merchandise trade slowed considerably in 2015, driven by a represents roughly half of global trade flows, deceleration in import demand from large emerging markets. China’s shows greater responsiveness to exchange rate rebalancing away from import- and commodity-intensive sectors and developments (IMF 2015a). economic contraction in Brazil and Russia appear to have played a particularly significant role. Given the rising importance of “south-south” trade flows, developing-country exports have been negatively affected. • Stabilization of value chains. During 1990- Currency depreciations have thus far shown limited benefits for exports, 2008, countries that were integrating faster which could partly reflect a reduced exchange rate elasticity. Slower value chain integration could also be factor capping trade opportunities for into global value chains also saw more rapid developing countries. export growth than others (Escaith and A. Global merchandise trade growth B. Merchandise import growth Miroudot 2015). Since then, value chains appear to have stabilized such that manufacturing sub-sectors with a higher degree of vertical specialization witnessed the largest deceleration in trade growth (Constantinescu, Mattoo, and Ruta 2015, World Bank 2015d). Estimates for trade flows in 2015 and forecasts for 2016-17 have been revised down, in line with the C. Contribution to global import D. Composition of global import weakened post-crisis relationship between trade growth demand and activity.3 Persistent weakness in global trade diminishes export opportunities but also the scope for productivity gains through increasing specialization and diffusion of technologies. This could continue to put a cap on growth prospects, particularly among smaller and more open developing economies. Renewed liberalization efforts could help reinvigorate trade.4 The Trans- Pacific Partnership (TPP), agreed at the technical E. Elasticity of exports to change in F. Export growth and value chain level between Australia, Brunei, Canada, Chile, real effective exchange rate integration Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, the United States, and Vietnam, could provide a new impetus to trade, and lift activity, by helping to reduce tariffs and other trade barriers (Chapter 4). By 2030, the TPP could lift member country GDP by an average of 1.1 percent, with much larger benefits in countries with currently high trade barriers like Vietnam and Malaysia. The spillover effects for non- members remain uncertain. Losses due to Sources: World Bank, IMF Direction of Trade Statistics (DOTS); CPB Netherlands Bureau for Economic Policy Analysis; Organization for Economic Co-operation and Development, TiVA; Ahmed, preference erosion and trade diversion could be Appendino, and Ruta (2015). partially offset by positive spillovers from A. Global merchandise trade measured in real term (deflated by unit value indexes); average of global imports and exports. Grey areas indicate period of global trade contraction. Last observation is regulatory convergence. October, 2015. B. Merchandise import volumes. Recently-graduated high-income countries (Argentina, Chile, Hungary, and the Russian Federation) are included in the developing country aggregate. Last 3 e post-crisis slowdown in global trade has been attributed to a observation is October, 2015. C. Import volumes for goods and non-factor services. 2015 are estimates. number of factors including (i) anemic growth in advanced econo- D. HIY are high-income countries, DEV are developing countries. Based on bilateral trade flows mies, (ii) the changing composition of global demand and persistent between G20 economies. Recently-graduated high-income countries (Argentina, Chile, Hungary, the weakness in investment, (iii) the maturation of global value chains, Russian Federation and República Bolivariana de Venezuela) are included in the developing-country aggregate. (iv) weak trade nance and (v) slow trade liberalization momentum E. Elasticities derived from a panel model regressing annual real export growth over annual real (World Bank 2015a). exchange rate growth across 46 countries and over the period 1996-2012 as in Ahmed, Appendino, 4According to some estimates, removing all tari s, state aid, export and Ruta (2015). F. Value chain integration measured as share of foreign value added in gross exports. Change in subsidies and other trade restrictions a ecting LDCs could boost value added trade share is computed from 2005 to 2011 (latest available data). their exports by up to 30 percent (Evenett and Fritz 2015). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 17 FIGURE 1.11 Growth in emerging and developing Developing countries economies Growth in developing countries slowed to 4.3 percent Growth in emerging and developing economies slowed to post-crisis low in 2015, reflecting domestic and external challenges. in 2015. The deceleration was driven by external and domestic factors and was highly synchronous. Investor confidence and credit ratings have been Domestic difficulties included slowing productivity adversely affected by deteriorating growth prospects, particularly among growth, policy uncertainty, and eroding policy buffers commodity-exporting countries. The recent slowdown partly results from that have led to contractionary monetary and fiscal the unwinding of cyclically strong post-crisis growth but also has a structural component across many developing regions. policies in some countries. External headwinds include persistently low commodity prices, subdued A. GDP Growth B. Share of countries experiencing global trade, spillovers from weakness in major three consecutive years of declining growth emerging markets, decelerating capital flows and rising borrowing costs. The slowdown reflects both cyclical and structural components. Commodity exporters have continued to adjust to steep declines in oil and other commodity prices. In low-income countries, however, growth has remained robust, as solid infrastructure investment and consumer spending has partly offset weakening external demand. The modest pickup in activity in developing countries expected in 2016 and 2017 is predicated C. Sovereign credit ratings D. Cyclical and structural growth slowdown in developing countries on continued growth momentum in high-income countries, stabilization of commodity prices, still- accommodative monetary policy in major economies, and a steady process of rebalancing in China. Recent developments Developing-country growth slowed in 2015 to 4.3 percent, its weakest showing since 2009, and a pace well below its pre-crisis average (Figure 1.11). Sources: World Bank; Standard & Poor’s; Haver Analytics; Didier et al. (2015). China’s economy continued to slow in an orderly A. B. Recently-graduated high-income countries (Argentina, Chile, Hungary, the Russian Federation, and República Bolivariana de Venezuela) are included in the developing country aggregate. fashion, and its rebalancing away from import and B. Figure shows share of emerging and developing countries slowing for three consecutive years out of a sample of 138 countries. commodity-intensive activities has had C. Latest observation is November, 2015. D. Unweighted average of emerging market economies. Potential growth defined as in Didier et al. repercussions for global trade and commodity (2015). prices. Brazil and the Russian Federation have taken a turn for the worse as a result of global and the ongoing deceleration in developing domestic headwinds, with both countries countries—more so than in any episode over the experiencing deepening contractions, above-target past 25 years, with the exception of the Great inflation, and deteriorating public finances. In Recession of 2009.5 South Africa, chronic power supply bottlenecks are a major factor behind weak growth. In contrast In about half of developing countries, growth in to other major developing countries, growth in 2015 is likely to fall short of expectations, with the India remained robust, buoyed by strong investor largest disappointments among energy exporters sentiment and the positive effect on real incomes (Angola, Colombia, Ecuador, Kazakhstan, of the recent fall in oil prices. Nigeria, the Russian Federation, the República Bolivariana de Venezuela) and countries The fact that four of the five BRICS are experiencing conflicts (Ukraine) or policy experiencing slowing or contracting activity, as are a substantial fraction of other developing 5 e impact of the BRICS on other emerging and developing countries, highlights the synchronous nature of economies is discussed in more detail in Chapter 3. 18 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 uncertainty (Brazil). In contrast, the continued slowing productivity growth, continued domestic recovery in the Euro Area has lifted growth more policy uncertainty, and—as discussed in detail than expected in some of its developing country later—eroding policy buffers that narrowed policy trading partners, including those in Europe and options. Central Asia and North Africa. • Slowing productivity growth. Total factor Both external factors—including weak global productivity (TFP) growth in emerging trade, financial market volatility, and persistently markets has declined steadily since 2010. By low commodity prices—and domestic factors have 2014, TFP growth had returned to its long- contributed to the slowdown. Adverse external term average of around 0.5 percent, well developments have continued to hit commodity- below the 2.3 percent gain recorded in 2010 exporting developing economies particularly hard. (Didier et al. 2015). The TFP slowdown was Growth in several of the largest ones (Brazil, pronounced in the Middle East and North Colombia, Nigeria, Peru, South Africa) weakened Africa, where TFP has been contracting since considerably in 2015, as the impact of 2007. In Latin America and the Caribbean, deteriorating terms of trade on exports was and Eastern Europe and Central Asia TFP compounded by tightening macroeconomic policy growth has ground to a virtual halt. and softening investor confidence. Governments responded to falling fiscal revenues from the • Policy uncertainty. Domestic policy uncertainty resource sector with spending cuts. Central banks increased in 2015 (including in Latin raised interest rates to help moderate pressures on America, East Asia and the Pacific, and exchange or inflation rates. Investor confidence Europe and Central Asia), as a result of weakened on deteriorating growth prospects and elections, or political unrest. Among low- credit ratings, resulting in declining capital inflows income countries, a flare-up of violence and currency depreciations. (Afghanistan), political tensions (Burkina Faso, Burundi, Guinea Bissau, Nepal), and The recent slowdown in developing-country uncertainty surrounding elections and labor growth partly reflects an unwinding of cyclically disputes (Benin, Democratic Republic of strong, policy-supported, post-crisis growth, Congo) drove up political risk in 2015. especially in East Asia and Pacific and in Latin Concerns about policy direction can hold America and the Caribbean. However, it also has a back domestic and foreign investors, reduce considerable structural component, which is most capital flows and dampen investment and pronounced in Europe and Central Asia and the consumption growth (Gourio, Siemer, and Middle East and North Africa. On average, Verdelhan 2014; Julio and Yook 2013). among the 24 largest emerging and developing economies, about one-third of the slowdown Policy uncertainty and the removal of policy between 2010 and 2014 was structural in nature stimulus have weighed on investment and (Didier et al. 2015). In particular, demographic consumption growth rates, which have fallen well trends have passed a turning point since the global below pre-crisis levels. Growth of credit to the crisis—with potentially profound implications for private sector has slowed sharply in several growth (World Bank 2015b). Since 2010, countries (Figure 1.12). In some places, credit working-age population growth has slowed, retrenchment reflects monetary policy tightening particularly in Europe and Central Asia and the to mitigate inflation concerns (Brazil, South Middle East and North Africa. As a result, the Africa) and slowing capital inflows, weighing share of the working-age population has risen only further on domestic liquidity and credit marginally or fallen in most regions other than conditions. Other reasons behind the slowdown in Sub-Saharan Africa, where many countries are still credit growth include weak domestic demand, in a phase of pre- or early demographic dividends. heightened uncertainty, and the government’s Other domestic sources of the slowdown include decision to reduce the use of public credit as a G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 19 counter-cyclical tool. In several countries, FIGURE 1.12 Domestic demand conditions in consumption growth has been further dampened developing countries by rising unemployment rates (including Brazil Credit growth has slowed, but private sector debt remains high in many and South Africa), and moderating employment countries. Investment and private consumption growth in emerging and growth. developing economies has been below pre-crisis rates. Rising unemployment has weighed on consumer confidence and spending in some countries, despite the increase in real incomes resulting from falling Partly reflecting uncertainty about the outlook, food and energy inflation. consumption growth remains below its pre-crisis and long-term averages, despite increased real A. Private sector credit growth B. Stock of private sector credit, 2014 incomes due to declines in food inflation and oil prices. In several countries, these developments have sharply reduced headline inflation, especially in countries with a large share of food in their consumption baskets (India, Pakistan, the Philippines). In some regions and countries (Europe and Central Asia, Thailand), falling food and oil prices have coincided with persistent economic slack and played a role in lowering C. Investment growth D. Private consumption growth inflation below target rates. Low-income countries have generally remained resilient, growing by 5.1 percent in 2015. Large- scale infrastructure investment and sustained consumer spending helped offset weakening external demand and low commodity prices. Even so, commodity-exporting low-income countries faced currency pressures, which contributed to a sharp increase in interest rates in Uganda and a E. Unemployment rate F. Food share in CPI basket and decline in reserves in many countries (Burundi, inflation Democratic Republic of Congo, Mozambique, Tanzania, Zimbabwe). Eroding buffers and lingering vulnerabilities Weakening activity in developing countries has been accompanied by eroding policy space and lingering vulnerabilities (Figure 1.13). Slowing Sources: World Bank; Bank for International Settlements; International Labor Organization; Haver growth, rising debt, and, for commodity exporters, Analytics. C. D. Recently-graduated high-income countries (Argentina, Chile, Hungary, the Russian Federation, weakening export and fiscal revenues, have eroded and República Bolivariana de Venezuela) are included in the developing country aggregate. credit ratings. Some large emerging and E. Unemployment rate data is seasonally adjusted. Latest observation November, 2015. F. Right vertical axis shows percentage point difference in average year-over-year inflation from April developing economies lost, or risked losing, to October 2015 versus October 2014 to April 2015. investment grade status in 2015 (Brazil, the Russian Federation), and some others appeared to deficits have widened from pre-crisis levels in be struggling to maintain it. commodity exporters and importers alike (World Bank 2015d,e). Inflation, especially in Eroding policy space. As growth has slowed and commodity exporters, has risen outside target as authorities have supported economic activity bands and external and foreign currency debt has with fiscal stimulus and monetary policy increased. With shrinking policy room, domestic loosening, policy buffers have eroded. Fiscal policy stimulus has been gradually withdrawn. 20 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 1.13 Macro-financial vulnerabilities construction and mining, and among firms with weakening balance sheets (IMF 2015b). Corporate Current account balances have improved modestly among oil importers, but deteriorated among exporters. Countries with elevated external debt or debt has been increasingly financed through with a high share of short-term external debt have made only limited international bond issuance rather than bank progress in reducing these exposures. More countries have seen lending. In some cases this has meant rising government debt and the sustainability gap deteriorate from pre-crisis levels. Fiscal balances have worsened rapidly among oil and other currency exposures, with debt service costs more commodity exporters in 2015 . sensitive to changing global financing conditions. Past experience suggests that rising corporate A. Current account balance B. External debt denominated in foreign currency leverage increases the probability of capital flow reversals (Mendoza 2010; Mendoza and Terrones 2008; Elekdag and Wu 2011). Finally, many developing-country banking sectors with high non -performing loan ratios have not seen much improvement in asset quality. Large external debt. Some developing countries with elevated total external debt, or with a high share of short-term external debt, have made little C. Short-term share of external debt D. Foreign reserve coverage progress in reducing such burdens (the Czech Republic, Malaysia, Mongolia, South Africa, Turkey). India, Mexico, and South Africa have reduced the share of their external debt denominated in foreign currency but still carry sizable stocks. As monetary policy tightens in the United States, some of these countries may be vulnerable to rollover, exchange rate, and interest rate risks (Borio 2014, IMF 2015b). Foreign reserves have come under pressure in many E. General government sustainability F. Projected fiscal balances, 2015 gaps commodity exporters (Indonesia, Malaysia), and in countries which are prone to capital flow reversals (Turkey). Current account balances have improved among a number of oil-importing economies, although deficits remain elevated for several of them. Deteriorating public sector balance sheets. General government debt has increased in many developing countries. Fiscal deficits have Source: World Bank, World Bank QEDS database; IMF World Economic Outlook October 2014 and deteriorated considerably more than expected in October 2015. A. Latest observation is 2015 Q3 for most countries. commodity exporters, while remaining broadly D. Latest observation is October, 2015 for most countries. E. Sustainability gap is defined as the difference between the actual primary balance and the debt- steady in other developing countries. As a result, stabilizing primary balance at current interest rates and growth rates. A negative sustainability gaps indicates an unsustainable stock of debt and deficit. Figure reflects data for the 123 developing the number of countries in which debt is rising countries with available data for all three years shown. F. Structural fiscal balance projections from October 2014 and October 2015 IMF World Economic has surged from pre-crisis levels. In a number of Outlook reports. developing countries (Indonesia, Peru, Poland, South Africa, Turkey), foreign participation in Weakening corporate balance sheets. Corporate government debt markets remains elevated, leverage has grown significantly since 2009. It has making them potentially vulnerable to global become increasingly concentrated in sectors more shifts in investor sentiment (Arslanalp and Tsuda exposed to business cycle swings, such as 2014). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 21 These vulnerabilities are further constraining FIGURE 1.14 Monetary and fiscal policy space policy room to support weakening activity (see Fiscal stimulus becomes less effective as fiscal deficits widen. Real policy Section on developing country policies). Large rates in many commodity exporting countries may still be below levels fiscal deficits and high government debt dampen implied by Taylor rules. This constrains central banks’ ability to respond to weakening growth with policy accommodation. the effectiveness of fiscal stimulus (World Bank 2015d, Figure 1.14). Rising foreign currency- A. Fiscal multiplier and fiscal balances B. Gap between Taylor-rule and actual real policy rates denominated debts, or rollover requirements generate risks from sharp depreciations or from spikes in interest rates (Chow et al. 2015). This requires central banks to take financial stability into greater account than otherwise when considering monetary stimulus to support activity, even when inflation expectations are anchored. Outlook Source: World Bank. A. Fiscal multipliers for different levels of fiscal balance (in percent of GDP) after two years, estimated from an IPVAR model using a sample of 15 emerging and frontier markets. Values on the x-axis Baseline projections assume that 2015 marked a correspond to percentiles of the fiscal balance; shaded area is the 16-84 percent confidence band. low point for developing country growth (Figure Fiscal multipliers are larger (fiscal stimulus is more effective), when fiscal deficits are lower. B. Real policy rate and inflation target data are for October 2015, expected inflation as of September 1.15). Growth is expected to rise to 4.8 percent in 2015. Taylor rules stipulate how much central banks should change interest rates in response to deviations from policy objectives (inflation target or others). The real Taylor rule interest rate is calcu- 2016, similar to the pace in 2014, and to 5.3 lated as 1.353*(expected inflation - inflation target) + 2.233 (Ostry, Ghosh, and Chamon 2012). A positive gap denotes current policy rates below those implied by the Taylor rule. percent in 2017 and 2018. This modest improvement is predicated on continued FIGURE 1.15 Developing-country outlook momentum in high-income countries, a stabilization of commodity prices, still- Developing-country and emerging-market growth is expected to recover somewhat in 2016. However, Brazil and Russia are expected to see further accommodative monetary policy in major contractions, which will exert a drag on trading partners’ activity. Among economies with no bouts of financial market low-income countries, the pace of growth is expected to be steady or turbulence, and a continued gradual slowdown in increasing. Persistent slowdown in emerging and developing economies have resulted in a significant downgrade of their underlying growth China. With stabilizing commodity prices, growth potential in recent years. in commodity exporters is expected to resume. A. Growth: Emerging and developing B. Growth: Low-income countries countries Among low-income countries, growth is mostly steady or rising. However, forecasts for 2016 have been downgraded for some countries from previous projections, reflecting lower commodity prices and rising security and political tensions in some countries. The persistent growth slowdown in emerging and developing economies has led to repeated forecast C. Change in 2020 growth forecasts, D. Manufacturing Purchasing Manag- downgrades. The largest emerging markets are 2010-15 ers indexes among the countries subject to significant downward revisions to their long-term forecasts in recent years. Many of the factors underpinning the slowdowns – low commodity prices, weak global trade, and slow productivity growth – are expected to persist (World Bank 2015e, World Trade Organization 2015). Also, developing countries will likely face rising borrowing costs. In particular, countries with large borrowing needs Sources: World Bank; Haver Analytics; Consensus Economics. C. Figure shows percentage-point revision to 2020 forecast between October 2010 and October and high levels of dollar-denominated debt could 2015. D. Latest data as of November 2015. be adversely impacted by rising U.S. interest rates. 22 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 1.16 Regional outlook will be a bright spot, reflecting improved conditions in India. And growth in Sub-Saharan There is considerable heterogeneity in regional developments and outlooks. In the East Asia and Pacific region, growth remains sustained Africa will continue to be negatively impacted by and inflation generally subdued. In Europe and Central Asia, the eastern low commodity prices and infrastructure part is negatively affected by developments in Russia while the western constraints, although low-income countries are part is benefits from the recovery in the Euro Area. Low commodity prices and domestic challenges will continue to weigh on growth in Latin America expected to remain resilient. and the Caribbean, the Middle East and North Africa, and Sub-Saharan Africa. Currency and fiscal pressures are building in 2015 in commodity- • East Asia and Pacific. Growth is estimated to exporting regions. have slowed to 6.4 percent in 2015, and is A. Developing regions: Growth B. Developing regions: Inflation in expected to decelerate to 6.3 on average in 2015 2016-18, reflecting the gradual slowdown in China and a sluggish recovery in the rest of the region. Growth is expected to rise modestly in Indonesia and Malaysia in 2016- 18, as political tensions subside in Malaysia, and reforms are implemented to spur investment growth in Indonesia. In Thailand, growth is expected to remain weak, at 2-2.7 percent in 2016-18, as political uncertainty continues to weigh on private investment, and C. Developing regions: Commodity D. Developing regions: Fiscal deficits high household debt constrains private exports consumption. Among the large developing ASEAN economies, growth in the Philippines and Vietnam will benefit from rising household incomes caused by low commodity prices, a diversified and competitive export base (Vietnam), and investment driven by robust FDI flows. Risks to the outlook remain tilted to the downside, stemming from a larger -than-expected slowdown in China and tightening global financing conditions. Sources: World Bank; Haver Analytics; IMF World Economic Outlook October 2015. A.D. “Range” denotes range from lowest quartile to highest quartile among countries in each region. Regional averages are GDP-weighted. • Europe and Central Asia. Growth is estimated to have dipped to 2.1 percent in 2015—the slowest rate since 2009. This reflects the Underneath these broad trends, there is combination of an unexpectedly sharp output considerable heterogeneity in regional growth contraction in Ukraine, slowdown in all major outlooks (Figure 1.16). In the East Asia and energy-exporting economies of the region, and Pacific region, a gradual slowdown is underway. In negative regional spillovers from Russia. Europe and Central Asia, weakness in the eastern Growth in Ukraine may start rebounding, part, mainly due to developments in Ukraine and helped by easing tensions and the IMF- spillovers from Russia, is offsetting improvements supported stabilization program. Economic in the western part resulting from recovery in the activity in Turkey will benefit from low fuel Euro Area. In Latin America and the Caribbean, prices, but will face headwinds from tepid persistently weak commodity prices and domestic export demand (including negative effects challenges will continue to weigh on regional from Russian sanctions) and tighter external growth. In the Middle East and North Africa, an financing conditions. Regional growth is international agreement expected to lift projected to strengthen to an average of 3.0 international sanctions on the Islamic Republic of percent in 2016 and 3.5 per cent in 2017-18, Iran is pushing up regional growth. South Asia helped in part by the ongoing Euro Area G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 23 recovery, though there are several downside exporters are grappling with the economic risks to the outlook, including possible consequences of low oil prices; most oil escalation of geopolitical tensions and importers are seeing benefits. Despite low oil continued recession in Russia and Ukraine. prices, growth in the region will accelerate to above 5 percent in 2016-18. The • Latin America and the Caribbean. After three improvement is predicated on a strong years of slowing growth, activity in the recovery in the Islamic Republic of Iran, the broader region is estimated to have contracted region’s largest developing economy. The by 0.9 percent in 2015, international agreement to suspend or remove as it grappled with the protracted decline of sanctions on international trade and financial commodity prices and domestic challenges transactions, beginning in 2016, is an weighing on the region’s largest economies. important supporting factor for the Iranian Declining demand and wage rigidities have economy (Devarajan and Mottaghi 2015). led to deteriorating labor market conditions The agreement stands to have positive and rising unemployment (World Bank spillover effects for oil-importing neighboring 2015f). However, there are substantial countries, but might have negative effects on differences among the sub-regions. Bearing developing oil exporters in the region if the brunt of the slump in commodity prices, additional oil production and exports put along with domestic headwinds, developing downward pressure on international oil prices South America’s output is estimated to have (Ianchovichina, Devarajan, and Lakatos declined 2.1 percent in 2015, including a forthcoming). Risks to the regional outlook contraction of 3.7 percent in Brazil. In are tilted to the downside and arise from both contrast, estimated growth rates for low oil prices and protracted domestic security developing Central and North America and challenges. the Caribbean were significantly more favorable, at 2.7 and 3.3 percent, respectively. • South Asia. Growth is projected to accelerate to For the region as a whole, stagnation is still 7.5 percent in 2016-18, from 7.0 percent in predicted in 2016, followed by a modest 2015—the fastest pace among all developing recovery of about 2.2 percent in 2017-18, as regions. Falling oil prices have improved commodity prices stabilize and some of the investor and consumer confidence, and policy challenges in large economies subside. domestic policy reforms in India and Pakistan The current recession in Brazil is expected to have reduced vulnerabilities. Domestic risks extend into 2016 reflecting tight include a stalling of the reform process and macroeconomic policy and, particularly, a loss political tensions in some countries. High of consumer and investor confidence partly levels of problem loans on bank balance sheets due to political uncertainty. Although remain a challenge to financial stability and to weighed down by low oil prices and associated the supply of credit for productive investment fiscal pressures, growth is expected to pick up (World Bank 2015g). External risks stem in Colombia and Mexico thanks to robust from potential volatility amid tightening demand from the U.S. market, dividends global financial conditions and weak from implementation of structural reforms remittances from Gulf Cooperation Council (Mexico), and a peace agreement with (GCC) countries. insurgents (Colombia). • Sub-Saharan Africa. Growth slowed to an • Middle East and North Africa. Growth is estimated 3.4 percent in 2015, the lowest rate estimated at 2.5 percent in 2015, unchanged since 2009, due to low commodity prices and from 2014. Among oil exporters, growth infrastructure constraints. A rebound is mostly slowed or was negative in 2015. The expected in 2016-18, as these headwinds one exception was Iraq, where oil production wane, providing some support for government has risen despite security problems. Oil spending and private investment. A modest 24 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 1.17 Slowdown in China in 2017-18. Overvalued currencies and larger fiscal and current account deficits over the Downside risks to Chinese growth have risen, debt levels are elevated and continued to increase despite decelerating credit growth. Total debt as a period 2011-14 have eroded policy buffers, percent of GDP is now significantly larger that in most other emerging and thus limiting policy options should shocks developing economies. However, ample policy buffers, large international reserves and current account surpluses limit the risk of sharp adjustment. arise (World Bank 2015h). Should the slowdown be more abrupt than currently predicted, other emerging and developing economies and, in particular, commodity exporters would be most affected. Risks to the outlook A. Private and public debt B. Exports to China Downside risks dominate and have become increasingly centered on emerging and developing countries, as a gradual recovery in major high-income countries takes hold. A slowdown in China, and widespread weakness across other BRICS, could have substantial spillovers on other emerging and developing economies. Financial market turbulence—triggered, for instance, by spikes in borrowing costs during the U.S. tightening cycle or by C. Impact of a 1 percentage point D. Impact of a 1 percentage point decline in China’s growth on growth in decline in China’s growth on rising risk aversion—could significantly impact other emerging economies commodity prices capital flows to the more vulnerable emerging and developing economies and intensify balance-sheet vulnerabilities. Commodity exporters and countries with large imbalances and policy uncertainty are particularly exposed to these risks. While past experience suggests that isolated terrorism-related events amid heightened global geopolitical risks do not appear to have lasting economic consequences, escalation could have uncertain regional and global Sources: Haver Analystics; IMF Direction of Trade Statistics (DOTS); Bank for International Settle- ments; World Bank. repercussions. As yet, unrealized gains from declining A. “DEV median” refers to the median value across developing countries in 2014. EA is Euro Area. oil prices for importers pose an upside risk. C. D. Cumulated impulse responses for different horizons due to a one-off (but persistent) unex- pected 1 percentage-point decline in Chinese growth. Commodity exporters are defined as those countries for which commodity exports exceed 30 percent of total exports during the estimation period, 1998-2014. Confidence bands span the 16th-84th percentiles. Global growth prospects have become more D. Cumulated impulse responses of trade-weighted commodity prices at different horizons due to a 1 percentage point decline in China growth. Confidence bands span the 16th-84th percentiles. uncertain, and risks are more skewed to the downside, than in the June 2015 forecasts. Rising uncertainty is evidenced by heightened volatility recovery is projected in Nigeria and South in global financial markets and a greater dispersion Africa, the region’s two largest economies. For of private sector forecasts for global growth, Nigeria, the forecast assumes that uncertainty interest rates, and inflation. While the balance of around government policy is lessened; that risks to global growth remains tilted to the fuel and power shortages become less severe; downside, the likelihood of a global recession in that fiscal consolidation tapers off; and that 2016 appears to be low, as world GDP per capita import costs decline. In South Africa, labor (measured in 2010 US$) was still growing by an and social tensions, high unemployment, and estimated 1.5 percent in 2015.6 The downside constraints associated with electricity supply will continue to weigh on activity. However, 6A global recession corresponds to a contraction in world real out- low-income countries may register relatively put per capita accompanied by a broad, simultaneous decline in high growth, supported by large-scale various other measures of global economic activity, including indus- trial production, trade, capital ows, employment, and energy con- infrastructure investment and resilient sumption. is has happened four times over the past half century: in consumer spending. Overall, growth in the 1975, 1982, 1991, and 2009. e world economy also experienced region is projected to accelerate to 4.2 percent two periods—in 1998 and 2001—when growth slowed signi cantly without tipping into an outright recession (Kose and Terroes 2015). in 2016, strengthening further to 4.7 percent G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 25 risks do though have the potential to exert a through the impact on international commodity significant drag on global growth. prices. Countries with impaired macroeconomic policy buffers could be particularly affected. Slowdown in China Financial stress in one or several commodity exporters could outweigh potential real income Although the growth slowdown in China gains for importers in the short term, hence continues to be gradual, downside risks to growth adding downward pressure on global growth. may have increased. Baseline growth forecasts are predicated on the assumption that reforms will Widespread weakness across the BRICS continue, and that the authorities will maintain sufficient buffers to ensure an orderly rebalancing. A growth slowdown in BRICS could have global repercussions, dampening growth across emerging Domestically, the main short-term risk is the and developing economies. A 1 percentage point unwinding of high leverage in sectors with excess growth slowdown in the BRICS as a whole could capacity. This may cause a sharper-than-expected result in a 0.8 percentage point decline in growth slowdown in investment, especially in residential in other emerging market countries over a span of estate, and hence in aggregate demand (Figure two years (Figure 1.18, Chapter 3). Growth 1.17). Debt levels are high and continue to rise shocks in Russia would reverberate across the ECA despite decelerating credit growth. Total (public region, reducing ECA growth almost one-for-one. and private) debt relative to GDP is larger than in In contrast, the international spillovers from most other developing countries, and is also above growth shocks in Brazil, India, and South Africa levels observed in economies affected by the Asian are not likely to be widespread. In the event of crisis in 1997. However, public debt is estimated acute stress in any of the BRICS, confidence in at less than 40 percent of GDP—or 60 percent if emerging market assets more broadly could suffer off-budget liabilities are included—and is from contagion effects, in which case spillovers predominantly held domestically. This provides could be considerably larger. the government with the fiscal space to deploy stimulus in the event of a sharper-than-expected Such spillovers would transmit through a number slowdown (IMF 2015c). of channels (Chapters 2 and 3). China is deeply integrated into supply chains in East Asia and the Capital controls on portfolio investment and bank Pacific, and constitutes a large export market for lending, as well as a largely state-owned financial commodity-exporting countries in Sub-Saharan system, limit the risk of financial instability and Africa and Latin America. Brazil trades disorderly capital outflows. If reduced confidence significantly with neighboring Latin American in the financial system leads to attempts to convert countries, partly as a result of regional free trade local currency deposits into foreign currency, the agreements. Remittances from Russia account for resulting spike in demand for foreign currency more than 10 percent of GDP in several countries could be met, for instance, with the ample central in the Caucasus and Central Asia (Armenia, bank international reserves, estimated at over $3 Kyrgyz Republic, Tajikistan). India is an trillion. important source of foreign direct investment and official development assistance for neighboring Over the last decade, China has become a major countries (Bhutan, Nepal).7 driver of demand for developing-country exports and a key source of investment and, most recently, finance (Eichengreen, Park, and Shin 2012). Trade linkages with China are significant for the East Asia region, and for commodity exporters 7 Spillover risks also emanate from large advanced and emerging globally; hence, the transmission of any growth markets other than BRICS. For example, commodity-exporting countries are an important export market for several commodity- fluctuation through trade should be larger for importing countries, accounting for 25 percent or more of exports those countries. This effect would be amplified from the latter group (Hungary, Korea, Poland, ailand, Turkey). 26 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 1.18 Spillovers from slowing growth in BRICS Financial market turbulence Spillovers from the slowdown in BRICS are primarily impacting other emerging and developing economies. This reflects strengthening trade, Amid lingering developing-country vulnerabilities, financial, and commodity market linkages. China constitutes a significant the risk of financial turbulence in some emerging export destination for commodity-exporting countries, which in turn are and developing economies has increased. This risk important export markets for many commodity importers. The Russian Federation has particularly tight interconnections with neighboring is exacerbated by an expected tightening in global economies though trade and remittance flows. borrowing costs and financial conditions, the potential for further U.S. dollar appreciation, the A. Impact of a 1 percentage point B. Impact of a 1 percentage point possibility of heightened risk aversion, and decline in BRICS growth on global and decline in each of the BRICS on global EM growth and EM growth worsening creditworthiness in emerging and developing economies. U.S. monetary policy tightening. Tighter U.S. monetary policy may affect the outlook for global borrowing costs. The adjustment may be smooth, as rising U.S. policy rates have long been anticipated by markets in the context of a robust recovery in the United States. At the same time, other major central banks will continue their very C. Value of exports from emerging D. Share of goods exports from com- accommodative policies, likely dampening the markets modity-importing EMs to commodity exporters, 2014 global impact of higher U.S. interest rates. However, this baseline of a modest and smooth U.S. tightening is subject to substantial risks (Figure 1.19). First, the U.S. term premium is unusually low and well below its historical average, and could rebound abruptly. Second, market expectations of future policy rates remain well below those of Fed policymakers following a first hike in December, 2015. A sudden closing in this gap could be disruptive. Third, fragile market E. Countries with largest share of F. FDI and remittances from Russia to exports to BRICS, 2014 neighboring developing countries liquidity conditions, even in deep sovereign bond markets, could amplify the impact of the initial shock and facilitate its propagation to other market segments. This context increases the risks of spikes in U.S. long-term yields and of financial market and exchange rate volatility. U.S. dollar strength, currency exposures, and corporate debt. A further appreciation of the U.S. dollar could add pressure on emerging and Sources: World Bank; United Nations Comtrade; IMF Direction of Trade Statistics (DOTS), IMF Coordinated Direct Investment Survey (CDIS). developing country currencies. This could A. B. Cumulated impulse responses at the two year horizon due to a 1 percentage point decline in growth in each of the BRICS economies. “EM” is emerging markets excluding BRICS. “Global” is contribute to a rising cost of debt refinancing and GDP weighted average of BRICS, EM, and G7. Confidence bands span the 16th-84th percentiles. expose vulnerabilities in domestic corporate and E. BRA, CHN, IND, RUS and ZAF are respectively Brazil, China, India, Russia and South Africa. banking sectors. Considering the negative correlation between commodity prices and the dollar, this effect could be reinforced by a negative income effect for some exporters (Druck, Magud, and Mariscal 2015). In the past, periods of rapid dollar appreciations were sometimes associated with a greater incidence of financial crisis in G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 27 emerging markets, such as during the first half of FIGURE 1.19 Rising borrowing costs and balance sheet 1980s in Latin America and second half of the pressures 1990s in Asia. In the latter episode, countries with The U.S. tightening cycle is expected to have a benign impact, but there currencies tightly connected to the dollar are risks of sudden adjustments in long-term yields and a further experienced a greater proportion of sudden stops strengthening of the U.S. dollar. High levels of private indebtedness could and sharper economic downturns (IMF 2015b). increase the risk of corporate defaults, while further credit downgrades and High and rising levels of private indebtedness rising political uncertainty could lead to a broad-based repricing of risk. increase the risk of corporate defaults. Banking A. Gap between FOMC and market B. Corporate debt of emerging sectors generally remain well capitalized, but expectations over time markets corporate debt represents a significant share of their assets, despite rising intermediation through bond markets in recent years. Widespread corporate distress could impair capital and reduce collateral values, constraining the supply of bank finance for the rest of the economy. Risk aversion and contagion effects. An abrupt increase in risk aversion—triggered, for instance, by a sudden increase in global interest rates, by C. Implied market ratings for selected D. Political Risk countries heightened concerns about debt in key developing countries, by a credit event in a major emerging market, or by rising geopolitical tensions—could lead to contagion affecting other economies, even if they have limited vulnerabilities. In particular, further credit downgrades in large emerging market economies could cause a general reappraisal of risk. Market-implied ratings, based on credit default swap prices, indicate heightened investor concerns about exposures to weak Source: World Bank; U.S. Federal Open Market Committee; Bloomberg; International Country Risk commodity prices, soft growth, and political risks. Guide (ICRG); World Bank; Escolano, Kolerus, and Ngouana (2014). B. GDP-weighted average. List of emerging markets includes China, Czech Republic, Hungary, India, In a financial stress situation, pro-cyclical behavior Indonesia, Mexico, Poland, South Africa, Thailand, and Turkey. C. Latest observation December, 2015. of asset managers could amplify asset price D. Unweighted averages of Political Risk Rating for emerging markets according to the International Country Risk Guide. A higher Political Risk Rating indicates lower political risk. Political Risk Ratings movements and contagion effects. are a weighted average of ratings of government stability, socioeconomic conditions, investment profile, corruption, the role of the military in politics, law and order, external and internal conflict, religious and ethnic tensions, democratic accountability, and bureaucratic quality. Volatility index is Capital flow reversals and the cost of sudden calculated by JPMorgan and tracks implied volatility from 13 emerging-market currencies against the U.S. dollar. Latest observation is November, 2015. stops. The materialization of the aforementioned risks could have significant effects on borrowing conditions and have a sizable adverse impact on developing-country capital flows (Arteta et al. rapidly. Financial stress associated with these 2015). A 50 basis point (two standard deviations) events could combine with domestic fragilities and jump in global long-term interest rates could increase the risks of multiple sudden stops across temporarily reduce aggregate capital flows to more vulnerable developing countries. The short- developing countries by 0.9 percentage points of run costs of these events could be substantial. In their combined GDP, with the effect peaking after the two years following a sudden stop, developing one year (Figure 1.20). Analogously, a 10 point countries could experience an average decline in (two standard deviations) shock in the VIX index GDP of almost 7 percentage points, a drop in of implied stock-market volatility (a proxy for risk investment of more than 21 percentage points, aversion) could reduce aggregate developing- and currency depreciation vis-á-vis the U.S. dollar country capital flows on impact by up to 2.2 of about 14 percentage points more than before percent of GDP, with the effect dissipating the event. 28 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 1.20 Deteriorating capital flows and sudden Weak commodity prices and other risks for stops low-income countries Rising borrowing costs and risk aversion could lead to an abrupt decline in developing-country capital flows. Financial stress could combine with Although all commodity prices have declined domestic fragilities, increasing the risks of damaging sudden stops in more sharply from their 2011 peaks, they are still higher vulnerable developing countries. The short-run costs of sudden stops in in real terms than their 1985 to 2004 average. terms of lost activity and investment can be substantial. While geopolitical risks and adverse weather conditions could lead to a more rapid recovery in A. Impact of U.S. interest rate and C. Sudden stops and investment commodity prices than currently predicted, most volatility shock on capital flows to growth in developing and emerging developing and emerging markets markets of the risks are on the downside. Since nearly two- thirds of current LICs are commodity exporters, the fall in commodity prices in recent years has dealt a major terms of trade shock and led to a substantial widening of fiscal and current account deficits. Further weakness in global commodity prices could result in even sharper fiscal and currency adjustments. It could also lead to delays in investments in energy and mining, particularly in East African countries. Fiscal risks are elevated Sources: World Bank; Arteta et al. (2015). in several countries in East Africa, relating to sharp A. VIX and G4 (Euro Area, Japan, the United Kingdom, and the United States) term spread shocks are two-standard deviation shocks, amounting respectively to a 10 index-point increase in VIX and 45 increases in public debt due to large infrastructure basis-point increase G4 term spreads. Impulse response are derived from VAR model linking capital inflows to emerging and frontier markets to quarterly real GDP growth in emerging and frontier mar- projects, public-private partnerships, contingent kets as well as G4 countries, real G4 short-term interest rates (three-month money market rates liabilities, and devolution processes (Mauro et al. minus annual inflation measured as changes in GDP deflator), G4 term spread (10-year government bond yields minus three month money market rates), and the VIX index of implied volatility of S&P 2015). Other risks involve political tensions and 500 options. Confidence bands span the 16th-84th percentiles. B. Blue line denotes averages for EFEs that experienced systemic sudden stops. Grey shades security issues (Afghanistan, Burkina Faso, denote 75th and 25th percentiles. A systemic sudden stop is a period when capital flows fall one standard deviation below their historical mean and, at the same time, the VIX index surpasses by one Burundi, Chad, Nepal, Niger), upcoming standard deviation its historical mean. The calculations include 21 nonconsecutive systemic sudden stop episodes for 58 EFEs in 1995-2014. elections (Benin), and labor disputes (Niger, Sierra Leone). Combined risk of BRICS weakness and Slower potential output growth financial stress Slowing actual and potential growth amid The spillover effects from a synchronous BRICS lingering vulnerabilities has left developing slowdown could be much more pronounced if it is countries more susceptible to external and combined with a tightening of risk spreads that domestic shocks. Potential growth in developing could result from developing-country financial countries has declined steadily since the global stress. The BRICS slowdown scenario discussed financial crisis, mainly reflecting the trend earlier, when combined with tightening financial slowdown in total factor productivity growth conditions—for instance, the EMBI spread (Figure 1.22). The slowdown in potential output increasing by 100 basis points from the current and productivity growth reflects slowing efficiency level in 2015—could cut growth in emerging and gains as well as demographic trends, which have frontier markets by about 1.3-1.5 percentage passed a turning point since the global crisis with points in 2015 (Figure 1.21). The effects of such a potentially profound implications (World Bank financial market turbulence would be more muted 2015b). Looking ahead, falling fertility rates and on the advanced economies. Global growth would rising life expectancy will intensify these trends in decline about 0.9-1.2 percentage point in 2015 countries with ageing populations, which may put from the baseline forecast. Financial tightening additional pressures on productivity growth and, would reduce growth particularly sharply in more broadly, on GDP growth. In particular, by frontier markets, with their less liquid, more 2025, outright declines in working age volatile, and fragile financial markets. populations are expected in Europe and Central G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 29 Asia—partly as a result of emigration—and in FIGURE 1.21 Growth slowdown in BRICS combined with East Asia and the Pacific. South Asia and Sub- financial stress Saharan Africa are exceptions, since still-high A combination of continued weak BRICS growth and rising emerging population growth will lead to an increase in the market bond spreads could considerably reduce growth in other emerging share of the working-age population. Although and developing countries. these trends should support stronger growth in A. Impact on growth in emerging mar- B. Impact on growth in frontier pre- and early-dividend regions, these also face the kets excluding BRICS markets highest poverty rates. Without improvements in poverty headcount rates, these regions could experience even greater concentrations of global poverty in the future. Terrorism and geopolitical tensions Recent terrorism-related violence in France and elsewhere has raised security concerns and C. Impact on G7 growth D. Impact on global growth highlighted rising geopolitical risks. Experience from past terrorist attacks in major economies suggests that isolated events are unlikely to have lasting economic consequences. Direct costs and the fiscal impact of security and emergency measures were generally limited, while effects on confidence and activity were generally short-lived. Even in the case of the September 11, 2001 attacks in the United States, financial markets and business confidence recovered within a few Source: World Bank staff estimates. Note: EMBI = Emerging Markets Bond Index. Conditional forecasts of emerging markets excluding BRICS, months (Figure 1.23).8 Other terrorist attacks in frontier markets, G7, and global growth, with conditions imposed on future BRICS growth and EMBI. The conditions are: (i) BRICS growing at the curent rate in 2015: BRICS continue to grow at its current 2015 level Europe, such as the Madrid and London (annualized rate of 3.2 percent) during the forecast horizon; (ii) BRICS growth with forecast downgrades as during 2010-14: BRICS continue to grow during the forecast horizon at its current 2015 level minus the aver- bombings in 2004 and 2005, had similarly small age forecast downgrades it saw during 2010-14. The forecast downgrades are based on the World Bank forecasts. In these two scenarios, EMBI is restricted to equal the unconditional forecasts from the aggregate effects on their respective economies and no VAR model during the forecast horizon; (iii) BRICS growth with forecast downgrades and financial stress: The second scenario is combined with EMBI rising by 100bp during the forecast horizon. Global growth is the GDP- perceptible global impacts (Kollias et al. 2011). weighted average of BRICS, emerging markets excl. BRICS, frontier markets, and G7 growth. The baseline forecasts are constructed from the forecasts presented in Chapter 1 by aggregating across countries in a given The negative effect of terrorism on economic group. Conditional forecasts are based on the aggregate VAR model. activity is generally estimated to be considerably FIGURE 1.22 Weakening potential growth smaller and less persistent than that related to external wars or internal conflict (Blomberg, Hess, Potential growth in emerging and developing countries has declined stead- ily since the global financial crisis, mainly because of the trend slowdown and Orphanides 2004). It is also viewed as less in total factor productivity (TFP) growth. pronounced in high income countries, with negative short-term effects offset by rising A. Contribution to emerging market B. TFP growth in emerging markets growth government spending. However, repeated threats or escalating geopolitical risks could potentially have more significant adverse effects. These include a more protracted impact on consumer and investor confidence, disruption to travel and tourism, heightened risk aversion, and higher transaction and insurance costs (IMF 2001, Johnston and Source: World Bank. A. Unweighted averages of key emerging and developing countries. GDP is decomposed into total 8 e overall cost of the September 11 attacks for the U.S. economy factor productivity (TFP) and factors of production using a Cobb-Douglas production function. Labor is proxied by employment, and the capital stock derived using the perpetual inventory method has been estimated at less than ½ percentage point of GDP (Roberts (assuming a labor share of national income of 0.7). Total factor productivity is derived as the residual. 2009). 30 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 1.23 Terrorism and geopolitical tensions terrorist attacks in 2014 was estimated at US$ 52 billion, a 10-fold increase from 2000 (Institute for Terrorist attacks in the United States in 2001, Spain in 2004, the United Kingdom in 2005 and France in January 2015 did not lead to lasting effects Economics and Peace 2015). on confidence and activity. Recurring terrorist-induced violence has been highly concentrated in a small number of developing countries, with A flaring up of geopolitical risks in the Middle significant regional implications. East remains a significant risk, as tensions have increased and non-conflict countries have been A. Purchasing Managers Index around B. Consumer confidence around significant terrorist attacks in major significant terrorist attacks in major affected by terrorist activity in 2015 (including high-income countries high-income countries Egypt, Tunisia and Turkey).10 Security concerns also remain prominent in some Sub-Saharan countries (Cameroon, Chad, Kenya, Mali, Niger, Nigeria) as well as in South Asia, with Afghanistan beset by domestic security and insurgency challenges. Taken together, a significant rise in geopolitical risks could potentially affect regional prospects and might, in a scenario of escalating tensions, disrupt an already fragile global recovery. Upside risk: Unrealized gains from the oil C. Number of terrorist attacks across D. Stock markets around major regions terrorist attacks in developing supply shock countries in 2015 The expected positive effect of falling oil prices on large oil importers and hence on global activity has been surprisingly muted. The increase in retail trade and private consumption across major high- income countries has fallen short of the real income gains conferred by lower energy prices since mid-2014 (Figure 1.24). There are several reasons for the muted response. First, the speed of Source: World Bank; Global Terrorism Database; Haver Analytics. the decline in oil prices has put severe strains on A. Date of significant attacks incorporated are: France (1/7/2015), UK (7/7/2005), Spain (3/11/2004) and United States (9/11/2001). Confidence measures are composite PMI indexes for France, Spain both private and public sector balance sheets and the United Kingdom, and manufacturing ISM for the United States. B. Data was originally collected by Pinkerton Global Intelligence Service (PGIS), Center for Terrorism among major oil exporters, with significant cross- and Intelligence Studies (CETIS), and Institute for the Study of Violent Groups (ISVG). Original GTD1 border spillovers for regional trading partners. (1970-1997) employed the definition of terrorism utilized by PGIS, and based on the original GTD1 definition, each incident included in the GTD2 (1998-2007) had to be an intentional act of violence or Second, oil importers are reacting with caution. threat of violence by a non-state actor. In addition, two of the following three criteria also had to be met for inclusion in GTD2: High indebtedness, limited room for additional 1.The violent act was aimed at attaining a political, economic, religious, or social goal; 2.The violent act included evidence of an intention to coerce, intimidate, or convey some other mes- monetary policy accommodation, and slowing sage to a larger audience (or audiences) other than the immediate victims; and 3.The violent act was outside the precepts of International Humanitarian Law. long-term growth prospects have encouraged debt C. Date of significant attacks incorporated are: Kenya (4/1/2015), Nigeria (1/3/2015, 7/1/2015, 9/20/2015), Turkey (10/10/2015) and Egypt (10/31/2015). reduction and precautionary savings, rather than consumption and investment. Empirically, there is Nedelescu 2005). In developing countries, the evidence that increased oil price volatility may rising number of terrorist incidents and related have a depressing effect, particularly on consumer conflict have already inflicted significant durables and investment outlays (Kilian 2011; economic, social and humanitarian costs for the Plante and Traum 2012; Guo and Kliesen 2005; affected countries. In 2014 alone, roughly 80 Elder and Serletis 2010; Kilian 2014). Should this percent of the people killed in terrorist activities uncertainty decline, the positive effects in were in just five countries (Afghanistan, Iraq, Nigeria, Pakistan, and Syria), with significant 10Global repercussions could include a further intensi cation of cross-border repercussions.9 The global cost of migration ows and rising volatility on international oil markets. In the medium and long term, the negative economic impacts in the 9Since 1989, 88 percent of all terrorist attacks occurred in countries region, along with already weak indicators of living conditions, may experiencing or involved in violent con ict (START 2015). contribute to further violence. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 31 importing economies represent an upside risk to FIGURE 1.24 Unrealized gains due to low oil prices baseline forecasts. Stable lower oil prices could eventually release pent-up demand. Such delayed Given the income boost from lower energy prices, the observed pickup in reaction to lower oil prices was observed in the private consumption generally fell short of expectations across oil importing countries. Stronger domestic demand might yet emerge, representing an 1980s and 1990s, especially in the United States, upside risks to projections. For instance, following the 1985-86 and 1997- where consumption initially slowed as consumers 98 oil price declines, the household saving rate in the United States initially were unsure whether lower prices would persist increased but subsequently decline. Debt deleveraging pressures and policy uncertainty could limit the potential for lower household savings this (IMF 2015d). As prices stabilized at lower levels, time. savings dropped and spending accelerated. A. Income gain from lower energy B. U.S. personal savings rate around prices and retail sales volume since previous oil price declines Policy challenges June 2014 Challenges in major economies In major high-income countries, monetary policy is expected to tighten very gradually in the United States, and to remain highly accommodative elsewhere. Fiscal consolidation is also expected to ease, but most major economies have yet to put in place plans for medium-term fiscal sustainability. China faces the policy challenge of supporting a gradual C. Debt D. Policy uncertainty slowdown and rebalancing while limiting financial vulnerabilities. However, the authorities retain significant policy buffers, and the government is proceeding with its comprehensive reform agenda. United States. U.S. labor market conditions have made significant headway over the last year, but there is still considerable uncertainty about the underlying strength of the economy, and the amount of remaining slack. This has led to a Sources: World Bank; Baker, Bloom and Davis (2015). debate about where policy interest rates are A. Standard ISO country codes. Income gain measured as changes in the energy component of consumer prices times the weight of energy consumption in the CPI basket. heading over the medium term. According to U.S. B. Latest observation 2015 Q3. D. The Economic Policy Uncertainty Index is derived from the weighted average of newspaper Fed policy makers, short-term interest rates should coverage of policy-related economic uncertainty and, depending on the country, disagreement among forecasters. A higher value indicates more uncertainty about economic policy. Latest observation stabilize around 3 percent over the long-run, November, 2015. reflecting a gradual increase in the natural rate of interest from current low levels (Figure 1.25). increasing volume of funds flowing to lower-rated However, uncertainty around estimates of this U.S. companies (OCC 2015). The U.S. banking natural rate could imply a more gradual increase in sector has strengthened its capital base since the policy rates than suggested by simple policy rules crisis, but some risks have migrated to non-bank (Hamilton et al. 2015). Conditions at present intermediaries which are subject to fewer therefore warrant a very gradual normalization of regulatory and supervisory rules (FSOC 2015). policy rates, balancing the risk of raising too quickly and potentially derailing the recovery, Fiscal deficits have been declining thanks to against that of raising too slowly and seeing spending restrictions and stronger growth, but a accelerated inflation. Very low interest rates carry there is still a need for a comprehensive plan for the additional risk of potentially excessive risk long-term fiscal sustainability. This will require tax taking amid a search for yield (IMF 2015d). Signs reform, and improved quality of public spending, of rising credit risks are already present, with including infrastructure investment (CBO 2015). weakening underwriting standards and an Brinkmanship around budget negotiations, 32 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 1.25 Policy challenges in the United States Reflecting a pickup in growth and low borrowing costs, the aggregate Euro Area fiscal deficit is According to U.S. Federal Reserve policy makers, short-term interest rates expected to narrow to 2.0 percent of GDP in should stabilize slightly above 3 percent over the long-run, reflecting a gradual increase in the natural rate of interest from current low levels. U.S. 2015. Fiscal policy appears to have been broadly fiscal deficits have been declining thanks to stronger growth, but there is neutral to growth in 2015, a trend that may still a need for a comprehensive plan to ensure fiscal sustainability over the medium-term. continue in 2016, although several countries require additional consolidation measures (European Commission 2015b). Countries with A. United States: Contribution to poli- B. United States: Government deficit cy interest rate projections projections available fiscal space could use it flexibly to support the recovery, generating positive cross- border spillovers, especially when cyclical conditions are weak (Auerbach and Gorodnichenko 2013), especially as monetary policy is constrained by the zero lower bound (Goujard 2013 and in‘t Veld 2013). Effective implementation of the European Investment Plan (catalyzing up to €315 billion in private investment through public funds and guarantees) Sources: World Bank; International Monetary Fund; U.S. Congressional Budget Office. could also help support growth in countries with A. Using the Taylor rule described in Yellen (2015) and the central tendency of FOMC forecasts for unemployment and inflation, FOMC projections for the federal funds rate path can be decomposed limited fiscal space and more fragile banking into the expected contribution from future labor market improvements, rising inflation, and the natural sectors. rate of interest. More specifically, the Taylor Rule is defined as R = RR* + p+ 0.5(p − 2) −(U − U*), where R denotes the Taylor Rule federal funds rate, RR* is the estimated value of the natural rate of interest, p is the current inflation rate (measured as PCE inflation), U is the unemployment rate, and U* is the natural rate of unemployment (considered to be the long-run FOMC forecast for the unem- Efforts to implement structural reforms are ployment rate). B. Baseline assumes current laws do not change. moving forward, but greater emphasis is needed to address rigidities and fragmentations of labor, product, and services markets, which are hampering productivity, innovation, and growth. spending, and debt caps remain an important Reforms in core countries could generate source of uncertainty, sporadically affecting significant cross-border spillovers, particularly in investor confidence and global financial markets. the area of innovation policies (Coe, Helpman, Structural reforms to facilitate re-entry into the and Hoffmaister 2009). Peripheral economies labor market and boost labor productivity are have urgent needs for reform to deal with needed. Longer-term challenges include stagnating domestic structural issues (Varga, Roeger, and in‘t wages for lower-income families, and deteriorating Veld 2014). In response to the unprecedented public infrastructure (OECD 2015). flow of refugees and migrants along the Eastern Mediterranean-Western Balkans, European Euro Area. The ECB’s asset purchase program has policymakers have agreed on a series of short-term helped ease financial conditions in the Euro Area. actions to rescue and support refugees, while It has reduced bond yields, weakened the euro, coordinating border policies. Establishing and improved the supply of credit (Georgiadis and equitable sharing of responsibility for resettlement Grab 2015). It has also mitigated the possible fall- of refugees and associated financial costs is key, out from the Greek debt crisis (European along with upholding EU’s law regarding the free Commission 2015b). Ongoing bank balance sheet movement of people, and addressing the root repair, and high levels of non-performing loans, causes of displacement through development may nevertheless continue to constrain the supply efforts. of credit in parts of the Euro Area (Figure 1.26). Speeding up the resolution of distressed assets is Japan. Amid record-low interest rates, continued needed to support bank lending. Further efforts to vigilance regarding financial stability risks is accelerate capital markets integration could help warranted, in particular through monitoring of improve the allocation of credit and support balance sheets and the use of stress tests to assess private sector investment. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 33 banks’ resilience to lower market liquidity and FIGURE 1.26 Policy challenges in Euro Area and Japan higher volatility of asset prices, exchange rates, and interest rates. Elevated levels of non-performing loans in the Euro Area continue to constrain the supply of credit. Faster resolution of distressed assets would help support bank lending. The recent acceleration of migrant flows to Fiscal consolidation has been delayed, and public Europe creates absorption challenges in the short term, but could have debt is expected to continue edging up (Figure benefits over time. In Japan, fiscal consolidation has been delayed and public debt is expected to edge further up. Relaxing immigration 1.26). The structural reform agenda is making restrictions in sectors with labor shortages could help counteract progress, with important new legislation passed or demographic pressures. under consideration by parliament, including in A. Euro Area: Non-performing loans B. Euro Area: Migrant flows the areas of energy, agriculture, and tax policies. across member states Removing tax-induced disincentives to work, broadening the availability of child-care facilities, increasing the participation of older workers and relaxing immigration restrictions in sectors with labor shortages would help counteract demographic pressures (IMF 2015e). Further reforms to reduce labor market duality, improve corporate governance, deregulate agriculture and domestic services, and eliminate barriers to C. Japan: Public deficit and debt D. Share of migrants in the labor force investment in Japan remain key policy priorities. projections China. Progress continues to be made in several of the reform areas announced in late 2013.11 According to the preliminary information following the fifth plenum, the 13th Five-Year Plan (FYP) indicative target for GDP growth is likely to be lowered to 6.5 percent (vs. 7 percent in the 12th FYP). By lowering growth targets, Chinese authorities are in a better position to Sources: World Bank; European Central Bank; International Monetary Fund; Organization for address key short-term risks while promoting the Economic Co-operation and Development. reforms needed for sustained medium-term A. Bank nonperforming loans to total gross loans are the value of nonperforming loans divided by the total value of the loan portfolio (including nonperforming loans before the deduction of specific loan- growth.12 A key policy challenge is to achieve an loss provisions). The loan amount recorded as nonperforming should be the gross value of the loan as recorded on the balance sheet, not just the amount that is overdue. orderly shift to a more sustainable economic path. B. Last observation is October, 2015. The transition will encompass an expanding role for the market and a shift from excessive investment in real estate and manufacturing from sectors that have accumulated excess capacity towards greater domestic consumption and to those with higher growth potential. Examples services (Figure 1.27). Achieving this will require of such policy steps include a gradual removal of policies that facilitate the reallocation of resources implicit state guarantees for loans (e.g. through implementing an integrated budget law and 11 In particular, there has been progress in nancial reforms (e.g., unified fiscal accounting), and allowing the interest rate liberalization, deposit insurance), external sector reforms (e.g., steps toward capital account liberalization and exchange-rate orderly exit of inefficient firms, including state- exibility), scal reforms (i.e., changes in scal framework of local owned enterprises. In the short term, market government debt), and pension reform (e.g., uni cation of civil servants’ pensions with the urban pension system). discipline in the financial sector should be 12 e new Five-Year Plan covers a broad range of reform areas to be strengthened to mitigate risks associated with a implemented by 2020. It pledges to accelerate reforms to: (i) reduce concentration of leverage among slowing sectors government intervention in the pricing of goods and services; (ii) relax restrictions on foreign investment; (iii) adjust scal (IMF 2015c). At the same time, ad hoc responsibilities between central and local governments; and (iv) administrative measures should be gradually reform state-owned enterprises as mixed ownership. It also relaxed the replaced by market-based mechanisms so that one-child policy. 34 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 1.27 Policy challenges in China Challenges in developing economies China’s key policy priorities include calibrating stimulus measures, providing a greater role to market forces, and ensuring a smooth transition In the short term, policy actions need to focus on from manufacturing and real estate to services and consumption. building resilience against downside risks to growth. As noted above, these risks include a slowdown in A. China: Lending rates B. China: Nominal GDP growth by major emerging and developing economies, financial sector sector turmoil amid tighter global borrowing conditions, and persistently low commodity prices. Where cyclical slowdowns are underway, and where there is sufficient policy space, countercyclical fiscal and monetary stimulus can be employed to support activity. Cyclical policies need to be reinforced with longer-term structural measures. These should focus on easing supply side constraints, and offsetting demographic headwinds in the relatively higher- Sources: World Bank; International Monetary Fund; U.S. Congressional Budget Office. income developing regions, where the working-age A. Lending rates are the interest rates applied to private sector companies and households. Latest share of the population is shrinking. Global poverty observation is September 2015. B. Latest observation is 2015Q3. will increasingly be concentrated in regions with the highest working-age population growth rates. Policy makers in such regions will face pronounced challenges to ensure productive employment for their credit is more efficiently allocated (World Bank expanding labor force. 2015i). The recent inclusion of the renminbi in the Special Drawing Right (SDR) basket of the Monetary and exchange rate policies International Monetary Fund is an important milestone in the integration of the Chinese Monetary policies continue to diverge between oil- economy into the global financial system. exporting and oil-importing countries. The deceleration of inflation in oil-importing countries Structural reforms will help support growth. For has allowed some easing in monetary policy. In oil instance, removing entry barriers and reducing -exporting countries, depreciation pressures have regulatory and administrative burdens will increased inflation and financial stability risks. enhance incentives for private investment. Several central banks have responded with foreign Likewise, implementation of fiscal reforms, such as exchange market intervention (Azerbaijan, consolidating the business tax with the VAT, will Kazakhstan, Mexico, Nigeria), and policy interest lower the tax burden and promote investment, rate increases (Angola, Colombia, Kazakhstan) in particularly in the transportation and financial the second half of 2015. Nevertheless, in several services sectors. Making more land available for countries, policy rates may still be lower than commercial activities will also improve the required to meet inflation targets, particularly prospects for service-sector investment and among commodity-exporting countries (Figure growth. Furthermore, efforts to gradually increase 1.28).13 In the event of a further slowdown in the retirement age could contribute to an increase these countries, central banks may not be able to in labor force participation. Reform efforts to lower rates further without raising risks to accelerate unification of the urban-rural hukou financial stability or inflation. system would also support more efficient labor 13 Such a relationship between monetary policy rates, cyclical condi- markets. Removing barriers to a structural shift tions, and in ation targets is estimated in a Taylor rule (e.g., as esti- towards services could help moderate the trend mated in Ostry, Ghosh, and Chamon 2012) for a sample of emerging decline in productivity growth, while an increase markets. e calculation assumes that monetary policy is in practice geared towards meeting the announced in ation target, that the in the labor share of GDP is critical to rebalance monetary policy rate is the main policy instrument, and that the growth on the demand side from investment to coe cient estimates from a cross-country regression is an adequate consumption. representation of the country-speci c relationships. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 35 Greater exchange rate flexibility may help absorb FIGURE 1.28 Monetary policy challenges in developing shocks, while conserving foreign exchange countries reserves. However, this benefit has to be balanced Commodity-exporting countries have tightened monetary policy to ease against domestic financial stability and inflation currency depreciation pressures and contain inflation and financial risks, which may be significant in some countries. stability risks. Inflation was still above targets in several commodity- In Kazakhstan, the shift to a floating exchange rate exporting countries in the second half of 2015. regime over the past year has raised concerns about the balance sheet risks associated with large A. Central bank policy rates B. Inflation versus inflation target, October 2015 foreign currency exposures. In contrast, in Qatar, Saudi Arabia, and the United Arab Emirates, large fiscal and reserve buffers have allowed fiscal policy to be loosened and currency pegs to remain supported (IMF 2015a). Financial globalization, and the rising influence of global interest rates in determining domestic financing conditions, will likely make domestic monetary policy objectives more difficult to Sources: World Bank; International Monetary Fund; Haver Analytics; Federal Reserve Board. achieve (Obstfeld 2015; Sobrun and Turner A. Data includes 11 commodity exporters and 13 commodity importers. Hikes and cuts refer to central bank rate decisions, including base rate, policy rate, repo rate, Selic rate, discount rate, reference 2015). This places a premium on credible rate, lending rate, refinancing rate, and benchmark rate. Latest data as of December, 2015. monetary policy that maintains price stability over the medium term, and institutional reforms that Financial sector policies limit the risk of pro-cyclical policies associated with capital flows. The pro-cyclicality of capital flows has been reflected in domestic credit conditions. Credit Policies concerning the joint choice of exchange- cycles have also turned in developing countries, rate regimes and the use of capital controls are of and high stock levels, which are the result of past key importance for emerging and developing rapid expansions in credit, remain a source of economies. Developing countries with fixed concern where growth is slowing or economies are exchange rates may choose to use capital controls already in recession. This highlights the need to to give monetary policy a degree of autonomy to reinforce macro-prudential policies aimed at achieve domestic macroeconomic objectives. mitigating systemic risk and reducing the pro- Developing countries appear to be more likely to cyclicality in domestic financial sectors (World have controls on capital flows if they also have Bank 2015b). Beyond the implementation of fixed exchange rates, and that the presence of this counter-cyclical capital buffers under Basel III effect depends upon the level of income per capita requirements, macro-prudential frameworks can (Chapter 4). In particular, lower-income countries be strengthened through a range of instruments, appear to set their policy with respect to capital including caps on loan-to-value or debt-to-income account measures with less independence relative ratios, dynamic provisioning, and credible stress to their exchange rate policies.14 tests. Banking sector vigilance and prudential monitoring also need to be stepped up where credit and solvency risks are high due to dollarized 14In principle, countries that choose to control both the exchange banking systems and currency depreciations rate and the capital account may still exercise monetary policy auton- (Central Asia and South Caucasus). In Europe and omy to stabilize economic conditions (Cordella and Gupta 2015). Central Asia and, to a lesser extent, the Middle is is only possible, however, if they have the necessary monetary East and North Africa, South Asia, and Sub- policy space—which has generally been narrowing recently, amid in ation and foreign reserve pressures. Saharan Africa, banking sectors are weighed down 36 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 1.29 Fiscal frameworks and financial stability countries. For commodity exporters in Sub- Saharan Africa, developing Middle East and A growing number of developing countries have adopted fiscal rules but many still need to strengthen fiscal management, including of commodity North Africa, and (to a lesser extent) Latin revenues for exporting countries. Banking sectors have elevated America and the Caribbean, fiscal spending nonperforming loans in ECA, MNA, and South Asia. This warrants close sustained by high commodity prices has been an supervision and monitoring. important driver of growth in the non-tradable B. Non-performing loans on banking A. Number of countries with fiscal sector balance sheets, by region sector (IMF 2015g). With revenues under rules pressure, and relatively small non-oil sectors, major fiscal adjustments have begun in several countries (Angola, Ecuador, Iraq, Nigeria). However, there has been considerable heterogeneity, with some oil-exporters with ample reserves implementing fiscal stimulus to support growth (Kazakhstan, Peru). Breakeven oil prices are particularly high in several Middle East and North African countries (Libya, the Republic of Sources: World Bank; International Monetary Fund; Haver Analytics. Note: A. Number of national and supranational fiscal rules in 89 LIC, MIC and HIC countries, covering Yemen), and non-oil fiscal deficits exceed 50 four types: budget balance rules, debt rules, expenditure rules, and revenue rules, applying to the central or general government or the public sector. percent of non-oil GDP in some GCC countries. B. Bank nonperforming loans to total gross loans are the value of nonperforming loans divided by the total value of the loan portfolio (including nonperforming loans before the deduction of specific loan- In Bolivia, Colombia, and Ecuador, fiscal revenues loss provisions). The loan amount recorded as nonperforming should be the gross value of the loan as recorded on the balance sheet, not just the amount that is overdue. over 2015-19 are expected to fall well below peak levels of 2011-14 (IMF 2015). by high levels of non-performing loans, and rising Fiscal policy as a countercyclical tool becomes concerns about asset quality and bank solvency particularly important to address cyclical weakness (Figure 1.29). This necessitates measures to when monetary policy is constrained by inflation, recapitalize banks and address problem loans and exchange rate movements, or financial stability longer-term reforms to improve governance, risks. However, in order for fiscal policy to be particularly in countries with a high share of state- implemented and be effective, economies need to owned banks. have the necessary fiscal space to employ Fiscal policy countercyclical measures (World Bank 2015a). Yet buffers have been significantly depleted since Like monetary policy, fiscal policies have diverged 2009, partly due to stimulus deployed during the among oil-importing and oil-exporting countries Great Recession. Rebuilding fiscal space therefore (Figure 1.30). For oil importers, the fall in oil remains a priority in order to expand buffers and prices has been fortuitous. Coupled with domestic reduce sovereign funding risks in case of an policy efforts, which include reducing energy adverse shock. In addition, rebuilding buffers will subsidies, fiscal deficits have shrunk, especially in enhance policy credibility and anchor investor South Asia, East Asia and the Pacific, and Europe confidence in major developing countries where and Central Asia. In many countries (including external and domestic imbalances remain large. Egypt and Lebanon) windfalls were typically saved to rebuild fiscal buffers. This fiscal consolidation Fiscal consolidation could also represent an amounted to about 0.5 percent of GDP, on opportunity for major public expenditure and average. In some countries, they were used to revenue reforms, for instance through better support investment spending (including India and targeted social welfare spending, subsidy reforms, Peru). Commodity exporters have seen a widening and more productive public investment spending in fiscal deficits due to revenue losses from the to alleviate supply side constraints. Governments resource sector. need to look more closely at the composition and efficiency of public spending and address fiscal Fiscal consolidation is expected to weigh risks that may be emerging from the way public increasingly on growth in commodity-exporting infrastructure investments are financed. Better G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 37 information on sources of fiscal risks from FIGURE 1.30 Fiscal policy challenges in developing contingent liabilities (e.g., from subnational countries borrowings, special purpose financial vehicles, and Fiscal buffers in developing countries have been significantly depleted public-private partnerships) and improved public post-crisis, partly due to stimulus deployed to support growth, and more debt management will be of critical importance. recently due to the impact of falling global commodity prices. Although commodity exporters on average have provided fiscal stimulus in 2015, Although many commodity exporting developing several are implementing or planning to implement fiscal consolidation. countries have made progress in enhancing A. Fiscal indicators in developing B. Change in structural fiscal balance, transparency in the extractive sector—11 are countries 2015 compliant with the Extractive Industries Transparency Initiative—only nine have fiscal rules or stabilization funds to act as buffers. Moreover, fiscal policy appears to have become more pro-cyclical in the years following the Great Recession, suggesting the need to further strengthen fiscal management of commodity revenues (World Bank 2015b). Structural reforms C. Fiscal and external breakeven oil D. Non-oil fiscal balances, 2015 prices, 2015 The deceleration of growth in emerging and developing economies is partly due to slower productivity growth. Structural reforms are therefore essential to support long-term growth. In the short run, a credible reform agenda could help lift investor confidence. In the longer run, reforms that improve economic governance, labor market functioning, and the efficient allocation of capital Sources: World Bank; International Monetary Fund; Haver Analytics, Federal Reserve Board. will help boost productivity, and may also help A. Data includes 23 oil exporting and 112 oil importing developing countries. Bars show interquartile offset demographic headwinds facing many range, dots show median across countries. B. Structural balances are available for five energy-exporting developing countries (Colombia, Ecua- countries. dor, Indonesia, Kazakhstan, Malaysia, Peru, and South Africa) and 25 non-energy exporting devel- oping countries (Bosnia and Herzegovina, Brazil, Bulgaria, China, Dominican Republic, Egypt, Geor- gia, Guyana, India, Lebanon, Mauritius, Mexico, Morocco, Panama, Paraguay, the Philippines, Romania, Serbia, Suriname, Thailand, Tunisia, Turkey, and Ukraine). The benefits from governance and business C. Fiscal break-even prices are oil prices associated with a balanced budget, while external breake- environment reforms are potentially large. Past ven prices are those that balance the current account. D. Non-oil fiscal balances are fiscal balances that excludes revenues from the oil sector. governance reform episodes in emerging markets have been associated with increased growth rates However, reform payoffs may take some time to (Didier et al. 2015). Similarly, large improvements be realized. It is therefore important to tailor in business environments are associated with a policies to the stage of development and the significant increase in annual per capita growth technology level of the country (Dabla-Norris et (Divanbeigi and Ramalho 2015). Banking, trade, al. 2013a-b). and agricultural liberalization can have particularly large economic benefits, while lower startup costs, Structural reforms combined with infrastructure easier registration requirements, improved investment can have especially potent growth management practices, and better access to effects. In China, for example, the long-term finance, have been linked to more firm entry and increase in real incomes from eliminating hukou employment creation in a range of countries.15 restrictions allied to large-scale infrastructure investment is larger than that from infrastructure 15 e positive e ects of market liberalization are highlighted in Beck investment alone (Bosker, Deichmann and and Demirguc-Kunt (2006); IMF (2008); Klapper and Love (2004); Roberts 2015). Topoleva and Khandelwal (2011), while factors supporting market entry are described in Desai, Gompers, and Lerner (2003); Klapper and Love (forthcoming); Klapper, Laeven, and Rajan (2006); Major changes in the size of working-age McKenzie and Woodru (2015). populations have taken place (Figure 1.31). More 38 CHAPTER 1 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 1.31 Structural reform needs than 90 percent of poverty is concentrated in pre- and early-dividend countries with young Commodity-boom years have left many exporters with small or shrinking manufacturing sectors. The quality of infrastructure and access to populations that lag in key human development electricity remain key bottlenecks for many developing countries. Structural indicators, register rapid population growth, and reforms are generally associated with higher growth and will become are seeing their working-age populations swell.16 increasingly necessary in the face of significant demographic shifts and to prevent a reversal of hard-won achievements in poverty reduction. In these countries, the demographic transition to lower fertility should help raise living standards A. Size of manufacturing sectors in B. Infrastructure quality index and should be supported by policies investing in commodity exporters, 2000 and 2014 better education, health, and women empowerment. In late- and post-dividend countries, which exhibit much lower fertility rates and more pronounced population ageing, it will be especially important to mobilize savings for productive investment and reforming welfare systems to ensure fiscal sustainability, while supporting the elderly and more vulnerable (World Bank 2015b). Most countries in East Asia and the Pacific and Europe and Central Asia C. Access to electricity D. Growth differential during episodes already have shrinking working-age populations. of reforms and setbacks in govern- ance quality since 1996 Incentives for greater or longer labor force participation may offset these demographic pressures. The associated reduction in benefits and increased social contributions could also help increase fiscal space. In many countries in Europe and Central Asia, however, policies need to go beyond reforming transfer and pension systems, and must encompass improvements in health and education that increase productive lifetimes, and labor market reforms that encourage greater E. Working-age population growth F. Extreme poverty in low-income participation by older people and women (World countries Bank 2015l). Where the working-age population is expanding, structural reforms are vital for other reasons. In South Asia, for instance, an estimated 300 million-plus working-age adults are expected to enter the labor force by 2040, more than half of them in a handful of historically slow-growing and less-developed sub-regions. Reforms that equip Sources: World Bank; International Monetary Fund; Haver Analytics; World Bank Doing Business new cohorts of workers entering the labor force database; Didier et al. (2015). C. Shows access to electricity as a percent of population; number of power outages; value lost due to with the right skills will accordingly remain key to power outages in percent of sales; and electricity transmission and distribution losses in percent of total output. International best practice is the average of values for the top 5th percentile for access to absorbing the growing workforce. Important areas electricity and the average of the bottom 5th percentile for power outages, value lost to power outag- es, and power losses. of policy intervention for South Asian D. Based on an event study of episodes of significant reform spurts and setbacks (two standard-error change in at least one of four WGI ratings) for 64 EM and FM countries for 1996-2014 (Didier et al. governments include improving access and quality 2015). Growth differential from baseline without significant reform spurts or setbacks. of education, as well as strengthening E. Working-age population is population aged 15-64 years. F. Measured as poverty headcount ratio (% of population) at $1.25 a day (purchasing power parity). accountability mechanisms, particularly in public schools (Dundar et al. 2014). 16 See World Bank 2015c for a description of typologies. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 1 39 Poverty-related policy challenges exporters in the region, where extreme poverty rates average 43 percent in the region, even the There are growing concerns that poverty will limited gains in poverty reduction made over the become increasingly concentrated in natural- past decade could rapidly reverse. Poor resource-based economies, and in fragile and households in these countries have been hit by conflict states. Many of these are in Sub-Saharan higher import prices from sharp currency Africa (World Bank 2015c). This region, which declines, the disappearance of jobs in has very high poverty rates, will account for more construction and other non-tradable sectors, and than half of working age population growth cutbacks in relief programs because of fiscal through 2050. For low-income commodity pressures (World Bank 2015a-b). References Board of Governors of the Federal Reserve System, Washington, DC. Ahmed, S., M. 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World Bank, Washington, DC G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 S P EC IAL FO CU S 47 Special Focus From Commodity Discovery to Production: Vulnerabilities and Policies in LICs Major resource discoveries have transformed growth prospects for many LICs. The sharp downturn in commodity prices may delay the development of these discoveries into production. During the pre-production development process, macroeconomic vulnerabilities in these economies may widen as a result of large scale investment needs. This heightens the importance of reducing lead times between discovery and production. Over the medium term, lead times may be reduced by improved quality of governance. Growth has eased in LICs but continued to be robust at about 5 percent in 2015, sustained by public investment, rising farm output and continued mining investments. For 2016-17, strengthening import demand in major advanced economies should help support activity in these countries. Introduction African LICs that could affect growth prospects. In Uganda, for instance, slower-than-anticipated The surge in commodity prices over the past infrastructure development has already delayed oil decade has played a pivotal role in spurring faster production start dates, from 2016 to as late as growth in low-income countries (LICs). As 2020. In Tanzania and Mozambique, final industry exploration and investment spending investment decisions on major LNG projects have climbed to record highs, a spate of commodity yet to be made (Bennot, 2015).3 In Afghanistan, discoveries—notably “giant” oil and gas investment plans for the development of copper discoveries in East and West Africa—has and iron ore mines leased for development in transformed the long-term growth outlook in 2008 and 2012 have been significantly scaled several countries (World Bank, 2015a and b).1 back. Mining has expanded rapidly in many LICs in Sub-Saharan Africa over the past decade. For Project delays are detrimental for several reasons. example, the number of active industrial gold They prolong the period of heightened mines reached historic highs by 2011 across Sub- vulnerabilities associated with the pre-production Saharan Africa after half a decade of soaring gold investment and delay the boost to growth that is prices (Tolonen 2015). typically associated with production. Additional concerns arise in hydrocarbon projects where However, with the turn in the commodity delays may increase the risk of “stranded assets” as supercycle, industry spending on investment has global efforts to tackle climate change induce a dropped sharply.2 In Africa the number of oil rigs shift towards less carbon-intensive technologies for on-land drilling has already fallen by 40 and greater energy efficiency (Stevens et. al. 2015, percent from their peak in Q1 2014 (Figure SF.1), Carbon Tracker Initiative 2004, McGlade and and mining production has been disrupted in Ekins 2015).4 Such stranded assets pose financial Sierra Leone and Democratic Republic of Congo and growth risks to the companies that own or (DRC). There are risks of delays in major mining operate them and the governments that back and energy projects under development in East them. Note: is Special Focus was prepared by Tehmina Khan, Trang Nguyen, Franziska Ohnsorge and Richard Schodde. 1 “Giant” elds are conventional elds with recoverable reserves of 3 Coal projects in Mozambique are reportedly losing money, 500 million barrels of oil equivalent or more. Despite the increasing because of the slump in coal prices, and inadequate infrastructure importance of unconventional shale oil and gas elds, current and (Almeida Santos, Ro arello, and Filipe 2015). 4“Stranded assets” refer to resource capacity, speci cally for future oil and gas supply is dominated by conventional giant elds (Bai and Xu 2014). hydrocarbons (coal, oil, gas), that remains unused as the world 2 e drop in industry investment has partly re ected growing reduces its hydrocarbon consumption in order to reduce risks arising concerns about misallocation of capital expenditures into exploration from climate change (Carbon Tracker Initiative, 2004, McGlade and over the past decade (McIntosh, 2015). Ekins, 2015). 48 S P EC IAL FO CU S G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE SF.1 Prospects and risks from resource • What factors determine the lead time between investment discovery and production? Following a decade of major resource discoveries, the drop in oil prices raises concerns that long-planned investment to develop discoveries into • What are growth prospects for LICs? production is delayed in low-income countries. This would set back growth. Lead times between discovery and A. Rig counts in Africa and North B. Resource discoveries eventually production America converted into production Typically, developing a resource discovery requires large upfront investments, over a considerable period. During this time, there may be high uncertainty about prices and macroeconomic and policy environments (IMF, 2012a). Broadly, the process of development of most mines undergoes five major stages. Since cross- C. Contribution of investment to real D. Growth in low- and middle-income country data is not publicly available, four of these GDP growth, 2010-14 countries with resource discoveries stages are illustrated in Figure SF.2 for two copper mines, one in the United States and another in Mongolia. The process begins with exploration to establish the existence of a potentially commercially viable deposit (4-5 years in the two illustrative examples).5 Once such a deposit is confirmed, feasibility, environmental and other impact studies are conducted and financing plans developed to establish commercial viability. Once Source: World Bank staff estimates, World Development Indicators, MinEx Consulting. commercial viability has been confirmed, a mining A. The rig count is the number of oil rigs in operation. C. Contribution of investment in percentage point, GDP growth in percent. license is obtained, a process that can take several years in some countries (2-3 years, on average, in This Special Focus discusses the evolution of Africa; Gajigo et al. 2012). Finally, the duration of macroeconomic vulnerabilities during the construction of the physical facility (3 years in the development of major resource discoveries, the two illustrative examples) depends on the impact of slowing commodity prices on accessibility of the deposit. development times, and policies to shorten these times. The analysis rests on a dataset for gold and All steps depend on the quality of governance, the copper discoveries worldwide since 1950 reliability of institutions, and macroeconomic (proprietary to MinEx Consulting). Over this stability that facilitates predictable policies. period, gold and copper discoveries have Investment risks tend to be high in the accounted for two-thirds of non-ferrous exploration, pre-feasibility and feasibility stages, discoveries worldwide. The results shown here and decline as a deposit gets closer to production. therefore are illustrative of the impact of policies Stylized facts on lead times by type of commodity and commodity prices on project development. and size of deposit are as follows: This Focus addresses the following issues: • Oil and gas. Conventional discoveries can take 30-40 years to develop (Clo 2000), but lead • What are typical lead times between discovery times for giant oil and gas discoveries can be and production? shorter (Arezki et al. 2015). For oil deposits, • How do economies evolve between 5In African LICs, the average duration of an exploration license is commodity discovery and production? for three years (Gajigo et al. 2012). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 S P EC IAL FO CU S 49 such as shale, short lead times of 2-3 years FIGURE SF.2 The mining project cycle reflect technological improvements since the Most mining projects are characterized by several key stages that include 1980s, and reduced entry barriers for small, exploration, discovery, feasibility assessments and regulatory compliance agile firms (Wang and Xue, 2014, World (including obtaining licenses), project construction, production and eventually closure. Bank 2015a). Monetizing gas discoveries is harder than oil discoveries: final markets are A. Time lines for mine development B. Duration of mining leases and typically far away, so that simultaneous exploration licenses in selected LICs investments in drilling and transport infrastructure are required, and long-term price contracts need to be agreed with end- users (Huurdeman 2014) • Mining. Lead times can range from a few years to decades, depending on the type of mineral, size and grade of the deposit, financing conditions, country factors and commodity C. Investment risk over a mining D. Number of years from gold and project lifecycle copper discovery to production prices (UNECA 2011, Schodde 2014). • Copper mining versus other mining. Average lead times for gold discoveries are ten years, but more than 15 years for zinc, lead, copper and nickel discoveries (Schodde 2014). Development of most gold deposits tends to begin immediately, whereas a significant share of copper discoveries takes several decades Source: World Bank, Perott-Humphrey (2011); Gajigo et. al. (2012); http://ot.mn/history, http:// (Figure SF.4). For instance, one-third of pumpkinhollowcopper.com/project-timeline/, both accessed November 4, 2015. A. Illustrative example of timeline from two copper mines, in the United States and Mongolia. copper discoveries since 1950 have had lead Exploration is not included in lead times discussed in the text. times to eventual production of 30 or more D. Based on a sample of 46 countries with copper discoveries and 73 countries with gold discoveries. SST denotes Sub-Saharan Africa. EAP = East Asia and Pacific; ECA = Europe and years, compared with only 4.5 percent of gold Central Asia; HIY = High-income countries; LAC = Latin America and the Caribbean; MNA = Middle East and Africa; SAR = South Asia; SSA = Sub-Saharan Africa. discoveries. Similarly, industry estimates place the period from early exploration to final production of copper mines at close to 25 production, and less than 40 percent of copper years (McIntosh 2015). Longer lead times for and nickel discoveries (Schodde, 2014). Once copper mines reflect greater complexity and developed, the market value of discoveries can be greater infrastructure investment to transport large compared to the size of LIC and MIC the ore to export markets.6 Average lead times economies. For copper mines, for example, to production have fallen sharply in recent production in 2014 alone accounted for 6 percent decades. of LIC GDP and 2 percent of MIC GDP, on average (Figure SF.3). Evolution from commodity discovery to production Depending on the commodity and the size of discovery, during the lead time between Resource discoveries matter to the economy only commodity recovery and extraction, countries can insofar as they can be developed into production. accumulate sizeable vulnerabilities as investment However, since 1950, less than 60 percent of gold, rises and external liabilities grow.7 In the dataset zinc and lead discoveries have made it to eventual used here, investment growth increased sharply in 6For instance, the location of Chile’s copper mines close to the sea 7An event study of macroeconomic developments between discovery has made it easier to pro tably ship concentrates, whereas copper and production of copper deposits illustrates the domestic demand mines in central Africa have had to rely on local smelting and re ning pressures that can prevail during these lead times. In a panel to reduce the volumes transported to ports (Crowson, 2011). regression, in ation, import growth and the current account de cit were regressed on a dummy variable that takes the value of 1 during 50 S P EC IAL FO CU S G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE SF.3 Developments during lead times between the five to ten years before actual extraction of the resource discovery and extraction resource began (Figure SF.3). This effect was only Gold and copper discoveries have been sizeable compared to the size of apparent in low-income countries. Since they tend LIC and MIC economies. However, a significant portion of discoveries to be smaller and less diversified than middle- and never get developed. Between resource discovery and production, investment growth rises sharply and vulnerabilities can increase. Growth high-income countries, the development of a large can become vulnerable to setbacks in mining sectors. mine can create significant domestic demand pressures. Using a global database on giant oil A. Share of non-ferrous discoveries B. Average value of copper produc- discoveries (those exceeding ultimately recoverable converted into production tion, 2014 reserves of 500 million barrels), including in Africa, Arezki et. al. (2015a) find that investment growth rises immediately upon discovery and current account deficits widen. GDP growth and private consumption growth respond only once extraction begins. The full increase in GDP growth materializes with commercial production, when vulnerabilities unwind as exports expand. C. Investment growth during lead D. GDP growth in Sierra Leone The size of vulnerabilities depends on two factors: times how mine construction is financed, whether governments borrow in anticipation of rising commodity revenues in the future, and whether private consumption and investment rises in anticipation of rising incomes. If rising imports and current account deficits are financed by FDI, which tends to be less prone to sudden stops than debt financing, short-term vulnerabilities are more limited (Levchenko and Mauro 2008). E. Public debt ratios in selected East F. Current account deficits in selected Nevertheless, a sudden stop in FDI projects could African LICs East African LICs also disrupt foreign exchange markets and sharply dampen activity. In particular, expectations of greater FDI (including as a result of recent natural resource discoveries) can encourage long-maturity non-resource investment projects. If these expectations are not validated, a sudden stop could follow and trigger fire sales of long-term assets and a collapse in activity (Calvo 2014). Additional, fiscal risks arise if governments expand spending Source: World Development Indicators, World Economic Outlook, MINEX Consulting, World Bank staff estimates., World Bank Commodity Markets Outlook World Bank (2015d). and borrow against future commodity revenues. A. C. LIC stands for low-income countries, MIC for middle-income countries, and HIC for high-income countries. B. Annual copper production evaluated at average 2014 price in percent of GDP (World Bank 2015a). C. Based on a sample of 46 countries with copper discoveries and 73 countries with gold discoveries. The following examples illustrate the heightened D. IMF projections for GDP growth in Sierra Leone, which discovered major iron-ore deposits in 2009. vulnerabilities associated with lead times in a number of LICs. the ve years that precede the beginning of production. Time and country dummies control for global and country-speci c factors. e sample period is 1980-2014. e estimates suggest that on average, • Sierra Leone: The discovery of major iron-ore lead-time investment associated with resource development deposits in 2009 led to a substantial upward contributed to an increase in in ation of 9 percentage points, and of import growth by 1 percentage point. e estimates were somewhat revision in growth forecasts to over 50 percent larger for copper than other mineral discoveries. Current account in 2012 as mining production came onstream. de cits were 3.6 percentage points of GDP wider. ese estimated However, work stoppages and a breakdown in e ects were particularly pronounced in LICs: in ation was 14.5 percentage points higher during these episodes and current account the railway system delayed the start of the de cits 4.3 percentage point of GDP wider. mine, so that actual growth results were much G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 S P EC IAL FO CU S 51 lower than initial projections. Since then, a FIGURE SF.4 Lead times between resource discovery collapse in global iron ore prices by 50 percent and extraction in 2014 has led to severe financial difficulties Lead times between discovery and production are considerably longer for at the country’s two foreign-owned and highly copper deposits than gold deposits, especially when commodity prices indebted mining operators, with one declaring are low. However, they can be shortened by improving business bankruptcy and the other halting operations environments. (World Bank 2015e, IMF 2012b and 2015a). A. Time from discovery to B. Scenarios: Reductions in lead times This and the outbreak of the Ebola epidemic production for copper mines set back activity, with the economy estimated to have contracted by 20 percent in 2015. • Uganda: Oil was discovered in 2006. Although production has yet to start, the government has borrowed in anticipation of future oil revenues. The public debt ratio has nearly doubled since 2007, reflecting loans from Chinese state banks and other lenders to Source: World Bank staff calculations, MinEx Consulting. A. Number of discoveries for each number of years. finance large hydropower and other B. Reduction in average lead times for average LIC mine if price downturn shifts to price upswing, if control of corruption is improved to the level of Chile or Namibia, or if quality of governance was infrastructure projects. With production dates improved to the level of Chile or Namibia. Derived from differences in predicted values predicted by a duration model described in Annex SF.1. “Price upswings” denotes reductions in lead times for the being postponed, infrastructure projects largest quartile of copper discoveries in LIC since 2000 as a result of switching from a commodity price downturn to an upswing. Reductions in other variables for the same mines as a result of raising affected by cost overruns, and the current control of corruption and quality of governance to average levels prevailing in Namibia and Chile. account deficit reaching over 10 percent of GDP in 2015, fiscal risks and external financing risks have increased (World Bank accelerate the start of development after discovery 2015f). (Schodde 2014). Once started, however, sunk costs may make mining companies reluctant to • Mozambique. The discovery of massive gas disrupt ongoing projects, particularly if deposits in 2012 has lifted medium to long- development is already well advanced (McIntosh term growth prospects. However, the sharp 2015, Crowson 2011).8 fall in oil and gas prices since 2014, delays in mining infrastructure projects and highly A duration analysis helps assess the relative expansionary fiscal policies are generating importance of these factors, using a proprietary major short-term challenges. Public debt dataset for the years 1950-2015 provided by ratios have risen sharply from 2007, to finance MinEx Consulting. It comprises 273 copper government infrastructure spending. But with discoveries in 46 countries, and 687 gold finances under pressure, the country has discoveries in 73 countries. The methodology is a turned to the IMF for a potential loan standard survival analysis (Jenkins 2006, Annex program (IMF 2015b). SF.1) to estimate the probability of a particular mine reaching production in any given year. Determinants of the lead time Explanatory variables are global gold and copper prices (World Bank 2015d), and the policy Lead times to production depend on a wide range environment at the time of discovery, controlling of technical, economic, social, and political for the physical characteristics of the deposit. factors. They include the accessibility and quality of the discovery, commodity prices, and policy A “good” policy environment conducive for environments. Larger discoveries closer to the surface in more predictable policy environments 8In general, the option value of delaying project completion may appear to see faster development (World Bank be lower in the resource sector than in non-resource sectors, due to a limited number of alternative feasible projects, and heavy 2015a). Higher commodity prices increase the involvement of the state, which provides some insulation from feasibility of marginal projects, and could political shocks (Crowson, 2011). 52 S P EC IAL FO CU S G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 resource investment—as well as non-resource generally sounder and more predictable investment—has many dimensions. It includes macroeconomic policies. sound macroeconomic policies that ensure sustainable fiscal positions (as measured by While lower commodity prices could lengthen government debt in percent of GDP at the time of lead times for copper mines, their effects can be discovery), and domestic demand pressures (as mitigated by strengthened policies. Had the proxied by inflation at the time of discovery). A average LIC had the same quality of government more stable macroeconomic environment can be index or the same control of corruption index as associated with more predictable tax and Chile or Namibia, the lead times for the expenditure decisions. A conducive policy development of copper discoveries since 2000 environment also includes high quality of might have been shortened by as much as two institutions, at the time of the discovery, that years (Figure SF.4). affect mining operations. This is proxied by the World Bank Governance Indicators for Control of Policy Implications Corruption and by the QOG Institute’s Index of the Quality of Government.9 These are some of Many low-income countries remain at the frontier the same conditions that would help avoid the of resource exploration and they are expected to be macroeconomic volatility and stunted growth in a major source of commodity supplies over the resource-based economies that has been labelled long-term (ICMM, 2012). Under the right the “resource curse” (Sachs and Warner 2001; conditions, new resource production should boost Mehlum, Moene and Torvik 2002; Humphreys, their exports and growth. With fiscal institutions Sachs and Stiglitz 2007). in place to manage the volatility of resource revenues (World Bank 2015a), new resource The results suggest an important role for the production could provide a major opportunity for commodity price cycle, sound macroeconomic development over the medium to long term. management and the quality of governance. Higher commodity prices, on average, are not However, the sharp drop in commodity prices significant determinants of lead times, probably since 2014 is already affecting resource sector because of the significant sunk costs involved. investments and could further delay the However, for copper deposits, an upswing in development of discoveries in several LICs. This, copper prices at the time of discovery—the crucial in turn, could prolong vulnerabilities—inflation, period when licenses are obtained and exploration fiscal and balance of payments pressures—often and extraction rights negotiated—accelerates associated with resource development as development. For example, in LICs since 2000, governments and private sectors borrow and invest rising copper prices at the time of discovery may in anticipation of future income growth. For the have shaved off about two to three years from lead largest deposits, a price downturn in the early times. For the largest quartile of copper discoveries stages of development, when licenses and in LICs since 2000, the price boom may have extraction rights are negotiated, could potentially reduced lead times by 2½ years (Figure SF.4). delay development by a few years, which could be Sound macroeconomic policies also appear to be critical for some LICs with growing fiscal and important: lowering government debt below 40 current account pressures. percent of GDP, or reducing inflation below 10 percent, accelerates development times by about Countries, in which resource development is still 10 percent. These variables may proxy for in initial stages, could consider accepting further delays to contain vulnerabilities and reduce the 9 e importance of the policy environment is also borne out in long-term risk of stranded assets (Steven et. al. anecdotal evidence. For instance, the Oyu Tolgoi mine in Mongolia—despite being one of the largest copper deposits in the 2015). Where development is already far world—took nearly a decade to become operational in 2013, advanced, this option may be unattractive. In following initial exploration in the early 2000s, lengthy feasibility these countries, especially, improvements in studies and negotiations between the government and Rio Tinto over the nancing of the mine’s construction. business environments could offset some of the G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 S P EC IAL FO CU S 53 price pressures on resource development. At the FIGURE SF.5 Growth prospects in LICs same time, they would benefit non-resource investment and help reduce macroeconomic Growth remains supported by strong outturns in the largest LICs. However the fall in commodity prices is taking a toll on commodity exporters. Risks vulnerabilities (Loayza and Raddatz 2007). Other lie on the downside. means of expediting resource developments are A. LICs: GDP growth B. LICs: Currency depreciations likely to be less helpful in the long-run, including increased tax incentives for mining companies. Mining companies have reportedly often negotiated tax exemptions that go above provisions specified in enacted legislation and are higher than warranted by mine profits (Curtis et al. 2009; Gajigo et al. 2012). Recent developments and C. LICs: Revisions to fiscal balance for D. LICs: Growth forecasts near-term outlook in 2015 low-income countries Growth in low-income economies (LICs) eased during 2015, reflecting headwinds from falling commodity prices and security and political tensions (Figure SF.5, Table SF.1). Nevertheless, on average, growth has remained solid at 5.1 percent. Source: World Bank World Development Indicators, IMF, World Economic Outlook. B. A negative value indicates depreciation. D. “GEP Jan 2015” indicated forecasts published in the January 2015 Global Economic Prospects Growth was particularly strong in several of the (World Bank 2015a). largest LICs, sustained by public investment, rising farm output and continued mining Tonkolili (the second largest iron ore mine in investments.10 In oil-importers, including Ethiopia Africa) after its operator when bankrupt. Copper and Rwanda, low commodity prices supported production in the Democratic Republic of Congo activity. In Ethiopia, the largest LIC economy, has been hit hard, following the suspension of growth of 10.2 percent in 2015 was also lifted by copper and cobalt production at the Katanga good harvests, rising public investment and Mining unit by Glencore, its mining operator, booming manufacturing and construction. Even amid declining profitability and a slump in copper in several metal and mineral resource-rich LICs, prices to a six-year low. In Afghanistan, large activity has thus far been resilient despite the investments associated with the award of copper commodity price decline, as development of major and iron-ore mining projects have failed to mining and gas projects has continued (Tanzania, materialize – partly due to unsettled domestic Mozambique, Uganda). Growth in these countries security and political conditions, but also due to ranged between 5-7 percent during 2015. the fall in global commodity prices – weighing on sentiment and outlook, and resulting in a In other commodity-exporting countries, in downward revision in medium term growth contrast, the fall in commodity prices led to prospects. Monetary tightening has further outright disruptions in production. Sierra Leone’s weighed on growth as policy makers responded to economy, already hit hard by Ebola in 2014, is sharp depreciations by lifting interest rates estimated to have contracted by a fifth during (Uganda) or drawing down reserves (Burundi, 2015 due to the closure of mining operations at Tanzania, Dem. Rep. of Congo, Zimbabwe and 10Strong growth over the past few years has lifted four LIC coun- Mozambique). tries (Bangladesh, Kenya, Myanmar and Tajikistan) to middle in- come status. In several LICs, political and social tensions are 54 S P EC IAL FO CU S G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 taking a toll on economic activity. In Afghanistan, activity in these countries. Large-scale investment growth has slowed as a result of continued projects in mining, energy and transport, political uncertainty and increase in violence, consumer spending, and public investment should amidst a drawdown in NATO troops. In Nepal, help keep growth upwards of 7 percent in the estimated value of damage from the Ethiopia, Mozambique, Rwanda, and Tanzania. earthquakes in April-May 2015 amounts to a third Improvements in electricity supply in Ethiopia of GDP. Since the earthquakes, domestic tensions and Rwanda but particularly in Guinea—where due to a new constitution, and severe fuel supply has doubled with the start of production shortages resulting from the closure of land from the Kaleta dam in 2015—will also support trading routes through India have further weighed activity, but a shortage of power is expected to on activity. Political tensions remain elevated in remain a drag in Benin and Madagascar. The several LICs in Sub-Saharan Africa, as a result of growth outlook remains weak, and only a gradual insurgencies or unsettled political conditions recovery is projected due to persistent political (Burkina Faso, Burundi, Chad, Niger), upcoming tensions in Haiti, Burundi, Benin, Guinea Bissau, elections (Benin), or labor disputes (Sierra Leone, Burkina Faso, Nepal and Afghanistan. Niger). This has increased uncertainty and weighed on activity. Risks to the outlook are mainly tilted on the downside. These include: Fiscal and current account deficits have widened in most countries. Falling commodity prices • Further weakness in global commodity prices (commodity exporters), political tensions could require sharper fiscal adjustments in (Burundi), or uneven policy direction (The commodity exporters. Several countries have Gambia) have weakened export and fiscal limited reserve buffers to stem depreciation revenues. In several countries, however, large pressures to contain financial stability risks current account and/or public sector deficits and inflation. Lower commodity prices and reflect rising infrastructure spending or the high expected investment costs also increase construction of mining projects that should the risk of a delay of investments in energy support potential growth over the medium term. and mining in East African countries that In Ethiopia for instance, the current account would weigh on medium-term prospects. deficit has remained relatively well funded by FDI, as is also the case in Mozambique and Tanzania, • Fiscal risks are elevated in some countries, while aid inflows have been important in Rwanda. relating to large infrastructure projects, Public -Private Partnerships, and contingent While lower global oil prices have kept inflation liabilities (Mauro et. al. 2015). Countries pressures muted in some oil importers where government debt has risen rapidly in (Afghanistan, Benin, Rwanda), inflation has recent years, such as Uganda, to finance remained high in several other countries due to mining infrastructure, may find it harder to limited spare capacity (Ethiopia); large currency service debt if production start dates for oil depreciations over the past year (commodity projects are delayed further. Inconsistent and exporting LICs) and those where political and poor macroeconomic management has been social tensions remain high. Nepal has also seen a accompanied by sizeable fiscal slippages in sharp acceleration in essential food and fuel prices, The Gambia. As a result of growing fiscal due to the severe disruption in trade through pressures from the drop in commodity prices India. and contingent liabilities in state-owned enterprises, which required government For 2016-18, growth in LICs is expected to support in 2015, considerable risks remain in remain resilient at above 6 percent, on aggregate. Mozambique and have led it into negotiations Strengthening import demand in the U.S. and with the IMF for a fiscal support program Euro Area, which are key trading partners for (IMF, 2015b). West African countries, should help support G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 S P EC IAL FO CU S 55 • Political risks could deter domestic and foreign prospects are therefore key to reducing global investment in some countries, weigh on poverty. A robust policy environment can tourism, and add to fiscal pressures. strengthen growth to levels that can make a clear Fragmented political situations could also dent in poverty. For commodity-exporting LICs, undermine the ability of governments to this includes policies that ensure that the growth undertake and implement needed policies. potential from natural resources is used effectively: reducing regulatory hurdles, clarifying legislation One-third of the world’s poor are located in LIC and strengthening infrastructure. countries (World Bank 2015c).11 Their growth 11 ere remain bright spots among LICs, notably Rwanda: the country is on track to meet all of its Millennium Development Goals, and some 650,000 Rwandans have been lifted out of poverty since 2011. 56 S P EC IAL FO CU S G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 Table SF.1 Low Income country forecastsa (Annual percent change unless indicated otherwise) (percentage point difference from June 2015 projections) 2013 2014 2015e 2016f 2017f 2018f 2015e 2016f 2017f Low Income Country, GDP b 6.4 6.1 5.1 6.2 6.6 6.6 -0.7 -0.1 0.1 Afghanistan 2.0 1.3 1.9 3.1 3.9 5.0 -0.6 -1.9 -1.2 Benin 5.6 5.4 5.7 5.3 5.1 5.1 1.1 0.7 0.4 Burkina Faso 6.7 4.0 4.4 6.0 7.0 7.0 -0.6 -0.2 0.5 Burundi 4.6 4.7 -2.3 3.5 4.8 4.8 -7.1 -1.5 -0.4 Cambodia 7.4 7.0 6.9 6.9 6.8 6.8 0.0 0.0 0.0 Chad 5.7 7.3 4.1 4.9 6.1 6.5 -4.9 0.2 0.5 Comoros 3.5 3.0 2.3 2.5 3.1 3.1 -1.1 -1.2 -0.7 Congo, Dem. Rep. 8.5 9.0 8.0 8.6 9.0 9.0 0.0 0.1 0.0 Eritrea 1.3 1.7 0.9 2.0 2.2 2.2 -0.6 0.0 0.0 Ethiopiac 10.5 9.9 10.2 10.2 9.0 9.0 0.7 -0.3 0.5 Gambia, The 4.8 -0.2 4.0 4.5 5.3 5.3 1.0 -0.6 -0.8 Guinea 2.3 -0.3 0.4 3.5 4.0 4.2 0.7 1.2 1.5 Guinea-Bissau 0.3 2.5 4.4 4.9 5.3 5.3 0.2 1.0 1.3 Haitic 4.2 2.7 1.7 2.5 2.8 3.0 0.0 -0.7 -0.3 Liberia 8.7 1.0 3.0 5.7 6.8 6.8 .. .. .. Madagascar 2.4 3.0 3.2 3.4 3.6 3.6 -1.4 -1.4 -1.4 Malawi 5.2 5.7 2.8 5.0 5.8 5.8 -2.3 -0.6 -0.1 Mali 1.7 7.2 5.0 5.0 5.0 5.0 -0.6 -0.1 -0.2 Mozambique 7.3 7.4 6.3 6.5 7.2 7.2 -0.9 -0.8 -0.1 Nepalc 4.1 5.4 3.4 1.7 5.8 4.5 -0.8 -2.8 0.3 Niger 4.6 6.9 4.4 5.3 9.3 5.7 -0.1 -0.2 1.6 Rwanda 4.7 7.0 7.4 7.6 7.6 7.6 0.4 0.6 0.1 Sierra Leone 20.1 7.0 -20.0 6.6 5.3 5.3 -7.2 -1.8 -3.6 South Sudan 13.1 3.4 -5.3 3.5 7.0 7.0 .. .. .. Tanzania 7.3 7.0 7.2 7.2 7.1 7.1 0.0 0.1 0.0 Togo 5.1 5.7 5.1 4.9 4.7 4.7 0.0 0.0 0.0 Ugandac 3.6 4.0 5.0 5.0 5.8 5.8 -0.5 -0.7 0.0 Zimbabwe 4.5 3.2 1.0 2.8 3.0 3.0 0.0 0.3 -0.5 Source: World Bank. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not significantly differ at any given moment in time. a. Central African Rep., Democratic People's Republic of Korea, and Somalia are not forecast due to data limitations. b. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. c. GDP growth based on fiscal year data. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 S P EC IAL FO CU S 57 Annex SF.1 e duration model used in the multivariate Bank Governance Indicator for control of analysis is a standard accelerated-failure-time corruption (Dahlberg et al 2015).13 By choosing (AFT) model (Jenkins, 2006), based on the all these explanatory variables at the time of gamma distribution. In AFT models, the natural discovery, i.e. before the lead time begins, logarithm of the survival time, log t, is expressed as concerns about reverse causality are attenuated.14 a linear function of the covariates, yielding the Given that data on some of these variables (in linear model: particular, the governance variables) is not available for much of the 1980s (QOG) or the mid-1990s (governance indicator), the earliest where xj is a vector of covariates and β is a vector values are taken to indicate the quality of of regression coe cients. e choice of zj governance for discoveries that occurred prior to determines the regression method. Here, and those dates. Control variables are the logarithm of based on the Akaike Information Criterion to the size of the discoveries, a dummy variable for evaluate the best t across types of distributions, copper deposits, and dummy variables for middle- the standard generalized Gamma distribution income and low-income countries. In the absence appears to be most appropriate. of mine speci c information on the depth of the deposit and in light of the changing depth over e e ects of the explanatory variables on the time as deposits get depleted, it is not possible to baseline are given by time ratios (the control for this factor directly. Country dummies exponentiated coe cients). ese are reported proxy for unobserved characteristics like the below for each explanatory variable. e landlocked nature of the country. In addition, magnitude of these time ratios denotes the factor regression results are robust to the use of decadal by which the expected lead time to production dummies which could help control for the would be shortened or lengthened by a one-unit decelerating time to production since the 1950s change in a variable. A one-unit change in the (See Annex Table SF.1). variable changes the time scale by a factor of exp(xj β). Depending on whether this factor is e regression in Column (1) shows that expected greater or less than 1, time is either accelerated or times to production are nearly twice as long for decelerated. at is, if a subject at baseline copper deposits, and similarly 30-40 percent experiences a probability of survival past time t higher in MIC and LIC countries. High levels of equal to S(t), then a subject with covariates xj debt and in ation expand the lead times to would have probability of survival past time t production. Column (2) shows that high levels of equal to S(t) evaluated at the point exp(xj β)t, debt and in ation lengthen the lead time to instead.12 production by 16 and 8 percent respectively. e commodity price cycle measure is not statistically e main explanatory variables xi are measures for signi cant, but interacted with copper mine size, commodity prices (an indicator if prices are rising shows that copper mines tend to get developed at time of discovery and the price change between faster when commodity prices are rising.15 discovery and production); indicators of macro Governance variables indicate that when policy environment (dummies if public debt ratios governance improves (indicated by higher values are greater than 40 percent and in ation rates higher than 10 percent); and measures for 13 e QOG Institute’s ICRG Index of Quality of Governance is governance, including the QOG Institute’s ICRG the mean of the ICRG indices of corruption, bureaucracy quality, and law and order. Index of Quality of Governance, and the World 14Prices are evaluated relative to peaks and trough, de ned as in Harding and Pagan (2002). Higher values of the quality of govern- 12Ideally, the regression would have taken into account the selec- ance and control of corruption re ect better governance. 15A similar interaction for the price change between discovery and tion bias of mines that have been discovered but are not being devel- oped. However, such data is not available. production is not signi cant. 58 S P EC IAL FO CU S G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 of the corruption index), expected times to indicating a copper deposit, shows that times to production fall by nearly 10 percent. e quality production fall by nearly 30 percent when of government index is not statistically signi cant governance improves. on its own, but when interacted with the variable ANNEX TABLE SF.1 Duration regression of lead times Column (1) Column (2) Column (3) Column (4) Log(size of deposit, mt cu) 1.000 1.000 1.010 1.010 0.770 0.900 0.660 0.610 Copper 1.74*** 1.72*** 1.74*** 2.29*** 0.000 0.000 0.000 0.000 Comm. price upswing at discovery 0.940 0.950 0.950 0.990 0.160 0.270 0.290 0.860 Comm. price upswing x Copper mine Size 0.91** 0.92* 0.930 † 0.910 † 0.040 0.070 0.130 0.100 Comm. price change during lead +me to pro- duc+on 1.00*** 1.00*** 1.00*** 0.000 0.000 0.000 LIC 1.33*** 1.25*** 1.020 1.260 † 0.000 0.000 0.850 0.120 MIC 1.42*** 1.33*** 1.11 1.55*** 0.000 0.000 0.290 0.000 Debt>40% 1.16*** 1.16*** 1.38*** 0.000 0.000 0.000 Infla+on>10% 1.080 1.080 † 1.010 0.160 0.150 0.920 Corrup+on 0.92** -0.020 Quality of government 1.120 0.630 Copper x Quality of government 0.710 † 0.140 Non-linear interac on terms Comm. price upswing x Copper mine size + Comm. price upswing 0.85** 0.87** 0.89** 0.9 † Copper x Quality of government + Quality of government 0.79 Kappa 0.92 0.88 0.86 0.49 N 948 948 943 921 Log Likelihood -1080.04 -1072.31 -1059.94 -1166.18 Akaike Informa+on Criterion 2180.09 2168.61 2145.88 2358.36 Note: P-values are given below coefficient estimates. † indicates statistical significance at 15%, * at 10%, ** at 5%, *** at 1%. The Pagan-Harding measure of commodity prices is based on the Pagan-Harding algorithm (2002) which identifies turning points in a times series as local minima and maxima. These are used to identify up-cycles (when gold and copper prices are rising). Higher values of the Corruption indicator correspond to better outcomes (i.e. lower corruption) as do higher values of the ICRG Quality of Government indicator. As interaction terms are non-linear, the combined impact of these is shown separately. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 S P EC IAL FO CU S 59 References Network Africa, Action Aid International, Christian Aid. Almeida Santos, A., L. M. Ro arello, and M. Dahlberg, S., S. Holmberg, B. Rothstein, F. Filipe. 2015. “African Economic Outlook: Hartmann and R. Svensson. 2015. e Quality of Mozambique.” www.africaneconomicoutlook.org, Government Basic Dataset, version January 2015. Issy les Moulineaux, France. University of Gothenburg: e Quality of Government Institute. 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Jointly and Requests for Augmentation of Access Under published by Open Society Institute of Southern the Extended Credit Facility and Debt Relief Africa, ird World Network Africa, Tax Justice Under the Catastrophe Containment and Relief 60 S P EC IAL FO CU S G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 Trust.” Country Report 15/76. International Perott-Humphrey, F. 2011. “Market Capital- Monetary Fund, Washington, DC. ization.” In SME Mining Engineering Handbook, edited by Peter Darling. Englewood, CO: Society __________. 2015b. “IMF Holds Discussions on for Mining, Metallurgy and Exploration. the 5th Review under the PSI, on a New SCF Arrangement, and on the 2015 Article IV Sachs, J. D., and A. M. Warner. 2001. “ e Curse Consultation with Mozambique.” IMF Press of Natural Resources.” European Economic Release 15/488, October 29, 2015, Washington, Review 45 (4): 827-838. DC. Schodde, R. 2014. “Key Issues A ecting the Time Jenkins, S. 2006. “Introduction to the Empirical Delay Between Discovery and Development.” Analysis of Spell Duration Data.” Institute for MinEx Consulting presentation, March 3, 2014, Social and Economic Research, University of Toronto. Essex. Stevens, P. G. Lahn, and J. Kooroshy. 2015. “ e Levchenko, A. A., and P. Mauro. 2007. “Do Resource Curse Revisited.” Chatham House Some Forms of Financial Flows Help Protect Research Paper, London. Against ‘Sudden Stops’?” e World Bank Economic Review 21 (3): 389-411. Tolonen, A. 2015. “Local Industrial Shocks, Female Empowerment and Infant Health: Loayza, N. V., and C. Raddatz. 2007. “ e Evidence from Africa’s Gold Mining Industry.” Structural Determinants of External Draft paper presented at the World Bank, Nov. 5, Vulnerability.” e World Bank Economic 2014. Review 21 (3): 359-387. UNECA. 2011. Minerals and Africa’s Mauro P., H. Joly, A. Aisen, E. Alper, F. 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Presentation at Global Mining Finance, Autumn Washington, DC: World Bank. 2015 conference, London. __________. 2015c. Global Monitoring Report Mehlum, H., K. Moene, and R. Torvik. 2006. 2015. Washington, DC: World Bank. World “Institutions and the Resource Curse.” e Bank. 2015f. e Growth Challenge: Can Ugandan Economic Journal 116 (508): 1-20. Cities get to Work? Washington, D.C.: World Bank. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E A S T A S I A A N D P A C IF I C 63 Growth in the East Asia and Pacific (EAP) slowed from 6.8 percent in 2014 to 6.4 percent in 2015, and is expected to ease further through 2018. This projection assumes that a gradual slowdown in China offsets a modest pickup in ASEAN countries. Risks to the forecast remain tilted to the downside. They include a faster- than-expected slowdown in China, which would have sizable spillovers on the rest of the region. Highly leveraged economies, in particular, face risks. Divergent monetary policies among high-income countries and an overall tightening of global financing conditions could lead to financial market volatility and interruptions in lending to countries with lower credit ratings. Key policy challenges include ensuring a gradual rebalancing of economic activity in China from investment to consumption and services, and strengthening medium-term fiscal and macroprudential frameworks. Structural reforms to improve the functioning of labor markets could play a vital role in mitigating the impact of aging populations and supporting long-term growth. Recent developments sector in the second half.1 But excess capacity has been a drag on investment across a wide range of goods-producing industries. The producer price Growth in the EAP region slowed to an estimated index declined further, reflecting lower 6.4 percent in 2015, down from 6.8 percent the commodity prices and considerable industrial previous year (Table 2.1.1, Figure 2.1.1). This overcapacity. Robust service sector growth is estimate represents a 0.3 percentage point supporting consumption and helping to rebalance downward revision from June 2015 (World Bank the economy (Figure 2.1.2). Core inflation has 2015a). Decelerating growth in China and a been broadly stable, but consumer price inflation weaker-than-expected recovery in Thailand has remained below the 3 percent target of the account for much of the decline. Growth in the People’s Bank of China (PBOC) since mid-2014 region excluding China was 4.6 percent, about the as a result of low food and energy prices. same as in 2014. The weak growth in commodity- exporting economies (Indonesia, Malaysia) was Slowing growth and rebalancing in China have expected, while Vietnam surprised with a stronger- been accompanied by bouts of financial market than-expected performance. volatility. Following a 90 percent run-up in equity prices between November 2014 and early-June In China, policies are aimed at putting growth on 2015, valuations unwound sharply. Policy a more sustainable footing and reducing leverage measures helped restore order to markets, and by in heavily indebted sectors (World Bank 2015b). September, equity prices had returned to January In 2015, growth eased slightly more than expected 2015 levels. This correction was accompanied by to below 7 percent, reflecting soft exports and a sizeable capital outflows, reflecting steps to ease slowdown in investment. The deceleration was capital account restrictions, and efforts to reduce especially pronounced in the real estate and manufacturing sectors during the first half of the year. Policy support, including an easing of 1The PBOC progressively cut benchmark one-year lending rate (to financial regulations, helped stabilize the property 4.35 percent) and reserve requirements (to 17.5 percent). The government implemented fiscal support measures through infrastructure investment, which led to widening of the fiscal deficit Note: The author of this section is Ekaterine Vashakmadze. to a six-year high (around 2.3 percent of GDP) and eased regulations Research assistance was provided by Trang Nguyen. (such as cutting the down payment requirements for home buyers). 64 C H A P TE R 2. 1 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 FIGURE 2.1.1 Activity in East Asia and Pacific Relatively slow growth in the rest of the region since 2014 reflects weak global trade, Growth in EAP eased to 6.4 percent in 2015, largely because of a continued slowdown in China. EAP’s slowdown has been driven by weak slow investment growth, and, to a lesser degree, exports, and slower domestic demand in the case of Malaysia. Sharply continued fiscal consolidation. Export growth deteriorating terms of trade and a decline in investment growth from slowed across the region (Cambodia and Vietnam previous high rates are also important factors. Consumption has remained resilient. were exceptions) as global trade contracted (World Bank 2015c).2 Several countries made efforts A. Growth, year B. Growth, quarter to reduce fiscal deficits in 2015—by reforming fuel subsidies (Indonesia, Malaysia) and sales tax regimes (Malaysia)—despite revenue losses from lower commodity prices (World Bank 2015c, d, e). Weak external demand was partially offset by strong private consumption growth, which was supported by tight labor markets, a dynamic services sector, low domestic fuel prices, robust C. Components of growth D. Contribution to GDP growth for inflows of remittances, and broadly selected economies accommodative monetary policies. In Thailand, fragile confidence in the aftermath of political tensions in 2014 continued to weigh on consumption growth. Declining commodity prices have helped improve current account balances in commodity-importing countries. The Philippines and Thailand, both net oil importers, recorded larger current account surpluses. In Indonesia, also a net oil importer, the current account deficit Sources: World Bank; Haver; China Economic and Industry database (CEIC). dropped below 2 percent of GDP through C. Weighted averages. 2015Q3 for the first time since 2011Q4, also reflecting falling imports (Figure 2.1.4). foreign currency exposures and foreign short-term debt among corporations, as well as concerns Despite an accommodative monetary policy in about growth prospects. advanced economies, external financing conditions tightened across EAP in 2015, particularly for International reserves remain large, equivalent to commodity exporters and countries with 32.8 percent of GDP in 2015, despite sales in significant financing needs.3 Capital outflows have support of the Chinese currency (Figure 2.1.3). As accelerated, and corporate and sovereign spreads a result, the renminbi remained broadly stable have risen (Figure 2.1.5). Currencies, including against the U.S. dollar throughout 2015, with the the Indonesian rupiah and the Malaysian ringgit, exception of a 3 percent depreciation in August experienced sharp drops in the second half of the that was triggered by an unexpected change in the year. Credit default swap (CDS) spreads widened, calculation of the renminbi reference rate. On a trade-weighted basis, the renminbi continued to 2Vietnam, in particular, appears to benefit from China’s rise in 2015 to new highs, in spite of the decline rebalancing. Factors include its competitive and diversified export against the U.S. dollar. The implied loss of cost base, and China’s move from low-skill, labor-intensive exports toward more sophisticated products. Appreciation of the renminbi has competitiveness contributed to weaker exports. accelerated the shift of labor-intensive production from China to This was offset by stronger import compression, lower-income countries, including Cambodia and Vietnam. reflecting weaker domestic demand and lower 3Although regional economies have increasingly relied on domestic credit markets for finance, external debt exceeds 60 percent of GDP commodity prices, resulting in a widening current in Malaysia and Lao PDR, 100 percent in Papua New Guinea, and is account surplus. close to 200 percent in Mongolia. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E A S T A S I A A N D P A C IF I C 65 as did spreads over U.S. Treasury yields for U.S. FIGURE 2.1.2 Internal rebalancing in China dollar bonds of the major EAP issuers (Indonesia, Rebalancing from investment to consumption has been slow, but Malaysia, and Thailand). Prices on regional stock rebalancing from industry to services activity has proceeded rapidly. markets fell sharply amid volatility. A. Growth in components of demand B. Consumption and investment In contrast to volatile portfolio flows, foreign direct investment (FDI) remains robust and has helped to mitigate external pressures. In particular, China became the world’s largest single recipient of FDI in 2014, while Indonesia saw its highest FDI inflows since 1990, both in dollar terms ($23 billion) and relative to GDP (3 percent). FDI inflows to other large EAP economies remained generally robust in the first half of the year, rising C. Consumer and producer price D. Services and industry in all large countries except the Philippines in year inflation -on-year terms. In Thailand, FDI inflows rose above pre-global crisis levels. In the Philippines, FDI has lagged, partly owing to regulatory restrictions. Inflows to Vietnam remained buoyant, and were mostly directed at labor- intensive manufacturing (UNCTAD 2015; World Bank 2015c). Exchange-rate depreciation served as a shock E. Total social financing and bank F. Employment growth credit absorber, but some countries have also responded to balance of payments pressures by using reserves. Commodity exporters Indonesia and Malaysia tapped reserves when their currencies came under strong pressure in the second half of the year. This helped contain depreciation to 25 percent. Commodity importers Thailand and Philippines experienced less pressure on their currencies, with exchange rates depreciating 5-10 percent, and reserves even rising. Despite the declines in foreign Sources: World Bank; Haver Analytics; China Economic and Industry database (CEIC). C. Latest observation is November 2015. exchange reserves and depreciations of several E. Total social financing is the sum of total fundraising by Chinese non-state entities, including individ- uals and non-financial corporations. major currencies, reserves to imports ratios remain F. The secondary sector is predominantly industry, while the tertiary sector is predominantly services. adequate and consumer price inflation held steady across the region (Figure 2.1.6). substantial, especially for the non-financial corporate sector. Domestic debt-to-GDP ratios Tightening external financial conditions exceed pre-crisis levels in several countries, and are contributed to a gradual stabilization of domestic above 150 percent in China, Malaysia, and debt-to-GDP ratios. Credit-fueled investment Thailand (Figure 2.1.7). growth has slowed across most of the region from double-digit rates in 2011-12, to about 4 percent in 2014-15. Credit growth slowed across the Outlook region, reflecting tighter monetary policy in Indonesia (since 2013), proactive use of The global economic environment is expected to macroprudential policies in Malaysia, and firmer remain challenging. Although there are signs of a non-bank lending conditions in China. modest pickup in growth, global trade and Nevertheless, private sector debt remains commodity prices remain weak (Chapter 1). 66 C H A P TE R 2. 1 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 FIGURE 2.1.3 External rebalancing in China Against this backdrop, regional growth is expected to ease from 6.4 percent in 2015 to 6.2 percent on Although China’s export market share continues to rise, its current account surplus declined to 2 percent of GDP in 2014 from a peak of 10 percent of average in 2016-18. The continued slowdown in GDP in 2007. In 2015, the renminbi appreciated in real, trade-weighted China should be partly offset by a modest pickup terms, while it depreciated against the U.S. dollar, for a cumulative in- in the rest of the region, which is expected to crease of 55 percent since the exchange rate reform in 2005. Rapid capital outflows in 2015 have been met with foreign exchange market intervention, benefit from recovery in advanced countries, low but reserves remain ample. energy prices, improved political stability, and still ample liquidity in global financial markets (despite A. Exports to selected major B. Current account balance and real an expected gradual tightening in the United economies effective exchange rate (REER) States). In the rest of the region, growth is expected to pick up to 5 percent on average in 2016-18, driven by the large ASEAN economies (Table 2.1.2). • In China, growth is projected to moderate to 6.7 percent in 2016 and 6.5 percent in 2017 and 2018, reflecting policy efforts to promote sustainable and balanced growth. Continued measures to contain local government debt, C. Balance of payments D. Foreign currency reserves curb the shadow banking industry, and tackle excess capacity will weigh on investment and industrial output. Low oil prices will soften adverse impacts, and targeted policy measures are expected to be applied as needed to ensure that the growth slowdown is gradual. • The slowdown of GDP growth in Indonesia is expected to have bottomed out at 4.7 percent in 2015, and accelerate to Sources: Haver Analytics; China Economic and Industry database (CEIC); World Bank. B. CPI deflated real exchange rate (REER). An increase denotes appreciation. Latest observation is 5.4 percent on average in 2016-18. This December 17, 2015 for the REER and 2015 Q3 for the current account. assumes implementation of a reform package announced by the government in September- October 2015 to unlock investment and boost Gradually strengthening output growth in high- productivity growth.4 income countries is expected to provide opportunities for competitive and diversified • In Malaysia, adjustment to lower energy prices economies in the EAP region. Global financial is expected to keep growth at 4.7 percent in conditions are expected to tighten further, albeit 2015, lower than in recent years. The only gradually. Combined with low commodity slowdown in domestic demand is expected to prices, tighter conditions are expected to weigh on reduce GDP growth to 4.5 percent in 2016 capital flows to the region, particularly portfolio and 2017, before it accelerates to 5 percent in flows and FDI into commodity sectors. Tighter 2018, helped by gradually strengthening financing conditions and slowing growth in major global growth. emerging markets may also be associated with bouts of financial market volatility. EAP countries • In Thailand, growth will remain weak, at 2.4 mostly benefit from low fuel prices, but their percent on average over 2016–18. Policy impact varies across countries, depending on the magnitude of net fuel imports, the energy 4The reforms aim to cut regulatory red tape, lowering costs and intensity of production, and the share of oil and uncertainty for private investment, and reducing bottlenecks holding gas in energy consumption. back public investments. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E A S T A S I A A N D P A C IF I C 67 uncertainty is likely to weigh on private FIGURE 2.1.4 Trade investment, high levels of household debt may The terms of trade have deteriorated sharply in commodity-exporting EAP dampen private consumption, and export countries. Slowing or contracting export volumes have further weakened growth could remain subdued. The central current account balances. This has been accompanied by sharp, real ef- bank cut its interest rate three times in 2015, fective exchange rate depreciations. but inflation remains well below the policy A. Terms of trade B. Current account balance target of 2.5 percent. • The Philippines and Vietnam are among the countries with the strongest growth prospects. In the Philippines, growth is projected to firm to 6.4 percent in 2016, reflecting accelerated implementation of public-private partnership projects and spending related to the May 2016 presidential election. In 2017-18, growth is forecast to ease to 6.2 percent. In C. Real effective exchange rates D. Merchandise export growth, Sep Vietnam, growth is expected to expand at an 2014-Sep 2015 average of 6.3 percent in 2016-18. Contributing to the gains are rapid investment growth buoyed by robust confidence and FDI, consumption growth fueled by solid labor markets, and export growth as Chinese FDI projects in export industries come onstream. In several of the small economies in the region, growth will decelerate due to low commodity Sources: Haver Analytics; International Monetary Fund; International Financial Statistics; Bank for International Settlements; World Bank, World Development Indicators; Dealogic. prices and measures to unwind financial A. Terms of trade refers to the relative price of exports in terms of imports and is defined as the ratio of export prices to import prices. Latest observation is 2015 Q3. vulnerabilities. Mongolia continues to adjust to B. Rolling four-quarter sums in percent of annual GDP. Latest observation is 2015 Q3. C. Latest observation is December 16, 2015. CPI-deflated real effective exchange rates. An increase the end of a mining boom, with economic activity denotes an appreciation. held back by weakening mineral exports and efforts by the government to control its debt. In reflecting the completion of liquefied natural gas- Cambodia, growth will remain slightly below 7 related construction work. In Timor-Leste, where percent in 2016–18, reflecting weaker prices for government spending is expected to help the non- agricultural commodities, constrained garment energy sector, growth should gradually recover to exports amid real currency appreciation and 7 percent in 2017-18 (World Bank 2015c). competition from market entrants in other countries, and moderating growth in tourism after a period of strong gains. Risks Growth is expected to pick up to average about 7 Risks to this outlook remain tilted to the percent in Lao PDR in 2016-18 as a result of downside. Key downside risks include a faster higher electricity exports, and accelerate to 8.5 slowdown in China than expected, which would percent in Myanmar in 2017-18 as a result of have spillovers to the rest of the region. commodity-related investment. Growth in the Heightened market volatility and tightened global small Pacific Island countries will be supported by financing conditions are also potential risks, rising tourism and remittances, but the especially given high domestic debt and fiscal commodity exporters will face significant consolidation challenges in a number of countries. headwinds. In Papua New Guinea, in particular, Other risks include a sharp U.S. dollar growth will decline sharply after a 2015 peak, appreciation, which would exacerbate financial 68 C H A P TE R 2. 1 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 FIGURE 2.1.5 Financial markets to contain domestic financial contagion in the event of an abrupt unwinding of financial leverage Capital outflows have accelerated, and corporate and sovereign spreads have risen. Stock prices dropped sharply between July-September 2015. could pose short-term risks. These could result in Currencies of oil exporters depreciated substantially. Cumulatively, the a major correction in property and stock markets, portfolio outflows during this period have surpassed those during the and a sharper-than-expected slowdown in “taper tantrum” episode in May–June 2013. investment. Policy levers, however, are available to A. Interest rate spreads B. Stock prices reduce these risks (World Bank 2015a, b, c). A slowdown in major emerging markets would dampen regional growth through strong trade linkages and increasingly through financial market integration. Econometric estimates indicate that spillovers could be sizable, with a one-off (but persistent) unexpected 1 percentage point decline in China’s growth lowering growth in the rest of Asia by 0.5-1.4 percentage points after two years C. Commodity prices and nominal D. International bond and equity (see Box 2.1, Chapter 3). Weaker commodity effective exchange rates issuance prices would exacerbate the impact on commodity exporters (Indonesia, Malaysia, Mongolia). A rapid tightening of global financial conditions presents an important external risk to several countries. A sharper-than-expected rise in long- term U.S. rates during the policy tightening cycle could lead to spikes in global risk aversion and trigger sharp capital outflows from the region. This would weaken regional currencies and raise Sources: Haver Analytics; International Monetary Fund; International Financial Statistics; Bank for International Settlements; World Bank, World Development Indicators; Dialogic. domestic borrowing costs, posing potential A. Interest rate spreads refer to the credit risk premium over US 10-year Treasury bonds which is measured as the difference between the Yield to Maturity Bond and the Yield to Maturity of the balance sheet risks for corporations with corresponding point on the US Treasury spot curve. Latest observation is December 14, 2015. B. Latest observation is December 7, 2015. significant foreign exchange exposure or high C. An increase denotes an appreciation. Non-energy commodities include agriculture products, fertilizers, raw materials, metals and minerals, precious metals. Latest observation is November 2015. indebtedness (IMF 2015a; Acharya et al. 2015). Financial stability and creditworthiness could be vulnerabilities stemming from foreign-currency compromised as asset quality deteriorates (IMF denominated external debt, and a weaker-than- 2015b). Total debt as a share of GDP in major expected pickup in high-income country growth regional economies at above 200 percent on and trade, especially in high-income Asia (Japan, average, is now comparable to that in some Republic of Korea).5 Further weakening of advanced economies (averaging 280 percent of commodity prices, if sustained, are an upside risk GDP, compared with 121 percent for developing to the overall regional forecast, although a major countries, Dobbs et al. 2015). Although debt in downside risk for commodity exporters. major economies remains predominantly local- currency denominated, a high share of non- In China, key risks are internal. A reversal or resident holdings of local-currency debt poses risks inconsistent implementation of reforms present a of a debt selloff.6 downside risk to the medium-term forecast. Growth stabilization measures may prove less Although falling commodity prices are an upside effective. Excess capacity could combine with risk for the region as a whole, they would producer price deflation to steepen debt overhangs negatively affect commodity exporters. The steep and precipitate corporate financial distress. Failure decline in oil prices since mid-2014 has so far 6Nonresident investors remain key players in the local currency Exports to China and high-income countries account for about 60 5 bond markets of Indonesia and Malaysia, holding around 40 percent percent of Thailand’s exports and 90 percent of Malaysia’s exports. of domestic government bonds. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E A S T A S I A A N D P A C IF I C 69 provided limited impetus to growth in the region. FIGURE 2.1.6 Policy rates, credit growth, inflation, and Windfalls are estimated to have been mostly saved, fiscal balances either by the public sector (through reformed Policy tightening has helped ease credit growth in some EAP countries. subsidy regimes in some countries) or the private Lower oil prices have reduced headline inflation, but core inflation has sector (for precautionary purposes). If the declines remained stable and, in Indonesia it is elevated. Several countries are implementing fiscal consolidation to stabilize debt. prove to be persistent, consumers may start saving less and businesses investing more, providing a A. Policy rates B. Real credit growth boost to aggregate demand, especially in commodity importing economies, and a larger upside impetus to growth than currently envisaged. On the other hand, lower oil prices could hurt investment in the broader oil and gas sector (see IMF 2015a), which accounts for around 12 percent of corporate investment in Asia (even in oil-importing economies). Policy challenges C. Fiscal balances D. Consumer price inflation Key policy challenges in the EAP region include ensuring a gradual slowdown and rebalancing in China, strengthening medium-term fiscal and macroprudential frameworks, and implementing structural reforms to support long-term growth and mitigate the impact of aging populations. The continued slowdown and rebalancing may require diversification in some highly exposed trading Sources: Haver Analytics; International Monetary Fund, International Financial Statistics; Bank for partners. International Settlements; World Bank, World Development Indicators; Dialogic. B. Year-on-year credit growth as of June for 2012-14. Year-on-year credit growth as of July for 2015. C. CHN = China, IDN = Indonesia, KHM = Cambodia, LAO = Lao PDR., MMR = Myanmar, MYS = In China, reforms continue to focus on lowering Malaysia, PHL = Philippines, VNM = Vietnam. D. Malaysia does not have an inflation-targeting regime. leverage in the economy, while shifting growth away from credit-fueled investment in housing and industry towards consumption and services. In this process, the key short-term challenge is to prevent a sharp drop in overall demand and avoid positive impacts on the financial sector the risk of broad-based deflation that exacerbates (introducing of deposit insurance, liberalizing de debt burdens (Blanchard 2014). Going forward, jure of deposit and lending rates, and enabling the setting appropriate growth targets will allow establishment of private banks), the external sector Chinese policymakers to strike a balance between (liberalizing the capital account and adopting addressing key short-term risks, while reducing more exchange rate flexibility), the fiscal financial vulnerabilities and promoting the framework (implementing measures to contain reforms needed for sustained medium-term risks on local government debt), and the pension growth. Preliminary information about the fifth system (unifying pension systems for civil servants plenum indicates that the 13th Five Year Plan with the urban pension system, World Bank targets growth of about 6.5 percent over 2016-20, 2015b, c). Some progress has also been made in compared with 7 percent during 2011-15. This simplifying administrative barriers and would still allow a doubling of GDP and implementing reforms of prices, state-owned household income by 2020 from 2010. enterprises, and labor markets (World Bank 2015f). Key policy steps include strengthening Progress is being made in implementing reforms financial market discipline to improve credit in China. Ongoing reforms are expected to have allocation to high-productivity sectors. 70 C H A P TE R 2. 1 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 FIGURE 2.1.7 Regional vulnerabilities Despite a recent slowdown, gross domestic debt-to-GDP ratios remain significantly above 2007 levels—more than 150 percent of GDP in China, Malaysia, and Thailand. Although debt in major economies is largely local-currency denominated, a significant share is held by non- residents. A. Nonresident and foreign-currency B. Public and private debt C. Household debt in selected countries sovereign bond holdings, 2014 D. Non-financial corporate debt in selected E. External financing needs, 2014 F. External and short-term debt, 2014 countries Sources: Moody’s Statistical Handbook; Haver Analytics; International Monetary Fund, International Financial Statistics; Bank for International Settlements; World Bank, World Development Indicators; Debt database; McKinsey. A. Local debt is locally issued debt, including local-currency-denominated debt held by foreigners (a large part of external debt in Malaysia). In Mongolia, intra-company debt makes up a large share of external debt. B. For private debt, 2015 data is the average of 2015 Q1 and 2015 Q2. CHN = China, IDN = Indonesia, KHM = Cambodia, LAO = Lao PDR., MYS = Malaysia, PHL = Philippines, THA=Thailand, VNM = Vietnam. C. D. Pre-crisis indicates average of 2006Q1 to 2008Q4. E. Reserve data not available for Papua New Guinea. Strengthened fiscal frameworks could provide a taxes (Indonesia), and strengthen public revenue buffer if risks materialize. Fiscal deficits remain administration (Lao PDR, Philippines) (World elevated in several countries (Mongolia, Papua Bank 2015c).7 Expenditure reforms should New Guinea, Vietnam) where fiscal reform is improve the efficiency and transparency of public needed to stabilize government debt (World Bank spending, and focus on productivity 2015c, g, h). Tax revenues are low by high-income enhancements (investment in human capital and country standards and expenditure efficiency is infrastructure), basic service delivery, and poverty- weak (World Bank 2015c) (Figure 2.1.8). Fiscal reduction programs. State-owned enterprise policy measures should be framed within a reforms, including measures to enhance medium-term outlook to strengthen revenue, transparency and governance, could reduce drains increase investment, and bolster fiscal institutions. on fiscal resources (Thailand, Vietnam) (World On the revenue side, there is a need to broaden tax Bank 2015 b, c, h). bases (Indonesia, Malaysia, Philippines), reduce reliance on commodity-related revenues 7Malaysia remains heavily dependent on scal revenues from the oil (Indonesia, Malaysia, Mongolia), raise energy and gas sectors, although the introduction of a general sales tax in April has helped diversify the revenue mix. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E A S T A S I A A N D P A C IF I C 71 Strengthened financial sector (macro- and micro- FIGURE 2.1.8 Policy issues prudential) policies could help buttress financial Across the region, tax revenue collection remains low, by high-income stability in the event of market turmoil. Such country standards, and business environments are weak in several measures include risk-informed pricing, rigorous countries. borrower affordability assessments, supervisory A. Tax revenue, 2014 B. Ease of Doing Business: The dis- vigilance over underwriting practices and tance to frontier score, 2016 adequacy of capital requirements, elevated reserve requirements, higher liquidity ratios or loan-loss provisions, and appropriate loan-to-value limits (IMF 2015d). Exchange rate policies should remain a key shock absorber, but reserve interventions may be necessary to smooth large fluctuations (World Bank 2015c). The use of reserve interventions may be particularly constrained where growth prospects and/or terms Sources: World Bank, World Development Indicators; Organization for Economic Co-operation and of trade have deteriorated sharply (Indonesia, Lao Development; IMF Fiscal Monitor; IMF World Economic Outlook; World Bank, Doing Business PDR, Malaysia, Mongolia). indicators. B. The distance to frontier score aids in assessing the absolute level of regulatory performance and how it improves over time. This measure shows the distance of each economy to the “frontier,” which represents the best performance observed on each of the indicators across all economies in the Structural reforms should focus on supporting Doing Business sample since 2005. An economy’s distance to frontier is reflected on a scale from 0 to 100, where 0 represents the lowest performance and 100 represents the frontier. For example, a long-term growth and mitigating the impact score of 75 in Doing Business 2016 means an economy was 25 percentage points away from the frontier constructed from the best performances across all economies and across time. of aging populations. Raising the mandatory retirement age for civil servants and increasing female participation will help mitigate the impact of aging (ADB 2015, World Bank 2015j). The natural-resource prices (World Bank 2015 d, e). appropriate reform agenda differs considerably Other measures to promote economic across specific countries. In Thailand, key diversification include ensuring high-quality priorities include reducing price distortions education, increasing the integration and depth of by reforming rice and rubber price-support domestic financial markets, ensuring adequate schemes, and improving public infrastructure infrastructure to remove bottlenecks, and (World Bank 2015a). Banking sector reforms rank improving competitiveness by removing special high for improving efficiency and the allocation of privileges for established sectors or enterprises. capital in Vietnam and Mongolia (World Bank Finally, deepening regional trade and investment 2015 g-h). integration could lift economic activity and stimulate job creation (World Bank 2015c). The For commodity producers like Indonesia and Trans-Pacific Partnership agreement, signed in Malaysia, the decline in commodity prices 2015, for example, provides a good basis for underscores the need to enhance fiscal institutions energizing trade and economic growth in the to improve the management of fluctuations in region (Chapter 4). 72 C H A P TE R 2. 1 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 TABLE 2.1.1 East Asia and Pacific forecast summary (Annual percent change unless indicated otherwise) (Percentage point difference from June 2015 projections) 2013 2014 2015e 2016f 2017f 2018f 2015e 2016f 2017f Developing EAP, GDP a 7.1 6.8 6.4 6.3 6.2 6.2 -0.3 -0.4 -0.4 (Average including countries with full national accounts and balance of payments data only)b Developing EAP, GDPb 7.1 6.8 6.4 6.3 6.2 6.2 -0.3 -0.4 -0.4 GDP per capita (U.S. dollars) 6.4 6.0 5.7 5.6 5.5 5.6 -0.4 -0.5 -0.6 PPP GDP 7.1 6.7 6.4 6.3 6.1 6.2 -0.2 -0.3 -0.4 Private consumption 6.8 6.9 6.9 6.9 7.0 7.0 -0.5 -0.7 -0.6 Public consumption 7.8 6.2 6.3 6.1 5.9 5.7 -1.1 -1.4 -1.5 Fixed investment 8.8 6.5 6.4 6.3 6.1 5.9 -0.3 -0.5 -0.6 Exports, GNFSc 7.2 6.5 3.7 4.3 4.8 5.2 -4.0 -3.0 -2.2 Imports, GNFSc 8.5 5.7 3.2 4.7 5.1 5.6 -5.1 -3.4 -3.2 Net exports, contribution to growth -0.2 0.4 0.2 0.0 0.0 0.0 0.2 0.1 0.3 Memo items: GDP East Asia excluding China 5.2 4.7 4.6 4.8 5.0 5.1 -0.3 -0.6 -0.4 China 7.7 7.3 6.9 6.7 6.5 6.5 -0.2 -0.3 -0.4 Indonesia 5.6 5.0 4.7 5.3 5.5 5.5 0.0 -0.2 0.0 Thailand 2.8 0.9 2.5 2.0 2.4 2.7 -1.0 -2.0 -1.6 Source: World Bank. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not differ at any given moment in time. a. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. Excludes American Samoa and Democratic People's Republic of Korea. b. Sub-region aggregate excludes American Samoa, Democratic People's Republic of Korea, Fiji, Kiribati, Marshall Islands, Micronesia, Federated States, Myanmar, Palau, Papua New Guinea, Samoa, Timor-Leste, Tonga, and Tuvalu, for which data limitations prevent the forecasting of GDP components. c. Exports and imports of goods and non-factor services (GNFS). TABLE 2.1.2 East Asia and Pacific country forecastsa (Real GDP growth at market prices in percent, unless indicated otherwise) (Percentage point difference from June 2015 projections) 2013 2014 2015e 2016f 2017f 2018f 2015e 2016f 2017f Cambodia 7.4 7.0 6.9 6.9 6.8 6.8 0.0 0.0 0.0 China 7.7 7.3 6.9 6.7 6.5 6.5 -0.2 -0.3 -0.4 Fiji 4.6 4.3 4.0 3.5 3.1 3.0 1.5 1.1 0.5 Indonesia 5.6 5.0 4.7 5.3 5.5 5.5 0.0 -0.2 0.0 Lao PDR 8.5 7.5 6.4 7.0 6.9 6.9 0.0 0.0 -0.1 Malaysia 4.7 6.0 4.7 4.5 4.5 5.0 0.0 -0.5 -0.6 Mongolia 11.7 7.8 2.3 0.8 3.0 6.4 -2.1 -3.4 -0.9 Myanmar 8.5 8.5 6.5 7.8 8.5 8.5 -2.0 -0.4 0.5 Papua New Guinea 5.5 8.5 8.7 3.3 4.0 3.8 -7.3 -1.7 1.6 Philippines 7.1 6.1 5.8 6.4 6.2 6.2 -0.7 -0.1 -0.1 Solomon Islands 3.0 1.5 3.3 3.0 3.5 3.4 -0.2 -0.5 0.0 Thailand 2.8 0.9 2.5 2.0 2.4 2.7 -1.0 -2.0 -1.6 Timor-Lesteb 2.8 7.0 6.8 6.9 7.0 7.0 0.0 0.0 0.0 Vietnam 5.4 6.0 6.5 6.6 6.3 6.0 0.5 0.4 -0.2 Source: World Bank. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not significantly differ at any given moment in time. a. American Samoa, Democratic People's Republic of Korea, Kiribati, Marshall Islands, Micronesia, Federated States, Palau, Samoa, and Tuvalu are not forecast due to data limitations. b. Non-oil GDP. Timor-Leste's total GDP, including the oil economy, is roughly four times the non-oil economy, and highly volatile, sensitive to changes in global oil prices and local production levels. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E A S T A S I A A N D P A C IF I C 73 BOX 2.1.1 Regional integration and spillovers: East Asia and Pacific Countries in East Asia and Pacific (EAP) are deeply integrated with the global economy and with each other. China has become the largest trading partner and source of FDI for the region, although Japan remains one of the largest sources of FDI for several economies. Reflecting this integration, a growth slowdown in China could result in sizeable spillovers to a large number of countries, while a slowdown in Japan would primarily affect Malaysia, Thailand, and Indonesia. Slowdowns in major advanced economies outside the region could also have sizeable spillovers. Introduction FIGURE 2.1.1.1 Cross-region comparisons EAP is characterized by deep regional and global The region is open to global trade and finance. integration through trade and investment flows.1 The region accounts for about 25 percent of global trade A. EAP: Share of global activity, trade and finance, 2014 (Figure 2.1.1.1), and its economies are among the most integrated into global value chains. Intra-regional trade and foreign direct investment (FDI) are substantial: in 2014, countries within the region accounted for 51 percent of the region’s trade and 44.1 percent of its FDI inflows. Deep intra-regional trade and financial integration has fostered growth. These ties are also conduits for the transmission of growth fluctuations, in particular from China and Japan. Such transmission can arise both through direct economic links and through common shifts of investor sentiment across the region. China’s gradual slowdown over the past year has been accompanied market volatility and real-sector headwinds. Looking ahead, spillovers are a key concern, given the risk of a faster-than- expected slowdown in China, and the still-fragile recovery B. EAP: Trade and finance in regional comparison, 2014 in Japan. This box discusses two key issues: • How open is EAP to global and regional trade and financial flows? • How large are the potential intra-regional spillovers from the region’s two largest economies, China and Japan? The findings suggest that spillovers from growth fluctuations in China are sizeable, and affect a wide range of countries. For now, spillovers arise primarily through trade channels, given the region’s deeply integrated supply chains, and more limited intra-regional non-FDI financial Sources: IMF October 2015 World Economic Outlook, IMF International Financial Statistics, IMF Direction of Trade Statistics, UNCTAD FDI/TNC flows. Spillovers from growth shocks in Japan are modest database, IMF Coordinated Portfolio Investment Survey, World Bank in general, but pronounced in Thailand, which relies Remittance and Migration Database, World Bank World Development Indicators. heavily on FDI from Japan. B. The red bars denote exports, imports, trade, remittance inflows, portfolio liabilities and FDI inflows in percent of GDP on average across EAP countries. The vertical line denotes the range of averages for all six developing regions. 1Throughout this box, EAP is defined as consisting of developing EAP and high-income EAP. In turn, developing EAP comprises: American Samoa, Cambodia, China, Fiji, Indonesia, Korea, Kiribati, Lao PDR, Malaysia, the Marshall Islands, Micronesia, Mongolia, Myanmar, Palau, Note: This box was prepared by Ekaterine Vashakmadze, Nikola Papua New Guinea, the Philippines, Samoa, the Solomon Islands, Spatafora, and Duygu Guven. Modeling work was done by Raju Taiwan, China, Thailand, Timor-Leste, Tonga, Tuvalu, Vanuatu, and Huidrom and Jesper Hanson. Research assistance was provided by Trang Vietnam. High-income EAP comprises: Australia; Hong Kong SAR, Nguyen and Qian Li. China; Japan; New Zealand; and Singapore. 74 C H A P TE R 2. 1 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.1.1 Regional integration and spillovers: East Asia and Pacific (continued) How open is the region to global and regional trade FIGURE 2.1.1.2 Regional integration and financial flows? Countries in the region are deeply integrated with each EAP is characterized by large trade flows, including intra- other. China is a major export destination and source of regional flows (Figure 2.1.1.2). The region includes two of FDI for EAP countries. Japan remains one of the largest sources of FDI and portfolio inflows for several economies the world’s largest trading economies (China and Japan). It in EAP. also hosts two global trading hubs (Hong Kong SAR, China and Singapore). As a result, trade exceeds 45 percent A. Within-region integration, 2014 of GDP in three-quarters of the region’s economies, and 150 percent of GDP in Cambodia, Malaysia, Thailand, and Vietnam. Intra-regional exports account for more than 60 percent of total exports in China; Hong Kong SAR, China; Malaysia; Singapore; and Thailand. The region contains several large commodity importers and exporters. Demand from China for metals and energy has grown rapidly since 2000, reflecting the sharp expansion of the industrial sector. China now accounts for more than half of the global demand for metals, and 23 percent of the global demand for primary energy (Figure 3.5, Chapter 3).2 Several EAP countries, including Indonesia, Malaysia, and Mongolia, are globally important commodity producers.3 B. Major actual and potential free trade agreements Since 2000, intra-regional trade has gradually tilted from Japan to China, for commodity importers and exporters alike (Figure 2.1.1.4). The share of trade with China has doubled since 2000 for Australia, Japan, and the Republic of Korea, and tripled for Malaysia and New Zealand. China is now the largest trading partner for Australia; Hong Kong SAR, China; Malaysia; Myanmar; New Zealand; and Thailand. It represents the second-largest trading partner for Indonesia and Lao PDR, and the third- largest for the Philippines. That said, Japan remains an important trading partner for Australia, Indonesia, Malaysia, the Philippines, and Thailand. China is an increasingly important source of final demand for the rest of the region, for both commodities and Sources: International Monetary Fund (IMF), World Economic Outlook (WEO), manufactures. A large and rapidly growing share of the rest International Finance Statistics (IMF), Direction of Trade Statistics (DOTS), Coordinated Direct Investment Survey (CDIS); World Bank; Schott (2014), United Nations Economic and Social Commission for Asia and the Pacific (UN ESCAP). A. EAP includes American Samoa, Cambodia, China, Fiji, Indonesia, Japan, 2In contrast, China’s consumption of most agricultural commodities Kiribati, Lao PDR, Malaysia, Marshall Islands, Micronesia, Mongolia, Myanmar, Palau, Papua New Guinea, Philippines, Samoa, Solomon Islands, (except edible oils) has grown broadly in line with global consumption Thailand, Timor Leste, Tonga, Tuvalu, Vanuatu, Vietnam, Australia; Hong since 2000. Underlying this, consumption of industrial commodities, Kong SAR, China; Japan, New Zealand, and Singapore. Portfolio liabilities including metals and energy, tends to respond to economic activity. data include: Australia; Hong Kong SAR, China; Indonesia, Japan, Korea, Malaysia, Mongolia, New Zealand, Philippines, Singapore, and Thailand. FDI Consumption of food commodities (especially grains) is mainly inflow data include: Australia; Hong Kong SAR, China; Indonesia, China, associated with population growth (Baffes et al. 2015). Japan, Korea, Malaysia, Mongolia, New Zealand, Philippines, Samoa, 3Commodity exports in these countries account for 6–30 percent of Singapore, and Thailand. Portfolio investment denotes stocks of portfolio investment liabilities. their GDP. Indonesia’s share of global exports is 20 percent or more for B. FTAAP=Free Trade Area of the Asia-Pacific, RCEP=Regional aluminum, coal, natural rubber, nickel, palm oil and rubber. Malaysia’s Comprehensive Economic Partnership, TPP=Trans-Pacific Partnership share of global exports is 35 percent for palm oil, and 5 percent for Agreement, TTIP=Transatlantic Trade and Investment Partnership. petroleum gas. Thailand’s share of global exports is 20 percent or more for natural rubber and rice (World Bank 2015b). G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E A S T A S I A A N D P A C IF I C 75 BOX 2.1.1 Regional integration and spillovers: East Asia and Pacific (continued) FIGURE 2.1.1.3 Main spillover channels Each of these charts shows trade and financial links as a percent of the region’s GDP—red for outside the region, blue for inside the region. All regional economies are deeply integrated within the region through trade, FDI, and remittances. A. Export destinations, 2014 B. FDI inflows, 2008-12 C. Remittance inflows, 2014 D. Foreign value added share of gross exports Sources: International Monetary Fund (IMF), WB, UN Comtrade, Organization for Economic Co-operation and Development (OECD). D. This indicator reflects the share of total gross exports contributed by foreign value added in an industry’s exports. The sum over all industries is the total foreign value added share of gross exports. (OECD 2015). of the region’s value added is accounted for by exports including three comprehensive Free Trade Agreements used to meet final demand from Chinese consumers that are currently under negotiation (Chapter 4.1, and (World Bank 2015c). This applies to both the commodity- Figure 2.1.3 and Table 2.1.1.1).4 Partly as a result of trade and non-commodity trade. Malaysia, Thailand, and liberalization, regional economies, especially the Republic Vietnam are among the countries most dependent on final of Korea and the ASEAN countries, are highly integrated demand from China for non-commodity merchandise. 4China has implemented FTAs with ASEAN, other countries in Asia Trade liberalization has encouraged, and will continue to (Korea and Pakistan), Latin America (Chile, Costa Rica, and Peru), the boost, trade and supply-chain integration. China joined Pacific (New Zealand), and Europe (Iceland and Switzerland). Negotiations are advanced for FTAs with Australia, the Gulf Cooperation the World Trade Organization in 2001; it has Council (Bahrain, Kuwait, Qatar, Saudi Arabia, and the United Arab implemented free trade agreements (FTAs) with a wide Emirates), Japan, Norway, and Sri Lanka. FTAs with Columbia, Georgia, range of countries, and is in discussions on many others, India, and Moldova are under consideration. 76 C H A P TE R 2. 1 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.1.1 Regional integration and spillovers: East Asia and Pacific (continued) FIGURE 2.1.1.4 Trade and finance with China and Japan There has been a shift in within-region trade from Japan to China since 2000. For most countries (except the Philippines), the share of exports to China has grown steeply and that to Japan has declined. For FDI, however, Japan remains one of the largest sources. Outbound tourism from China has also increased significantly. A. Exports to China B. Exports to Japan C. FDI flows to the region, 2014 D. Total outbound tourism, 2013 Sources: UN Comtrade. into regional and global value chains (Figure 2.1.1.3).5 Chinese tourists are particularly important for Cambodia, Lao, PDR, Malaysia, Thailand, Vietnam, and some Pacific Intra-regional tourism has also grown robustly, with China Islands (Fiji and, especially, Palau). For instance, in accounting for a rapidly rising share. China has become Thailand, they account for 18 percent of all tourists and the world’s largest source of tourists (UNWTO 2015). over 2 percent of GDP in tourism revenues. There were 62 million outbound Chinese tourists in the first half of 2015, compared with 41 million in the whole The region is also characterized by large FDI inflows and of 2007 (China Tourism Research Institute 2015). outflows. Developing EAP accounts for more than half of all FDI inflows to developing regions. FDI has typically 5As measured by the Global Value Chain Participation Index. is gone into a wide variety of sectors, including measures the share of imported inputs used to produce a country’s ex- manufacturing (Cambodia, Indonesia, Vietnam), ports, and the share of a country’s exports that serve as intermediate construction (Cambodia and Lao PDR), tourism inputs into other countries’ exports (OECD 2009). G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E A S T A S I A A N D P A C IF I C 77 BOX 2.1.1 Regional integration and spillovers: East Asia and Pacific (continued) (Cambodia, Indonesia, Thailand), and resource extraction To capture direct as well as indirect effects, we used a (Lao PDR, Mongolia, Myanmar). China was the world’s Bayesian structural VAR to estimate spillover effects, using largest recipient of FDI in 2014, and the second-largest quarterly data from 1998Q1 – 2015Q2. For each country, source of FDI after the United States.6 Chinese investors the variables included are as follows, in order they are used have been heavily involved in power projects in Lao PDR, in the model: growth in the G7 excluding Japan; the garment manufacturing projects in Cambodia, and mining JPMorgan Emerging Market Bond Index; growth in Japan, in Mongolia. Japan remains an important source of FDI China, and Korea; trade-weighted average commodity flows to Thailand (accounting for 40 percent of total prices; growth in the affected country; and the real inflows), Korea, Malaysia, and the Philippines (Figure effective exchange rate of the affected country. Explicit 2.1.1.4). trade linkages (perhaps overestimated in the case of Hong Kong SAR, China because of large share of re-exports to The EAP region attracts substantial portfolio investment, China) should not affect estimation results, since the VAR most of which goes to Australia, Korea, Malaysia and model does not explicitly include variables for direct trade Singapore (Figure 2.1.1.5). Modest portfolio flows to links, it is rather estimating direct growth on growth China relative to its size reflect remaining restrictions on impact. such flows.7 Several regional economies have deep capital markets, including Australia; Hong Kong SAR, China; The model has a recursive structure, with earlier variables Japan; Korea; Malaysia; New Zealand; and Singapore. assumed to be contemporaneously unaffected by later However, economies in EAP are more financially variables. Spillovers are measured as the cumulative integrated with the major global financial centers than response of growth to a 1 percentage point decline in with each other (Park and Shin 2015; Kim et al. 2014). growth in China or Japan, upon impact, after one year, and after two years. How large are the potential intra-regional spillovers from the region’s two largest economies, China and The estimated magnitude of these spillovers varies across Japan? countries, particularly with respect to growth fluctuations in China (Figure 2.1.1.6): Growth fluctuations in the two largest countries in the region, China and Japan, would generate spillovers on • Spillovers from China. A one-off, 1-percentage-point other countries in the region. The transmission channels decline in China's growth reduces growth particularly include bilateral trade, including trade in intermediate sharply in the trading hub of Singapore; and in Hong goods within regional supply chains; FDI; and (especially Kong SAR, China.8 After two years, their growth rates for the Pacific Islands) tourism. A growth decline in China also decrease by around 1 percentage point.9 Growth would also affect global commodity markets, further in Indonesia, Malaysia, and Thailand decreases by reducing demand and prices. Lower export volumes and around 0.4 percentage point. Japan and Korea are weaker terms of trade would reduce growth prospects in affected to a much smaller degree. The magnitude of commodity-exporting countries. In addition to the trade spillovers from China could be more pronounced if and financial channels for the transmission of growth growth fluctuations are amplified via the confidence fluctuations within the region, there may be significant channel. In a historical decomposition, pre-crisis, spillovers through the confidence channel even though China’s growth appears to have contributed those are hard to estimate econometrically (Box 3.2). significantly to growth in the rest of the region. Since 2011, the slowdown in China weighed on activity in the rest of the region. These estimates are based on a sample period during which China’s integration into 6In 2000, China established a sovereign wealth fund to encourage global and regional trade was rapidly increasing. companies to invest abroad. It also began easing restrictions on FDI ows. ese actions resulted in sizeable FDI into foreign natural resources, including oil and minerals. 8Explicit trade linkages (perhaps overestimated in the case of Hong 7 e Chinese government actively encourages the use of the renminbi (RMB) in international trade. As a result, transactions volume has grown Kong SAR, China because of large share of re-exports to China) should rapidly, to make the RMB the seventh most traded currency globally, not a ect estimation results, since the VAR model does not explicitly with 1.72 percent of world payments settlements as of September 2014. include variables for direct trade links. e RMB is now the second most used currency in international trade 9 e impulse is quite persistent. After two years, the cumulative decline nance. in China’s output amounts to 2 percent of the baseline. 78 C H A P TE R 2. 1 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.1.1 Regional integration and spillovers: East Asia and Pacific (continued) FIGURE 2.1.1.5 Portfolio liabilities and capital account restrictions Portfolio investment inflows are largest into Japan and Korea. They are modest in China, partly as a result of capital account restrictions. A. Portfolio liabilities, 2011-2014 B. Capital account restrictions Source: Coordinated Portfolio Investment Survey (CPIS), IMF, Chinn and Ito (2006). A. Stock of portfolio liabilities, average for 2011-14. B. Chinn-Ito index is defined as an index measuring a country’s degree of capital account openness. The index by Chinn and Ito (2006) is based on binary dummy variables that codify the tabulation of restrictions on cross-border financial transactions reported in the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER). Negative values indicate less-than-average financial openness. FIGURE 2.1.1.6 Intra-regional spillovers Spillovers from a growth slowdown in China would be sizeable for Hong Kong SAR, China; Thailand; Malaysia; Singapore; and Indonesia. Spillovers from a growth slowdown in Japan mainly affect Thailand, reflecting deep FDI and trade links. A. Response of growth to 1 percentage point decline in growth B. Response of growth to 1 percentage point decline in growth in China in Japan Source: World Bank. Note: Based on a Bayesian structural VAR model. The maximum data coverage is 1998Q1-2015Q2; time series coverage for some countries is shorter. The model is estimated for each spillover destination country. For instance, when Thailand is the spillover destination country, the variables are included, in the following Cholesky ordering: G-7 growth, EMBI, Japan’s growth, China’s growth, Korea’s growth, Thailand’s trade-weighted commodity prices, Thailand’s growth, and Thailand’s real effective exchange rates. Global spillovers refer to spillovers from the G7 countries. The model includes a dummy that captures the global financial crisis of 2008-09. Further details of the model, including the construction of the trade weighted commodity prices, are provided in Annex 3.2 of Chapter 3. Solid bars represent the median responses and the errors bars represent the 33-66 percent confidence bands. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E A S T A S I A A N D P A C IF I C 79 BOX 2.1.1 Regional integration and spillovers: East Asia and Pacific (continued) • Spillovers from Japan. Spillovers from Japan are FIGURE 2.1.1.7 Spillovers from G7 considerably smaller. A 1-percentage-point decline in excluding Japan Japan's growth reduces growth by 0.8 percentage Spillovers from the G7 (excluding Japan) are larger than point in Singapore, 0.5 percentage point in Thailand spillovers from China and Japan, especially for the highly open economies of Hong Kong SAR, China; Korea; (which has deep FDI links with Japan) and Hong Malaysia; Singapore; and Thailand. China’s growth Kong SAR, China, 0.3 percentage point in Malaysia, bolstered EAP growth during the pre-crisis years, but has and smaller amounts elsewhere. since weighed on regional growth. Since 2010. The slowdown in China and Japan growth has accounted for a significant portion of the slowdown in the rest of EAP Other studies find similar results (Table 2.1.1.2). For region, especially in 2014 and 2015. instance, Duval et al. (2014) report that a 1 percentage point decline in China’s growth would lower growth in the A. Spillovers from G7 excluding Japan median Asian economy by about 0.3 percentage point after a year, as compared with 0.1 percentage point for the median non-Asian economy. The IMF (2011) estimates that a 1-percentage-point growth decline in Japan would reduce growth in China by 0.18 percentage point, and by less than this in Indonesia and Korea.10 Shocks to growth in major advanced countries outside the region, such as the G7 (excluding Japan), also have a material impact. The most open and diversified regional economies—including Hong Kong SAR, China; Singapore; Japan; and Malaysia—are particularly vulnerable to growth fluctuations in the G7 (excluding Japan) (Figure 2.1.1.7). Quantitatively, the spillovers on EAP countries from a 1-percentage-point decline in B. Contributions to EAP growth growth in G7 countries (excluding Japan) are in several cases more than twice as large as the spillovers from an equivalent slowdown in China, and seven times as large as the spillovers from Japan.11 The sizeable implications of G7 (excluding Japan) growth shocks reflect both the globally diversified nature of the region’s exports, and the amplification of these shocks through their impact on China and Japan. Conclusion Countries in EAP are highly exposed to external shocks, including those originating from developing countries within the region, advanced economies outside the region, and to a lesser degree, Japan. China has experienced a Source: World Bank. A. B. Based on a Bayesian structural VAR model. The maximum data cover- age is 1998Q1-2015Q2; time series coverage for some countries is shorter. The model is estimated for each spillover destination country. For instance, 10Since Japan’s nancial sector is largely domestically oriented, nancial when Thailand is the spillover destination country, the variables are included in the following Cholesky ordering: G-7 growth (excluding Japan), EMBI, Japan’s spillovers from Japan are smaller than those from other systemically growth, China’s growth, Korea’s growth, Thailand’s trade-weighted commodity prices, Thailand growth, and Thailand’s real effective exchange rates. Global important economies. spillovers refer to spillovers from G7 excluding Japan. The model includes a 11Since the volatilities of growth for G7 (excluding Japan), China and dummy that captures the global financial crisis of 2008-09. Further details of Japan are historically di erent we also estimated impulse de ned in terms the model, including the construction of the trade-weighted commodity prices, are provided in Annex 3.2 of Chapter 3. of a 1-standard-deviation decline in growth. In this case, for ailand and B. Demeaned growth rates. Actual is the simple average growth of Hong Kong Indonesia, the spillovers from growth in China are larger than the SAR, China, Indonesia, Malaysia, Singapore, and Thailand. External variables spillovers from G7 growth (excluding Japan); for Singapore, the spillovers include G7 growth (excluding Japan), EMBI, trade-weighted commodity prices, real effective exchange rate. Domestic variable is growth of the spillover from G7 growth (excluding Japan) are slightly larger; and for most other destination country. countries, the two spillovers are comparable in magnitude. 80 C H A P TE R 2. 1 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.1.1 Regional integration and spillovers: East Asia and Pacific (continued) gradual growth slowdown since 2010. Meanwhile, Japan mainly based on trade, foreign direct investment, and has struggled to emerge from recession, and a series of tourism. Going forward, financial integration could deflationary shocks. Slowing or weak activity in the two accelerate. For example, if China were to liberalize more largest economies in the region has already weighed on fully its capital account, it could generate large capital growth in EAP countries. In addition, EAP countries, with flows to other emerging markets, as Chinese investors their highly diversified export markets, have also been held diversify their assets (Bayoumi and Ohnsorge 2013, back by the anemic recovery in high-income countries Hooley 2013). This would yield benefits, including outside the region. through greater investment, but would at the same time raise the potential for the transmission of shocks. The magnitude of spillovers, and financial spillovers in particular, is likely to increase. So far, regional links are TABLE 2.1.1.1 Membership of major actual and potential free trade agreements ASEAN APEC RCEP TPP FTAAP T-TIP Brunei Darussalam X X X X X Malaysia X X X X X Singapore X X X X X Vietnam X X X X X Indonesia X X X X Philippines X X X X Thailand X X X X Cambodia X X Lao PDR X X Myanmar X X Australia X X X X Japan X X X X New Zealand X X X X Korea, Rep. X X X China X X X Canada X X X United States X X X X Mexico X X X Chile X X X Peru X X X Taiwan, China X X Hong Kong SAR, China X X Papua New Guinea X X Russian Federation X X India X European Union X Source: World Bank. Notes: ASEAN (Association of Southeast Asian Nations), APEC=Asia-Pacific Economic Cooperation, FTAAP=Free Trade Area of the Asia-Pacific, RCEP=Regional Comprehensive Economic Partnership, TPP=Trans-Pacific Partnership Agreement, TTIP=Transatlantic Trade and Investment Partnership. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E A S T A S I A A N D P A C IF I C 81 BOX 2.1.1 Regional integration and spillovers: East Asia and Pacific (continued) TABLE 2.1.1.2 Literature review Author Methodology Results A 1 percentage point growth slowdown in China and Japan Bayesian SVAR (structural World Bank (2016) reduces growth in Malaysia and Thailand between -0.2 and vector autoregression) -0.5 percentage point after two years, respectively. Growth slowdown in China would affect major commodity exporters with less diversified economies, such as Ahuja and Nabar Panel regression Indonesia. Economies that lie within the Asian regional (2012) supply chain—Republic of Korea; Taiwan, China; and Malaysia—would also be adversely affected. Panel regression based on new value-added trade data A 1 percentage point decline in China’s growth may lower Duval et al. (2014) for 63 advanced and GDP growth in the median Asian economy by about 0.3 emerging economies during percentage point after a year. 1995–2012 A slowdown in China’s real GDP growth has a significant impact on neighboring countries, especially commodity Inoue, Kaya, and GVAR (global vector exporters (e.g., Indonesia). Export-dependent countries on Ohshige (2015) autoregressive) the EAP production cycle (Japan, Malaysia, Singapore, and Thailand) are also severely affected. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E U R OP E A N D CE N T R A L A S I A 83 GDP growth in the Europe and Central Asia (ECA) region is estimated to have eased to 2.1 percent in 2015 from 2.3 percent in 2014. The eastern part of the region was hit hard by sharply lower oil prices, geopolitical tensions (resulting, inter alia, in an output collapse in Ukraine), and intra-regional spillovers, especially from the Russian Federation. The western part of the region is benefiting from lower fuel import costs and a moderate recovery in the Euro Area. Growth is projected to accelerate to 3 percent in 2016, helped by a steadying of oil prices, a smaller contraction in Russia, and a recovery in Ukraine that is being underpinned by an IMF-supported stabilization program. The projection assumes a reduction in geopolitical tensions. Risks remain biased to the downside. A deterioration in the geopolitical environment, further falls in oil prices, or financial market turbulence associated with the U.S. interest rate tightening cycle, among other factors, could darken the outlook. Key policy challenges include addressing high domestic and external imbalances, adjusting to low commodity prices, implementing structural reforms to support investment and strengthen market mechanisms, and reducing elevated levels of non-performing loans in banking systems. reserves, and exchange rates reflect these Recent developments differences. Regional growth has slowed in recent years, The region continues to grapple with a substantial decelerating from 3.9 percent in 2013 to 2.3 debt overhang from the global financial crisis of percent in 2014, and to an estimated 2.1 percent 2008, as reflected in high levels of non-performing in 2015 (Table 2.2.1, Figure 2.2.1). Geopolitical loans. Both monetary and fiscal policy are tensions associated with Russia-Ukraine relations constrained by the weakness of output and led to the imposition of international sanctions on employment. High inflation and downward Russia, and contributed to a weakening of pressure on exchange rates, including in the largest confidence and investment. The combination of economies, limit the scope for more sanctions and lower oil prices have strongly accommodative monetary policy (Figure 2.2.2). affected Russia, generating adverse spillovers for Central banks in the eastern part have even had to the region as a whole (Box 2.2.1). Sustained low raise interest rates (Figure 2.2.3). Eroding fiscal oil prices continue to dampen activity and expose buffers and the recognition that part of the vulnerabilities. The impact varies considerably slowdown may be structural in nature are within the region. The eastern part has been hit increasing the need for consolidation. Uncertainty more heavily than the western part, and associated with the tightening cycle by the U.S. commodity exporters more than importers.1 The Federal Reserve, among other factors, are making trajectories of current account balances, foreign external financing conditions more difficult, as evidenced by elevated sovereign spreads. Note: e authors of this section are Christian Eigen-Zucchi and Ekaterine Vashakmadze. Research assistance was provided by Trang The eastern part of the region (Central Asia, Nguyen. Eastern Europe, and South Caucasus) has suffered 1 e eastern part of the region comprises Eastern Europe (Belarus, acutely from low commodity prices (Kazakhstan), Moldova, and Ukraine), South Caucasus (Armenia, Azerbaijan, and Georgia), and Central Asia (Kazakhstan, Kyrgyz Republic, Tajikistan, spillovers from Russia (Belarus, Georgia, Turkmenistan, and Uzbekistan). e western part includes Bulgaria, Moldova), and conflict (Ukraine). Commodity Romania, and Turkey, as well as the Western Balkans (Albania, Bosnia and Herzegovina, Kosovo, the Former Yugoslav Republic of exporters, especially of oil, are under pressure as Macedonia, Montenegro, and Serbia). persistent low prices move current accounts into 84 C H A P TE R 2. 2 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 FIGURE 2.2.1 Key indicators The economic contraction in Russia is generating Growth has decelerated since 2013. While a pickup is anticipated in the negative spillovers to neighboring countries, forecast period, prospects have weakened, leading to downward forecast through trade, investment, and remittances (ADB revisions. There are significant differences across the region. Eastern commodity exporters have seen more slippage in current account 2015). Eastern countries, including Armenia, balances and reserves (but from a stronger starting position), and have Kyrgyz Republic, Moldova, Tajikistan, and faced greater pressure on their currencies. Elevated non-performing loans Ukraine, receive substantial remittances from are a concern mainly among western non-commodity exporters and eastern commodity exporters. Russia, and these are a consumption-sustaining source of income for many households (World A. ECA growth and forecast revisions B. Sub-grouping growth and forecast Bank 2015k, Figure 2.2.4). Because of the revisions downturn in Russia and exchange rate effects, remittance flows to the ECA region (expressed in U.S. dollars) contracted in 2014, and are projected to fall sharply again in 2015: more than 15 percent in Ukraine, 30 percent in Tajikistan, and 59 percent in Uzbekistan (World Bank 2015l). Several countries in the eastern part of the region are especially exposed to weakening external C. Current account balances D. Foreign reserves demand, with a large share of exports destined to contracting Russia and Ukraine, or to slowing China and Kazakhstan (Figure 2.2.5). Commodity exporters are exposed to the economic slowdown in China directly through lower export volumes and indirectly through weakened commodity prices in all export markets. Only Turkmenistan and Uzbekistan have been able to sustain robust expansion in 2015 (deploying substantial fiscal buffers to boost spending), though even in these E. Nominal effective exchange rates F. Non-performing loans countries growth is slowing as the low price of commodities and steep falls in remittances from Russia reverberate through their economies. Russia is also a key source of foreign direct investment to eastern countries, which may be slowing as Russia grapples with recession. Economies in the western part of the region are more diversified, have closer economic links with Sources: World Bank; Haver Analytics; IMF World Economic Outlook, October 2015. B. C. D. Data for groupings are simple averages for all countries where data is available. the Euro Area, and tend to be oil importers. With E. The nominal effective exchange rate (NEER) of the grouping is calculated as the median of all countries data. a consumption-led pickup of growth in their largest trading partners in the Euro Area (World deficit, push down high levels of reserves, and Bank 2015m), and the persistence of low fuel weaken currencies. Although currency prices, the western part has seen strengthening depreciation and exchange rate flexibility may help external accounts, firming exchange rates, and economies adjust, it can result in accelerating easing inflation. These positive factors have helped inflation, necessitating tighter monetary policy. As to maintain a modest rate of growth. Although regards fiscal policy, while several commodity progress has been made in some countries, exporters had built substantial buffers during the elevated levels of non-performing bank loans commodity boom years, these are being eroded as remain a financial stability concern (Albania, budgets swing into deficit, narrowing the space for Bulgaria, Romania, and Serbia). Turkey, significant further stimulus. accounting for about half of developing ECA G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E U R OP E A N D CE N T R A L A S I A 85 GDP, is posting solid growth, despite headwinds FIGURE 2.2.2 Inflation and exchange rates for selected from political uncertainty and escalating tensions, countries especially in the southeast of the country. Inflation remains elevated in the largest ECA economies, as exchange rates have come under pressure against the U.S. dollar. Russia has experienced an intensifying recession A. Inflation rates B. Exchange rates against the U.S. since late 2014, with GDP off an estimated 3.8 dollar percent in 2015 (Figure 2.2.6). Plunging oil export revenues precipitated a deterioration of the external trade balance and a depreciation of the ruble. This has stoked inflation and undermined consumer confidence. International sanctions imposed in connection with the conflict in Ukraine are restricting access to external finance, which combined with uncertainty around U.S. interest rate tightening has led to elevated Sources: World Bank; Haver Analytics. A. Latest observation is November 2015. sovereign risk spreads. Russian domestic demand, B. Latest observation is December 01, 2015. An increase denotes an appreciation. especially investment, has fallen precipitously because of policy uncertainty, lack of confidence, FIGURE 2.2.3 Monetary and fiscal policy and the high cost of capital. At the same time, the The scope for countercyclical monetary policy has declined in eastern ECA room for policy maneuver has steadily declined. commodity exporters, as the authorities seek to stem currency depreciation Since an emergency hike of the policy interest rate and address elevated inflation. Low energy costs are easing inflationary pressures in western ECA, enabling the maintenance of low policy interest to 17 percent in December 2014, it was cut by 6 rates. Fiscal buffers have eroded, constraining potential stimulus percentage points to 11 percent during 2015. But initiatives. the scope for further reductions is limited by high A. Selected countries: Central bank B. Fiscal balances inflation. On the fiscal side, the surplus has swung policy rates into deficit mainly due to falling oil and gas revenues, which account for over 40 percent of government receipts. The 2015 budget has been revised to reflect more realistic oil prices and macroeconomic assumptions. Budgetary resources in the Reserve Fund were used aggressively to support activity at the beginning of 2015, and continue to be eroded. Sources: World Bank; Haver Analytics; IMF World Economic Outlook, October 2015. B. The data on sub-groupings is a simple average of all countries in each grouping. Growth in Turkey is estimated to have accelerated to 4.2 percent in 2015 from 2.9 percent in 2014. and to output, but the lira has depreciated Activity has been substantially above expectations, substantially so far this year, stoking inflation. despite geopolitical tensions (violence in the Weak exports (especially to Russia, which will fall Southeast and the refugee crisis emanating from further with the Russian imposition of sanctions Syria), as well as continuing policy uncertainty on Turkey) kept the current account deficit at that was amplified by the inconclusive June around 5.0 percent of GDP in 2015, despite a elections. The November elections gave the ruling substantially lower fuel import bill. Confidence- Law and Justice Party a majority in Parliament, sensitive portfolio flows play an important role in enabling the formation of a government without the external financing picture. coalition partners, but policy uncertainty remains, as key economic policy decisions of the new Growth in Kazakhstan is estimated to have slowed government are awaited. Growth in the third to about 0.9 percent in 2015 from the high rates quarter was led by higher government and private since the 2008 global financial crisis, largely due to consumption. Lower fuel import costs have weakening external and domestic demand. The provided support to the current account balance fall in oil revenues (crude oil accounts for about 86 C H A P TE R 2. 2 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 FIGURE 2.2.4 Remittances U.S. dollar in the last 4 months of 2015. Buffers remain large, with reserves still equivalent to more Remittance flows to ECA are large. In many countries they are equivalent to a substantial share of GDP and sustain consumption spending. The than 15 months of imports (goods and services). combination of recession or weak growth in key remittance sending Spending from the oil fund helped provide a countries (like Russia) and exchange rate depreciations against the U.S. dollar has translated into declines in remittance flows expressed in U.S. cushion in 2014, but was reined in during 2015 in dollars. recognition that with persistent low oil prices, a large part of the slowdown of growth may be A. Remittance inflows B. Remittance inflows structural rather than just cyclical. Like other oil exporters in the region, Kazakhstan is in the midst of a challenging adjustment period. Progress has been made to bolster the stability of the banking system, with a restructuring that lowered non- performing loans from 23.5 percent at the beginning of 2015 to below 10 percent in August. With the conflict in the east and the challenging Source: World Bank 2015l. external economic environment, output in Ukraine is estimated to have contracted by 12 FIGURE 2.2.5 Exposure to spillovers through trade and percent in 2015, after falling by 6.8 percent in foreign direct investment 2014. Industrial activity fell by even more. With Several countries are exposed to weak external demand, both from the the continued depreciation of the exchange rate largest economies within the region and from China, and rely on Russia and Turkey for much of their foreign direct investment. and a utility tariff adjustment, the inflation rate stood over 50 percent (y/y) for much of 2015. A. Export destinations, 2014 B. FDI inflows for selected countries, Amid the economic contraction, banks have 2014 become increasingly stressed, and their capacity to lend sharply constrained. Exports are down due to disruptions in trade with Russia (which accounted for one-quarter of Ukraine’s exports on average in 2010-14), conflict in the east (which damaged metals and mining production), and low commodity prices for metals and agricultural goods (which comprised more than 30 percent of Sources: World Bank; Haver Analytics. exports in 2012-14). While the current account A. Selected countries in Europe are the 10 largest importers: Austria, Belgium, Germany, France, Italy, Netherlands, Spain, Sweden, Switzerland, and United Kingdom. has been broadly in balance since April, helped by lower fuel costs, the capital account has seen net 70 percent of exports) have combined with outflows, as external debt payments have exceeded spillovers from the deepening recession and financing assistance from abroad. Ukraine reached currency depreciation in Russia, and the agreement on an $18 billion private debt slowdown of growth in China, to reduce export restructuring deal in September (including a 20 receipts. Domestic demand was slowed by tighter percent write-down for creditors), but remains in a credit, as the authorities raised policy interest rates debt dispute with Russia. The authorities in defense of the exchange rate. As a result, announced a moratorium on $3 billion in bond industrial production stagnated during 2015. The repayments due to Russia in December; Kazakh tenge has been under severe pressure in negotiations are ongoing. Low investor confidence exchange markets. The central bank intervened is reflected in sovereign spreads that are an order of aggressively, spending about 23 percent of official magnitude larger than the wide spreads faced by reserves in 2014 and 2015 in order to maintain Kazakhstan and Russia. Through these challenges, the rate. In August 2015, the authorities moved to the authorities are endeavoring to implement a a floating exchange rate, but continued to stabilization program, and fiscal consolidation was intervene to steady the market. The tenge ahead of targets noted in the four-year IMF depreciated by more than 40 percent against the program agreed in March 2015. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E U R OP E A N D CE N T R A L A S I A 87 FIGURE 2.2.6 Recent developments at the country level Outlook Weakening or contracting activity in Kazakhstan, Russia and Ukraine may In light of the weaker-than-expected expansion in have bottomed out. Pressures on Turkey have eased despite policy uncertainty. 2015, the forecast strengthening of growth for 2016-17 has been scaled back and is now expected A. Russian Federation B. Turkey to average about 3.3 percent in 2016-17, compared with a projection of 3.8 percent made in January 2015. The moderate growth improvement in the forecast period over 2015 depends on the management and mitigation of several key vulnerabilities, including persistent geopolitical tensions, sustained low oil prices, continuing policy uncertainty, and challenging external financing conditions. Prospects vary C. Ukraine D. Kazakhstan substantially across the eastern and western parts of the region, and between commodity exporters and importers. After the sharp fall in 2014 and 2015, commodity prices may decline modestly in 2016 and stabilize in 2017 and 2018, helping support a modest growth pickup in the eastern part of the ECA region in 2016-18. Much depends on Russia, where the forecast assumes that a bottoming out Sources: World Bank; Haver Analytics; IMF Regional Economic Outlook Update. A: Latest observations are December 2015 for oil prices, November 2015 for forecast growth (consensus), and of the ongoing recession in 2016 and the Oct 2015 for actual growth. B: Latest observations are Q3 2015. beginning of a recovery in 2017 will help support C: Latest observations are November 2015. D: Latest observations are December 2015 for oil prices, November 2015 for forecast growth (consensus), and growth in the rest of the sub-region, including June 2015 for actual growth. through the provision of FDI. Ukraine’s contribution to the regional growth aggregate is will be helped by easing unemployment, lower likely to swing significantly, as it rebounds from borrowing costs, and cheaper fuel. However, high the large 2015 contraction. Still, growth will be reliance on bank finance and weak alignment of subdued compared to the average rates of the legal, tax, and regulatory regimes (both prudential previous decade, and vulnerabilities remain. and corporate), have contributed to delays in resolving the debt overhang. These need to be The western part of ECA should grow moderately addressed in order to sustain credit growth and in 2016-18—with GDP increases ranging from an boost investment to pre-crisis levels. average of 2.5 percent in Serbia to 4 percent in Romania. Economic activity and trade balances of In Russia, a fall in economic activity by 3.8 the sub-region will benefit from the recovery in percent this year is expected to be followed by a the Euro Area, where output is projected to further 0.7 percent contraction in 2016, before expand by an average of 1.7 percent in 2016-17 growth turns positive in 2017. Prospects are with the support of accommodative ECB policies. weighed down by sustained low oil prices and Some countries also receive direct support for international sanctions. Weakening investor capital spending from European Structural and confidence and elevated interest rates are Investment Funds.2 Private consumption growth hampering investment, and the steep fall in consumer purchasing power is undermining consumption. Fiscal buffers are strained and the 2European Structural and Investment Funds comprise ve funds Reserve Fund may be drawn down by about two- aiming “to support economic development across all European thirds by the end of 2016 if, as planned, it is used Union countries, in line with the objectives of the Europe 2020 strategy.” See the European Commission website at http:// as the main source of financing for the federal ec.europa.eu/regional_policy/en/funding/. budget deficit in 2016 (projected at about 3 88 C H A P TE R 2. 2 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 percent of GDP). Recovery would be helped by may weaken private consumption. Lower fuel structural reforms that diversify the economy, costs are helping narrow the current account improve resource allocation, and strengthen deficit, but external financing needs remain corporate governance, as well as by an easing of substantial. While the bulk of Ukraine’s debt has geopolitical tensions. been restructured, the moratorium on payments to Russia raises uncertainty around the resolution of In Turkey, growth could remain at about 3.5 the debt dispute. The costs of restructuring banks percent in 2016-18. Vulnerabilities center on and reforming state-owned enterprises may pose currency depreciation and elevated inflation, further challenges to fiscal consolidation. which are weakening private consumption. In addition, the continuing need for large capital Risks inflows is a concern, especially since net reserves are modest. While the November elections have The ECA region faces numerous risks, including returned the ruling party to power with a majority possible intensification of geopolitical tensions, adequate to form a government without coalition persistent low commodity prices, and weakening partners, policy uncertainty persists. Moreover, remittance flows. A new shock associated with the lira depreciation raises the debt service burden of U.S. interest rate tightening cycle could lead to the corporate sector, which has large foreign less favorable external financing conditions. currency exposures. This dampens investment and Overall, risks appear to be weighted on the down- impinges on growth. Low oil prices and a firming side, and could undermine expectations of of activity in the Euro Area are helping stabilize continuing moderate growth, improving public the current account deficit at below 5 percent of finances, and firming external accounts. GDP. An acceleration of growth hinges on de- escalating tensions in the southeast and managing Several countries in the region face significant the refugee crisis emanating from Syria. geopolitical risks. An escalation or failure to resolve the conflict in eastern Ukraine would harm Growth in Kazakhstan is projected to remain flat the prospects of one of the largest economies in in 2016 and pickup in 2017-2018, with the the region and undermine confidence. It might Kashagan off-shore oil field coming online and also lead to sustained or sharpened sanctions on Russia’s economy improving. Weak domestic Russia, with additional negative spillovers. demand may limit industrial and services growth, Similarly, intensified violence and instability in however, as households seek to restore savings, Syria, with the attendant refugee crisis, would have firms endeavor to strengthen balance sheets, and direct impacts on Turkey, the Western Balkans, the government moves to consolidate fiscal and other parts of ECA. The economic effects of accounts. External demand may also remain weak, the refugee crisis over the next 1-2 years may be as non-commodity trade volumes are subdued. predominantly fiscal. Over time, as refugees Hence, growth is likely to be less than half the integrate into host countries and find productive average seen in 2011-14, and far below the 8.3 employment, the overall economic effects need percent rate averaged between 2000 and 2010. not be negative (EC 2015, World Bank 2015l). After a 12 percent contraction in 2015, Ukraine’s The structural adjustment to lower commodity economy may rebound modestly in 2016-18, prices, especially for oil, has been challenging for supported by an easing of the conflict in the east the region. With global markets well supplied and and continued progress on its IMF-backed reform demand subdued, commodity prices could remain program. Fiscal consolidation measures have been soft for some time, with a risk of further declines if introduced aiming to lower the deficit from 4.2 the slowdown in major emerging markets sharpens percent of GDP in 2015 to 3.2 percent of GDP in and the agreement with the Islamic Republic of 2017. These include cuts in pension benefits, Iran leads to a significant rise in oil supplies on reductions in the government workforce, and an world markets over the medium term. This could increase in utility tariffs combined with more increase pressure on commodity exporters and targeted social assistance. This fiscal tightening generate spillovers on economic partners. Low G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E U R OP E A N D CE N T R A L A S I A 89 commodity prices are already complicating the FIGURE 2.2.7 External financing efforts of commodity exporters to sustain buffers In a context of elevated risk spreads and lift-off of U.S. interest rates, meeting external financing needs may become significantly more costly. and pursue diversification strategies, and a further softening of prices would make this more difficult. A. External financing needs B. EMBI spreads Modest growth and weak exchange rates of remittance sending countries, especially Russia, may delay any rebound in remittances (now at comparatively low levels). This would increase vulnerabilities in countries like Tajikistan that are highly dependent on remittance inflows. The weakness in flows is being compounded by political factors, such as the repatriation of Tajik migrants from Russia after Tajikistan chose not to Sources: World Bank; Haver Analytics; IMF Regional Economic Outlook Update. B. Latest observation is December 01, 2015. join the Eurasian Economic Union. Many ECA countries have substantial external financing needs (Figure 2.2.7), and external credit Policy challenges conditions may become more difficult in part as a Policy needs to be aimed squarely at mitigating result of the U.S. interest rate tightening cycle. risks and addressing vulnerabilities, while boosting An instructive example is the “taper tantrum” in growth trajectories. Helped by stabilizing mid-2013, when market participants reassessed commodity prices and a more favorable economic the timeframe of the tapering of quantitative impetus from Russia, the authorities will need to easing in the United States, and developing rebuild buffers, including the scope for countries quickly felt the impact. At that time, implementing countercyclical monetary and fiscal the “Fragile Five” countries came under severe policy (IMF 2015f). Structural reforms will also be currency pressure as a result of a loss of investor essential to boosting long-term growth potential. confidence.3 Today, Kazakhstan, Russia, and Ukraine face similar macroeconomic The scope for countercyclical monetary policy is vulnerabilities, and spreads remain elevated. While mixed across the region, as the authorities seek to a U.S. tightening cycle has been widely anticipated balance growth and stabilization goals (Figure for some time, the first increases in U.S. policy 2.2.3). In many instances, this depends on interest rates since 2006 could bring bouts of whether or not the country is a commodity financial market volatility, uncertainty, and shifts exporter, and how the vulnerabilities associated in risk aversion, which could combine with with low prices have been managed. differences in near-term growth expectations to raise financing costs and curtail external financial Some oil exporters (Kazakhstan and Russia) have flows in some countries. Elevated funding costs had to implement pro-cyclical policy tightening to may also complicate efforts to repair balance sheets contain accelerating inflation and bolster and address high non-performing loan levels weakening currencies. Allowing further currency (EBRD 2015a). In the western part of ECA, depreciation could raise financial stability issues to challenges in Greece may generate spillovers the extent that debt is denominated in foreign (especially through financial sector channels) and currencies and debt service becomes more weaken investor confidence. difficult. Countries with sizable reserves have intervened aggressively in foreign exchange markets in order to support their currencies and smooth the adjustment process (Kazakhstan in 2014 and 2015, Russia in 2014). In countries where reserves may be insufficient for credible and 3 e“Fragile Five” comprised Brazil, India, Indonesia, Turkey, and South Africa. Turkey’s position is now somewhat improved, but sustained foreign exchange market intervention, remains vulnerable (Arteta et al. 2015). and foreign currency exposures threaten financial 90 C H A P TE R 2. 2 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 stability in the event of depreciation, capital countries are entering a period of fiscal outflow restrictions could be considered—as long consolidation that may further dampen growth. as they are accompanied by credible They face particular challenges in seeking to macroeconomic, financial, and structural policies rebuild fiscal space, as the fiscal break-even oil to restore long-term growth and reduce prices in many instances are far above the 2015 vulnerabilities. average of under $51/bbl. In the western part of ECA, composed mainly of Much of western ECA has benefitted from easing oil-importing countries, sustained low oil prices fiscal pressures in 2014 and 2015, helped by lower are easing pressure on exchange rates and helping fuel costs. Still, several countries (Albania, Bosnia dampen inflation. This has provided room to and Herzegovina, Kosovo, Former Yugoslav maintain low interest rates or reduce them further Republic of Macedonia, and Serbia) have had to support growth (Romania and Serbia). substantial budget deficits for much of the post- 2008 period, and will need to accelerate fiscal Monetary policy going forward may be consolidation in order to build fiscal space and complicated by the U.S. interest rate tightening strengthen buffers. These will be important not cycle. Higher U.S. rates could limit the scope for only to enable counter-cyclical fiscal policies going accommodative monetary policy in some ECA forward, but also to enhance the effectiveness of countries, which has been helping reduce fiscal stimulus, should it be needed in the future. borrowing costs and support efforts to repair bank balance sheets. Distressed assets held by banks are In a context of slowing growth, structural reforms a cause for concern, calling for measures to aimed at addressing supply side bottlenecks and recapitalize banks and address problem loans, as boosting potential growth become all the more well as longer-term reforms to improve important. Developing and articulating a clear governance, particularly in state-owned banks. program of reforms can help differentiate investor Enhanced supervision and prudential monitoring sentiment and support growth. While are needed where credit and solvency risks are implementation remains challenging, with benefits exacerbated by dollarization of the banking typically felt only in the medium and long term, system, as in several countries of the South they are essential and can play an important role Caucasus and Central Asia. in addressing vulnerabilities. Fiscal policy has varied considerably across the In the eastern part of ECA, there is substantial region. Many countries that were negatively scope to enhance competition and ease affected by the oil price declines (and spillovers administrative burdens (Belarus, Moldova and from Russia) implemented expansionary fiscal Ukraine), reduce energy subsidies (Azerbaijan, policy to cushion their slowdowns. Those less Tajikistan and Uzbekistan), and facilitate regional affected (or benefiting from smaller fuel import integration (as through the Eurasian Economic bills) used the opportunity to build fiscal buffers Union). Governance reforms will also be and lower fuel subsidies. Hence, there is important to improving medium-term prospects, substantial heterogeneity across the region, with especially restructuring state-owned enterprises eastern commodity exporters and others seeing a (Belarus) and implementing legal changes aimed significant erosion of fiscal buffers from positions at combating corruption and strengthening the of surplus in 2012, while western countries rule of law (Turkmenistan and Ukraine). strengthened public accounts but with deficits still averaging between 3 and 4 percent of GDP More rapid growth in the western part of the (Figure 2.2.3). region will hinge on supporting a rebound of investment, which remains subdued compared to Many oil exporters have had to tap into their pre-crisis levels. Public investment in several reserve funds. But with buffers falling and the countries is constrained by limited fiscal space. recognition that the growth slowdown may be in Private investment faces headwinds from firms still large part structural rather than cyclical, these working off their debt overhangs, and would be G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E U R OP E A N D CE N T R A L A S I A 91 helped by improving the business environment view of the heavy reliance on the banking sector to and easing regulatory burdens (Albania, Bosnia fund investment in the region, financial sector and Herzegovina, Serbia, and Turkey). In reforms can also play an important role in European Union member states (Bulgaria and strengthening the capacity to intermediate credit, Romania), investment is being supported by thereby boosting investment and job creation European Structural and Investment Funds, (Bulgaria, Romania, and Serbia). though absorptive capacity remains a challenge. In TABLE 2.2.1 Europe and Central Asia forecast summary (Annual percent change unless indicated otherwise) (Percentage point difference from June 2015 projections) 2013 2014 2015e 2016f 2017f 2018f 2015e 2016f 2017f Developing ECA, GDPa 3.9 2.3 2.1 3.0 3.5 3.5 0.3 -0.4 -0.2 Developing ECA, GDP excl. Ukraine 4.3 3.1 3.3 3.1 3.6 3.6 0.7 -0.4 -0.2 (Average including countries with full national accounts and balance of payments data only) b Developing ECA, GDPb 3.9 2.3 2.1 2.9 3.4 3.4 0.4 -0.5 -0.3 GDP per capita (U.S. dollars) 3.0 1.5 1.4 2.3 2.9 3.0 0.3 -0.4 -0.2 PPP GDP 3.8 2.1 1.5 2.8 3.4 3.4 0.1 -0.5 -0.3 Private consumption 5.1 0.5 1.8 3.3 3.6 3.6 -0.7 -0.3 -0.3 Public consumption 5.0 4.8 4.6 3.9 4.3 4.3 0.2 0.1 0.3 Fixed investment 2.1 -2.2 1.1 1.7 3.4 3.5 1.2 -0.9 0.2 Exports, GNFSc 0.6 1.2 -0.3 4.7 4.8 4.9 -4.1 0.0 -0.1 Imports, GNFSc 4.2 -3.6 -1.2 4.2 5.0 5.1 -5.4 -1.4 -1.7 Net exports, contribution to growth -1.4 1.7 0.3 0.1 -0.2 -0.2 0.6 0.6 0.7 Memo items: GDP Broader geographic regiond 2.2 1.8 0.2 1.7 2.7 2.8 -0.1 -0.6 -0.4 Central Europe, Western Balkans, and Turkey 2.4 2.8 3.6 3.3 3.4 3.4 0.8 0.0 0.0 Central Europee 1.3 2.8 3.3 3.2 3.4 3.4 0.5 0.2 0.2 Western Balkansf 2.5 0.4 1.9 2.6 3.0 3.5 0.4 0.1 0.1 Eastern Europeg 0.6 -4.0 -9.1 0.5 1.7 1.7 -3.0 -0.6 -0.7 South Caucasus h 5.0 3.2 2.1 1.3 2.0 3.1 0.6 -1.4 -1.1 Central Asiai 6.8 5.6 2.8 3.2 4.8 4.9 -0.6 -1.2 -0.6 Russian Federation 1.3 0.6 -3.8 -0.7 1.3 1.5 -1.1 -1.4 -1.2 Turkey 4.2 2.9 4.2 3.5 3.5 3.4 1.2 -0.4 -0.2 Ukraine 0.0 -6.8 -12.0 1.0 2.0 2.0 -4.5 -1.0 -1.0 Source: World Bank. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not differ at any given moment in time. a. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. b. Sub-region aggregate excludes Bosnia and Herzegovina, Kosovo, Montenegro, Serbia, Tajikistan, and Turkmenistan, for which data limitations prevent the forecasting of GDP components. c. Exports and imports of goods and non-factor services (GNFS). d. Includes developing ECA and the following high-income countries: Croatia, Czech Republic, Hungary, Poland, Russian Federation, Slovak Republic, and Slovenia. e. Includes Bulgaria, Croatia, Czech Republic, Hungary, Poland, Romania, Slovak Republic, and Slovenia. f. Includes Albania, Bosnia and Herzegovina, Kosovo, FYR Macedonia, Montenegro, and Serbia. g. Includes Belarus, Moldova, and Ukraine. h. Includes Armenia, Azerbaijan, and Georgia. i. Includes Kazakhstan, Kyrgyz Republic, Tajikistan, Turkmenistan, and Uzbekistan. 92 C H A P TE R 2. 2 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 TABLE 2.2.2 Europe and Central Asia country forecasts (Real GDP growth at market prices in percent, unless indicated otherwise) (Percentage point difference from June 2015 projections) 2013 2014 2015e 2016f 2017f 2018f 2015e 2016f 2017f Albania 1.4 2.0 2.7 3.4 3.5 3.5 -0.3 -0.1 0.0 Armenia 3.3 3.5 2.5 2.2 2.8 3.0 1.7 -0.5 -0.2 Azerbaijan 5.8 2.8 2.0 0.8 1.2 2.7 0.5 -1.8 -1.5 Belarus 1.1 1.6 -3.5 -0.5 1.0 1.0 0.0 0.5 0.0 Bosnia and Herzegovina 2.5 0.8 1.9 2.3 3.1 3.5 -0.1 0.0 0.2 Bulgaria 1.3 1.5 2.9 2.2 2.7 2.7 1.8 0.2 0.0 Georgia 3.3 4.8 2.5 3.0 4.5 5.0 0.5 0.0 -0.5 Kazakhstan 6.0 4.4 0.9 1.1 3.3 3.4 -0.8 -1.8 -0.8 Kosovo 3.4 1.2 3.0 3.5 3.7 4.0 0.0 0.0 0.0 Kyrgyz Republic 10.9 3.6 2.0 4.2 3.4 4.3 0.3 1.0 -0.6 Macedonia, FYR 2.7 3.5 3.2 3.4 3.7 3.7 -0.3 -0.4 -0.3 Moldova 9.4 4.6 -2.0 0.5 4.0 4.0 0.0 -1.0 0.0 Montenegro 3.5 1.8 3.4 2.9 3.0 2.9 0.0 0.0 0.1 Romania 3.5 2.8 3.6 3.9 4.1 4.0 0.6 0.7 0.6 Serbia 2.6 -1.8 0.8 1.8 2.2 3.5 1.3 0.3 0.2 Tajikistan 7.4 6.7 4.2 4.8 5.5 5.5 1.0 0.4 0.3 Turkey 4.2 2.9 4.2 3.5 3.5 3.4 1.2 -0.4 -0.2 Turkmenistan 10.2 10.3 8.5 8.9 8.9 8.9 0.5 -0.1 -0.1 Ukraine 0.0 -6.8 -12.0 1.0 2.0 2.0 -4.5 -1.0 -1.0 Uzbekistan 8.0 8.1 7.0 7.5 7.7 7.7 -0.6 -0.3 -0.3 2013 2014 2015e 2016f 2017f 2018f 2015e 2016f 2017f Recently transitioned to high income countriesa Croatia -1.1 -0.4 1.0 1.4 1.7 2.0 0.5 0.2 0.2 Czech Republic -0.5 2.0 4.0 2.5 2.9 2.9 1.6 0.0 0.1 Hungary 1.9 3.7 2.8 2.5 2.7 3.0 0.4 0.0 0.0 Poland 1.7 3.4 3.5 3.7 3.9 3.9 -0.1 0.1 0.3 Russian Federation 1.3 0.6 -3.8 -0.7 1.3 1.5 -1.1 -1.4 -1.2 Slovak Republic 1.4 2.5 3.1 3.3 3.5 3.5 0.7 0.6 0.3 Slovenia -1.1 3.0 2.4 2.1 2.0 2.0 0.7 -0.4 0.0 Source: World Bank. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not significantly differ at any given moment in time. a. Based on the World Bank's reclassification from 2004 to 2015. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E U R OP E A N D CE N T R A L A S I A 93 BOX 2.2.1 Regional integration and spillovers: Europe and Central Asia As a region with a generally high degree of openness, Europe and Central Asia (ECA) is vulnerable to spillovers from major advanced economies and emerging markets. Although there is wide heterogeneity, spillovers reflect the region’s increasing integration with the European Union and dependence of several large economies in ECA on commodity exports. China is gaining prominence as a trading partner especially for energy exporting economies. Within-ECA ties are pronounced with the Russian Federation, particularly in the eastern part of the region. Estimates suggest that a 1 percentage point growth slowdown in Russia could set back growth in other ECA countries by an average of 0.3 percentage point over two years. Spillover effects from Turkey, the second largest emerging market economy in the region, are small and limited to a few neighboring countries. Encouraging investment into internationally competitive sectors and increasing geographic diversification could lessen vulnerabilities to growth shocks. Introduction FIGURE 2.2.1.1 Cross-region comparison The Europe and Central Asia region is generally very open, The ECA is generally very open, despite wide within- region heterogeneity. The region accounts for about 8 despite wide within-region heterogeneity. Its economy percent of world trade flows and 12 percent of represents about 6 percent of global GDP, broadly similar international remittances. Exposures to global financial to that of the Latin America and Caribbean region, but investment tend to be lower, with the exception of Turkey. about a third less than that of the East Asia and Pacific region. The region accounts for about 8 percent of world A. ECA: Share of global activity, trade and finance, 2014 trade flows, and 12 percent of international remittances (Figure 2.2.1.1). Trade is equivalent to 74 percent of GDP and remittance inflows about 1.5 percent of GDP. Exposures to global financial investment tend to be lower, with the exception of Turkey. The region’s openness reflects increasing integration with the European Union (EU) and the presence of several large commodity-exporting economies. The latter makes ECA vulnerable to global commodity price fluctuations. Goods and factor market integration with the rest of the world stems from extensive trade and economic agreements, as well as well-linked transportation networks. The Western part of the region includes several members of the EU and is integrated with EU supply chains and labor markets B. ECA: Trade and finance in regional comparison, 2014 (Figure 2.2.1.2). In the eastern part, notwithstanding trade and economic agreements with Russia, trade and investment from China are gaining prominence (Chapter 3). Meanwhile, the share of the U.S. in regional trade has gradually diminished. Russia is a prominent source of within-region trade and remittance flows and, to a lesser extent, foreign direct investment. These linkages are tighter in the Eastern part of the region. Integration with Turkey—the second largest regional economy—is limited, and associated spillovers are correspondingly modest. This box discusses the main spillovers from outside the region, as well as from the two largest economies inside the Sources: IMF October 2015 World Economic Outlook; IMF International Finan- cial Statistics; IMF Direction of Trade Statistics; IMF Coordinated Portfolio region, Russia and Turkey. Specifically, it discusses the Investment Survey; UNCTAD FDI/TNC database; World Bank Remittance and Migration Database; World Bank World Development Indicators. following questions: B. The red bar denotes exports, imports, trade, remittance inflows, portfolio liabilities and FDI inflows in percent of GDP on average across ECA countries. The vertical line denotes the range of averages for all six developing country Note: Prepared by Ekaterine Vashakmadze and Duygu Guven, with regions. contributions from Raju Huidrom and Jesper Hanson. Research assistance was provided by Trang Nguyen and Qian Li. 94 C H A P TE R 2. 2 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.2.1 Regional integration and spillovers: Europe and Central Asia (continued) • How open is the ECA region to global and regional trade and financial flows? FIGURE 2.2.1.2 Main features of the ECA region • How large are the potential intra-regional spillovers There are deep trade and remittance networks within the from the region’s two largest economies, Russia and region and with the Euro Area. Intra-region flows of Turkey? remittances are large. Russia and Turkey together account for more than 50 percent of the region’s GDP and How open is the ECA region to global and regional exports. trade and financial flows? A. Regional Integration, 2014 Despite wide regional variation, the majority of ECA countries are highly open to global trade (Figure 2.2.1.3). They also receive substantial FDI and remittance inflows, especially from the Euro Area. Most countries in the region, with the exception of Turkey, receive limited portfolio inflows. Integration with the Euro Area. ECA countries, like those in other developing regions, are predominantly linked to the major advanced countries in their proximity: the Euro Area is the single largest trading partner and source of financial flows to ECA. In addition to geographical proximity, interlinkages with the Euro Area also reflect that most countries in the western part of the region are B. Six largest economies of the region (average 2011-14) members of the EU or have European Association Agreements in place. This has deepened supply-chain integration and encouraged labor mobility. ECA’s trade with the Euro Area rose from negligible levels in the 1990s to over 50 percent of total trade in 2014, including for the eastern part of the region (over 40 percent in Azerbaijan, Kazakhstan, and Russia, and over 25 percent in Armenia, Belarus, Georgia, and Ukraine). The EU is the primary source of remittances for the Western Balkans (Albania, Bosnia and Herzegovina, Kosovo, FYR Macedonia, Montenegro, Serbia) and to a lesser extent, for Armenia, Georgia, and Moldova. They amount to around 10 percent of GDP in Kosovo and Moldova, 7 percent of GDP in Albania, and about 2 percent of GDP in Armenia and Georgia. Sources. IMF World Economic Outlook; IMF International Financial Statistics; IMF Direction of Trade Statistics; IMF Coordinated Direct Investment Survey; World Bank; International Investment Position. A tilt towards China. Trade with China has increased A. ECA countries include: Albania, Armenia, Azerbaijan, Belarus, Bosnia and Herzegovina, Bulgaria, Czech Republic, Georgia, Hungary, Kazakhstan, sharply since 2009, especially for energy-exporting Former Yuguslav Republic of Macedonia, Moldova, Montenegro, Poland, Romania, Serbia, Tajikistan, Turkey, Turkmenistan, Ukraine, Uzbekistan, and economies like Azerbaijan, Kazakhstan, Russia, and Russia. Turkmenistan, where exports to China surpassed 10 A. B. Portfolio liabilities denote stock of portfolio investment liabilities. percent of total exports in 2014 (Figure 2.2.1.4). Over the medium term, trade with China should continue to grow Within-region ties. Within-region ties to Russia are as new pipelines between the major energy exporters particularly strong regarding trade and remittance flows. (Kazakhstan, Uzbekistan, Russia) and China are Direct economic ties with other large economies in the constructed, and the on-going negotiations of free trade region, which are predominantly trade-based, have grown agreements between China, Georgia, and Moldova are rapidly from a low base. Thus, the share of exports to approved and implemented. Turkey increased substantially in the 2000s, reaching 20 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E U R OP E A N D CE N T R A L A S I A 95 BOX 2.2.1 Regional integration and spillovers: Europe and Central Asia (continued) FIGURE 2.2.1.3 Trade, remittances, and foreign direct investment Intra-regional trade integration is divided between east and west. The eastern part of the ECA region is integrated with the rest of the region—especially Russia—through trade and remittances. The western part of the region is integrated with the Euro Area through trade, portfolio flows, FDI, and remittances. A. Trade linkages, 2014 B. Remittances, 2014 C. FDI inflows, 2008-12 D. FDI inflows from to Russia, Euro Area, and United States, 2013 Sources: IMF; World Bank; UN Comtrade. Note: Region includes Russia. Euro Area is considered outside the region. percent of total trade for Georgia and is around 7 percent ECA’s trade and 30 percent of trade in some Central for Bulgaria, Tajikistan, and Uzbekistan. Asian countries (Figure 2.2.1.4).1 This reflects the large size of the Russian economy and the legacy of Ties with Russia. Intra-regional ties are deepest in the Eastern part of the region, mainly reflecting the close links 1In Central Asia, the share of exports to Russia was 15.4 percent of total between Russia and its Eurasian Economic Union trade exports in 2014. Exports to Russia account for about half of Azerbaijan’s partners (Armenia, Belarus, Kazakhstan, and the Kyrgyz non-oil exports, while for Armenia, exports to Russia, mostly food and Republic), despite a declining share of Russia in the brandy, constitute about 20 percent. Turkmenistan and Uzbekistan region’s trade. export gas to Russia, though they have been increasingly diversifying toward other markets, primarily China. Imports from Russia, especially energy, are also relatively large. For Armenia and Tajikistan, energy • Trade. Russia remains a major trading partner for imports from Russia amount to about 30 percent of their total energy regional economies, accounting for 8 percent of consumption (IMF 2015g). 96 C H A P TE R 2. 2 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.2.1 Regional integration and spillovers: Europe and Central Asia (continued) FIGURE 2.2.1.4 Main export markets Russia is an important export market for the eastern part of the region, whereas the Euro Area is the main export destination for the western parts of the region. Over the 2000s, there has been a gradual shift towards exports to China and, for countries in the South Caucasus, exports to Turkey. A. Exports to major economies, 2014 B. Exports to China, Euro Area and Russia, C. Exports to Russia 2014 D. Exports to China E. Share of within-region trade over time F. Exports to countries within the region, 2014 Sources: IMF; World Bank; UN Comtrade. Note: Region includes Russia. Euro Area is considered outside the region. trade integration and economic agreements within the • Migration and remittances. Remittances from Russia region. The Eurasia Economic Union (EEU) among account for about 62 percent of remittance inflows to Armenia, Belarus, Kazakhstan, the Kyrgyz Republic, the eastern part of the region. Large migration and Russia, came into force in 2015, aiming to movements have been fostered by free or liberal visa promote closer economic integration. Still, Russia’s regimes, strong historic ties, and a common language. share in the region’s trade has diminished steadily over Opportunities created by a shrinking Russian working the past two decades, following trade liberalization -age population in contrast to a growing Central Asian and expansion with Europe and more recently with one have also encouraged migration of workers to China. Russia. Remittances from Russia represent an important source of income for several regional • Tourism. Russia’s rapidly growing tourism industry has economies in Central Asia (the Kyrgyz Republic, created economic opportunities for the region. Tajikistan, Uzbekistan), South Caucasus (Armenia, Providing tourism-related services to Russia has Georgia), and Eastern Europe (Moldova, Ukraine).2 become an important source of external earnings for In 2015, these remittance flows and their real value several countries in Southeastern Europe (Bulgaria, dropped sharply with the steep recession in Russia and Croatia, Romania, and the Western Balkans) and the South Caucasus (Azerbaijan, Belarus, Bulgaria, Kazakhstan, Montenegro, Turkey) (World Economic 2In 2014, remittances from Russia accounted for about 43 percent of Forum 2015; Figure 2.2.1.5). GDP in Tajikistan, 30 percent in the Kyrgyz Republic, and 20 percent in Armenia. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E U R OP E A N D CE N T R A L A S I A 97 BOX 2.2.1 Regional integration and spillovers: Europe and Central Asia (continued) FIGURE 2.2.1.5 Tourism and remittances Central Asia relies heavily on remittances from Russia, whereas countries in the South Caucasus receive large remittances from the Euro Area. Outbound tourism from Russia is an important source of income for several countries in the region, including Bulgaria, Georgia, Montenegro, and Turkey. A. Inbound tourism B. Outbound tourism C. Remittance inflows by source economy, 2014 Source: World Bank; World Tourism Organization. A. Inbound tourism denotes non-resident visitors within the economic territory of the country of reference. B. Outbound tourism denotes resident visitors outside the economic territory of the country of reference. the large ruble depreciation (World Bank 2015l). In • Foreign direct investment. Russian foreign direct addition, new Russian regulations, which took effect investment accounts for a sizeable share of foreign in January 2015, bar immigrants who overstay their direct investment in Armenia, Belarus, and the Kyrgyz one year visas from re-entering Russia for the next ten Republic (all members of the EEU), as well as in years, as well as raising fees for migrant laborers and Tajikistan. migrants from non-EEU countries. These regulations may encourage many, especially for non-EEU How large are the potential intra-regional spillovers countries, to leave earlier than they had planned.3 from the region’s two largest economies, Russia Absorbing returning workers into domestic economies and Turkey? could pose challenges. Reflecting openness and substantial commodity exports, • Bank lending. Direct cross-border lending by Russian the ECA region is more vulnerable to growth shocks banks is limited, but Russian-owned banks account originating outside the region than within (Chapter 3). for about 10 percent of banking system assets in Nevertheless, strong within-region trade, finance and several countries (Belarus, Kazakhstan, Ukraine) remittance links are reflected in sizeable spillovers, (Stepanyan et al. 2015). Some Azerbaijani and Kazakh especially from Russia. banks have subsidiaries in Russia, but their assets are small (about 2 percent of the home country’s GDP). In addition to the trade and financial channels for the Latvia is the recipient of large non-resident deposits, transmission of growth shocks within the region, there equivalent to about 50 percent of total deposits, much may be significant spillovers through less measurable of which is presumed of Russian origin (Stepanyan et channels, including through policy and confidence al. 2015). (Clinton et al. 2010). To capture direct as well as indirect effects, a Bayesian structural vector autoregression model is estimated for 1998Q1-2015Q2. For each country, the variables included are as follows, in order they are used 3Hundreds of thousands of migrant workers are reported to have in the model: growth in the rest of the world; the returned to Tajikistan, Uzbekistan and, to a lesser extent, the Kyrgyz JPMorgan Emerging Market Bond Index; growth in Republic (EBRD 2015b). Russia and Turkey; trade-weighted average commodity 98 C H A P TE R 2. 2 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.2.1 Regional integration and spillovers: Europe and Central Asia (continued) prices; growth in the affected country; and the real effective exchange rate of the affected country. Explicit FIGURE 2.2.1.6 Regional spillovers trade linkages should not affect estimation results, since the Spillovers from Russia are sizeable, particularly in the VAR model does not explicitly include variables for direct eastern part of the region, which is deeply integrated with trade links, it is rather estimating direct growth on growth Russia through trade and remittances. Spillovers from impact. The exercise focuses on estimating the impact of Turkey are smaller, and mostly local, but may be gaining growth shocks in the two largest economies—Russia and importance. Turkey—on other countries in the region. Spillovers are A. Impact on growth of a 1 percentage point decline in estimated as the response of growth in a country to a 1 Russia’s growth percentage point decline in growth in the source country of the shock (Russia or Turkey).4 Russian growth shocks have sizeable effects across the region. The estimates suggest that a 1 percentage point decline in Russian growth reduces growth in other ECA countries by an average of 0.3 percentage point over two years (Figure 2.2.1.6). The estimated impact is larger in countries in the South Caucasus (0.6 percentage point in Armenia). The estimated impact for Kazakhstan (0.3 percentage point)—the only central Asian economy where data was available for the estimation—was in line with the average impact for the region. In other countries, the impact is more modest. Other authors report similar findings (see summary table B. Impact on growth of 1 percentage point decline in below). The remittances channel is particularly important Turkey’s growth for oil importers in the eastern part of the region; the trade channel has weakened over time; the FDI channel is significant for Armenia and Tajikistan; and the financial sector channel is limited, because of the modest presence of Russian banks (Ilahi et al. 2009, IMF 2015g). Overall, the study finds that Russian growth shocks are associated with sizable effects on growth in Belarus, Kazakhstan, and Tajikistan.5 These authors find that a severe simulated shock, involving a 4 percent decline in Russian GDP, a deterioration in confidence, an increase in capital cost, and a slowdown in the productivity growth of the Russian tradable goods sector, could reduce GDP in CIS countries by 2.5-3 percent below the baseline over one year (IMF, 2015f). This is broadly proportional to the results presented above and the magnitude of spillovers is broadly Source: World Bank. Note: Cumulative impact response after two years of each country’s real GDP growth to a 1 percentage point decline in Russia’s or Turkey’s growth. Based on estimates of a structural VAR using data from 1998Q2-2015Q2. 4To facilitate comparisons across models, responses are scaled by the cumulative change in the source country in the same quarter (1 percentage point, by de nition), after one year and after two years. e estimations require quarterly data . in line with trade links (Stepanyan et al. 2015). Effects are 5 e estimated spillover e ects of a one standard deviation shock to amplified by remittances from Russia (for Armenia, the Russian GDP (about 2 percent) peak after two quarters to reach 0.6 percent in Belarus, 1.7 percent in Kazakhstan, and 2 percent in Moldova and other oil importers in Caucasus and Central Tajikistan. e impact would last between 3 and 6 quarters. e Asia) and the impact of depreciations on banking sectors estimated e ects are less signi cant in Georgia and the Kyrgyz Republic (Kazakhstan). The ongoing crisis in Russia and Ukraine and not signi cant in Moldova and Uzbekistan. has had limited spillovers on Europe (Husabø 2014). The G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 E U R OP E A N D CE N T R A L A S I A 99 BOX 2.2.1 Regional integration and spillovers: Europe and Central Asia (continued) growth by 0.5 and 0.2 percentage point, respectively, over FIGURE 2.2.1.7 Spillovers from the rest two years. Spillovers to other ECA countries are smaller. of the world Global spillovers are larger than within-region spillovers, Estimated spillovers from the rest of the world are larger reflecting the openness of the region, especially to the than those from either Russia or Turkey. A 1 percentage Euro Area and to world commodity markets. point decline in the rest of the world growth would reduce Impact on growth of 1 percentage point decline in the rest of growth in ECA countries by 1.7 percentage points over the world growth two years (Figure 2.2.1.7). This broadly reflects the deep integration of the western part of the region with the Euro Area, and of the eastern part of the region with global commodity markets. Conclusion ECA is one of the most open developing regions to trade, remittances, and FDI. For historical reasons, it has vibrant intra-regional trade and financial networks, especially in the East of the region, which retains strong ties to Russia despite a gradual shift towards China. The West of the region is deeply integrated into supply chains and, to some extent, labor markets in the EU. Because of this openness, and the presence of several large commodity exporters, the Source: World Bank. ECA region is more vulnerable to global growth shocks Note: Cumulative impulse response after two years, scaled by cumulative impulse response of growth in source country of shock. than to shocks originating from within the region. The Solid bars represent the median responses and the errors bars represent the rapid expansion of economic links with China is shifting 33-66 percent confidence bands. the potential source of external disturbances. The eastern part of the region remains vulnerable to a growth slowdown in Russia, through trade and remittances links. largest estimates are for countries with sizeable export exposures to Russia (Finland, Latvia, Lithuania, Slovakia, Planned infrastructure investment into regional road and and Slovenia), but even in these cases there is less than 0.5 rail corridors, combined with continued trade percentage point decline in growth in response to a liberalization and improved business environments, negative 1 percent shock in Russia. Others have also found could help diversify the region’s trade partners and sources that the effects of shocks from Russian GDP on activity in of finance. Barriers to open markets are particularly Baltic countries are not large (Obiora 2009). At most, a 1 significant in Central Asia (World Bank 2015f). Reducing percent decline in Russia’s GDP reduces Lithuania’s GDP these barriers would spur productivity and increase by about 0.5 percentage point. These spillovers are resilience to external shocks. Tariffs remain relatively weak because of increasing trade and financial high in Uzbekistan and Turkmenistan; non-tariff barriers integration with the EU and declining trade with Russia require streamlining in Kazakhstan and Russia; and trade (Shiells et al. 2005). facilitation can be further improved across the region. Current low commodity prices heighten the importance Our estimates suggest that growth shocks in Turkey have of diversification in commodity-exporting countries, smaller, and mostly local, repercussions for countries in the by initiatives to build institutions that reduce economic neighborhood. A 1 percentage point decline in growth in volatility, change incentives away from non-tradables, Turkey reduces growth in other ECA countries by an penetrate new and dynamic export markets, encourage average of 0.1 percentage point over two years. The FDI in new industries, and build human capital (Gill et estimated impact is larger in Bulgaria and Romania where al. 2014). a 1 percentage point decline in growth in Turkey reduces 100 C H A P TE R 2. 2 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 TABLE 2.2.1.1 Summary of the literature Author Methodology Results World Bank (2016) Bayesian A 1-percentage-point growth decline in Russia reduces GDP in structural vector Armenia and Kazakhstan by 0.6 and 0.3 percentage point, autoregression respectively, after two years. Growth shocks in Turkey have a smaller effect on growth in other countries in the region. A 1-percentage-point decline in growth in Turkey reduced growth in the region by 0.1 percentage point on average after two years. Ilahi et al. (2009) Panel regression; Russian growth shocks have strong effects on Belarus, Kazakhstan, Vector Tajikistan, and, to some extent, Georgia and the Kyrgyz Republic. In autoregression Belarus, Kazakhstan, and Tajikistan the spillover effects on GDP (VAR). 1997-2008 growth are 0.6 percent to 2 percent, respectively. The effects are less significant in Georgia and the Kyrgyz Republic, and not significant in Panel: annual Moldova and Uzbekistan. data. VAR: quarterly data. Obiora (2009) VAR There are significant cross-country spillovers to the Baltics with those from the EU outweighing spillovers from Russia. Lithuania’s GDP response to a one percent shock from Russia occurs contemporaneously with growth of about ½ percent. Husabø (2014) VAR Spillovers from Russian GDP growth are largest for Finland, Latvia, Lithuania, Slovakia, and Slovenia (i.e., countries with the largest export exposures to Russia). Economic activity in the broader Latin America and the Caribbean contracted in 2015, amid lower commodity prices, decelerations in major trading partners, and persistent domestic challenges among the region’s largest economies. With commodity prices expected to stabilize, coupled with the continued recovery in the United States and Euro Area, regional growth is expected to improve over the medium term. Major downside risks include further declines in commodity prices, bouts of financial volatility, sharp falls in capital flows, and protracted economic downturns among the region’s largest economies. Recent developments Output in the South American sub-region experienced a particularly marked reduction in 2015.1 With GDP falling in Brazil, Ecuador and Economic activity in the broader Latin America the República Bolivariana de Venezuela, South and the Caribbean (LAC) region contracted in America saw overall economic growth turn 2015. Following three consecutive years of slowing negative, to an estimated -2.1 percent in 2015, growth, output in the region fell 0.9 percent in after tepid growth in 2014. Investment in Brazil 2015, partly reflecting sharp declines in economic has been dropping since 2013 due to investors’ activity of large regional economies, such as Brazil loss of confidence, which was exacerbated in 2015 and the República Bolivariana de Venezuela by the widening investigations into the Petrobras (Table 2.3.1, Figure 2.3.1). This reduction in scandal. Monetary and fiscal tightening, output stemmed from a combination of global accelerating inflation, and concerns about growing and domestic factors, particularly the continued fiscal deficits also weighed on investment. The slump in commodity prices. Lower crude oil prices República Bolivariana de Venezuela too is in – down around 45 percent from 2014 levels – recession, with very high rates of inflation. have reduced export earnings and fiscal revenues Controls that restrict imports of vital consumer of regional oil exporters, such as Belize, Colombia, goods and intermediate inputs have curtailed Ecuador, Mexico, and the República Bolivariana private consumption and impeded manufacturing. de Venezuela. Depressed prices of copper, iron The appreciation of the U.S. dollar has meant a ore, gold, and soy beans have worsened the terms- loss of competitiveness for the fully dollarized of-trade for commodity exporters, such as Brazil, Ecuadorean economy. This, together with lower Chile, the Dominican Republic, and Peru. A oil prices, has pushed Ecuador into a recession in number of governments had to undertake pro- 2015. In contrast, Argentina saw activity rebound cyclical fiscal tightening, aggravating the economic in 2015.2 However, the increase in activity might slowdown. Several large South American not be sustainable as it was partly due to a surge in economies have also been grappling with severe pre-election public spending, while net exports domestic macroeconomic challenges that have have been falling and inflation has been high. eroded consumer and investor confidence, further Other large economies, particularly commodity contributing to the regional output decline in exporters, are continuing to grow at tepid rates. 2015. Note: e author of this section is Derek H. C. Chen. Research 1 e South American sub-region includes: Argentina, Bolivia, assistance was provided by Mai Anh Bui. e discussion in this Brazil, Chile, Colombia, Ecuador, Guyana, Paraguay, Peru, Uruguay, section includes both developing and high-income economies in the and the República Bolivariana de Venezuela. Latin America and the Caribbean region. 2Based on o cial national accounts data. 102 C H A P TE R 2. 3 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 FIGURE 2.3.1 GDP growth, 2014-2015 curtailed government revenues, and compelled Regional GDP contracted in 2015, because of recessions in large South fiscal tightening. American economies. Output continued to grow in developing Central and North America and the Caribbean. Economic growth in the Caribbean moderated in 2015, with output expanding by 3.3 percent.4 The Dominican Republic, the largest economy in the sub-region, experienced a contraction in mining exports, as prices fell. A surge in investment, including the construction of new public schools and two new coal-fired power plants, provided some support to output. In contrast, Jamaica saw growth pick up, amid increased business and consumer confidence, a successful IMF Extended Fund Facility program review, and stronger mining output.5 The sharp fall in commodity prices, predominantly due to well-supplied markets, adversely affected commodity exporters in LAC. In 2015, prices of agricultural products declined Source: World Bank. by about 13 percent, metals by 21 percent, and Note: e= estimated. GDP weighted averages. precious metals by 11 percent from 2014 (Figure FIGURE 2.3.2 Commodity prices 2.3.2). Oil prices towards the end of the year were about 45 percent below 2014 prices. This hurt tax Commodity prices continued to soften across the board in 2015, amidst and export revenues, and exerted pressures on well-supplied markets. fiscal balances of oil exporters (Belize, Colombia, A. Commodity prices B. Prices of key commodity exports Ecuador, Mexico, Venezuela). Similarly, the slump in copper prices, along with the continued slowdown in major trading partners, dampened investment into the mining sector, weighing on growth in Chile and Peru. Regional currencies continued to depreciate in 2015. Commodity exporters in the region saw large depreciations on account of the continued slump in commodity prices (Figure 2.3.3). At end- Source: World Bank. October 2015, the currencies of Chile, Colombia, Note: e = estimated; f = forecast. Mexico and Uruguay depreciated by an average of Despite strong economic ties to a strengthening 13 percent in nominal terms and around 9 percent United States, developing Central and North in real effective terms with respect to their levels at America saw growth rates in 2015 rise modestly the beginning of the year. The Brazilian real saw from 2014.3 The sub-region’s largest economy, an exceptionally large depreciation, due to investor Mexico, saw a small pickup in growth in 2015 on concerns about macroeconomic imbalances and the back of expanding exports to the United political uncertainty. The Argentine peso States. However, the Mexican economy has been depreciated 27 percent on December 17, 2015 weighed down by low oil prices and reduced oil when capital controls were lifted. production. Lower oil prices have severely 4 e Caribbean sub-region includes: Antigua and Barbuda, e Bahamas, Barbados, Belize, Dominica, Dominican Republic, Haiti, Jamaica, St. Lucia, St. Vincent and the Grenadines, and Trinidad and 3 e developing Central and North America sub-region includes: Tobago. Costa Rica, Guatemala, Honduras, Mexico, Nicaragua, Panama, and 5Higher mining output was led by increased production of El Salvador. alumina, boosted by higher global demand. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 L A T I N AM E RI C A A N D T H E C A R I B B E A N 103 Regional export performance improved in 2015, FIGURE 2.3.3 Exchange rates boosted by weak exchange rates and continued LAC currencies continued to depreciate against the U.S. dollar in 2015. recoveries in the United States and the Euro Area. The depreciation of the Brazilian real was particularly steep. Because of Regional export volumes of goods and services high inflation, the real effective exchange rates of Argentina and the Republica Bolivariana de Venezuela rose, indicating a loss of cost climbed around 5 percent in 2015 after remaining competitiveness. broadly unchanged in 2014 (Figure 2.3.4). Exports in South America expanded by about 4 A. Exchange rates against U.S. dollar B. Real effective exchange rates percent, led by Brazil with a substantially depreciated real. Similarly, with its close ties with the United States, developing Central and North America experienced export growth of more than 8 percent. Led by strong tourism demand, the Caribbean’s exports of goods and services rose almost 5 percent in 2015. There was a large divergence in inflation Source: Haver Analytics. performance across the region. Reduced oil prices A. Last observation is November 2015. B. Last observation is September 2015. An increase denotes real appreciation. led to lower inflation in developing Central America, North America, and the Caribbean. For example, despite seeing a 12 percent depreciation FIGURE 2.3.4 Exports of the peso against the U.S. dollar and being an oil Regional export performance improved in 2015, boosted by weak exporter, Mexico’s consumer price inflation exchange rates and continued recoveries in the United States and Euro Area. reached historic lows in 2015 (Figure 2.3.5). The mild inflation rates enabled the Banco de México A. . Regional export growth B. Export growth in selected countries to maintain a record low interest rate of 3 percent for most of 2015 (Figure 2.3.6).6 Inflation pressures in Nicaragua also eased sharply following a cut in electricity prices in April. El Salvador, which imports almost all of its oil, saw annual inflation turn negative for most of 2015. Similarly, consumer prices in Costa Rica fell in the latter half of 2015, and the central bank further lowered its policy rate to 2.25 percent in October. Also with Source: IMF 2015i; Haver Analytics. Note: e = estimated. low inflation, the Dominican Republic reduced A. GDP weighted averages. B. Last observation is Q2 2015, except for Brazil, Chile, Paraguay and Peru, for which the last obser- interest rates and lowered commercial bank reserve vation is Q3 2015. requirements in the first half of 2015. FIGURE 2.3.5 Inflation rates In contrast, consumer price inflation ran at very Inflation rates are diverging across countries. high rates in Argentina, Brazil, and especially the República Bolivariana de Venezuela. In Brazil, A. Regional consumer price inflation B. Headline and core inflation, selected countries, 2015 inflation reached a 12-year high in the second half of 2015. This was in part due to the one-off effect of a reduction in subsidies and an increase in administered prices, but the main reason was higher underlying inflation, as the core inflation accelerated to above 9 percent. In a series of upward adjustments, the Banco do Brasil raised policy interest rates to 14.25 percent, a nine-year Source: IMF 2015i; Haver Analytics. Note: e = estimated. 6 e central bank of Mexico raised its benchmark interest rate by A. GDP weighted averages. 25 bps to 3.25 percent at its December 17th, 2015 meeting. B. Year to date, last observation is November 2015, except for Jamaica, which is October 2015. 104 C H A P TE R 2. 3 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 FIGURE 2.3.6 Central bank policy rates, 2014-2015 inflation also remains elevated, at over 14 percent in the second half of 2015.8 Reflecting different inflation pressures, monetary policies are diverging among countries. Inflation in Colombia is under better control, but A. Central bank policy rates: B. Central bank policy rates: Countries has been above the central bank’s 2-4 percent Countries with monetary policy with monetary policy tightening loosening target band since mid-2015. Continued weakness in the peso, along with a poor harvest of staple crops, contributed to the increase. To guide inflation back to target, the central bank raised its policy rate in a number of successive adjustments in the latter half of 2015. Similarly, headline and core inflation in Peru have been steadily rising and have remained above the Peruvian central bank’s upper bound target of 3 percent since 2014. This prompted the central bank to lift the policy rate in Source: Haver Analytics. Note: The central bank of Mexico raised its benchmark interest rate by 25bps to 3.25 percent at its September and December. December 17th, 2015 meeting. Fiscal balances are also on differing paths across FIGURE 2.3.7 Fiscal indicators LAC. Due to lower commodity and export Fiscal balances are diverging, with balances deteriorating in South Ameri- revenues, coupled with the slowdown in growth, ca and improving in the rest of the region. regional fiscal balances deteriorated, and the debt/ A. Regional general government fiscal B. Change in fiscal and structural GDP ratio increased in 2015 (Figure 2.3.7). Given balances balance, 2014-15e the large proportion of major commodity exporters in the sub-region, fiscal balances in South America as a share of sub-regional GDP are projected to deteriorate by more than 2 percentage points in 2015. The deficit to GDP ratio for Brazil widened further, after doubling in 2014. Weak revenues, swelling interest payments, and losses on central bank dollar swaps, were responsible for the slide. The Chilean fiscal deficit doubled in 2015. C. Regional general government gross D. Change in general government Government revenues have been depressed by low debt gross debt, 2014-15e copper prices. At the same time, the government has boosted public spending in line with the fiscal stimulus program launched in 2014 to counter slowing growth. In contrast, Ecuador is projected to see a narrowing of the fiscal balance in 2015, due to a series of fiscal consolidation measures. Weaker oil export earnings have led the Ecuadorian government to decrease expenditures by $2.2 billion in 2015, with cuts almost entirely Source: IMF 2015i; World Bank. on capital expenditures. Note: e = estimated. A. and C. GDP weighted averages. Central and North America, and the Caribbean too saw a narrowing of fiscal deficits in 2015, high. Consumer price inflation in the República predominantly due to fiscal consolidation. In Bolivariana de Venezuela reached well over 100 Mexico, lower oil prices and production were percent in 2015, as policy has failed to establish an offset by a sharp increase in non-oil revenues in anchor for inflation expectations.7 Argentina’s the wake of the tax reform in 2014 and the 7As estimated in IMF 2015i. Based on official data. 8 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 L A T I N AM E RI C A A N D T H E C A R I B B E A N 105 increase in excise taxes on domestic fuels in 2015. FIGURE 2.3.8 Current account balances In addition, the government enacted spending Current account balances have deteriorated in a number of countries. cuts equivalent to 0.7 percent of GDP. Supported by the 48-month IMF-supported Extended Fund A. Regional current account balance B. Current account balance in selected countries Facility, Jamaica introduced new consumption taxes and reduced the public sector wage bill, as well as sharply lowering gross debt as a share of GDP. After settling a debt due to the República Bolivariana de Venezuela at a sharp discount, the Dominican Republic saw a large drop in its debt service costs and registered a substantial narrowing of its fiscal deficit. Current account balances deteriorated throughout Source: IMF 2015i; Haver Analytics. Note: e = estimated. most of the region. Despite rising volumes of total A. GDP weighted averages. B. Last observation is for Q2 2015, except for Peru, Brazil and Mexico, which is for Q3 2015. exports, the LAC’s current account deficit as a share of GDP widened to 3.4 percent in 2015 from 2.8 percent in 2014, partly due to reduced FIGURE 2.3.9 Gross capital flows export revenues associated with lower commodity Gross capital flows declined in 2015. prices (Figure 2.3.8). South America’s current account deficit is estimated to have widened 0.8 A. Gross capital inflows B. Bond issue by currency and issuer percentage point in 2015 to 3.6 percent of GDP. Developing Central and North America saw a smaller current account deterioration of 0.2 percentage point. As the exception to the trend, the Caribbean’s deficit narrowed due to elevated tourism receipts. Colombia saw a current account deficit in the first half of 2015 of more than 6 percent of GDP, due to a plunge in oil export revenues. Similarly, Mexico’s current account Source: Dealogic, World Bank. balance suffered from lower oil revenues, owing both to weaker prices and declining production. However, this was offset by strengthening export issuance slumped more than 40 percent from performance of manufactures, which represent a 2014 levels, mainly on account of a $35 billion far larger share of Mexico’s trade and benefited decline in new Brazilian bonds. Other economies from the weak peso. took advantage of the still favorable global monetary conditions to put in place refinancing Gross capital flows contracted in 2015. Following and pre-financing arrangements. In April, Mexico the sharp slowdown in flows in 2014, gross capital sold the world’s first 100-year government notes flows to the region are estimated to have in euros, as it locked in lower borrowing costs. contracted by another 40 percent in 2015 (Figure Colombia issued $4 billion worth of bonds. 2.3.9). Brazil and Mexico accounted for around Syndicated bank lending dove by 20 percent, 80 percent of the decline. Weaker-than-expected reflecting local banks’ lower funding needs as growth prospects and increased political regional economies cooled. uncertainty, especially in Brazil, discouraged investors. The large decline in bond issuance mostly occurred among corporate issuers, particularly All three components of gross capital flows Brazilian corporate deals. Despite its significant declined in 2015, with equity issuance contracting appreciation, the U.S. dollar is still by far the the most, falling more than 60 percent. Bond currency of choice for debt issuance in Latin 106 C H A P TE R 2. 3 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 FIGURE 2.3.10 Regional outlook Outlook Regional growth is projected to recover in 2016-18. A gradual return to growth is anticipated over the medium term, as commodity prices stabilize and economic growth firms in the United States and the Euro Area. Activity at the broader regional level is projected to be flat in 2016. Growth will then recover and strengthen to an average of 2.2 percent for 2017-18 (Figure 2.3.10). South America is not expected to resume growth until 2017. This baseline projection assumes that the sub-region’s largest economies gradually adopt policies to reduce macroeconomic imbalances and restore business and consumer confidence. Output is expected to continue contracting in 2016, before increasing by 1.8 percent in 2017-18, on a rebound in investment and exports. Depreciated Source: World Bank. LAC exchange rates and the ongoing recovery in Note: e = estimated; f = forecast. the Euro Area underpin this projection. Domestic constraints among the regions’ largest economies FIGURE 2.3.11 Remittance flows are also expected to gradually ease in the medium term. Brazil continues to grapple with political Remittance inflows to developing Central and North America surged in uncertainty, as the government faces obstacles to 2014, as incomes in the United States grew, and the U.S. dollar fiscal austerity measures in Congress. The forecast appreciated. nevertheless assumes that an eventual re-anchoring of inflation expectations and narrowing of the fiscal deficit, will lessen the need for further monetary and fiscal tightening. The baseline projection for the República Bolivariana de Venezuela, with its new National Assembly, assumes a very gradual shift towards a stronger macroeconomic and business-friendly environment. The new government in Argentina is expected to implement monetary and fiscal tightening in 2016, pushing a rebound in growth to 2017, as investment slowly strengthens on renewed investor confidence and leads the recovery. Prospects are brighter for developing Central and North America. The sub-region will benefit from Source: World Bank Migration and Remittances Database, Central Bank of Honduras. close economic ties to the firming U.S. economy and is projected to see a gradual acceleration in economic activity. Growth is expected to reach 3.0 America. From January to September 2015, over percent in 2016, and to 3.2 percent by 2017. 80 percent of bonds issued were denominated in Output in Mexico, although weighed down by U.S. dollars, slightly higher than the same period a fiscal austerity through 2016, will benefit from a year ago. weak peso. This will provide a competitive boost G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 L A T I N AM E RI C A A N D T H E C A R I B B E A N 107 to its export-based manufacturing sector. In external and internal, and include potential bouts addition, the opening of the energy sector to of financial volatility, protracted slowdown in the foreign investment has begun to perk investors’ region’s largest economies, a sharper slowdown in interests, resulting in a successful auction of oil major trading partners and further commodity sector licenses. Implementation of other planned price weakness, and adverse effects from El Niño reforms should unclog various growth bottlenecks, weather patterns. providing growth dividends in the medium term. Financial volatility. Higher borrowing costs, Developing Central and North America account amid tighter U.S. monetary policy, and for about 60 percent of total remittances flows to heightened risk aversion could be accompanied by LAC, and benefited from an 8 percent surge in bouts of financial stress. Downgrades to sovereign remittances in 2014 (Figure 2.3.11).9 Remittances credit ratings, such as those by Standard and are projected to stay robust over the next few Poor’s and Fitch for Brazil recently, could years, in line with stronger U.S. labor market heighten the risk of large capital outflows. conditions and improving employment Financial market volatility could also be associated opportunities for migrants in the United States. with China’s efforts to stabilize its economy (IMF On the other hand, remittance growth to South 2015j). Should financial stresses ensue, capital America has been sluggish, and even declined in flows to the region could stagnate or even reverse, Peru in 2014, partly due weak economic activity hampering growth. Risks will be most pronounced in Spain. Some 30 percent of immigrants in Spain among developing economies with large levels of are from South America.10 short-term or external debt (versus long-term domestic debt), or where credit has been Prospects are also favorable for the Caribbean expanding rapidly in recent years. economies. The Caribbean is projected to expand at an average of 3.0 percent in 2016-18, in light of Protracted slowdown in the region’s largest some positive spillovers with the continued U.S. economies. Two of the region’s largest expansion. Similar to Central America, remittance economies, Brazil and the República Bolivariana flows to the Caribbean have been robust and de Venezuela, are grappling with high inflation stable. Moreover, Caribbean economies have been rates and output contractions, coupled with buttressed by increasing tourism. For example, macroeconomic imbalances and political tourist arrivals to the Dominican Republic uncertainty. In Brazil, the baseline projection is between January and September 2015 rose 8.4 predicated on a reduction in the fiscal deficit and percent relative to the same period in 2014, with an anchoring of inflation expectations without visitors from the United States jumping nearly 10 considerable further policy tightening, which may percent over the same period. In the years ahead, not prove feasible. A protracted slowdown in one the ongoing normalization of ties between Cuba or both of these economies could have sustained and the United States is expected to boost travel to negative spillovers across the region. Econometric Cuba.11 analysis presented in Box 2.3.1 shows that decreases in Brazil’s GDP growth lead to Risks statistically significant declines in output growth for Argentina, Chile, Colombia, Ecuador, Paraguay and Peru.12 Specifically, a one percentage The balance of risks in the regional forecasts leans point decline in Brazil’s growth tends to reduce heavily towards the downside. The risks are both growth in Argentina, after 2 years, by 0.7 9Fajnzylber and Lopez (2008) found that remittance ows lead to higher rates of economic growth throughout the developing world. 10Compared to 5 percent of immigrants from Central America categories of authorized travel to Cuba in January 2015. U.S. and the Caribbean. Calculated from World Bank Bilateral Migration citizens can legally travel to Cuba if they are engaging in 12 Matrix 2013. categories of activities such as professional research, participating in 11While U.S. citizens are still not allowed to visit Cuba for the an athletic event, performing in a concert, working on a purposes of tourism, President Barack Obama expanded the humanitarian project, or taking part in educational activities. 108 C H A P TE R 2. 3 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 percentage point, in Paraguay by 0.6 percentage Paraguay, and Uruguay have experienced point, in Ecuador and Peru by 0.3 percentage exceptionally heavy rains and flooding. Drought point, and in Chile and Colombia by 0.2 afflicted Brazil and the north of Uruguay, and percentage point. The República Bolivariana de led to emergency water restrictions (EIU 2015). Venezuela’s Petrocaribe program, which provides Drought has also damaged crops, including coffee, subsidized oil to certain countries, is one possible over a wide swathe of Central America. As the channel of negative spillovers to its LAC El Niño season unfolds, worse effects might yet be neighbors. The economic downturn in the in store. country has led to a scaling-down of the program, but the impact has been limited by the sharp fall Policy challenges in oil prices. A downturn in major trading partners and With commodity prices expected to stabilize protracted slump in commodity prices. The around the current low prices through the baseline forecast assumes commodity prices will medium term, economies in LAC, especially stabilize at around current levels. A further drop in commodity exporters, will no longer benefit from demand from major emerging markets and commodity-driven global tailwinds to boost continued over-supply of commodities on world economic growth. Regional economies will markets could lead to further declines in therefore need to transition to new engines of commodity prices, which may lower government growth, while using a combination of monetary revenues, reduce export receipts, and widen and fiscal policies to smooth the trajectory, current account deficits commodity exporters. tailored to available policy space at the country Investment, especially in mining industries, could level. continue to decline. Countries with higher shares of commodity exports are more vulnerable to Monetary policy trade-offs. In response to tighter commodity price declines. On the other hand, monetary policy in the United States (and, at a lower oil prices in the medium term will again later stage, in other developed economies), central represent an upside risk to the forecast for oil- banks in LAC may need to raise interest rates for a importing economies in the region. while to stave off currency depreciation and inflationary pressure. However, in countries Adverse effects from El Niño. Recent weather already grappling with weak growth, some decline forecasts suggests that the current El Niño episode in the external value of the currency would be a could be one of the strongest on record (World normal part of the adjustment process. Where Bank 2015o). The experience of the 1997-98 expectations of low inflation are firmly anchored, episode, which inflicted widespread damage depreciation causes a small, temporary, increase in in LAC, suggests that the current El Niño weather the inflation rate. In countries where the nominal pattern is likely to have significant adverse effects anchor is weak, however, a drop in the exchange on the region’s agricultural sector, as well as rate risks setting off an inflation spiral, and the potentially crippling infrastructure. With growth central bank may have to tighten its monetary already negative in 2015, a severe El Niño season policy stance. Moreover, the effectiveness of an could result in a second year of contraction for the interest rate hike in stemming depreciation region. A number of countries have already pressures depends on the credibility of the experienced volatile and damaging climatic effects. monetary policy framework (Arteta, Kose, For example, Argentina, Chile, Colombia, Peru, Ohnsorge and Stocker 2015; Eichengreen and Rose 2003). Regaining fiscal space. The room for fiscal Uruguay is also expected to be adversely a ected by the recession 12 in Brazil as Brazil is the second largest destination for Uruguayan maneuver has deteriorated across LAC since 2008. merchandise exports. In addition, the Uruguayan peso has appreciat- The expansionary, countercyclical policies ed signi cantly in real terms against the Brazilian real, further weigh- implemented in response to the 2008 global ing on Uruguayan merchandise exports to Brazil. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 L A T I N AM E RI C A A N D T H E C A R I B B E A N 109 financial crisis led to a build-up of debt and a the needed revenues, together with strong reduction of fiscal space (World Bank 2015n, IDB institutions to monitor public spending. 2015). The protracted decline in commodity Innovative public-private investment models may prices and slowdown of economic growth reduced help to fund projects. Policy makers undertaking tax revenues and further eroded fiscal positions in fiscal consolidation, however, often include several countries. Consequently, most were measures that reduce or postpone capital compelled to embark on new rounds of pro- expenditures (such as Ecuador). This reduces cyclical fiscal tightening in 2015, deepening the fiscal pressures in the short term, but delays negative output impact of the external shock. much-needed infrastructure investment, and Economies that resisted – or were unable to has detrimental medium- and longer-term con- implement required fiscal adjustments – have seen sequences to productivity and economic growth. severe declines in fiscal balances and increases in The need for stable infrastructure investment public debt ratios. Only a handful of countries, again underlines the urgency of consolidating such as Chile and Peru, have managed to government consumption outlays when possible, undertake fiscal stimulus measures to support and reducing dependence on commodity-based growth in 2015, and even in those cases, spending fiscal revenues. has been curtailed on account of lower commodity revenues. With commodity prices across the board Economic diversification. Commodities exports projected to stabilize around current low levels, represented more than 50 percent of the region’s regional commodity exporters need to diversify exports for the years 2012-14. The current away from commodity-based activities, and over slowdown could help garner private and public time reestablish fiscal buffers before the next sector support for renewed regional efforts to downturn. promote economic diversification. These could promote specialization based on comparative Greater investment in infrastructure will be advantage, and encourage participation in cross- essential to boost competitiveness. The region border value chains. The associated transfers of needs to modernize its transportation know-how can facilitate diversification towards infrastructure or risk impeding advances in other engines of growth.13 To this end, initiatives productivity and development. Physical that promote business-friendly environments, infrastructure will play a key role, and its enhance workforce skills, and boost physical and modernization will require sizable financial telecommunication infrastructure will be crucial resources. Fiscal reforms are needed to generate for private sector development. 13IMF 2015h found that LAC economies could enhance long-term growth if they shift their economies toward producing a wider scope of products that are more knowledge- or technology-intensive. For example, Ecuador would grow approximately 0.4 percentage point faster every year for the next decade if its level of economic modernization was at the LAC average. 110 C H A P TE R 2. 3 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 TABLE 2.3.1 Latin America and the Caribbean forecast summary (Annual percent change unless indicated otherwise) (Percentage point difference from June 2015 projections) 2013 2014 2015e 2016f 2017f 2018f 2015e 2016f 2017f Developing LAC, GDP a 3.0 1.5 -0.7 0.1 2.3 2.5 -1.5 -2.3 -0.6 (Average including countries with full national accounts and balance of payments data only)b Developing LAC, GDPb 3.0 1.5 -0.7 0.1 2.3 2.5 -1.5 -2.3 -0.6 GDP per capita (U.S. dollars) 1.8 0.3 -1.8 -1.0 1.2 1.4 -1.5 -2.3 -0.7 PPP GDP 3.1 1.7 -0.2 0.5 2.5 2.6 -1.4 -2.1 -0.6 Private consumption 3.3 2.0 -0.8 -0.1 1.9 2.1 -1.9 -2.2 -0.4 Public consumption 2.3 2.2 0.1 -0.6 -0.5 0.9 0.1 -0.7 -2.2 Fixed investment 4.2 -0.5 -7.7 -2.2 2.9 3.5 -6.2 -5.0 -0.9 Exports, GNFSc 2.7 3.5 4.7 5.0 5.0 5.0 -0.8 -0.6 -0.9 Imports, GNFSc 4.3 2.9 -2.1 1.7 2.9 3.9 -5.4 -2.2 -1.3 Net exports, contribution to growth -0.4 0.0 1.4 0.7 0.5 0.2 1.0 0.4 0.2 Memo items: GDP Broader geographic regiond 2.9 1.0 -0.9 0.0 2.1 2.4 -1.4 -2.1 -0.7 South Americae 3.3 0.4 -2.1 -1.1 1.7 2.0 -1.8 -2.8 -0.8 Developing Central and North Americaf 1.8 2.5 2.7 3.0 3.2 3.4 -0.1 -0.4 -0.4 Caribbeang 3.0 4.2 3.3 3.1 2.9 3.1 -0.2 -0.4 0.0 Brazil 3.0 0.1 -3.7 -2.5 1.4 1.5 -2.4 -3.6 -0.6 Mexico 1.4 2.3 2.5 2.8 3.0 3.2 -0.1 -0.4 -0.5 Colombia 4.9 4.6 3.1 3.0 3.3 3.5 -0.4 -0.9 -0.9 Source: World Bank. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not differ at any given moment in time. a. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. Excludes Cuba, Granada, and Suriname. b. Sub-region aggregate excludes Cuba, Dominica, Granada, Guyana, St. Lucia, St. Vincent and the Grenadines, and Suriname, for which data limitations prevent the forecasting of GDP components. c. Exports and imports of goods and non-factor services (GNFS). d. Includes the following high-income countries: Antigua and Barbuda, Argentina, The Bahamas, Barbados, Chile, Trinidad and Tobago, Uruguay, and Venezuela, RB. e. Includes Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Guyana, Paraguay, Peru, Uruguay, and Venezuela, RB. f. Includes Costa Rica, Guatemala, Honduras, Mexico, Nicaragua, Panama, and El Salvador. g. Includes Antigua and Barbuda, The Bahamas, Barbados, Belize, Dominica, Dominican Republic, Haiti, Jamaica, St. Lucia, St. Vincent and the Grenadines, and Trinidad and Tobago. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 L A T I N AM E RI C A A N D T H E C A R I B B E A N 111 TABLE 2.3.2 Latin America and the Caribbean country forecastsa (Real GDP growth at market prices in percent, unless indicated otherwise) (Percentage point difference from June 2015 projections) 2013 2014 2015e 2016f 2017f 2018f 2015e 2016f 2017f Belize 1.5 3.6 3.0 2.5 2.6 2.8 0.5 -0.1 -0.1 Bolivia 6.8 5.5 4.0 3.5 3.4 3.4 -0.8 -0.7 -0.7 Brazil 3.0 0.1 -3.7 -2.5 1.4 1.5 -2.4 -3.6 -0.6 Colombia 4.9 4.6 3.1 3.0 3.3 3.5 -0.4 -0.9 -0.9 Costa Rica 3.4 3.5 2.8 4.0 4.2 4.4 -0.6 -0.2 -0.2 Dominica 1.7 3.4 -3.0 4.0 2.0 2.0 -4.3 2.5 0.4 Dominican Republic 4.8 7.3 5.6 4.6 3.8 3.9 0.4 -0.2 0.4 Ecuador 4.6 3.7 -0.6 -2.0 0.0 0.5 -2.5 -5.0 -4.2 El Salvador 1.8 2.0 2.4 2.5 2.6 2.8 0.2 0.0 0.0 Guatemala 3.7 4.2 3.7 3.6 3.5 3.6 -0.3 -0.3 -0.4 Guyana 5.2 3.9 3.5 3.8 4.0 4.0 -0.2 0.0 0.0 Haitib 4.2 2.7 1.7 2.5 2.8 3.0 0.0 -0.7 -0.3 Honduras 2.8 3.1 3.4 3.4 3.5 3.6 0.5 0.1 0.0 Jamaica 0.5 0.7 1.3 2.1 2.4 2.6 -0.2 -0.1 -0.1 Mexico 1.4 2.3 2.5 2.8 3.0 3.2 -0.1 -0.4 -0.5 Nicaragua 4.6 4.7 3.9 4.2 4.1 4.0 -0.3 -0.1 -0.1 Panama 8.4 6.2 5.9 6.2 6.4 6.6 -0.3 -0.2 -0.1 Paraguay 14.0 4.7 2.8 3.6 4.0 4.2 -1.4 -0.5 -0.1 Peru 5.8 2.4 2.7 3.3 4.5 4.6 -1.2 -1.7 -0.5 St. Lucia -1.9 -0.7 1.7 1.6 1.9 2.1 2.3 0.8 0.5 St. Vincent and the Grenadines 2.3 -0.2 2.1 2.7 3.0 3.4 -0.5 -0.2 -0.4 2013 2014 2015e 2016f 2017f 2018f 2015e 2016f 2017f Recently transitioned to high income countriesc Argentina 2.9 0.5 1.7 0.7 1.9 3.0 0.6 -1.1 -1.1 Chile 4.2 1.9 2.1 2.4 2.9 3.1 -0.8 -0.9 -0.6 Trinidad and Tobago 1.7 1.0 0.0 0.5 1.2 1.5 -1.8 -1.5 -1.0 Uruguay 5.1 3.3 1.5 1.9 2.8 3.0 -1.1 -1.2 -0.4 Venezuela, RB 1.3 -4.0 -8.2 -4.8 -1.1 0.0 -3.1 -3.8 -2.2 Source: World Bank. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not significantly differ at any given mo- ment in time. a. Cuba, Grenada, and Suriname are not forecast due to data limitations. b. GDP is based on fiscal year, which runs from October to September of next year. c. Based on the World Bank's country reclassification from 2004 to 2015. 112 C H A P TE R 2. 3 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.3.1 Regional integration and spillovers: Latin America and the Caribbean The Latin America and Caribbean region (LAC) is less open than other emerging and developing regions to global trade and finance. Despite a multitude of regional trade agreements, economic linkages within the region tend to be limited and largely confined to sub-regions. Estimated spillovers from growth slowdowns in Brazil are modest for its South American neighbors (Argentina, Chile, Colombia, Ecuador, Paraguay and Peru), while those from Mexico are negligible. Introduction How open is the LAC region to global and regional trade and financial flows? Although there is considerable heterogeneity among countries, the LAC region is one of the least open regions Of the six World Bank developing country regions, LAC is to trade, despite a large presence in global commodity the least open to trade, and the region’s role in global trade markets. Commodity discoveries, and the prospect of large is considerably less than its contribution to global activity domestic markets, have attracted considerable FDI and (Figure 2.3.1.1). The region is not well integrated into portfolio flows into the region. Among the three sub- international supply chains, in contrast to East Asia, for regions, South America is most dependent on global example (Estevadeordal 2012; De la Torre, Dider, Ize, commodity markets, while its trade and financial partners Lederman and Schmukler 2015). The region’s heavy are broadly diversified. In contrast, the main economic reliance on primary commodity exports, the associated lack partner of developing Central and North America, and the of economic diversification, and the narrow product base Caribbean is the United States. Regional trade and finance are additional contributing factors for being relatively flows are limited. However, the three sub regions have closed. However, the region has absorbed a large share of forged somewhat closer sub-regional ties, especially in global FDI, which has been attracted by rapidly growing South America. domestic markets, and by commodity discoveries. Portfolio inflows into LAC have been quite high, but the This box addresses the following questions: stock of liabilities relative to GDP has declined (Figure 2.3.1.2). Post-crisis, LAC trade has grown broadly in line • How open is the LAC region to global and regional with the global economy, while remittance flows have trade and financial flows? lagged behind those of other developing regions. The anemic recovery and weak labor market in Spain, which • How significant are the potential intra-regional hosts about 5 percent of South American migrants, has spillovers from the region’s two largest economies, held back remittance flows to the sub-region (Figure Brazil and Mexico? 2.3.1.3). Similarly, in the United States, modest growth in the sectors employing a large share of immigrants Brazil and Mexico are the two largest economies in the (construction and agriculture) and stricter enforcement of region. Brazil has slipped into recession due to a immigration laws have discouraged migrant inflows from combination of global and domestic challenges. While Central America, constraining remittance flows (Chishti still positive, Mexico’s growth has been tepid recently, and Hipsman 2015). compared to the pre-crisis and immediate post-crisis years. While the low growth of the region’s largest economies The United States and Europe continue to be the most may weigh on the outlook of trading partners and important economic partners for the region, accounting financial counterparts elsewhere in the region, limited for 40-80 percent of LAC’s trade and financial flows intra-regional ties reduce the potential drag. Growth (Figure 2.3.1.4). The United States remains the largest slowdowns in Brazil are estimated to have measurable importer from the region (exceeding 7 percent of regional spillovers to South American neighbors (Argentina, Chile, GDP in 2011-14). That said, for South and Central Colombia, Ecuador, Paraguay and Peru), whereas growth America as well as the Caribbean, the share of exports to decelerations in Mexico have negligible spillovers to other the United States has steadily declined since 2000, as countries in the region. exports to other major destinations and other LAC economies have gained ground (Cesa-Bianchi et al. 2012). The LAC region does have a large global presence in Note: is box was prepared by Derek H. C. Chen with contributions commodity markets. On average, primary commodities from Raju Huidrom, Duygu Guven, Jesper Hanson and Mai Anh Bui. constitute more than 50 percent of regional goods exports G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 L A T I N AM E RI C A A N D T H E C A R I B B E A N 113 BOX 2.3.1 Regional integration and spillovers: Latin America and the Caribbean (continued) and 9 percent of GDP (Figure 2.3.1.5). South America is, by far, the most commodity-intensive sub-region, with FIGURE 2.3.1.1 International linkages: commodities making up more than 70 percent of Cross-region comparison merchandise exports, and nearly 10 percent of GDP. Although developing Central and North America is The Latin America and Caribbean (LAC) region is the considerably less commodity dependent than South least open to trade among the six World Bank developing regions. But it absorbs a large share of America, commodities still account for about one quarter global FDI. Portfolio inflows are small on a global of exports, and 7.5 percent of GDP. Reliance on scale, but the stock of portfolio liabilities relative to commodity exports tends to be associated with a high GDP is similar to the average for the other developing correlation between commodity prices and GDP, implying regions. a higher susceptibility to commodity price fluctuations and increased volatility in activity (Camacho and Perez-Quiros A. LAC share of global activity, trade and finance, 2014 2013). There are important differences in regional and global integration across the three sub-regions within LAC. Regional economic links are generally modest, and mostly within sub-regions. Examples are trade among Central American countries (excluding Mexico), and trade and remittances within South America (World Bank 2005, ECLAC 2014, Villarreal 2012). Even within regional trade agreements, trade remains modest, partly reflecting low road and rail density (Scholvin and Malamud 2014). Argentina, Bolivia, Paraguay and Uruguay, which are Mercosur members, ship only 20 to 30 percent of their exports to Brazil—compared with 40-60 percent of within -region trade for member countries of the North American B. LAC trade and finance in regional comparison, 2014 Free Trade Agreement (NAFTA) and the European Union (EU) (Chapter 4.1).1 FDI flows from Brazil and Mexico are largely confined to their respective sub-regions as well (Figure 2.3.1.6). South America’s trade links are well-diversified, but its financial flows predominantly originate from Europe, and its remittances inflows originate about equally from the United States and Europe. Central America’s trade, remittances and, to a lesser extent, portfolio flows, rely heavily on the United States. Other financial flows predominantly originate from Europe. With its economic linkages enhanced by NAFTA, around 80 percent of Mexican exports are shipped to the Sources: IMF October 2015 World Economic Outlook, IMF International Financial Statistics, IMF Direction of Trade Statistics, UNCTAD FDI/TNC United States. Mexico’s trade with Central America is database, World Bank Remittance and Migration Database, World Bank modest (with the exception of Nicaragua, which ships World Development Indicators. B. The red bar denotes exports, imports, trade, remittance inflows, portfo- about 20 percent of its exports to Mexico, IMF 2012a). lio liabilities and FDI inflows in percent of GDP on average across LAC countries. The vertical line denotes the range of averages for all six devel- oping country regions. 1Bolivia is an associate state and in the nal stages of the accession to become a full and the sixth member of Mercosur. 114 C H A P TE R 2. 3 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.3.1 Regional integration and spillovers: Latin America and the Caribbean (continued) The Caribbean is deeply tied to the United States and to FIGURE 2.3.1.2 Evolution of openness Japan, via foreign claims on Caribbean banks. Similar to Central America, sub-regional trade is modest (around 16 External ties—other than remittances—have grown percent of total sub-regional total merchandise exports in broadly in line with the global economy. However, they 2014). This may partly reflect countries having similar have shrunk relative to regional GDP as a result of rapid growth led by domestic demand that was economic structures and a prevalence of services trade. supported by policy in the wake of the crisis. Slow growth in Europe and a fragile recovery in the United Major trade agreements such as NAFTA and CAFTA-DR States have set back remittances. deepened ties between LAC and North America (World Bank 2014a). The 1994 NAFTA between Canada, A. LAC’s share of global GDP, population, trade and finan- Mexico, and the United States, was aimed at eliminating cial flows tariffs and substantially reducing nontariff barriers in a broad range of sectors by 2008. NAFTA has greatly boosted trade and FDI flows, and at the same time increased business cycle co-movement among the three North American economies (Lederman, Maloney and Servén. 2005). For example, NAFTA is estimated to have increased Mexican exports to the United States by 5-8 percent per year. Other estimates attribute to NAFTA as much as half of the post-1993 increase in exports from Mexico to the United States.2 The Dominican Republic-Central America FTA (CAFTA- DR) is a free trade agreement between the United States and Central American economies (Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, the Dominican Republic), which came partially into effect in 2005 and B. Trade and financial flows in percent of regional GDP fully in 2009. Total goods trade between the U.S. and the six CAFTA-DR partners increased from $35 billion in 2005 to $60 billion in 2013 (USTR 2015). The trade and growth benefits of the agreements would be considerably enhanced by domestic reforms and infrastructure investment (Lopez and Shankar 2011). Regional integration has been promoted through various regional agreements within the sub-regions (Figure 2.3.1.4): • The Mercosur (Common Market of the South) customs union came into force in 1991, and comprises five member countries—Argentina, Brazil, Paraguay, Uruguay, and the República Bolivariana de Sources: IMF April 2015 World Economic Outlook, IMF International Venezuela—and Bolivia, which is in the final stages of Financial Statistics, IMF Direction of Trade Statistics, UNCTAD FDI/TNC database, World Bank Remittance and Migration Database, World Bank the accession to become the sixth member. While World Development Indicators. Note: Tourist arrivals and tourism expenditures data are average 2011- 2See Romalis (2007); CBO (2003); Easterly, Fiess and Lederman 2013. (2003); Cuevas, Messmacher, and Werner (2002); Torres and Vela (2003); Kose, Meredith, and Towe (2005). Lederman, Maloney, and Serven (2005) estimate that Mexico’s exports would have been 50 percent lower and its FDI 40 percent less without NAFTA and the agreement may have lifted GDP per capita by some 4 percent during 1994-2002. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 L A T I N AM E RI C A A N D T H E C A R I B B E A N 115 BOX 2.3.1 Regional integration and spillovers: Latin America and the Caribbean (continued) FIGURE 2.3.1.3 Sources of trade and financial flows LAC has a diversified set of export markets. Remittances are predominantly from the United States, and financial inflows are mostly from Europe. However, there are considerable differences between sub-regions. Central America, Mexico and the Caribbean are most closely tied to the United States. South America is most closely tied to Europe and other countries within the region. A. Latin America and the Caribbean B. South America C. Central America and Mexico D. Caribbean Sources: IMF April 2015 World Economic Outlook, IMF International Financial Statistics, IMF Direction of Trade Statistics, UNCTAD FDI/TNC database, World Bank Remittance and Migration Database, Wor ld Bank World Development Indicators, UNWTO, Bank for International Settlements. Note: Exports and remittance inflows are average 2011-14. Portfolio liabilities and tourist arrivals are average 2011-13. FDI inflows are average 2010-12. Foreign banking claims are for 2014. there has been some controversy about the net impact (Guatemala, Honduras, El Salvador, Nicaragua, Costa of Mercosur, the share of exports to other members Rica) that was formed in 1960 to facilitate regional has increased from 7.6 percent in 1990 to 13.3 economic development through free trade and percent in 2014 (Connolly and Gunther 1999). economic integration. Exports among members have steadily increased from about 15 percent in 1990 to • CACM (Central American Common Market) is an around 22 percent of total exports in 2014. Since its association of five Central American nations inception, CACM is estimated to have tripled 116 C H A P TE R 2. 3 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.3.1 Regional integration and spillovers: Latin America and the Caribbean (continued) FIGURE 2.3.1.4 LAC exports LAC exports to the United States have grown less rapidly than those to China (especially for South America) and to other LAC countries (especially in the Caribbean). A. Latin America and the Caribbean B. South America C. Central America and Mexico D. Caribbean E. Exports destinations of LAC’s largest F. Exports within trade arrangements economies Source: IMF Direction of Trade Statistics. E. Data is for 2014. F. Mercosur members: Argentina, Brazil, Paraguay, Uruguay, and República Bolivariana de Venezuela (established 1991). CACM members: Guatemala, Honduras, El Salvador, Nicaragua, Costa Rica (established 1960). Caricom members: Antigua and Barbuda, the Bahamas, Barbados, Belize, Dominica, Grenada, Guyana, Haiti, Jamaica, Montserrat, St. Lucia, St. Kitts and Nevis, St. Vincent and the Grenadines, Suriname, Trinidad and Tobago (established in 1973). PetroCaribe members: Antigua and Barbu- da, the Bahamas, Belize, Cuba, Dominica, Dominican Republic, Grenada, Guatemala, Guyana, Haiti, Honduras, Jamaica, Nicaragua, Saint Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, Suriname, and República Bolivariana de Venezuela (established in 2005). Chart shows República Bolivariana de Venezuelan exports to PetroCaribe members as a share of total exports. member country exports compared to a baseline (Moreira and Mendoza 2007). Within-agreement without such an agreement (Baier and Bergstrand exports constituted 13 percent of total exports in 2009). 2014. • Caricom (The Caribbean Community) is a common • PetroCaribe is an energy initiative launched in 2005 market established in 1973. Members consist of to supply Venezuelan crude oil to countries in the Antigua and Barbuda, the Bahamas, Barbados, Belize, Caribbean region on discounted terms. Current Dominica, Grenada, Guyana, Haiti, Jamaica, members of PetroCaribe include Antigua and Montserrat, St. Lucia, St. Kitts and Nevis, St. Vincent Barbuda, the Bahamas, Belize, Cuba, Dominica, and the Grenadines, Suriname, Trinidad and Tobago. Dominican Republic, Grenada, Guatemala, Guyana, Empirical estimates have found that the agreement Haiti, Honduras, Jamaica, Nicaragua, Saint Kitts and has had a modest impact on trade among members Nevis, St. Lucia, St. Vincent and the Grenadines, G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 L A T I N AM E RI C A A N D T H E C A R I B B E A N 117 BOX 2.3.1 Regional integration and spillovers: Latin America and the Caribbean (continued) Suriname, and República Bolivariana de Venezuela.3 The share of Venezuelan exports to PetroCaribe FIGURE 2.3.1.5 LAC commodity exports members has remained broadly unchanged since the The LAC region’s exports are heavily concentrated in inception of the initiative. primary commodities. How large are the potential regional spillovers from A. Primary commodity exports Brazil and Mexico? Brazil and Mexico are the largest economies in LAC. Together, these two countries account for 60 percent of regional GDP and trade, 50 percent of population, 75 percent of portfolio and 50 percent of FDI flows and 30- 40 percent of tourism expenditures and remittance flows (Figure 2.3.1.7). Business cycle co-movements can be indicative of intraregional spillovers. Correlations of quarterly growth suggest that business cycles of a number of LAC economies are positively correlated with those of Brazil and Mexico (Figure 2.3.1.8). South American economies tend to exhibit higher business cycle correlations with B. Primary commodity exports Brazil, and Central American economies have higher business cycle correlations with Mexico. These correlations appear to be driven mainly by relative trade shares, but they could also be indicative of economies responding together to a common external shock. To examine the magnitude of spillovers from Brazil and Mexico to their Latin American neighbors, while accounting for common external factors, a series of country-specific Bayesian structural vector autoregressions (VARs) models are estimated. The VARs include G-7 growth, EMBI as a proxy for external financing conditions, growth in China (a major non-G7 trading partner for the region), growth in Brazil and Mexico as Source: UN Comtrade Database 2015. A. and B. GDP-weighted averages for 2013-14. source countries of shocks, trade-weighted commodity prices, growth in each spillover destination country, and real effective exchange rates (see Annex 3.2 for details). LAC.4 The data coverage is for 1998 Q1 - 2015 Q2, The analysis includes 13 spillover destination countries in except for Colombia and Honduras where the data runs from 2000 Q2 – 2015 Q2, and Jamaica, where it 2002 Q2 – 2015 Q2. A dummy variable is included for the global financial crisis. 3Under the PetroCaribe program, the member countries that purchase The results suggest that spillovers from Brazil to oil from República Bolivariana de Venezuela pay for a certain percentage neighboring countries are moderate, while those from of the oil (depending on world oil prices) within 90 days, and the remainder is paid over a period of 25 years with an interest rate of one Mexico are negligible. percent annually. Part of the cost may be offset by the provision of goods or services. Recently, to secure external funds, the government of 4Southern Cone countries include Argentina, Chile, Paraguay and República Bolivariana de Venezuela has renegotiated repayment, at deep Uruguay. Andean Community countries include Bolivia, Colombia, discounts, of commercial credits to the Dominican Republic, Jamaica Ecuador and Peru. Central America and Caribbean economies include and Uruguay. Belize, Guatemala, El Salvador, Honduras and Jamaica. 118 C H A P TE R 2. 3 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.3.1 Regional integration and spillovers: Latin America and the Caribbean (continued) FIGURE 2.3.1.6 Within-region trade and FDI Brazil accounts for a significant share of trade and FDIs to other South American countries, while Mexico only has significant FDI links. Remittances come predominantly from outside the region. A. South America: Export destinations B. Central America and Mexico: Export C. Caribbean: Export destinations destinations D. South America: FDI inflows E. Central America and Mexico: FDI inflows F. Remittances inflows Source: IMF Direction of Trade Statistics, UNCTAD FDI/TNC database, World Bank Bilateral Remittance Matrix 2014. Notes: A-C. Data for 2014. D-E. Data for average of 2010-12. F. Data is for 2014. • Spillovers from Brazil. In the estimation results, growth • Spillovers from Mexico. In contrast, spillovers from declines in Brazil tend to have measurable or Mexico to Central America are negligible or not statistically significant spillovers to its South American statistically significant (Figure 2.3.8). This result is in neighbors. A one percentage point decline in Brazil’s line with findings in other studies (Adler and Sosa growth tends to reduce growth in Argentina, after 2 2014; Kose, Rebucci and Schipke 2005; Swiston years, by 0.7 percentage point, in Paraguay by 0.6 2010). percentage point, in Ecuador and Peru by 0.3 percentage point, and in Chile and Colombia by 0.2 While there are measurable regional spillovers, particularly percentage point (Figure 2.3.1.9).5,6 in South America, they are modest compared to those from the region’s main external trade and financial 5Brazil is Argentina’s largest trading partner. In some sectors, such as partners. Over the two years following the growth decline, automobiles, Brazil accounts for about 80 percent total exports. Spillovers a one percentage point decrease in G7 growth lowers from Brazil to Argentina play a big role in these sectors, and contracting economic activity in Brazil has adversely a ected the auto industry in Argentina, spurring waves of production stoppages in major auto plants in 2015. eir results show that spillovers from Brazil are signi cant for Argentina, 6 e estimates from Adler and Sosa (2014) di er somewhat, partly Bolivia, Paraguay, Peru, Uruguay, and the República Bolivariana de because their sample time period includes the Tequila crisis of 1994. Venezuela, but less so for Ecuador. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 L A T I N AM E RI C A A N D T H E C A R I B B E A N 119 BOX 2.3.1 Regional integration and spillovers: Latin America and the Caribbean (continued) growth by more than 1 percentage point in Brazil, Chile, Mexico, Honduras and Ecuador. This is broadly in line FIGURE 2.3.1.7 The role of the largest with Österholm and Zettelmeyer (2008) who find a economies in LAC roughly one-for-one response to a change in growth in the United States. Similarly, Izquierdo, Romero, and Talvi Brazil and Mexico are, by far, the largest economies in (2008) also find a pass through of 0.6 percentage point to the region. In 2011-2014, these two countries accounted for 60 percent of regional GDP and trade, LAC GDP growth in response in 1 percentage point 50 percent of its population, 75 percent of portfolio and increase in G7 industrial production. 50 percent of FDI flows, and 30-40 of tourism expenditures and remittance flows. As a result of deep trade and financial links, spillovers from A. Share of regional total, 2011-14. the United States to the region are particularly strong. Peaks and troughs of industrial production in some of the largest LAC countries—especially Mexico—tend to coincide with those in the United States (Cuevas, Messmacher and Werner 2003; Mejía-Reyes 2004). U.S. growth and U.S. industrial production are significantly correlated with growth in Mexico and Central America (IMF 2007; Fiess 2007; Roache 2008). In addition, these estimates also show sizable linkages with China. A one percentage point growth deceleration in China reduces growth in Argentina by about 1.9 percentage points, in Brazil, Peru, Paraguay and Uruguay by 0.5 percentage point, and in Ecuador, Chile, Bolivia, Source: IMF April 2015 World Economic Outlook, IMF International Financial Honduras, Guatemala, Colombia, El Salvador, and Statistics, IMF Direction of Trade Statistics, UNCTAD FDI/TNC database, World Bank Remittance and Migration Database, World Bank World Development Mexico by 0.2 percentage point.7 While larger than the Indicators. estimated regional spillovers from Brazil and Mexico, the Note: GDP, Exports, FDI inflows and Remittance inflows are average for 2011-14. Portfolio liabilities are average 2011-13. estimated spillovers from G7 economies to the LAC region are smallest among six World Bank regions of developing economies (see Box 3.4 and Figure 3.4.3), largely because FIGURE 2.3.1.8 Correlations with Brazil the LAC region is more closed to the global economy than and Mexico other regions. Overall, these findings are broadly in agreement with Boschi and Girardi (2011) and Caporale Business cycles of a number of LAC economies are positively correlated with cycles in Brazil and Mexico. and Girardi (2012), who find that global factors are Correlations tend to be larger for countries in close somewhat more important sources of output growth proximity. variability in LAC than regional factors.8 Conclusion Despite a number of regional agreements, regional trade remains limited, partly reflecting the lack of an extensive 7Similar findings were reported in World Bank (2015n) and Cesa- Bianchi et al. (2012). 8A number of previous authors who have found that country-specific factors explain the majority of cyclical variation and output variability in LAC growth (Kose, Otrok and Whiteman 2003; IMF 2007; Loayza, Lopez and Ubide 2001; Boschi and Girardi 2011). On the other hand, other studies have also documented that external factors nevertheless do account for a significant share of growth variance of LAC economies Source: Haver Analytics and World Bank staff estimates. (Izquierdo, Romero and Talvi 2008; Österholm and Zettelmeyer 2008; Note: Cross-country average of contemporaneous correlations in each country’s quarterly growth with that of Brazil or Mexico. Aiolfi, Catão and Timmermann 2011). 120 C H A P TE R 2. 3 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.3.1 Regional integration and spillovers: Latin America and the Caribbean (continued) FIGURE 2.3.1.9 Spillovers from Brazil, Mexico, G7 and China Growth shocks in Brazil have measurable spillovers to its South American neighbors - Argentina, Chile, Colombia, Ecuador, Paraguay and Peru. Estimated spillovers from growth shocks in Mexico are not statistically significant. Within- region spillovers are considerably smaller than spillovers from growth shocks in G7 countries or China. A. Impact on growth of a 1 percentage point decline in Brazil’s B. Impact on growth of a 1 percentage point decline in growth Mexico’s growth C. Impact on growth of a 1 percentage point decline in G7 D. Impact on growth of a 1 percentage point decline in China’s growth growth Source: World Bank staff estimates. Note: Spillover estimates derived from impulse responses after two years from a Bayesian structural vector autoregression estimated using quarterly seasonally adjusted GDP data. The maximum data coverage is 1998Q1-2015Q2; while coverage for some countries is shorter (from 2000Q2 for Colombia and Honduras and from 2002Q2 for Jamaica). The model is estimated for each spillover destination country and the variables include, in this Cholesky ordering: G-7 growth, EMBI, China growth, Brazil and Mexico growth, the country’s trade-weighted commodity price growth, the country’s real GDP growth, and the country’s real effective exchange rate appreciation. Quarterly GDP data was download- ed from Haver Analytics on November18, 2015. Bars represent medians, and error bars 33-66 percent confidence bands. international value chain network and heavy reliance on nature of the region (IMF 2015h). Poor quality of commodity exports to external markets. The lack of regional transport networks and associated infrastructure economic diversification and narrow product base could further hinder within-region trade (World Bank 2012a; be another contributing factor to the generally closed Figure 2.3.1.10). Intraregional trade linkages and FDI G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 L A T I N AM E RI C A A N D T H E C A R I B B E A N 121 BOX 2.3.1 Regional integration and spillovers: Latin America and the Caribbean (continued) flows within Latin America are largely confined within sub -regions (De la Torre, Lederman and Pienknagura 2015). FIGURE 2.3.1.10 Ease of trading across These linkages are stronger in South America than in borders Central America. LAC economies are ranked low in terms of ease of trading across borders. Reflecting these modest within-region ties, spillovers from growth decelerations in Brazil to some of its South A. Rankings in Ease of Trading Across Borders, 2015 American neighbors are estimated to be modest, while spillovers from Mexico are negligible. Spillovers from the region’s main trading partners, however, tend to be considerably larger than within-region spillovers, albeit less than in other emerging and developing country regions. Regional trade could strengthen in the medium term. With commodity prices expected to stabilize around current low levels, export baskets could shift towards a more diversified export product mix among regional commodity exporters, facilitating regional trade. Moreover, the sharp depreciations of regional currencies against the U.S. dollar may favor imports from intra- regional partners at the expense of those from the United States. Source: World Bank 2015f. Growth in the Middle East and North Africa was stable in 2015, at 2.5 percent. Accelerating activity in most oil-importing countries more than o set a slowing in oil exporters. Growth is expected to jump to more than 5 percent in 2016 and 2017. is re ects an expected rapid growth pickup in the Islamic Republic of Iran, the largest developing economy in the region, as sanctions are suspended or removed under the Joint Comprehensive Plan of Action. e forecast also depends on a stabilization of oil prices, and measured improvement in security in some countries. e outlook remains subject to signi cant downside risks stemming from possible escalation of con ict, a further decline in oil prices, and social unrest. Key policy challenges are to reduce unsustainable scal de cits, particularly in oil-exporting countries, and to harness the potential of the working-age population. Recent developments following the 2014 war supported growth in the West Bank and Gaza, while strong investment growth boosted activity in Djibouti. However, Growth in developing countries in the Middle growth in Tunisia was held back by security East and North Africa was unchanged in 2015, at concerns, and in Jordan and Lebanon by spillovers 2.5 percent (Table 2.4.1). In most oil-exporting from the conflict in Syria. Subdued activity in countries (Algeria, the Islamic Republic of Iran, Tunisia also reflected weak credit growth linked to and Libya), growth slowed, as oil production and a delay in recapitalization of ailing publicly-owned investment fell with the steep decline in oil prices banks. since mid-2014. The situation was worsened in Libya by ongoing conflict.1 In Iraq, however, A potentially pivotal development was the despite protracted conflict, expansion in the oil international agreement, signed in July 2015, of sector was sufficient to reverse an economic the Joint Comprehensive Plan of Action for contraction in 2014. limitations on Iranian nuclear development. For their part, the five permanent members of the In most oil-importing countries, growth United Nations Security Council, plus Germany strengthened in 2015, as lower oil prices provided and the European Union, agreed to remove and, support to demand and allowed reductions in fuel in the case of the United States, suspend, trade subsidies. Activity in Egypt and Morocco and finance sanctions on the Islamic Republic of rebounded significantly, reflecting rising domestic Iran. The agreement opens the door for re- consumption (Egypt) and a strong rebound in the integration of the country into the global economy agricultural sector (Morocco). Reconstruction and the reinvigoration of its oil, natural gas, and automotive sectors. Sanctions could begin to be Note: The author of this section is Dana Vorisek. Research lifted in early 2016 if the International Atomic assistance was provided by Qian Li. Energy Agency (IAEA) indicates the Iranian 1This report covers low- and middle-income countries in the Middle East and North Africa region; Gulf Cooperation Council government has fulfilled its commitments under (GCC) countries are excluded. The developing countries are further the pact. Renewed optimism about the potential divided into two groups, oil importers and oil exporters. Oil of the Iranian economy has already generated a importers are Djibouti, the Arab Republic of Egypt, Jordan, Lebanon, Morocco, the Syrian Arab Republic, Tunisia, and West flurry of investment interest by foreign companies. Bank and Gaza. Oil exporters are Algeria, the Islamic Republic of Iran, Iraq, Libya, and the Republic of Yemen. Syria and the Republic of Yemen are excluded from regional growth forecasts due to data The toll of conflict in several countries in the limitations. region showed little sign of abating in 2015. The 124 C H A P TE R 2. 4 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 number of people in the region who are internally Oil prices are now below fiscal break-even levels displaced or who have left their home countries as (i.e., the levels that balance the government a result of conflict is unprecedented. In Iraq, 3.6 budget) in all oil-exporting countries in the million people were internally displaced as of Middle East and North Africa (IMF 2015g). December 2014. An estimated 4.8 million people Violent conflict, which has reduced oil revenues have left Syria as migrants or refugees, while 7.6 while necessitating increased spending on security, million are internally displaced. The rising outflow is further straining government budgets of oil of migrants from Syria, and to a lesser extent Iraq, exporters across the region. In Algeria and Iraq, moved to the forefront of the European Union’s fiscal deficits deteriorated by more than 10 policy agenda in 2015. The average monthly percentage points of GDP between 2013 and number of first-time asylum seekers to the 2015, and in Libya by 50 percentage points. In European Union more than doubled between Iraq and Libya, budget deficits were financed in 2013 and the first eight months of 2015, to more 2015 predominantly by borrowing from state- than 66,000 people. Nearly one-third of asylum owned banks, the Development Fund for Iraq seekers in July and August 2015 were from Syria, having been exhausted by 2014. The bank up from less than one-quarter during the same borrowing is putting liquidity under strain. Algeria months in 2014 and roughly 10 percent in 2013. continues to draw on a sovereign wealth fund. Separately, high-profile terrorist attacks aimed at tourists in Egypt and Tunisia in 2015 negatively For oil-importing countries, declining oil prices, affected tourism in those countries. together with falling food prices, have been generally beneficial, as they have reduced the cost The economic impact of Syrians seeking to escape of imports and, in Morocco and Lebanon, war has been very heavy for Lebanon and Jordan, contributed to higher consumption growth. which the United Nations High Commissioner Declining oil and food prices have also kept indicates host 1.1 million and more than 630,000 inflation subdued (Figure 2.4.2). For some Syrian refugees, respectively, as of November. The countries (Jordan and Morocco), the period of low number of Syrian refugees in Lebanon and Jordan oil prices has helped stabilize government debt. is equivalent to a respective 25 percent and 9 Nevertheless, fiscal deficits were 10 percent or percent of the populations, putting severe strain more of GDP in Egypt and Djibouti in 2015, and on public service delivery and infrastructure. above 7 percent in Lebanon. Another 1.9 million refugees from Syria are in Turkey. In Egypt, Jordan, and Lebanon, real effective exchange rates (REERs) appreciated during 2015, For most oil-producing countries where conflict is weighing on export competitiveness. In Egypt, the entrenched, oil production has dropped. In Syria appreciating REER reflects high inflation, which and the Republic of Yemen, oil production has all averaged 10.3 percent in the first ten months of but collapsed. For Syria, the decline reflects 2015. The central bank carried out several disruptions from conflict as well as trade sanctions nominal devaluations, and restricted access to imposed by the European Union and the United foreign currency, in attempt to resolve a deepening States. In Libya, production has dropped by nearly foreign currency shortage. In Jordan and, in 75 percent since 2010, from an average of 1.6 particular, Lebanon, whose currencies are pegged million barrels per day (mbd) to 0.4 mbd in 2015. to the U.S. dollar, real appreciation mostly In contrast, oil production in Iraq has steadily reflected the rise of the U.S. dollar against the increased, despite the conflict (Figure 2.4.1), as euro, as inflation was negative through most of the important oil fields are not in the immediate 2015. Among oil exporters, the currencies of geographical vicinity of the territory now Algeria, the Islamic Republic of Iran, and Libya controlled or contested by the Islamic State of Iraq have depreciated, partially offsetting the local- and the Levant (ISIL). Average oil production in currency revenue loss from lower U.S.-dollar Iraq, at approximately 4 mbd in 2015, is more prices of oil exports (IMF 2015g). Although than 65 percent higher than in 2010. international sanctions on the Islamic Republic of G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 M I D D LE E AS T A N D N O R T H A F R I C A 125 Iran contributed to an episode of extremely high FIGURE 2.4.1 Oil production and fiscal balance inflation in 2012 and 2013, inflation has Crude oil production has declined in countries where conflict is entrenched moderated more recently, despite a depreciating except Iraq. Low oil prices and the direct and indirect costs of conflict are rial. straining government budgets in oil-exporting countries in the Middle East and North Africa. Falling oil prices have helped improve fiscal balances in oil-importing countries. Low oil prices are also contributing to adjustments in external balances. Whereas all oil exporters in A. Crude oil production B. Fiscal balance the Middle East and North Africa had current account surpluses in 2013, balances in all of these countries except the Islamic Republic of Iran had swung into deficit by 2015, particularly in Libya, Algeria, and Iraq. Algeria and Libya have been able to rely on official reserves, but these have been depleted rapidly since mid-2014. Although Lebanon’s large current account deficit (21 percent of GDP in 2015) is a vulnerability, the country has been able to finance it in recent years, Source: World Bank, International Energy Agency. A. Figure reflects average monthly production for each year; value for 2015 is the average for January to mainly through portfolio investment. Capital November. flows to Lebanon declined sharply in the first half of 2015, however, by 33 percent year over year. FIGURE 2.4.2 Exchange rates, inflation, and current Inflows to other oil-importing countries (Egypt, account balances Morocco) were up in 2015, mostly as a result of strengthening foreign direct investment (FDI). Low commodity prices have helped keep inflation subdued in oil-importing countries except Egypt, where rising prices are reflected in an However, the pickup in FDI to Egypt has not appreciating real exchange rate. Low oil prices are contributing to been as strong as expected given pledges at an adjustments in external balances, worsening deficits in oil-exporting international economic development conference in countries and narrowing them in oil importers. March 2015. A. Inflation in oil-importing countries B. Inflation in oil-exporting countries Remittance flows to developing countries in the region are estimated to have expanded by 1.6 percent in 2015, a slower pace than in 2014 (World Bank 2015l). Flows to Egypt, Jordan, and the Republic of Yemen rose, as inflows from GCC countries remained strong. Flows to Algeria, Morocco, and Tunisia, however, declined in U.S. dollar terms due to the depreciation of the euro, the currency in which 90 percent of remittance C. Egypt: real effective exchange rate D. Current account balances inflows are received. Remittances have represented and foreign reserves a major source of foreign earnings for Lebanon and Jordan in recent years (16 percent and 10 percent of GDP in 2014, respectively, according to World Bank data). The inflows may have helped to smooth consumption in the weak growth environment (World Bank 2015n). Source: World Bank, Haver Analytics. C. Foreign reserves include gold. On left axis, an increase denotes real appreciation. 126 C H A P TE R 2. 4 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 Outlook are interested in operating in the Islamic Republic of Iran. Despite low oil prices—assumed to be $49 per barrel in 2016, broadly at 2015 levels—and several Among other oil exporters, growth in Iraq and major conflicts, growth in developing countries in Algeria should be lifted in 2016 and 2017 by a the Middle East and North Africa as a group is recovery in the non-oil sector, in addition to expected to rebound to 5.1 percent in 2016, and continued oil sector growth. The baseline assumes to 5.8 percent in 2017 (Table 2.4.2). The that the impact of ISIL on Iraq’s economy will predominant reason for the improvement is an slowly become more limited. In Libya, a UN- expected growth spurt in the Islamic Republic of sponsored political agreement reached at the end Iran, the largest developing economy in the of 2015 should allow oil production and GDP region, from 1.9 percent in 2015 to 5.8 in 2016 growth to recover. and 6.7 percent in 2017. The outlook also reflects Growth should also strengthen in most oil- slightly higher growth among other oil exporters, importing countries. In Tunisia, growth should especially Iraq and Algeria, and a more modest rise to 2.5 percent in 2016, predicated on a better medium-term improvement among oil importers, security environment and progress on reforms. In from 3.5 percent in 2015 to an average of 4 Jordan, implementation of a new 10-year percent in 2016–18. The forecasts assume economic and social development plan is stabilization of oil prices and an improvement in anticipated to lift confidence and push growth to the security situation in some countries. 3.5 percent. The exceptions are Morocco and Egypt. In Morocco, growth is expected to revert to Crude oil production in the Islamic Republic of 2.7 percent in 2016, around the same as in 2014, Iran is expected to increase rapidly following the as rainfall patterns reduce agricultural output from removal or suspension of sanctions, by an an exceptionally high level in 2015. In Egypt, estimated 0.5–0.7 million barrels per day (mbd) in growth is forecast to moderate to 3.8 percent in 2016 (World Bank 2015o), up from the 2015 fiscal year 2015/16 as the tourism sector weakens level of 2.8 mbd. The potential increase in capital following the October plane crash in the Sinai and inflows in the post-sanctions environment could a foreign currency shortage persists for at least help expand exploitation of proven natural gas part of the year. Growth in FY2016/17 should rise reserves, which are the largest in the world. The to 4.4 percent, driven by an uptick in investment. release of frozen Iranian assets currently overseas Rising growth in Egypt would have only a modest will also boost the economy. The ramping up of impact on the rest of the region, however (see Box oil production over time, contingent upon 2.4.1). significant infrastructure repair and investment, could help keep global oil supply high, and prices Fiscal deficits among oil-exporting countries, low, over the medium term. although still large in some cases, will begin to narrow in 2016. The improvement reflects fiscal A rebounding Iranian economy will affect consolidation following the oil price drop. Iraq’s neighboring countries within the Middle East and 2015 budget contained spending cuts (merging of North Africa to varying degrees. A rapid rise in some ministries, government job cuts, and Iranian oil production would dampen growth reduction in construction spending) that will help prospects in oil-exporting countries and improve shrink the deficit in 2016. The deficit will remain them in oil-importing countries (Ianchovichina, wide, however. Lending from official sources will Devarajan, and Lakatos forthcoming). If pre-2010 fill a large financing gap. The Algerian government -sanctions trade patterns are a guide, the export intends to reduce spending by 9 percent in 2016, opportunities for other developing countries in the with cuts in utility subsidies and infrastructure region from a rapidly growing Iranian economy projects but not in health, education, or housing. may be limited, but perhaps greatest for Lebanon. The expected budget adjustments among oil Lebanese banks have already indicated that they exporters are, however, unlikely to be sufficient to G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 M I D D LE E AS T A N D N O R T H A F R I C A 127 stabilize government debt in the absence of a broader risks to oil prices, depending on how fast significant rise in oil prices. new investment and technology can be mobilized to tap the Islamic Republic of Iran’s oil and gas Fiscal deficits are expected to fall or remain reserves. broadly stable in oil-importing countries other than Djibouti. In Egypt, consolidation reflects The primary downside risk for the regional lower energy subsidy spending and announced economy remains escalation or prolongation of increases in electricity tariffs, among other things. conflict. In Iraq, Libya, Syria, and the Republic of In Lebanon, the expectation that the fiscal deficit Yemen, countries directly impacted by conflict, will not fall substantially during the forecast the loss of life, outward migration of skilled period will contribute to a continued rise in workers, destruction of infrastructure, and government debt, already at approximately 145 disruption of trade routes have significantly set percent of GDP at the end of 2015. back economic activity in recent years, and have slashed potential output. Conflict has also stalled Current account deficits are expected to narrow in regional trade integration that was in its infancy most countries in the region in 2016. With five years ago (Ianchovichina and Ivanic 2014). external financing conditions expected to tighten, Spillovers from conflicts in the region could have however, some countries, such as Iraq, could have ongoing impacts on neighboring countries beyond difficulty attracting enough foreign capital to what has already occurred, through trade finance their deficits. Oil-importing countries will disruption, reduction in cross-border investment, continue to benefit from low oil prices over the evaporation of tourism, or an inability to manage medium term, while North African countries with pressure on public services from a large number of deep trade ties with Europe (Algeria, Morocco, Syrian refugees. Lebanon and Jordan are and Tunisia) may receive an export boost as the particularly at risk in this regard. Euro Area economy improves (Figure 2.4.3). In the medium term, Tunisia’s agricultural sector Even in countries not facing large-scale conflict may also benefit from a deep and comprehensive within their borders, security risk and political free trade agreement with the European Union, on uncertainty have impacted consumer, business, which negotiations began in October. Successfully and investor confidence. Egypt, for instance, had boosting services exports, in particular through two new governments in the second half of 2015. tourism, could contribute to further narrowing of Lebanon has been without a president since mid- current account deficits in several countries. 2014. Terrorist attacks, such as those that targeted Tourist arrivals are below pre-Arab-Spring levels tourists in Egypt and Tunisia in 2015, would across the region. further damage the tourism sector. For Egypt, the contraction in foreign currency inflows that would Risks accompany a shrinking tourism industry would not only negatively impact growth, but would The growth outlook for the Middle East and exacerbate the existing foreign currency shortage. North Africa is subject to several major and longstanding downside risks: economic spillovers For oil exporters, another significant risk is from conflict; a renewed decline in oil prices; and potential additional downward movement in oil the absence of progress in living conditions, which prices should global supply stay high for an could reinvigorate social unrest. The Iran nuclear extended period of time. This could stifle growth agreement could be an upside or a downside risk in economies highly dependent on oil revenues for the region: upside if economic recovery in the and exports (Libya, Iraq, Algeria) and put further country is faster than in the baseline forecast pressure on already large fiscal and external following lifting of sanctions, and downside if the imbalances. government’s commitments are implemented Across the Middle East and North Africa, lack of more slowly than called for under the accord. improvement in labor markets and living Over the long term, the agreement does generate conditions increases the risk of further social 128 C H A P TE R 2. 4 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 FIGURE 2.4.3 Trade including Egypt, Morocco, Tunisia, and Jordan North African countries may experience a boost to growth through exports found that the first three of these countries have as Euro Area growth rises during the forecast period. Security risks weigh significant gaps relative to other developing on the tourism industry in several countries, and tourism arrivals remain countries with regard not only to youth below pre-Arab-Spring levels. employment, but also the quantity and quality of A. Goods exports, 2014 B. Average monthly tourist arrivals education and skills mismatches (EBRD 2015a; Jelassi, Zeghal, and Malzy 2015).2 Of the seven developing Middle East and North African countries assessed in the World Economic Forum’s Global Competitiveness Index, five scored worst in the labor market efficiency category in the 2015-16 index, and four of these countries (Algeria, Egypt, the Islamic Republic of Iran, and Tunisia) have been in the bottom decile Source: IMF DOTS database, Haver Analytics, Lebanon Central Administration of Statistics, World of rankings of labor market efficiency for the past Bank. B. Tourist arrivals for 2015 are the average of January-August for Egypt, January-September for three years. Jordan, and January-October for Lebanon and Tunisia. Other indicators of living conditions are also FIGURE 2.4.4 Labor market conditions weak. The United Nations Human Development Index, a composite measure of gross national Unemployment rates in the Middle East and North Africa are high relative income per capita, life expectancy, and schooling, to other developing regions and higher than before the Arab Spring in some countries. Cross-country comparisons reveal poor labor market shows less progress in Arab states in 2013 and efficiency across the region. 2014 than in any other developing region, and a A. Unemployment rate B. Labor market efficiency decline in the index for Libya and Syria. Household surveys find that people in the Middle East were less satisfied in 2014 with their standard of living than they were in 2007, and that only 43 percent of people perceived their standard of living as improving in 2014, down from 58 percent in 2007 (Figure 2.4.5). These indicators suggest an increasing sense of disenfranchisement in the region. While the lack of progress in living conditions may be partly due to conflict, it is also Source: World Bank, Haver Analytics, IMF, World Economic Forum Global Competitiveness Index. A. Unemployment rates shown for 2015 are the average of Q1-Q3 rates. Data for 2011 missing for self-reinforcing and has the potential to contribute Tunisia. to further social unrest, extremism, and violence. B. Figure reflects percentile of individual country rankings among 135 countries ranked in 2015-16, 144 in 2014-15, and 148 in 2013-14. The labor market efficiency index includes 10 subcomponents: cooperation in labor-employer relations, hiring and firing practices, flexibility of wage determination, effect of taxation on incentives to work, redundancy costs, pay and productivity, reliance on profes- sional management, country capacity to retain talent, country capacity to attract talent, and ratio of Policy challenges women to men in the labor force. unrest. Unemployment rates, which have long In view of their large budget deficits, there is a been high relative to other developing regions, are pressing need among oil exporters in the Middle above 2011 levels in Algeria, Egypt, Morocco, and East and North Africa for deeper cost-cutting and Tunisia (Figure 2.4.4). Youth unemployment, at revenue-generating measures. In Algeria and Iraq, 32 percent in Jordan and 21 percent in Morocco, this means successful implementation of fiscal is more than double the overall unemployment consolidation already planned. The urgency of rate. Employment growth is chronically weak or fiscal adjustment in Iraq, Libya, and the Republic negative in countries with available data, and of Yemen, and to a somewhat lesser extent, unemployment in the large informal sector is 2An explanation of the variables included in these four categories likely much higher than in the formal sector. A and the statistical method for generating cross-country comparisons is cross-country study of developing countries given in EBRD (2015a). G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 M I D D LE E AS T A N D N O R T H A F R I C A 129 Algeria, will become stronger in the medium term FIGURE 2.4.5 Perception of standard of living given that fiscal buffers are rapidly narrowing, Indicators of living conditions in the Middle East have declined in recent financing needs are high, and borrowing capacity years, suggesting an increasing sense of disenfranchisement in the region that may contribute to future social unrest. is weak (IMF 2015g). Furthermore, the decline in oil prices since mid-2014 is estimated to reflect a large permanent component (Husain et al. 2015), making the longstanding need for economic diversification in oil-exporting countries even more urgent. Fiscal adjustment can also be accelerated in oil- importing countries, notwithstanding subsidy reforms already undertaken (Egypt, Jordan, and Morocco). In Egypt, introduction of a second round of energy subsidy cuts and a value-added tax has stalled. The political impasse in Lebanon is holding back the reform agenda, and impedes the functioning of public services. In Tunisia, progress on energy subsidy reductions and other fiscal adjustments has lagged. Low oil prices could be used as an opportunity to advance fiscal reforms during the forecast period. Source: Gallup World Poll 2014. Note: Figure reflects responses to 1) “Are you satisfied or dissatisfied with your standard of living, all the things you can buy and do?”, 2) “Right now, do you feel your standard of living is getting better?”, Central banks in the region also face challenges. 3) “Have there been times in the past 12 months when you did not have enough money to buy food that you and your family needed?”, and 4) “Do most children in this country have the opportunity to The new governor of the Central Bank of Egypt learn and grow?” in nationally representative household surveys. will need to oversee a boosting of critically low levels of foreign reserves. Additional rounds of With respect to labor market policies, currency devaluation are likely, which means policymakers in the region should move forward monetary policy will have to resist pressure on an with measures to remove supply-side constraints, inflation rate that is already high. Iranian such as improving the quality of education in policymakers have said they will make it a priority some countries and implementing programs to to reduce inflation, which may become an easier better match labor force skills with those task as sanctions are loosened. demanded by job markets. These efforts will need to be combined with the removal of constraints to In the medium and long term, it is critical that competition and impediments to equality of developing countries the Middle East and North opportunity among businesses, such as exclusive Africa reduce inequality of opportunity and foster operating license requirements and trade barriers more inclusive growth. Working-age population (Schiffbauer et al. 2015). Such measures in turn growth in the region is higher than in all other can be expected to improve labor demand. developing regions except Sub-Saharan Africa Removing rigidities in hiring, firing, and wage and will continue to be so over the next decade. setting should also be a priority. To improve From this demographic perspective, it is public sector accountability, particular effort imperative that labor market and other policy should be made to curtail corruption, including by adjustments begin now, and that there be a special removing opportunities for rent-seeking among emphasis on addressing shortcomings affecting politically-connected people (World Bank 2015p). youth. Reform efforts would be well placed in two broad areas: labor market policy and public sector accountability. 130 C H A P TE R 2. 4 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 TABLE 2.4.1 Middle East and North Africa forecast summary (Annual percent change unless indicated otherwise) (Percentage point difference from June 2015 projections) 2013 2014 2015e 2016f 2017f 2018f 2015e 2016f 2017f Developing MENA, GDP a 0.6 2.5 2.5 5.1 5.8 5.1 0.1 1.4 2.0 (Average including countries with full national accounts and balance of payments data only)b Developing MENA, GDPb 1.0 3.6 2.8 4.4 5.1 4.9 0.2 1.0 1.6 GDP per capita (U.S. dollars) -0.9 1.7 1.0 2.8 3.5 3.5 -0.3 0.7 1.2 PPP GDP 0.9 3.6 2.8 4.5 5.2 5.0 0.1 1.1 1.6 Private consumption 2.5 2.5 2.7 3.1 3.3 3.3 -0.8 -0.5 -0.2 Public consumption 0.3 3.7 2.6 3.9 4.4 4.5 -1.2 1.0 1.5 Fixed investment -0.1 8.3 4.9 7.3 8.8 7.9 2.0 0.6 4.8 Exports, GNFSc -1.6 2.4 -0.4 7.0 7.5 8.3 -5.0 2.2 2.4 Imports, GNFSc -1.2 2.0 1.3 4.5 4.9 5.1 -4.0 -1.6 -1.7 Net exports, contribution to growth -0.1 0.0 -0.5 0.6 0.6 0.8 -0.1 1.2 1.4 Memo items: GDP Broader geographic regiond 1.9 3.0 2.6 3.8 4.4 4.1 -0.5 0.2 0.6 High Income Oil Exporterse 3.1 3.5 2.7 2.7 3.0 3.0 -1.1 -0.8 -0.8 Developing Oil Exporters -1.0 2.3 1.7 6.2 7.0 5.6 0.4 2.9 3.8 Developing Oil Importers 2.9 2.8 3.5 3.5 4.1 4.4 -0.4 -0.8 -0.5 Egypt, Arab Rep. 2.2 3.2 4.0 4.1 4.6 4.8 -0.3 -0.6 -0.2 Fiscal Year Basis 2.1 2.2 4.2 3.8 4.4 4.8 0.0 -0.7 -0.4 Iran, Islamic Rep. -1.9 4.3 1.9 5.8 6.7 6.0 0.9 3.8 4.7 Algeria 2.8 3.8 2.8 3.9 4.0 3.8 0.2 0.0 0.0 Source: World Bank. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not differ at any given moment in time. a. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. Excludes Syria and Republic of Yemen due to data limitations. b. Sub-region aggregate excludes Djibouti, Iraq, Libya, Republic of Yemen, Syria, and West Bank and Gaza, for which data limitations prevent the forecasting of GDP components. c. Exports and imports of goods and non-factor services (GNFS). d. Includes developing MENA and the following high-income countries: Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates. e. Includes Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 M I D D LE E AS T A N D N O R T H A F R I C A 131 TABLE 2.4.2 Middle East and North Africa country forecastsa (Real GDP growth at market prices in percent, unless indicated otherwise) (Percentage point difference from June 2015 projections) 2013 2014 2015e 2016f 2017f 2018f 2015e 2016f 2017f Algeria 2.8 3.8 2.8 3.9 4.0 3.8 0.2 0.0 0.0 Djibouti 5.0 6.0 6.5 7.0 7.1 7.0 0.0 0.0 0.0 Egypt, Arab Rep. 2.2 3.2 4.0 4.1 4.6 4.8 -0.3 -0.6 -0.2 Fiscal Year Basis 2.1 2.2 4.2 3.8 4.4 4.8 0.0 -0.7 -0.4 Iran, Islamic Rep. -1.9 4.3 1.9 5.8 6.7 6.0 0.9 3.8 4.7 Iraq 4.2 -0.5 0.5 3.1 7.1 6.5 1.5 -2.4 1.2 Jordan 2.8 3.1 2.5 3.5 3.8 4.0 -1.0 -0.4 -0.2 Lebanon 3.0 2.0 2.0 2.5 2.5 3.0 -0.5 0.0 0.0 Libya -13.7 -24.0 -5.2 35.7 27.6 8.4 -5.7 20.7 16.7 Morocco 4.7 2.4 4.7 2.7 4.0 4.0 0.1 -2.1 -1.0 Tunisia 2.9 2.7 0.5 2.5 3.3 4.5 -2.1 -0.9 -1.2 West Bank and Gaza 2.2 -0.4 2.9 3.9 3.7 3.7 2.0 -0.4 -0.4 2013 2014 2015e 2016f 2017f 2018f 2015e 2016f 2017f Recently transitioned to high-income economiesb Oman 3.9 2.9 3.7 3.2 3.0 2.5 0.0 -0.4 -0.5 Saudi Arabia 2.7 3.5 2.8 2.4 2.9 2.9 -1.8 -1.7 -1.4 Source: World Bank. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not significantly differ at any given moment in time. a. Syria and Republic of Yemen are not forecast due to data limitations. b. Based on the World Bank's country reclassification from 2004 to 2015. 132 C H A P TE R 2. 4 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.4.1 Regional integration and spillovers: Middle East and North Africa Most of the external trade and nancial ties of countries in the Middle East and North Africa (MENA) region are with countries outside the region. Trade and nancial ows between MENA countries are modest. As a result, within-region growth spillovers even from the largest developing countries in the region—the Arab Republic of Egypt—are small. Spillovers from a large neighboring developing economy—Turkey——are also limited. In contrast, spillovers from G7 countries and GCC countries are considerably larger. Introduction FIGURE 2.4.1.1 Cross-region comparison The MENA region is highly open to trade and remittance The MENA region is one of the most open regions to global trade and remittances but receives limited financial flows (Figure 2.4.1.1).1 Trade accounts for more than 60 flows by comparison with other developing regions. percent of GDP for both oil exporters and oil importers in the region. There has, however, been a decline in economic A. MENA: Share of global activity, trade and finance, 2014 integration with the rest of the world since the global financial crisis. Trade as a percentage of GDP has declined (Figure 2.4.1.2). Political uncertainty and falling commodity prices have contributed to a sharp fall in foreign direct investment (FDI) inflows to below 2 percent of GDP, about 1 percentage point below the average for other regions and considerably below the high FDI inflows pre-crisis. Remittance receipts in oil-importing countries have recovered only modestly after dropping significantly during the crisis. With anemic growth in advanced economies, the pattern of MENA’s trade and remittances links has shifted. Trade with other emerging markets, especially the BRICS (Brazil, Russia, India, China, and South Africa), has increased threefold compared to 2000 (Figure 2.4.1.3). Within- B. MENA: Trade and finance in regional comparison, 2014 region trade and remittance flows have increased, but remain low. In addition to direct economic ties, confidence shocks, related to the recent conflicts and security issues in the region may also affect the economies of neighboring countries and are of increasing concern to policymakers. This box addresses the following two questions: • How open is the MENA region to global and regional trade and financial flows? • How large are the potential intra-regional spillovers from one of the region’s largest developing countries, Note: is box was prepared by Ergys Islamaj and Jesper Hanson. 1Unless otherwise speci ed, the MENA region is de ned to include oil- Sources: IMF October 2015 World Economic Outlook, IMF International Finan- exporting countries (Algeria, Bahrain, the Islamic Republic of Iran, cial Statistics, IMF Direction of Trade Statistics, UNCTAD FDI/TNC database, World Bank Remittance and Migration Database, World Bank World Develop- Kuwait, Oman, Qatar, Saudi Arabia, the United Arab Emirates and the ment Indicators. Republic of Yemen ) and oil-importing countries (Djibouti, Egypt, Israel, B. The red bar denotes exports, imports, trade, remittance inflows, portfolio Jordan, Lebanon, Morocco, Tunisia and West Bank and Gaza). GCC liabilities and FDI inflows in percent of GDP on average across MENA coun- tries. The vertical line denotes the range of averages for all six developing stands for Gulf Cooperation Council countries. For the purposes of this country regions. box, Israel is also included as a recipient country of shocks (although it is not part of the World Bank’s de nition of the geographic region) since it has substantial trade ties to some other countries in the region. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 M I D D LE E AS T A N D N O R T H A F R I C A 133 BOX 2.4.1 Regional integration and spillovers: Middle East and North Africa (continued) FIGURE 2.4.1.2 Trade, FDI, and remittances The MENA region is highly open to trade and remittances despite a decrease since 2008. FDI inflows have fallen steeply in both oil exporters and importers, partly as a result of political uncertainty and falling commodity prices. A. Trade B. Foreign direct investment C. Remittances D. Exports of GCC and non-GCC MENA countries, 2011 Sources: World Bank World Development Indicators; IMF Balance of Payments Statistics; World Bank Export Value Added Database. Notes: A., B. and C. Trade is defined as the sum of exports and imports. Oil-exporting countries include Algeria, Bahrain, Iraq, Islamic Republic of Iran, Kuwait, Libya, Oman, Qatar, Saudi Arabia, United Arab Emirates and Yemen. Oil-importing countries include Djibouti, Egypt, Jordan, Lebanon, Morocco, Tunisia and West Bank and Gaza. Data unavailable for Islamic Republic of Iran, Iraq, Libya, Qatar, and the United Arab Emirates. Lines show sums of all countries in each sample. D. GCC countries include Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, the United Arab Emirates; non-GCC countries include Algeria, Djibouti, Egypt, Islamic Republic of Iran, Iraq, Jordan, Lebanon, Libya, Morocco, Tunisia, West Bank and Gaza, the Republic of Yemen. Data is unavailable for Algeria, Djibouti, Iraq, Jordan, Lebanon, Libya West Bank and Gaza, Yemen. Bars show unweighted averages. Egypt, and from one of its largest neighboring formal estimation. Other types of shocks—for example, of developing countries, Turkey? a political, security or financial nature—may also generate important spillovers that are not captured in the The empirical results suggest that the region is econometric analysis. predominantly vulnerable to growth shocks originating from outside the region. Growth shocks from developing How open is the MENA region to global and countries inside the region have negligible spillovers on regional trade and financial flows? other MENA countries. Potential spillovers from Gulf Cooperation Council (GCC) countries could be Trade and financial ties with countries outside the region significantly larger, although data limitations prevent a far outweigh those within the region (Figure 2.4.1.3). On 134 C H A P TE R 2. 4 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.4.1 Regional integration and spillovers: Middle East and North Africa (continued) average across the MENA region during 2011-14, the MENA region. This average masks considerable cross- United States, the Euro Area, and Japan combined country heterogeneity, however. For many MENA accounted for 31 percent of exports, 69 percent of inward countries, the Euro Area and the United States together FDI, and 62 percent of banking claims on countries in the account for more than 50 percent of export revenues and FIGURE 2.4.1.3 Openness inside and outside the region The main economic partners of MENA countries are outside the region, although within-region remittance and official development assistance flows are important. Since 2000, ties with the United States and the Euro Area have weakened while those within the region and the BRICS countries have strengthened. A. Trade, investment, remittances, and official development B. Trade within and outside the region, average 2011-14 assistance in MNA region, average 2011-14 C. Evolution of trade within and outside the region D. Remittance Inflows Source: IMF Direction of Trade Statistics (DOTS); IMF Coordinated Direct Investment Survey (CDIS); Bank for International Settlement (BIS) Consolidated Banking Statistics; World Bank Remittances and Migration database and WB country economists’ estimates; OECD. Notes: BRICS = Brazil, Russia, India, China, and South Africa; EA = Euro Area. Also see abbreviations above. A. ODA = Official Development Assistance. Latest available data: 2014 for trade, remittances, BIS-reporting banks’ consolidated foreign claims; 2013 for foreign direct investment and official development assistance. FDI claims from CDIS not available for China, and replaced with BBVA data. Data provided for Algeria, Bahrain, Djibouti, Egypt, Iraq, Islamic Republic of Iran, Jordan, Kuwait, Lebanon, Libya, Morocco, Oman, Qatar, Saudi Arabia, Tunisia, United Arab Emirates, West Bank and Gaza, and the Republic of Yemen. Within-region FDI reported only for Kuwait. Within-region ODA includes Kuwait, Saudi Arabia and the United Arab Emirates. B. Includes Algeria, Bahrain, the Arab republic of Egypt, the Islamic Republic of Iran, Jordan, Kuwait, Morocco, Oman, Qatar, Tunisia, Lebanon, Saudi Arabia, the United Arab Emirates, and Yemen. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 M I D D LE E AS T A N D N O R T H A F R I C A 135 BOX 2.4.1 Regional integration and spillovers: Middle East and North Africa (continued) FDI inflows. The openness of the region to global trade negative shocks in GCC source countries to other and finance is reflected in spillovers of global shocks to countries in the region (IMF 2014d), remittances also financial market activity. For example, equity returns in help smooth consumption against unexpected the MENA region move strongly with U.S. and European variations in output in recipient countries (Balli, equity markets (Khalifa, Hammoudeh and Otranto 2013; Basher and Louis 2013; World Bank 2015q; Abdih et Balli et al. 2015).2 al. 2012; IMF 2014d). Within-region remittance and official development • Official development assistance. ODA from GCC to assistance (ODA) flows remain significant and potentially other oil-importing MENA countries was scaled up constitute important channels for within-region spillovers. during the financial crisis of 2008 and the Arab In contrast, within-region trade and financial links are Spring. It has remained high since then. GCC modest by comparison with other regions. Given the countries have provided or pledged loans and grants to proximity to the EU, one of the world’s largest trading Egypt, Jordan, Morocco, Tunisia and Yemen to blocs, MENA countries trade predominantly with finance infrastructure investment, balance of countries outside the region. Nevertheless, since they payments deficits, and commodity imports (Rouis continue to face trade barriers in the EU, MENA countries 2013). ODA from Kuwait, Saudi Arabia and UAE trade more with each other than would be expected based represents more than 18 percent of total aid to the on the size of their economies and transport cost (Freund region, ranging from 4 percent of total ODA for and Jaud 2015). Limited within-region trade links also Morocco to 72 percent of total ODA for Egypt. partly reflect close similarities in the export base of many Historically, GCC aid to other MENA countries has energy-exporting countries in the MENA region. varied with oil revenues (Talani 2014, Rouis et. al. 2010). The revenue losses associated with falling oil Bilateral trade and official assistance flows from GCC to prices in GCC countries may make GCC assistance to some oil importing countries have grown, but remain the region less forthcoming. modest on average, with considerable heterogeneity. Since 2000, trade within the region has doubled, to an average of Disruptions in trade and finance and displacements of 4 percent of GDP. Remittances from GCC to other large parts of the population during conflicts in parts of the MENA countries have risen by one third, to 0.9 percent of region can also generate significant spillover effects to GDP. Official development assistance from GCC neighboring countries. These could be both positive and countries to Egypt, Jordan and the Republic of Yemen negative. Disruption of trade routes and trade increased from near-zero in 2000 to 2.7, 1.7, and 0.6 disintegration lowers potential output. Migrants can percent, respectively, of recipient government revenues occupy jobs previously held by low-skilled workers in the during the 2011-2013 period. Since the Dubai World debt host country (Del Caprio and Wagner 2015). However, restructuring and the Arab Spring uprisings, comovement the domestic demand generated by large numbers of of GDP among MENA countries has increased somewhat migrants or government expenditures related to migrants (IMF 2013). could stimulate activity. The net effect has been estimated to be positive for Lebanon—reflecting the large share of Two channels are particularly likely to generate within- the migrant population—but negative or mixed for region spillovers: Turkey, Egypt and Jordan (Ianchovichina and Ivanic 2014, Cali et al. 2015, Del Caprio and Wagner 2015). • Remittances. Remittance inflows ranged from 5 percent of GDP in Tunisia to close to 11 percent of GDP in How large are the potential intra-regional spillovers Jordan during 2011-2014. More than three-fifths of from one of the region’s largest economies, Egypt, these remittances were from GCC countries. While and from one of its largest neighboring countries, large remittances increase the risk of transmission of Turkey? Several countries in the MENA region have stronger ties 2Khalifa et al. (2013) finds significant spillovers from U.S. equity with other MENA economies than others: the GCC markets to Saudi Arabia and UAE equity indices, while Balli et al. (2015) countries and Egypt. Trade links are similarly sizeable with document spillovers from U.S. equity markets to all GCC countries and Turkey, one of the largest economies neighboring the from European equity markets to Qatar and Oman. MENA region. 136 C H A P TE R 2. 4 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.4.1 Regional integration and spillovers: Middle East and North Africa (continued) • GCC countries account for more than half of in Tunisia by the end of the first year. A decline in growth remittance inflows to Jordan and Egypt (50 and 60 in Egypt does not appear to have significant effects respectively). elsewhere. The correlation between shocks to Egypt’s growth and growth in Jordan and Tunisia reflect trade and • Egypt and Turkey are sizeable export markets for remittances ties between these countries, as well as Jordan, Lebanon, Morocco and Tunisia. proximity in the case of Tunisia. In a similar regression using Islamic Republic of Iran as source country of the • Turkey remains an important trading partner for shock, estimates suggest a negligible effect of a slowdown Egypt and the Islamic Republic of Iran. Anecdotal on Israel, Jordan, Morocco and Tunisia.6 and survey data suggest sizeable informal trade between the Islamic Republic of Iran and other Growth spillovers from outside the region are larger in countries in the region. magnitude than those within the region, but mostly insignificant, with the exception of Morocco. A 1 A sufficiently long time series of quarterly data is available percentage point decline in G7 growth is associated with to estimate growth spillovers only from Egypt and Turkey an average 1 percentage point decline in growth in to several non-GCC economies in the MENA region. A countries in the MENA region.7 Bayesian structural vector autoregression (VAR) model is estimated, using data for 1998Q1-2015Q2. The variables These results are broadly comparable to the few available are: G7 average growth; JPMorgan’s Emerging Market studies by other authors. Using a global VAR, Cashin, Bond Index; growth in the shock source countries (Egypt Mohaddess and Raissi (2012) show that growth shocks and Turkey); trade-weighted commodity prices; and from Europe and the United States have a modest, but growth and real effective exchange rates of the countries negative effect on the output growth of countries like subject to the external shock. Figure 2.4.1.4 shows the Egypt, Jordan, Morocco and Tunisia.8 Behar and Espinosa cumulative response after four quarters of recipient- -Bowen (2014) suggest that non-oil trade in MENA country growth to a 1 percentage point decline in growth countries would decline considerably following shocks to in Egypt or Turkey.3 growth in Europe and the global economy. Growth spillovers from Egypt and Turkey appear to be Conclusion modest, and, in most cases, not statistically different from The MENA region is highly open, but with fewer within- zero, reflecting limited within-region ties.4 A 1 percentage region ties than other regions. As a result, spillovers from point drop in Turkey’s growth is associated with small or the larger developing countries in the region and from statistically insignificant growth effects across the region.5 neighboring Turkey are modest. A 1 percentage point decline in growth in Egypt is associated with a 0.16 percentage point decline in growth Although not estimated explicitly for lack of comparable in Jordan and a 0.15 percentage point decrease in growth data, spillovers from GCC countries to the rest of MENA region are likely to be significantly larger than spillovers 3Quarterly GDP data are available from IMF’s International Financial from Egypt and Turkey, given large remittance and ODA Statistics, Haver and Bloomberg for 1998Q1-2014Q4. Countries for flows from GCC to non-GCC countries in the region which there were considerable differences amongst the three sources were dropped. The resulting unbalanced panel included Egypt, Islamic Republic of Iran, Jordan, Morocco and Tunisia. For Lebanon, quarterly 6The response of the non-GCC MENA countries’ average growth energy production data was used as a proxy for output. For Egypt, the data starts in 2002Q2 and for Tunisia in 2000Q2. rate to a one percentage point decline in Turkey and Egypt is also near- 4The results in Figure 2.4.4 include four lags. They are robust to zero. Because of the higher volatility of industrial production (IP), alternative specifications: different Cholesky ordering, Bayesian priors, measured spillovers from industrial production are somewhat larger: a 1 decay in the lag structure, correlation across variable lags, and number of percentage point decline in IP growth in Egypt and Turkey is associated lags. with 0.15 and 0.2 percentage point decline in growth in the other 5Shocks in Turkey seem to be inversely correlated with growth in countries. 7Spillovers from a decline in G7 growth to electricity production Tunisia. This may reflect competition in key export sectors, especially tourism: when tourist arrivals to Tunisia declined during 2005-13, those growth in Lebanon could be sizable (shown on the right axis of Figure to Turkey increased as tourists shifted their destinations during bouts of 2.4.1.4). Those to Egypt are not statistically significantly different from political uncertainty. Tourism has been a significant channel for the zero after 4 quarters. 8They find that the cumulative effect after four quarters of a 1 transmission of spillovers in Mediterranean countries (Canova and Dallari 2013). As expected, the estimated spillovers are smaller if the percentage point decline in growth in Europe is not statistically period after the Arab Spring (starting 2010Q4) is excluded. significantly from zero or on the order of 0.1-0.2. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 M I D D LE E AS T A N D N O R T H A F R I C A 137 BOX 2.4.1 Regional integration and spillovers: Middle East and North Africa (continued) FIGURE 2.4.1.4 Spillovers from Egypt and Turkey Output spillovers between non-GCC MENA countries have been modest, reflecting the predominance of trade and financial ties of non-GCC MENA countries to economies outside the region. A. Trade ties B. Response to a 1 percentage point C. Response to a 1 percentage point decline in Turkey’s and Egypt’s GDP decline in G7 growth growth Source: World Bank staff estimates. Notes: B and C. Cumulative response of each country’s growth after 1 year to a 1 percentage point decline in growth rates of Egypt, Turkey and World GDP, respectively. World GDP refers to average GDP growth in G7 countries. Energy production data used for Lebanon. Quarterly GDP data for Tunisia and Egypt are available from 2000Q2 and 2002Q2, respectively. All other series are available from 1998Q1. Bayesian VARs include Arab Spring dummies for Tunisia (2010Q4-2011Q4) and Egypt (2011Q1-Q4), financial crises dummy (2008Q2-2009Q2), a dummy for Turkey’s financial crises (2001Q1), a dummy for conflict in Lebanon (2006Q1-Q4) and dummies for droughts in Morocco (2002, 2003, 2006 and 2012). Horizontal line represents MENA average response. Vertical lines show a one standard deviation confidence band. Solid bars represent medians and the error bands represent 33-66 percent confidence bands. Lebanon shown on the right axis. (Cashin, Mohaddess and Raissi 2012, IMF 2012c). GCC Going forward, more stability in the MENA region economies may also have a significant effect on developing will not only allow countries to benefit from deepening MENA countries through their investments in trade and finance, but will also alleviate some of the infrastructure, such as airlines, telecom and multi-country fiscal burden associated with creating infrastructure to help railway projects, as well as banking and financial ties people displaced by conflicts. Continued turmoil (World Bank 2014b). will derail efforts to tackle problems of corruption, and prolong necessary reforms in the labor markets (World In addition, spillovers from political uncertainty, security Bank 2015f). concerns or spreading violence could also be sizeable. GDP growth in South Asia rose from 6.8 percent in 2014 to 7.0 percent in 2015, the fastest rate among developing regions, as recovery took hold in India, and as the region bene ted from lower oil prices and improved resilience to external shocks. A moderate further acceleration in economic activity is projected, with regional growth rising to 7.5 percent in 2018, buoyed by strengthening investment and a broadly supportive policy environment. Risks are mainly domestic. ey include reform setbacks in the reform momentum in India, political tensions or con icts in smaller economies, and, over the longer term, the commitment of governments to the necessary scal adjustment. South Asia may also face external headwinds from an increase in interest rates in the United States, although vulnerabilities are greatly reduced since the “taper tantrum” of 2013. Key policy challenges include the substantial non-performing bank loans in several countries, and the need for further reforms—in particular, to improve the ability of rms to do business within and outside the region, and to fully harness the ongoing demographic dividend. Recent developments e orts to crack down on violent crime in Karachi, the country’s industrial and commercial hub, are Regional growth remained robust at an estimated supporting investor con dence. e China 7.0 percent in 2015, helped by strengthening Pakistan Economic Corridor (CPEC) agreement, activity in the region’s largest economies (Table signed in 2015, has further bolstered investor 2.5.1). In India, brisk growth continued, at an optimism, and, if implemented, has the potential estimated 7.2 percent year-on-year in the rst half to lift long-term growth. Pakistan once again of the 2015/16 scal year compared with 7.3 tapped the international capital markets and percent in FY2014/15 as a whole. Monetary and launched a US$500 million Eurobond in scal restraint, the fall in global crude oil prices September 2015, with the same maturity and and a moderation in food price in ation have coupon as its issue a year earlier. contributed to a steep drop in in ation and a narrowing of current account and scal de cits. Sri Lanka has completed a major political Momentum in industrial output has slowed and transition, with a national unity and reform- both the services and manufacturing Purchasing oriented government formed after the August Managers’ Indices (PMIs) have softened (Figure 2015 parliamentary election. Growth in 2013 and 2.5.1). However, the investment cycle is gradually 2014 was revised downward from 7.2 and 7.4 picking up, led by a government e orts to boost percent to 3.4 and 4.5 percent, respectively, as a investment in infrastructure, particularly roads, result of a rebasing of the national accounts.1 railways and urban infrastructure. India’s currency Incoming data show growth picking up mid-year, and stock markets were largely resilient over the led by robust service sector growth, and supported past year, even during bouts of volatility in global by rising tourism in ows and strong remittances. nancial markets. In Bangladesh, as political tensions have abated, exports have rebounded strongly, supporting Elsewhere in the region, macroeconomic activity. adjustment in Pakistan under an International Monetary Fund program is progressing, while 1 e GDP series was rebased from 2002 to 2010. e new GDP series also captures new activities such as professional services, and Note: e author of this section is Tehmina Khan. Research better measures value added in other sectors, notably in services. In assistance was provided by Xiaodan Ding. level terms, both nominal GDP and per capita GDP have increased. 140 C H A P TE R 2. 5 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 FIGURE 2.5.1 Recent developments In ation, which tends to be structurally high in the region, slowed further in 2015 (Figure 2.5.1). Industrial activity has slowed in India and Pakistan, while external trade remains weak. Inflation has moderated sharply across most of the region, e decline is showing signs of bottoming out, as except in Bangladesh where it has contributed to an appreciation of the oil prices stabilize. In India, drought for the currency in real terms. second consecutive year in 2015 has weighed on A. Industrial production growth B. Export growth farm output, with some indications of food price pressures starting to build toward the end of the year. However, both India and Pakistan have been on a path of scal consolidation over the past three years, and scal restraint is curbing demand-side pressures. Lower in ation has enabled central banks in India and Pakistan to cut policy rates to support activity and, in Sri Lanka, keep policy rates at record lows. In contrast, in ation in Bangladesh has remained persistently high, C. Inflation D. Real effective exchange rate (REER) re ecting transport bottlenecks in early 2015, limited spare capacity, and limited pass through from low global oil prices to domestic oil prices, contributing to a signi cant and steady appreciation in the real exchange rate (Figure 2.5.1). e currencies of India, Pakistan and Sri Lanka, which had appreciated in real e ective terms since 2013, have stabilized in recent months. Source: World Bank, IMF, WITS, Haver Analytics. A.B. Quarter-an-quarter, seasonally adjusted. India has sharply curtailed its current account B. Nominal export growth. D. An increase denotes an appreciation. de cit, to about 1 percent of GDP in Q2 2015 (on a four-quarter rolling basis) from about 5 In contrast, security conditions remain unsettled percent of GDP in mid-2013 when the nancial in Afghanistan, as international forces reduce markets were shaken by the “taper tantrum” troop deployments. However, e orts are being nancial market turmoil over U.S. Federal Reserve made to strengthen macroeconomic stability and policy. India’s central bank has rebuilt reserves reduce vulnerabilities in the banking sector. while net FDI ows have remained positive. Political tensions and domestic unrest have also Pakistan’s current account de cit has continued to increased in Maldives following the arrest of narrow, re ecting lower oil import cost and strong several politicians during 2015. In Nepal, the cost remittance in ows. from the earthquakes in the spring of 2015 is estimated at about a third of GDP. Activity has Ongoing scal consolidation in India has reduced since been further hurt by domestic protests and a the central government’s scal de cit to close to 4 closure of land trading routes through India in the percent of GDP (on a 12-month rolling basis), second half of 2015. is has led to acute fuel and down from a peak of 7.6 percent in 2009. food shortages, and put a halt to reconstruction Pakistan has also made progress in reining in its e orts. In Bhutan, tourism in ows have been budget de cit from 8.4 percent of GDP in a ected by spillovers from the earthquake and FY2013 to 5.3 percent in FY2015.2 However, disruption in trade in Nepal, although, overall, debt levels remain high at 65 percent of GDP, the activity continues to be supported by the result of years of scal slippages, and interest construction of major hydropower projects, payment costs are about 4.4 percent of GDP. notably Dagachhu, which went into production in Nepal is planning to substantially increase March 2015. 2Including grants. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 S O U TH A S I A 141 spending for reconstruction. is is expected to FIGURE 2.5.2 Risks and challenges push the scal balance into a modest de cit. Fiscal The region has limited trade exposure to slowing investment in China, and discipline has weakened in Bangladesh and Sri as a net importer of oil will continue to benefit from low global energy Lanka. e de cit in Bangladesh is set to widen to prices. This is particularly the case for Indian firms that are energy 5 percent of GDP, the largest since 2008, in line intensive. Insufficient jobs at home have led to large numbers of South Asians migrating overseas. Major human development and infrastructure with the doubling of public sector wages. In Sri challenges remain in India. Lanka, the scal de cit is estimated to have widened to 5.7 percent of GDP, and public debt A. Exports by major trading partner B. Energy intensity, 2007 has reached over 70 percent of GDP. Most countries in the region struggle to raise taxes, particularly from goods and services taxes (GST) or value-added taxes which are typically a lynchpin for sustainable public nances in developing countries. Persistent de cits in previous years have saddled the country with a public debt ratio amounting to 75 percent of GDP in 2014. Incomplete scal consolidation in 2015 and a large increase in foreign- nanced capital C. Stock of migrants by developing D. Human and infrastructure region, 2014 indicators in India expenditure projects budgeted for 2016 risks increasing the level of external public debt further. Two key critical legislative reforms (GST and land acquisition) are still pending in India. Nevertheless, the government has made progress in key areas, such as energy, and in November announced major reforms to liberalize FDI in several sectors. e central bank, meanwhile, has liberalized the medium-term framework for Source: World Bank; IMF Direction of Trade Statistics (DOTS); Global Trade Analysis Project (GTAP) foreign portfolio investment, in an e ort to database, Kumar (2014). B. Energy intensity is defined as energy cost in percent of total cost per unit of output. increase its role in market development and for C. EAP stands for East Asia and Pacific; ECA stands for Europe and Central Asia; LAC stands for Latin America and the Caribbean; MNA stands for Middle East and North Africa; SAR stands for attracting long-term investors. In Pakistan, the South Asia; SSA stands for Sub-Saharan Africa. D. Data are sourced from Kumar (2014) and reflect indicators based on a variety of household, labor authority to grant tax exemptions has been force and other micro-survey datasets covering the mid-late 2000s. Data for infant mortality is for transferred from the Revenue Board to parliament 2007. Life expectancy is in years. AP stands for Andhra Pradesh, HP stands for Himachal Pradesh, MP stands for Madhya Pradesh, UP stands for Uttar Pradesh. while e orts continue to implement an ambitious tax reform agenda. e central bank, with IMF assistance, is gradually strengthening monitoring government e orts to accelerate infrastructure of nancial stability risks, and is in the process of development and boost Public Private instituting a modern deposit insurance scheme in Partnerships (PPPs), and in Pakistan due to CPEC line with international best practices. e new Sri implementation. In Bangladesh and Sri Lanka, Lankan government has announced governance public sector wage increases and an easing of reforms that should strengthen democratic political tensions or uncertainty should bolster institutions. private consumption. e region also has relatively limited trade Outlook exposure to slowing demand in major emerging markets (Figure 2.5.2), and as a net importer of oil Growth in the region is expected to edge up, will continue to bene t from low global energy reaching 7.5 percent by 2017, driven mainly by prices. Generalized weakness in the global trading domestic demand. Investment growth is expected environment, and indirect spillovers from slower to continue strengthening in India due to growth in major developing economies is expected 142 C H A P TE R 2. 5 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 to partly o set the positive impulse to exports new port of Gwadar. Estimated at around US$45 from high-income country demand. With activity billion of investment until 2030, the initiative will slowing in oil-rich GCC countries, growth in nance a series of transport infrastructure projects remittances is also expected to moderate. (US$11 billion, mostly public investment) and energy projects (US$33 billion, mostly private).4 Compared to most other major developing countries, India is well positioned to withstand Increased infrastructure spending and public sector near-term headwinds and volatility in global wage hikes in Bangladesh are expected to keep nancial markets due to reduced external growth high at 6.8 percent over the medium term, vulnerabilities, a strengthening domestic business but also to widen the scal de cit. An amendment cycle, and a supportive policy environment. to labor laws in September that strengthened Although the pace of reforms has slowed workers’ rights and workplace safety should assist somewhat, growth is expected to strengthen to 7.9 export performance, particularly in light of the percent in FY2017/18, from an expected 7.5 ongoing U.S. review of Bangladesh’s trade status percent in FY2015/16. Progress on infrastructure under its Generalized System of Preferences improvements and government e orts to boost (GSP). investment are expected to o set the impact of any tightening of borrowing conditions resulting from In Nepal, the devastation caused by the tighter U.S. monetary policy. Such investment earthquake and the disruption of trade in 2015 will also lift potential growth over the medium have hurt investment and activity hard. Growth term. Low international energy prices and for FY 2015/16 has been revised down to 1.7 domestic energy reforms will ease energy costs for percent (versus an estimate of 3.7 percent prior to Indian rms that tend to be energy intensive the trade disruption). However, there remains (Figure 2.5.2). Although rural incomes have considerable uncertainty around the point forecast, su ered as a result of two successively weak with growth likely to range anywhere between 1- monsoon seasons, urban spending has been 2.3 percent. Activity should gradually recover as supported by the decline in in ation, and will also government reconstruction spending is ramped up bene t in the near term from public sector wage in the later years of the forecast period. Plans to increases announced recently. India accounts for build major hydropower projects in partnership more than 90 percent of portfolio and FDI with China and India are likely to see considerable in ows to the region. Better growth prospects delays in the current environment. A mild relative to other major developing countries recovery is projected in Afghanistan, conditional should help ows remain resilient during the on improvements in security and domestic transition to tighter global nancing conditions reforms. (although there may be volatility in the near term). In Bhutan, growth is expected to remain strong over the forecast period, as major hydropower Pakistan stands to bene t from three tailwinds projects are built. ree major projects are over the near- to medium- term, with average expected to come online by 2017 that should help growth projected at 5.5 percent over the forecast to boost exports and scal revenues. Tourism period.3 ese include rising investments from in ows are expected to support services in Bhutan China under the CPEC agreement; the and Sri Lanka. Robust service sector growth and anticipated return of the Islamic Republic of Iran policy e orts to improve competitiveness in the to the international economic community; and manufacturing in Sri Lanka are expected to lead to persistently low international oil prices. CPEC will a steady pickup in growth to 6 percent in 2017, connect Western China to the Arabian Sea via the from 5.3 percent in 2015. 3For cross-country comparability, this is projected growth in real GDP “at market prices”. e Government of Pakistan usually refers 4 e projects foreseen in the CPEC to receive funding from to growth in real GDP “at factor cost” for policy purposes. Real GDP China's US$4 billion Silk Road Fund include partial nancing for growth at factor cost is projected at 4.5 percent in FY2015/16. the US$1.65 billion Karot hydropower project. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 S O U TH A S I A 143 Risks spending ramps up in the pre-election period. In addition, sovereign guarantees associated with the CPEC could pose substantial scal risks over the Risks are mostly of domestic origin and mainly on medium term. Large scal de cits in Bangladesh the downside. In India, progress in reforms is not and Sri Lanka increase risks that rising assured as the upper house of parliament, which government borrowing will crowd out private the ruling party does not control, has the power to investment. In Sri Lanka, external debt has block the government’s legislative agenda. Slow increased since 2014, due to both private and progress on land reforms could add to investment public (mainly non-concessional) borrowing, and delays, and private investment growth may be government contingent liabilities have also risen unable to build further momentum. e nancing fast. A growth slowdown increases the risk of of public-private partnerships also remains a deteriorating public debt ratios and rising external challenge. A failure to pass the goods and services costs of borrowing. tax could hamper the government’s ability to ramp up spending on infrastructure needs and preserve Although less pressing than domestic risks, the status quo of fragmented domestic markets. In external risks remain. e region will not be addition, although India has made good progress immune to trade and nancial market headwinds on reducing external vulnerabilities and if there is a slowdown in major developing strengthening the credibility of the macro policy countries. Other external risks include increased framework, high levels of nonperforming loans in volatility in nancial ows as U.S. monetary the banking sector, concentrated in construction, policy is tightened. A substantial share of South natural resource and infrastructure sectors, could Asian migrants are also located overseas, including impede a pickup in investment if left unaddressed in GCC countries (Box 2.5), where scal strains (World Bank 2015a, IMF 2015k). ere are also are emerging and construction activity is slowing downside risks to growth in the near term from amid the slump in oil prices. With remittances a sub-par monsoon rainfall across most of India, major source of support for households in several and farm output growth may prove weaker than South Asian countries, any decline in in ows in projected. the event of further oil prices declines and a sharp slowdown or scal retrenchment in GCC Stronger growth and investment in Pakistan is countries could hurt private consumption. predicated on reforms to strengthen the business climate, an improvement in the security situation, implementation of the CPEC and an associated Policy challenges easing in energy constraints. ese developments might not materialize as expected. A resumption South Asian countries face substantial challenges of political tensions in Bangladesh and an on the scal front. Generally, scal de cits and escalation of existing tensions in Nepal and public debt levels remain high in the region Afghanistan are key risks in these countries. including in India, Pakistan and Sri Lanka. Budget execution, particularly capital spending, Afghanistan has seen a sharp drop in the domestic has been a longstanding challenge in Nepal, and revenue-to-GDP ratio, mainly because of the slow progress in post-earthquake reconstruction, growth slowdown. e country remains coupled with political tensions, could dampen any dependent on high levels of donor nancing to post-earthquake rebound. Afghanistan, fund critical security and social spending meanwhile, faces substantial scal risks and programs. Over the longer term, anchoring scal challenges, a ecting nancing of civilian and sustainability will require tax reforms, given security spending. generally low tax-to-GDP ratios in the region (World Bank 2015a). Fiscal risks are elevated across the region. In Pakistan, with national elections due in 2018, Further, as discussed in Box 2.5.1. South Asia is hard won scal consolidation gains may be lost if one of the least globally integrated regions, and 144 C H A P TE R 2. 5 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 FIGURE 2.5.3 Demographic challenges region, save the Middle East and North Africa (Box 2.5). is re ects underdeveloped capital In some states, creating jobs for a rapidly growing share of young people will be a key policy challenge. markets, poor corporate governance, and in ow restrictions in some countries (Romero-Torres et al. 2013). Over the medium term, enhancing integration and cooperation at the national, regional, and global level will help raise levels of productivity and growth. It will also help channel domestic savings more e ciently, creating jobs, diversify growth away from a narrow set of high- income countries, and reducing poverty (Palit et al, 2013; Ahmed and Ghani, 2008, De et al. 2012). Finally, South Asia is one of the few developing regions where the demographic dividend is expected to remain positive over the next few decades as the share of the working age population increases in size (World Bank, 2015j). For instance, in India, an estimated 300 million Source: Kumar (2014). working age adults are expected to enter the labor A. HP denotes Himachal Pradesh; MP denotes Madhya Pradesh. force by 2040. Traditionally slow-growing and relatively under-developed Indian states of Bihar, regional integration is even more limited. A Madhya Pradesh, Rajasthan, and Uttar Pradesh number of factors are at work: poor connectivity are expected to contribute more than half of the within South Asia and to global markets; poor increase in country’s working-age population in trade facilitation policies re ected in high costs of coming decades (Figures 2.5.2 and 2.5.3). States trading across borders in general; and restrictions which perform better on various indicators of on doing business with countries within the region infrastructure, health, education, and investment that are in some cases due to strained political climate seem to be the ones that best exploited the relations and have contributed to substantial demographic dividend and in addition, also numbers of South Asians migrating overseas in generated additional growth on top of it (Kumar search of better employment opportunities (Figure 2014). Accordingly, reforms targeted at lifting 2.5.2c; Ahmad and Ghani, 2007; De et al. 2013; these indicators—particularly in the states with Palit and Spittel, 2013; World Bank, 2013a). the fastest growing population—will be critical to managing this transition. e size of private capital ows to South Asia is also much lower than to every other developing G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 S O U TH A S I A 145 TABLE 2.5.1 South Asia forecast summary (Annual percent change unless indicated otherwise) (Percentage point difference from June 2015 projections) 2013 2014 2015e 2016f 2017f 2018f 2015e 2016f 2017f South Asia, GDPa, b 6.2 6.8 7.0 7.3 7.5 7.5 -0.1 0.0 0.0 (Average including countries with full national accounts and balance of payments data only)c South Asia, GDPc 6.2 6.9 7.0 7.3 7.5 7.6 -0.1 -0.1 0.0 GDP per capita (U.S. dollars) 4.8 5.5 5.6 6.0 6.2 6.2 -0.1 0.0 0.0 PPP GDP 6.2 6.9 7.0 7.3 7.5 7.5 -0.1 0.0 0.0 Private consumption 5.5 6.0 6.5 6.6 6.3 6.2 0.0 0.3 0.1 Public consumption 6.5 7.1 8.1 7.5 6.6 6.4 -0.3 0.3 0.1 Fixed investment 2.3 4.2 4.7 9.1 11.4 11.5 -2.3 -2.2 -1.6 Exports, GNFSd 6.7 1.8 2.3 4.0 5.0 5.7 -0.9 -0.8 -1.9 Imports, GNFSd -3.3 -1.9 1.6 4.6 5.8 6.5 -2.6 -2.2 -2.7 Net exports, contribution to growth 2.8 1.1 0.1 -0.3 -0.4 -0.5 0.5 0.5 0.4 Memo items: GDPb South Asia excluding India 5.0 5.4 5.7 5.8 6.0 6.0 0.0 0.3 0.3 India 6.9 7.3 7.3 7.8 7.9 7.9 -0.2 -0.1 -0.1 Pakistan 4.4 4.7 5.5 5.5 5.4 5.4 -0.5 1.8 0.9 Bangladesh 6.1 6.5 6.5 6.7 6.8 6.8 0.2 0.0 0.1 Source: World Bank. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not differ at any given moment in time. a. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. b. National income and product account data refer to fiscal years (FY) for the South Asian countries, while aggregates are presented in calendar year (CY) terms. The fiscal year runs from July 1 through June 30 in Bangladesh, Bhutan, and Pakistan, from July 16 through July 15 in Nepal, and April 1 through March 31 in India. 2014 data for India, Pakistan, and Bangladesh cover FY2014/15. c. Sub-region aggregate excludes Afghanistan, Bhutan, and Maldives, for which data limitations prevent the forecasting of GDP components. d. Exports and imports of goods and non-factor services (GNFS). 146 C H A P TE R 2. 5 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 TABLE 2.5.2 South Asia country forecasts (Real GDP growth at market prices in percent, unless indicated otherwise) (Percentage point difference from June 2015 projections) 2013 2014 2015e 2016f 2017f 2018f 2015e 2016f 2017f Calendar year basisa Afghanistan 2.0 1.3 1.9 3.1 3.9 5.0 -0.6 -1.9 -1.2 Bangladesh 6.3 6.5 6.6 6.8 6.8 6.8 0.1 0.1 0.1 Bhutan 3.9 6.3 6.8 7.2 5.6 6.0 -1.1 -1.2 -1.4 India 6.4 7.2 7.3 7.7 7.9 7.9 -0.1 -0.1 -0.1 Maldives 4.2 5.9 4.4 3.1 4.2 4.5 -0.9 -1.9 -0.8 Nepal 4.7 4.4 2.6 3.7 5.1 4.5 -1.8 -1.3 -0.4 Pakistan 4.6 5.1 5.5 5.5 5.4 5.4 0.7 1.4 0.9 Sri Lanka 3.4 4.5 5.3 5.6 6.0 6.0 -1.6 -1.0 -0.5 Fiscal year basisa Bangladesh 6.1 6.5 6.5 6.7 6.8 6.8 0.2 0.0 0.1 India 6.9 7.3 7.3 7.8 7.9 7.9 -0.2 -0.1 -0.1 Nepal 4.1 5.4 3.4 1.7 5.8 4.5 -0.8 -2.8 0.3 Pakistan (market prices) 4.4 4.7 5.5 5.5 5.4 5.4 -0.5 1.8 0.9 Pakistan (factor cost) 3.7 4.0 4.2 4.5 4.8 4.8 .. .. .. Source: World Bank. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not significantly differ at any given moment in time. a. Historical data is reported on a market price basis. National income and product account data refer to fiscal years (FY) for the South Asian countries with the exception of Afghanistan, Maldives and Sri Lanka, which report in calendar year (CY). The fiscal year runs from July 1 through June 30 in Bangladesh, Bhu- tan, and Pakistan, from July 16 through July 15 in Nepal, and April 1 through March 31 in India. 2014 fiscal year data, as reported in the table for India, Paki- stan, Bangladesh, Nepal, cover FY2014/15. GDP figures presented in calendar years (CY) terms for Bangladesh, Nepal, Bhutan, and Pakistan are calculated taking the average growth over the two fiscal year periods to provide an approximation of CY activity. Historical GDP data in CY terms for India are the sum of GDP in the four calendar quarters. Historical data from Sri Lanka has recently been revised. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 S O U TH AS I A 147 BOX 2.5.1 Regional integration and spillovers: South Asia South Asia’s integration with the global economy is low and integration within the region is even more limited. The ability to do business across borders is constrained by poor business environments and policies that have weighed on competitiveness, contributed to large-scale emigration and limited the ability to do business across borders. While this has reduced exposure to global shocks in the short-term, these very factors limit the potential of South Asian firms to fully benefit from the strengthening demand in the United States and Europe over the medium term. Over the long term, enhancing regional and global integration will be critical in raising productivity and growth, providing jobs and reducing poverty. Introduction FIGURE 2.5.1.1 Cross-region comparison South Asia is one of the least globally integrated regions (Figure 2.5.1.1), both in trade and finance. However, the South Asia is one of the least globally integrated regions, degree of integration at the regional level, measured by in terms of trade and finance. However, it absorbs a large share of global remittances. flow in goods, capital and ideas, is even lower. This is despite shared cultural ties, extensive common borders, A. SAR: Share of global activity, trade and finance, 2014 and high population densities with large populations living close to border areas (Ahmad and Ghani 2007; Kemal 2005; Palit and Spittel 2013). This box takes a closer look at South Asia’s openness to the rest of the world, and to countries within the region itself. It discusses the following questions: • How open is South Asia to global and regional trade and financial flows? • How large are the potential intra-regional spillovers from the region’s largest economy, India? The box documents that spillovers from global output B. SAR: Trade and finance in regional comparison, 2014 shocks are generally small, but large for financial shocks (for India). Regional spillovers are also small. This implies that positive spillovers to the region from the strengthening economic cycle in the US and India to other large South Asian economies will likely be modest. How open is South Asia to global and regional trade and financial flows? Although economic linkages between South Asia and the rest of the world have deepened in recent decades, progress has been slow and uneven (Ahmad and Ghani 2007). High -income countries and China account for the bulk of exports earnings, portfolio investments, FDI and aid Sources: IMF October 2015 World Economic Outlook, IMF International Finan- (Figure 2.5.1.2). Regional integration, meanwhile, has cial Statistics, IMF Direction of Trade Statistics, UNCTAD FDI/TNC database, World Bank Remittance and Migration Database, World Bank World Develop- lagged considerably (Ahmad and Ghani 2008 and Ahmad ment Indicators. et. al. 2010). A number of factors are at work: poor B. The red bar denotes exports, imports, trade, remittance inflows, portfolio liabilities and FDI inflows in percent of GDP on average across SAR countries. transport connectivity within South Asia and to global The vertical line denotes the range of averages for all six developing country regions. markets; poor trade facilitation policies and trade barriers Note: This box was prepared by Tehmina Khan, Jesper Hanson and Raju Huidrom. 148 C H A P TE R 2. 5 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.5.1 Regional integration and spillovers: South Asia (continued) FIGURE 2.5.1.2 Regional and global integration in South Asian countries Flows of goods and capital across borders are low compared to other regions. Exports have increased by much less over the past two decades than in other regions, and remain concentrated by destination. A. Regional and global integration, 2014 B. Increase in exports since 1990 C. Trade openness, 2014 D. Exports by major trading partners, 2014 Source: World Bank, BIS, IMF, OECD. Notes: Weighted averages. B. EAP stands for East Asia and Pacific. ECA stands for Europe and Central Asia. LAC stands for Latin America and the Caribbean. MNA stands for Middle East and North Africa. SAR stands for South Asia Region. SSA stands for Sub-Saharan Africa. that have resulted in high costs of trading; and restrictions less, of GDP in most countries. Moreover, export flows on doing business with countries within the region (De et tend to be highly concentrated, with the European Union al. 2013; Palit and Spittel 2013; Romero-Torres 2014; and United States as major trading partners World Bank 2013b). The exception are within-region notwithstanding a recent shift of India and Pakistan remittances: the Bangladesh-India migrant corridor, for toward East Asia and Sub-Saharan Africa. instance, is the third largest in the world. As a share of GDP, intra-regional exports are smaller than Trade: Unilateral trade liberalization measures anywhere else in the world (Palit and Spittel 2013). On introduced in the late 1980s and 1990s have led to rising average, India, Pakistan, Sri Lanka and Bangladesh’s trade flows between South Asia and the rest of the world exports to each other amount to less than 2 percent of total (Ahmad and Ghani 2007). Still, the degree of integration exports. Average trade costs between country pairs in remains much lower in South Asia than in other major South Asia are 85 percent higher than between country developing regions, with exports amounting to a fifth, or pairs in East Asia (Kathuria et al. 2015) reflecting border G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 S O U TH AS I A 149 BOX 2.5.1 Regional integration and spillovers: South Asia (continued) barriers, poor infrastructure and transport connectivity, chemicals, food processing, banking and garments and generally poor business environments. However, production in Bangladesh, and a similarly diverse range of unofficial trade (in narcotics, but also illegal food trade in sectors in Sri Lanka over the past decade (World Bank the Punjab) is reported to be significant (Fagan 2011). 2013a). Estimates of the size of unofficial trade vary between countries (Taneja 2004), with recent studies placing the Remittances: South Asia’s diaspora stock is the largest value of Indian exports to Pakistan at about $1.8 bn (or among developing regions, and remittances exceed 6 nearly 1 percent of GDP, Ahmed et. al. 2014). While the percent of GDP in Pakistan, Sri Lanka, Nepal and larger countries in the region predominantly trade outside Bangladesh. India is the largest recipient country in the the region, India is the dominant trading partner for the world in terms of value of remittances (about $US 70 smallest countries in the region: Bhutan (mainly hydro- billion). By source, Gulf Cooperation Council (GCC) electricity), Nepal (textiles, agriculture, tourism) and countries account for just over half of total remittances to Afghanistan (for which, Pakistan too is a major trading the region, with the United States and United Kingdom partner).1 also major source countries. Within-region migration flows are also substantial: the Bangladesh-India migrant Capital flows: Relative to GDP, capital flows to South corridor is the third largest in the world (after the Mexico- Asia are lower than those to East Asia and the Pacific and U.S. and Ukraine-Russia corridors), with more than 40 Europe and Central Asia regions (Figure 2.5.1.3), percent of Bangladeshi emigrants located in India. India reflecting underdeveloped capital markets as well as inflow also hosts large numbers of migrants from Bhutan, Nepal restrictions in some countries (Romero-Torres et. al. and Sri Lanka, and Pakistan from Afghanistan (World 2013). They are dominated by banking sector flows, Bank 2015l). mainly from the United Kingdom. Financial integration is limited by restrictive domestic policies. For instance, in Official development assistance: Although the bulk of aid India, notwithstanding some gradual liberalization over the flows to South Asia originate from OECD countries, years, and in Sri Lanka non-resident holdings of among non-OECD countries both India and China are government debt remain capped. increasingly important sources of development finance (mixing grants, loans and project finance). The recently India receives over 90 percent of the region’s FDI and signed US$46 billion China Pakistan Economic Corridor portfolio inflows, a substantial share of which originates (CPEC) agreement should see rising investment in energy, from Mauritius and Singapore (low-tax countries with port and transport infrastructure in Pakistan over the next which India has double taxation treaties).2 In recent years few years. India, meanwhile, allocates nearly two thirds of FDI has tended to head into services rather than mining or its foreign aid budget to Bhutan, and significant amounts industry (World Bank 2013a). China has made substantial to Nepal, Afghanistan, Sri Lanka and Bangladesh (Piccio investments into the region in recent years, in extractives in 2015). Afghanistan, renewable energy in Nepal, port construction in Sri Lanka, and manufacturing and infrastructure in How large are the potential intra-regional spillovers Pakistan. from the region’s largest economy, India? Within-region FDI accounts for only a small share of all India’s sizeable remittances and FDI flows to neighboring FDI inflows. Bhutan, Nepal, Maldives and Sri Lanka do, countries may give rise to spillovers. To analyze spillovers however, receive non-negligible amounts of FDI from within the region, a Bayesian structural vector India. Cross-border investments from India have flowed autoregression model is estimated using quarterly data to into energy and public sector-linked investment in Nepal; 2015Q2 from 1998Q1 (Bangladesh) 2002Q2 (Sri Lanka) or 2001Q3 (Pakistan), the only countries in the region with sufficient data. The model focuses on the short- and 1Several countries run sizable merchandise trade de cits with India, medium term effects of negative growth shocks in India on including Nepal, Bhutan, Bangladesh and Sri Lanka. Large imports from India mainly re ect capital goods (in Bhutan, related to hydropower other countries in the region. The estimation includes G7 investments), other production-side inputs and food in the smaller country growth, JP Morgan’s Emerging Market Bond landlocked countries. In Bangladesh, for instance, these comprise mainly Index, India’s growth, a trade-weighted commodity price cotton for the garment sector, food and other consumer goods. index, and SAR country growth and real effective exchange 2FDI in ows from Mauritius and Singapore may also, indirectly, originate in India. rate. Data is available for Bangladesh, Pakistan, and Sri 150 C H A P TE R 2. 5 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.5.1 Regional integration and spillovers: South Asia (continued) FIGURE 2.5.1.3 Financial flows to SAR Relative to GDP, capital flows to South Asia are smaller than to other major developing regions, excluding MNA. They are dominated by banking sector flows, mainly from the United Kingdom. India receives over 90 percent of FDI inflows. South Asia’s diaspora is the largest among developing regions, with a substantial number located in GCC countries. A. Capital flows to developing regions, B. Composition of capital flows to South C. BIS foreign claims on SAR by source 2014 Asia D. FDI flows by country, 2014 E. FDI inflows, 2003-11 F. South Asian migrants by destination, 2013 Source: IMF, World Bank, BIS, UNCTAD. Note: Weighted averages. A.C.E. EA stands for Euro Area. EU stands for European Union. EAP stands for East Asia and Pacific. ECA stands for Europe and Central Asia. LAC stands for Latin Ameri- ca and the Caribbean. MNA stands for Middle East and North Africa. SAR stands for South Asia Region. SSA stands for Sub-Saharan Africa. F. Number above columns indicate total number of migrants in millions of people. GCC stands for Gulf Cooperation Council. Lanka. For Bangladesh and Pakistan, industrial production Estimated within-region growth spillovers are smaller than growth is used to proxy real GDP growth. those from the rest of the world to the region. A 1 percentage point decline in GDP growth in G-7 countries The estimates suggest that spillovers from a 1 percent causes growth in India to fall by 1.7 percentage points. negative growth shock in India result in a 0.6 percentage This is broadly in line with earlier findings that external points decline in Bangladesh, and a 0.2 percentage points spillovers to India are smaller than those in other more fall in Sri Lanka. There are no statistically significant open economies in East Asia (Chapter 3, Box 3.5). They spillovers for Pakistan (Figure 2.5.1.4). Other studies find are, however, larger than other results in the literature that positive, but modest, spillovers from India to Pakistan, Sri find that a 1 percentage point decline in U.S. GDP is Lanka and Bangladesh (World Bank 2013b; IMF 2014e). associated with a 0.12 percent fall below baseline in India’s Using a panel regression framework covering 1961-2009, GDP (IMF 2014e). In Bangladesh and Sri Lanka, growth Ding and Masha (2012) find that growth in India is useful falls by 1.2 and 0.5 percentage points respectively in in explaining overall growth in South Asia, but only after response to a 1 percent decline in global growth, and by 2 1995, and that a 1 percentage point increase in India’s percentage points in Pakistan (although, as before, the last growth is associated with a 0.37 percentage point increase result is not statistically significant). This is consistent with for South Asian countries. World Bank (2013b) that finds that a positive impulse G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 S O U TH AS I A 151 BOX 2.5.1 Regional integration and spillovers: South Asia (continued) from the US or other advanced economies tends to be associated with a one- to two- quarter initial increase in FIGURE 2.5.1.4 Global and regional growth cyclical real GDP in India and the rest of South Asia. spillovers Financial shocks and rising global financial volatility reduce output and depreciate the exchange rate in India Spillovers from a growth shock in India are sizeable for (IMF 2014e, 2015j).3 Bangladesh, modest for Sri Lanka and statistically uninformative for Pakistan. Spillovers from large advanced countries are larger, reflecting greater integration with Conclusion trading partners outside the region. Limited global and regional economic integration in South A. Impact of a 1 percentage point decline in India’s growth Asia partly reflects business environments that have constrained the ability to do business across borders and policies that have weighed on competitiveness, growth and job creation (Palit and Spittel 2013, De et al. 2012). For instance, an improvement in South Asia’s infrastructure to around 50 percent of East Asia’s could improve intra- regional trade by about 60 percent (Wilson and Ostuki 2005). Although India is major source of spillovers for some economies, poor trade and transport connectivity in South Asia also implies fewer benefits to smaller economies in the region (relative to potential) from stronger growth in India. While the closed nature of the region (compared with other emerging market regions) has reduced exposure to large global shocks, it also limits the potential of South B. Impact of a 1 percentage point decline in G7 growth on Asian firms to benefit from the strengthening of demand growth in the United States and Europe over the medium term. At the same time, the scope for negative spillovers from global financial market volatility may be rising as India increasingly integrates into global capital markets. This was evident during the “taper tantrum” of 2013, although vulnerabilities have since receded. Source: World Bank. Notes: Based on country-specific structural vector autoregressions (VARs) using the earliest possible data from 1998:1 to 2015:2 for India, Pakistan, Bangladesh and Sri Lanka; time series coverage for some countries is shorter. The country-specific VARs include G7 growth, the EMBI, a trade-weighted commodity price index, India’s growth and country-specific growth of spillover source and recipients. For instance, when Pakistan is the spillover destination country, the variables include, in this Cholesky ordering: G-7 growth, EMBI, India’s growth, Pakistan’s trade-weighted commodity prices, Pakistan’s growth, and Pakistan’s real effective exchange rates. The model includes a dummy that captures the global financial crisis of 2008-09. Further details of the 3Although India’s capital account remains relatively closed, an active model, including the construction of the trade weighted commodity prices, are provided in Annex 3.2. Solid bars indicate medians and error bars indicate the offshore derivatives market in the Indian Rupee may be a conduit for 33-66 percent confidence bands. volatility in global markets to currency markets. Economic activity in Sub-Saharan Africa slowed to 3.4 percent in 2015 from 4.6 percent the previous year. A combination of external and domestic factors was responsible for the slowdown. External factors included lower commodity prices, a slowdown in major trading partners, and tightening borrowing conditions. Domestic factors included political instability and con ict, and electricity shortages. In 2016, GDP growth is projected to pick up to 4.2 percent, as commodity prices stabilize and supply constraints ease. Nonetheless, risks remain tilted to the downside. Domestic risks include political uncertainty associated with upcoming elections and the Boko Haram insurgency. In addition, power shortages might not ease as the forecast assumes. External risks include the possibilities of a further drop in commodity prices, a faster than expected slowdown in China, and a decline in capital ows as the United States normalizes monetary policy. Rising scal and external vulnerabilities, and domestic constraints to growth, pose challenges for policy, particularly among commodity exporters, where extreme poverty rates remain very high. Recent developments reflecting lower exposure to the commodity slowdown, and tailwinds from large-scale infrastructure investment. Economic activity in Sub-Saharan Africa (SSA) decelerated from 4.6 percent in 2014 to 3.4 Following their sharp decline in 2014, commodity percent in 2015, the weakest performance since prices weakened further in 2015 (Figure 2.6.1A). 2009, due to a combination of external shocks and The prices of oil and metals, such as iron ore, domestic constraints (Table 2.6.1). The slowdown copper, and platinum, declined substantially. was most pronounced among oil exporters. Those of some agricultural commodities, such as In Nigeria, the region’s largest economy and oil coffee, fell moderately, although the prices of exporter, growth slowed to 3.3 percent, down cocoa and tea showed small gains. The region’s from 6.3 percent in 2014. Growth moderated in pattern of exports makes it particularly vulnerable several mineral and metal exporters – including to commodity price shocks. Fuels, ores, and metals Mauritania, South Africa, and Zambia (Table accounted for more than 60 percent of the 2.6.2). In South Africa, the economy expanded by region’s total exports in 2010-14 compared with 1.3 percent, compared with 1.5 percent in 2014. 16 percent for manufactured goods (Figure With the Ebola crisis receding, activity rebounded 2.6.1B). somewhat in Liberia, but remained weak in the other affected countries (Guinea, Sierra Leone) Lower commodity prices obliged a fiscal with GDP falling sharply in Sierra Leone as tightening in several commodity exporters, which mining production contracted. Activity weakened caused a sharp slowdown. Angola and Nigeria are substantially in Burundi and South Sudan amid heavily dependent on oil for fiscal revenues and political instability and civil strife. However, reserves—oil accounts for more than 60 percent of in other countries, including low-income ones their fiscal revenues and more than 80 percent of and some fragile states—Côte d’Ivoire, Rwanda, exports. Governments in the two countries and Tanzania—growth remained robust, reduced expenditures sharply, which adversely impacted other areas of their economies. The Note: e author of this section is Gerard Kambou. Research assis- decline in metal prices hit Mauritania and Zambia tance was provided by Xinghao Gong. 154 C H A P TE R 2. 6 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 FIGURE 2.6.1 Commodity market developments that these effects could be sizeable and have likely contributed to the ongoing slowdown in the Following sharp declines in 2014, commodity prices weakened further in 2015. Expectations of slower global growth and abundant supplies led to region.1 a renewed plunge in the price of oil. The prices of ores and metals, such as iron ore, copper, and platinum, also declined substantially. With fuels, Capital flows to the region slowed in 2015, as ores, and metals accounting for more than 60 percent of its exports, the region is particularly vulnerable to commodity price shocks. cross-border bank lending declined (Figure 2.6.2A). Many countries tapped the international A. Commodity prices B. Share of commodities in SSA bond market to finance their investment exports programs, taking advantage of the global low- interest-rate environment, and investors’ search for yield. Côte d’Ivoire’s sovereign bond issuance in February was followed by five other countries – Gabon, Zambia, Ghana, Angola, and Cameroon – with Angola and Cameroon issuing maiden 10- year bonds. Yields were higher than in previous issuances, however. They exceeded 9 percent in several countries and 10 percent in Ghana. Sovereign spreads rose across the region (Figure Source: World Bank, World Integrated Trade Solutions database, 2015. 2.6.2B). This indicates a re-assessment of risk among sovereign-debt investors as global hard, as low prices of copper and iron ore headwinds, and the expectation of a rate hike by prompted mining companies to reduce production the U.S. Federal Reserve that materialized in and to delay planned investments; exports, December, weigh on the region. Increased foreign employment, and domestic spending fell. exchange liabilities, which leave many countries Exporters of agricultural commodities, which vulnerable to the risk that future currency include many of the region’s low-income depreciation could pressure debt servicing costs, countries, experienced a less pronounced would be a factor in this re-assessment. slowdown in activity as a result of the relatively moderate decline in the price of their exports. The external headwinds of low commodity prices, of a slowdown in major emerging markets, and Low commodity prices reflected weak global rising borrowing costs were compounded by demand for raw materials, including from large domestic problems. These included severe developing countries where growth has continued infrastructure constraints, especially power supply, to slow. Most importantly, the region has had to in several countries. The slowdown in Nigeria was deal with a pronounced slowdown in major accounted for by non-oil sectors (Figure 2.6.3A). trading partners. SSA’s external trade has A large part of the slowdown in manufacturing undergone a shift in direction towards China and was oil-related as oil refining recorded a steep away from traditional advanced country trading decline. However, the pronounced contraction of partners, driven by China’s demand for primary manufacturing in the first half of 2015 also commodities (Box 2.6.1). As SSA’s largest national reflected Nigeria’s huge infrastructure and trading partner, China’s rebalancing away from electricity deficits, which are impairing factory raw material-intensive sectors has direct operations. In South Africa, power supply implications for the region. In addition, foreign bottlenecks, compounded by a severe drought and direct investment flows from China have grown difficult labor relations, weighed heavily on rapidly in recent years and are important for growth (Figure 2.6.3B). Insufficient power supply several countries (e.g., Zambia and South Africa), although the United States and the Euro Area still remain the largest sources of FDI in the region. 1A recent World Bank study (Lakatos et al. 2015) nds that a Spillovers from China’s slowdown are likely to be slowdown in China’s GDP growth to an average of 6 percent per year over 2016-30 and to 4.6 percent in 2030 could result in a GDP loss transmitted to countries in SSA through trade and in Sub-Saharan Africa of 1.1 percent compared with the baseline by financial channels. World Bank estimates suggest 2030. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 S U B- S A H A R A N A F R I C A 155 emerged as a leading constraint to activity in a FIGURE 2.6.2 Capital market developments number of frontier markets, including Botswana, Capital flows to the region slowed in 2015, led by reduced cross-border Ghana, and Zambia. In some countries bank lending. Several countries tapped the international bond market, (Botswana, Zambia), shortages of hydroelectric taking advantage of the global low-interest rate environment and investors’ power were due to drought; in others, they were search for yield. However, yields were higher, as sovereign spreads rose, reflecting a re-assessment of risk by investors as headwinds, and driven by underinvestment in new capacity (South expectations of interest rate increases in the U.S., weighed on the region. Africa), and lack of reforms to encourage private investment (Ghana, Nigeria). A. Capital flows B. Sovereign bond spreads The growth slowdown was associated with mounting fiscal vulnerabilities in a number of countries. Fiscal deficits widened in oil exporters (Republic of Congo, Gabon, Nigeria) due to falling revenues. In other countries, the widening deficits reflected increased government spending, including on arrears (Zambia), infrastructure projects (Kenya), and subsidies (Malawi). Some countries (Angola, Ghana) implemented Source: Dealogic, Bloomberg. expenditure measures – including removing fuel A. Data for 2015 are from January to September. subsidies and freezing public sector hiring – that reduced the deficits. In many countries, fiscal average movement in real effective exchange rates deficits are larger relative to GDP than they were across the entire region was relatively small (Figure at the onset of the global financial crisis (Figure 2.6.5A). The Ghanaian cedi weakened the most, 2.6.4A). As a result, government debt ratios have by more than 30 percent, in large part because of continued to rise (Figure 2.6.4B). While debt-to- loose monetary and fiscal policies, followed by the GDP ratios remain manageable in most low- South African rand. The Nigerian naira was income countries, they rose rapidly in several about 5 percent stronger than its 2014 average. frontier markets, led by non-concessional Early in 2015, the Central Bank of Nigeria borrowing. By contrast, Nigeria’s sovereign debt introduced a range of administrative measures to has remained low, at less than 15 percent of GDP. stem the demand for foreign currencies. These measures have hampered private sector activities. External imbalances widened across the region. A severe liquidity squeeze emerged in the Current account balances turned sharply negative interbank market in the second half of 2015, in Angola and Nigeria due to lower oil prices. prompting the central bank to reduce the cash Deficits remained large among oil importers reserve ratio. because of low commodity prices and rising non- oil imports. In Kenya, the current account deficit Consumer price inflation remained moderate remained high as security concerns weighed on across the region, except in Ghana, Angola, and tourism earnings. In South Africa, in contrast, the Zambia, where it was in the double digits (Figure current account deficit narrowed on the back of 2.6.5B). Low fuel prices helped keep inflation export growth. In addition, the depreciation of the down. However, currency weaknesses contributed rand partly offset the decline in commodity prices. to higher inflation in many countries. In Angola In Ghana, Kenya, and Namibia, the twin fiscal and Nigeria, inflation exceeded the central bank’s and current account deficits have remained large. target. Concerns about inflation led central banks in several countries to hike interest rates (Angola, High fiscal and current account deficits, combined Ghana, Kenya, Mozambique, South Africa, with strong demand for the U.S. dollar, kept Uganda, Zambia). The Central Bank of Nigeria, currencies under pressure. Currencies of in contrast, cut the benchmark interest rate in an commodity exporters and frontier-market attempt to stimulate growth. In CFA franc economies saw sharp depreciations against the countries, the peg to the euro kept inflation low, U.S. dollar. However, because of inflation, the and underpinned greater economic stability. 156 C H A P TE R 2. 6 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 FIGURE 2.6.3 Domestic constraints Investment dynamics will also differ among SSA commodity exporters. The slowdown in major The headwinds of low commodity prices and higher borrowing costs were compounded by severe infrastructure constraints in many countries. In emerging markets, low commodity prices, and Nigeria, the pronounced contraction of the manufacturing sector reflected deteriorating growth prospects in many huge electricity deficits. In South Africa, power supply bottlenecks, commodity exporters, are expected to result in compounded by difficult labor relations, weighed heavily on growth. lower FDI flows. Exploration and development A. Growth in Nigeria’s non-oil sectors B. Electricity supply in South Africa activity is expected to be curtailed in oil and gas. Continuing fiscal consolidation in oil-exporting countries is expected to result in further capital expenditure cuts, as governments seek to limit cuts in public-sector wages and protect social spending. However, in a number of low-income, non-oil commodity exporters, governments are expected to continue to invest heavily in energy and transport infrastructure in a bid to improve the operational environment for growth, drawing in part on the Source: Nigeria National Bureau of Statistics, Statistics South Africa. proceeds from previous bond issuances (Ethiopia), public-private partnerships (Mozambique, Rwanda, Tanzania), donor aid (Rwanda) and, in some cases, financing from Chinese entities Outlook (Ethiopia, Tanzania). Although debt levels may rise, they remain manageable in most low-income Sub-Saharan Africa faces a challenging near-term countries as growth has been robust. outlook. Commodity prices are expected to stabilize but remain low through 2017 (Figure The fiscal policy stance in commodity exporters is 2.6.6A). The normalization of U.S. monetary expected to ease gradually as commodity prices policy is expected to tighten global financial stabilize. In Nigeria, ongoing efforts to rationalize conditions. Although governments are taking steps the management and operation of the Nigeria to resolve power issues, electricity supply National Petroleum Corporation should also help bottlenecks are expected to persist. These factors enhance revenue mobilization. However, with oil point to a somewhat weaker recovery in 2016 than prices projected to remain below their recent previously anticipated. After slowing to 3.4 peaks, fiscal revenues are expected to remain low percent in 2015, activity is expected to pick up to in Angola and Nigeria. As a result, fiscal deficits 4.2 percent in 2016 and to 4.7 percent in 2017-18 are likely to increase in these countries, despite (Figure 2.6.6B). This projection assumes that efforts to restrain spending. Fiscal deficits are also commodity prices stabilize and electricity expected to remain elevated in oil importers, as constraints ease (Table 2.6.1). There are, however, spending on goods and services, wages, and considerable variations within the region. physical infrastructure continues to expand. Consumption dynamics will continue to differ for Net exports are expected to make a negative oil exporters and importers. Private consumption contribution to real GDP growth in the near term, growth is expected to remain weak in oil exporters despite currency depreciations. Still-low as the removal of subsidies to alleviate pressure on commodity prices will depress export receipts, budgets results in higher fuel costs, and as especially among oil exporters, even as export currency depreciation weigh on consumers’ volumes rise. The pull from advanced economies is purchasing power. By contrast, lower inflation in expected to stay modest, given their moderate oil importers, owing in part to lower fuel prices, prospects for medium-term growth. Among oil should help boost consumer spending. The price importers, current account balances are expected level impact of currency depreciation combined to deteriorate in many countries on account of with interest rate increases could, however, strong import growth, driven by capital goods moderate these effects. imports for infrastructure projects. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 S U B- S A H A R A N A F R I C A 157 In this context: FIGURE 2.6.4 Fiscal deficits and government debt • Activity is expected to remain subdued in the Fiscal deficits widened across the region. In oil exporters, it was due to falling oil revenues. In other countries, the widening deficits reflected region’s three largest economies (Table 2.6.2). higher government spending, including on wages, infrastructure projects, In Nigeria, power and fuel shortages, and and subsidies and transfers. In a few countries, measures were implemented that reduced the deficits. In many countries, fiscal deficits are fiscal consolidation, which weighed on activity now larger than at the onset of the financial crisis. As a result, government in 2015, are expected to diminish gradually. debt has continued to rise, especially in frontier markets. Growth is expected to remain weak in South A. Fiscal balance B. Government debt Africa, as inadequate power supply, weak business confidence, difficult labor relations, and policy tightening slow activity. In Angola, government spending remains constrained, and elevated inflation has weakened consumer spending. • Among the region’s frontier markets, rising oil production and diminishing fiscal and current account imbalances are expected Source: IMF Fiscal Monitor, IMF World Economic Outlook. to help lift growth in Ghana. However, in Zambia, low copper prices, compounded expected to see steady growth, helped in part by regulatory uncertainty and electricity by the stable currency peg to the euro. shortages, will curtail copper production, export, and investment. Meanwhile, despite pressure on the shilling, Kenya is expected Risks to grow at a robust pace, supported by large- The balance of risks to the outlook remains tilted scale infrastructure projects, including the to the downside. On the domestic front, political expansion of the railway system, which should upheavals and conflicts in Burundi, Burkina Faso, help boost domestic trade, and a new port. and South Sudan suggest that political risks • The region’s low-income countries are associated with the electoral process will remain a expected to continue to sustain high GDP key issue for the region in 2016. Security risks tied growth. Many of these countries have limited to Boko Haram insurgencies are significant for exposure to the commodities that are Cameroon, Chad, Niger, and Nigeria; while experiencing the most severe decline in prices. terrorist threats remain a concern for Kenya and Meanwhile, large-scale investment projects in Mali. These events could generate greater political energy and transport are ongoing, consumer instability for the region if they were to escalate, spending remains robust, boosted by lower hurting growth. The assumption that electric fuel prices, and despite low minerals prices, power constraints will ease might prove too mining output is set to rise in several optimistic. The power supply crisis may worsen, as countries. Public investment, consumer a result of a lack of reforms, which would hold spending, and mining production will help economic activity back in many countries. Côte d'Ivoire, Ethiopia, Mozambique, Many countries of the region have domestic Rwanda, and Tanzania sustain rapid growth macroeconomic weaknesses that leave them in 2016 and beyond. Several low-income vulnerable to shocks. In these countries, fiscal and countries in the West African Economic and current account deficits are sizeable and debt levels Monetary Union (WAEMU)2 region are are rising. If these conditions were to deteriorate significantly, shocks could manifest themselves in 2WAEMU countries are Benin, Burkina Faso, Côte d’Ivoire, Guinea Bissau, Mali Niger, Senegal, and Togo. ey share the same currency, substantial currency pressures, higher inflation, the CFA franc, which is pegged to the euro. and lower business confidence. 158 C H A P TE R 2. 6 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 FIGURE 2.6.5 Exchange rates and inflation environment. However, they may need to tighten their macroeconomic policy stances, and High fiscal and current account deficits kept currencies under pressure, particularly against the U.S. dollar. However, in real effective terms, the strengthen their monetary policy frameworks, to average exchange rate movement for SSA as a whole has been relatively prevent inflation induced by currency depreciation small. Inflation remained moderate for the most part in the region, helped from becoming a constant threat. It will also be by low commodity prices, although currency weaknesses contributed to higher inflation in many countries, including Angola, Ghana, and Zambia. critical for these countries to carefully manage sovereign borrowing on international capital A. Real effective exchange rates B. Consumer price inflation markets. In many countries, measures to strengthen domestic resource mobilization to reduce overdependence on revenue from the resource sector, and to raise the efficiency of public expenditures, are needed to rebuild fiscal space and resilience to shocks. Funding much-needed social programs and public infrastructure could help reduce the inequality of opportunity that is Source: Haver Analytics, World Bank. A. An increase denotes real appreciation. contributing to high poverty rates in the region (World Bank 2015r). On the external front, there are a number of major risks to the forecast. A further decline in oil prices Resource-rich countries would benefit from would sharply reduce government spending in oil- improving their non-resource tax systems. Tax producing countries. A sharper-than-expected revenues in SSA, as a share of GDP, have slowdown in China could result in a renewed increased since the 1980s. However, much of the across-the-board weakening in commodity prices, improvement was driven by the growth in which would delay further or lead to a cancelation revenues from oil producers. Excluding resource- of planned investments in resource sectors. A based revenues, there has been limited sudden deterioration in global liquidity conditions improvement in the domestic mobilization of tax could push up financing costs and result in cut- revenues in the region. A number of studies offs of capital flows. (AfDB and OECD 2010) have identified broad areas in which tax systems in SSA could usefully Policy challenges strengthened. In the short run, policy makers need to concentrate on ways to broaden the tax base. The global economic environment will be less Policy options include removing tax preferences, conducive to growth in Sub-Saharan Africa over streamlining transfer pricing by multinational the next several years than in the recent past. companies, and doing a better job of taxing Lower commodity prices and tightening global extractive industries fairly and transparently. In financial conditions will hinder activity. In most the medium term, policy makers need to design commodity exporters, thin buffers limit the scope strategies to bring small enterprises into the tax net for counter-cyclical policies to support economic and boost administrative capacity. Over the long activity without exacerbating existing fiscal and run, instruments such as urban property taxes external vulnerabilities. Policies are needed to could help generate revenues from a more respond to growing vulnerabilities, address balanced tax mix. domestic constraints to activity, and promote non- commodity sources of growth. The decline in commodity prices makes it important for resource-rich countries to improve Oil, mineral, and metal exporters are the most their public investment management (PIM) exposed to the decline in commodity prices. In system, which could help boost growth (Rajaram these countries, exchange rate flexibility could help et al. 2014). SSA’s oil-exporters, on average, have an adjustment to a low commodity-price lower PIM scores than others, especially at the G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 S U B- S A H A R A N A F R I C A 159 project appraisal and evaluation stages of the PIM FIGURE 2.6.6 Outlook process (Dabla-Norris et al. 2011), reflecting weak Prices of SSA’s commodity exports are expected to stabilize but remain administrative capacity and low transparency in low throughout 2017, China is in the midst of rebalancing growth away the use of public resources. Upgrading the quality from raw-material-intensive sectors, and the normalization of U.S. monetary policy is expected to tighten global financial conditions. Electricity supply of infrastructure investment spending in these bottlenecks are also expected to persist in many countries. These factors countries would require enhancing the planning, point to a weaker recovery in 2016 than previously anticipated. bidding, contracting, and evaluation process of quality projects, and improving the selection and A. Commodity prices B. SSA growth forecasts implementation of these projects (Keefer and Knack 2007). Structural reforms are needed to alleviate domestic impediments to growth and to accelerate economic diversification. Creating the conditions for a more competitive manufacturing sector would require, in particular, a major improvement in providing electricity. Addressing power sector problems should therefore be a priority. Source: World Bank. Investments in new energy capacity (South Note: Shaded area denotes an estimated or forecast value. Africa), attention to drought and its effects on hydropower (Botswana, Zambia), and a new focus on encouraging private investment (Ghana, Nigeria) would help build resilience in the power sector. An increasing share of the world’s poor resides in Sub-Saharan Africa (World Bank 2015j). Reviving growth and reducing vulnerabilities will be important for progress toward eradicating extreme poverty, and achieving the recently adopted Sustainable Development Goals. Policies to enhance domestic revenue mobilization, increase the efficiency of public spending, and boost growth and economic diversification will play a critical role in these efforts. 160 C H A P TE R 2. 6 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 TABLE 2.6.1 Sub-Saharan Africa forecast summary (Annual percent change unless indicated otherwise) (Percentage point difference from June 2015 projections) 2013 2014 2015e 2016f 2017f 2018f 2015e 2016f 2017f Developing SSA, GDPa 4.9 4.6 3.4 4.2 4.7 4.7 -0.8 -0.3 -0.3 (Average including countries with full national accounts and balance of payments data only)b Developing SSA, GDPb 4.8 4.6 3.5 4.2 4.7 4.7 -0.7 -0.4 -0.3 GDP per capita (U.S. dollars) 2.0 1.9 0.8 1.5 2.0 2.0 -0.9 -0.6 -0.5 PPP GDP 5.0 4.9 3.7 4.4 4.9 5.0 -0.7 -0.4 -0.3 Private consumptionc 9.9 3.2 3.1 3.7 4.0 4.1 -0.9 -0.5 -0.5 Public consumption 1.9 3.9 3.2 3.5 3.7 3.8 -0.4 -0.2 -0.1 Fixed investment 9.6 8.7 6.2 6.6 7.1 7.2 -0.5 -0.7 -0.7 Exports, GNFSd -2.2 5.0 2.1 2.6 2.9 2.9 -0.7 -0.5 -0.4 Imports, GNFSd 6.8 3.0 3.0 3.1 3.2 3.2 0.0 0.0 0.0 Net exports, contribution to growth -2.8 0.5 -0.3 -0.2 -0.2 -0.2 -0.2 -0.1 -0.2 Memo items: GDP Broader geographic regione 4.8 4.5 3.3 4.2 4.6 4.7 -0.7 -0.3 -0.4 SSA excluding South Africa 5.8 5.7 4.1 5.1 5.7 5.7 -0.8 -0.3 -0.2 Oil exportersf 5.5 5.4 3.3 4.5 5.2 5.2 -0.8 -0.3 -0.3 CFA countries g 4.6 5.5 4.4 5.7 6.0 5.9 0.3 0.2 0.0 South Africa 2.2 1.5 1.3 1.4 1.6 1.6 -0.7 -0.7 -0.8 Nigeria 5.4 6.3 3.3 4.6 5.3 5.3 -1.2 -0.4 -0.2 Angola 6.8 3.9 3.0 3.3 3.8 3.8 -1.5 -0.6 -1.3 Source: World Bank. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not differ at any given moment in time. a. GDP at market prices and expenditure components are measured in constant 2010 U.S. dollars. Excludes Somalia, Central African Republic, and São Tomé and Principe. b. Sub-region aggregate excludes Liberia, Somalia, Central African Republic, São Tomé and Principe, and South Sudan, for which data limitations prevent the forecasting of GDP components. c. The sudden surge in private consumption in the region in 2013 is driven by the revised and rebased NIA data of Nigeria in 2014. d. Exports and imports of goods and non-factor services (GNFS). e. Includes developing SSA and the following high-income countries: Equatorial Guinea and Seychelles. f. Includes Angola; Côte d’Ivoire; Cameroon; Congo, Rep.; Gabon; Nigeria; Sudan; Chad; and Congo, Dem. Rep. g. Includes Benin; Burkina Faso; Central African Republic; Côte d’Ivoire; Cameroon, Congo, Rep.; Gabon; Equatorial Guinea; Mali; Niger; Senegal; Chad; and Togo. G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 S U B- S A H A R A N A F R I C A 161 TABLE 2.6.2 Sub-Saharan Africa country forecastsa (Real GDP growth at market prices in percent, unless indicated otherwise) (Percentage point difference from June 2015 projections) 2013 2014 2015e 2016f 2017f 2018f 2015e 2016f 2017f Angola 6.8 3.9 3.0 3.3 3.8 3.8 -1.5 -0.6 -1.3 Benin 5.6 5.4 5.7 5.3 5.1 5.1 1.1 0.7 0.4 Botswanab 9.3 4.4 3.0 4.0 4.2 4.2 -1.3 -0.2 0.0 Burkina Faso 6.7 4.0 4.4 6.0 7.0 7.0 -0.6 -0.2 0.5 Burundi 4.6 4.7 -2.3 3.5 4.8 4.8 -7.1 -1.5 -0.4 Cabo Verde 1.0 1.8 2.9 3.5 4.1 4.1 -0.1 0.1 0.6 Cameroon 5.6 5.9 6.3 6.5 6.5 6.4 2.3 1.9 1.5 Chad 5.7 7.3 4.1 4.9 6.1 6.5 -4.9 0.2 0.5 Comoros 3.5 3.0 2.3 2.5 3.1 3.1 -1.1 -1.2 -0.7 Congo, Dem. Rep. 8.5 9.0 8.0 8.6 9.0 9.0 0.0 0.1 0.0 Côte d'Ivoire 9.2 8.5 8.4 8.3 8.0 8.0 0.4 0.6 0.5 Eritrea 1.3 1.7 0.9 2.0 2.2 2.2 -0.6 0.0 0.0 Ethiopiab 10.5 9.9 10.2 10.2 9.0 9.0 0.7 -0.3 0.5 Gabon 4.3 4.3 4.1 5.1 5.3 5.3 0.1 -0.1 -0.2 Gambia, The 4.8 -0.2 4.0 4.5 5.3 5.3 1.0 -0.6 -0.8 Ghana 7.3 4.0 3.4 5.9 8.2 8.2 -0.1 0.0 0.4 Guinea 2.3 -0.3 0.4 3.5 4.0 4.2 0.7 1.2 1.5 Guinea-Bissau 0.3 2.5 4.4 4.9 5.3 5.3 0.2 1.0 1.3 Kenya 5.7 5.3 5.4 5.7 6.1 6.1 -0.6 -0.9 -0.4 Lesotho 4.6 2.0 2.6 2.8 4.5 4.5 -1.4 -1.7 0.0 Liberia 8.7 1.0 3.0 5.7 6.8 6.8 .. .. .. Madagascar 2.4 3.0 3.2 3.4 3.6 3.6 -1.4 -1.4 -1.4 Malawi 5.2 5.7 2.8 5.0 5.8 5.8 -2.3 -0.6 -0.1 Mali 1.7 7.2 5.0 5.0 5.0 5.0 -0.6 -0.1 -0.2 Mauritania 5.5 6.9 3.2 4.0 4.0 4.0 -2.3 -1.7 -1.6 Mauritius 3.3 3.6 3.5 3.7 3.7 3.7 0.0 0.0 0.0 Mozambique 7.3 7.4 6.3 6.5 7.2 7.2 -0.9 -0.8 -0.1 Namibia 5.7 6.4 5.0 5.5 5.9 5.9 -0.5 0.2 0.8 Niger 4.6 6.9 4.4 5.3 9.3 5.7 -0.1 -0.2 1.6 Nigeria 5.4 6.3 3.3 4.6 5.3 5.3 -1.2 -0.4 -0.2 Rwanda 4.7 7.0 7.4 7.6 7.6 7.6 0.4 0.6 0.1 Senegal 3.5 3.9 5.0 5.3 5.3 5.3 0.2 0.3 0.1 Sierra Leone 20.1 7.0 -20.0 6.6 5.3 5.3 -7.2 -1.8 -3.6 South Africa 2.2 1.5 1.3 1.4 1.6 1.6 -0.7 -0.7 -0.8 South Sudan 13.1 3.4 -5.3 3.5 7.0 7.0 .. .. .. Sudan 3.3 3.1 3.5 3.4 3.9 3.9 0.9 -0.1 0.0 Swaziland 2.8 2.5 1.3 0.8 0.8 0.8 -0.7 -1.0 -0.8 Tanzania 7.3 7.0 7.2 7.2 7.1 7.1 0.0 0.1 0.0 Togo 5.1 5.7 5.1 4.9 4.7 4.7 0.0 0.0 0.0 Ugandab 3.6 4.0 5.0 5.0 5.8 5.8 -0.5 -0.7 0.0 Zambia 6.7 5.6 3.5 3.8 5.4 6.0 -2.1 -2.4 -1.5 Zimbabwe 4.5 3.2 1.0 2.8 3.0 3.0 0.0 0.3 -0.5 Recently transitioned to high-income countriesc Equatorial Guinea -4.8 -3.1 -9.3 2.3 -0.4 -0.2 6.1 -1.3 -4.1 Seychelles 6.6 2.8 3.5 3.7 3.6 3.6 0.0 0.0 -0.1 Source: World Bank. World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently, projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not significantly differ at any given moment in time. a. Central African Republic, São Tomé and Principe, and Somalia are not forecast due to data limitations. b. Fiscal-year based numbers. c. Based on the World Bank’s reclassification from 2004 to 2015. 162 C H A P TE R 2. 6 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.6.1 Regional integration and spillovers: Sub-Saharan Africa Over the past decade, regional integration in Sub-Saharan Africa (SSA) has expanded. Though still low, intraregional trade represents a growing share of the region’s trade. Cross-border financing flows within Sub-Saharan Africa have increased rapidly. Nevertheless, shocks to growth in the two largest economies – Nigeria and South Africa – appear to have no measurable effects on other countries in the region. Introduction from the traditional advanced country markets. The export exposure of SSA countries to advanced-economies has SSA is an open region, with diversified trade partners and halved over the decade ending 2014. The fall in the share sources of finance (Figure 2.6.1.1). Much of Sub-Saharan of the region’s exports to the United States, to about 1 African trade takes place with countries outside the region. percent of GDP in 2014 from its peak of 8 percent in Advanced economies remain the largest destinations of 2005, was particularly pronounced (Figure 2.6.1.2). This Sub-Saharan Africa’s exports. However, China and other reflected in part a sharp decline in Nigeria’s oil exports as developing countries in Asia are increasingly prominent. U.S. oil shale production expanded. More broadly, the Intraregional trade and financial linkages within the region anemic recovery in Euro Area countries and other have expanded in recent years and look set to expand faster advanced economies following the global financial crisis in the years ahead. underpinned the decline in the share of SSA’s exports to advanced economies. This box examines the extent of regional integration. In particular, it takes a closer look at linkages between SSA’s China’s trade with Sub-Saharan Africa has been driven by two largest economies—Nigeria and South Africa—and China’s fast growth of investment in capital goods that the rest of the region to assess the potential significance of require intensive inputs of primary commodities, notably intra-regional growth spillovers. The box addresses the oil and metals (Drummond and Liu 2013). By 2012, following questions: China had become SSA’s single largest national trading partner. Angola, Democratic Republic of Congo, • How open is Sub-Saharan Africa to global and Equatorial Guinea, Republic of Congo, and South Africa regional trade and financial flows? account for about 75 percent of SSA’s exports to China (oil, metals, and mineral fuels). Similarly, Angola, Benin, • How large are the potential intra-regional spillovers Ghana, Liberia, Nigeria, and South Africa account for from the region’s two largest economies, Nigeria and more than 80 percent of SSA’s total imports from China South Africa? (mainly machinery, chemicals, and manufactured goods). The region is highly open to the world economy, with a Financial linkages between SSA and the rest of the world diverse group of trade and financial partners, and intra- have grown considerably in the last decade, with some regional ties have grown rapidly since the mid-2000s. shift in composition towards flows into regional capital Nevertheless, estimated growth spillovers from South markets and direct investment. Africa and Nigeria to the rest of SSA are statistically insignificant. This may reflect the globally diversified • The stock of private external claims on SSA nature of SSA’s global trade and financial partners. It may represented 40 percent of the region’s GDP in 2013, also reflect inadequate data for countries most closely slightly lower than its peak of 45 percent of GDP in integrated with South Africa and Nigeria. 2010. Although most SSA countries have limited or no access to international capital markets, portfolio How open is Sub-Saharan Africa to global and investment claims on the region—originating mostly regional trade and financial flows? from the U.S. and Euro Area—more than doubled between 2001 and 2010. South Africa, with its highly SSA’s integration into global trade networks has increased developed financial markets, has been the main remarkably over the past three decades (UNCTAD 2013). recipient of portfolio investments. Cross-border Advanced economies remain the main trading partners for banking claims on SSA, which before the global SSA. However, recent years have seen a fundamental shift financial crisis had risen above portfolio claims, have in the direction of SSA trade towards China and away since moderated. European banks have deleveraged and oriented their activities toward developing Note: This box was prepared by Gerard Kambou and Jesper Hanson, countries in Asia. Cross-border bank lending flows with contributions from Raju Huidrom. originate mainly from U.K. and Euro Area lenders, G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 S U B- S A H A R A N A F R I C A 163 BOX 2.6.1 Regional integration and spillovers: Sub-Saharan Africa (continued) with Angola, Botswana, Mozambique, Tanzania, and Zambia among the largest recipients. Foreign direct FIGURE 2.6.1.1 Cross-region comparison investments are the largest capital inflows to the The region is open to global trade and finance. It region. FDI liabilities represented more than 15 accounts for about 2 percent of global GDP and trade. percent of SSA’s GDP in 2013. While the Euro Area In relation to GDP, the levels of external trade, remains an important source of FDI in the region, investment, and remittances for the average SSA economy are similar to other developing regions. FDI flows from China have grown rapidly in recent years, and are mostly allocated to the natural resource A. SSA: Share of global activity, trade, and finance, 2014 and infrastructure sectors (World Bank 2015a). • Remittances and official development assistance amounted to 2 percent and 1.5 percent of GDP in 2014 and 2013, respectively, lower than their levels in 2010. Official development assistance and remittances from advanced economies have been on a declining trend in recent years, reflecting weak growth and austerity budgets in these economies. While most economic ties of SSA are to non-SSA countries, intraregional trade, foreign direct investment, cross-border banking flows, and remittances have risen in recent years (Figure 2.6.1.3). The number of Pan-African banking groups has increased rapidly across the region, B. SSA: Trade and finance in regional comparison, 2014 partly influenced by rising trade flows (IMF 2015l). Furthermore, trade linkages between the region’s largest economies (Nigeria and South Africa) and the rest of the region have been growing and look set to deepen. Linkages between South Africa and the rest of the region Trade linkages: South Africa, the region’s second largest economy, accounting for 21 percent of its GDP, is an important export market for its immediate neighbors (Figure 2.6.1.4). In 2011, exports to South Africa accounted for over 80 percent of trade within the South African Customs Union, or SACU (Canales-Kriljenko, Gwenhamo and Thomas et al. 2013).1 Exports to South Sources: IMF October 2015 World Economic Outlook, IMF International Financial Statistics, IMF Direction of Trade Statistics, UNCTAD FDI/TNC database, World Africa are particularly large for Swaziland (25 percent of Bank Remittance and Migration Database, World Bank World Development Indicators. GDP) and Lesotho (10 percent of GDP). Exports from B. The red bar denotes exports, imports, trade, remittance inflows, portfolio liabilities, and FDI inflows in percent of GDP on average across SSA countries. SACU countries consist mostly of agricultural goods; they The vertical line denotes the range of averages for all six developing country also include some manufacturing products, chemicals and regions. metals. South Africa is also an important export market for countries in the 15-member Southern African South Africa account for less than 5 percent of GDP in Development Community (SADC) region, especially West African countries such as Ghana and Nigeria. Mozambique (10 percent of GDP) and Zimbabwe (5 percent of GDP). Fuels dominate Mozambique’s exports Financial linkages: South Africa is the largest source of to South Africa, while Zimbabwe’s exports consist mainly foreign direct investment for Botswana, Lesotho, Namibia, of agricultural goods and metals. By contrast, exports to and Swaziland (BLNS) (Figure 2.6.1.4), accounting for up to 80 percent of total inward FDI in these countries. 1SACU member countries are Botswana, Lesotho, Namibia, South South African firms (e.g. Massmart, Nampak, MTN Africa, and Swaziland. Group) also have a strong presence in the SADC region 164 C H A P TE R 2. 6 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.6.1 Regional integration and spillovers: Sub-Saharan Africa (continued) FIGURE 2.6.1.2 Linkages between Sub-Saharan Africa and the rest of the world Countries in Sub-Saharan Africa increasingly participate in international trade. The region’s trade has undergone a shift in direction towards China and away from traditional advanced country trading partners. Foreign direct investment liabilities have increased considerably, while remittances and official development assistance from advanced countries have declined. Relative to GDP, bilateral development assistance has halved over the last ten years to 1.5 percent of regional GDP. A. Exports B. Financial liabilities C. Remittances by source country D. Bilateral official development assistance Source: IMF Direction of Trade Statistics, Coordinated Portfolio Investment Survey, Coordinated Direct Investment Survey; Bank for International Settlements Consolidated Banking Statistics; World Bank Remittances and Migration database, OECD. B: Coordinated Direct Investment Survey (CDIS) is not available for 2001 and 2005; Coordinated Portfolio Investment Survey (CPIS) is not available for 2001. Liabilities to banks stand for claims of BIS-reporting banks on SSA countries. BIS stands for Bank for International Settlements. (Mozambique, Zimbabwe), East African Community they average more than 20 percent of GDP (2011-2014), (Kenya, Uganda, and Tanzania) and countries in West reflecting the large number of migrant workers employed Africa (Nigeria, Ghana). South Africa-based banks in South African mines.3 (Standard Bank, First Rand Bank, Nedbank) and other financial institutions are active across the continent, and Institutional linkages: South Africa’s monetary and are systemically important in neighboring countries, as exchange rate policies and the revenue sharing gauged by deposit shares.2 Remittances from South Africa arrangements under SACU are significant sources of to neighboring countries are also significant—for Lesotho, linkages. 2Operations are deemed systematically important if the share of their 3Though still sizeable, remittances to Lesotho have steadily declined in deposits in total banking system deposits exceeds 10 percent; or if their line with the long-term decline in South Africa’s gold production. asset share exceeds 7 percent of GDP (IMF 2015l). G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 S U B- S A H A R A N A F R I C A 165 BOX 2.6.1 Regional integration and spillovers: Sub-Saharan Africa (continued) • South Africa’s currency, the rand, circulates freely in the Common Monetary Area (CMA) formed by FIGURE 2.6.1.3 Intra-regional linkages South Africa, Lesotho, Namibia, and Swaziland Most of the region’s economic ties continue to be with whose currencies are pegged to the rand. Through non-SSA countries. The region’s largest economies are interest rate and exchange rate movements, policy among its leading sources of intraregional trade. actions in South Africa immediately affect economic conditions in the CMA. A. Exports, FDI inflows, remittance inflows • The revenue sharing mechanism in SACU has created strong linkages between South African imports and budget revenue in BLNS. South African imports account for more than 90 percent of total SACU imports, the taxes on which are a major source of SACU customs revenue. Customs revenues across SACU are pooled and allocated to members. About 85 percent of forecast excise revenues are distributed based on the share of each country in total SACU GDP, and the remaining is distributed according to a formula that favors countries with lower per capita GDP, typically with a lag of two years. Since imports tend to be more volatile than overall economic activity, the revenue sharing mechanism contributes B. Leading sources of intra-regional trade, 2014 (millions of to significant volatility in budgetary revenue in BLNS. US$) Linkages between Nigeria and the rest of the Exports to the Rest of Africa Imports from the Rest of Africa region Country Value Country Value South Africa 27,041 South Africa 12,504 Trade linkages: Following the data revision of 2013, Côte d’Ivoire 3,978 Botswana 5,985 Nigeria has become SSA’s largest economy, accounting for Zimbabwe 2,782 Zambia 5,833 31 percent of its GDP. It is also the region’s largest oil Zambia 2,170 Zimbabwe 3,388 exporter. Official data suggest that trade links exist Tanzania 2,161 Mozambique 3,121 between Nigeria and a number of West African countries, Botswana 1,691 Côte d’Ivoire 2,954 but are modest (Figure 2.6.1.5). Nigeria’s share in exports Senegal 1,309 Cameroon 2,054 to the Economic Community of West African States (ECOWAS)4 fell from an average of 7 percent in 2001-06 Congo, Rep. 1,247 Burkina Faso 1,873 to 2.3 percent in 2010, but has been recovering (Chete Mozambique 1,198 Tanzania 1,496 and Adewuyi 2012). Nigeria is an important export Uganda 789 Malawi 1,153 market for agricultural or manufacturing goods from neighboring Guinea-Bissau (6 percent of exports), Côte Source: World Bank (remittances), IMF DOTS (exports), IMF CDIS (FDI), WITS. A. Data on FDI liabilities is not available for Angola, Ghana and Nigeria. d’Ivoire (3 percent of exports), and Niger (2.8 percent of exports). Implementation of the ECOWAS common external tariff, which became effective in January 2015, is expected to further boost sub-regional trade, including Financial sector linkages: Cross-border activity of between Nigeria and the West African Economic and Nigerian-based banks in SSA has expanded substantially, Monetary Union (WAEMU) member countries.5 in part as Nigerian banks follow up on opportunities to finance trade between Nigeria and countries across SSA. 4The ECOWAS member states are Benin, Burkina Faso, Cape Verde, The number of subsidiaries of Nigerian banks licensed in foreign jurisdictions increased from two in 2002 to 64 in Côte d’Ivoire, Gambia, Ghana, Guinea, Guinea Bissau, Liberia, Mali, Nigeria, Senegal, Sierra Leone and Togo. 2013, operating in more than 20 countries across SSA. 5WAEMU countries are Benin, Burkina Faso, Côte d’Ivoire, Guinea The United Bank for Africa, the largest pan-African bank Bissau, Mali Niger, Senegal, and Togo. They share the same currency, from Nigeria, has a widespread presence in SSA, and is the CFA franc, which is pegged to the euro. systematically important in several countries, with 19 166 C H A P TE R 2. 6 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.6.1 Regional integration and spillovers: Sub-Saharan Africa (continued) FIGURE 2.6.1.4 Linkages between South Africa and the rest of Sub-Saharan Africa South Africa is an important market destination for immediate neighboring countries, as well as for countries in the broader Southern African Development Community region. South Africa is the largest source of FDI for Botswana, Namibia, Lesotho, and Swaziland. It remains an important source of remittances for many countries in the Southern Africa region. South Africa-based banks are active across SSA and systematically important in neighboring countries. A. Exports to South Africa, 2011-14 B. FDI inflows and remittances from South Africa, 2011-13 C. Selected South Africa banks: share of deposits by country, D. Selected South Africa banks: assets by country, 2013 2013 Source: IMF Direction of Trade Statistics, Coordinated Direct Investment Survey, World Bank Migration and Remittances Database, IMF staff reports. Note: BNLS denotes Botswana, Namibia, Lesotho, and Swaziland. A: Chart shows countries with exports to South Africa higher than 2 percent of GDP. B: Chart shows countries with FDI from South Africa higher than 2 percent of GDP. subsidiaries contributing 15 percent to total assets.6. This neighboring countries are small relative to GDP; and rapid cross-border expansion increases the potential for foreign direct investment from Nigeria in the region, financial sector shocks in Nigeria to be transmitted across outside the financial sector, is negligible. the region. Other potential spillover channels appear limited. In particular, remittances from Nigeria to Informal sector linkages: Strong informal cross-border trade links exist between Nigeria and neighboring countries that are only partially captured in official 6Ecobank, a full service bank based in Togo, is one of the region’s statistics. Estimates of informal cross-border trade in West largest pan-Africa Banks with operations in 36 African countries. Africa show that it could represent 20 percent of GDP in G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 S U B- S A H A R A N A F R I C A 167 BOX 2.6.1 Regional integration and spillovers: Sub-Saharan Africa (continued) FIGURE 2.6.1.5 Linkages between Nigeria and the rest of Sub-Saharan Africa Trade links between Nigeria and neighboring countries remain modest. Strong informal cross-border trade links exist between Nigeria and its neighbors that are only partially reflected in official trade statistics. Cross-border activity of Nigeria-based banks has expanded in recent years. United Bank for Africa and Guaranty Trust Bank, two Pan-African banks from Nigeria, have widespread presence in Sub-Saharan Africa. United Bank for Africa is systematically important in several countries. A. Exports to Nigeria, 2011-14 B. Selected Nigerian banks: Share of C. Selected Nigerian banks: Assets by deposits by country, 2013 country, 2013 Source: IMF Direction of Trade Statistics (DOTS) database; IMF staff reports. Nigeria (Afrika and Ajumbo 2012). In particular, a own growth, South African growth, Nigerian growth, the significant share of trade in agriculture goods and real effective exchange rate, growth in the rest of the world petroleum products is unrecorded. (as exogenous variable), and a dummy that captures the global financial crisis of 2008-09.8 Figure 2.6.1.6 shows • Cross-border trade in grain and livestock has helped the estimated response of each destination country’s improve food availability in Benin, Cameroon, Chad, output growth to a 1 percentage point decline in real GDP Ghana, Mali, and Niger.7 growth in Nigeria, South Africa, and the rest of the world. • Nigerian subsidies have kept fuel prices much lower The impulse responses suggest that global growth has a than in neighboring countries, generating strong significant influence on growth in Sub-Saharan Africa. informal trade in fuel. It is estimated that three- Growth in Nigeria or South Africa, in contrast, does not quarters of the fuel consumed in Benin is imported appear to have significant spillover effects on neighboring through informal channels from Nigeria (World Bank as well as geographically more distant countries. The two 2014c). Changes in Nigeria’s pricing policies for fuel largest economies in SSA have insignificant spillovers to products could have significant spillovers for each other.9 neighboring countries. These results are broadly in line with, and complement, those found by a number of previous authors. For How large are the potential intra-regional example, using a global vector autoregression (GVAR) spillovers from the region’s two largest model, Gurara and Ncube (2013) found a significant growth spillover effect to African economies from both the economies, Nigeria and South Africa? Eurozone economies and BRICS. Kinfack and Bonga- A Bayesian vector autoregression model is used to estimate Bonga (2015) employ a GVAR model and find that growth spillovers from Nigeria, South Africa, and the rest Africa’s real GDP has a positive response to increases in of the world. Sufficient data exists for Botswana, Ghana, GDP in the Euro Area and in China. Spillovers of growth and Uganda, but only from 2007 Q2 to 2015 Q2. For shocks from Nigeria and South Africa to the rest of Sub- each of these countries, the variables in the model include Saharan Africa were the focus of the studies by IMF 8Further details on the model, including the construction of the rest of 7Nigeria supplies about 60-70 percent of Niger’s grain imports (mostly the world growth variable, are provided in Annex 3.2. maize, millet, and sorghum), thereby contributing to food security in 9For a comparison of within-region spillovers across regions, see Niger. Box 3.4. 168 C H A P TE R 2. 6 G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 BOX 2.6.1 Regional integration and spillovers: Sub-Saharan Africa (continued) FIGURE 2.6.1.6 Regional spillovers in SSA Events that affect world growth spill over into SSA. Growth shocks in Nigeria and South Africa do not appear to have significant spillovers to neighboring countries. A. Impact of 1 percentage point decline in B. Impact of 1 percentage point decline in C. Impact of 1 percentage point decline in growth in the rest of the world Nigeria’s growth South Africa’s growth Source: World Bank. Note: The results show the cumulative change in growth after two years in response to 1 percentage point change in the rest of the world, Nigerian and South African growth based on Bayesian vector autoregression, using data for 2007Q2-2015Q2. Bars are the median estimates and the error bands represent the 33-66 percent confidence bands. SSA refers to the cross sectional median estimates across BWA, GHA, NGA, UGA, and ZAF. BWA = Botswana; GHA = Ghana; NGA = Nigeria; UGA = Uganda; ZAF = South Africa; SSA = Sub-Saharan Africa. (2012b) and Canales-Kriljenko et al.(2013), with the latter South Africa, the region’s two largest economies, and the focusing on the BLNS countries. Both studies used vector rest of the region have been growing. Notwithstanding autoregression models. They find that shocks to South this development, the quantitative analysis suggests that Africa’s growth have no significant spillover effects on the growth in Nigeria and South Africa has negligible spillover BNLS countries, or the rest of the continent. Similarly, effects on their neighbors as well as more distant countries. spillovers from Nigerian growth to neighboring countries were found to be insignificant, suggesting that Nigeria still While intra-African trade has increased in recent years, it has weak links with the rest of the region. remains low. Formal barriers to trade, including tariff and quotas, inefficient customs procedures, and the inadequate The finding that developments in Nigeria and South state of transport infrastructure within the region are Africa have limited effects on growth in other countries in among the major reasons for low trade flows between SSA the region could be due to a number of factors. The first is countries (World Bank 2012b). These are several areas in the possibility that the economies of South Africa and which policy can make a difference. Reductions in tariff, those of the rest of SSA may have decoupled in the 1990s streamlining customs procedures, and investments in following the removal of international sanctions as infrastructure—especially for landlocked countries— apartheid ended and South Africa re-integrated into the would raise the prospects for mutually beneficial growth world economy (Basdevant et al. 2014). As SSA countries spillovers. integrated rapidly with the rest of the world during the 2000s, external shocks became the predominant cause of Policy actions are also needed to stem the rise of fluctuations in SSA activity (Kabundi and Loots 2007). informality in the region by facilitating the transition of Second, those countries that are most deeply integrated firms from the informal to the formal economy. This with Nigeria and South Africa—for example, Benin, would require intensifying ongoing efforts to improve the Ghana, Lesotho, Namibia, Swaziland—do not have business climate across the region, including simplified sufficiently long time series of data to estimate spillovers. procedures for obtaining permits for business registration, simplified tax systems, and reduced compliance costs for Conclusion and policy implications laws and regulations. A strengthened capacity of government agencies to administer laws and to improve While the region’s main economic partners are outside the the quality and efficiency of regulations would help in region, intraregional trade and financial links in Sub- making such reforms effective (World Bank 2015f). Saharan Africa have expanded in recent years. Trade, financial, and institutional linkages between Nigeria and G L O B A L E CO N O MI C P R OS P E C TS | J A N U A R Y 20 1 6 R E FE R E N CE S 169 References Arteta, C., M. A. Kose, F. 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Specifically, a 1 percentage point decline in BRICS growth is associated with lower growth in other emerging markets by 0.8 percentage point, in frontier markets by 1.5 percentage points, and in the global economy by 0.4 percentage point over the following two years. Spillovers could be considerably larger if the BRICS growth slowdown were combined with financial market stress. Adverse growth spillovers present challenges that need to be addressed with both fiscal and monetary policies as well as structural reforms. Introduction prices (which have dampened prospects in the half of emerging markets that are commodity exporters), and bouts of financial market Growth in emerging markets (EM) has been turbulence. Since 2014, however, a series of slowing, from 7.6 percent in 2010, to 3.7 percent country-specific, domestic shocks have in 2015 and is now below its long-run average become the main source of the slowdown (Figure 3.1). This slowdown has been highly (Didier et al. 2015). Such country-specific synchronized across emerging markets, with challenges have included a steady slowdown in significant declines in growth in most emerging productivity growth, bouts of policy market regions.1 In the largest emerging uncertainty, and shrinking fiscal and markets—the heterogeneous group of BRICS monetary policy buffers that have constrained (Brazil, Russia, India, China, and South Africa)— the use of policy stimulus (Box 3.1). Total growth has slowed from almost 9 percent in 2010 factor productivity growth, especially, has to about 4 percent in 2015, on average, with India almost halved in emerging markets to just being a notable exception. This slowdown reflects over 1 percent, on average, in 2010-14 from both easing growth in China, persistent weakness about 2 percent in 2000-07, on average. This in South Africa, and steep recessions in Russia has been only partially offset by higher capital since 2014 and in Brazil since 2015. accumulation, including as a result of crisis- related investment stimulus in several large Both external and domestic as well as cyclical and emerging markets. structural factors have contributed to the slowdown in emerging markets (Didier et al. 2015). • Structural versus cyclical factors. One-off, cyclical and structural factors have driven the slowdown to varying degrees across countries. • External versus domestic factors. On average, On average across emerging markets, longer- external factors have been the main cause of term structural factors may have accounted for the slowdown between 2010-13. Such factors about one-third of the growth slowdown have included weak global trade after the during 2010-14. In individual countries, global financial crisis, falling commodity however, the contribution of structural factors has ranged from one-tenth to virtually all of Note: This chapter was prepared by Raju Huidrom, Ayhan Kose the slowdown since 2010. and Franziska Ohnsorge with contributions from Jose Luis Diaz Sanchez, Lei Sandy Ye, Jaime de Jesus Filho, Xiaodan Ding, Sergio Kurlat, and Qian Li. The slowdown follows a decade during which 1Emerging markets (EM) generally include countries with a record of significant access to international financial markets. Frontier record-high emerging market growth transformed markets (FM) include countries that are usually smaller and less the global economic landscape. Emerging markets financially developed than emerging market economies. Therefore, accounted for 46 percent of global growth during the emerging and frontier market group excludes low-income countries with minimal or no access to international capital markets. 2000-08 and 60 percent during 2010-14. By The country sample is provided in Annex 3.1. 2014, emerging markets constituted 34 percent of 180 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 3.1 Emerging market growth slowdown larger size, the broader group of BRICS plays a special role. The BRICS are the largest and most Emerging market growth has slowed steadily since 2010, coinciding with a gradual recovery in advanced market economies. The slowdown is broad- regionally integrated emerging markets in their based, reaching across regions and affecting an unusually large number of respective regions and they have been the main emerging markets for several years, comparable only to previous crisis source of emerging market growth and integration periods. Unprecedented since the 1980s, the majority of BRICS (Brazil, Russia, India, China, and South Africa) economies are slowing into the global economy. During 2010-14, the simultaneously. BRICS contributed about 40 percent to global growth, up from about 10 percent during the A. Emerging market growth B. Synchronous growth slowdown 1990s. They now account for two-thirds of emerging market activity and more than one-fifth of global activity—as much as the United States and more than the Euro Area—compared with less than one-tenth in 2000.2 This chapter studies the following four questions: • What are the key channels of spillovers from the major emerging markets? C. Share of emerging markets with D. Emerging market growth across growth below long-term average regions • Do business cycles in BRICS move in tandem with those in other emerging markets and frontier markets? • How large are spillovers from the major emerging markets? • What are the policy implications? Source: World Bank Global Economic Prospects and IMF World Economic Outlook. Previous studies have typically focused on global Note: Due to data availability, FM long-run average for 1990-2008 starts in 1993. GDP data for Czech Rep. are only available from 1990. EM, FM, and AM are defined in Annex 3.1. growth spillovers from individual BRICS (Box A. Weighted average growth. B. Number of emerging market countries (EM) in which growth slowed for three consecutive years. 3.2). The chapter adds to the existing literature on C. Long-term averages are country-specific for 1990-2008. Long-term average for the Czech Rep. starts in 1991. spillovers in four dimensions. First, it extends the D. EAP = East Asia and Pacific; ECA = Europe and Central Asia; LAC = Latin America and Caribbean; MNA = Middle East and North Africa; SAR = South Asia; SSA = Sub-Saharan Africa. analysis to spillovers from a synchronous BRICS slowdown. Second, it includes an explicit comparison of global, regional, and local spillovers global GDP (in current market prices), more than from individual BRICS. Third, it systematically one-and-a-half as much as they did in 1980 differentiates the cross-border spillovers by (Figure 3.2). The rising share of the emerging country groups, including by region and by world in the global economy was also reflected in commodity exporter/importer status. Fourth, in a their increased integration into international trade transparent framework, it examines how and finance. Emerging markets have become turbulence in financial markets can interact with major export destinations for the rest of the world the slowdown in BRICS to generate cross-border and important sources of remittances, commodity growth spillovers.3 supply and demand, foreign direct investment, and official development assistance. 2The economic size of BRICS is much larger in terms of PPP adjusted GDP. BRICS constitute about 30 percent of global activity China is by far the largest emerging market, two- while the United States constitutes only about 16 percent. thirds the size of all the other emerging markets 3 e magnitude of spillovers may depend on the nature of the shock originating in BRICS. Given data limitations, a detailed combined and twice as large as the other BRICS examination of the sources of the growth shock and its implications economies combined. Notwithstanding China’s goes beyond the scope of this chapter. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 3 181 The findings are as follows: FIGURE 3.2 Rising economic significance of emerging markets • Channels. Cross-border economic linkages Emerging markets have increasingly contributed to global growth since the among emerging markets, and with BRICS 1980s. Their rising economic significance is also reflected in other specifically, have grown significantly since dimensions: trade, financial flows, and remittances. 2000. Reduced import demand from BRICS would weaken trading partner exports. A. Emerging market share of global B. Emerging market contribution to GDP global growth In particular, reduced commodity demand would dampen growth in commodity exporters. Lower remittances from Russia would reduce household incomes and consumption in neighboring countries. In addition, although not estimated econometrically here, confidence spillovers could be sizeable and affect a larger group of countries (Levchenko and Pandalai-Nayar 2015). C. Emerging market share of global D. BRICS’ share of global trade, trade, financial flows, and remittances financial flows, and remittances • Impact. A 1 percentage point decline in BRICS growth would reduce growth in other emerging markets by 0.8 percentage point and in FM by 1.5 percentage points at the end of two years. The estimated impacts on advanced markets are modest, on average. On balance, a 1 percentage point decline in BRICS growth is estimated to reduce global growth by 0.4 percentage point at the end of two years. Sources: World Development Indicators; UNCTAD; Bank for International Settlements; World Notwithstanding sizeable impacts of growth Economic Outlook. A. B. EM stands for emerging markets, FM for frontier markets. fluctuations in BRICS on other emerging C. D. Due to data constraints, global trade (exports plus imports) from 2000 and 2013; remittances markets and frontier markets, those from (inflows plus outflows) data from 2000 and 2013; foreign direct investment (FDI) flows (inflows plus outflows) from 2000 and 2014; and international investment position (IIP, including direct investment, major advanced economies remain larger still. portfolio investment, financial derivatives, and other investment assets and liabilities) from 2005 and 2013. • Global versus regional effects. A growth impulse in China would affect growth in other in other emerging markets could fall short of emerging markets in East Asia by about as expectations by about 1 percentage point and much as growth in other emerging markets global growth by 0.7 percentage point. If such around the world. In contrast, the a BRICS growth decline scenario were to be repercussions of a slowdown in Russia would combined with financial sector turbulence, be mostly confined to Europe and Central e.g. similar to the 2013 “Taper Tantrum,” Asia. Slowdowns in Brazil, India, and South emerging market growth could slow by an Africa would mainly affect smaller, additional 0.5 percentage point and global neighboring countries. growth by an additional 0.4 percentage point. • Interacting effects. Slower-than-expected • Policy responses. The growth slowdown in growth in BRICS could coincide with other BRICS has been part cyclical decline from the strains on the global economy such as bouts of immediate post-crisis rebound in 2010, part global financial market volatility. If, in 2016, structural slowdown. Hence, a mix of counter BRICS growth slows further, by as much as -cyclical fiscal or monetary policy stimulus the average growth disappointment over 2010 and structural reforms could be used to -14, instead of picking up as forecast, growth support activity. A renewed structural reform 182 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 BOX 3.1 Sources of the growth slowdown in BRICS BRICS growth has been slowing since 2010, increasingly because of moderating potential growth. Until 2013, the slowdown was predominantly driven by external factors, but the role of domestic factors has increased since 2014. Deceleration in productivity growth suggests that a return to pre-global crisis rates of BRICS growth is unlikely. e so-called BRICS (Brazil, Russia, India, China, and External factors South Africa) are the largest emerging markets, accounting for about two-thirds of emerging market GDP. BRICS Among the most important external factors are weak growth has slowed from almost 9 percent in 2010 to global trade, a steady decline in commodity prices since about 4 percent in 2015. By 2015, three of the BRICS 2011, and tightening global nancial conditions. e (China, Russia, South Africa) had been slowing for three model indicates that such factors were predominant or more consecutive years and Brazil was in a steep 2010Q1-2014Q1 (Figure 3.1.1). recession. Long-term growth expectations in these economies have been repeatedly downgraded since 2010.1 Weak trade. During 2000-07, global trade grew at an average annual rate of about 7 percent. Since 2010, A country-speci c Bayesian Vector Autoregression however, global trade growth has slowed. By 2014, global (BVAR) model helps quantify some of the sources of this trade had fallen 20 percent short of its pre-crisis trend slowdown (Didier et al. 2015).2 e model explains (World Bank 2015a). An outright contraction in the rst BRICS growth as a function of domestic factors (domestic half of 2015—the rst since 2009—re ected falling in ation, short-term interest rates, and the real exchange import demand from emerging markets, including from rate), and external factors (U.S. growth, 10-year bond Asia and Central and Eastern Europe. Five factors have yields, China’s growth, the EMBI spread, and terms of contributed to the weakness in global trade. trade).3 • Advanced markets, which constitute about 60 percent An unfavorable external environment—including a terms- of world import demand, have been growing at a rate of-trade deterioration and U.S. growth setbacks in 2013 of less than 2 percent. By 2014, real GDP in the and early 2014—appears to have been the main source of United States and the Euro Area was 8-13 percent the slowdown between 2010 and the rst quarter of 2014. below the pre-crisis trend level, and import demand However, since then, domestic factors—including rising was 22-23 percent below the pre-crisis trend. short-term interest rates and, in China, real appreciations—have been the predominant cause (Figure • Investment demand in advanced markets has been 3.1.1). Underlying these short-term movements has been a particularly weak. Since capital goods are typically the steady decline in productivity growth. Although di cult most import-intensive component of aggregate to measure on a high-frequency and comparable cross- demand, the switch in composition has reduced the country basis, bouts of political uncertainty have dented income elasticity of trade. investor sentiment in some BRICS. • e maturation of global value chains has further is box addresses the following questions: reduced the elasticity of trade ows to activity and exchange rates (Ahmed, Appendino, and Ruta 2015). • What have been the external factors driving the BRICS slowdown? • Higher capital requirements and tightened nancial regulations have reduced banks’ willingness to extend • What have been the domestic factors driving the trade nance (World Bank 2015a). BRICS slowdown? • e pace of trade liberalization has slowed since the crisis. Note: This Box was prepared by Lei Sandy Ye. The average five-year ahead consensus growth forecast of Brazil, 1 Easing commodity prices. A steady decline in commodity China, India, and Russia has decreased from 6.5 percent in 2010 to 4.7 prices has set back growth in commodity-exporting BRICS percent in 2015. (Russia, Brazil, and South Africa). Prices of oil and metals 2The Bayesian methodology follows Litterman (1986). The sample have declined by 50-60 percent from their 2011 peaks and includes quarterly data for 1998Q1 to 2015Q2 for all BRICS economies. 3Estimates for China do not separately include its growth as an are expected to remain low for the next decade (World external factor. Bank 2015b, Ba es et al. 2015). Agricultural prices are G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 3 183 BOX 3.1 Sources of the growth slowdown in BRICS (continued) FIGURE 3.1.1 Sources of the growth slowdown in BRICS Since 2010, the drivers of the BRICS growth slowdown have pivoted from external to domestic factors. External drivers included weak global trade and commodity prices and bouts of financial market turmoil. Domestic factors included slowing productivity growth, rising domestic policy uncertainty and eroding buffers that have constrained the use of accommodative policies. TFP growth and potential growth in BRICS have slipped to below pre-global crisis averages. A. Contribution to BRICS growth B. Contribution of domestic factors to C. Contribution to BRICS growth BRICS growth D. TFP growth in BRICS E. Potential growth in BRICS F. Contribution to potential growth in BRICS Source: Didier et al. (2015). A. B. Each bar shows the percentage point deviation of growth from the sample mean. External factors include U.S. growth and 10-year bond yields, Chinese growth, EMBI spreads, and terms of trade. Domestic factors include domestic inflation, the real exchange rate, and short-term interest rates. Unweighted average contribution to BRICS growth, including China. Based on Bayesian VAR (Didier et al. 2015). The last observation is 2015:2. C.D.E.F. Unweighted averages. about 30 percent below their 2011 peaks. is has sharply e volatility of capital ows to BRICS has weighed on worsened the terms of trade of Brazil, Russia, and South investment. Since 2010, investment growth in BRICS has Africa. Slowing growth in commodity-importing BRICS slowed from 16 percent in 2010 to 5 percent in 2014. A (China, India) itself contributes to softening commodity series of country-speci c factors have contributed to this, prices (World Bank 2015b). including political and geopolitical uncertainty, structural bottlenecks and uncertainty about major reform initiatives. Tighter financing conditions. Net capital flows to BRICS e slowdown in remittances may directly impact have undergone bouts of volatility, culminating in sharp consumption in these economies (World Bank 2015a). and sustained capital out ows in the rst half of 2015. e decline in net capital ows largely re ected Domestic factors developments in China: in the rst half of 2015, portfolio out ows from China rose ten-fold and net other Domestic factors include a sustained productivity investment in ows fell by four- fths from the second half slowdown and bouts of policy uncertainty. e BVAR of 2014. Remittance in ows to BRICS have also slowed results suggest that since 2014Q1 these have overtaken sharply, from a rate of increase of 15.4 percent in 2010 to external factors as the main contributors to decelerating under 3 percent in 2015. BRICS output (Figure 3.1.1). 184 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 BOX 3.1 Sources of the growth slowdown in BRICS (continued) Productivity growth slowdown. Domestic factors 2007, and Brazil and India’s debt levels are in excess of 60 accounted for a sizable share of the slowdown in BRICS, percent of GDP. Monetary policy space has diverged especially since early 2014. ese included a productivity between commodity exporters and importers. In Brazil slowdown. Using a production function approach, GDP and Russia, monetary policy is constrained by above-target growth may be decomposed into the contributions of total in ation, partly as a result of depreciation. In contrast, low factor productivity (TFP), and the individual factors of oil prices have reduced in ation and increased room for production (Didier et al. 2015). Based on this rate cuts in China and India. However, this room may decomposition, slowing BRICS growth has mostly diminish if in ation rebounds once oil prices stabilize. re ected slowing TFP growth (Figure 3.1.1). Since 2012, TFP growth in BRICS has been below its historical Conclusion average during 1990-2008. Slowing TFP growth has also been re ected in declining potential growth. e factors driving the growth slowdown in BRICS are likely to remain in place, although sharp recessions in Uncertainty. Bouts of uncertainty in BRICS have Brazil and Russia are expected to begin to ease in 2016. weighed on investment. is was associated with periods e external environment is likely to remain challenging of stock market and currency volatility. Looking ahead, if for emerging markets. As global supply chains mature, the heightened policy, and especially political, uncertainty advanced market recovery remains fragile, and emerging persists, it may constrain policymakers’ ability to support market growth remains reliant on government support, growth. Counter-cyclical scal and monetary policies may trade is likely to remain weak. Large investments world- be harder to implement when investors focus on rising wide in commodity production over the past decades are uncertainty or widening vulnerabilities or both. Capital likely to keep downward pressure on commodity prices. out ows and depreciations amidst weakening con dence may limit the e ectiveness of counter-cyclical policies in Domestic policy environments may become increasingly lifting activity. Structural reforms also often stall amidst constrained as weak growth erodes the resilience of private political uncertainty. and public balance sheets. Aging populations may dampen potential growth. Weak growth prospects are likely to Eroding policy buffers. Since the crisis, the scal positions continue to weigh on investment, which may, in turn, of BRICS have deteriorated considerably. On average, slow the technological progress required to sustain high their scal balance has weakened from near-balance in productivity growth. A combination of countercyclical 2007 to -4 percent of GDP in 2014. In South Africa, debt policies and structural reforms are needed to reinvigorate has increased by about 19 percentage points of GDP since growth. push could help lift growth prospects and, to of global output and growth. They have become the extent it encourages investment, support important export markets and significant sources domestic demand, as well as help improve of remittances. Some of them also supply foreign investor sentiment and capital flows. This direct investment (FDI) and official development would be especially useful for countries that assistance (ODA) to other emerging markets, have limited room for expansionary fiscal and frontier markets, and low-income countries (LIC) monetary policies. as well as advanced markets. What are the key channels Global output and growth. Since 2000, emerging markets have accounted for much of world of spillovers from the major growth. During the pre-crisis years of 2003-08, emerging markets? emerging market growth averaged 7.1 percent, well above its long-term average of about 5 A growth slowdown in emerging markets, in percent. During the crisis, global activity was particular in one or several of the BRICS, could shored up by emerging markets, despite a sharp have significant spillover effects given their share slowdown in 2008. Partly as a result of large-scale G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 3 185 stimulus in the largest emerging markets, they FIGURE 3.3 BRICS in EM and FM trade continued to grow in 2009, when the rest of the world contracted, and they expanded strongly in Among emerging markets, trade linkages with BRICS, especially China, have increased in the last two decades. Advanced markets continue to be 2010. Frontier markets have grown almost as important trading partners for emerging markets. rapidly as emerging markets since 2000, though from a smaller base, to 4.6 percent of global GDP A. Emerging market exports to other B. Emerging market exports emerging markets in 2014. Global trade. Emerging markets now account for 32 percent of global trade (compared with 16 percent in 1994). This has partly reflected their deepening integration into global supply chains. For example, the value added from emerging markets embedded in U.S. or Euro Area exports nearly doubled to about 7 percent in 2011 from 3 percent in 2000. Among emerging markets, the BRICS have accounted for most of the increase in C. Emerging market exports to other D. Emerging market exports emerging markets (value-added) (value-added) trade flows to emerging markets and frontier markets between 2000 and 2014 (Figure 3.3). Most of the emerging markets’ value-added trade with other emerging markets and frontier markets is with the BRICS. As the largest economies in their respective developing country regions, the BRICS also account for a sizeable share of regional exports. Global commodity markets. BRICS have played E. Frontier market exports to emerging F. Frontier market exports a significant role in global commodity markets markets (World Bank 2015c). Rapid growth in China’s industrial production through the 2000s was accompanied by a sharp increase in demand for metals and energy. Virtually all of the increase in global metals demand and more than half of the increase in global primary energy demand between 2000 and 2014 originated in China (Figure 3.4).4 India’s demand for primary energy and metals has also grown rapidly but less than China’s, partly as Sources: Direction of Trade Statistics (DOTS); OECD Trade in Value Added (TiVA) database; World a result of more services-based growth (World Bank. Note: EM stands for emerging markets, FM stands for frontier markets, AM stands for advanced Bank 2015b). Large emerging market and frontier markets. market commodity producers have benefited from C. D. Data only available for 1995, 2000, 2005, and 2008-11. this increased demand for their products. For several commodities, a few individual emerging for nickel, aluminum and coal; Chile for copper; markets and frontier markets accounted for 20 Russia for oil; and Brazil for iron ore and percent or more of global exports (e.g. Indonesia soybeans; World Bank 2015c). 4Chinese demand for agricultural commodities has grown in line During the 2000s, high prices and improved with global demand. In general, demand for metals and primary technology encouraged the development of new energy tends to be highly income elastic whereas demand for capacity, including U.S. shale oil production, new agricultural commodities tends to have low income elasticities but grows in line with population (World Bank 2015b). copper mines in Eritrea and new oil fields in 186 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 3.4 Commodity demand and supply those in many advanced markets, emerging markets have attracted a large amount of FDI China, and to a lesser extent, India, are major sources of demand for key (30 percent of global FDI inflows, on average commodities. In addition, China is a major source of global coal production, and Russia, of oil and gas. during 2000-14). Most of this amount, about two-thirds, has been received by the BRICS. A. BRICS demand for key commodities B. BRICS supply of key commodities Among BRICS, China is not only the single largest recipient country of FDI inflows, it has also become an important source country for FDI, especially in Sub-Saharan Africa and other natural resource-producing countries (World Bank 2015c). • Banking and portfolio investment. Although from a low starting point, bank claims and portfolio investment to emerging markets C. Global export share of key D. Global import share of key have doubled since the early 2000s to about 6 commodities commodities percent and 5 percent of global GDP, respectively. As with FDI, BRICS account for a sizeable portion of these flows. From a much smaller base, global banking flows to frontier markets have also risen, to 1 percent of global GDP in mid-2015. • Remittances. Emerging markets are now among the largest source and destination countries for remittances, accounting for 40 percent of Sources: BP Statistics Review; U.S. Department of Agriculture. C. D. Share of each emerging market in total global exports and imports of each commodity, average global remittance in- and outflows. Five 2008-13. Includes exports and imports of ores (e.g. bauxite) and oil products. emerging market and frontier market source countries (Kuwait, Qatar, Russia, Saudi Myanmar (Baffes et al. 2015, World Bank 2015c). Arabia, and United Arab Emirates) account The commodity super-cycle, however, began to for 20 percent of global remittance outflows. unwind in early 2011 when most commodity Emerging market and frontier market prices began to slide as new capacity came recipient countries such as Egypt, India, onstream at the same time as growth in major Nigeria, Philippines, Pakistan, and Vietnam emerging markets increasingly tilted away from account for 28 percent of global remittance commodity-intensive industrial production. Oil receipts. Remittances from the BRICS are prices were initially kept high by OPEC significant, particularly for the ECA and SAR production cuts but, in the second half of 2014, regions (Figure 3.5). halved with OPEC’s policy shift towards targeting market share. • Official development assistance (ODA). The GCC countries, especially Saudi Arabia, Global finance. Emerging markets have started Kuwait and the United Arab Emirates, playing a major role in a wide range of global provided significant ODA to Egypt in 2010- financial flows, including foreign direct 14 (on the order of 7 percent of GDP in investment, banking and portfolio investment, Fiscal Year 2013/14). China has become an remittances and official development assistance. important source for Sub-Saharan Africa while India is providing ODA to Bhutan amounting • Foreign direct investment (FDI). Since emerging to 37 percent of GDP in Fiscal Year 2015/16 market growth prospects remain better than (World Bank 2015c). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 3 187 FIGURE 3.5 BRICS in regional trade and remittances Do business cycles in BRICS move in tandem with those Exports to BRICS are particularly high in EAP, MNA, and SSA regions. BRICS constitute a major source of remittance flows to other emerging in other emerging markets markets, especially in ECA and SAR. and frontier markets? A. Destinations of exports by regions B. Remittance inflows from BRICS The rising role of BRICS in the world economy suggests that growth fluctuations in their economies could lead to sizeable spillovers to other emerging markets and frontier markets. As the group of emerging and frontier markets has established stronger intra-group trade and financial linkages, common movements in their business cycles have become more pronounced. Growth fluctuations in major emerging markets Sources: Direction of Trade Statistics (DOTS); World Bank. tend to lead growth in other emerging markets Notes: EAP = East Asia and Pacific, ECA = Europe and Central Asia, LAC = Latin America and Caribbean, MNA = Middle East and North Africa, SAR = South Asia, and SSA = Sub Saharan Africa. and frontier markets. In addition, growth Graphs use 2014 data for countries of all income categories. B. Blue bars “Region” show remittance inflows from BRICS into each region. Red bars “Countries slowdowns in major emerging markets have been (RHS)” show remittance inflow to the three countries with the largest remittance inflows from BRICS (in percent of GDP). The three countries are Kiribati, Mongolia, and Philippines in the EAP region; associated with lower growth in other emerging Armenia, Kyrgyz Republic, and Tajikistan in the ECA region; Bolivia, Guyana, and Paraguay in the LAC region; Egypt, Jordan, and Lebanon in the MNA region; Bangladesh, Nepal, and Pakistan in the markets and frontier markets and, to a much lesser SAR region; and Lesotho, Mozambique, and Swaziland in the SSA region. extent, in advanced markets. Emergence of an emerging-frontier market in growth in emerging and frontier markets— business cycle. The drivers of business cycles can almost as much as the global cycle (Figure 3.6).5 be decomposed into global, group, and country- These results suggest that a more pronounced EM specific factors. This decomposition exercise is -FM business cycle has emerged over time. Hence, conducted for a sample 106 countries (advanced the risk has increased that adverse developments in markets, emerging markets and frontier markets, BRICS could be a source of a broader and other developing countries, Annex 3.1). The synchronous downturn across the EM-FM group. global factor represents business cycle fluctuations that are common to all countries and to output, Higher synchronization of growth fluctuations. investment and consumption. The group-specific Since the global financial crisis, BRICS growth has factor captures fluctuations that are common to a become increasingly correlated with growth particular group of countries, in this case to the in other emerging markets and frontier markets, group of emerging and frontier markets, and the but also with growth in advanced markets. Lead group of advanced markets and the group of other correlations—correlations between BRICS growth developing countries. and other emerging market, frontier market, and advanced market growth in the subsequent The degree of business cycle synchronization quarter—are sizeable, suggesting the possibility among emerging and frontier markets is captured of spillovers from BRICS growth to these by the contribution of the factor specific to countries (Figure 3.7). In contrast, lag correlations emerging-frontier markets (EM-FM-specific with BRICS growth and other countries are factor) to variations in their growth. The EM-FM generally small. factor explained a small part of growth fluctuations before the 1980s, when emerging and 5Business cycle synchronization here is analyzed in terms of output frontier markets were little integrated with each comovement. The results generally extend to consumption and other (and with the global economy). Since then, a investment as well. Business cycle co-movement could reflect both common EM-FM-specific factor has emerged that the greater trade and financial linkages between emerging and frontier markets that are discussed in the previous section and greater co- now accounts for about a quarter of the variation movement with common external factors. 188 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 BOX 3.2 Understanding cross-border growth spillovers Growth spillovers can operate via trade and nancial linkages. e con dence channel—consumer and business sentiment—can also be an important mechanism for cross-border spillovers of growth. e empirical literature nds sizeable spillovers from China for countries with close trade ties, e.g. countries in the EAP region, Japan and Germany among the advanced markets, and commodity exporters. Growth in Russia and Brazil tends to a ect growth of their neighbors and those with whom they have strong trade and remittance linkages. This box discusses cross-border transmission of shocks to principle, also possible if incentives to diversify risk growth and examines empirical estimates of the size of internationally are sufficiently strong. For example, if these spillovers. investors are concerned about growth setbacks in one country, they may choose to increase their investments in Transmission channels others with better growth prospects. As a result, capital could flow out of countries with negative growth shocks Trade channel. A growth slowdown can reduce growth in and into less-affected countries where it would lift activity trading partner countries directly by lowering import (Canova and Marrinan 1998; Kalemli-Ozcan, Sørensen, demand and, indirectly, by lowering growth in third and Yosha 2003; Imbs 2004; Heathcote and Perri 2004). countries or by slowing technological advances and productivity growth intrinsic to imports (Kose, Prasad, Commodity channel. A growth slowdown in a major and Terrones 2009; Jansen and Stockman 2004). commodity-importing country could reduce global commodity demand and reduce global commodity prices. While this suggests greater spillovers between countries This would set back investment and growth in commodity with closer trade ties, in principle, the opposite can arise exporting countries around the world, even those without when mutual trade generates particularly strong direct trade relations with the source country of the shock specialization. For example, close trade ties can result in (Kose and Riezman 2001; Eicher, Schubert, and heavy specialization in goods in which countries have a Turnovsky 2008; Broda and Tille 2002; World Bank comparative advantage. As countries become heavily 2015a). reliant on individual industries, they may become more sensitive to industry-specific shocks, with less correlation Confidence channel. Trade, financial, and commodity in broader growth between trading partners (Frankel and channels do not appear to explain the unprecedented Rose 1998).1 severity and cross-country synchronization of contractions and slowdowns in the global financial crisis of 2007-09 Financial channel. A growth slowdown can reduce portfolio (Kalemli-Ozcan, Papaioannou, and Perri 2013; Bacchetta investment and foreign direct investment outflows to other and van Wincoop 2014). In addition to direct economic countries. Arbitrage between different global financial ties, consumer and business sentiment (over and above systems could quickly propagate shocks from one country developments in underlying fundamentals)—i.e., the to another (Kose, Otrok, and Whiteman 2003; Doyle and confidence channel—can be an important transmission Faust 2002). Rising banking sector cross-border exposures mechanism for cross-border spillovers (Levchenko and also raise the potential for growth spillovers (IMF 2014). Pandalai-Nayar 2015). Reduced financial flows could set back investment growth and longer-term growth potential in destination countries. Identifying the individual effects of each of these International remittances may also transmit spillovers, as transmission channels is empirically challenging, and the they tend to vary with incomes in sending countries. Some literature has mostly focused on aggregate effects. The low- and lower-middle-income countries that rely heavily importance of each transmission channel likely depends on on remittance inflows are particularly vulnerable to the nature of the underlying shock although the debate on disruptions in foreign labor markets that reduce the relative importance of different shocks is not yet remittances (Dabla-Norris, Espinoza, and Jahan 2015). settled.2 This box focuses on the aggregate effects of growth spillovers without dwelling on their fundamental While this suggests greater spillovers between countries drivers. with larger mutual financial flows, the opposite is, in 2For instance, Mendoza (1995) and Kose (2002) attribute a sizable portion of output fluctuations to international shocks through the terms Note: This Box was prepared by Raju Huidrom. of trade, while a part of the real-business-cycle literature focuses on the 1For a detailed discussion, see Kose and Terrones (2015). effects of technology shocks. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 3 189 BOX 3.2 Understanding cross-border growth spillovers (continued) Empirical estimates of spillovers countries tend to be larger than those from Russia, reflecting declining trade and financial integration with Advanced economies. Monfort et al. (2003) find sizeable co- Russia and increased ties to the European Union (Andrle, movement in output among the G-7 economies during Garcia-Saltos, and G. Ho 2013; Ayvazyan and Dabán 1972-2002. Before 1985, a large part of this co-movement 2015; Obiora 2009). can be explained by common shocks (e.g., oil price swings), while in the period after 1985 spillovers, South African growth has a substantial positive impact on especially from North America to Europe, have become long-run growth in the rest of Africa (Arora and Vamvakidis more dominant. Stock and Watson (2005) find sizeable 2005). Short-run spillovers from South Africa, however, are spillovers among G7, accounting for 5-15 percent of the not significant, even to neighboring countries (IMF variance of growth depending on the country and the 2012a). South Africa’s trade with the rest of the continent period examined. They, however, find that both overall co has been limited despite some increase since 1994, in part -movement and spillovers have declined since 1985, reflecting trade patterns that prevailed under the apartheid possibly reflecting lower volatility of shocks in the later regime that ruled South Africa until 1994. There are period (the pre-global crisis “great moderation”). Yilmaz significant growth spillovers effect to African economies (2009) finds sizeable spillovers from the United States to from both the Euro Area and the BRICS (Gurara and other advanced economies, especially during the global Ncube 2013), with spillovers from the Euro Area financial crisis. Financial shocks from the United States exceeding those from the BRICS. appear to be transmitted particularly rapidly to the Euro Area (Dees et al. 2007). Latin America is characterized by the presence of two large countries (Brazil and Mexico) that may affect smaller Emerging markets. The literature has focused on spillovers neighboring economies significantly (IMF 2012b). from large EM, often with a regional perspective (Annex Spillovers from Brazil to some of its neighbors can be 3.3). For the EAP region, spillovers from China are considerable, both by transmitting Brazil-specific shocks significant, especially for EAP countries integrated into and by amplifying global shocks. Southern Cone countries Chinese supply chains (Japan, Singapore, Malaysia and (Argentina, Bolivia, Chile, Paraguay, and Uruguay), given Thailand), and for commodity exporters that are less their sizeable export linkages, are particularly vulnerable to diversified, e.g. Indonesia (Duval et al. 2014; Inoue, Kaya, spillovers from Brazil. In the Andean region, however, and Ohshige 2015; Ahuja and Nabar 2012). Beyond EAP, trade linkages with Brazil are generally weak. Likewise, growth spillovers from China are also significant for Latin reflecting Central America’s modest trade linkages with American countries, especially for commodity exporters Mexico, growth spillovers from Mexico are modest (Adler (World Bank 2015a). The spillover implications of China and Sosa 2014). for advanced markets and global growth are generally found to be modest (Ahuja and Nabar 2012; IMF 2014b). Low income countries (LIC) have become increasingly Among the advanced economies, Germany and Japan are integrated with emerging markets, through stronger trade most affected (Ahuja and Nabar 2012). links, rising cross-border financial asset holdings and capital flows, and higher remittance flows (Dabla-Norris, In the ECA region, Russia seems to influence regional Espinoza, and Jahan 2015).3 In particular, emerging growth mainly through the remittance and—albeit markets are an important source of remittances for LIC, decreasingly—through the trade channel and somewhat especially within their own region – e.g. India for LIC in less through the financial channel. Russian growth shocks Asia, Russia for LIC in ECA, and Saudi Arabia for LIC in are associated with sizable effects on Belarus, Kazakhstan, MNA. This was most evident in the aftermath of the Kyrgyz Republic, Tajikistan, and, to some extent, Georgia global financial crisis, when recovery in many LIC (Alturki, Espinosa-Bowen, and Ilahi 2009). That said, mirrored the economic rebound in emerging market growth spillovers from the rest of the world to ECA trading partners (IMF 2010). 3Informal sector trading links are also important for LIC as a channel of transmission (IMF 2012a). 190 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 Lower growth during slowdowns in BRICS. An advanced markets; proxies for global financial event study suggests that slowdowns in BRICS conditions (U.S. 10-year sovereign bond yield and have been accompanied by lower growth in other EM Bond Index EMBI); growth in BRICS; oil emerging markets and frontier markets and, to a prices; growth in emerging markets excluding much lesser extent, in advanced markets. There BRICS; and growth in frontier markets.7 were seven slowdown episodes which are defined Spillovers are inferred by tracing out the responses as troughs in BRICS growth over five-quarter to a one-off exogenous shock to BRICS growth rolling windows from 1997Q2-2015Q1.6 During that reduces it by 1 percentage point on impact.8 these episodes, BRICS growth was, on average, about 2 percent, compared with the long-run Spillovers from BRICS. A growth slowdown in average of 5 percent. Although there is wide BRICS could reduce global growth and, especially, variation, median emerging-frontier market growth in other emerging markets and in frontier growth fell by almost a percentage point during markets. On average, a 1 percentage point decline these BRICS slowdowns, and median advanced in BRICS growth could, over the following two market growth eased by about one-quarter years, reduce global growth by 0.4 percentage percentage point (Figure 3.8). BRICS growth point, growth in other emerging markets by 0.8 shocks appear to have been at least partly percentage point and growth in frontier markets transmitted through declining imports. by 1.5 percentage points (Figure 3.9).9 The Commodity prices—especially energy prices— stronger response of frontier markets to BRICS decelerated sharply, and emerging-frontier market growth fluctuations may reflect the smaller size export growth slowed during these episodes. and greater openness of most frontier markets than emerging markets.10 These findings together point to the possibility of significant growth spillovers from the BRICS to In contrast, the estimated impact on G7 growth is, other emerging and frontier markets. However, on average, modest and statistically insignificant in the growth slowdowns in other emerging markets the structural VAR model. This may reflect both and frontier markets during episodes of lower pro-active countercyclical policy in G7 countries growth in BRICS may have been pure and their net oil-importing status. G7 central coincidence, or the result of a common external banks tend to respond to external shocks, adverse shock. The next section presents a formal including those from BRICS, with econometric analysis of growth spillovers from accommodative monetary policy. To the extent BRICS that addresses these concerns. that this is not fully controlled for, measured spillovers are small (Bodenstein, Erceg, and How large are the spillovers Guerrieiri 2009). Furthermore, as net oil importers, G7 economies tend to benefit from the from the major emerging markets? 7 e VAR methodology follows World Bank (2015a, 2015b). Technical details of the VAR model are provided in Annex 3.2. e recursive identi cation scheme requires quarterly data and hence In order to quantify growth spillovers from spillover analysis in this chapter is limited to those countries for BRICS to the global economy and to other which quarterly data is available. e list of countries and their emerging markets and frontier markets, a categorization is provided in Annex 3.1. As is usual in standard (linear) VARs, these estimates do not capture highly disruptive structural vector autoregression (VAR) model, shocks that trigger con dence e ects, nancial market swings, or with a recursive identification scheme, is estimated policy responses to amplify growth impacts. for 1998Q1–2015Q2. The model includes growth 8 e shock is quite persistent. BRICS growth declines by about 2.5 percentage points in cumulative terms at the end of two years due to in G7 countries as a measure of activity in the impact of the shock. 9Using a panel regression framework, Akin and Kose (2008) also nd intensive intra-group growth spillovers among emerging 6 e seven episodes identi ed are 1998Q1, 2000Q4, 2003Q1, markets. 2004Q4, 2006Q2, 2008Q4, and 2011Q3. For instance, the 1998 10 e group of frontier markets in this sample is dominated by one episode corresponds to the Russian crisis; 2008 to the global nancial commodity importer (Romania) which accounts for about 45 crisis; and 2011 to the recent growth slowdown episode. percent of frontier market GDP. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 3 191 lower oil prices induced by a BRICS slowdown. FIGURE 3.6 Emergence of emerging and frontier market That said, slowdowns in BRICS can weigh on business cycle growth in individual advanced markets that have Business cycles among emerging and frontier markets have become strong trade links with the BRICS, notably increasingly synchronous, reflecting the increased integration of these Germany and Japan. Confidence effects— economies into global and regional trade and financial flows. A significant although not explicitly captured econometrically portion of this synchronicity is explained by an emerging and frontier market (EM-FM) specific factor. here—could also amplify spillovers as discussed in detail later. A. Variance share of growth: Emerging B. Variance share of growth: Frontier markets markets While rapid growth in BRICS has buttressed global growth, its synchronous deceleration since 2010 (India recently being the exception) has contributed to the slowdown in other emerging markets and frontier markets. In China, policies have helped rein in growth in excess capacity sectors. Geopolitical tensions, sanctions, and falling oil prices in Russia and falling commodity prices and political tensions in Brazil have C. Variance share of growth: BRICS D. Variance share of growth: Non-BRICS emerging markets weakened investor sentiment. In South Africa, energy bottlenecks and labor unrest have weighed on growth. The associated slowdowns (China, South Africa) and recessions (Brazil, Russia) have dampened imports (including commodity imports) from trading partners, remittances to Central Asia, and FDI flows from major emerging markets. In a decomposition of historical contributions to growth, the BRICS slowdown Source: World Bank staff estimates. Note: A dynamic factor model is separately estimated over the two periods, 1960-1984 and 1985- since 2010 appear to have accounted for the bulk 2015, using a sample of 106 countries grouped into three regions: advanced markets (AM), emerging of the growth slowdown in other emerging and frontier markets (EM-FM), and other developing countries. Variance decompositions are computed for each country and, within each country, for output in each of these two periods. Each bar markets and frontier markets between 2010 and then represents the cross-sectional mean of the variance share attributable to the global factor and the EM-FM-specific factor among the emerging markets (EM) and frontier markets (FM). 2015.11 FIGURE 3.7 Role of BRICS in business cycle Spillovers from G7. Spillovers from BRICS synchronization remain smaller than those from advanced markets (Figure 3.10). After two years, a decline in G7 BRICS growth tends to lead growth in other emerging and frontier markets, suggesting the possibility of spillovers from BRICS to these countries. growth reduces emerging market growth by one- A. Contemporaneous correlations B. Lead correlations with BRICS with BRICS growth growth 11 Because of lack of sufficiently long time series of quarterly data for low-income countries, the estimations here are restricted to emerging and frontier markets. Other studies have estimated spillovers based on annual data—in which shocks are less clearly defined—and found that growth shocks in major emerging markets can have a similarly large impact on low- and lower-middle-income country growth. During 1980-2010, a 1 percentage point decline in growth in BRICS, Mexico, Saudi Arabia and Turkey may have reduced growth in low- and lower-middle-income countries in Sub-Saharan Africa, the Middle East and North Africa, and in Europe and Central Asia by 0.5-1 percentage point in the same year (Dabla-Norris, Espinoza and Jahan 2015). During 1970-2008, a 1 percentage point decline in BRIC growth may have reduced growth Sources: Haver Analytics; World Bank staff estimates. in oil-exporting low- and lower-middle-income countries by about Note: EM stands for emerging markets, FM stands for frontier markets, AM stands for advanced markets. For each group, the figures refer to the cross-sectional average correlation coefficient 0.7-1.4 percentage points over the following two years and in between BRICS growth and individual countries in that group. Lead correlations refer to correlations oil-importing ones by about 0.2-0.6 percentage point (Samake and with BRICS growth and growth in the rest of the countries in the subsequent quarter. Estimates are Yang 2014). based on quarterly data for 1997Q2-2015Q1 for 56 countries. 192 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 3.8 Growth slowdown in BRICS market growth (excluding BRICS) and frontier market growth as well as for growth in most Growth slowdowns in BRICS are associated with slowdowns in the other EM, FM, and to a lesser extent, AM. Such slowdowns are also associated individual emerging and frontier markets in the with falling exports and commodity prices. sample used here. A. GDP growth: Emerging markets B. GDP growth: Frontier markets Stronger spillovers from G7 countries reflect their excl. BRICS larger economic size. While the BRICS account for one-fifth of global GDP, G7 countries account for almost half of global GDP. In addition, G7 countries account for a larger share of global trade and play a central role in global finance.12 Financial flows can quickly transmit shocks originating in G7 economies around the world. Spillovers from individual BRICS. In order to analyze spillovers from individual BRICS, the C. GDP growth: Advanced markets D. Export growth: Emerging markets VAR model is re-estimated by replacing aggregate BRICS growth with growth in each BRICS economy, one at a time. The magnitude of spillovers varies across the BRICS (Figure 3.11).13 A 1 percentage point decline in China’s growth could reduce growth in non-BRICS emerging markets by 0.5 percentage point and in frontier markets by 1 percentage point over two years whereas a similar shock in Russia would reduce growth in other emerging markets by 0.3 E. Export growth: Frontier markets F. Energy and metals price growth percentage point. Spillovers from a growth shock in Brazil to other emerging markets would be much smaller and to frontier markets, statistically insignificant. In general, spillovers from India and South Africa to other emerging markets and frontier markets would be much smaller and/or statistically insignificant.14 The magnitude and reach of spillovers from major emerging markets reflect their size and integration. Sources: Haver Analytics; World Bank staff estimates. In current dollar terms, China’s economy is more Note: The graphs show GDP, export, and commodity prices growth in the quarters around a growth slowdown event in BRICS (t=0) indicated by the solid bar. Slowdown events are defined as troughs in than four times the size of the next-largest BRICS BRICS growth over a 5-quarter rolling window. There are seven GDP slowdown events during 1997Q2-2015Q1. They are 1998Q1, 2000Q4, 2003Q1, 2004Q4, 2006Q2, 2008Q4, 2011Q3. The economy (Brazil); its imports are six times the size solid line refers to cross-sectional mean growth and the dotted lines refer to the 25th and 75th of those of Russia; and its demand for primary percentiles. There is one slowdown event during the global financial crisis of 2008-09; results are generally robust when that event is excluded. energy and metals is four to ten times the size of that of India. third more and frontier market growth by one-half more than a similarly sized growth slowdown in 12At end-2014, more than half of global banking assets and BRICS. Over the sample period, G7 growth liabilities were on G7 country banks’ balance sheets. The G7 shocks explain about 30 percent of the variation in accounted for one-third of global foreign direct investment flows and emerging and frontier market growth at the two- almost half of global portfolio investment. The IMF (2011) argues that the largest spillovers arise from U.S. growth shocks although the year horizon, compared with 10 percent and 7 U.S. economy is similarly sized to the Euro Area’s which has been percent, respectively, explained by BRICS growth attributed to the predominance of the United States in global finance. 13Details of this version of the model are presented in Annex 3.2. shocks. This is true for both aggregate emerging 14These estimates are generally in line with the literature (Box 3.2). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 3 193 In order to analyze the regional implications FIGURE 3.9 Spillovers from BRICS of spillovers from individual BRICS, country- A growth slowdown in BRICS can have a significant adverse effect on specific VAR models are estimated for each global growth, especially in other emerging and frontier markets. The effect spillover destination country (Annex 3.2). on advanced markets is estimated to be modest. The slowdowns in BRICS Whereas growth fluctuations in China would have since 2010 has weighed on growth in other emerging and frontier market. global repercussions, those in other BRICS tend to radiate more narrowly. A growth impulse in A. Impact of 1 percentage point B. Impact of 1 percentage point decline in BRICS growth on growth decline in BRICS growth on G7 China changes growth in other emerging markets in emerging markets excluding and global growth in East Asia by about as much as growth in other BRICS and frontier markets emerging markets around the world. On the other hand, a 1 percentage point growth slowdown in Russia reduces growth in other emerging markets in Europe by 0.4 percentage point over two years but its impact on growth outside the region is negligible. Brazil has a small impact even on its own region.15 A sufficiently long time series of quarterly GDP data for a strict comparison is unavailable for other emerging markets in South Asia and Sub-Saharan Africa, C. Contributions of BRICS shocks to D. Contributions of BRICS shocks to growth: Emerging markets excluding growth: Frontier markets but there are indications that spillovers from BRICS South Africa and India to their respective regions are modest (Box 3.3). Transmission channels of spillovers. Commodity markets are a key transmission channel of spillovers (Box 3.2). China accounts for 30 percent or more of global demand for copper, iron ore, nickel, aluminum and soybeans and 10 percent of global demand for coal. Among the largest producers of these commodities are Brazil, Source: World Bank staff estimates. A. B. Cumulated impulse responses for different horizons due to a 1 percentage point decline in Chile, Colombia, Indonesia, Peru, Philippines, BRICS growth on impact. Global is GDP-weighted average of BRICS, emerging and frontier markets, and G7 responses. Bars represent medians, and error bars 16-84 percent confidence bands. and Poland (World Bank 2015d). This is reflected C. D. Historical decomposition of demeaned emerging market (C) and frontier market (D) growth. Domestic shock in Figure C (D) refers to the shock to emerging market (frontier market) growth. in country-specific VAR model estimates (Figure External shock refers to the combined contributions from shocks to G7 growth, U.S. interest rates, EMBI, frontier market (emerging market) growth, and the oil price. Annual figures are obtained by 3.12).16 As a result of these commodity price summing across quarters in a given year. declines, growth in commodity exporters could slow by somewhat more than growth in commodity importers.17 integration since its WTO accession in 2001 has increased the potential for global spillovers from Another important channel of spillover growth shocks. In addition to emerging and transmission is trade. China’s rapid trade frontier markets, several advanced markets are also 15This weaker result than found by other authors (e.g. IMF 2014b) among China’s closest trading partners, including partly reflects that the sample here excludes the Tequila crisis. Germany and Japan. A Global Vector 16These are based on country-specific VAR models. Commodity Autoregressive (GVAR) model is employed to prices here refer to trade-weighted commodity prices. To provide some perspective on the size of the response of commodity prices due estimate spillovers to a large number of advanced, to a growth shock, the standard deviation of commodity prices in the emerging, and frontier markets from a growth sample is about 9 percent. The magnitude of the response of com- slowdown in China, specifically through the trade modity prices is generally in line with the literature (e.g. IMF 2014b). 17These findings are broadly in line with the literature (World Bank channel. 2015c; Inoue, Kaya, and Ohshige, 2015; Ludovic and Cyril 2013). For commodity importers, the commodity channel would mitigate To examine the implications of the growing trade the adverse spillover effects from a slowdown in major emerging markets. presence of China, two sets of estimates are 194 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 3.10 Spillovers from BRICS and advanced The magnitude of spillovers from BRICS could be markets more pronounced if shocks are amplified via the confidence channel (Box 3.2). A sharp slowdown Spillovers from advanced market growth slowdown to emerging and frontier market growth are typically larger than those originating from in a large BRICS economy could lead to general BRICS. reassessment of investor risk sentiment. This could trigger a plunge in prices of emerging market A. Impact of 1 percentage point B. Variance share of growth explained assets, currency depreciations, equity market decline in G7 and BRICS growth on by G7 and BRICS growth shocks: growth in emerging markets Emerging markets excluding BRICS drops, and bond yield spikes across emerging excluding BRICS markets. In the analysis here, such spillovers are only partially captured through the impact of a BRICS shock on the EMBI which then feeds into growth elsewhere. In the event of a severe adverse shock to BRICS, however, the EMBI could spike more sharply and the distress spread through a greater range of financial markets than suggested by these, essentially linear, response estimates. Synchronous slowdown in BRICS. A C. Impact of 1 percentage point D. Variance share of growth explained decline in G7 and BRICS growth on by G7 and BRICS growth shocks: synchronous slowdown in BRICS would have growth in frontier markets Frontier markets considerable global growth effects (Figure 3.13).20 A synchronous BRICS slowdown is defined as one in which BRICS growth declines by the same amount as an isolated decline in growth in China. Activity in China’s trading partners that are also closely linked to their regional BRICS would be doubly hit. As a result, emerging market, frontier market, and global growth could decline by around 0.1-0.2 of a percentage point more, over two years, in a synchronous BRICS slowdown Source: World Bank staff estimates. than in an isolated slowdown in China. A. C. Cumulated impulse responses of emerging (A) and frontier market (C) growth, at different horizons, due to a 1 percentage point decline in G7 and BRICS growth. B. D. Variance share of emerging (B) and frontier market (D) growth explained by G7 and BRICS growth shocks. With every year of slowing BRICS growth, the probability increases that the slowdown turns into an outright recession, as household, corporate, and government buffers erode and expectations of derived. The first assumes bilateral trade links as in future growth prospects shift downwards (Didier 1998-2000 (when China accounted for 3 percent et al. 2015). A synchronous, steepening BRICS of global trade). The second assumes trade links as growth slowdown could considerably depress in 2010-12 (when China accounted for over 8 emerging and frontier market growth and weigh percent of global trade).18 For the majority of on advanced market and global growth as well countries, and especially Brazil among emerging (Figure 3.14). If, for example, BRICS growth markets and the United States, Japan, and Canada persisted at its current weak levels (3.2 percent among advanced markets, stronger trade linkages annualized) through 2017 instead of the currently have raised the estimated spillovers.19 projected pickup, the rest of emerging market growth could slow by about 0.4 percentage point 18In addition to these direct trade links, commodity exporters are from the baseline forecast in 2016 and about 1 also affected by the impact of growth fluctuations in China on global commodity markets. 19Among the advanced economies, other studies have also found 20This compares the results of two different regressions: one in that spillovers from China to Japan can be quite significant (IMF which BRICS as a whole are included; and another in which China is 2014b; Inoue, Kaya, and Ohshige 2015). included. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 3 195 percentage point in 2017.21 The impact would be FIGURE 3.11 Spillovers from individual BRICS considerably larger if BRICS growth were to slide The magnitude and reach of spillovers from individual BRICS differ. below current levels. For instance, if BRICS Spillovers from China are significant for countries in the EAP and ECA growth slowed by as much as the average forecast regions as well as some commodity exporters in Latin America. While downgrade during 2010-14 (0.2 percent), growth spillovers from the rest of BRICS countries generally tend to be small, spillovers from Russia within the ECA region can be sizeable. in the rest of emerging markets and in frontier markets could fall 1-1.3 and 0.5-1.5 percentage A. Impact of 1 percentage point B. Impact of 1 percentage point decline in individual BRICS growth on decline in China, Russia, and Brazil points below the baseline forecasts in 2016-17, growth in emerging markets excluding growth on emerging and frontier respectively. Growth in G7 countries would fall BRICS and frontier markets market growth considerably less, by about 0.3-0.6 percentage point during 2016-17. Overall, global growth would decline by about 0.7-1.1 percentage points below the baseline forecasts in 2016-17. A perfect storm: BRICS weakness combined with financial turmoil. The current BRICS growth slowdown coincides with tightening global financial conditions. In December 2015, the U.S. Source: World Bank staff estimates. A. Cumulated impulse responses at the end of two years. Shocks are scaled such that China’s Federal Reserve increased monetary policy rates growth declines by 1 percentage point on impact. Shock sizes for the rest of BRICS countries are for the first time since the global financial crisis calibrated such that their growth declines by exactly the same amount as China at the end of two years. These results are from the aggregate VAR model. Bars represent the median and the error and is expected to continue to gradually raise bands denote the 16-84 percent confidence bands. B. Cumulated impulse responses at the end of two years due to a 1 percentage point decline on policy rates. In all likelihood, this tightening cycle impact in China, Russia, and Brazil growth. For each spillover source country, the bar denotes the 20 -80 percentile range of the responses of all countries in all regions (excluding the spillover source will proceed smoothly as it has long been country) and the orange dash denotes the respective cross-sectional median response. The red diamond denotes the cross-sectional average response across countries in the specific region as the anticipated, and would have only a modest impact spillover source country (excluding itself). These results are from country-specific VAR models. ECA results exclude Turkey, for which estimated spillovers are negligible. Positive estimates for shocks on emerging and frontier markets. from Brazil are statistically insignificant. However, the tightening cycle carries significant combined with a tightening of risk spreads. When risks of financial market turmoil. This could be combined with tightening financial conditions, accompanied by a broad-based repricing of e.g. EMBI increasing by 100 basis points from the emerging and frontier market assets and sizeable current level in 2015 (an increase comparable to declines in capital inflows to emerging and frontier the taper tantrum), the BRICS slowdown could markets (Arteta et al. 2015). Investor sentiment cut growth in other emerging markets by about could deteriorate sharply on weakening emerging 1.3-1.5 percentage points and in frontier markets and frontier market growth prospects. As a result, by 1-1.8 from the baseline forecasts in 2016-17 risk spreads for emerging and frontier market (Figure 3.14). Global growth would decline about assets could widen steeply and raise overall 0.9-1.2 percentage points in 2016-17 below the financing costs for emerging and frontier markets, baseline forecast. Financial tightening could further dampening growth. An increase in reduce growth particularly sharply in frontier financing costs can also reduce policy space, in markets, with their less liquid, more volatile and particular fiscal space, limiting the firepower that fragile financial markets. countries need to respond to slowing growth (World Bank 2015c). What are the policy A synchronous BRICS slowdown could have implications? much more pronounced spillover effects if it is Emerging and frontier market policies can play an 21 The baseline forecasts for emerging markets, frontier markets, and the G7 are constructed by aggregating the country level forecasts important role in mitigating the persistence and presented in Chapter 1 across countries in each group. Global in this depth of spillovers from slowing BRICS growth. exercise refers to the combined set of BRICS, emerging markets excluding BRICS, frontier markets, and the G7 used in the VAR The appropriate policy response depends on the estimation. nature of the shock and the spillovers: 196 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 3.12 Channels of spillovers Among emerging markets, spillovers from China to commodity exporters are larger than to commodity importers, suggesting a role of the commodity channel in the transmission of shocks from BRICS. A. Impact of 1 percentage point decline in B. Impact of 1 percentage point decline in C. Impact of 1 percentage point decline in China’s growth on commodity price growth China’s growth on growth in emerging and China’s growth on growth in other countries frontier market commodity exporters and importers Source: World Bank staff estimates. A. Cumulated impulse responses of trade-weighted commodity prices of commodity exporters, for different horizons, due to a 1 percentage point decline in China growth. Solid bars denote the median and the error bars denote the 16-84 percent confidence bands. The average quarterly growth rate of commodity prices is about 0.9 percent in the sample. Commodity exporters include Chile, Malaysia, Paraguay, and Peru. B. Cumulated impulse responses of GDP growth, at the two year horizon, due to a 1 percentage point decline in China’s growth. For each group, the figures refer to the cross-sectional average response across all the countries in that group. Commodity exporters include Chile, Malaysia, Paraguay, and Peru. Commodity importers include Bulgaria, Croatia, Hong Kong SAR, China, Hungary, Jordan, Mexico, Poland, Republic of Korea, Romania, Singapore, Thailand, and Turkey. C. Based on the GVAR model described in Annex 3.2. This excludes Chile, India, Republic of Korea, Malaysia, and Turkey. Model is estimated twice, using average trade weights for 2010- 12 and average trade weights for 1998-2000. FIGURE 3.13 Spillovers from a synchronous slowdown • A cyclical downturn in BRICS would generate in BRICS temporary adverse spillovers that could be A synchronous slowdown in BRICS would have larger adverse spillover mitigated by counter-cyclical fiscal and effects on other emerging and frontier markets than just a slowdown monetary policies; in China. • A structural downturn in potential growth in Impact of a decline in China’s and BRICS growth on global growth, growth in emerging markets excluding BRICS and in frontier markets BRICS would require structural reforms in other emerging markets to adjust to a “new normal” of lower growth in core trading partners and sources of remittances. About one-third of the growth slowdown in emerging markets, including BRICS, is structural and the remainder is a cyclical downturn from the immediate post-crisis rebound of 2010 (Didier et al. 2015). However, this assessment of the relative strength of cyclical and structural factors is subject to considerable uncertainty. Hence, the optimal policy mix, even in countries where spillovers from external shocks are considered temporary, includes structural policies to improve medium- and long- term growth prospects. Source: World Bank staff estimates. In addition, counter-cyclical fiscal and monetary Note: Cumulated impulse responses of EM and global growth at the two-year horizon. The shock size policies can be used effectively when there is is such that China’s growth declines by 1 percentage point on impact. The shock size for BRICS is calibrated such that its growth declines by exactly the same amount as that of China at the end of two sufficient policy space (see discussion below). years. Solid bars denote the median and the error bars denote the 16-84 percent confidence bands. Many emerging and frontier markets used up G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 3 197 much of their policy space during the global FIGURE 3.14 Growth slowdown in BRICS combined with stimulus of 2009 and have yet to rebuild it (World financial stress Bank 2015a). They may therefore not be in a A combination of continued weak BRICS growth and rising emerging position to implement effective counter-cyclical market risk premia could considerably reduce growth in other countries. stimulus. Faced with this predicament, structural reforms to lift long-term growth could help, A. Growth: Emerging markets B. Growth: Frontier markets bolster investor sentiment in the short run, help excluding BRICS lift domestic demand to the extent they encourage investment, and support capital flows even amidst financial market tightening. The appropriate policy response also depends on the source of the external shock. A growth shock may be more appropriately addressed with fiscal policy and structural reforms whereas a financial shock may be more effectively mitigated by C. Growth: G7 D. Growth: Global economy monetary, exchange rate, or financial policies. The boundaries between these shocks and policies, however, may at times be blurred. This argues, again, for a policy mix of fiscal, monetary, and exchange rate policy coupled with structural reforms. Fiscal policy. Fiscal stimulus could help stabilize a cyclical slowdown in activity. Fiscal multipliers—the change in real GDP generated by Source: World Bank staff estimates. Note: EMBI = Emerging Markets Bond Index. Conditional forecasts of emerging markets excluding a 1 dollar increase in fiscal spending—for BRICS, frontier markets, G7, and global growth, with conditions imposed on future BRICS growth and emerging markets are up to 0.6 in the short-term EMBI. The conditions are: (i) BRICS growing at the curent rate in 2015: BRICS continue to grow at its current 2015 level (annualized rate of 3.2 percent) during the forecast horizon; (ii) BRICS growth with and up to 0.9 in the medium-term (World Bank forecast downgrades as during 2010-14: BRICS continue to grow during the forecast horizon at its current 2015 level minus the average forecast downgrades it saw during 2010-14. The forecast 2015a). Fiscal multipliers tend to be larger during downgrades are based on the World Bank forecasts. In these two scenarios, EMBI is restricted to equal the unconditional forecasts from the aggregate VAR model during the forecast horizon; (iii) recessions than expansions, in countries with BRICS growth with forecast downgrades and financial stress: The second scenario is combined with EMBI rising by 100bp during the forecast horizon. Global growth is the GDP-weighted average of ample fiscal space, in less open economies, and for BRICS, emerging markets excl. BRICS, frontier markets, and G7 growth. The baseline forecasts are a GDP-weighted average of growth forecasts presented in Chapter 1 for the sample of countries used stimulus conducted through expenditure increases, here. Conditional forecasts are based on the aggregate VAR model. especially public investment, rather than tax cuts (World Bank 2015a; Ilzetzki, Mendoza, and Vegh the largest infrastructure deficits have been 2013). identified for low-income countries and frontier markets, emerging markets also lag by global A spillover-induced, cyclical slowdown in activity comparison. may be an opportunity to address sizeable infrastructure needs in emerging markets, since However, most emerging markets do not have the infrastructure investment can be a particularly policy room to sustain fiscal stimulus over effective form of fiscal stimulus.22 While some of anything other than the briefest period. 22Multipliers from public investment have been estimated to range from 0.25 to 1 in emerging markets over the medium-term (IMF thus growth of partner countries), reduce income inequality, and 2014c). Multipliers from increases in economy-wide physical capital boost employment. Infrastructure investment needs, however, have to stock have been estimated to range from 1 to 2 in Sub-Saharan Africa be assessed against financing cost and implementation capacity and Latin America and the Caribbean (Calderón and Servén 2008, (Kraay and Servén 2013). Because of less economic slack and lower 2010). Estimates of longer-term output effects of public investment efficiency of investment in emerging and frontier markets than vary widely but are generally positive (Bom and Ligthart 2014). In advanced markets, growth benefits in the former are smaller, subject addition to raising overall growth in the country investing in public to significant uncertainty, and raise public debt (IMF 2014a; Gupta infrastructure, infrastructure investment may also foster trade (and et al. 2014). 198 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 BOX 3.3 Within-region spillovers While spillovers from BRICS are often large, those from other large emerging markets (EM) and frontier markets FIGURE 3.3.1 Openness (FM) may also be strong within regions and especially to Most regions are highly open to global trade. neighboring countries. Remittances inflows are of similar or greater magnitude to FDI for several regions. Over time, portfolio inflows is box adds granularity, and expands the coverage of have led to the accumulation of some sizable liability positions, especially in LAC. Chapter 3, in the following directions. A. Trade and remittance inflows, 2014 • How do within-region and global linkages compare across regions? • How do within-region spillovers compare across regions? How do within-region and global linkages compare across regions? Global integration. Several developing country regions are highly open to global trade (Figure 3.3.1). Exposures to global nancial investment, however, tend to be lower— indeed, for several regions, remittances have been as large a source of in ows as foreign direct, portfolio, or bank investment ows. e relative importance of these links B. FDI inflows and stock of portfolio investment liabilities, di ers across regions. 2014 • EAP and ECA consist of countries that are highly open to trade and receive sizeable amounts of foreign direct investment (FDI) and portfolio investment but limited remittance in ows from outside the region. • Large oil exporters in the Middle East and North Africa (MNA) are deeply integrated into global trade, and some are a large source of remittances. Following a sharp slowdown since 2005, the region now receives modest FDI in ows and little portfolio investment. Latin America and the Caribbean (LAC) and South Asia (SAR) are generally less open to trade than other regions.1 Sources: WDI; World Bank; UNCTAD; CPIS database. However, LAC has received sizeable FDI. SAR receives Note: In percent of each region’s GDP. Regions are defined as all non- large remittance in ows from outside the region but advanced market countries in each region. EAP = East Asia and Pacific; ECA = Europe and Central Asia; LAC = Latin America and the Caribbean; MNA = limited FDI and portfolio investment (World Bank Middle East and North Africa; SAR = South Asia; SSA = Sub-Saharan Africa. 2015e). Emerging and frontier markets in SSA are, on average, well integrated into global trade and receive considerable FDI and remittance in ows. Note: This Box was prepared by Jesper Hanson, Raju Huidrom, and Franziska Ohnsorge. Integration with large advanced markets. Most regions 1LAC is generally less open to trade than other regions, although there tend to be closely linked to a neighboring major economy. is considerable heterogeneity across the region. For LAC, the United States is the single largest trading G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 3 199 BOX 3.3 Within-region spillovers (continued) FIGURE 3.3.2 Within-region integration Within-region trade links are strongest in EAP, ECA, and LAC. Remittances from inside the region are sizeable, except for the LAC region. Except in EAP, internal FDI flows are generally quite low compared to those from the rest of the world. MNA has considerable within-region ODA flows. A. Trade B. Remittance inflows C. FDI inflows D. Official development assistance Sources: WITS; Bilateral Remittances Database; CDIS database; CPIS database. Note: In percent of each region’s total. Regions include countries of all income categories, except for United States, Canada, Euro Area, and Japan. EA = Euro Area. A. 2011-14 average. B. 2014 C. 2011-13 average. partner and source of remittances and other nancial countries within the region represent more than 30 ows. e Euro Area and China play similar roles for ECA percent of the total for EAP, ECA, MNA, and SSA. Intra- and EAP, respectively. Partly re ecting greater region FDI, in contrast, is low, with the exception of EAP geographical distance to the world’s largest economies, where both Japan and China are important sources for MNA, SAR, and SSA are more diversi ed in their trade FDI to support supply chain integration. Likewise for and nancial ties. o cial development assistance, with the exception of MNA. Within-region integration. Several regions have strong within-region trade and remittance links (Figure 3.3.2). In How do within-region spillovers compare EAP, ECA, and LAC, within-region trade accounts for 20 across regions? percent or more of the total. In MNA, limited within- region trade re ects similar export specialization, especially e di erences in within-region economic links are of oil-exporting countries. Remittance in ows from re ected in spillovers from shocks in large emerging and 200 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 BOX 3.3 Within-region spillovers (continued) market source country of shocks in each region.2 Since the FIGURE 3.3.3 Spillovers from large BRICS are typically the largest countries in their regions, emerging markets in each region shocks in these economies have the strongest spillovers Strong within-region trade and remittance links are inside their respective region. reflected in sizeable spillovers in ECA to a growth decline in Russia and, in EAP, to a growth decline in • Strong within-region trade and remittance links are China. Other within-region spillovers tend to be modest. re ected in sizeable and often statistically signi cant A. Impact on growth of 1 percentage point decline in growth spillovers – for example, in ECA to a growth decline in large emerging markets within the region in Russia and in EAP to a growth decline in China (Boxes 2.1, 2.2).3 • In other regions, spillovers are typically statistically insigni cant. In SAR, a growth shock in India would have a marginal impact on growth in Pakistan and Sri Lanka, which have limited trade links with India (Box 2.5). In SSA, spillovers from growth shocks in South Africa and Nigeria are generally insigni cant. In MNA, growth spillovers from Egypt and Turkey are negligible, despite the size of these two economies, because of their limited ties to other countries in the region (Box 2.3).4 Similarly, growth spillovers in Mexico and Brazil on countries in LAC are, on average, modest although they can be sizeable for a B. Impact on growth of 1 percentage point decline in G7 few neighboring countries of Brazil with strong trade growth ties (Box 2.4).5 All regions are more vulnerable to growth shocks originating outside their region than shocks originating within their regions. e discrepancy is most pronounced for the highly open regions such as EAP, ECA, MNA, and SSA. Conclusion e emerging market and developing economy regions are generally much more vulnerable to external growth shocks than to shocks originating within each region. e within- region spillovers are limited in scope, and tend to be concentrated among neighboring countries, re ecting Source: World Bank staff estimates. modest within-region trade and nancial links. However, a Note. Based on country-specific structural vector autoregressions (VARs) using the earliest possible data from 1998Q1 to 2015Q2 for 7 countries in few countries in EAP and ECA are vulnerable to a growth EAP, 20 countries in ECA, 15 countries in LAC, 8 countries in MNA, 3 countries in SAR, and 4 countries in SSA. Estimation sample for the SSA slowdown in large neighboring emerging and frontier region starts in 2007 and within-region spillovers in SSA are statistically markets. insignificant. Details of the model are provided in Boxes 2.1-2.6. B. For EAP, the shock refers to growth in G7 excluding Japan; and for SSA and ECA, the shock refers to growth in the rest of the world. For the SAR region, only spillovers from India are considered. 2 Other studies have also found significant spillovers from Russia to 3 ECA (e.g., Alturki, Espinosa-Bowen, and Ilahi 2009; Ratha et al. 2015) frontier markets (Figure 3.3.3). ese large emerging and and from China to EAP (e.g., Ahuja and Nabar 2012; Inoue, Kaya, and frontier markets include BRICS, along with Egypt, Ohshige 2015). 4For lack of a sufficiently long quarterly data series, Gulf Cooperation Korea, Mexico, Nigeria, and Turkey. Similar to the Council countries could not be included in the analysis. estimation of spillovers from BRICS, spillovers are 5For instance, Southern Cone countries (Argentina, Bolivia, Chile, estimated in country-speci c structural vector Paraguay, and Uruguay), given their sizeable export linkages, are subject autoregressions, including the second large emerging to spillovers from Brazil (Adler and Sosa 2014). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 3 201 • Oil exporters that have entered the oil price FIGURE 3.15 Fiscal policy and fiscal space slump of 2014 with large surpluses and low Fiscal space is necessary to ensure that fiscal policy is effective. Among debt (Oman, Qatar, Saudi Arabia, and United emerging and frontier markets, fiscal space has shrunk significantly since Arab Emirates) can still smooth the the financial crisis as government debt and fiscal deficits have increased— adjustment to external shocks. However, in and sharply in some countries. This has also been reflected in deteriorating credit ratings. most oil-exporting emerging markets, surpluses have already turned into sizeable A. Share of emerging markets with B. Share of emerging markets with deficits and rising debt. elevated general government debt negative sustainability gaps • In several non-oil commodity-exporting emerging markets, deficits have widened by more than a percentage point from a less favorable starting position (Brazil, Chile, Peru) and debt has risen above 50 percent of GDP in 2015 (Brazil, Colombia). Further deterioration in fiscal sustainability could weaken investor sentiment. Sources: World Bank (2015a); Haver Analytics. B. Sustainability gap is defined as the difference between the actual overall balance and the debt- stabilizing overall balance at current growth rates. A negative sustainability gap indicates an • Similarly, several commodity-importing unsustainable stock of debt and deficit. economies entered the emerging market growth slowdown in 2010 with deficits above 4 percent of GDP and debt above 50 percent of GDP (Egypt, Hungary, India, and Poland), shocks. Some commodity-importing emerging and deficits remain elevated despite markets with low inflation, in contrast, may have consolidation efforts (Figure 3.15). some room to dampen external shocks with further interest rate cuts. However, once oil prices Monetary policy. Like fiscal policy, monetary stabilize and inflation begins to rise, this room policy could boost growth amidst a temporary may diminish. slowdown in activity.23 Effective monetary policy stimulus, however, relies on well-functioning Structural policies. The BRICS slowdown may financial markets (Lane 2003; Chinn 2014); turn out to be a sustained, structural decline in limited balance sheet exposures to exchange rate growth potential rather than a temporary cyclical and interest rate risk; well-anchored inflation downturn. This would generate spillovers that expectations; and policy credibility in the eyes of force other emerging markets to face an era of investors. lower growth in key trading partners and sources of finance. The potential for spillovers will However, room for monetary policy stimulus has increase as BRICS integrate further into the global narrowed in many emerging markets. To contain economy and as BRICS growth continues to inflation and financial stability risks resulting from outpace advanced market growth sharp depreciations, several commodity-exporting (notwithstanding the recent slowdown). While at emerging markets have been forced to tighten times politically challenging to implement, monetary policy despite faltering growth (Figure structural reform measures can help emerging 3.16). Most have limited monetary policy room to markets adjust to this new era. support activity in the event of further external Structural reforms have collateral benefits of buttressing investor confidence and lifting 23Monetary easing works through a number of channels: by domestic demand—whether in the event of reducing interest rates on government securities, interbank borrowing cyclical or structural external shocks. By lifting and bank lending; by depreciating the exchange rate; by increasing asset prices (especially equity and house prices) and thus by inflating investor confidence in growth prospects, they can the value of collateral for borrowing. support capital inflows amidst financial market 202 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 3.16 Monetary policy room turmoil. To the extent structural reforms are associated with investment—especially in the Among oil-importers, the oil price drop has reduced inflation below target levels and created policy options. Among oil exporters, currency presence of economic slack—or with increased depreciation has raised inflation and added to pressures on central banks labor force participation, they can also increase to raise policy rates. In contrast, central banks in oil importers have been domestic demand (World Bank 2015a). able to reduce policy rates. Gains in long-term growth from structural A. Inflation in emerging markets B. Monetary policy rate hikes in emerging markets reforms could be particularly large in emerging and frontier markets because they tend to display elevated inter-sectoral dispersion in productivity and because some struggle with pervasive misallocation of capital and labor.24 A growing literature has documented the long-term benefits from structural reforms in emerging and frontier markets, especially of reforms that improve governance and business environments. These include growth spurts triggered by reforms (Figure Sources: Hammond (2012); World Bank; Haver Analytics; Didier et al. (2015). A. Latest observation is October 2015. Includes both formal and informal inflation targets. 3.17, Didier et al. 2015), amplification of the B. Latest data for December 2015. Hikes and cuts refer to central bank rate decisions, including base growth dividend from public investment, greater rate, policy rate, repo rate, Selic rate, discount rate, reference rate, lending rate, refinancing rate and benchmark rate. The number of countries implementing rate cuts is shown with a negative sign. job creation and formal sector activity. For There are 11 commodity exporters and 13 commodity importers. example, the growth slowdown in 2010-14 was least pronounced in the quartile of countries with FIGURE 3.17 Growth slowdown and structural reforms the strongest governance environment reforms and most pronounced in those with the weakest Significant reforms in governance are positively associated with growth governance environment reforms (Figure 3.17). performance. During the most recent slowdown (2010-14), economies that demonstrated the highest rise in governance quality experienced milder slowdowns. Conclusion A. Growth differential during episodes Growth slowdown in 2010-14 of reform spurts and setbacks since and change in governance quality Over the next few years, growth in BRICS is likely 1996 in 2010-14 to face persistent headwinds from low commodity prices, weak trade, and higher borrowing costs. Meanwhile, productivity growth is likely to remain weak as populations age in large emerging markets, and investment weakness slows the adoption of new technologies. A weaker external environment, and slowing growth, may further erode policy buffers and constrain the use of counter-cyclical stimulus to support activity. The strengthening recovery in advanced markets is Sources: World Bank’s World Governance Indicators (WGI); Didier et al. (2015). A. The columns show the cumulative growth differential of economies during and prior to a reform expected to only partially offset these risks. spurt or setback episode, relative to those that experienced neither spurts nor setbacks. Spurt (setback) is defined by a two-year increase (decrease) by two standard deviations in one or more of the following four measures of the WGI index: regulatory quality, government effectiveness, rule of The results presented in this chapter suggest that law, and control of corruption. Differentials are based on estimates from a panel data regression with continued weakness or a further slowdown in time and country fixed effects. The sample spans 64 EM and FM over 1996-2014. Annex 3.2 provides additional details about the empirical exercise. BRICS growth could add to the challenges faced by emerging and frontier markets from a deteriorating external environment. It would 24Dabla-Norris et al. (2013); Hsieh and Klenow (2009); IADB (2013). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 3 203 weigh on growth in other emerging markets—as it If, instead of the projected pickup, BRICS growth has done already since 2010—and frontier slows further—by as much as the average growth markets. Activity in close trading partners of disappointment over 2010-14—and if financial BRICS and in commodity exporters would be conditions tightened moderately—such as during particularly susceptible to a setback. the financial market turmoil of the summer of 2015—global growth could be cut by one-third in In response to a 1 percentage point decline in 2016. BRICS growth, growth in other emerging markets and in frontier markets could slow by 0.8 and 1.5 Policy makers in emerging markets may need to percentage points, respectively, over two years. support activity with fiscal and policy stimulus, at This would set back global growth by 0.4 least where policy buffers are sufficient. In all percentage point, over two years. cases, countries could derive substantial gains from well-designed, credible structural reforms that There is a risk that growth weakness in BRICS retain investor confidence and capital flows in will be accompanied by bouts of financial market the short-run, and that lift growth prospects for volatility through the U.S. monetary policy the long-run. tightening cycle, or in some cases domestic factors. 204 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 Annex 3.1 Data Country classification Italy; Japan; Netherlands; New Zealand; Norway; Portugal; Singapore; Spain; Sweden; Switzerland; Emerging markets (EM) generally include (non- United Kingdom; United States), 16 emerging advanced) high-income and middle-income countries markets (Brazil; Chile; China; Czech Republic; with a record of signi cant access to international Hungary; India; Indonesia; Malaysia; Mexico; Peru; nancial markets. Frontier markets (FM) include, Philippines; Poland; Russian Federation; South generally middle-income, countries that are usually Africa; ailand; Turkey), six frontier markets smaller and less nancially developed than emerging (Bulgaria; Costa Rica; Croatia; Jordan; Paraguay; markets, and have more limited access to Romania), and eight other economies (Cyprus; international capital markets. Estonia; Israel; Latvia; Lithuania; Slovak Republic; Slovenia; Taiwan, China). For this Chapter, emerging markets are countries that are classi ed as such in at least two of the three e dynamic factor model uses annual growth in following stock indexes: S&P, FTSE, and MSCI. GDP, private consumption, and private investment Frontier markets are countries that are classi ed as for 106 countries from IMF World Economic such by at least two of the same three indexes. For Outlook database during 1960-2015. e sample countries not covered by all of these three indexes, we includes 23 advanced markets (Australia, Austria, also include those that are classi ed as emerging/ Belgium, Canada, Denmark, Finland, France, frontier markets by Bloomberg, Citi, and JP Morgan Germany, Greece, Iceland, Ireland, Italy, Japan, bond indexes, even though these latter lists do not Luxembourg, Netherlands, New Zealand, Norway, have a break down between emerging markets and Portugal, Spain, Sweden, Switzerland, United frontier markets. Kingdom, United States), 17 emerging markets (Brazil, Chile, China, Colombia, Arab Republic of Data used in modelling Egypt, India, Indonesia, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Republic of Korea, South e structural vector autoregressions, the correlation Africa, ailand, Turkey), 25 frontier markets analysis, and the event study use quarterly real (Argentina, Bangladesh, Bolivia, Botswana, Costa GDP data from Haver, OECD, and IMF World Rica, Cote d’Ivoire, Ecuador, El Salvador, Gabon, Economic Outlook with a maximum coverage from Ghana, Guatemala, Honduras, Jamaica, Jordan, 1997Q2 to 2015Q2. e sample includes 24 Kenya, Mauritius, Nigeria, Panama, Paraguay, advanced markets (Australia; Austria; Belgium; Senegal, Sri Lanka, Tunisia, Uruguay, República Canada; Denmark; Finland; France; Germany; Bolivariana de Venezuela, Zambia) and 41 other Greece; Hong Kong SAR, China; Iceland; Ireland; developing countries. Emerging markets Frontier markets Advanced markets Brazil Morocco Argentina Ghana Panama Australia Ireland Chile Pakistan Azerbaijan Guatemala Paraguay Austria Iceland China Peru Bahrain Honduras Romania Belgium Italy Colombia Philippines Bangladesh Jamaica Senegal Canada Japan Czech Republic Poland Bolivia Jordan Serbia Switzerland Luxembourg Egypt, Arab Qatar Botswana Kazakhstan Sri Lanka Germany Malta Rep. Hungary Russia Bulgaria Kenya Tunisia Denmark Netherlands India Saudi Arabia Costa Rica Kuwait Ukraine Spain Norway Indonesia South Africa Côte d’Ivoire Lebanon Uruguay Finland New Zealand Korea, Rep. Thailand Croatia Mauritius Venezuela, RB France Portugal Malaysia Turkey Ecuador Mongolia Vietnam United Kingdom Singapore United Arab Mexico El Salvador Namibia Zambia Greece Sweden Emirates Hong Kong Gabon Nigeria United States SAR, China Georgia Oman G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 3 205 Annex 3.2 Methodology A. VAR models weighted average of growth of individual emerging markets minus BRICS and frontier markets e chapter uses a structural vector autoregression respectively.3 e U.S. interest rate (the yield on model to quantify growth spillovers from BRICS 10-year U.S. treasury bills) and the EMBI serve as to other countries, in particular emerging markets proxies for global nancial conditions. e model (EM) excluding BRICS and frontier markets is estimated using Bayesian techniques and (FM). Exogenous shocks to BRICS growth are inferences are made using 2000 Monte Carlo identi ed using a recursive scheme, and then the draws. A lag length of four quarters is used, which spillover e ects of those shocks are traced out. e is standard for VAR models estimated with recursive identi cation scheme requires quarterly quarterly data. data, and hence spillover analysis in this chapter is limited to those countries for which quarterly data To evaluate growth spillovers from each of the is available.1 In the baseline (aggregate) model, the individual BRICS countries, the model above is re variables included are, in this order: G7 growth, -estimated by replacing aggregate BRICS with the the U.S. interest rate, Emerging Market Bond individual BRICS country in question as the Index (EMBI), BRICS growth, oil price, emerging spillover source. For instance, to obtain growth market (excluding BRICS) growth, and frontier spillovers from Brazil, the model is re-estimated by market growth.2 e ordering is based on the including Brazil’s growth instead of aggregate presumed exogeneity, or predetermination, of BRICS growth. Positive or negative correlations variables where more exogenous variables are between growth of individual BRICS could bias ordered rst. For instance, it assumes that G7 the estimates upwards or downwards. growth is exogenous to emerging market growth: G7 growth shocks a ect emerging market growth While the baseline model is used to infer spillover within a quarter, whereas shocks to emerging implications for aggregate global, emerging market growth can a ect G7 growth only with a market, and frontier market growth, an alternative lag of at least one quarter. By ordering oil price (country) speci cation is deployed to evaluate after BRICS growth, the chapter implicitly spillover e ects for each emerging market and assumes that oil prices are relatively endogenous to frontier market. is speci cation is used in the BRICS growth. chapter to understand the intra- and inter-regional spillover e ects from a growth slowdown in G7 growth, taken to be the proxy for growth in BRICS countries. Among the BRICS countries, the advanced economies, is constructed as the Brazil, Russia, and China matter empirically for weighted average of the growth of individual G7 spillovers (Figure 3.11). To preserve model economies, the weights being their respective parsimony, the alternative speci cation considers average GDP shares during the estimation period, spillovers only from these three countries. e 1998Q1-2015Q2. BRICS growth is similarly model is estimated for each emerging market and constructed as the weighted average of growth of frontier market (as spillover destination country) individual BRICS countries. Emerging market one at a time with the following variables: G7 and frontier market growth are constructed as the growth, EMBI, China’s growth, Brazil’s growth, Russia’s growth, commodity prices, emerging 1Alternatively, a local projections model could have been used. market/frontier market growth, and emerging However, this would have rst required identifying exogenous market/frontier market real e ective exchange BRICS growth shocks often proxied in the literature by growth rate. Simultaneously including all three spillover forecast errors. A consistent measure of the latter is not available. Simply assuming BRICS growth as exogenous shocks is less plausible source countries (China, Brazil, and Russia) in the for several countries in the sample. model allows estimating spillovers from one source 2 e ordering closely follows World Bank (2015a, 2015b) and IMF (2014b). e main results in the chapter are robust to including VIX instead of EMBI in the model. e list of countries classi ed as 3 e results are robust when emerging market growth includes emerging markets and frontier markets are provided in Annex 3.1. growth in Brazil, India, Russia, and South Africa. 206 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 country (e.g., Brazil) while explicitly controlling U.S. CPI. e resulting real prices are converted for the rest of the spillover source countries into indices by setting January 2010 as 100. en, (China and Russia). the monthly indices are converted into quarterly indices by taking averages across the months in a Commodity prices are weighted by the average given quarter. Country-speci c trade weights are share of exports of each commodity in the then applied to these real quarterly commodity commodity export basket of the spillover price indices to yield a trade-weighted real destination country in question. With respect to commodity price index for each country. For a the baseline model, including trade-weighted given country, the trade weights are the average commodity prices (instead of oil prices) and the share of exports of each commodity in the total real e ective exchange rate in the model results in commodity export basket during the period 2007- a better empirical description of the small open 2014. Commodity exports are de ned in terms of economies in the sample. Finally, again in the SITC 4th revision at 4 digits from the World interests of parsimony, U.S. interest rates are Integrated Trade Solution (WITS) database. excluded in the alternative speci cation. e results are, however, robust to inclusion or While estimating the model, some of the data are exclusion of U.S. interest rates. transformed to yield stationary series. us, real GDP, oil and commodity prices, and real e ective e estimation uses a balanced panel of quarterly exchange rate, originally in levels, are converted observations for 57 countries between 1998Q1 into quarter-on-quarter growth rates. Any residual and 2015Q2. Real GDP for 29 of these countries linear trends in those growth rates are removed. is based on the quarterly database in Ilzetzki, e U.S. interest rate and the EMBI are rst Mendoza, and Vegh (2013) which is extended to di erenced. e baseline (aggregate) VAR model 2015Q2 by splicing real GDP series from the uses aggregate GDP growth rates for various OECD Quarterly National Accounts and Haver geographic regions and/or market groups. ose Analytics. Real GDP data for the remainder of the are calculated as the GDP weighted growth rates 28 countries are sourced from the OECD of all the countries in a given region/group. e Quarterly National Accounts and Haver Analytics. GDP weights are calculated using the annual Real e ective exchange rates are the narrow constant GDP (2005 US$) series from the World (wherever available) and the broad indices from Bank’s World Development Indicators. the Bank for International Settlements (BIS) supplemented with the Bruegel database. e B. Dynamic factor model EMBI spread series is taken from J.P. Morgan. e U.S. long-term interest rate is the 10-year Dynamic factor models are widely used for generic government yields from Bloomberg. identifying common elements in national business Nominal oil prices are obtained from the World cycles (for an extensive discussion see, for instance, Bank Pink Sheet and de ated using seasonally Kose, Otrok, and Prasad 2012). is chapter adjusted U.S. CPI series from Haver Analytics.4 estimates a dynamic factor model that captures common factors in the uctuations of real output, e trade-weighted commodity prices for each private consumption, and private investment over emerging market/frontier market are constructed the 1960–2015 period in 106 countries using as follows: nominal monthly prices of 35 annual data obtained from the World Economic commodities are obtained from the World Bank Outlook database. Speci cally, the model pink sheet.5 As in the case of oil prices, these decomposes uctuations in these variables into nominal commodity prices are de ated by the four factors: 4 Available at http://www.worldbank.org/commodities. 5 Commodity prices include aluminum, banana, barley, beef, • A global factor captures the broad common chicken, coal, cocoa, coconut oil, co ee, copper, copra, cotton, crude elements in the uctuations across countries. oil, gold, ground nut oil, iron ore, lead, maize, natural gas, nickel, orange, palm oil, platinum, rice, rubber, silver, sorghum, soybean oil, soybeans, sugar, tea, tin, tobacco, wheat, and zinc. • Group factors capture the common elements G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 3 207 in the cyclical uctuations in the countries in and lags and follow an autoregressive process. e a particular group. In this paper, the world is same block of equations is repeated for each divided into three regions: advanced markets, country in the three regions in the system. e emerging and frontier markets, and other model is estimated using Bayesian techniques as developing countries.6 described in Kose, Otrok, and Whiteman (2003). • Country-speci c factors capture factors To measure the importance of each factor, we common to all variables in a particular compute variance decompositions that decompose country. the total volatility of output growth into volatility components due to each factor. is is achieved by • Residual (“idiosyncratic”) factors capture applying the variance operator to each equation in elements in the uctuations of an individual the system. For the case of output in the example variable that cannot be attributed to the other above, factors. Dynamic factor models are designed to extract a small number of unobservable common elements from the covariance or co-movement between (observable) macroeconomic time series across Since there are no cross-product terms between countries. us, the model allows for a more the factors because they are orthogonal to each parsimonious representation of the data in terms other, the variance in output attributable to the of the unobservable common elements – typically global factor is: referred to as factors. From a theoretical standpoint, dynamic factor models are appealing because they can be framed as reduced-form solutions to a standard Dynamic Stochastic e variance share due to the regional and country General Equilibrium (DSGE) model. factors and the idiosyncratic term are calculated using a similar approach. e dynamic factor model used in this paper has 106 blocks of equations, one for each country. For C. GVAR model instance, the block of equations for an emerging market economy, say Mexico, takes on the Originally proposed in a seminal paper by following form: Pesaran, Schuermann and Weiner (2004), the GVAR methodology presents a simple and practical alternative to overcome the dimensionality problem (“curse of dimen- sionality”) on the macro-econometric study of global macro-linkages. e GVAR approach can be brie y described in where Y, C, and I denote growth in output, two steps. In the rst step, country-speci c small- consumption, and investment respectively. e dimensional VAR models are estimated, which global, EMFM (group), and country factors are include domestic variables and cross-sectional represented by , and respectively; averages of foreign variables. In the second step, and the coe cients before them, typically referred the estimated coe cients from the country- to as factor loadings, capture the sensitivities of the speci c models are stacked and solved in one large macroeconomic series to these factors. e error system, which is used in this report for impulse- terms are assumed to be uncorrelated at all lead responses analysis. 6 For the list of countries included in each region, see Annex 3.1. 208 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 e model For the estimation of the marginal model for the dominant variables, d, feedback e ects from xt are Consider a panel of N countries, each featuring k i allowed. us, we have the following expression × 1 of endogenous variables observed during the for the marginal model: time periods t=1, 2, …, T. Let xit denote a vector of k i × 1 of endogenous variables speci c to country i in time period t, and let xit = (x'1, x'2 ,… x'N)' denote a k i × 1 vector of all the variables in Following Pesaran et al. (2004) the chapter the panel, where k = ki . proceeds to estimate the individual VARX* in equation (2) on a country-by-country basis. e A set of small-scale, country-speci c conditional marginal model (3) is also estimated by least models can then be estimated separately. e squares. Once the estimations have been carried individual models explain the domestic variables on, we stack together the N models of equation of a given economy, xit, conditional on country- (2) and the models in equation (3) and solve it all speci c cross-section weighted averages of foreign as one global system, explicitly taking into account variables, . e foreign variables' expression is as that . follows: Empirical exercise e GVAR model is estimated for 32 countries: ese weights are constructed using data on Australia, Austria, Belgium, Brazil, Canada, Chile, bilateral foreign trade. xit is modelled as a VARX* Finland, France, Germany, India, Indonesia, Italy, model, namely a VAR model augmented by the Japan, Malaysia, Mexico, Netherlands, Norway, vector of the foreign variables and their lagged New Zealand, Peru, Philippines, Republic of values: Korea, South Africa, Saudi Arabia, Singapore, Spain, Sweden, Switzerland, ailand, Turkey, United Kingdom, and the United States. e estimation period is 1998Q1-2014Q4. for i = 1,2,…N , where , l = 1,2,…, p i , , for l = 1,2,…, qi, are ki × k i and k i × k * matrices of ree endogenous variables are considered: real unknown parameters, respectively, and are k i × output, the rate of in ation, and the real e ective 1 vectors of errors. Foreign variables in country exchange rate. Due to the limited degrees of -speci c models are treated as weakly exogenous freedom, only one country-speci c foreign variable for the purpose of estimation of unknown is considered and constructed from real output. coe cients of the conditional country models. e xed trade weights are de ned as the average trade ows computed over a given period of time. e assumption of weak exogeneity can be easily ese weights are used for the estimation of the tested and is often not rejected when the economy individual models but also later on for the solution under consideration is small relative to the rest of the GVAR. of the world and the weights used in the construction of the foreign variables are Finally, price indices for oil and metals are granular . included in the model as dominant variables. Common variables in the country models are Generalized impulse-responses introduced as dominant variables as de ned in Chudik and Pesaran (2013). us, (1) becomes: In a single-country VAR, exact identi cation of shocks is commonly achieved by imposing a few restrictions derived from economic theory. However, in the case of a GVAR, exact identi cation of shocks would require an G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 3 209 astonishing 192 (based on the number of in which there were improvements in one measure countries considered in this chapter) restrictions and simultaneous setbacks in another are derived from economic theory, . excluded. e sample spans 64 EM and FM over Consequently, the generalized impulse responses 1996-2014. is approach yields 50 episodes of proposed by Pesaran and Shin (1998) are used, signi cant reform spurts and 47 episodes of which produce one unique set of responses. reform setbacks (Didier et al. 2015). Nevertheless, it is important to note that this approach does not attempt to recover any Let t denote the end of a two-year spurt or structural shocks. Instead, this methodology setback. e coe cients are dummy variables for describes how the system reacts after a speci c spurts and setbacks over the [t-3, t+2] window historical/observable shock, taking into account around these episodes. In Figure 3.17A, “Reform” the correlation among shocks. denotes the t=[-1,0] window (i.e. during the two years of improvement/deterioration). “Pre-reform” D. The benefits of reform denotes the t=[-3,-2] window. For each window, each column shows the sum of coe cients. All Values in columns of Figure 3.17A are based on a coe cients show the growth di erential of panel data regression in which the dependent economies during an episode compared to those variable is real GDP growth. A reform spurt that experienced neither improvements nor (setback) is de ned as a two-year increase setbacks. All estimates include time xed e ects to (decrease) by two standard deviations in one or control for global common shocks and country more of the following four measures of the WGI xed e ects to control for time-invariant index: regulatory quality, government heterogeneity at the country-level. Under robust e ectiveness, rule of law, and control of standard errors, estimates during the reform spurt corruption. e WGI indicators are principal window are jointly signi cant at the 10 percent components of a wide range of survey-based and level, and likewise for the reform setback window. other indicators. For each index, the standard e growth di erentials during reform spurts deviation is measured as the average of the associated with IMF programs are jointly standard errors of the WGI index in the beginning signi cant at the 1 percent level. and at the end of each two-year interval. Episodes 210 CHAPTER 3 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 Annex 3.3 Empirical estimates of spillovers from emerging markets Author Country/data Methodology Results A one percentage point slowdown in investment in China is associated Ahuja and Nabar (2012) with a reduction of global growth of just under one-tenth of a percentage point. Regional supply chain economies and commodity Factor Augmented exporters with relatively less diversified economies, such as Vector Indonesia, are most vulnerable. Economies that lie within the Asian G20/monthly, 2000-11 autoregression regional supply chain—Korea; Taiwan, China; and Malaysia— would Ahuja and Myrvoda (FAVAR) also be adversely affected. Among the advanced economies, spillover (2012) effects most significant for Japan and Germany. Commodity prices, especially metal prices, could fall by as much as 0.8–2.2 percent below baseline one year after the shock. 63 advanced and A 1 percentage point decline in China’s growth may lower GDP growth Duval et al. (2014) emerging markets/ Panel regression in the median Asian economy by about 0.3 percentage point after a quarterly, 1995-2012 year. A decline in China’s real GDP has a significant impact on neighboring economies, especially on commodity exporters (e.g. Indonesia). 26 advanced and Global VAR (GVAR) Inoue, Kaya, and Export-dependent countries in the EAP production cycle (Singapore, emerging markets/ with time- varying Ohshige (2015) Malaysia and Thailand) and commodity exporters like Australia are quarterly, 1979-2013 trade weights also severely affected. Commodity prices (metals, crude oil and agriculture products) are also affected. Spillovers to advanced economies are larger than to emerging economies. A one percentage point reduction in China’s growth can 21 advanced and GVAR with value- reduce growth in advanced economies by 0.15 percentage point at the IMF (2014b) emerging markets/ added trade end of one year, with effects most significant for Japan and the Euro quarterly, 1979-2009 Area. The effects on emerging economies is smallest, around 0.06 percentage point. A 1 percentage point reduction in Chinese growth can reduce growth Bayesian SVAR with LAC region/quarterly, in the LAC region by 0.6 percentage point at the end of two years, with World Bank (2015a) Cholesky 1992-2014 effects most significant for Peru and Argentina (around one identification percentage point). Effects on Brazil are around 0.8 percentage point. Bayesian SVAR with South Africa/quarterly, A 1 percentage point reduction in Chinese growth can reduce growth World Bank (2015b) Cholesky 2000-2014 in South Africa by 0.4 percentage point at the end of two years. identification A 1 percentage point rise in China’s growth increases other emerging market economies’ growth by about 0.1 percentage point on impact. The impact elasticity is high for some economies in Asia, such as Bayesian SVAR with Emerging markets/ Thailand, but also for commodity exporters such as Russia. Growth IMF (2014a) Cholesky quarterly, 1998-2013 fluctuations in China also feed back into the global economy. A 1 identification percentage point growth increase in China boosts U.S. growth with a lag, the cumulative effect rising to 0.4 percentage point for a cumulative rise in China’s growth to 4.6 percent after two years. Spillover effects of China’s growth have increased in recent decades. A 1 percentage point impulse to China’s GDP growth is followed by a VARs and error - cumulative response in other countries’ GDP growth of 0.4 percentage Unbalanced panel of correction models for point over five years. The trade channel is significant: about 60 Arora and Vamvakidis 172 economies / short run effects. percent of the impact seems to be transmitted through trade channels. (2011) annual data, 1960– Panel regressions for Moreover, while China’s spillovers initially only mattered for 2007 long run effects neighboring countries, the importance of distance has diminished over time. Long-term spillover effects are also significant and have extended in recent decades beyond Asia. Russia and 11 Russia appears to influence regional growth mainly through the Commonwealth of remittance channel and somewhat less through the financial channel. Panel regression; Alturki, Espinosa- Independent States There is a shrinking role of the trade (exports to Russia) channel. Vector Bowen, and Ilahi (2009) (CIS) countries / Russian growth shocks are associated with sizable effects on Belarus, autoregression (VAR) annual and quarterly, Kazakhstan, Kyrgyz Republic, Tajikistan, and, to some extent, 1997-2008. Georgia. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 3 211 Author Country/data Methodology Results There are significant cross -country spillovers to the Baltics with Baltic countries and those from the European Union outweighing spillovers from Obiora (2009) Russia / quarterly, 2000- VAR model Russia. This reflects increasing trade and financial integration of 07 the Baltics with EU and a declining role of Russia as an export destination for the Baltics. Spillovers from Russian GDP growth are largest for Latvia, European countries and Lithuania, Slovakia, Slovenia and Finland (i.e. countries with the Norges Bank (2014) Russia / quarterly, 2003- VAR model largest export exposures to Russia). For Europe as a whole, 13 spillover effects from Russia seem limited. Growth regressions South African growth has a substantial positive impact on growth 47 African countries and based on a panel of in the rest of Africa: a 1 percentage point increase in South Africa Arora and Vamvakidis (2005) South Africa/ five-year countries' average five-year growth is associated with a 0.5 – 0.75 percentage point growth, 1960-99 growth rates during increase in five-year growth in rest of Africa. five-year subperiods Growth in LIC depends increasingly on external factors with bulk of this attributable to economic ties developed with EM leaders Low income countries (eight EM that are the largest destination of LIC exports in each Dabla-Norris, Espinoza, and (LIC) and emerging VAR model and region). LIC in SSA and MNA regions are particularly exposed to Jahan (2015) markets (EM) / annual, growth regressions spillovers from the EM leaders via the trade channel. A 1 1980/90 - 2008 percentage point increase in GDP growth in EM leaders raises activity by between 0.5 and one percentage point in SSA LIC. Growth spillovers from Nigeria to neighboring countries are African countries / negligible. Given closely linked food markets, inflation spillovers annual, 1980/89- Pooled regression are significant. There is no clear evidence that growth in South IMF (2012a) 2010/11 for growth and VAR Africa’s main partners in sub-Saharan Africa is affected by South analysis; quarterly for African developments or policies. Global developments are, inflation analysis however, an important determinant of growth. BLNS countries (Botstwana, Lesotho, Canales -Kriljenko, South Africa’s real GDP growth does not seem to contribute Namibia, and Gwenhamo, and Thomas VAR much to GDP growth in BLNS countries. However, spillovers Swaziland) and South (2013) from global growth are significant. Africa / annual, 1986- 2010 There is a significant growth spillover effect to African economies from both the Euro zone economies and BRICS. In terms of the 46 African countries and magnitudes, a percentage decline in Euro zone growth rate could 30 developed and lead to 0.34 to 0.6 percentage point drop in African countries’ emerging markets/ Gurara and Ncube (2013) GVAR growth rates while an equivalent shock in BRICS growth could quarterly data (GDP dent African growth rates by 0.09 to 0.23 percentage point. In interpolated from annual both cases, spillover effects on fragile and resource-dependent data), 1980-2011 economies are stronger than those on more diversified African countries. MNA countries are more sensitive to developments in China than 38 countries that include to shocks in the Euro Area or the United States, in line with the advanced, emerging, Cashin, Mohaddes, and direction of evolving trade patterns. 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G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 4 217 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 4 219 Potential Macroeconomic Implications of the Trans-Pacific Partnership On October 4, 2015, 12 Pacific Rim countries concluded negotiations on the Trans-Pacific Partnership. If ratified by all, the agreement could raise GDP in member countries by an average of 1.1 percent by 2030. It could also increase member countries’ trade by 11 percent by 2030, and represent a boost to regional trade growth, which had slowed to about 5 percent, on average, during 2010-14 from about 10 percent during 1990 -07. To the extent that the benefits of reforms have positive spillovers for the rest of the world, the detrimental effects of the agreement due to trade diversion and preference erosion on non-members, would be limited. e global significance of the agreement depends on whether it gains broader international traction. Introduction The TPP is one of several Mega-Regional Trade Agreements (MRTAs) that have emerged since the mid-1990s. As a deep and comprehensive “new- Over the last quarter century, trade flows of goods generation” trade agreement, the TPP covers and services have increased rapidly (Figure 4.1.1). traditional barriers to trade in goods and services The value of world trade has more than (e.g. tariffs, restrictions on the movement quintupled, from $8.7 trillion in 1990, to more of professionals), investment activities, and other than $46 trillion in 2014. The relative importance trade-related areas. Such areas include formal of trade has increased too, from 39 percent of restrictions on some trade and investment world GDP in 1990, to 60 percent in 2014. That activities, burdensome and inconsistent said, global trade growth has slowed to about 4 regulations, varying treatment of intellectual percent per year since the crisis from about 7 property, differing labor and environmental percent, on average, during 1990-07. This standards, issues specific to small and medium-size slowdown in world trade reflects weak global enterprises, and new challenges arising from investment growth, maturing global supply chains, rapidly growing digital technologies. China, and slowing momentum in trade liberalization the largest trading partner for most member (World Bank 2015). countries of the agreement, is not included, nor is On October 4, 2015, 12 Pacific Rim countries the Republic of Korea. The TPP, however, is concluded negotiations on the Trans-Pacific designed as a “living agreement” to allow for Partnership (TPP), the largest, most diverse and membership expansion as well as broadening of potentially most comprehensive regional trade coverage. agreement yet. The 12 member countries are This analysis aims to address the following Australia, Brunei, Canada, Chile, Japan, Malaysia, questions: Mexico, New Zealand, Peru, Singapore, United States, and Vietnam. While a detailed assessment will take time, this analysis and the assumptions • How do new-generation trade agreements used in its modelling exercise are based on a (such as the TPP) differ from traditional free preliminary assessment of the agreement published trade agreements (FTAs)? in early November 2015. • What are the main features of the Trans- Note: is analysis was prepared by Csilla Lakatos, Maryla Pacific Partnership? Maliszewska, Franziska Ohnsorge, Peter Petri, and Michael Plum- mer. It partly draws from a background paper by Petri and Plum- • What are the potential macroeconomic mer (forthcoming). implications of the TPP? 220 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 4.1.1 Growth in world trade Provisions can go well beyond WTO standards. Specific measures include the following: International trade flows of goods and services have increased rapidly until the global financial crisis but then slowed. • a negative-list approach for liberalizing trade A. Trade B. Trade in services, which covers all sectors except those explicitly listed (as opposed to the positive list of sectors under GATS); • new rules for internet and digital commerce; • across-the-board national treatment for foreign investors, both pre- and post- establishment; Source: World Development Indicators 2015. A. EAP = East Asia and Pacific, ECA = Europe and Central Asia, LAC = Latin America and the Caribbean, MNA = Middle East and North Africa, SAR = South Asia, SSA = Sub-Saharan Africa. • streamlined regulations through standardized Regional aggregates include high-income and advanced countries, including the European Union. principles; • enhanced intellectual property protection, How do new generation with more comprehensive rules and greater enforcement obligations than in the TRIPS trade agreements differ from agreement; traditional FTAs? • government procurement commitments Rule-making in the world trading system has (covered under the plurilateral Government shifted from global to bilateral, regional, and Procurement Agreement in the WTO); sectoral agreements. The Uruguay Round of multilateral trade negotiations, which culminated • competitive neutrality for state-owned in the establishment of the World Trade enterprises; Organization (WTO) in 1994, produced a comprehensive agreement to reduce tariffs on • labor and environment codes; and manufactured goods. It also expanded into areas such as agriculture, trade in services, and • improved dispute resolution for many issues intellectual property. However, complex trade covered in the agreement. policy issues, including regulatory barriers, modern services trade and cross-border investment Regional and mega-regional trade (covered in the General Agreement on Trade in agreements Services, GATS) and the knowledge economy (key aspects covered under the Trade-Related Aspects In the 1990s, before the surge in bilateral and of Intellectual Property Rights Agreement smaller regional agreements of the 2000s, two (TRIPS) have been challenging to address at a large Regional Trade Agreements (RTAs) multilateral level. Hence, cooperation on these emerged: the European Union (EU) Single issues has recently taken place through bilateral Market (established 1993) and the North and/or regional agreements. While there were only American Free Trade Agreement between Canada, a few of these before 2000, their number Mexico, and the United States (NAFTA, ballooned to 266 by 2014 (Figure 4.1.2). established 1994). These agreements had evolved from two earlier agreements—the European At the same time, the concept of deep and Economic Community, established in 1957 with comprehensive FTAs has taken hold. These FTAs six member countries, and the Canada-US Free offer expanded market access, even for products Trade Agreement in 1987. that have previously aroused domestic sensitivities. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 4 221 Several other RTAs were established in the 1990s. FIGURE 4.1.2 Importance of regional trade agreements • Mercosur: Established in 1991, the agreement The number of regional trade agreements (RTAs) has grown rapidly. has six member states in Latin America, including Argentina, Bolivia, Brazil, Paraguay, A. Number of regional trade agree- B. GDP and trade covered by major ments RTAs Uruguay and the Republica Bolivariana de Venezuela. • South Asian Preferential Trading Arrangement (SAPTA): Originally signed in 1993, the agreement deepened into the South Asian Free Trade Area (SAFTA) in 2004 and now covers eight South Asian countries, including India and Pakistan. • Association of South East Asian Nations Free C. Share of major RTAs in global GDP D. Intra-RTA trade and trade Trade Area (ASEAN): Signed in 1992, the agreement now includes ten East Asian countries, including Indonesia, Malaysia, and Thailand. By 2015, the number of RTAs reached 274. The EU Single Market—now covering 28 members— and NAFTA are by far the largest RTAs in terms of GDP and trade. Together, their member countries account for 50 percent of global GDP Sources: World Trade Organization’s Regional Trade Agreement database; World Development Indicators; World Integrated Trade Solution (WITS) database. and 37 percent of global trade (more than two B. RTAs are reciprocal trade agreements between two or more partners and include both free trade agreements and customs unions. times as much as the members of the smaller three C. D. SAPTA = South Asian Preferential Trading Arrangement; ASEAN = Association of South East Asian Nations Free Trade Area; EU = European Union; NAFTA = North American Free Trade RTAs combined). The EU Single Market and Agreement; RCEP = Regional Comprehensive Economic Partnership; FTAAP = Free Trade Area of the Asia-Pacific; TPP = Trans-Pacific Partnership; TTIP = Transatlantic Trade and Investment NAFTA are also the agreements with the largest Partnership. intra-regional trade. Intra-EU trade accounts for 60 percent of total member trade, while intra- NAFTA trade accounts for 41 percent of total FIGURE 4.1.3 RTAs: Tariffs and membership member trade. This compares with less than 20 percent among members of the other three RTAs While earlier RTAs predominantly aimed at reducing tariffs, the new (Figure 4.1.2). generation of trade agreements focuses more on reducing the restrictiveness of non-tariff measures. There is considerable overlap in the membership of the three agreements currently under discussion in Asia. Mega-regional trade agreements (MRTAs), as defined here, are regional agreements that have A. Average tariffs B. Pacific mega-RTAs systemic, global impact. In other words, they are sufficiently large and ambitious to influence trade rules and trade flows beyond their areas of application. Earlier RTAs began as initiatives to reduce tariffs. Over time they grew to reduce non-tariff barriers. More recent regional negotiations have, from the outset, focused on more ambitious, deep, and comprehensive agreements. In addition to the Sources: World Integrated Trade Solution (WITS) database; Petri and Raheem (2014). TPP, major new negotiations include the Regional 222 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 Comprehensive Economic Partnership (RCEP) 1997). Blocs that gain critical mass—for example, among 16 Asian economies, and the Trans- the European Union—will therefore likely attract Atlantic Trade and Investment Partnership a growing membership. Outside the bloc, the between the European Union and the United bloc’s policies could become an external anchor States. An even larger Free Trade Area of the Asia- for institutional reforms in potential future Pacific (FTAAP) among 21 Asia-Pacific Economic member countries (IMF 2003). In addition, Cooperation (APEC) economies is also in early internal political constituencies change as blocs stages of discussion. There is substantial overlap in grow. membership of these groups (Figure 4.1.3). Drawbacks for members and non-members. Benefits offered and challenges posed While RTAs may significantly benefit members, by RTAs they can set back economic activity for non- members (Baldwin and Wyplosz, 2006; Krueger The rise of regional agreements has rekindled 1999). The competitiveness gains developed in debate on whether they support or impede global these new blocs could potentially divert trade away efficiency and activity in member and non- from more efficient non-member exporters member countries (WTO 2011; Freund and towards less efficient member ones (Viner 1950; Ornelas 2010; World Bank 2005, Maggi 2014). Balassa 1967; Baldwin 2006), a phenomenon called the “trade diversion” effect. In addition, Benefits for members. RTAs open markets RTAs can result in the erosion in the value of between partners, leading to a more efficient preferences given to Least Developed Countries division of labor, technology spillovers and related (LDCs) under existing duty-free, quota-free, productivity growth (“trade creation”; Hoekman preferential schemes, such as the “Everything but and Javorcik 2006, Blyde 2004). A growing Arms Initiative” of the European Union and the literature suggests that trade agreements foster “African Growth and Opportunities Act” of the domestic reforms in developing countries (Baccini U.S. This phenomenon (which applies to both and Urpelainen, 2014a,b). For example, a range of regional and multilateral agreements) is sometimes regulatory reforms have followed EU enlargement called the “preference erosion” effect. (Schönfelder and Wagner 2015; Staehr 2011; Mattli and Plümper 2004; Milner and Kubota RTAs within natural trading blocs—among 2005). RTAs are also often a step toward larger countries that already trade intensively with each agreements through the process of competitive other—tend to have modest diversion effects liberalization (Baldwin and Jaimovich 2010). For (Eicher et al. 2012). As a percentage of their total example, the European integration project has trade, trade among the prospective member states expanded from six to 28 members so far. NAFTA of TPP, FTAAP, and RCEP (35-60 percent) grew out of an agreement between Canada and the already exceeds that within NAFTA (Figure United States, and while it did not itself expand 4.1.2). further, it did spawn a network of agreements between its members and third partners. The Asia- What are the main features Pacific integration process appears to be following this path. of the Trans-Pacific Partnership? Studies of the internal political economy of trading blocs point to other positive impacts of The TPP will expand mutual market access among RTAs. The domino theory of regionalism argues member countries by lowering tariffs and easing that as a bloc grows, potential partners likely the restrictiveness of non-tariff measures. Non- benefit more from joining, and therefore offer tariff measures (NTMs) cover a wide range of better deals to secure admission (Baldwin 1993). measures that can be obstacles to trade, including This tilts the political calculus within blocs toward import licensing requirements, rules for customs admitting new members (McCulloch and Petri valuations, discriminatory standards, pre-shipment G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 4 223 inspections, rules of origin to qualify for lower FIGURE 4.1.4 The main features of the TPP tariffs, investment measures (e.g. local content The TPP is primarily focused on reducing the restrictiveness of non-tariff requirements), and local sourcing for government measures (NTMs), but also incorporates provisions to cut tariffs. The use of procurement. In addition, the TPP will facilitate restrictive NTMs is more prevalent in TPP advanced market economies, supply chain integration by encouraging greater with a higher incidence of restrictive NTMs and lower incidence of less restrictive NTMs. regional coherence in standards and regulations. A. Intra-TPP tariffs B. Average intra-TPP non-tariff Tariff and non-tariff measures measures by ad-valorem equivalent size Although both tariffs and restrictions caused by non-tariff measures between many TPP members are already low by historical and international comparison, the currently negotiated TPP, would over time eliminate nearly all of tariffs among its members, including very high ones such as the 350 percent tariff on US tobacco imports (Oliver 2015). Also, it would lower trade barriers associated with sizeable non-tariff measures in many member countries (Figure 4.1.4). C. Foreign value-added share of D. Distribution of non-tariff barriers by exports ad-valorem equivalent size Partly due to the general decline in worldwide tariffs, but also because of the proliferation of free trade agreements among TPP countries, average intra-TPP tariffs have more than halved since 1996, to 2.7 percent in 2014 from 5.6 percent in 1996. Much of TPP trade is already covered by trade agreements, including NAFTA; the ASEAN Free Trade Area; the free trade agreement between ASEAN, Australia, and New Zealand; the free Sources: International Trade Center MACMAP database; Kee et al. (2009) trade agreement between ASEAN and Japan; and D. AM = TPP advanced market economies (Australia, Canada, Japan, New Zealand, Singapore, the P4 Agreement. 1 United States), EM = TPP emerging and frontier market economies (Brunei, Chile, Malaysia, Mexico, Peru, Vietnam). These averages, however, hide some high tariff barriers on individual goods. Product lines with average tariffs exceeding 15 percent—sometimes dubbed “international peaks”—often protect key only moderately restrictive NTMs (from zero to domestic interests or industries (UNCTAD, 10 percent) and a lower incidence of highly 2000). In the United States and Canada, peaks restrictive NTMs (greater than 100 percent) than comprise 3-5 percent of tariff lines. Some other countries. Within the TPP group, NTMs advanced countries still apply very high tariff rates are more restrictive in Asia than in North America on imports of certain items. Peru and Chile, in and Latin America. Studies have noted that more contrast, have zero peak tariffs. restrictive NTMs have partially offset lower tariffs Restrictions caused by NTMs, measured as ad- in advanced economies (Kee, Nicita and Olarreaga valorem equivalents, appear to be less prevalent 2008). That said, assessing NTMs and their among TPP member countries than elsewhere. impact is particularly fraught with uncertainty TPP member countries have a higher incidence of since data on the existence of restrictive NTMs are highly uneven. Unlike tariffs, data on the intensity of NTMs is typically only inferred from bilateral 1 e P4 agreement between Brunei, Chile, Singapore, and New trade flows. Zealand came into force in 2006. 224 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 Development of production and supply • Labor and environment. Standards for labor chains and environmental sustainability are politically contentious. What some interpret In addition to promoting comprehensive market as civil rights and sustainability concerns are access by reducing tariffs and the restrictiveness of seen by others as hidden protectionism and NTMs, the TPP seeks to facilitate the restrictions on competition (Lukauskas et al. development of supply chains among its members. 2013). The TPP seeks to incorporate Supply chain integration has deepened rapidly International Labor Organization (ILO) since 1995, raising the share of foreign value obligations, require domestic laws to be added in TPP member countries’ exports. TPP consistent with international standards, and member countries’ share of foreign value added in provides for enforcement. Environmental exports ranges from 15 percent in advanced standards introduced in the agreement address countries such as the United States, Australia, and illegal wildlife trafficking, logging and fishing. Japan, to 40 percent in Singapore and Malaysia They also include provisions on conservation, (Figure 4.1.4). The upper end of this range is high biodiversity, protecting the ozone layer and by international comparison, and broadly in line environmental goods and services. with foreign content shares in Eastern Europe, which is deeply integrated into Western European • Intellectual property rights. The TPP goes supply chains (OECD 2015).2 The expertise of somewhat beyond the WTO’s TRIPS advanced country firms—at either the marketing agreement. It requires penalties for the end of the chain, or in providing crucial unlawful commercial exploitation of production technologies at the upstream end of copyrighted work, and prescribes measures to the chain—could contribute to the development reduce the illegal online distribution of of more complex value chains (Humphrey and copyrighted material and strengthen copyright Schmitz 2002; Kowalski et al. 2015). Conversely, terms.4 Some of the IP-related TPP provisions supply chains also create interdependencies that are highly controversial, including those for can accelerate the transmission of shocks. biologics and trademarks.5 Proponents argue that strong rules and enforcement are Supply chains involve the close coordination of necessary in order to support investments in production decisions among different locations. innovation, whereas critics maintain that They depend on rapid and reliable ways for current levels of IP protection already stifle shipping goods, making investments, and innovation and generate monopoly rents.6 transferring information. Attracting supply chains There is also a concern that greater IP to an economy requires good physical connectivity protection will raise the cost of necessary through ports, roads and telecommunications— medicines (Hersh and Stiglitz 2015; Stiglitz along with policies that facilitate trade in 2008; Gosselin 2015). intermediate products and services, as well as foreign investment. Research suggests that liberal service sector rules are especially important, since Declaration of the Macroeconomic Policy Authorities of Trans- high-quality logistics, transportation, financial and Pacific Partnership Countries) that addresses unfair currency practices by promoting transparency and accountability. consulting services help to support supply chain 4IP provisions lengthen copyright terms, protect clinical data connections (World Economic Forum, 2012). developed by pharmaceutical firms from being used by competitors for a certain period of time, and set transparency standards for choosing medicines for reimbursement by national health plans. The TPP also includes social and environmental 5 e debate around biologics (drugs and vaccines created from provisions that may impact trade and production living organisms) centers on data developed by the innovator to demonstrate the safety and effectiveness of a product. e US was chains:3 reportedly seeking 12 years of data protection while the agreement settled on five years plus additional commitments by some members. 2Foreign value added accounts for 45-49 percent of exports in 6See Pugatch (2006) for a review of legal and political economy Hungary, Czech Republic, and Slovak Republic (OECD 2015). issues associated with this debate; and Boldrin and Levine (2013) for 3In addition, for the first time in the context of a free trade a critical view of the economic benefits of patent protection. agreement, countries have adopted a Declaration ( e Joint G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 4 225 Although not explicitly modelled in this study, the What are the potential harmonization of labor and environmental standards within the TPP could have important macroeconomic implications for participating developing implications of the TPP? countries, such as Malaysia, Mexico, Peru, and Vietnam. While such harmonization, which goes The estimations are based on a computable beyond product standards to encompass general equilibrium model as originally described production process standards, has social and in Zhai (2008). Annex 4.1.1 provides details of environmental benefits, it may also affect the analytical approach. The model is particularly competitiveness of firms in countries that well suited to analyzing trade policies and trade currently do not meet such standards. Trade- links because it allows the emergence of trade in related product standards typically apply only to products which were not previously traded products destined for specific destinations, and a between pairs of countries. While the model has firm can choose whether to meet them. However, some dynamic features (through savings and labor and environmental standards apply across investment), it lacks positive dynamic feedback the board to all production, including that loops in member countries such as the destined for consumption at home and in non- accumulation of knowledge and the absorption of TPP countries, and compliance is mandatory (and foreign technology through TPP-facilitated FDI. subject to dispute settlement).7 As a result, the benefits derived here could underestimate the eventual impact on member Some of these broader provisions, including labor, countries. Conversely, TPP-triggered productivity environmental, pharmaceutical and state-owned increases in member countries could undermine enterprise regulation, may require deep reforms the competitiveness of non-member countries and and a difficult adjustment process in member exacerbate the detrimental effects on countries. They are not modelled in the approach non-members. taken here, but could affect aggregate gains if fully implemented. For example, state-owned enterprise The results rest on planned tariff cuts in reform could generate significant productivity accordance with the provisions of TPP and on gains; tightened labor and environmental several key assumptions about the theoretically regulation could reduce competitiveness and GDP desirable and politically feasible non-tariff barrier gains but achieve other regulatory objectives (Box cuts, dubbed “actionable,” and the actual cuts 4.1.1). Similarly, free trade agreements are often implemented in the TPP. The macroeconomic followed by tariff reductions for non-members, implications of the TPP are evaluated relative to a which are not modelled here (Estevadeordal, baseline scenario that includes pre-existing trade Freund and Ornelas 2008; Freund and Ornelas agreements among member countries (e.g. 2010). Policy changes in non-members could NAFTA, AFTA, the ASEAN-Australia-New enhance the benefits of TPP to them (Ciuriak and Zealand FTA, the ASEAN-Japan FTA and the P4 Singh 2015). Agreement). Three assumptions are of particular importance to the results: the restrictiveness of new rules of origin, cuts in barriers to services, and spillovers from regulatory harmonization.8 • “Cumulative” rules of origin could encourage 7See Mattoo (2001). A review of the literature finds no clear regional production networks but may require empirical evidence that adherence to stronger labor standards has a significant impact on trade performance (Salem and Rozental 2012). However, there is some evidence that certain types of envi- 8A further assumption is that the agreement will be implemented ronmental regulation can adversely affect productivity (e.g., Green- in 2017. However, the agreement has yet to be ratified by all its stone, List and Syverson 2012). members. 226 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 4.1.5 Aggregate impact of TPP: GDP and trade United States (e.g. provisions pertaining to by 2030 greater transparency and enforceable negative TPP is expected to increase member country GDP and exports. The lists). Therefore, the fraction of actual estimated impact on non-member country GDP is negligible, on average, reductions in actionable services barriers is although some East Asian countries could face declining exports. assumed to be similar to that observed in the A. Change in GDP: TPP members B. Change in GDP: Non-members agreement between Korea and the United States. • Non-discriminatory trade liberalization (positive spillovers) will be a byproduct of the TPP, to some extent, as common and more transparent regulatory approaches also facilitate trade of non-members with TPP members (Box 4.1.1). Many TPP provisions that are designed to reduce the restrictiveness C. Change in trade: TPP members D. Change in trade: Non-members of NTMs focus on increasing the transparency and predictability of regulations, and still others require policies (such as rules for government procurement or electronic commerce) that are not easily restricted to members. Provided these provisions are fully implemented in a non-discriminatory manner, they will benefit members and non-members alike. At an aggregate level, 20 percent of NTM liberalization adopted in the TPP is Source: Authors’ simulations. assumed to consist of such non-discriminatory some producers to replace more inputs with provisions. Although the debate on the precise higher-cost inputs from TPP members to number is not yet settled, this is at the low qualify for low TPP tariffs. The rules of origin end of assumptions used in other studies affect the share of exports that benefit from based on business surveys (European tariff preferences. These shares are assumed to Commission 2013).9 rise from 30 percent to 69 percent over a decade in the case of apparel, but more Overall member country impact. e model quickly for other products. The model simulations suggest that, by 2030, the TPP will assumes that rules of origin lead to the raise member country GDP by 0.4-10 percent, replacement of 40 percent of imported inputs and by 1.1 percent, on a GDP-weighted average with higher-cost regionally originating ones, basis (Figure 4.1.5). The benefits are likely to on average. materialize slowly but should accelerate towards the end of the projection period. The slow start • Existing services barriers are estimated indirectly results from the gradual implementation of the from bilateral trade flows (Fontagne, Guillin agreement and the lag required for benefits to and Mitaritonna 2011). Only half of these materialize utilization rises. The benefits of the estimated barriers are assumed to be TPP would mostly derive from reductions in non- actionable through policy changes, and only a tariff-based measures and measures that benefit part of those are assumed to be eliminated by 9European Commission (2012) in the study of the EU-Japan FTA the TPP. While this fraction will depend on assumed that 65 per cent of NTM reductions yield benefits for third actual implementation, a preliminary countries, while 35 per cent of any reductions deliver a strictly bilat- assessment of the TPP suggests that the eral benefit, an assumption based on the examination of barriers identified with a business survey in Copenhagen Economics, 2009. provisions are broadly in line with those in the European Commission (2013) in the analysis of TTIP applies the existing agreement between Korea and the assumption of 20 per cent spillovers to non-members. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 4 227 services.10 For TPP members, only 15 percent of FIGURE 4.1.6 Country specific impact of TPP: GDP and the GDP increase would be due to tariff cuts, trade by 2030 whereas cuts in NTMs, in goods and services, Vietnam and Malaysia would be among the TPP member countries would account for 53 percent and 31 percent of benefiting most. As a result of shrinking market access and greater the total increase in GDP, respectively.11 competition in export markets, activity in Korea and Thailand could be set back. Non-member countries like Russia could benefit from greater harmonization of standards in export markets. Individual member country impact. The largest gains in GDP are expected in smaller, open A. Change in GDP: TPP members B. Change in GDP: Non-members member economies, such as Vietnam and Malaysia (10 percent and 8 percent, respectively).12 Both countries would benefit from lower tariffs and NTMs in large export markets and at home and from stronger positions in regional supply chains through deeper integration (World Bank 2015b). The impact on NAFTA members (all also members of TPP) would be small, on the order of 0.6 percent of GDP, C. Change in exports: TPP members D. Change in exports: Non-members because trade represents a modest share of GDP and because existing barriers to their trade (which is already mostly among them) are already low for the most traded commodities. Non-member impacts. Since almost half of trade is among TPP member countries, trade diversion effects could be limited (Figure 4.1.4). Non- discriminatory liberalization effects (positive spillovers) account for 21 percent of the gains of Source: Authors’ simulations. Note: “LAC nei” includes Argentina, Bolivia, Brazil, Costa Rica, Ecuador, Guatemala, Honduras, Rest members and 42 percent of estimated global gains, of the Caribbean, Nicaragua, Panama, Rest of Central America, Paraguay, El Salvador, Uruguay, reflecting improved regulatory processes and the Venezuela RB, Rest of North America, Rest of South America.“Asia nei” includes Bangladesh, Kazakhstan, Kyrgyz Republic, Mongolia, Nepal, Pakistan, Rest of South Asia, Rest of Former Soviet streamlining and harmonization of NTMs and Union, Rest of Western Asia, Sri Lanka. “EAP nei” covers: Cambodia, Lao PDR, and Rest of Southeast Asia. “SSA” indicates Sub-Saharan Africa. investment barriers among TPP members. As a result, aggregate GDP losses to non-members could be of limited size (0.1 percent by 2030). markets (Figure 4.1.6).13 While the adverse Only in Korea, Thailand and some other Asian effects of TPP on Korea could be attributed countries, the estimated GDP losses would exceed mostly to preference erosion (due to its existing 0.3 percent of GDP since they would lose FTA with the United States), losses for Thailand competitiveness in TPP members, which are and other Asian countries could be mainly due to currently among their most important export trade diversion. This supports similar concerns raised for Asian LDCs not individually considered here, such as Bangladesh, Laos, 10Some agricultural NTMs are grouped with tariff cuts in these Cambodia and Nepal (Lehmann 2015). These calculations. 11Despite overall long-term gains, member countries could experi- countries with strong comparative advantage in ence sizeable adjustment costs and transitional losses in the short run sectors such as apparel, textiles and footwear (Trefler 2001). In principle, factor reallocation triggered by trade liberalization can be disruptive. However, in the TPP agreement could face greater competition by Vietnam in reductions in nontariff measures and implementation of common TPP markets. For Russia, positive spillovers regulatory practices are back-loaded and so will be any transition could slightly outweigh trade diversion effects. effects and gains from TPP. 12Vietnam’s textile and garment exports are expected to expand 28 While aggregate output effects among non- percent by 2030, following the reduction of tariffs of up to 8.7 members would likely be limited, the TPP could percentage points in export markets such as the United States e impact on Malaysia is slightly higher than estimated in Petri, 13EAP nie (not elsewhere included) covers Lao PDR, Cambodia, Plummer and Zhai (2012) due to several updates to data and assumptions as explained in more detail in Annex 4.1.1. Myanmar and Timor Leste. 228 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 4.1.7 Impact of TPP on sectoral output by 2030 sectors of non-member economies towards services sectors. Skilled labor intensive sectors (such as chemicals, vehicles and machinery) are likely to expand faster in some advanced economies, while unskilled labor intensive (such as textiles, apparel and metal products) Sectoral shifts within TPP area. Although the sectors are likely to expand faster in some emerging and frontier market TPP is unlikely to affect overall employment in member countries. the long run, it may accelerate structural shifts between industries based on comparative advantage and scale economies.14 In advanced economies, these mechanisms favor traded services, advanced manufacturing, and, for some resource-rich countries, primary products and investments. In developing countries, they benefit manufacturing, especially in unskilled labor- intensive industries, and some primary production. As a result, participating advanced economy members are likely to experience a slight increase in skill premia while others benefit from a higher increase in the wages of unskilled workers (Figure 4.1.7). In the United States, for example, changes in real wages are expected to be small as unskilled and skilled wages increase by 0.4 and 0.6 Source: Authors’ simulations. Note: Skilled or unskilled labor-intensive industries are defined depending on whether they are above percent, respectively, by 2030. In contrast, in or below the average skill intensity across the sample, respectively. Vietnam, TPP could increase the real wages of FIGURE 4.1.8 Comparing TPP to other trade agreements unskilled workers by more than 14 percent by 2030, as production intensive in unskilled labor (e.g. textiles) shifts to Vietnam. The estimated impact of TPP on member country GDP—broadly in line with earlier studies—could be similar to impacts of other large regional trade agreements. Comparison with other studies. Results reported here are broadly consistent with those of other A. Long-term impact of major RTAs B. Estimated impact of TPP on mem- on member country GDP ber country GDP studies, although estimating the impact of deep and comprehensive trade agreements is still very much a work in progress. The few studies that assess the economic impact of TPP find overall impacts for members on the order of 0.8-1.8 percent of GDP. This would be similar to those estimated for existing RTAs: in the long run (15- 20 years), NAFTA has been estimated to have raised member country GDP by 1-2 percent, and the European Single Market has been estimated to Sources: Cecchini (1988), Campos et al. (2014), Harrison et al. (1994), Baldwin (1989), Marinello et have lifted member country GDP by 2-3 percent al. (2015), Vetter and Bottcher (2013); Brown et al. (1992), Cox and Harris (1992), Hufbauer and Schott (1993), Peterson Institute (2014); Kawasaki (2014), Lee and Itakura (2014), World Bank (Figure 4.1.8).15 (2015), Petri et al. (2014). A. Red dots denotes the average estimate among a number of studies; blue bars denote range. 14Trade agreements may lead to small increases in employment if Studies include for EU: Cecchini (1988), Harrison et al. (1994), Baldwin (1989), Marinello et al. (2015, excluding their highest estimate), Vetter and Bottcher (2013); for NAFTA: Brown et al. (1992), Cox they raise wages and the supply of labor responds positively to wage and Harris (1992), Hufbauer and Schott (1993), Peterson Institute (2014); for TPP: Kawasaki (2014), increases. However, theory does not argue for strong (or even Lee and Itakura (2014), World Bank (forthcoming), Petri et al. (2014). Studies differ in methodologies. positive) labor supply effects, and empirical estimates of labor supply Depending on the study, the period of coverage considers either comparative static effects or long elasticities are generally low (OECD, ITO, World Bank 2010). run (15-20 years) effects. 15Figure 4.1.8 also include estimates for the European Single Market of outlier studies such as that of Campos et al. (2014) that induce significant sectoral shifts. In particular, estimates that EU GDP per capita would be 12 percent lower on average in the absence of EU integration. A more selective recent competition from TPP member countries may review identifies the 2-3 percent range as most persuasive (Vetter and shift resources away from the manufacturing Böttcher 2013). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 4 229 Conclusion countries see the liberalization required by the TPP as a driver for difficult policy changes. However, This analysis discussed the features of new- implementation of MRTAs, including the TPP, generation free-trade agreements and TPP, requires institutional capacity not available to specifically, and traced out potential some developing countries (Michalopoulos 1999; macroeconomic implications for member and non Hoekman et al. 2003). As the TPP is implemented -member countries. As a new-generation, deep and over time, emphasis on the following issues would comprehensive trade agreement, TPP addresses a be important to mitigate unfavorable effects on wide range of complex trade policy issues that go developing countries: beyond the scope of traditional trade agreements. The agreement will reduce tariffs and • Capacity building. Capacity building and restrictiveness of non-tariff measures as well as technical assistance for developing country harmonize a range of regulations to encourage the members are an important building block of integration of supply chains and cross-border the TPP. investment. • Liberal rules of origin. TPP members and non- TPP could be an important complement to other members will benefit if rules of origin policies to lift medium-term growth: mandating higher-cost inputs from TPP members are implemented in a permissive • By shifting resources towards the most rather than restrictive manner. productive firms and sectors and expanding export markets, TPP has the potential to lift • Liberalize labor- and resource-intensive overall GDP of member countries by 1.1 industries. Low- and middle-income economies percent by 2030. The impact could be often have a comparative advantage in labor- considerably more in countries facing and natural-resource intensive industries. By currently elevated barriers to trade (as much as cutting tariffs for labor-intensive garments, the 10 percent in Vietnam and 8 percent in TPP thus benefits countries like Vietnam. Malaysia). In countries that export labor- intensive products, incomes of low-income • Multilateral framework. Bringing MRTAs into a and low-skilled households could expand global framework would broaden the gains to strongly. a wider set of countries and reduce detrimental diversion effects for non-members. • To the extent that the TPP produces positive Implementation of the “living agreement” spillover benefits for other countries, clause that keeps TPP membership open is detrimental effects on non-member countries particularly important. may be limited. Such positive spillovers could Against the background of slowing trade growth, arise from harmonized regulatory regimes in rising non-tariff impediments to trade, and TPP export markets. insufficient progress in global negotiations, the • TPP could also lift member countries’ trade TPP represents an important milestone. The TPP by 11 percent by 2030. This would be an stands out among FTAs for its size, diversity and important counterweight to the trade rulemaking. Its ultimate implications, however, slowdown underway since 2011. At current remain unclear. Much will depend on whether the 2011-14 trends, member countries’ trade TPP is quickly adopted and effectively would fall 25 percent below pre-crisis trend by implemented, and whether it triggers productive 2030. reforms in developing and developed countries. Broader systemic effects, in turn, will require Policy reforms are needed to enhance the benefits expanding such reforms to global trade, whether of TPP—like other RTAs—in developing through TPP enlargement, competitive effects on countries. Governments in several member other trade agreements, or new global rules. 230 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 BOX 4.1.1 Regulatory convergence in mega-regional trade agreements TPP aims to promote a common regulatory approach, either through mutual recognition agreements or outright harmonization. Benefits for members and non-members tend to be higher when members choose mutual recognition and rules of origin are not restrictive. Introduction preferential trade agreements, with its almost exclusive focus on tariffs and (sometimes) quotas, provides only Trade policy makers like to think of standards as the limited illumination on the implications of agreements on seabed rocks that are revealed as the tide of tariffs ebbs. standards. Baldwin (2000) presented a useful analytical Not surprisingly, the European Union and the United framework for the analysis of mutual recognition States, with their relatively low tariffs, have decided to agreements (MRAs), but assumed identical countries with address the trade impact of mandatory standards—referred identical costs of complying with standards. Few previous to formally as Technical Barriers to Trade (TBT) and, studies have empirically explored the impact of shared when they concern food safety and animal and plant standards on trade (e.g., Swann et al. 1996, Moenius health standards, as Sanitary and Phytosanitary (SPS) 2004, Shepherd 2007, Reyes 2011, and Orefice et al. measures—in the context of the prospective Transatlantic 2012). Trade and Investment Partnership (T-TIP). To a more limited extent, the diverse group of countries that has just This box draws on one of the few papers to analyze the concluded the Transpacific Partnership (TPP) have also implications of preferential agreements on standards decided to adopt a “common regulatory approach” in (Chen and Mattoo, 2008). It addresses the following certain respects. For the most part, the TPP initiates a questions pertaining to a common regulatory approach: cooperative process rather than an obligation of early implementation. Would all countries, within and outside • How could it be implemented? the TPP, benefit from these developments? • What are its implications? Whereas the T-TIP has an ambitious agenda on regulatory convergence, parties to the TPP have settled on a dual • What policy choices would ensure that it produces approach. First, they have agreed on “transparent, non- wider gains? discriminatory rules for developing regulations, standards and conformity assessment procedures, while preserving How could a common regulatory approach be TPP Parties’ ability to fulfill legitimate objectives.” In this implemented? respect, the TPP rules broadly reflect, and in fact, directly incorporate some of the main rules already contained in Based on earlier experience, notably in the European the WTO, TBT, and SPS agreements. In specific sectors, Union, three broad types of agreements are available to the Parties have also agreed to promote a more streamlined deal with technical barriers to trade. The TPP seems to regulatory approach across the TPP region. The sectors place emphasis primarily on the third type of agreement selected for such an approach include cosmetics, medical listed below. devices, pharmaceuticals, information and Mutual recognition of existing standards. The simplest, communications technology products, wine and distilled and potentially most powerful, is the mutual recognition spirits, proprietary formulas for prepackaged foods and of existing standards, whereby a country grants food additives, and organic agricultural products. The unrestricted access to its market to products that meet any provisions of the agreement cover labelling requirements participating country’s standards. This was the approach for wine, marketing authorizations for pharmaceuticals, taken in principle by the European Union following the medical devices and cosmetics, and encourage mutual Cassis de Dijon judgment of the European Court of recognition of standards for organic products as well as Justice. Mutual Recognition Agreements (MRAs) are, mutual recognition of conformity assessment of however, not likely to be an option if there is a significant telecommunications equipment. difference in the initial standards of the countries, as What does regulatory convergence as envisaged in the T- became evident in the context of the European Union. TIP and TPP imply? The voluminous research on Harmonization of standards. In such cases, a certain degree of harmonization is a precondition for countries to Note: is box was prepared by Aaditya Mattoo. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 4 231 BOX 4.1.1 Regulatory convergence in mega-regional trade agreements (continued) allow products of other countries to access their markets. firms from other countries, then the former can suffer a The most important example of such harmonization is the decline in exports to the integrated market when current approach of the European Union where directives harmonization raises some destination countries’ from the European Commission set out essential health standards. and safety requirements for most regulated products. Available evidence suggests that harmonization within the Mutual recognition of conformity assessments of EU tended toward the high range of initial standards due requirements. In many other cases, neither mutual to pressure from the EU’s richer members (see Vogel recognition nor harmonization of substantive standards are 1995). For example, in the late 1990s, when the EU deemed feasible or desirable. Instead, countries may choose decided to harmonize standards for aflatoxins (a group of to mutually recognize each other’s conformity assessment toxic compounds produced by certain molds), eight requirements (e.g., Country A trusts Country B to certify member states—including Italy, the Netherlands, and that the products made by Country B conform to Country Spain—raised their national standards substantially. This A’s standards). Examples of such initiatives are the intra- likely caused African exports of cereals, dried fruits, and EU MRAs on some unharmonized industries and the EU’s nuts to Europe to decline by as much as $670 million agreements with a number of other countries. A key (Otsuki et al. 2001). Recent research using firm-level data element of these agreements is the rule of origin. Previous for 42 developing countries also suggests that an increase MRAs between the EU and US and the EU and Canada in the distance between source and destination country specify that conformity assessments done in one of the standards can have an adverse effect on both firm entry MRA countries, in which products are manufactured or into exporting and export volumes (Fernandes et al. 2015). through which they are imported, is accepted throughout the entire agreement region. Other agreements, such as the Mutual recognition of standards. The economic impact of MRAs the EU has concluded with Australia and New an MRA depends critically on the choice of rules of origin. Zealand, impose restrictive rules of origin that require third country products to meet the conformity assessment • Member countries. An MRA of standards is in effect a of each country in the region. downward harmonization of standards since firms are now free to meet the least costly of the initial What are the implications of a common standards: trade is stimulated not only by market regulatory approach? integration but also by the reduced stringency of the standard. The implications of a common regulatory approach depend on the chosen approach. A significant upward • Non-member countries. The implications for imports harmonization of standards can be more detrimental to from third countries differ dramatically with rules of exporters in non-member countries than mutual origin. If the firms of non-participating countries are recognition of standards that avoids restrictive rules of also entitled to access the entire region by conforming origin. to the least costly standard, then they too reap benefits.16 In contrast, if firms of third countries are Harmonization of standards. Harmonization of product denied the benefits of the MRA and must continue to standards implies that firms do not need to create different meet the original standard in each market, they will products for different markets. In the resulting integrated face unchanged absolute conditions but suffer a market, firms can reap economies of scale. These benefits decline in relative competitiveness—and hence a accrue not just to firms of participating countries but also decline in exports to the region.17 to firms in third countries. However, the economic impact 16 e best example of liberal rules of origin is the EU’s regime for of standards harmonization also depends on the level at goods: thanks to the Cassis de Dijon judgment, even the products of a which the harmonized standard is set. The impact on the third country, say a Korean medical device, admitted for sale in one EU firms of a specific country depends on how the costs of country are free to circulate in all EU countries. 17Restrictive rules of origin have proved problematic for some of the meeting the new harmonized level of the standard EU’s previous recognition agreements, such as those governing profes- compare with the benefits from economies of scale in sional-services standards. For example, while a Brazilian orange admitted integrated markets. If firms from some countries incur a for sale in Portugal can be sold throughout the EU, a Brazilian engineer higher cost in meeting the harmonized standard and reap or accountant licensed in Portugal must fulfill separate licensing require- fewer scale economy benefits in integrated markets than ments to work elsewhere in the EU, forcing non-European services pro- viders to endure costly and inefficient bureaucratic procedures. 232 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 BOX 4.1.1 Regulatory convergence in mega-regional trade agreements (continued) Mutual recognition of conformity assessments falls short harmonization) and benefit less from economies of of an MRA of standards in that it does not lead to full scale in integrated markets. market integration. Nevertheless, the MRA of conformity agreements does remove duplicated testing and • Restrictive rules of origin. Mutual recognition with certification procedures and lowers the excess costs that restrictive rules of origin reduces the probability of the firms face in demonstrating compliance of their goods to relevant good being imported from non-members the standards in each country. Whether the benefits are (even more than in harmonization agreements) and restricted to member countries or also accrue to non- reduces trade volumes. In contrast, mutual member countries again depends on the rules of origin. If recognition with permissive rules of origin boosts the firms of third countries are denied the benefits of the likelihood of trade with non-members and enhances MRA, they must continue to fulfil conformity assessment trade volumes (Figure 4.1.1.1). requirements in each market and are likely to suffer a decline in competitiveness relative to firms of member What policy options could ensure gains from a countries. common regulatory approach? Empirical analysis. In order to test the empirical validity Multilateral rules on trade have taken a permissive of these propositions, Chen and Mattoo (2008) approach to regional agreements on standards. While it is constructed a dataset that directly identified policy neither feasible nor desirable to restrict the freedom of initiatives of different types on standards for countries to harmonize or mutually recognize their manufacturing industries in 42 countries over the period standards, more could be done to strike a better balance of 1986-2001. These include all OECD countries and 14 between the interests of integrated and excluded countries. developing countries that are the largest exporters of manufactured goods outside the OECD and account for Even in the absence of international rules, two steps could over 80 percent of non-OECD manufactured exports. The be taken to avert any adverse consequences for third policy measures include each harmonization directive and countries. MRA concluded between the countries in the set. They then estimate the significance of the impacts of these • Favor MRAs, with permissive rules of origin. T-TIP and measures on bilateral trade across countries and over time, TPP members could generally favor mutual controlling for other influences. recognition over harmonization, as long as regulatory objectives are met, and agree not to impose restrictive The limited available evidence broadly confirms the rules of origin. Just as producers in the member intuitive results spelled out above. A common regulatory countries would be able to supply the entire market approach—whether achieved through harmonization or by fulfilling requirements of any member country, so mutual recognition—significantly increases intra-regional would producers in third countries. trade in affected industries. For trade with non-members, however, the implications of harmonization depend on • Balance non-trade objectives with trade losses from more existing standards in non-member countries and of mutual restrictive standards. Where members do consider recognition agreements on the rules of origin. harmonization, they could favor the less stringent of the original standards unless there is credible evidence • Standards in non-member countries. With that these would not meet regulatory objectives. This harmonization, exports of excluded developed is akin to a WTO test for departures from established countries to the region also increase, but exports of international standards. However, such an approach excluded developing countries decline. These may be more feasible in the T-TIP context than in the asymmetric effects may arise because developing TPP context because of much greater divergence country firms are hurt more by an increase in the between the standards of TPP member countries. stringency of standards in some markets (as a result of G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 4 233 BOX 4.1.1 Regulatory convergence in mega-regional trade agreements (continued) FIGURE 4.1.1.1 Implications of a common regulatory approach Mutual recognition without restrictive rules of origin promises the greatest benefits to third countries. A. Impact on the probability of trading with non-members B. Impact on trade volumes with non-members Source: Chen and Mattoo (2008). Notes: ROO = Rules of origin. A. Bars indicate the percentage point increase in the probability that a good is traded as a result of a common regulatory approach (Chen and Mattoo 2008). B. Bars indicate the percent increase in average annual trade volume as a result of a common regulatory approach (Chen and Mattoo 2008). 234 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 Annex 4.1 Methodology Modelling strategy productivity increases from the accumulation of knowledge and other endogenous growth effects, Results are based on a 19-sector, 29-region, TPP-induced inflows of foreign technology and dynamic computable general equilibrium (CGE) capital, and follow-up trade liberalization that may model. CGE models account simultaneously for result from an agreement. Introducing such effects interactions among firms, households, and can dramatically change the results, as governments in multiple product markets—and demonstrated by experiments reported in Todo across several countries and regions of the world (2013). economy. Firms are assumed to maximize profits and consumers to maximize utility. After transfers Retrospective studies have shown that estimates among firms, households, and governments, based on conventional CGE models have under- incomes are spent on goods, or are saved and predicted actual increases in trade (Kehoe, 2005). invested, both at home and abroad. e model e likely reason is that traditional models finds an equilibrium solution by calculating prices projected trade increases only for products already that equate supply to demand for each product exported (the intensive margin of trade), but had and factor of production (labor, capital, and land) no mechanisms for anticipating new trading in every region. e effects of FTAs are simulated activities (the extensive margin of trade) (see by introducing changes in tariffs and other Kehoe 2005, Zhai 2008, Hammouda and parameters, finding a new equilibrium, and Osakewe 2008, Costinot and Rodriguez-Clare comparing new prices, output, trade, income, and 2013). is confirms the need for modeling the demand to pre-change levels. extensive margin of trade in assessing trade agreements as implemented in this study. In Several innovative features of the model are based addition, several previous CGE applications were on a specification as in Zhai (2008). is relies on based on comparative static models with constant the theoretical work of Melitz (2003) and others returns to scale, not incorporating the potential of that recognizes heterogeneity in firms’ FTAs for stimulating investment, capital stock productivity levels, even within narrowly defined growth, and productivity gains (Nielsen 2003, sectors. e model assumes that exports in any Hammouda and Osakewe 2008, Costinot and given sector involve special fixed costs, which only Rodriguez-Clare 2013, Kose, Meredith and Towe the most productive firms in the sector can cover. 2005, Kouparitsas 1998). e present study allows In this setting, FTAs affect not only inter-sectoral for the dynamic accumulation of capital stock via specialization, but also the range of products investment and increases in productivity following traded, and the distribution of firms within entry and exit of firms in increasing returns to industries. Liberalization causes more varieties to scale sectors. It does not however capture the be exported and imported, the expansion of the dynamic growth effects via technological spillovers most productive firms, and the contraction of the and “learning by doing” (Arrow 1962). least productive firms. is specification predicts more trade and greater benefits than conventional Compared to Petri et al. (2012), the modeling approaches based on inter-sectoral specialization framework used here introduces numerous effects alone. updates to the underlying data and modeling specifications. First, the underlying database has e model is dynamic in the sense that been updated to 2011 (compared to 2007 in the simulations track changes in the volume of previous study) to incorporate not only savings, which affects capital accumulation over macroeconomic changes but also updated tariff time. However, the model does not include other information. Baseline projections are updated dynamic factors proposed in the literature, such as (World Bank 2014; World Bank, forthcoming). e estimates also incorporate new trade balance G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 4 235 projections (IMF 2015). Second, based on the more than that for some commodities and in latest news about the TPP, the published TPP early stages of the agreement. For large tariffs agreement, tariffs and the scoring of NTM cuts, for which the preference margin changes provisions have been updated. Finally, the by more than 5 percentage points, the effect updated results include, as explained below, of tariffs cuts is reduced by only 10 percent revised non-tariff barriers and limited non- (rather than 31 percent) in the long run. discriminatory liberalization effects (positive spillovers). • Rules of origin. To qualify for preferential intra-TPP tariffs, TPP member countries need Assumptions to comply with sector-specific rules of origin, which require a minimum share of inputs e results rest on a number of key assumptions, from inside the TPP.1 On the surface, rules of which are elaborated in more depth below. Tariff origin are particularly stringent for garments and non-tariff cuts are benchmarked against and apparel (“yarn forward”); however, a existing trade agreements. Since cross-country data number of exceptions soften the impact. Rules is scarce, assumptions about utilization of of origin in automotives, in contrast, appear preferential tariffs are based on eclectic survey less restrictive than in the agreement between information. the United States and Korea (45 percent within-TPP content compared with 55 Tariff cuts. The results incorporate the full, percent in the Korea-U.S. agreement). Again, published schedule of tariff cuts under the TPP the impact is mitigated by a revised definition agreement. ese commit the eventual elimination of domestic and foreign content. As a result of of nearly all tariffs, including on major imports rules of origin, where the tariff reduction is into the United States (such as textiles and high, some inputs may now be sourced from apparel) and developing countries (such as motor within the TPP membership, replacing lower- vehicles). Sixty percent of these tariff cuts will cost inputs used earlier. e fraction of inputs enter into force immediately, but a few, like those thus replaced is estimated to depend on the on trucks imported by the United States, are very tariff preference margin and the economic size back-loaded. ese potential tariff cuts are, (GDP) of the membership of the agreement, however, de facto mitigated by (i) less than full since larger agreements are more likely to utilization rate of preferential tariffs and (ii) include more efficient input suppliers (Petri additional costs to meet rules of origin and Plummer forthcoming). Specifically, for requirements. 40 percent of inputs, costs are assumed to rise by 10 percent of the tariff reductions offered • Utilization rate of preferential tariffs. As by the agreement. demonstrated by prior bilateral agreements, preferential tariff rates are seldom fully utilized Actionable non-tariff measures. NTMs for goods due to either restrictive rules of origin, the and services sectors are constructed from the high cost of compliance compared to benefits estimates of Kee, Nicita, and Olarreaga (2009), from preferential rates, or low initial tariffs. updated to 2012 for goods, and from estimates by e exercise here assumes that less than full Fontagne, Guillin, and Mitaritonna (2011), for utilization of preferences will reduce the services. ree-quarters of these measured effective tariff cuts from TPP membership. A barriers—which include regulations that increase formula is constructed to estimate utilization consumer welfare—are assumed to be rates based on the preferential tariff margin impediments to trade and subject to reduction and the size of the TPP relative to other agreements for which some survey data is 1For example, the “yarn forward” rule of origin requires a TPP available (Petri et al. 2012). As a result, the member to use a TPP member produced yarn in textiles in order to effect of tariff cuts introduced by TPP are qualify for duty-free access. ese ”yarn forward” rules in apparel seem restrictive, while rules of origin in automobiles are more liberal reduced by 31 percent in the long run, and by according to the text of the TPP agreement. 236 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE A.4.1.1 Modeling assumptions similar to that in the Korea-US agreement, with some modifications based on analysis of the TPP Key modeling assumptions relate to cuts to tariffs and NTBs. On average, text. is fraction is derived—for 21 separate the liberalization of tariffs is assumed to be more front-loaded, and that of NTBs more back-loaded. Sectors such as apparel are relatively more issues areas—based on a score from 0-100, with a protected by tariff measures, processed food more by NTBs. higher score indicating larger reductions in trade barriers by TPP compared with existing FTAs A. Intra-TPP average tariffs B. Restrictiveness of intra-TPP non- (Figure 4.1.1). e issues areas range widely from tariff measures on goods government procurement, dispute settlement, and environment to tariffs and customs procedures. Non-discriminatory liberalization (positive spillovers). As noted above, some of the bilateral reductions in the restrictiveness of NTMs and investment barriers that countries make under an agreement are assumed to reduce barriers also against countries not participating in the agreement. ese include especially efforts to C. Restrictiveness of intra-TPP non- D. Scoring provisions: where agree- improve the transparency and predictability of tariff measures on services ments have greatest impact regulations and mechanisms to bring together regulators to encourage streamlining of regulations. Estimates of this “spillover” ratio range from 20 to 65 percent in the literature (Francois et al. 2013, Kawasaki 2014); the exercise here uses the low end of this range, or 20 percent. Largest cuts.2 ese assumptions yield the highest tariff cuts in sectors such as apparel, where on average intra-TPP trade weighted tariffs decline by Source: Petri and Plummer (forthcoming). A. B.“Other agr.” = other agricultural products, “Electrical” = electrical equipment, “Transport” = 8.8 percentage points. With respect to reductions transport equipment, and “Other mfg.” = other manufacturing. Restrictiveness of non-tariff measures is defined as tariff equivalent. in the restrictiveness of NTMs, the largest are in D. Scores range from 0 to 100, with 100 indicating full elimination of actionable barriers and 0 indicat- ing none. goods such as apparel, textiles and processed food (cuts by 7.2, 5.0 and 5.4 percentage points, through trade policy, with the rest representing respectively), and construction and private services quality-increasing regulations. Further, only three- (cut by 8.0 and 8.5 percentage points, quarters of the remaining NTMs in the case of respectively). In contrast, reductions would be goods, and only one-half in the case of services, are marginal in mining. On average, the liberalization assumed to be politically feasible in a trade of tariffs is assumed to be more front-loaded, and agreement (i.e., “actionable”). that of the restrictiveness of NTMs more back- loaded. ese reductions in the restrictiveness of Actual NTM reductions. The rationales laid out NTMs are based on the assumption of the degree above derive the theoretically desirable and of implementation consistent with Korea-US politically feasible reductions in the restrictiveness FTA. In the event actual implementation is of NTM. However, trade negotiations do not incomplete, the likely gains from TPP could be necessarily achieve full liberalization of actionable significantly diminished. barriers. A preliminary assessment suggests that the provisions in TPP resemble those in the agreement between Korea and the United States. While the actual impact depends on the degree to 2 ese cuts are shown in effective terms, i.e. adjusting for expected which these are implemented, the assumption is use of the tariff cuts by exporters. that the fraction of actionable NTM reductions is G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 4 237 Peg and Control? The Links between Exchange Rate Regimes and Capital Account Policies In a context of rising risks, choices with respect to exchange rate regimes and capital account policies are of key importance for emerging and developing countries. is essay explores the empirical links between a country’s choice of currency regimes and of capital flow measures. e results suggest that developing countries appear to be more likely to have capital flow restrictions if they also have fixed exchange rates. is effect is particularly pronounced for lower-income countries, suggesting complex policy choices with respect to exchange rate regimes and capital flow measures. Introduction options in countries where exchange rate fluctuations have a rapid impact on inflation or e outlook for emerging and developing where inter-sectoral factor mobility is limited countries is clouded by various downside risks, (Ostry, Ghosh, and Chamon 2012). Conversely, a including a deterioration in global financial fixed exchange rate regime can serve as a conditions, sudden reappraisal by market stabilizing nominal anchor in the presence of participants of lingering domestic vulnerabilities, financial volatility. It can also boost trade, which and adverse spillovers from weaker growth may offset weakness in external demand (Rose (Chapter 1). Should one or more of these risks 2000; Rose and van Wincoop 2001; Frankel and materialize, they could have significant effects on Rose 2002; Klein and Shambaugh 2006). economic conditions in many emerging and However, in the presence of high capital mobility, developing countries. ese effects may include a fixed regime may require the central bank to large currency depreciations in some countries direct monetary policy towards the maintenance with flexible exchange regimes, reserve losses in of the peg rather than towards the promotion of some countries aiming to preserve exchange rate economic activity (Frankel, Schmukler, and pegs, and restrictions on capital mobility in some Serven 2004; Shambaugh 2004; Obstfeld, countries facing capital flight. More generally, Shambaugh, and Taylor 2010; Klein and how countries fare and how policymakers respond Shambaugh 2015). to the realization of these risks will depend on a A country’s choice of capital flow measures can wide range of factors, but two macroeconomic affect the performance of asset markets, the cost of policy choices play fundamental roles: the capital, and technological progress embodied in exchange rate regime (ERR) and the stance foreign direct investment (Henry 2007). More towards capital flows (i.e., the use of capital flow broadly, capital account policies can affect the measures, CFMs). pace of economic growth (Kose, Prasad, Rogoff, and Wei 2009). Accordingly, there have been A flexible exchange rate regime can provide greater extensive discussions about the appropriate role of room for monetary policy to stabilize output capital flow measures. In the wake of the global fluctuations in countries with open capital financial crisis, a case has been made for the use of accounts, as well as encourage a more proper CFMs, recognizing that capital flows can affect the assessment of currency risk. However, it can incidence of boom-and-bust cycles in financial sometimes be associated with volatility in currency markets. e effectiveness of these policies, markets, which can raise financial stability risks in however, has been the subject of debate.1 countries with significant currency mismatches on balance sheets. It can also restrict monetary policy 1Korinek (2011); Ostry, Ghosh, Chamon, and Qureshi (2011); Jeanne and Korinek (2010); and Jeanne, Subramanian, and Note: is essay was prepared by Carlos Arteta, Michael Klein, and Williamson (2012) argue for the use of capital controls. A more Jay Shambaugh. It is based on materials compiled from its skeptical view of the use of capital controls is presented by Klein background paper (Arteta, Klein, and Shambaugh forthcoming). (2012) and Forbes and Klein (2015). 238 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 e joint choice of exchange rate regimes and What does economic theory capital account policies therefore has important implications for macroeconomic outcomes. While say about the choice of some studies have explored the choice of the ERR ERRs and CFMs? and others have examined the use of CFMs, there has been little empirical analysis on the links e choice of a country’s exchange rate regime can between ERR and CFM choices.2 is essay be based on a variety of theoretical considerations, documents the association between the choices of including the following:3 exchange rate regime and capital account policies in emerging markets, frontier markets, and other • Optimal currency area factors. Policymakers in middle- and low-income countries. While this some countries may weigh the advantages of analysis focuses on emerging and developing pegging—such as more stable trade and countries, it provides some context by including investment flows, particularly vis-à-vis a large data on advanced high-income economies as well. trading partner—against the disadvantages of Specifically, the essay asks three questions: forgoing exchange rate flexibility as a stabilizer for external shocks. • What does economic theory say about the choice of ERRs and CFMs? • Sources of macroeconomic shocks. A small open economy may choose to peg if it is often • What do the data say about ERRs and CFMs? subject to highly volatile shocks to its asset markets or prices. In the face of such • What are the main empirical linkages between “nominal” shocks, a fixed exchange rate could the choices of ERR and CFM? provide a nominal anchor that stabilizes prices and activity (provided that the shock is For this essay, emerging and developing countries temporary). A country may also choose to peg are divided into three groups. e first category is if it faces similar economic shocks to those of Emerging Market Economies—in general, (non- the base country. In contrast, a floating advanced) high-income and middle-income exchange rate can provide greater stability if countries with a record of significant access to an economy is often facing “real” shocks— international capital markets. e second category that is, disturbances to factors that affect its is Frontier Market Economies—generally middle aggregate demand or supply. income countries that are usually smaller and less financially developed than emerging market • Monetary policy independence. e choice of economies and have more limited access to currency regime may reflect an emphasis on international capital markets. e third category the importance of either monetary autonomy, comprises other middle-income countries that are when the central bank is not obliged to direct neither emerging nor frontier markets (and its efforts towards the maintenance of a therefore have little to no access to international pegged regime, or of importing the monetary- capital markets) along with low-income countries. policy credibility of the base country in order to better manage inflationary expectations. e decision of whether, and how, to control capital flows weighs the benefits of a liberal regime 2Research on the choice of ERR includes Leblang (1999); Carmi- with no capital controls against those of an gnani, Colombo, and Tirelli (2008); Klein and Shambaugh (2010); and Berdiev, Kim, and Chang (2012). Research on the use of CFMs environment in which the flow of capital is includes Grilli and Milesi-Ferretti (1995); Quinn (1997); Chinn and managed: Ito (2008); Schindler (2009); and Fernández, Rebucci, and Uribe (2014). Von Hagen and Zhou (2007) is one of very few studies that 3 e choice of currency regime is, of course, time variant, as there explore the interaction between exchange rate regimes and capital have been numerous instances of countries shifting between peg and flow restrictions, finding some influences in both directions between float (Klein and Shambaugh 2008; Ghosh, Ostry, and Qureshi de facto exchange rate regimes and capital account policies. 2015). G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 4 239 • Benefits of freely flowing international capital. FIGURE 4.2.1 Exchange rate regime categories by ese include the scope for an efficient country grouping allocation of capital, risk diversification, and In emerging markets, floating exchange rates are more common than soft consumption smoothing. Countries with pegs or pegs. In frontier markets, pegged exchange rates are the most insufficient savings can draw on world savings common regime. Other middle- and low-income countries have a relatively even distribution across the three regime categories. Advanced to finance the expansion of their capital stock. economies, excluding euro area countries, have a relatively even e world capital market can also help distribution of floats and soft pegs, and a lower incidence of pegs. countries diversify risk and, in so doing, undertake projects that would otherwise not be financed. Also, borrowing during slowdowns and paying back during expansions can help the residents of a country avoid wide swings in their consumption. Free capital flows may also be welfare-enhancing, as capital controls can generate distortions in real and financial activity if they are not properly designed. • Potential downsides of open capital markets. Open capital markets could allow global financial cycles to adversely affect an economy. In this way, a country could lose control over its macroeconomic outcomes. Capital inflows could contribute to an Sources: Obstfeld, Shambaugh, and Taylor (2010); authors’ calculations. unsustainable asset price boom and exchange Notes: MICs = middle-income countries. LICs = low-income countries. This ERR classification uses rate overvaluation. Capital outflows, and exchange rate behavior to see if a country stays within a +/- 2 percent band over the course of a year against a relevant base currency. If so, it is classified as a “peg.” Otherwise, it is a non-peg. To especially a sudden stop, could be a source of a insure the stability is deliberate and not a random lack of volatility, countries that peg for only one currency collapse, financial disruption, and a year are not coded as pegs. To handle one-off realignments, a country that has zero volatility in 11 out of 12 months is also considered a peg (again, as long as it is also pegged the year before or sharp decline in real activity.4 after). Soft pegs are identified as countries that do not maintain the strict boundary, but stay within 5 percent bands or stay within moving 2 percent bands in every month (that is, the change in any given month is never greater than 2 percent). ere may be links across the joint choice of ERRs and CFMs. e importance and extent of these they may choose to use CFMs to stabilize the links may depend upon other factors, such as exchange rate, allowing monetary policy to financial development, openness to trade, and focus on domestic macroeconomic goals sectoral diversification (and, therefore, the (Shambaugh 2004; Obstfeld, Shambaugh, sensitivity of domestic activity to exchange rate and Taylor 2010; Klein and Shambaugh movements). e nature of the interaction 2015). between ERR and CFM is shaped by a number of factors, including the following: • e preservation of a pegged regime. Capital flows may also make the preservation of a • e trilemma. Countries can choose only two of fixed exchange rate more difficult since, under the following three objectives: open capital certain circumstances, capital flight could account, independent monetary policy, and cause a peg to break.5 is suggests another exchange rate stability. us, countries with fixed exchange rates would have to give up 5 ere is a large body of literature investigating why pegged free capital mobility in order to have an exchange rates collapse (Berg, Borensztein, and Pattillo 2005). Fixed exchange rates should probably be easier to maintain if CFMs independent monetary policy. In other words, dissuade speculative attacks. However, the effectiveness of these policies depends on their credibility. If a pegged regime is perceived 4An early theory of sudden stops is presented in Calvo (1998). to be unsustainable and the exchange rate out of line with More recently, Rey (2013) has emphasized the spillover effects of U.S. fundamentals, capital controls may be of limited effectiveness to ward monetary policy and volatility in U.S. asset markets. off financial turmoil. 240 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 4.2.2 Capital control categories by country grouping What do the data say about ERRs and CFMs? Most emerging, frontier, and other developing countries have Partially Open capital accounts, with occasional use of capital controls. Advanced economies are far less likely to use capital controls, and none do so in a Combining two extensive databases on exchange persistent and systematic way. rate regimes and capital flow measures, this analysis uses data on 93 countries over the period 1995 to 2013. Both the country list and the time period are determined by data availability. e set of emerging and developing countries is divided into three categories: 24 emerging market economies, 29 frontier market economies, and 13 other middle-income and low-income countries. For comparison purposes, a fourth category comprising 27 advanced high-income economies is included. (A listing of the countries in each of these four categories is provided in Annex Table 4.1.) Exchange rate regimes e exchange rate regime classification is based on the de facto regime classification from Shambaugh Sources: Fernández, Klein, Schindler, Rebucci, and Uribe (2015), authors’ calculations. Notes: MICs = middle-income countries. LICs = low-income countries. This CFM classification divides (2004) and updated in Obstfeld, Shambaugh, and countries into three groups: “Open,” for countries that almost never use capital controls (the average value of the capital control index over the sample period is less than 0.15, the maximum value in any Taylor (2010) to include a soft peg variable (see one year is less than 0.25, and the standard deviation of the index across time is less than 0.10); “Closed,” for countries that have capital controls in the vast majority of asset categories and for the Annex 4.2 for details on the classification vast majority of years (the average value of capital controls across the sample period is greater than 0.70, the minimum value is greater than 0.60, and the standard deviation is less than 0.10); and methodology). ese studies use actual exchange “Partially Open,” for countries that make use of capital controls occasionally (i.e., countries that are rate movements to classify regimes into pegs, non- neither Open nor Closed are classified as Partially Open). pegs, and soft pegs. Among emerging market economies, floating exchange rate regimes are more common than soft pegs or tightly pegged exchange rates (Figure 4.2.1). ese observations span emerging market economies that have had floating regimes during all or almost all of the link between ERR and CFM, especially for 1995-2013 period (e.g., Turkey, South Africa) controls on outflows relative to inflows if there and those that have had tight pegs during all the is a greater concern about a devaluation than a period (e.g., Qatar, Saudi Arabia, United Arab revaluation. Controls on inflows could also be Emirates). important if they drive currency appreciation (with flexible exchange rates) or an asset price e exchange rate regime choice of frontier boom (with pegged rates). market economies is the mirror image of emerging market economies, with the highest number of • e type of pegged regime. Some of these issues observations being pegs and the fewest number of are conditional on the form of the peg. For observations being floats. In this group, relatively example, if the regime is a credible hard peg few frontier markets have had floating regimes for (e.g., a currency union), monetary autonomy most of the period (e.g., Paraguay, Zambia), while is fully surrendered, and the peg’s preservation several countries have had tight pegs for all 19 is generally not a concern. In this case, capital years of the period (e.g., Bahrain, Cote d’Ivoire, controls may not be as prevalent as in other Lebanon, Oman, Panama). Other middle- and types of fixed exchange rate regimes. low-income countries have an even distribution G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 4 241 across the three exchange rate regime categories, FIGURE 4.2.3 Trade and exchange rate regimes: with a few countries exhibiting floating regimes Frequency distributions for most of the period (e.g., Algeria, Uganda) and Pegged exchange rate regimes appear to be associated with greater trade some countries with tight pegs for all 19 years openness than flexible regimes. The frequency distributions of (e.g., Burkina Faso, Swaziland, Togo). For trade-to-GDP ratios for economies with mostly pegged currencies lie to the comparison, advanced economies, excluding Euro right of those for more flexible currencies. Area countries, have a relatively even distribution A. Trade by proportion of years with B. Trade by proportion of years with of floats and soft pegs and a lower incidence of pegged exchange rates, full sample pegged exchange rates, emerging and pegs. developing country sample Capital flow measures is analysis uses the Fernández et al. (2015) de jure capital control data. These data are used to construct an aggregate capital control indicator as the average of nine categories for both inflows and outflows (see Annex 4.2 for details on the classification methodology). For each country and Source: Authors’ calculations. for each year, the average of inflow controls and Note: These figures present kernel frequency distributions of trade relative to GDP for countries that have pegged exchange rates for less than half the years in the sample (blue lines) and for those that outflow controls for the nine categories of assets is have pegged exchange rates for more than half the years in the sample (red lines). computed. is aggregate indicator takes a value between 0 and 1, with 0 indicating no controls on any category of assets and 1 indicating controls on both inflows and outflows of all nine categories of FIGURE 4.2.4 Trade and capital controls: Frequency assets. distributions Countries that use capital controls occasionally appear to trade somewhat ese data can be used to place countries in one of less than countries that have either no capital controls or those that have three categories with respect to their use of CFMs pervasive capital controls. The frequency distributions of trade-to-GDP ratios for the Partially Open group lie to the left of those for the other (as in Klein 2012). e first category is “Open,” groups. for countries that almost never use capital controls. e second category is “Closed,” for A. Trade by capital control category, B. Trade by capital control category, countries that have capital controls in the vast full sample emerging and developing country sample majority of asset categories and for the vast majority of years. e third category is “Partially Open,” for countries that make occasional use of capital controls. Among emerging and developing countries, the most common classification is Partially Open (Figure 4.2.2). ese include 17 out of 24 emerging markets (including Arab Republic of Egypt, Brazil, Chile, Indonesia, ailand, and Source: Authors’ calculations. Turkey), 15 out of 29 frontier markets (including Note: These figures present kernel frequency distributions of trade relative to GDP for Closed coun- tries (yellow line), Partially Open countries (red line) and Open countries (blue lines). Argentina, Bahrain, Kazakhstan, Kenya, República Bolivariana de Venezuela, and Vietnam), and 7 out of 13 other middle-income and low-income countries (including Algeria, Burkina Faso, Ethiopia, Kyrgyz Republic, and Uganda). In groups, and none do so in a persistent and comparison, advanced countries are far less likely systematic way (that is, none are classified as to use capital controls than countries in the other Closed). 242 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 FIGURE 4.2.5 Financial development and capital Trade openness and financial controls: Frequency distributions development across ERRs and CFMs Open countries appear more likely to be financially developed (have larger financial sectors as a share of GDP) than Partially Open and Closed Pegged exchange rate regimes appear to be countries. The distribution for the Open group of credit-to-GDP ratios is associated with greater trade openness than flexible more skewed to the right than those for the Partially Open and Closed groups for the full sample—but not for the emerging/developing country regimes, in both the full sample as well as in the sample. sample comprised of emerging and developing countries. at is, the frequency distributions of A. Credit by capital control category, B. Credit by capital control category, trade-to-GDP ratios for economies with mostly full sample emerging and developing country sample pegged currencies (red lines in Figure 4.2.3) lie to the right of those for more flexible currencies (blue lines in Figure 4.2.3). In addition, countries that use capital controls from time to time appear to trade somewhat less than countries that have either no capital controls or those that have pervasive capital controls. at is, the frequency distributions of trade-to-GDP ratios for the Partially Open group (red lines in Figure 4.2.4) lie to the left of those for the other groups. Source: Authors’ calculations. Note: These figures present kernel frequency distributions of domestic credit relative to GDP for Open countries appear more likely to be Closed countries (yellow line), Partially Open countries (red line) and Open countries (blue lines). financially developed (have larger financial sectors as a share of GDP) than Partially Open and FIGURE 4.2.6 Pegged regimes and capital controls Closed countries. at is, for the full sample, the distribution for the Open group of credit-to-GDP There is a statistically significant partial correlation between pegged ratios (blue line in the upper panel of Figure regimes and capital controls among emerging and developing countries. 4.2.5) is more skewed to the right than those for the Partially Open and Closed groups. at said, a large literature on financial development and growth suggests that richer countries are more financially developed (King and Levine 1992, Sahay et al. 2015). Since emerging and developing economies tend to have more capital controls than advanced economies, the greater financial development for Open countries may largely reflect the role of advanced economies. Confining the sample to emerging and developing economies, there is indeed no apparent evidence of higher levels of financial development in Open countries—that is, frequency distributions show no discernible difference in the skewness of the Open group (blue line in the lower panel of Figure 4.2.5) relative to the others. Source: Authors’ calculations. Note: Using the emerging and developing country sample, this figure presents the estimate of the partial correlation between the logarithmic transformation of the capital control index and of the peg index, controlling for GDP per capita, GDP, trade share, size of the financial sector, (all of which are expressed as logarithms), and a currency union control. This is the graphical depiction of Column I of Annex Table 4.2. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 4 243 FIGURE 4.2.7 Pegged regimes and capital controls What are the main empirical across per capita income levels linkages between the The association between pegged exchange rates on capital controls varies choices of ERR and CFM? with the level of income per capita for frontier markets and other middle- and low-income countries. However, there is no significant association of this kind for emerging markets or advanced economies. e discussion above suggests that the choice of ERR may predetermine the extent of CFMs. A multivariate regression model, focusing on the sample of emerging and developing countries, is used to estimate the partial correlation between capital controls and pegged exchange rates, while controlling GDP per capita, GDP, trade share, size of the financial sector, and currency union membership (Column I of Annex Table 4.2). e regression estimate shows a positive, statistically significant partial correlation between the extent of capital controls and the propensity to peg (Figure 4.2.6).6 It also shows a statistically significant negative correlation between capital controls and income per capita, and a statistically significant positive correlation between capital controls and both income and trade. Source: Authors’ calculations. Note: This figure shows the total impact of pegging on the likelihood of capital controls at different income levels using the cross country regression reported in Column II of Table 2, by including an e negative relationship between income per interaction between the logarithm of income per capita and the logarithmic transformation of the peg exchange rate variable. The bottom panel of that table shows the partial derivative ∂ ln(kci)/ ∂ ln(pegi) capita and the CFM variable is further explored by for the average levels of income per capita for each of the four categories of countries. In this figure, the thick solid black line shows the estimated value of ∂ ln(kci)/ ∂ ln(pegi) for each level of income per estimating a regression that allows the association capita, and the dashed lines show the 95 percent confidence interval of this estimate. The vertical yellow line at 9.34 shows the point after which this partial derivative is no longer significant at the 95 of the pegged exchange rate on capital controls to percent level of confidence. The points on the solid line show the average values of income per capita vary with the level of income per capita. is is for the four country categories. done by including an interaction term between the GDP per capita variable and the peg variable advanced economies, providing additional (Column II of Annex Table 4.2). ese results also evidence that the effect of peg regimes on CFMs show the effects for the average levels of income are contingent on income per capita.8 per capita for each of the three categories of emerging and developing countries (bottom of Figure 4.2.7 presents the effect of pegged regimes Column II). For comparison, the fourth category on capital controls as a function of income per of advanced economies is also included. is effect capita. e thick solid black line shows the is statistically significant for the average income estimated value of the effect of peg regimes on per capita of frontier markets and other middle- capital controls for each level of income per capita, and low-income countries, but not for emerging and the dashed red lines show the 95 percent market economies.7 It is also insignificant for confidence interval of this estimate. e vertical 6 ese results do not imply causality. And while there are reasons periods also seem to have long standing capital controls. ere is to believe that the ERR may predetermine CFMs, joint weak evidence of a link among countries that switch their ERR determination or reverse causality cannot be ruled out. It may be that or CFM within the sample period (Arteta, Klein, and Shambaugh countries that peg prefer to have capital controls to make it easier to forthcoming). us, it is not clear what one should expect if a maintain the peg or to allow for greater monetary autonomy, or it country frees up its exchange rate peg or dismantles its CFM. In may be that the costs of pegging are lower for countries with capital addition, these results might be highlighting heterogeneity across controls. Alternatively, the positive correlation may reflect ideological developing regions. views of the acceptability of market intervention in both the price of 8Additional robustness analysis using panel data methods foreign exchange and the flow of capital. suggests that factors associated with the nexus between ERR and 7 is association should be interpreted with some care. e results CFM seem to be country-specific and relatively time-invariant primarily come from the cross section: countries that peg for long (Arteta, Klein, and Shambaugh forthcoming). 244 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 line shows the level of per capita income after that policy choices are not independent from which this effect is no longer statistically each other. significant. e points on the solid line show the average values of income per capita for the four • Higher levels of development may allow country categories. e solid line is downward greater discretion to implement some variant sloping, suggesting that the association between of these two policies. Alternatively, countries the capital control and peg indices decreases with that are more financially developed might an increase in income per capita. Moreover, in find it harder to control the capital account emerging market economies (as well as in regardless of currency regime given their advanced economies), there appears to be no high level of international financial statistically significant association between the integration. In this context, attempts to choice of exchange rate regime and the choice of control capital flows would be more likely to capital account policies. fail due to circumventions by market participants. Conclusion • In principle, emerging and developing As emerging and developing countries prepare countries that choose to control both the against various risks besetting the global economy, exchange rate and the capital account may they need to consider policy responses to adjust to still exercise monetary policy autonomy to external shocks. Among these policy responses, stabilize economic conditions (Cordella and some countries might rely on exchange rate Gupta 2015). is is only possible, however, flexibility as a buffer, some might aim to minimize if they have the necessary monetary policy currency fluctuations, and some might consider space—which has generally been narrowing capital flow measures as they seek to keep some recently, amid inflation and foreign reserve degree of monetary policy control. pressures (Chapter 1). Policies concerning the choice of the exchange rate • ese choices could also reflect preferences regime and the use of capital flow measures are among policymakers. ose who have a central to macroeconomic management, especially preference for intervening in the market may in emerging and developing countries. An see both CFM and a fixed exchange rate as empirical exploration using a comprehensive desirable, whereas those who prefer to let database of exchange rate regimes and capital flow market forces reign may prefer a floating measures suggests that capital controls are more exchange rate and unfettered capital flows. A likely to be present when a country has a fixed preference for greater intervention may be exchange rate. Moreover, this correlation is mainly more prevalent at lower levels of present in countries at lower levels of income per development, perhaps reflecting actual or capita. ese findings raise a number of policy- perceived constraints faced by policymakers related issues: at such levels. • At lower levels of economic and financial • Finally, it remains to be established development—proxied by lower levels of empirically whether the joint choice to income per capita—policymakers may be control both the exchange rate and the constrained to jointly and tightly control both capital account implies welfare gains or the exchange rate and the capital account. losses—for example, in terms of output Accordingly, policy choices in developing growth or financial stability—for lower- countries should not be seen in isolation, and income countries. policy recommendations need to recognize G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 4 245 Annex 4.2 Data and Methodology ERR Data 261 country-year observations with a pegged exchange rate are countries in the Euro Area. e exchange regime classification is based on After excluding Euro Area members, there is a Shambaugh (2004) and updated in Obstfeld, relatively even distribution of observations Shambaugh, and Taylor (2010). It uses actual among floats (118) and soft pegs (134), and a exchange rate movements to see if a country stays lower incidence of pegs (79). within a +/- 2 percent band over the course of a year against a relevant base currency. If so, the Note the persistence of these choices across country is classified as having a “peg.” Otherwise, countries. ere is a considerable amount of it is classified as a non-peg. To insure the stability “flipping” behavior by countries (Klein and is deliberate and not a random lack of volatility, Shambaugh 2008). Exchange rate pegs frequently countries that peg for only one year are not coded break, but they also frequently re-form, such that as pegs. To handle one-off realignments, a country some countries flip back and forth from a peg to a that has zero volatility in 11 out of 12 months is float and back. at said, in shorter samples— also considered a peg (again, as long as it is also such as this 19-year period—it is more common pegged the year before or after). Soft pegs are to find a country with just one regime (especially identified as countries that do not maintain the if limiting the categorization to the binary peg or strict boundary, but stay within 5 percent bands or non-peg). stay within moving 2 percent bands in every month (that is, the change in any given month is In this sample of 93 countries, 30 countries never never greater than 2 percent). Given the interest in peg and 16 always do, leaving the remaining 37 the correlation of ERR and CFM, it is preferable countries having some pegged years and some to use a classification that uses only official market non-peg years. Adding the 9 countries that peg in exchange rate behavior, not interest rates or black only 1 or 2 years and 6 countries that float in only market exchange rates whose behavior may be a 1 or 2 years, one is left with 39 countries that function of capital controls. nearly always float and 22 that nearly always peg. e remaining 32 countries flip between floating ere are 1765 available observations with ERR and pegging, with 8 of these transitioning from data in the sample for 93 countries over 19 years. one ERR to another only once, but the 14 flipping ere are 707 pegs, 527 soft pegs, and 531 non- two or three times, and 10 flipping four or more pegged country-year observations in the data set. times. • In emerging markets, there are 109 CFM Data observations of pegged exchange rates, 147 observations of soft pegs, and 200 e capital flow measures classification is based on observations of floats. Fernández, Klein, Schindler, Rebucci, and Uribe (2015). is classification scheme is based on • Among frontier markets, there are 246 peg controls and requirements reported in the IMF’s observations, 163 soft peg observations, and Annual Report on Exchange Arrangements and 141 float observations. Exchange Restrictions (AREAER). This data set includes separate indicators for inflows and • In the other middle-income and low-income outflows for ten categories of assets. For this essay, group, there are 91 peg observations, 83 soft as explained in the text, an aggregate indicator is pegs observations, and 72 floats observations. constructed as the average of nine of these categories for both inflows and outflows, omitting • In the advanced economies group, 182 of the controls on direct investment because these 246 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 controls often reflect non-economic concerns, measure—ln((100×kc )+1) where kc is capital such as national security. For each country and for control index (average value over sample period), each year, the average of inflow controls and in any one year 1 ≥ kc ≥ 0, with larger values outflow controls for the nine categories of assets is representing more controls in place. e main used. is aggregate indicator takes a value independent variables is a logarithmic between 0 and 1, with 0 indicating no controls on transformation of the above-mention pegged any category of assets and 1 indicating controls on regime indicator — ln((100×peg )+1), where peg both inflows and outflows of all nine categories of is proportion of years country had a pegged assets. exchange rate, 1 ≥ peg ≥ 0. e other controls are the logarithms of GDP per capita, GDP, trade • e “Open” category is for countries that share, and size of the financial sector, as well as a almost never use capital controls. For this currency union control dummy. ( e regressions category, the average value of the capital in Columns I and II use 64 rather than 66 control index over the sample period is less observations because there are missing values for than 0.15, the maximum value in any one GDP variables for Argentina and Jamaica.) e year is less than 0.25, and the standard plot shown in Figure 4.2.6 suggests that the results deviation of the index across time is less than in Annex Table 4.2 are not driven by a small set of 0.10. outliers. • e “Closed” category is for countries that Figure 4.2.7 shows the effect of peg regimes on have capital controls for almost all (or all) capital controls as a function of income per capita. categories of assets for almost all (or all) years. e thick solid black line shows the estimated For this category, the average value of capital value of the effect of peg regimes on capital controls across the sample period is greater controls for each level of income per capita, and than 0.70, the minimum value is greater than the dashed red lines show the 95 percent 0.60, and the standard deviation is less than confidence interval of this estimate (again, all 0.10. expressed in logarithms). e vertical line at 9.34 means that the partial correlation is significant at • e “Partially Open” category is for countries the 95 percent level of confidence only for that make occasional use of capital controls. countries with the logarithm of income per capita Countries that are neither Open nor Closed below 9.34. e four richest countries with a value are classified as Partially Open. of the logarithm of income per capita below this cutoff are Algeria, Costa Rica, South Africa, and In the data set of 93 countries, 30 are classified as ailand. e solid line is downward sloping, Open, 13 as Closed, and 50 as Partially Open. In suggesting that the association between the capital the emerging market group, 17 countries are control and peg indices decreases with an increase classified as Partially Open, 5 as Closed, and only in income per capita. 2 as Open. In the frontier market group, 15 are classified as Partially Open, 10 as Open, and 4 as A number of robustness tests using additional Closed. e other middle- and low-income group panel regressions were conducted and reported in includes 7 Partially Open countries, 4 Closed the accompanying background paper (Arteta, countries and 2 Open countries. In advanced Klein, and Shambaugh forthcoming). ose economies, 16 countries are classified as Open, results support the central result above, and also and 11 as using CFM in an occasional fashion. justify the focus on using a cross-country sample rather than a panel consisting of country-year Regression Analysis in Annex Table 4.2 observations. Annex Table 4.2 presents results of regressions where the dependent variable is a logarithmic transformation of the above-mentioned CFM G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 CHAPTER 4 247 ANNEX TABLE 4.1 Listing of countries by category Emerging Market Economies (EMEs) generally include countries with a long-established record of significant access to international financial markets. Frontier Market Economies (FMEs) include countries that are usually smaller and less financially developed than EMEs, and with more limited access to international capital markets. For this essay, EMEs are countries that are classified as such in at least two of the three following stock indexes: S&P, FTSE, and MSCI. FMEs are countries that are classified as such by at least two of the same three indexes. For countries not covered by all of these three indexes, we also include those that are classified as EME/FME by Bloomberg, Citi, and JP Morgan bond indexes, even though these latter lists do not have a break down between EMEs and FMEs. Source of classification: World Bank, IMF, Standard & Poor’s, Financial Times Stock Exchange, Morgan Stanley Capital International, JPMorgan, Bloomberg, and Citigroup. Categories Countries Brazil, Chile, China, Colombia, Czech Republic, Arab Republic of Egypt, Hungary, India, Indonesia, Republic of Korea, Malaysia, Mexico, Morocco, Emerging Market Economies (24) Pakistan, Peru, Philippines, Poland, Qatar, Russian Federation, Saudi Arabia, South Africa, Thailand, Turkey, United Arab Emirates. Argentina, Bahrain, Bangladesh, Bolivia, Bulgaria, Costa Rica, Cote d'Ivoire, Georgia, Ghana, Guatemala, Jamaica, Kazakhstan, Kenya, Kuwait, Lebanon, Frontier Market Economies (29) Mauritius, Nigeria, Oman, Panama, Paraguay, Romania, El Salvador, Sri Lanka, Tunisia, Ukraine, Uruguay, Venezuela, RB, Vietnam, Zambia. Algeria, Angola, Dominican Republic, Kyrgyz Republic, Moldova, Nicaragua, Other Middle and Low Income Countries (13) Swaziland, Republic of Yemen (all middle income), as well as Burkina Faso, Ethiopia, Tanzania, Togo, Uganda (all low income). Australia, Austria, Belgium, Canada, Cyprus, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Israel, Italy, Japan, Latvia, Malta, Advanced Economies (27) Netherlands, New Zealand, Norway, Portugal, Slovenia, Spain, Sweden, Switzerland, United Kingdom, United States. 248 CHAPTER 4 G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 ANNEX TABLE 4.2 Partial correlation of capital control index with pegged exchange rate and other variables Cross country regressions for emerging and developing countries Dependent variable: ln (capital control indicator) I II ln(peg) 0.15* 1.66** (s.e.) (0.075) (0.69) ln(peg)×ln(GDP/Cap) -0.16** (s.e.) (0.073) ln(GDP/Cap) 0.075 -0.52*** (s.e.) (0.32) (0.16) ln(GDP) 0.52*** 0.48*** (s.e.) (0.11) (0.10) ln(Dom.Credit) -0.096 -0.16 (s.e.) (0.22) (0.23) ln(Trade) 0.95** 0.89*** (s.e.) (0.39) (0.34) Currency Union -1.25* -1.40 (s.e.) (0.72) (1.43) Elasticity of ln(capital control) to ln(peg) for average values of ln(GDP/Cap) of different country groups a Other middle and low income 0.35*** (s.e.) (0.13) Frontier 0.18** (s.e.) (0.072) Emerging 0.10 (s.e.) (0.062) Advanced -0.054 (s.e.) (0.092) R 0.36 0.41 No. of Obs. 64 64 a e values shown are βln(peg) + ln(GDP/Cap) × βln(peg) ×ln(GDP/Cap) for average ln(GDP/Cap) for each of the four country groups. Sample based on values in 1995–2013. Dependent variable: ln(capital control) is ln((100×kc )+1) where kc is capital control index (average value over sample period); 1 ≥ kc ≥ 0 in any one year, with larger values representing more controls in place. Key independent variable: ln(peg) is ln((100×peg )+1), where peg is proportion of years country had a pegged exchange rate; 1 ≥ peg ≥ 0. Other controls: Currency Union is proportion of years a country has been in currency union. GDP/capita and GDP are average values of real GDP/capita and real GDP over sample period. Dom. 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Hungary 1.9 3.7 2.8 2.5 2.7 3.0 2.8 4.7 2.7 2.9 2.2 1.9 2.3 Seychelles 6.6 2.8 3.5 3.7 3.6 3.6 .. .. .. .. .. .. .. Venezuela, RB 1.3 -4.0 -8.2 -4.8 -1.1 0.0 .. .. .. .. .. .. .. Developing Countries 5.3 4.9 4.3 4.8 5.3 5.3 5.0 4.4 5.5 4.1 3.9 4.0 5.3 East Asia and the Pacific 7.1 6.8 6.4 6.3 6.2 6.2 5.9 7.1 7.0 7.0 5.2 6.8 6.6 Cambodia 7.4 7.0 6.9 6.9 6.8 6.8 .. .. .. .. .. .. .. China 7.7 7.3 6.9 6.7 6.5 6.5 .. .. .. .. .. .. .. Fiji 4.6 4.3 4.0 3.5 3.1 3.0 .. .. .. .. .. .. .. Indonesia 5.6 5.0 4.7 5.3 5.5 5.5 .. .. .. .. .. .. .. Lao PDR 8.5 7.5 6.4 7.0 6.9 6.9 .. .. .. .. .. .. .. Malaysia 4.7 6.0 4.7 4.5 4.5 5.0 5.5 6.7 3.3 7.3 4.7 4.5 2.6 Mongolia 11.7 7.8 2.3 0.8 3.0 6.4 .. .. .. .. .. .. .. Myanmar 8.5 8.5 6.5 7.8 8.5 8.5 .. .. .. .. .. .. .. Papua New Guinea 5.5 8.5 8.7 3.3 4.0 3.8 .. .. .. .. .. .. .. Philippines 7.1 6.1 5.8 6.4 6.2 6.2 .. .. .. .. .. .. .. Solomon Islands 3.0 1.5 3.3 3.0 3.5 3.4 .. .. .. .. .. .. .. Thailand 2.8 0.9 2.5 2.0 2.4 2.7 -2.9 2.6 3.7 4.7 1.4 1.4 4.0 Timor-Leste 2.8 7.0 6.8 6.9 7.0 7.0 .. .. .. .. .. .. .. Vietnam 5.4 6.0 6.5 6.6 6.3 6.0 .. .. .. .. .. .. .. Europe and Central Asia 3.9 2.3 2.1 3.0 3.5 3.5 2.8 -1.8 0.5 1.0 2.6 3.3 .. Albania 1.4 2.0 2.7 3.4 3.5 3.5 .. .. .. .. .. .. .. Armenia 3.3 3.5 2.5 2.2 2.8 3.0 .. .. .. .. .. .. .. Azerbaijan 5.8 2.8 2.0 0.8 1.2 2.7 .. .. .. .. .. .. .. Belarus 1.1 1.6 -3.5 -0.5 1.0 1.0 .. .. .. .. .. .. .. Bosnia and 2.5 0.8 1.9 2.3 3.1 3.5 .. .. .. .. .. .. .. Herzegovina Bulgaria 1.3 1.5 2.9 2.2 2.7 2.7 0.4 2.5 1.7 2.6 3.5 2.6 2.9 Georgia 3.3 4.8 2.5 3.0 4.5 5.0 .. .. .. .. .. .. .. Kazakhstan 6.0 4.4 0.9 1.1 3.3 3.4 .. .. .. .. .. .. .. Kosovo 3.4 1.2 3.0 3.5 3.7 4.0 .. .. .. .. .. .. .. Kyrgyz Republic 10.9 3.6 2.0 4.2 3.4 4.3 .. .. .. .. .. .. .. Macedonia, FYR 2.7 3.5 3.2 3.4 3.7 3.7 .. .. .. .. .. .. .. Moldova 9.4 4.6 -2.0 0.5 4.0 4.0 .. .. .. .. .. .. .. Montenegro 3.5 1.8 3.4 2.9 3.0 2.9 .. .. .. .. .. .. .. Romania 3.5 2.8 3.6 3.9 4.1 4.0 0.5 0.4 6.3 3.1 5.7 0.2 5.7 Serbia 2.6 -1.8 0.8 1.8 2.2 3.5 .. .. .. .. .. .. .. Tajikistan 7.4 6.7 4.2 4.8 5.5 5.5 .. .. .. .. .. .. .. Turkey 4.2 2.9 4.2 3.5 3.5 3.4 5.9 -0.9 1.5 4.0 6.0 5.5 .. Turkmenistan 10.2 10.3 8.5 8.9 8.9 8.9 .. .. .. .. .. .. .. Ukraine 0.0 -6.8 -12.0 1.0 2.0 2.0 .. .. .. .. .. .. .. Uzbekistan 8.0 8.1 7.0 7.5 7.7 7.7 .. .. .. .. .. .. .. 260 S TATIS TICAL APP ENDIX G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 TABLE 1: GDP Growth (continued) (Percent) Annual a Quarterly b 2014 2015 2013 2014 2015e 2016f 2017f 2018f Q1 Q2 Q3 Q4 Q1 Q2 Q3 Latin America and the Caribbean 3.0 1.5 -0.7 0.1 2.3 2.5 2.6 -1.7 1.1 1.4 -0.8 -3.4 -3.0 Belize 1.5 3.6 3.0 2.5 2.6 2.8 .. .. .. .. .. .. .. Bolivia 6.8 5.5 4.0 3.5 3.4 3.4 .. .. .. .. .. .. .. Brazil 3.0 0.1 -3.7 -2.5 1.4 1.5 2.5 -5.1 -0.4 0.3 -3.3 -8.0 -6.7 Colombia 4.9 4.6 3.1 3.0 3.3 3.5 6.2 1.2 4.3 2.0 3.5 2.1 5.1 Costa Rica 3.4 3.5 2.8 4.0 4.2 4.4 .. .. .. .. .. .. .. Dominica 1.7 3.4 -3.0 4.0 2.0 2.0 .. .. .. .. .. .. .. Dominican Republic 4.8 7.3 5.6 4.6 3.8 3.9 .. .. .. .. .. .. .. Ecuador 4.6 3.7 -0.6 -2.0 0.0 0.5 -3.0 7.9 4.4 1.3 -0.4 -1.0 .. El Salvador 1.8 2.0 2.4 2.5 2.6 2.8 .. .. .. .. .. .. .. Guatemala 3.7 4.2 3.7 3.6 3.5 3.6 .. .. .. .. .. .. .. Guyana 5.2 3.9 3.5 3.8 4.0 4.0 .. .. .. .. .. .. .. Haitid 4.2 2.7 1.7 2.5 2.8 3.0 .. .. .. .. .. .. .. Honduras 2.8 3.1 3.4 3.4 3.5 3.6 .. .. .. .. .. .. .. Jamaica 0.5 0.7 1.3 2.1 2.4 2.6 .. .. .. .. .. .. .. Mexico 1.4 2.3 2.5 2.8 3.0 3.2 2.4 3.0 2.3 2.8 2.1 2.5 3.0 Nicaragua 4.6 4.7 3.9 4.2 4.1 4.0 .. .. .. .. .. .. .. Panama 8.4 6.2 5.9 6.2 6.4 6.6 .. .. .. .. .. .. .. Paraguay 14.0 4.7 2.8 3.6 4.0 4.2 .. .. .. .. .. .. .. Peru 5.8 2.4 2.7 3.3 4.5 4.6 .. .. .. .. .. .. .. St. Lucia -1.9 -0.7 1.7 1.6 1.9 2.1 .. .. .. .. .. .. .. St. Vincent and 2.3 -0.2 2.1 2.7 3.0 3.4 .. .. .. .. .. .. .. the Grenadines Middle East and North Africa 0.6 2.5 2.5 5.1 5.8 5.1 8.0 4.3 3.8 2.2 4.3 .. .. Algeria 2.8 3.8 2.8 3.9 4.0 3.8 .. .. .. .. .. .. .. Djibouti 5.0 6.0 6.5 7.0 7.1 7.0 .. .. .. .. .. .. .. Egypt, Arab Rep.d 2.1 2.2 4.2 3.8 4.4 4.8 .. .. .. .. .. .. .. Iran, Islamic Rep. -1.9 4.3 1.9 5.8 6.7 6.0 9.3 2.0 6.8 5.0 0.1 .. .. Iraq 4.2 -0.5 0.5 3.1 7.1 6.5 .. .. .. .. .. .. .. Jordan 2.8 3.1 2.5 3.5 3.8 4.0 .. .. .. .. .. .. .. Lebanon 3.0 2.0 2.0 2.5 2.5 3.0 .. .. .. .. .. .. .. Libya -13.7 -24.0 -5.2 35.7 27.6 8.4 .. .. .. .. .. .. .. Morocco 4.7 2.4 4.7 2.7 4.0 4.0 .. .. .. .. .. .. .. Tunisia 2.9 2.7 0.5 2.5 3.3 4.5 1.7 2.0 3.2 3.3 -1.1 -2.1 1.0 West Bank and Gaza 2.2 -0.4 2.9 3.9 3.7 3.7 .. .. .. .. .. .. .. South Asia 6.2 6.8 7.0 7.3 7.5 7.5 7.3 9.2 12.6 -1.6 10.3 7.4 13.8 Afghanistan 2.0 1.3 1.9 3.1 3.9 5.0 .. .. .. .. .. .. .. Bangladeshd 6.1 6.5 6.5 6.7 6.8 6.8 .. .. .. .. .. .. .. Indiad 6.9 7.3 7.3 7.8 7.9 7.9 .. .. .. .. .. .. .. Maldives 4.2 5.9 4.4 3.1 4.2 4.5 .. .. .. .. .. .. .. Nepal d 4.1 5.4 3.4 1.7 5.8 4.5 .. .. .. .. .. .. .. Pakistand e 4.4 4.7 5.5 5.5 5.4 5.4 .. .. .. .. .. .. .. Sri Lanka 3.4 4.5 5.3 5.6 6.0 6.0 .. .. .. .. .. .. .. G LO BAL EC O NO MIC P ROS P EC TS | J AN U ARY 2016 S TATIS TICAL APP ENDIX 261 TABLE 1: GDP Growth (continued) (Percent) Annual a Quarterly b 2014 2015 2013 2014 2015e 2016f 2017f 2018f Q1 Q2 Q3 Q4 Q1 Q2 Q3 Sub-Saharan Africa 4.9 4.6 3.4 4.2 4.7 4.7 2.0 4.8 3.7 5.4 -1.6 0.5 4.0 Angola 6.8 3.9 3.0 3.3 3.8 3.8 .. .. .. .. .. .. .. Benin 5.6 5.4 5.7 5.3 5.1 5.1 .. .. .. .. .. .. .. Botswana d 9.3 4.4 3.0 4.0 4.2 4.2 .. .. .. .. .. .. .. Burkina Faso 6.7 4.0 4.4 6.0 7.0 7.0 .. .. .. .. .. .. .. Burundi 4.6 4.7 -2.3 3.5 4.8 4.8 .. .. .. .. .. .. .. Cabo Verde 1.0 1.8 2.9 3.5 4.1 4.1 .. .. .. .. .. .. .. Cameroon 5.6 5.9 6.3 6.5 6.5 6.4 .. .. .. .. .. .. .. Chad 5.7 7.3 4.1 4.9 6.1 6.5 .. .. .. .. .. .. .. Comoros 3.5 3.0 2.3 2.5 3.1 3.1 .. .. .. .. .. .. .. Congo, Dem. Rep. 8.5 9.0 8.0 8.6 9.0 9.0 .. .. .. .. .. .. .. Côte d'Ivoire 9.2 8.5 8.4 8.3 8.0 8.0 .. .. .. .. .. .. .. Eritrea 1.3 1.7 0.9 2.0 2.2 2.2 .. .. .. .. .. .. .. Ethiopia d 10.5 9.9 10.2 10.2 9.0 9.0 .. .. .. .. .. .. .. Gabon 4.3 4.3 4.1 5.1 5.3 5.3 .. .. .. .. .. .. .. Gambia, The 4.8 -0.2 4.0 4.5 5.3 5.3 .. .. .. .. .. .. .. Ghana 7.3 4.0 3.4 5.9 8.2 8.2 .. .. .. .. .. .. .. Guinea 2.3 -0.3 0.4 3.5 4.0 4.2 .. .. .. .. .. .. .. Guinea-Bissau 0.3 2.5 4.4 4.9 5.3 5.3 .. .. .. .. .. .. .. Kenya 5.7 5.3 5.4 5.7 6.1 6.1 .. .. .. .. .. .. .. Lesotho 4.6 2.0 2.6 2.8 4.5 4.5 .. .. .. .. .. .. .. Liberia 8.7 1.0 3.0 5.7 6.8 6.8 .. .. .. .. .. .. .. Madagascar 2.4 3.0 3.2 3.4 3.6 3.6 .. .. .. .. .. .. .. Malawi 5.2 5.7 2.8 5.0 5.8 5.8 .. .. .. .. .. .. .. Mali 1.7 7.2 5.0 5.0 5.0 5.0 .. .. .. .. .. .. .. Mauritania 5.5 6.9 3.2 4.0 4.0 4.0 .. .. .. .. .. .. .. Mauritius 3.3 3.6 3.5 3.7 3.7 3.7 .. .. .. .. .. .. .. Mozambique 7.3 7.4 6.3 6.5 7.2 7.2 .. .. .. .. .. .. .. Namibia 5.7 6.4 5.0 5.5 5.9 5.9 .. .. .. .. .. .. .. Niger 4.6 6.9 4.4 5.3 9.3 5.7 .. .. .. .. .. .. .. Nigeria 5.4 6.3 3.3 4.6 5.3 5.3 .. .. .. .. .. .. .. Rwanda 4.7 7.0 7.4 7.6 7.6 7.6 .. .. .. .. .. .. .. Senegal 3.5 3.9 5.0 5.3 5.3 5.3 .. .. .. .. .. .. .. Sierra Leone 20.1 7.0 -20.0 6.6 5.3 5.3 .. .. .. .. .. .. .. South Africa 2.2 1.5 1.3 1.4 1.6 1.6 -1.5 0.5 2.1 4.2 1.4 -1.3 0.7 South Sudan 13.1 3.4 -5.3 3.5 7.0 7.0 .. .. .. .. .. .. .. Sudan 3.3 3.1 3.5 3.4 3.9 3.9 .. .. .. .. .. .. .. Swaziland 2.8 2.5 1.3 0.8 0.8 0.8 .. .. .. .. .. .. .. Tanzania 7.3 7.0 7.2 7.2 7.1 7.1 .. .. .. .. .. .. .. Togo 5.1 5.7 5.1 4.9 4.7 4.7 .. .. .. .. .. .. .. Ugandad 3.6 4.0 5.0 5.0 5.8 5.8 .. .. .. .. .. .. .. Zambia 6.7 5.6 3.5 3.8 5.4 6.0 .. .. .. .. .. .. .. Zimbabwe 4.5 3.2 1.0 2.8 3.0 3.0 .. .. .. .. .. .. .. Source: World Bank, WDI, Haver Analytics, WEO Note: e = estimates; f = forecast. Aggregates based on constant 2010 dollar GDP. a. Annual percentage change b. Quarter-over-quarter growth, seasonally adjusted and annualized c. Based on the 2015 World Bank's reclassification. d. Annual GDP is on fiscal year basis, as per reporting practice in the country e. GDP data for Pakistan are based on market prices.