Subregional performance
South Asia's GDP grew by 8.7% in 2006 (Figure 1.3.3), the second year above 8.5%, having averaged more than 7.5% a year growth since 2003. The GDP of nearly every country in the subregion grew at over 6.0% in 2006. India turned in the highest growth rate of 9.2% among the large economies and the Maldives grew at 18.2%, fastest among the small economies. The services sector contributed most to growth in South Asia, but industry sector growth accelerated in India and Bangladesh, buttressing the sustainability of high growth rates in the future. High levels of consumption and investment boosted growth rates. Domestic demand expanded because of rising incomes, credit expansion, and strong workers' remittances. World economic expansion kept external demand strong fostering export growth, while an improved business climate attracted increased domestic private investment and foreign direct and portfolio investment, both reaching the highest historical levels in the large economies.
Demand pressures and high world oil and commodity prices led to an increase in the subregion's inflation rate to 6.0% in 2006. Inflation picked up in Bangladesh, India, and Nepal, but came down in Pakistan and Sri Lanka (though from much higher levels). Despite several central banks' monetary policy measures that increased nominal interest rates to tighten liquidity, rising inflation rates kept real interest rates low. Simultaneously, government budget deficits remained at elevated levels to reinforce credit expansion, partly because of the increased subsidy to buffer rising oil prices, reconstruction efforts following natural disasters, and high development expenditures.
South Asia's current account deficit increased marginally in 2006 to 2.1% of GDP. Although merchandise exports grew at a robust rate of 18.8%, imports grew at an even higher rate of 24.9%, induced by domestic demand pressures and high world commodity prices. Exports of services and the surge in workers' remittances brought the current account to a narrow deficit. The subregion's foreign exchange reserves increased because of large net capital inflows. Real effective exchange rates remained stable.
Subregional prospects
Economic growth in developed countries is expected to slow in 2007 and stage a modest recovery in 2008. The world price of oil and other commodities is likely to fall. With this backdrop, South Asia's prospects still remain bright due to strong domestic demand and investment. Nevertheless, regional economic performance is likely to modulate in step with developed-country trends, though at robust levels of GDP growth of 7.7% in 2007, rising to 8.0% in 2008. Larger countries in the subregion are forecast to maintain high rates of growth, with India averaging about 8% a year and Pakistan and Bangladesh around 7% a year over the next 2 years. GDP growth in the smaller countries over the same period is likely to be varied, ranging from yearly average growth rates of 14% in Bhutan to 3% in Nepal. The services sector is anticipated to lead economic growth, backed by accelerated growth in manufacturing.
Monetary policy measures taken in 2006 by several countries are likely to curb credit growth to the private sector for consumption and investment, reinforcing sluggish demand from developed countries. Moreover, improving fiscal balances resulting from increased tax revenues and lower subsidies to buffer high oil prices are also expected to rein in credit growth to the public sector. These developments will probably dampen the pace of economic growth and reduce the subregion's rate of inflation to about 5% a year during 2007 and 2008.
Despite the reduction in world commodity prices, South Asia's growth of merchandise imports is likely to outstrip exports because of high regional growth rates and lower demand in developed countries. Vigorous growth in exports of services and workers' remittances is expected to substantially compensate for the trade shortfall, leaving the current account with small deficits of about 2% of GDP for the next 2 years. High growth rates in the subregion will continue to attract large capital flows. Countries are likely to add to their international reserves and maintain stable exchange rates.
Country highlights
Islamic Republic of Afghanistan
In the licit economy, economic growth slowed to 8.0% in 2006 as agriculture was hit by another drought, while reconstruction-linked construction and services continued to expand. Growth is expected to recover to 10% in 2007, assuming normal rainfall.
The Government continued along its track of solid macroeconomic policy and structural reforms. Yet popular discontent with slow reconstruction, pervasive corruption, as well as sharply deteriorating security, institutional and human resource constraints, a heavy reliance on aid, and a very low domestic revenue base, all remain formidable challenges. As does the impact of opium production, which reached record levels in 2006. Since current, licit, drivers of growth cannot provide sustained growth, creating a private sector enabling environment and diversifying the economy remain crucial tasks.
Bangladesh
At 6% over the past 4 years, strong GDP growth has been underpinned by more market-oriented economic policies, a dynamic garment sector, and substantial inflows of overseas workers' remittances. The lead-up to the parliamentary elections in January 2007 was generally expected to be a rough patch given the country's contentious political environment; the constitutional mechanism of a neutral caretaker government was expected to help smooth the way. Deepening political deadlock culminated with the president in January declaring a state of emergency and calling off the elections.
The new caretaker Government has continued with established economic policies and expedited structural and sector reforms. It has taken a broad agenda of activity, including an extensive anticorruption drive that it sees necessary to establish better foundations for holding the elections. GDP is forecast to maintain its recent momentum and grow by 6.5% in 2007. Inflation, which has trended upward in recent years, is expected to keep inflation in check at 7% by a tightened monetary policy.
Bhutan
The huge Tala hydropower project started commercial production in July 2006 boosting GDP growth for the year to 9.0%. Tala is forecast to double electricity export capacity, boosting GDP growth to 18% in 2007, raising government revenues significantly and pushing the current account into surplus. This is all highly beneficial, however, the employment elasticity of hydropower is low and has little impact on creating jobs for the many tens of thousands of young people entering the labor market or migrating to urban areas. While some progress has been made, Government policies need to stimulate further greater private sector activity and to diversify the economy.
India
Two years of above-trend growth at around 9% are causing inflation. Optimism over growth prospects has brought high capital inflows and currency appreciation pressure. Manufacturing and construction growth have stimulated a voracious appetite for credit, which in turn complicates attempts to control the money supply.
Agricultural stagnation is the key structural challenge. Rising food prices contribute to inflation. Stagnation also widens inequality, as industry accelerates and services pull on robustly. It also raises pressures to transfer land out of agriculture into industry, and highlights the importance of industrial job creation for growth, labor absorption, and poverty reduction. Yet land transfer from agriculture to industry implies significant worker displacement, and has caused serious social unrest. With inflation high, and serious structural hurdles for the economy to overcome, the Reserve Bank of India finds itself in a precarious position, since it must damp expenditures in the short run, while also ensuring adequate credit supply to promote manufacturing and agricultural investments in the medium term.
However, interest rates have risen, construction growth has already tapered, and the rupee is appreciating slightly. Agricultural planting has responded to rising prices. These trends will help moderate inflation. A soft landing therefore appears likely as growth is expected to decelerate smoothly to 8% in 2007.
Maldives
The economy took a downturn in 2005, largely due to the impact of the December 2004 tsunami but growth rebounded sharply in 2006 as tourist arrivals essentially reached their earlier peak level. However, the Government's expansionary fiscal policy adopted in response to the disaster, building on long-standing structural issues, is worsening the fiscal indicators. This deterioration could threaten long-term prospects. Nevertheless, tourism is expected to expand further in 2007 and growth is projected at 12.1%.
Nepal
Economic growth in 2006 remained hobbled at 2.3% by the long-running insurgency, political instability, and poor weather. Yet there is now guarded optimism on the political, and thus economic, front, due to major political breakthroughs starting in April 2006. These brought a comprehensive peace agreement that officially ended the 11-year armed insurgency and started a political process that holds promise of peace and a transition to a more productive economy. Nevertheless, the challenges are huge, and include widespread poverty, pervasive social inequality, low economic growth, and the legacy of a quasi-feudal political structure.
Pakistan
Buoyant growth, improved macroeconomic fundamentals, and strengthened international credit ratings have been the economy's hallmarks in recent years. In 2006, high oil prices, a weak agricultural performance, as well as the effect of the October 2005 earthquake, trimmed the expansion to 6.6%, while strong demand-side pressures have exposed macroeconomic stresses.
The economy is expected to pick up slightly in 2007 to grow by 6.8%, reflecting some strengthening in agriculture and manufacturing. Inflation is set to moderate to 7.0% (from 7.9% a year earlier), after a further tightening of monetary policy, but still come in above the central bank's target (6.5%). Spurred by an expansionary, pro-growth fiscal policy, the budget deficit will widen slightly (to 4.5% of GDP), as will the current account deficit (also to 4.5% of GDP). The medium-term outlook remains positive, but macroeconomic stability has to be maintained and structural issues addressed.
Sri Lanka
Despite resurgence of the civil conflict, the impact of the Asian tsunami, and near doubling of oil prices since 2004, the economy in 2006 grew at 7.2%, its fastest rate since 1978. This strength was fueled by buoyant private activity and expansionary macroeconomic policies that, though, accelerated Colombo consumer price inflation to 20.5% by January 2007. Growth is forecast to moderate to 6% over the next 2 years, given the conflict, slow pace of structural reform, and need to cool the economy. Further out, if the fiscal consolidation and increased investment envisaged in the new 10-year development framework are achieved, growth is expected to pick up substantially.
Development challenges
South Asia's recent economic performance shows it can match East Asia's growth rates. To sustain this accelerated growth, the subregion faces challenges and opportunities at global, regional, and country levels. Although the world price of oil is expected to decline somewhat with the slowdown of the US and EU economies, it may not happen because of political developments in the Middle East. The earlier oil price hike hit South Asian economies hard, imposing a burden of about 20% of export earnings. Moreover, governments shielded their economies from the full impact of rising prices with subsidies, which are unsustainable. South Asia needs to develop an energy policy aimed at reducing demand, supporting the expansion of local energy supplies, and developing regional distribution networks that allow cost-effective transfers of power and gas among countries.
Growing global payments imbalances pose a risk to South Asia as a disruptive correction could abruptly check capital flows, increasing the cost of funds, and possibly deflating the ballooning asset prices in the subregion. To buffer such an eventuality, reforms of the subregion's financial systems, which started in the early 1990s, must continue apace, especially in the inefficient public sector banks that still predominate in several countries.
The incomplete pass-through of oil prices implies that inflationary tendencies remain suppressed throughout the subregion. If domestic demand pressures are not successfully checked by tightening monetary and fiscal policies, inflation and the current account deficits could rise to acute levels. Macroeconomic policies therefore have to be carefully crafted to sustain economic growth and maintain price stability to insure the regional economies a soft landing.
Moreover, the structural policy reforms that have spurred recent private sector-led growth should continue with emphasis on reducing barriers to employment growth that would alleviate poverty. In South Asia, the agriculture sector provides the most employment, but falling levels of public investment, deterioration in support services and inappropriate output pricing, marketing and subsidy policies in several countries have led to erratic performance.
As industrial growth is picking up, policies that improve the business climate and infrastructure are needed to sustain that accelerated pace. Despite recent liberalization policies, South Asia's regulations for industry, trade, labor, finance and taxes are limiting its growth and employment potential. A recent analysis concluded that improving these regulations to the level of Thailand would generate additional GDP growth of 0.8% in Bangladesh and Pakistan, and 1.6% in India. Electricity, water, road, rail, airports, and port services are poor throughout the subregion. Improvements within every country and in intraregional connections would yield substantial dividends by reducing costs of production and trade.
India accounts for 80% of South Asia's GDP, and so its accelerated growth can benefit the subregion by policies to integrate regional economies. South Asia has not done well in integrating with the rest of the world and, although steps for regional integration have been taken, the subregion is still far behind Southeast Asia on both counts, achieving only about one fourth of its total trade to GDP and intraregional trade penetration levels.
Through integration, enhancing efficiency and improving product quality offers immense opportunities for sustaining rapid growth and reducing poverty. As India shares borders with most South Asian countries, it could be the hub for expanded trade and investment for goods and services in the subregion. Obstacles to intraregional trade remain high, but can be overcome by following the example of the ASEAN group of countries, which eliminated nontariff barriers, reduced tariffs, and simplified and harmonized customs procedures.
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