After growing a robust 9.3 percent during calendar year 2010, activity in South Asia moderated in the first quarter of 2011—pointing to a projected slowdown in aggregate regional growth to a still buoyant 7.5 percent in 2011. This slowdown partly reflects macroeconomic policy tightening aimed at curbing stubbornly high price pressures and reducing large fiscal deficits. Tighter financing conditions have contributed to a moderation in private investment growth, while private consumption growth has been hit by high and rising food and fuel inflation. The moderate compression of domestic demand has been partly offset by strong exports, as countries in South Asia have benefited from robust import demand in developing countries, recovering demand in high-income countries and resilient worker remittances inflows (see Regional forecast summary table).
The regional economic slowdown in 2011 mainly reflects a fall-off in activity in India, which represents about 80 percent of South Asia’s GDP, where growth is projected to ease to 8 percent in FY2011/2012 from 8.8 percent in FY 2010/11 (see note on the region's GDP reporting practices). The slowdown stems from a moderation in domestic demand, as elevated inflationary pressures have cut into disposable incomes and household spending¸ and as more restrictive monetary conditions have contributed to a dampening of investment activity. In particular, investment growth decelerated sharply in Q1-2011 to 0.4 percent from 7.8 percent in Q4-2010 and 14.1 percent for 2010 overall (year-on-year). At the sectoral level, a recent good harvest buoyed agricultural production, following poor crops on low rainfall with the 2009 monsoon. In contrast, industrial output growth was weak in early-2011.
Economic growth in Pakistan—the region’s second largest economy (representing about 15 percent of regional GDP)—significantly lags much of South Asia, and is projected to slow to 2.5 percent in FY2010/11 (ending June-2011) from 4.1 percent in FY2009/10, reflecting the devastating flooding across much of the country in July and August 2010. The easing of GDP growth is also tied to worsening security conditions, heightened political uncertainty, stalled policy implementation, and extensive infrastructure bottlenecks. While whole year growth numbers are expected to be weak, activity has begun to firm recently, as the effects of the 2010-flooding (which affected an estimated one-fourth of agricultural productive capacity) wear off, supported by a surge in exports in early-2011, and an upswing in worker remittances inflows.
Real GDP growth in Sri Lanka remains buoyant, but has decelerated in early-2011, due to floods that damaged a significant share of this year’s early crop. GDP growth in 2010 (calendar year) registered 8 percent and has been strongly underpinned by the peace dividend following the end of the decades-old civil war. The recovery was led by private consumption and investment. Agricultural output growth was boosted by the return to production of previously fallowed land with the cessation of fighting, while services activity benefitted from an upsurge in tourism. Activity in the first few months of 2011 has slowed due to waning of these rebound effects from the end-of-conflict and more normal growth rates in agriculture (aside from the negative impact of floods).
Afghanistan’s GDP (on a fiscal year basis) is expected to have grown 8.2 percent in FY2010/11 (ending June-2011), down from an unsustainable 20.1 percent increase in FY2009/10 that was driven by a record harvest (following a long period of drought) and an upswing in donor grants. Output this year continues to be bolstered by reconstruction and strong aid inflows, which are reflected in a robust expansion of services (including transport) and vibrant construction activity.
Nepal also experienced a moderation in activity in early-2011. Ongoing political uncertainty attached to the post-conflict transition to a new government has extended into its fourth year, with law and order problems, continued extensive infrastructure bottlenecks (particularly widespread load-shedding and unreliable power delivery) projected to limit real GDP growth to 3.5 percent in FY2010/2011 (ending mid-July-2011), down from 4.6 percent in FY2009/10.
GDP growth has been picking up in Bangladesh, where private consumption spending has been supported by higher private sector credit growth and public- and private-sector wage increases. However, the strong boost to consumer incomes from worker remittances in 2009 (up 17.1 percent in dollar terms that year) has given way to a much more modest 2.7 percent gain in 2010, reflecting falling net outmigration since 2009 and fewer remitters following last year’s return of workers from several gulf states. At the sectoral level, rising agricultural output reflects good harvests, and strengthened industrial production has been buoyed by a revival in garment exports. However, Bangladesh’s output continues to be constrained by widespread power supply outages, which are expected to limit GDP gains to 6.2 percent FY2010/11 (ending June-2011) from 5.8 percent in FY2009/10.
Among the remaining economies in South Asia, Bhutan’s real GDP is firming, underpinned by construction of additional hydropower projects, and to a lesser extent by a revival in tourism. In FY2010/2011 GDP growth is projected to rise to 8.3 percent, up from 6.9 percent in 2009/10, (ending June-2010). The recovery in the Maldives appears to have firmed slightly in early-2011 with strong tourism arrivals. In 2011, GDP growth is projected to accelerate to 5 percent (calendar year) following 4.8 percent in 2010. Tourism is expected to remain the key driver for growth, supported by a 17.4 percent expansion of capacity (number of beds) at end-2010 and robust growth in arrivals stemming from diversification to faster-growing new markets. In particular, China surpassed the United Kingdom in 2010 as the largest source of tourists to the Maldives.
Inflationary pressures are elevated across South Asia reflecting various factors, including higher international food and fuel prices, tight capacity utilization, and past macroeconomic loosening, which have led to elevated inflation expectations and higher core prices. High international fuel and food prices are key factors in South Asia because of its heavy reliance on imports of oil and some staples, such as edible oils. Additionally, food represents a large share (about 40 percent) of the regional household consumption basket, a key concern from a poverty perspective.
In particular, international wheat and edible oils prices have surged, while rice prices have remained more stable. Afghanistan, the Maldives and Sri Lanka—where at least one-third of domestic consumption of grains (including rice, wheat, pulses) and edible oils is imported—are most exposed to an imported pass-through of higher international commodity prices. Indeed, reliance on imported edible oils is high across the region, where at least two-thirds of consumption is imported (in Afghanistan, Bangladesh, India, Pakistan, and Sri Lanka, for which data is available). Some countries are self-reliant in key staples, such as Bangladesh, India and Nepal, where rice-imports represent a very small share of consumption (2 percent or less). Notably, the short-run pass-through (monthly) of international grain prices is generally low in South Asia, partly reflecting administered prices. For example, in India, wheat prices have remained well-below international prices, compared to near complete pass-through in Bangladesh.
The strength of the recovery in South Asia partly explains the persistence of inflation in the region, as little spare capacity remains. Although estimates of potential output can vary depending on methodology and assumptions—especially for countries with ongoing conflict, such as Pakistan, or coming out of conflict, such as Sri Lanka—measures across sources for many of the region’s economies (Afghanistan, Bangladesh, India, Sri Lanka) suggest output gaps narrowed (or closed) in 2010, which has likely contributed to price pressures. In addition, a series of local one-off factors have contributed to price pressures including: the economic disruptions from flooding in Pakistan (during the second half of 2010) and Sri Lanka (early-2011); the partial liberalization of petroleum prices in India (mid-2010); and the raising of administered petrol prices elsewhere in the region (including Bhutan, the Maldives, and Pakistan). A recent devaluation of the Maldives’ currency, following the introduction of an exchange rate band around the Rufiyaa/US-dollar peg (R12.85/$1) of plus or minus 20 percent, has also contributed to a resurgence of inflation in that country.
To rein-in domestic demand and inflationary pressures, monetary authorities have initiated policy rate hikes in Bangladesh, India, and Pakistan, with the Reserve Bank of India having started raising rates in March 2010. Despite these measures, real policy interest rates are negative—or remain looser than they were prior to the crisis. Unfortunately, bringing inflation back down will be complicated by the trend rise in inflation over the past decade, which has contributed to an increase in inflationary expectations in recent years. Household surveys in India, for example, indicate that consumers’ inflation expectations have increased over the last four years (from 5.8 percent in Q4-2006 to 13.1 percent in Q4-2010 for year-ahead inflation), and have recently jumped by 1.2 percentage points in the second half of 2010.1
Despite the steps taken earlier to reduce fuel subsidies, the pass-through of higher international energy prices is incomplete, increasing subsidization costs and contributing to fiscal deficits. The region’s large general government budget deficits are also complicating efforts to restrict domestic demand and reduce inflation. South Asia’s aggregate fiscal deficit continues to outstrip those of other developing regions. And, despite progress toward fiscal consolidation in some countries (India, Maldives and Sri Lanka) in 2010, general government deficits remain very high, at 8.8 percent of GDP in India for FY2010/11, 20.7 percent in the Maldives for CY2010, and 7.9 percent in Sri Lanka for CY2010. Large outlays for interest payments are slowing progress toward fiscal consolidation, and—while improving in some countries (Afghanistan, Maldives, and Sri Lanka, for example)—the region’s low tax base makes consolidation particularly challenging.
Elsewhere in the region, fiscal balances have deteriorated. In Pakistan—after rising to 6.3 percent of GDP in FY2009/10—the deficit continued to expand in the first half of FY2010/11 tied to flood-related outlays, high power-sector subsidies and increased defense spending. In Bhutan, the fiscal deficit rose to an estimated 4.4 percent of GDP in FY2010/11, as the government continues to plow money into development and infrastructure projects (including roads, financial services and information technology) that are only partly funded by the Tala hydroeclectic project revenue stream. In Bangladesh, the deficit rose to 4.9 percent in 2010/11, due to large outlays for investment in power generation and higher subsidies. Sizeable foreign aid inflows and improved revenue performance helped contain Nepal’s deficit to a relatively modest 2.8 percent of GDP and helped Afghanistan retain a surplus of 0.6 percent of GDP.
Given high inflation rates—currencies in South Asia appreciated in real effective (trade-weighted and inflation adjusted) terms, with the largest increases in Pakistan and Nepal, where currencies stood about 15 percent above mid-2008 levels at end-2010. Bangladesh’s real effective exchange rate had appreciated strongly as well, but depreciated during much of 2010 and ended the year 12 percent above pre-crisis levels. In India and Sri Lanka, real effective exchange rate appreciation has been less pronounced, about half the rates of appreciation across the rest of the region (8 percent and 6 percent, respectively, over the same period).
Despite headwinds implied by appreciating currencies, regional merchandise export volume growth accelerated sharply in the second half of 2010. As the global growth recovery has deepened, external demand for South Asia has firmed, with volume growth given an extra impetus following a shift in export market composition toward higher-growth developing countries (China) and away from traditional export markets in slower-growing Europe and the United States. In India, the value of exports rose by 37.5 percent year-on-year to reach $245 billion in FY2010/11, exceeding the $200 billion government target. Among other factors, this strong performance reflects the success of the government's strategy to expand export markets in emerging economies, particularly in Latin America and Asia. Regional merchandise import volume growth remained robust as well, which in combination with higher import prices led to a modest deterioration in the region’s trade deficit from 6.2 percent of GDP in 2009 to 6.4 percent of GDP in 2010.
Tourism receipts rebounded in 2010 following the 2009 downturn with nearly all countries in the region registering a recovery (Bhutan, India, Maldives, Nepal, and Sri Lanka). Sri Lanka in particular posted a 46 percent upsurge in tourist arrivals following the end of civil war in 2009. In general, higher regional tourist arrivals reflected recovery in high-income Europe and vibrant growth in developing East Asia, especially China.
Worker remittance inflows to South Asia rose in U.S.-dollar terms by 8.2 percent in 2010 to $81 billion, helping to offset sizeable trade deficits, remaining a critical source of foreign exchange.2 However, when measured in local currency terms, remittances inflows to the region grew by only 4.1 percent in 2010, while high inflation rates meant that the real value of these inflows declined by 3.9 percent.
The pick-up in the dollar value of remittances was strongest in Sri Lanka, where they increased 24 percent in 2010—reflecting increased inflows through official channels and the boost in confidence following the end of the civil war. In Nepal, the dollar value of remittances expanded 17 percent, supported in part by vibrant growth in India, a key source-country for Nepalese remittances. In India, the uptick in the dollar value of remittances inflows was more modest (7.4 percent), reflecting larger shares of Indian migrants in high-income countries that have yet to fully recover from the financial crisis.
Elsewhere in the region, remittances inflows moderated sharply in 2010 (in dollar terms) by 2.7 percent in Bangladesh, following 19.4 percent growth in 2009. The deceleration appears to partly reflect a delayed impact of the decline in the net outflow of migrants, which nearly halved during the first half of 2009 and continued to decline in 2010 and into early-2011.
South Asia’s current account deficit deteriorated in early 2011, reflecting higher oil import bills and strong, albeit moderating, import volume growth. Helping to contain the deterioration in external balances, the region recorded strong export volume growth in early-2011 (led by India, Pakistan and Sri Lanka)—supported by strong external demand from China. During calendar year 2011, the regional current account deficit is projected to expand to 2.8 percent as a share of GDP from 2.4 percent in 2010. In part this reflects a projected shrinking of Bangladesh’s current account surplus, due to a stronger pace of growth in imports over exports, falling terms of trade (driven by rising international food and fuel prices) and a major slowdown in worker remittances receipts. Indeed, deterioration in the current account prompted the government of Bangladesh to seek IMF funding to help maintain business and investor confidence. While FDI to the region has fallen (India and Pakistan), the regional current account deficit is expected to continue to be covered by significant foreign exchange reserve holdings, particularly in India, and sustained capital inflows.
1 The Reserve Bank of India’s Inflation Expectations Survey of Households conducted in Q4-2010 (Round 22) shows households expect inflation to increase 130 basis points to 13.1 percent from the perceived current rate of 11.8 percent—compared with the expected 11.9 percent inflation rate from the Q2-2010 survey (Round 20), (1-year-ahead expected rates).
2 Nepal, Bangladesh, and Sri Lanka, were among the top 15 recipients of remittances in 2009—with inflows representing the equivalent of 23.8% of GDP in Nepal, 11.8% in Bangladesh, 8% in Sri Lanka, 5.4% in Pakistan and 3.6% in India.