Chapter

1 Sustaining and Broadening the Growth Momentum

Author(s):
International Monetary Fund
Published Date:
April 2008
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Following a long uninterrupted period of strong global expansion, world economic growth has begun to moderate in response to the continuing financial market turbulence that started in August 2007. Although downside risks have increased, global growth prospects remain broadly positive, with world GDP growth in 2008 slowing to a projected 3.7 percent, from 4.9 percent in 2007. What makes this period of economic expansion different from previous periods is the broad-based character of the growth momentum: emerging market economies and other developing countries have rapidly increased their shares in global production and trade.1 The resulting convergence of income levels between advanced and developing economies helps in the fight against poverty, because poverty reduction will be elusive without strong, private sector-based economic growth. The increasing significance of developing countries as attractive places to invest, the international migration of labor, and the emergence of new donors have also changed the composition of international financial flows: private capital and workers’ remittances have grown in importance as main sources of financing in many developing countries. The benefits of the global expansion, however, have not reached all developing countries, especially the many fragile states where per capita growth rates remain negative. Also, income inequality has risen within many countries, mainly as a result of the effects of technological progress on relative wages of unskilled workers, confirming the importance of improving access by low-income workers to high-quality education.

A stable macroeconomic policy framework, strong private sector development, and good governance are key to strong growth and poverty reduction. Many developing countries have made steady progress in improving macroeconomic policies, the investment climate, and governance in recent years. The World Bank’s Doing Business 2008 and Enterprise Surveys show that changes are occurring across many areas, although governments need to step up their reform efforts in areas such as labor laws, property rights, and contract enforcement. Also, the depletion of natural resources and environmental degradation undermines the long-term growth prospects of many developing countries.

The Global Economy: Recent Developments and Prospects

Notwithstanding the tightening of global credit conditions following problems in the U.S. subprime mortgage markets and the spread to other segments of financial markets, global growth eased only modestly in 2007, to 4.9 percent, supported by robust expansions in emerging market and other developing countries (table 1.1). Rapid growth in most emerging markets counterbalanced the slowing of growth in the United States, which grew at about 2.2 percent in 2007 (compared with 2.9 percent in 2006), as the correction in the housing market continued to act as a drag on the economy. Growth in the Euro area and Japan slowed in the last quarter of the year after two years of strong gains. Global growth is projected to slow in 2008 to 3.7 percent. As a result of revisions to estimated purchasing power parity exchange rates, historical data for world economic growth were revised in early 2008 (see box 1.1).

Table 1.1Summary of world outputannual % change
200220032004200520062007a2008

(projectedb)
2009

(projectedb)
World output3.14.05.34.45.04.93.73.8
Advanced economies1.61.93.22.53.02.71.31.3
of which
United States1.62.53.63.12.92.20.50.6
Euro Area (15)0.90.82.01.52.82.61.41.2
Japan0.31.42.71.92.42.11.41.5
United Kingdom2.12.83.31.82.93.11.61.6
Canada2.91.93.13.12.82.71.31.9
Other advanced economies3.92.64.93.94.54.63.33.4
Emerging market and developing countries5.16.77.77.07.87.96.76.6
Africa3.64.75.85.95.96.36.36.4
Central & Eastern Europe4.54.86.75.66.65.74.44.3
Commonwealth of Independent States5.37.98.46.68.28.57.06.5
Developing Asia7.08.38.89.09.69.78.28.4
Middle East4.06.65.65.65.85.86.16.1
Western Hemisphere0.32.46.04.65.55.64.43.6
Source: IMF.Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during January 30–February 27, 2008.

Country weights used to construct aggregate growth rates for groups of countries were revised from those reported in the October 2007 World Economic Outlook to incorporate updated purchasing power parity (PPP) exchange rates released by the World Bank.

Source: IMF.Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during January 30–February 27, 2008.

Country weights used to construct aggregate growth rates for groups of countries were revised from those reported in the October 2007 World Economic Outlook to incorporate updated purchasing power parity (PPP) exchange rates released by the World Bank.

Core inflation has increased since mid-2007 in both advanced and emerging economies, driven by the spillovers of higher energy and food prices to other sectors of the economy. While prices in Japan have essentially been flat, headline inflation in the United States and the Euro area increased in February 2008, to 4.1 percent and 3.3 percent, respectively. Inflation has also picked up in a number of emerging market and developing countries, reflecting strong domestic demand and rising food prices. The upward pressure on food prices reflects the increasing use of corn and other food items for biofuel production, poor weather conditions, supply disruptions in a number of countries, and global demand growth. Meanwhile, oil prices rebounded to new highs in March 2008.

Global credit market conditions have deteriorated sharply since August 2007 as a repricing of credit risk sparked increased volatility and a broad loss of liquidity (box 1.2). Rising delinquencies on U.S. subprime mortgages have led to higher yields on securities collateralized with such loans and a sharp widening of spreads on structured credits, particularly in the United States and the Euro area. Market strains are amplified by uncertainty about the distribution of associated losses and the exposures of financial institutions through off-balance-sheet liabilities. These strains have led to a drying up of high-yield corporate bond issuance, a sharp contraction in the asset-backed commercial paper market, a sharp reduction in liquidity in the interbank market, and stress on financial institutions relying on wholesale markets for funding. The resulting flight to quality has served to drive down yields on government debt. Although emerging markets have thus far been less affected by the financial turmoil, sovereign spreads have widened, with some scaling back of capital flows, and stock market volatility has increased considerably. Although the liquidity tensions in the interbank market eased somewhat in early 2008, the problems in the structured credit markets put pressure on some financial institutions’ balance sheets and have also started to affect the financial guarantors of over US$3 trillion in securities (monoline insurers), which could undermine the functioning of other financial markets in 2008.

box 1.1Recent revisions of purchasing power parities

The International Comparison Program (ICP) has recently revised its estimates of purchasing power parities (PPP) for exchange rates of developing countries. The PPP rate is defined as the amount of currency that would be needed to purchase the same basket of goods and services as one unit of the reference currency, usually the U.S. dollar. The ICP project, coordinated by the World Bank, produces PPP estimates based on statistical surveys of price data for a basket of goods and services for 100 developing countries. The Eurostat-OECD (Organisation for Economic Co-operation and Development) PPP program provides estimates for another 46 countries. In December 2007 the ICP released preliminary PPP estimates for the 2005 benchmark year, replacing previous benchmark PPP estimates, which date back to 1993 or earlier for most emerging market and developing countries.

The PPP rate can deviate by a large amount from the market exchange rate between two currencies. For example, developing countries typically have relatively low prices for nontraded goods and services, and a unit of local currency thus has greater purchasing power within a developing country than it does internationally. Whereas PPP-based GDP takes this into account, conversions based on market exchange rates typically underestimate the value of economic activity and output of a developing country relative to an advanced economy. PPP exchange rates are used in estimating aggregate economic activity across the world, because they tend to lead to a more accurate estimate of global economic activity than is produced by simply using market exchange rates.

The ICP revisions have implications for the share of global GDP accounted for by individual countries and aggregate global growth based on PPP exchange rates: the International Monetary Fund’s estimate for global growth in 2007 has been revised down to 4.9 percent from 5.2 percent in the October 2007 World Economic Outlook. Downward revisions for PPP-based GDP of two of the world’s fastest-growing economies, China and India, are mainly responsible for the overall reduction of global growth estimates. For 2007 China’s share of global output is now estimated at 10.9 percent (down from 15.8 percent) while India’s share has declined to 4.6 percent (from 6.4 percent). Reflecting the overall reduction in GDP in PPP terms of other countries, the share of the United States in global GDP has been revised up from 19.3 percent to 21.4 percent. Notwithstanding these changes, it remains true that emerging market countries have been the main recent driver of global growth in PPP terms—led by China, which alone contributed nearly 27 percent to global growth in 2007.

Inevitably the new PPPs will also lead to revisions of poverty estimates, such as the number of people living under US$1 a day. The new PPP-based poverty estimates, being prepared by the World Bank, are likely to become available later this year. While poverty levels (number of poor) for some countries may change appreciably, changes in poverty levels over time are likely to be less affected.

Overall, economic activity in emerging economies remained buoyant in 2007. Direct spillovers from the turmoil on emerging economies have been largely contained to date. In contrast to previous episodes of financial turbulence, the effects on emerging and other developing economies have thus far been relatively limited although trade and industrial production are beginning to moderate. This is not to say, however, that these countries have not been affected. Not only have emerging markets seen a marked increase in risk premiums and substantial reductions in equity valuations, but aggregate capital flows to these economies have also moderated since August 2007. Overall flows, however, remain well sustained, and international reserves have continued to rise.

box 1.2The recent financial market turbulence

Mature financial markets have been experiencing significant turbulence since July 2007. In the summer of 2007 problems that surfaced in the U.S. subprime mortgage and leveraged loan markets prompted a retrenchment from risky assets and a process of deleveraging, causing severe disruptions in money markets, funding difficulties for several financial institutions, a widening of credit spreads in riskier asset classes, and more volatile bond and equity markets. Major central banks have responded with exceptionally large liquidity injections, and the U.S. Federal Reserve has lowered interest rates six times since August.

Although immediate pressures in mature money markets have eased somewhat, financial sector problems have both widened and deepened in recent months as the size of the credit losses and their impact on banks’ balance sheets have become more evident. Spillover effects on other segments of financial markets, in particular credit insurance, have also emerged. Meanwhile, the combination of financial sector weakness and an ongoing deepening of the slump in the U.S. housing sector have increased the risk of a sharp slowdown in U.S. output growth and dampened the outlook for global growth. This worsening outlook has been reflected in substantial corrections in global equity markets.

The problems in credit and asset markets have been principally a mature market phenomenon, and—in contrast to previous episodes of financial turbulence—the effects on emerging markets and other developing countries have thus far been less severe than in previous crises. This is not to say, however, that these countries have not been affected. Emerging markets have seen a marked increase in risk premiums (EMBIG spreads have roughly doubled since June 2007) and orderly but substantial reductions in equity valuations, in line with mature markets.

Generally, however, these developments have not given rise thus far to acute financing difficulties in developing countries, although private external debt market issuance has declined. Some repricing of risk was inevitable, and even desirable, because risk appetite had risen to unprecedented levels and was contributing to demand booms and excessive borrowing, fueling vulnerabilities in some countries.

Several factors help explain why developing countries have been relatively resilient. The recent turbulence has been closely related to innovative financial instruments that so far are less prevalent in less-developed markets. More important, many of these countries exhibit stronger fundamentals and improved policies than in the past. In particular, in many countries current account positions are more favorable this time around, with developing countries as a group showing a significant surplus. And several emerging economies benefit from high levels of foreign exchange reserves and are thus more resilient to short-term funding disruptions.

This improved resilience notwithstanding, the persistence and recent deepening of turbulence in mature markets, and the knock-on effects on world growth that are gradually becoming evident, pose significant risks to economic conditions in developing countries.

There is a risk that a continuation and further deepening of problems in mature financial markets, and a further retreat of risk appetite, may start to affect flows to emerging markets in a more profound way. In particular, this would seem a risk in countries that have large current account deficits, that have experienced sharp increases in asset prices fueled by foreign currency lending, or that have large balance-sheet vulnerabilities, including substantial currency and maturity mismatches (examples include various countries in Central and Eastern Europe, some of which exhibit all of these characteristics).

But more important, emerging economies and other developing countries will be affected through the channel of lower global economic growth. Against the backdrop of lower global demand, trade flows and commodity prices may potentially see substantial corrections. Since the boom in commodities prices has been one of the key factors underpinning the strong performance in many commodity exporters, a sustained decline in commodity prices may have significant adverse effects on economic performance and balance of payments positions.

For low-income commodities exporters, to the extent that they are less diversified, the direct effects of falling commodities prices on economic growth may be particularly acute. For emerging markets, however, a sharp worsening of the external environment could trigger a vicious cycle of lower growth, weaker fundamentals, higher risk premiums, and faltering asset prices. Commodity importers, however, may experience beneficial effects from lower commodity prices.

Given current uncertainties and country differences, there is no single policy prescription for developing countries: vulnerabilities and the appropriate policy responses must be assessed on a country-by-country basis.

However, countries with prudent external debt management, fiscal discipline, and flexible exchange rate policies will be in a better position to cushion shocks and facilitate adjustment when faced with external shocks such as the current financial market turbulence. Financial sector supervisors—in financial systems that have not yet been tested—also need to learn from the fault lines exposed in the current market turmoil and strengthen their arrangements to facilitate the continued capacity of their financial systems to support growth.

Source: Bloomberg.

For 2008 growth for emerging and developing economies as a group is projected to slow to 6.7 percent, from 7.9 percent in 2007. Although the underlying driving forces and economic policy settings differ from country to country, the growth trends are broadly based, affecting all major regions. Growth performance in emerging Asia reflects high productivity growth and sound economic policies in general. The regional expansion in Asia continues to be led by China and India, where real GDP growth is projected to reach 9.3 percent and 7.9 percent in 2008, respectively, reflecting strong exports and gains in domestic investment demand. Economic activity remains buoyant in most other emerging economies in the region as well, including Indonesia and the Philippines. Emerging economies in the Middle East continue to benefit from high oil prices and strong domestic demand, with GDP growth projected to reach 6.1 percent on average in 2008. Economic activity in the oil-exporting countries is particularly buoyant in the non-oil sectors, fueled by increasing public investment in infrastructure, social spending, and consumer demand. Oil-importing countries in the region are benefiting from the favorable external environment in the region and beyond: their GDP growth rates outpace growth in the oil-exporting countries. Although economic developments in emerging Europe have benefited from the sustained recovery in Western Europe and further integration in the global economy, the outlook is clouded because of the recent slowdown in Western Europe and the prospect of lower capital inflows on which a number of countries are reliant. Regional growth is expected to reach 4.4 percent in 2008, with the Baltics in the lead. By historical standards, growth in emerging economies in Latin America remains robust, although the growth prospects for 2008 are vulnerable to the slowdown in the United States.

Many emerging economies should be relatively well-prepared to deal with a less favorable external environment, as their underlying vulnerabilities have declined to the lowest level in a decade. Underlying trends, however, vary considerably across regions. While emerging Asia, the Middle East, and Latin America are showing continuous improvements, less progress has been made in reducing vulnerabilities in emerging Europe. External and financial sector vulnerabilities in emerging Europe have edged up in recent years, reflecting weak current account positions, rapid credit growth, and extensive foreign currency lending to unhedged borrowers.

Continuing the trend that started in the beginning of the decade, many low-income countries are benefiting from strong demand for commodities. Growth performance in Sub-Saharan Africa, projected to reach 6.3 percent in 2008, will be led by the expansion of oil production and the traditional nonfuel commodity exporters, although the slowing of the global economy could threaten the outlook in some countries. Many low-income countries in the region are experiencing positive spillovers in the non-commodity sectors, as evidenced by broad-based domestic demand growth. The positive domestic growth dynamics, against the backdrop of continued progress in macroeconomic stabilization, steady improvements in the business climate, the favorable impact of debt relief, and increased capital inflows, may put Sub-Saharan Africa on a sustained path toward more rapid poverty reduction. Growth performance in the region is uneven, however, with some subregions and countries (e.g., countries in the CFA franc zone, fragile states) remaining on a low growth path, and most countries will need to make further progress in improving the business climate to attract investment and foster growth in the nontraditional sectors. Although resource-intensive low-income countries in Asia and the Commonwealth of Independent States (CIS) are benefiting from high commodity prices and expansion of production capacity in traditional export sectors as well, achieving higher productivity growth and attracting investment in the nontraditional sectors remains a challenge.

The overall balance of risks to the global outlook is tilted to the downside. The main risk to the outlook for global growth is that ongoing turmoil in financial markets will further reduce domestic demand in the advanced economies with more significant spillovers into developing countries, leading to sharper downturns. Emerging market countries that are heavily dependent on capital flows could be particularly exposed. In addition, a number of other risks remain elevated. Oil and nonfuel commodity prices continue to pose risks to both activity and inflation, so that monetary policy could face the difficult challenge of balancing the risks of higher inflation and slow economic activity. Heightened financial sector vulnerabilities also raise risks of a disorderly unwinding of global imbalances should investor preferences shift abruptly.

Growth in Developing Countries: Strong but with Widening Gaps

The favorable global economic environment of the past years has contributed much to the fight against poverty in the world. Overall, developing countries remain on track to meet the first Millennium Development Goal (MDG), with the population share of the extremely poor (living on less than $1 a day) projected to fall from 29 percent in 1990 to 10 percent in 2015. By 2004 this share had already dropped to 18 percent. Preliminary estimates suggest that the number of extremely poor people in developing countries fell by about 278 million between 1990 and 2004. There are, however, significant differences between groups of countries. Most Sub-Saharan African countries remain a long way off the path that would take them to MDG 1, even assuming projected growth rates higher than the historic averages since 1990. Progress among fragile states with relatively low growth rates, most of which are in Sub-Saharan Africa, is particularly disappointing: income poverty rates in these countries have not declined much since the early 1990s (figure 1.1).

figure 1.1Poverty head count

percent of population living on less than $1 a day and $2 a day

Source: World Bank.

Note: Figures for 2015 reflect poverty headcount projections. Poverty numbers based on new estimates of purchasing power parities are forthcoming.

Per capita growth performance shows marked differences within regions and groups of countries, with implications for progress in reaching the poverty MDG (figure 1.2). To get a clearer picture of the differences in performance and the potential impact of growth on poverty reduction, figure 1.3 presents developing countries’ per capita growth performance in four subcategories: countries with negative average growth; with less than 2 percent average growth; with between 2 percent and 5 percent average growth; and with more than 5 percent average growth during the period 2003–07. In about one-fourth of developing countries, per capita growth during the past five years remained on average below 2 percent a year, which was in most cases insufficient to make a serious dent in income poverty rates. This group of countries includes some emerging market economies and a number of other developing countries (mainly low-income countries in Sub-Saharan Africa and Latin America) and fragile states. The situation of the 17 fragile states in the low-growth category is particularly worrisome: over this period, per capita income contracted annually by about 1 percent on average. Although many fragile states in this group showed some improvement in growth trends in recent years, their overall performance remains disappointing.

figure 1.2Per capita GDP growth rates by country group 2003–07

Source: IMF.

figure 1.3Number of emerging-market and developing countries by annual real GDP per capita growth rates, 2003–07

Source: IMF.

The diversity of development in Sub-Saharan Africa is particularly striking (box 1.3). Countries with good growth performance, such as Ghana, Mozambique, Tanzania, and Uganda, which a decade ago appeared to have grim prospects, are making solid progress toward the MDGs. These countries are also stepping up investment in infrastructure and energy, thereby strengthening the foundation for sustained, broad-based growth. At the same time, about a third of Africa’s population lives in countries that are facing economic conditions severely constrained by internal conflict and weak governance. These countries are facing a mixture of security, political, legal, economic, and developmental challenges. Poverty in many of them has increased, and problems in some cases have spilled over to their neighbors.

Per capita growth performance in the majority of developing countries, however, improved significantly during the past years, including in some fragile states. Most countries achieved average per capita growth rates above 2 percent during 2003–07, laying the basis for steady progress in reducing poverty rates. Emerging market economies in this category (including countries in emerging Europe, Latin America, and Southeast Asia) led in this respect, with per capita growth rates roughly doubling in comparison with the 1990s. Several fragile states experienced a strong acceleration of growth in recent years, reflecting the transition from a conflict situation (Sierra Leone), or the effects of higher oil and gas exports (Angola, Chad, and Sudan).

Rising Commodity Prices: Impact and Implications

The positive growth trends in developing countries in recent years occurred against the background of strong upward movements in world commodity prices (figure 1.4).2 World prices for key commodities exported by developing countries increased by 100–300 percent during the past four years. Exporters of copper and uranium experienced the steepest world market price increases, which more than quadrupled, while oil prices tripled and aluminum, coal, and gold prices doubled.

figure 1.4Commodity price indexes, 1991–2007

Source: IMF.

Note: Price index in special drawing rights.

box 1.3Growth in Africa: rising but uneven

Economic growth in Africa has been rising, from a low of 2.3 and 2.1 percent annnually in the 1980s and 1990s, respectively, to an average of 5.6 percent in the past five years. The growth performance, and related policy challenges, however, vary considerably across countries (see map below for growth dispersion during 2004–06). Reviewing trends over the past 10 years, three broad groups of countries can be distinguished. The first group has enjoyed strong growth averaging about 9 percent annually during that period. It comprises 7 resource-rich countries accounting for about one-third of the region’s population. The main challenge they face is in managing and transforming their natural resource wealth into long-term sustainable growth. This calls for good governance to support extracting and managing the resource wealth efficiently and transparently and transforming resource revenues into productive investments that help diversify the economic base.

The second group has achieved moderate to strong growth averaging about 5.5 percent in the past 10 years. This group comprises some 18 countries, home to roughly one-third of the region’s population. These countries have fairly well-managed economies and potential to improve their growth performance. Their main challenge is to build on reforms to strengthen the foundation for strong, sustained, and broad-based growth. Further improving the climate for private investment, through regulatory and institutional reform and strengthening physical infrastructure, and deepening regional and global links are key elements of the policy agenda. In support of this agenda, they need scaled-up assistance from development partners.

The third group is characterized by low, and in some cases negative, growth. It comprises some 20 countries, accounting for the remaining one-third of the region’s population, that achieved average growth of only 2.1 percent in the past 10 years. These countries have much weaker policies and institutions, with many affected by conflict. Their policy agenda consists of a challenging mixture of security enhancement, political reform and consolidation, capacity building, and actions to build private sector growth opportunities. They need international aid but must build basic governmental capacity to ensure its effective use.

GDP per capita growth in Africa

Nonfuel and fuel commodities constitute about one-fifth of world trade. Developing countries are highly dependent on commodity exports: On average commodities represented about 74 percent of developing countries’ exports during 2003–06. Oil exporters are among the countries having the least diversified export base, with oil exceeding 70 percent of total exports. At the same time, developing countries are affected, as importers, by the commodity price boom. Rising energy and food prices affect the external payments positions and growth prospects of those developing countries that are less well-endowed with natural resources.

The commodity price boom has led to important shifts in the terms of trade of developing countries. Terms-of-trade changes have been a factor contributing to the differential growth performance of these countries (figure 1.5).3 Staff calculations of the effects of terms of trade on domestic purchasing power show that the recent commodity price boom has positively affected most oil exporters among emerging countries (Kazakhstan, República Bolivariana de Venezuela), other developing countries (Azerbaijan, the Islamic Republic of Iran), and the fragile states (Angola, Sudan). Other commodity exporters, in particular of metals such as copper, gold, nickel, cobalt, and uranium (Mongolia, Niger, Papua New Guinea, and Zambia) have also benefited from the terms-of-trade gains. For these countries sound management of the rise in natural resource revenues will be important to translate this boom into laying stronger foundations for sustainable growth (box 1.4).

figure 1.5Terms-of-trade changes by country group, 1991–2007

Source: IMF.

Note: Low-growth countries have per capita growth rates of less than 2 percent. Medium-growth countries have per capita growth rates between 2 percent and 5 percent. High-growth countries have per capita growth rates above 5 percent.

At the same time, many countries experienced a negative terms-of-trade shock, with particularly damaging effects on the urban poor faced with high petroleum and food prices: for example, El Salvador among emerging markets, Jordan, Madagascar, and Mauritius among other developing countries, and Haiti and Togo among the fragile economies. The large group of fragile states with weak growth performance and deteriorating terms of trade is particularly hard hit: during the period 2003–07, their domestic per capita purchasing power declined by an average annual rate of 2 percent, as against an annual per capita GDP decline of almost 1 percent (figure 1.6). For countries negatively affected by oil and food price increases, possible policy responses range from energy demand management and targeted safety nets for the affected poor to longer-term measures to encourage energy production and diversification and to promote agricultural growth (boxes 1.5 and 1.6).

figure 1.6Real per capita GDP growth rate for low-growth fragile states, adjusted for terms-of-trade changes, 1991–2007

Source: IMF.

Rising Income Inequality within Countries

Although high growth rates have helped reduce global poverty, they have been accompanied by rising income inequality in many developing countries. A recent study by International Monetary Fund (IMF) staff shows that since the beginning of the 1980s, per capita incomes rose in most countries, making most people in developing countries better off.4 However, income inequality within countries, as measured by the Gini coefficient, also increased in most cases (figure 1.7). The increase in inequality in general was more pronounced in countries with relatively high growth rates. At the same time, income inequality tended to decline or remain relatively stable in countries with lower growth rates, primarily CIS countries and countries in Sub-Saharan Africa. In some of these countries, the poorest quintiles of the population have benefited from rapidly growing private transfers and higher agricultural exports.

figure 1.7Annual change in Gini coefficient in 59 developing countries

Source: World Bank staff calculations based on latest available country surveys.

Technological progress has had the greatest impact on increasing income inequality within countries (figure 1.8).5 It has been found to affect adversely the distribution of income in both developed and developing countries by reducing demand for low-skill activities and therefore the incomes of low-skilled workers. Financial globalization has also been a factor contributing to increased inequalities. Although financial deepening promotes higher growth, it can also increase income inequality because richer segments of society have better access to financial services. The strong growth of foreign direct investment in recent years has been directed mainly to technologically intensive sectors, pushing up wages of skilled labor relative to those of unskilled labor. In contrast, trade liberalization has had the effect of reducing income inequality in developing countries. It has helped increase exports and incomes in agriculture, an important source of income for less-skilled workers. The overall effect of globalization in most developing countries has been to lower inequality marginally, with the effect of financial globalization being more than offset by the effect of trade liberalization.

figure 1.8Decompositions of change in the Gini coefficient

Source: IMF 2007.

Note: 1991–2006, or shorter periods dependent on data availability. “Globalization” includes both trade and financial globalization.

box 1.4Management of natural resource revenues

Economies benefiting from additional revenue inflows face a fundamental choice on how to manage the resulting gains. The windfall from high prices on oil and other primary commodities accrues to both public and private sectors in many commodity-exporting developing countries. For the public sector, such a windfall translates into higher fiscal revenues, but its potentially destabilizing effects are a challenge for macroeconomic management.

Experience in macroeconomic management of the recent resource revenue windfall suggests that policy responses can be guided by the following principles:

  • The medium-term fiscal policy should be guided by estimates of the magnitude and permanency of additional fiscal revenue. If the increase is substantial and is considered permanent, the government can build a gradual increase of spending into its expenditure plans. Such an increase should be made effective with a certain lag from the initial rise of revenue to create a safety margin and ensure that the price increase is indeed permanent. If the gains are expected to be reversed soon—either because of a price reversal or because of the depletion of natural resources—the increase in permanent income will be limited and most of the windfall should be saved. Countries faced with a rapid decline in their natural resources and permanent income should consider allocating the windfall revenue to investments that will generate alternative sources of permanent income in the future. Depending on the circumstances, this could include higher public investment in growth-enhancing projects and the accumulation of foreign financial assets.
  • One-off increases in spending financed by temporary windfalls are possible, as long as they are limited in duration and address a specific problem. Natural and health disasters and crucial development needs where short-term investment may make an immediate and substantial difference are the obvious target areas for the one-off increases in spending. Such additional spending of part of the temporary windfall should be limited to projects that do not entail sizable recurrent spending in the future and in areas where the implementation capacity is not a binding constraint. The windfall can be also spent on retirement of public—domestic or external—debt, in particular the repurchase of nonconcessional debt held by external commercial creditors. In all cases, the absorptive capacity and the quality of spending should remain the guiding posts.
  • The overall macroeconomic policy mix should be geared to reconciling the effective use of all resources with price stability. Under a flexible exchange rate regime, to control inflation the authorities have a policy choice between sterilization through higher fiscal surpluses and nominal exchange rate appreciation. As time passes, however, sterilization through higher fiscal surpluses may not be sustainable, as pressing spending needs translate into an adjustment of spending levels to higher permanent fiscal income. Therefore, some appreciation of the nominal exchange rate seems to be the appropriate medium-term policy response. In the case of a fixed exchange rate regime, temporary higher domestic inflation and real appreciation may be unavoidable. Improvements in productivity are the main way to address the resulting loss of competitiveness in these countries.
  • Sound institutions, governance, and public finance management are essential to ensure quality spending of the windfall. Windfall gains should be considered in a medium-term framework, which would link annual budgets to longer-term policy objectives. The development of special institutions to manage resource windfalls (i.e., oil and stabilization funds, oil accounts, special fiscal rules and legislation, and the like) is in general useful, if such institutions are well-designed, transparent, and accountable. Integration of the special institutions with the budget and the legislated budgetary procedures generally helps strengthen their transparency and quality of spending of the windfall gains. Countries also should be encouraged to participate in the Extractive Industries Transparency Initiative, which is making headway with 15 confirmed candidate countries and 7 countries with reports out and a system in place for validating performance.

These findings point to the importance of expanding access to education to broaden opportunities for workers to participate in more technologically advanced and remunerative sectors of the economy. They also suggest the need to broaden access to financial services. Finally, they underscore the opportunities for countries to harness trade for stronger and more inclusive growth, a topic discussed in chapter 4. Vietnam provides an example of a successful reform strategy for growth with equality (box 1.7).

Continuing Shifts in Foreign Public and Private Financing Flows

The favorable global economic environment in the past years was associated with a strong increase in net capital flows and current transfers to developing countries, both in U.S. dollar terms and as a share of GDP (table 1.2). Emerging market economies benefited most from the expansion in financial flows, but flows to some other developing countries and fragile states also increased.

Table 1.2Net financial flows to developing countriesin % of GDP
Average

1991–2001
200220032004200520062007
Emerging market economics6.76.47.57.38.38.29.9
Private capital flows (net)3.42.33.63.75.05.06.3
Private current transfers (net)2.33.23.53.63.63.63.5
Official capital flows and transfers (net)1.00.90.40.0-0.3-0.40.1
Memorandum item:
Reserve assetsa-1.2-1.0-3.4-2.7-3.0-4.0-4.4
Other developing countries12.913.514.014.816.516.215.9
Private capital flows (net)2.44.85.05.36.45.75.8
Private current transfers (net)3.03.74.04.75.35.55.7
Official capital flows and transfers (net)7.45.05.04.84.85.04.4
Memorandum item:
Reserve assetsa-1.5-1.6-2.3-2.3-2.9-4.7-3.9
Fragile statesb14.019.317.817.921.720.518.9
Private capital flows (net)2.84.92.41.14.75.73.5
Private current transfers (net)3.24.76.17.06.86.46.3
Official capital flows and transfers (net)8.09.79.39.810.28.59.1
Memorandum item:
Reserve assetsa-0.5-1.70.5-1.2-2.3-2.1-1.4
Memorandum item:
Total net private financial flows including
current transfers (US$ billions)166.0206.4297.7411.0502.5496.9872.3
Of which:
China19.044.570.6128.387.734.8119.9
India15.727.242.142.042.364.3119.6
Source: IMF staff estimates.Note: Percentage numbers represent unweighted averages.

A minus sign denotes an increase.

Calculations exclude Sierra Leone, Timor-Leste, and Zimbabwe.

Source: IMF staff estimates.Note: Percentage numbers represent unweighted averages.

A minus sign denotes an increase.

Calculations exclude Sierra Leone, Timor-Leste, and Zimbabwe.

In many developing countries, private sources of external financing have grown in importance relative to official sources.6 During the 1990s about half of external financing available to developing countries (as a percentage of GDP) consisted of private financing in various forms; by 2007 the share of private financing had increased to about two-thirds of total external financing. Much of private financing went to resource-rich economies, such as Guyana and, until recently, Azerbaijan. The increase in private financing has also been particularly clear in some fragile states, where private flows have almost doubled as a share of GDP. However, among the fragile states only a handful of countries can be seen as relatively stable destinations for private financing. These are either countries with a substantial mining potential (e.g., Chad and Sudan) or small economies, where a significant part of the private flows consist of workers’ remittances. In emerging market economies, official financing has not been very significant in relative terms since the beginning of the 1990s and, on average, became negative (on a net basis) in the past few years, as many countries accelerated the repayment of their official debt. With improved fundamentals and high growth rates, demand for private equity and bonds in emerging markets was already high in the 1990s, in particular in emerging European economies (Bulgaria, Hungary, Serbia, Ukraine) and some other emerging economies (China, Kazakhstan).

Debt-generating financing (official and private) has become less important in comparison to nondebt forms of financing. Foreign direct investment and workers’ remittances have grown considerably in emerging markets, other developing countries, and some fragile states. Although much of the growth in foreign direct investment is related to investment in extractive sectors in resource-rich countries, macroeconomic stabilization and improvements in the investment climate have facilitated the expansion of investment in other sectors as well. As a result of the shifts in the composition of external financing and debt reduction operations, net liabilities to official creditors have dropped noticeably. Also, in many countries the accumulation of foreign reserves during the past five years exceeded the growth in capital inflows and current transfers, reflecting the improvements in their trade accounts. As a result, the external asset/liability profiles of many developing countries have changed considerably over time: short-term debt instruments held by the monetary authorities have increased as a percentage of GDP.

box 1.5Impact of oil price increases on low-income countries

Oil prices have tripled in the past five years to record nominal highs of over $100 a barrel. The rise in oil prices has been mainly the result of strong growth in demand in combination with two decades of limited investment in production capacity. New capacity is only slowly coming onstream because of investment lags of several years and because of rising development costs, shortages of services and trained workers, and constraints on access to reserves in some oil-producing countries. Oil prices are also sensitive to geopolitical developments.

In real terms, oil prices are near their historical peak of $96 a barrel (in today’s dollars) reached in 1979. Part of the large increase in prices results from to the depreciation of the U.S. dollar. Expressed in euros, oil prices have only doubled over the last five years. Oil prices are expected to stabilize and fall gradually in the coming years. High oil prices have led to slowing demand growth and increasing supply, with rising capacity in OPEC (Organization of Petroleum Exporting Countries) and non-OPEC countries. Nevertheless, on current projections, prices could remain well above $60 a barrel this decade, before declining to $50 a barrel by 2015. Risks to this outlook are mainly to the upside.

The oil price shock has had a mixed impact on oil-importing low-income countries. In a recent working paper on the effects of the 2003–05 oil price increases on 62 of these countries, International Monetary Fund (IMF) staff concluded that:

  • For 16 countries there was a decline in the oil import bill relative to GDP owing to a contraction in the volume of oil imports. Many countries passed on world market price increases to domestic prices. The oil price rise did not lead to an adverse impact on the balance of payments for this set of countries, as they saw improvements in both the current and capital accounts during 2003–05.
  • Another 12 countries faced higher oil imports but benefited from substantial current account offsets in the form of improved exports or grant receipts, or both.
  • A third category of 12 countries faced both higher oil imports and a worsened current account but a substantial improvement in the capital account.
  • The remaining 22 importers benefited from neither current account nor capital account improvements sufficient to offset the oil shock and thus saw a deterioration in their international reserves. Within this group, however, a majority of countries maintained relatively comfortable reserve coverage levels and could thus accommodate the drawdown in reserves. Only in a subset of 7 countries did reserves fall to very low levels.a

Although more recent detailed cross-country analyses are not yet published, country-by-country information points to similar factors at work in 2006–07, underscoring the variable impact on countries.

The impact, however, of higher oil prices—compounded by rising food prices—on the most vulnerable segments of the population may be severe. Even in countries that benefited from offsetting price increases in commodity exports or capital inflows, the oil shock may have disproportionate effects on the poorest. Going forward, it cannot be excluded that the current mitigating factors reverse if oil and commodity prices decouple, a scenario in which oil prices soar (as a result of political developments) while commodity prices deflate in a context of lower global demand.

The IMF and the World Bank stand ready to assist their members in dealing with exogenous shocks of this nature. Under the IMF’s Exogenous Shocks Facility, balance of payments support can be provided to countries faced with a significant increase in world market prices for major import products, such as oil or food. International Development Association financing could help prevent costly disruptions to priority spending and mitigate the impact on the poorest. At the same time, countries need to pursue policies to reduce their vulnerability to oil shocks through energy diversification and improved energy efficiency. The World Bank can assist countries in this endeavor with development policy and sector support operations.

a. Dudine and others 2006.

box 1.6Rising food prices and their policy implications

Over the past 12 months, the world has experienced an average food price increase of 15 percent. Although this price shock does not necessarily translate into higher sustained inflation, it is bound to have adverse effects on poor urban residents in low-income countries. On the positive side, farmers in low-income countries may benefit from higher prices for their crops. A major driver of the food price increases has been high rates of global economic growth in recent years. Demand growth in emerging markets has been particularly strong. Price developments have also been affected by serious droughts and animal diseases in some parts of the world.

More recently food prices have jumped sharply, at least in part because of an attempt to encourage the use of biofuels in industrial countries. Although the use of biofuels has the advantage of diversifying energy sources, the production of ethanol from corn does not generate much net energy, and it has led to a doubling of corn prices during the past two years. This has had knock-on effects on other crops, as land is switched from wheat on the margin, for example, into corn or, as has been most marked in Europe, out of dairy production and into crops used for biodiesel.

The industrial-country policy on biofuels is partly driven by agricultural protectionism. A number of countries, including Brazil, can produce ethanol much cheaper, with a greater saving of nonrenewable energy and lower emissions, for example, by using sugar. But this sugar-based ethanol is subject to prohibitive trade barriers in the United States and Europe. In addition, production subsidies in industrial countries, which are intended to encourage innovation in this sector, seem to have led to excessive entry into the U.S. ethanol distillery business.

Farm subsidies of various kinds in industrial countries have long affected the international trading system and currently make it difficult to move forward with further trade liberalization in the context of the Doha Round. With high food prices, subsidies are less compelling and—depending on how they are structured—may not even pay out when prices are above a certain level. Industrial countries need to seize this moment and eliminate subsidies. Industrial-country tariffs on ethanol should also come down. Allowing free trade in biofuels should generally help agricultural sectors everywhere and bring benefits to poor, rural societies. Opportunities to expand land use will be greater if all countries have a fair chance to produce biofuels.

At the same time, developing countries should pursue policies aimed at increasing growth in agricultural production through small-holder productivity gains. In the short term, there will likely also be the need to cushion the impact of food price increases on the affected poor. In particular, actions in the following areas will be needed:

  • Trade reforms to facilitate flows within and among developing countries. Reducing barriers to regional trade can help improve the efficiency of regional markets. Also, improved infrastructure would reduce transportation cost.
  • More investment in the generation of improved technologies and improved extension services to promote the adoption of better crop varieties.
  • Well-designed, targeted safety nets to provide transitory support to the affected poor in response to price shocks, avoiding recourse to distortive price controls and trade restrictions.
  • Access to weather-based index insurance, which can reduce weather risks and cover loans necessary to finance new technologies.

The World Bank is actively engaged in supporting countries in these efforts and could respond with additional financing if necessary.

Private capital flows have a broadly positive impact on growth. Recent studies generally find bidirectional causality between foreign direct investment and growth, although the impact of foreign direct investment on growth is almost always stronger than that of growth on investment.7 Most country studies confirm that foreign direct investment and private loans are usually associated with higher growth as they help increase production capacity, technology transfer, and improvements in quality standards. Research on the impact of foreign direct investment on growth at the industry level underlines the importance of the quality of investment. Some studies of specific countries actually find an opposite direction of causality, from GDP to foreign direct investment (e.g., in the case of Chile). There have been no conclusive studies on the impact of portfolio investments on growth, although they may contribute to a deepening of financial markets and enhanced financial intermediation, which promote growth in recipient economies.

The Growing Importance of Workers’ Remittances

The growth of workers’ remittances as a source of foreign financing for the economy has been particularly strong in recent years (table 1.3). Remittance flows represent the single largest source of foreign exchange for many countries, exceeding total development assistance.8 Cross-border movements of people and labor are increasingly important factors affecting growth and poverty, with very sizable positive realized or potential welfare effects. Nearly 200 million people now live outside their country of birth. Recorded remittance flows to developing countries grew fourfold between 1991 and 2006 and exceeded US$200 billion in 2006—twice the amount of official assistance to developing countries. If unrecorded flows through formal and informal channels are included, the actual flows would be significantly larger.

Table 1.3International remittancesUS$ billions
Average

1991–2001
20022003200420052006
Emerging market economies43.576.995.3100.2118.9128.0
Inflows50.990.9112.3123.5146.2161.2
Outflows7.414.017.023.327.333.2
Other developing countries11.917.022.227.432.135.5
Inflows15.822.427.933.739.443.2
Outflows3.95.45.76.37.37.7
Fragile states0.11.11.61.81.51.5
Inflows1.02.22.83.12.72.7
Outflows0.91.01.21.31.21.2
Sources: World Bank; IMF.Note: Remittances include workers’ remittances, compensation of employees, and migrant transfers.
Sources: World Bank; IMF.Note: Remittances include workers’ remittances, compensation of employees, and migrant transfers.

The economic gains for both receiving and sending countries may be significant (box 1.8). According to one estimate, an increase in migrants that would raise the workforce in high-income countries by 3 percent by 2025 could increase global real income by 0.6 percent, or US$356 billion.9 On average, the gains are higher for developing-country households than for rich-country households. Improved flows of migrants and remittances by reducing international impediments, transaction costs, and red tape would help realize these gains.

Remittances have had a positive impact on poverty alleviation. Remittances mainly finance primary consumption, critical for the poorest segments of the population. For example, a survey of remittances in Tajikistan showed that most remittances are under US$1,000 a year and tend to be spent mainly on consumption, primarily food, clothing, and medical care.10 In the period of booming remittances in 2000–06 the poverty rate in Tajikistan declined by 20 percent. Poverty-reducing effects are particularly large in the countries where migrants are associated with the lower part of income distribution. For example, extreme poverty fell by 35 percent in El Salvador and Mexico, and moderate poverty fell by 21 percent in El Salvador and 15 percent in Mexico.11 A study of 76 countries (of which 24 are in Sub-Saharan Africa) that utilized poverty surveys beginning in 1980 found that every 10-percent increase in remittances led to a 1-percent decline in poverty.12

box 1.7Vietnam: Growth with equality leads to dramatic success in reducing poverty

Over the last 15 years, Vietnam has achieved one of the world’s fastest declines in poverty. Vietnam’s income poverty rate declined from about 58 percent in 1993 to about 16 percent in 2006 and some 34 million people have come out of poverty. Steady and rapid growth in income, of 7–8 percent, has been a key factor in reducing poverty.

The high growth rates have been accompanied by only limited increases in inequality. The Gini coefficient increased from 0.34 in 1993 to 0.36 in 2006, a much lower increase than in many other emerging economies. Growth and poverty reduction have come in both rural and urban areas. While urban poverty is much smaller—about 4 percent in 2006—rural poverty has declined from two-thirds of the population in 1993 to about one-fifth today. The reduction in poverty has occurred in all parts of the country. Poverty is much lower in the Mekong and Red River delta than in other parts of the country, but the decline in poverty has also been felt in the Northern Mountains and Central Highlands where poverty is relatively higher. Three factors have led to Vietnam’s inclusive growth—literacy, trade, and infrastructure.

Vietnam’s drive towards literacy began as early as 1945 and was reinforced throughout the 1970s and 1980s. A final major push for universal literacy was made between 1990 and 2000, when provincial and commune level literacy campaigns were launched. Today Vietnam has achieved over 95 percent literacy. Access to schools has improved dramatically, with average travel time to lower secondary school down to 15 minutes.

Vietnam’s openness to trade—the ratio of exports plus imports to GDP is about 150 percent—has been a second key to inclusive growth. From a food-deficit country in the early 1990s Vietnam has emerged as a major exporter of agricultural products. Bilateral and multilateral trade agreements have also helped to generate foreign direct investment and have made it a major exporter of apparel, wood products, and light industrial products, with major employment benefits to the economy.

Finally, infrastructure, especially rural electrification and rural roads programs, has ensured that remote areas are not left behind. Today, almost 95 percent of Vietnamese households have electricity connections, compared with only 50 percent in the early 1990s, and 90 percent of the population is within two kilometers of an all-weather road. This has allowed connectivity between rural and urban areas and to the country’s main ports and transport and communication networks.

Can Vietnam sustain its inclusive development model as it rapidly approaches middle-income-country status? Vietnam will need to help its citizens access higher education, just as it did with basic education, to ensure that rural productivity is lifted as it industrializes further and to see that its ethnic minorities are provided opportunities to develop. It will also need to build modern social safety nets to assist those affected by future transitions and to ensure that its growth does not come at the cost of its environment.

The evidence on the impact of remittances on social outcomes is ambiguous. Remittances have contributed to better access to health care and education by providing additional means to recipient households for financing their educational and health needs. For example, a study of three country cases (Guatemala, Mexico, and the Philippines) showed that remittances had reduced poverty and increased private spending on education and health.13 At the same time, in most developing countries international migration involves relatively better-educated people, reducing the number of doctors, teachers and engineers in those countries. The brain drain exhibits significant regional differences and dynamics, with more serious implications for isolated smaller economies. Smaller low-income countries, such as Haiti and Jamaica, tend to suffer a greater brain drain with a large negative social impact than do larger countries like India and China. While skilled emigration may raise the incentive to acquire skills for those who stay, the departure of skilled labor can adversely affect the livelihood of the majority left behind.14

box 1.8Private remittances: positive effects and risks

Remittances may have significant positive effects on the receiving countries:

  • Poverty reduction. In countries without a developed social insurance system and efficient domestic labor market, labor migration and remittances often play an important role in addressing poverty. By financing primary consumption, remittances help alleviate extreme poverty, in particular in the countries where migrants represent the lower part of income distribution.
  • Public finances. Imports boosted by remittances are a source of additional revenue collection in the form of value added taxes and import duties. Emigration helps ease the unemployment problem and contain the associated fiscal expenditures.
  • Financial intermediation. As more recipients gain the confidence needed to deposit remittances, the scope for financial intermediation will grow. Remittances have also helped strengthen microfinance institutions, which in turn will be important in channeling remittances to productive use. Several banks in Brazil, the Arab Republic of Egypt, El Salvador, and Kazakhstan have raised cheaper international long-term financing by the securitization of future remittance flows. The inflow of remittances to a bank helps mitigate its currency convertibility risks and makes its securities more attractive for international investors.
  • Investment, and entrepreneurship. There are strong indications that remittances in excess of a certain amount tend to be used for investment, rather than on subsistence consumption. Although a substantial part of large-scale remittances is directed to residential construction and imports, these remittances represent a financial source for establishing small business and equity participation.At the same time, reliance on remittances presents certain risks:
  • Monetary management. In a small economy with a shallow foreign exchange market and insufficient monetary policy instruments, the magnitude of remittances may create challenges for monetary management. Like other large inflows, they may entail currency appreciation and inflationary pressures and may call for greater exchange rate flexibility.
  • The risk of a brain drain. The current flood of emigration from many developing countries is a mixture of unskilled and skilled labor (teachers, doctors, engineers), which is already depriving the country of its future manpower. Although the returning workers provide additional qualified labor for low-income countries, on a net basis the flow of remittances continues to reflect the dominance of emigration.
  • Diminishing pressure for reforms. Remittances may create an illusion of growing and sustainable affluence. The ability of the private sector to address its immediate needs independently from the government can create a disincentive for the authorities to deal with the underlying problems that forced the people to leave the country initially.

Remittances-receiving countries need to develop a strategy to maximize the benefits of remittances while minimizing their negative repercussions. As a first step, it is important to determine whether or not remittances are likely to be a permanent phenomenon. Most developing countries already grant tax exemptions for remittances, and some match investments by migrant organizations in development projects with public funds. Also, many countries have simplified banking procedures for deposits and withdrawals of remittances and increasingly involve microfinance institutions in the remittance market. Reducing the costs of sending remittances would increase the disposable income of migrants’ families and would encourage them to use the official banking channels. However, banking regulations in some sending countries, in particular those related to anti-money-laundering, while necessary for security purposes, remain unfavorable for remittances and are demanding on the migrants, for whom sending money home may be the only contact with the banking system. Encouraging partnership between the international banking and postal services and money transfer operators would help reduce remittance costs while preserving high security standards.

Policies for Strong and Inclusive Growth

Strong and inclusive growth is central to achieving the MDGs and related development outcomes. A key challenge is to spur growth in lagging countries that have not shared in the surge in growth witnessed in much of the developing world over the past several years. Factors underlying the different growth experiences in developing countries are only partly known and continue to be the subject of much research (box 1.9). Specific policy priorities and sequencing of actions to promote growth necessarily vary by country. Across developing countries there is considerable diversity in economic circumstances. The specifics of the policy agenda for growth at the country level must be defined as part of individual country development strategies. Looking across countries, three broad areas emerge as being essential to robust growth: sound macroeconomic policies, a conducive private investment climate, and good governance. This section reviews progress in these areas.

Quality of Macroeconomic Policies

Since 2003 IMF staff have used annual surveys to monitor the quality of macroeconomic policies mainly in low-income countries (table 1.4). The assessment of fiscal policies remains mixed, although there have been marked improvements. Almost half of the monitored countries consistently have scored good ratings on fiscal policy during the past five years, and the number of countries with unsatisfactory policies has declined substantially. Although the composition of public spending has also improved, the quality of policies in this area remains weak, as policies in almost half of the countries continue to be rated unsatisfactory.

Table 1.4The quality of macroeconomic policies in low-income countries, 2003–07share of countries falling in each category, %
Fiscal

policy
Composition

of public

spending
Fiscal

transparency
Monetary

policy
Cosistency

of macro

policies
Governance

in monetary

and financial

institutions
Access to

foreign

exchange
2007 survey
Unsatisfactory18.545.722.59.917.38.64.9
Adequate34.645.745.018.537.028.412.4
Good46.98.632.571.645.763.082.7
2006 survey
Unsatisfactory20.548.721.810.315.415.43.9
Adequate33.338.543.619.232.128.212.8
Good46.212.834.670.552.656.483.3
2003 survey
Unsatisfactory33.849.411.722.417.19.2
Adequate19.532.5..11.729.022.413.2
Good46.818.2..76.648.760.577.6
Fragile states (2007 survey)
Unsatisfactory31.371.945.212.528.118.812.5
Adequate37.525.035.56.337.528.118.8
Good31.33.119.481.334.453.168.8
Fragile states (2006 survey)
Unsatisfactory46.770.040.020.030.030.010.0
Adequate26.720.043.310.030.033.320.0
Good26.710.0016.770.040.036.770.0
Source: IMF Staff.Note: The 2007 survey includes countries absent in the 2006 survey: Cape Verde, Central African Republic, and São Tomé and Principe. It also includes Montenegro and Serbia, two new and separate countries.
Source: IMF Staff.Note: The 2007 survey includes countries absent in the 2006 survey: Cape Verde, Central African Republic, and São Tomé and Principe. It also includes Montenegro and Serbia, two new and separate countries.

Monetary policy, access to foreign exchange, and governance of financial institutions remain relatively strong areas of macroeconomic policies. In particular, there have been improvements in access to foreign exchange and governance in monetary and financial institutions in a number of countries. Consistency of macroeconomic policies remains mixed, as a number of relatively strong-performing countries scored lower in 2007 compared with 2006 and policies in some new countries were rated as unsatisfactory.

The overall quality of policies in countries with low growth rates and in fragile states remains clearly inferior to that of other countries. The composition of public spending, fiscal transparency, and governance of the public sector remain weak in these countries. Monetary policies and access to foreign exchange represent the few relatively strong areas of their macroeconomic policies, but still remain weak relative to many other low-income countries. However, some fragile states (Afghanistan, Haiti, and Liberia) have undertaken efforts in the past few years to improve their macroeconomic policies.

Improvement of Private Investment Climate

Many developing countries have made further progress in improving the investment climate (table 1.5). The World Bank’s Doing Business 2008 report shows that reforms have been most frequent in the area of starting a business. Within the last five years, 92 of the 175 countries covered have reduced the number of days needed to register a business, with 57 reducing the number of procedures needed to do this. The time and number of procedures needed to trade goods across borders have been other areas where improvements have been made in a large number of countries. Notable progress is also indicated in information and legal processes for getting credit. The Bank’s Enterprise Surveys confirm that changes are occurring across many areas—although not always uniformly within a country.

Table 1.5Status of investment climate reform, 2003–07
2005–072003–07
Regulatory actionReformReversalNo changeReformReversalNo change
Starting a business
Number of procedures437125578110
Time (days)66610392578
Dealing with licenses
Number of procedures116158
Time (days)3412128
Employing workers
Hiring index23201322328124
Firing index4516667162
Restrictions on hours worked6316673165
Labor firing costs37164612156
Getting credit
Legal rights index202153
Credit information index507118
Protecting investors
Disclosure index100165
Extent of director liability index41170
Ease of shareholder suits index50170
Registering property
Number of procedures83160114156
Time (days)325134367128
Paying taxes
Number of procedures198148
Time (days)105150
Trading across borders
Number of procedures (exporting)3114130
Time (days) (exporting)5011114
Number of procedures (importing)476122
Time (days) (importing)508117
Enforcing contracts
Number of procedures236146326137
Time (days)100165310144
Closing a business
Time (years)111137143132
Source: Doing Business database.Note: The table shows the number of countries that have reformed, reversed, or made no change in regulations regarding various investment climate indicators. The number of countries has increased overtime from 133 in 2003 to 175 in 2007. Because some indicators are available for five years and others for three years, both time frames are shown. Only countries with at least two years of data are included in the chart.—Not available.
Source: Doing Business database.Note: The table shows the number of countries that have reformed, reversed, or made no change in regulations regarding various investment climate indicators. The number of countries has increased overtime from 133 in 2003 to 175 in 2007. Because some indicators are available for five years and others for three years, both time frames are shown. Only countries with at least two years of data are included in the chart.—Not available.

box 1.9The Commission on Growth and Development

The Commission on Growth and Development was established in April 2006 to learn from the growth experience of the past couple of decades and to assess the opportunities and challenges arising from globalization. Its objective is “to take stock of the state of theoretical and empirical knowledge on economic growth with a view to drawing implications for policy for the current and next generation of policymakers.” The commission does not seek to design a blueprint, but instead aims to provide policy makers and others with the most current assessment of the forces that drive economic growth and with a framework to help design and implement strategies and policies to achieve and sustain rapid growth. The independent commission comprises 21 members (15 are political and policy leaders from developing countries), most with policy-making and business experience. There are two academics on the commission: the chair, Michael Spence; and Robert Solow, both Nobel Laureates. It is funded by the William and Flora Hewlett Foundation; the governments of Australia, the Netherlands, Sweden, and the United Kingdom; and the World Bank (www.growthcommission.org).

The commission invited world-renowned academics, practitioners, and experts to write papers exploring the state of knowledge on growth-related issues, which were reviewed and discussed at several workshops. The commission’s final conclusions and report are scheduled to be published in May 2008. They are expected to cover a range of issues that were discussed at the workshops.

One set of issues relates to the changing growth strategies and role of government in the course of development. Successfully making the strategic and policy transitions as the economy evolves is key to achieving sustained growth. Since World War II, 12 countries, most of them in East Asia, have managed to grow at rates in excess of 7 percent for 25 years or more—rates that allow “catch-up” with advanced economies in a generation or two. However, many more countries—mostly in Africa, Latin America, and the Middle East—have been able to achieve high growth but have been unable to sustain it over time.

Another set of issues discussed by the commission concerns the implications of the new global environment for developing countries’ growth strategies: globalization; global imbalances and financial risks; the demographics of aging in many countries and high youth unemployment in others; and global warming. Also on the commission’s agenda have been the equity dimensions of growth and key sectoral issues in growth including infrastructure, education, health, and labor markets where public sector investment is an important enabler of sustained growth dynamics.

Results show that governments are relatively reluctant to pursue reforms in more sensitive areas, such as labor regulations or bankruptcy law, where social considerations or the existence of significant interest group pressures may be important. Overall, there has been slower progress made in areas where reform requires larger institutional changes, such as labor laws, property rights, and contract enforcement.

Rankings on the “ease of doing business” index generally improve with the income level, but there is considerable variation within each income group. A number of lower-middle-income counties—and even some low-income countries—rank in the top half of countries (figure 1.9), illustrating that fostering a stronger business environment does not require a lot of resources.

figure 1.9Average ranking of “ease of doing business,” by region and income group

Source: Doing Business database.

Note: Each line shows the rank of one country in the group.

In 2006 Sub-Saharan Africa had the third-highest share of reforming countries. In 2007 the region slipped to fifth place on that score. However, some countries made impressive gains: Ghana rose in the Doing Business rankings from 109 to 87, Madagascar from 160 to 149, and Kenya from 82 to 72.

Research confirms impact of reforms.

The top constraints to growth of firms vary by country and firm characteristics. Recent analysis of the investment climate in 34 Sub-Saharan countries, using data from Enterprise Surveys, shows that unreliable or costly infrastructure is particularly constraining in landlocked countries, where it hampers access to markets, and in countries with greater concentration of manufacturing exports, where timely delivery is increasingly important (table 1.6). A more developed financial system and supportive but prudent regulatory frameworks are associated with better outcomes, particularly in lower-income countries. Addressing skill shortages and improving access to finance are most helpful to expanding firms, while labor regulations and corruption are most constraining to declining firms.15 Another recent study based on Enterprise Surveys in Latin America highlights the importance of the governance agenda (figure 1.10).16 The study calls for strengthening of the rule of law and of institutional frameworks to enforce compliance as key priorities for improving firm performance in the region. Additional areas highlighted include expanding access to credit, followed by policies to encourage innovation and investments in human capital.

Table 1.6Low coverage and high cost of Africa’s infrastructure
Coverage deficitHigh costs
ItemSub-Saharan

Africa
Other developing

countries
ItemSub-Saharan

Africa
Other developing

countries
Paved road density

(per 1,000 sq. km)
31134Power tariffs (US$c/kWh)0.05–0.300.05–0.10
Total road density

(per 1,000 sq. km)
137211
Mainline density (lines

per 1,000 people)
1078Road freight tariffs (US$c/ton-km)0.05–0.250.01–0.04
Mobile density (lines

per 1,000 people)
5586
Generation capacity

(MW per million

people)
37326International phone

call (US$/3-min.

call to the United

States)
0.800.20
Electricity coverage

(% of population)
1641
Improved water

(% of population)
6072Internet dial-up

service (US$/month)
5015–25
Improved sanitation

(% of population)
3451
Source: World Bank Africa Region Infrastructure Country Diagnostic project.
Source: World Bank Africa Region Infrastructure Country Diagnostic project.

figure 1.10Aggregate labor productivity gains in Latin America, by firm size

Source: World Bank 2007.

Note: The figure depicts the potential percentage gains that could beachieved if firms were to move to the 75th percentile of the same industry and firm size.

Investment climate reform promotes a level playing field and broad-based growth.

Weak investment climates affect the prospects of small, medium, and large enterprises in different ways. One dimension by which the impact of the investment climate varies across firms is by size. The impact has something of a u shape—with a weak investment climate generally hurting small and medium enterprises (SMEs), while often encouraging the growth of micro- and informal firms and having less of a detrimental impact on the large firms. Weak infrastructure and corruption are most strongly associated with encouraging the growth of microfirms. In the case of the former, the effect comes through the choice of technology and greater reliance on labor-intensive processes. In locations where the incidence of bribes is higher, firms have the incentive to remain small and “fly below the radar screen” of officials.

Among formal firms, a weak investment climate generally lowers productivity and growth prospects. It is often SMEs that are hurt most as they have fewer alternative ways of compensating for limited access to finance, inefficient government services, and poor infrastructure. SMEs not only have less access to formal finance and pay more in bribes than larger firms, their growth opportunities are more sensitive to financing constraints. In contrast, larger firms can be disproportionately hurt by a weak judicial or property rights system. Weak property rights lower the ability of firms to undertake arms-length transactions, activities most associated with larger firms.17 Strengthening the investment climate is thus an important way of leveling the playing field and ensuring a dynamic SME sector with incentives—and opportunities—to grow and prosper.

Interactions across policy areas are important.

The effectiveness of reforms can depend importantly on the broader quality of institutions. For example, using data from 27 countries in Eastern Europe and Central Asia, a recent study shows that changing the formal rights of creditors has little effect on the share of bank financing available to firms.18 However, the effect is larger when complemented by an efficient court system, which affects enforcement. An evaluation of the impact of Mexico’s reform of the time and costs associated with registering a business on new business entry also confirms the importance of regulatory complementarities.19 The impact was greater in states that had lower regulatory burdens overall.

Need for greater emphasis on implementation and enforcement.

Reforming what is on the books is an important step but only part of the story. What matters is how measures are actually implemented or enforced. The gap between what is on the books and what happens on the ground can be large. In many cases the gap can be explained by corruption. Greater numbers of procedures and longer delays open opportunities for demands for extra payments or offers of speed money, particularly if democratic institutions are weak.20 The effectiveness of investment climate reforms is enhanced by broader improvement in the quality of a country’s institutions and governance.

Governance Reform

Good governance has a positive impact on growth. Research shows that it can also support growth that is more inclusive (box 1.10). An increased focus on governance reform is yielding progress, but institutional weaknesses remain a key obstacle to better growth and development outcomes in many countries.

The World Bank’s Country Policy and Institutional Assessment (CPIA) ratings suggest that governance in developing countries improved between 2000 and 2006 (figure 1.11). Governance in low- and middle-income countries has incrementally improved in almost all categories. All groups of countries experienced the most progress on revenue mobilization and budget management and the least progress on property rights and quality of public administration. As a group, fragile states showed only limited progress in most areas and did not advance on the quality of public administration and transparency, accountability, and corruption.

figure 1.11CPIA governance indicators, 2000–06

Source: World Bank CPIA database.

Note: CPIA is on a scale from 1 to 6, with a higher score denoting better performance. LICs = Low-income countries; MICs = middle-incomecountries; AFR = Sub-Saharan African countries.

Important progress has been made in implementing the Public Expenditure and Financial Management (PEFA) indicator system.21 At end-February 2008, 74 countries had completed or substantially completed a PEFA assessment, with 4 countries having had repeat assessments. Since the PEFA framework was launched only in 2005, it is too early to have a broad assessment of progress over time. A recent analysis of data on poverty-reducing public spending in heavily indebted poor countries (HIPCs), however, shows some improvements in public financial management between 2001 and 2006.22 As of end-February 2008, only 28 PEFA reports had been made public and posted on the PEFA Web site. Efforts toward increased disclosure of these reports must be continued.

Environmental Sustainability and Growth

In the previous sections, progress toward the income poverty MDG is analyzed on the basis of traditional economic variables: per capita GDP, corrected for variations in the external terms of trade. The discussion shows that developing countries’ strong growth performance in recent years has made a crucial contribution to the poverty reduction effort; without strong growth, achieving the MDGs will remain illusory. The traditional measures of economic growth, however, do not take into account the long-term effects of natural resource depletion and environmental degradation on growth and poverty. One of the defining characteristics of developing countries is their high dependence on natural resources. This resource dependence can have implications for the sustainability of poverty reduction if growth is heavily based on the depletion and depreciation of natural assets.

Development policy challenges depend importantly upon whether a country has abundant produced or human capital, cropland or pastureland, forests or fish, minerals or energy. Tables 1.7 and 1.8 present asset accounts for developing regions and income groups in 2005.23 Oil-producing countries are shown separately to account for the special characteristics of their economies. The tables also include a breakout of developing countries into emerging economies, fragile states, and other developing countries. In these tables natural capital consists of cropland, pastureland, timber and nontimber forest resources, protected areas, and subsoil assets (minerals and energy). “Intangible” capital is an amalgam of human capital and institutional quality.

Table 1.7Total per capita wealth and its components, by developing region and economy type, 20052000 US$ thousands
2000 US$ per capitaPercent
Total

wealth
Produced

capital
Natural

capital
Intangible

capital
Produced

capital
Natural

capital
Intangible

capital
East Asia & Pacific16.44.75.66.1283437
Europe & Central Asia36.29.211.515.5253243
Latin America & the Caribbean66.310.216.639.5152560
Middle East & North Africa22.35.512.24.5255520
South Asia8.31.62.74.1193249
Sub-Saharan Africa10.51.43.95.2133749
Emerging market economies22.74.86.611.2212950
Other developing countries12.63.07.22.4245719
Fragile states4.90.75.4-1.315111-26
High-income countries453.478.621.0353.917578
World93.116.99.067.3181072
Major oil producers30.910.431.6-11.134102-36
Source: World Bank estimates. All dollar figures are at nominal exchange rates.
Source: World Bank estimates. All dollar figures are at nominal exchange rates.
Table 1.8Per capita natural wealth and its components, by developing region and economy type, 20052000 US$ thousands
2000 US$ per capitaPercent
Natural capitalAgricultural landForest resourcesProtected areasSubsoil assetsAgricultural landForest areasProtected areasSubsoil assets
East Asia & Pacific5.62.60.40.22.4477442
Europe & Central Asia11.52.20.70.67.9206669
Latin America &the Caribbean16.64.82.60.98.42916550
Middle East & North Africa12.22.10.10.110.0171181
South Asia2.71.70.20.10.7628525
Sub-Saharan Africa3.92.00.80.21.05119426
Emerging market economies6.62.50.60.33.2389548
Other developing countries7.22.10.90.23.92913355
Fragile states5.41.91.00.12.43618145
High-income countries21.05.61.12.112.22751058
World9.03.00.70.64.7338752
Major oil producers31.61.70.81.227.853488
Source: World Bank estimates. All dollar figures are at nominal exchange rates.
Source: World Bank estimates. All dollar figures are at nominal exchange rates.

box 1.10Institutions, inequality, and growth

Research shows a negative relation across countries between income inequality and institutional quality (see box figure). This modern-day association between inequality and institutions is the result of long and complex historical processes in which both inequality and institutions have influenced each other: a process the 2006 World Development Report (WDR) referred to as virtuous and vicious circles between the two. In countries where wealth and income were concentrated in the hands of the few, exclusive institutions developed to concentrate power in the hands of the few and perpetuate the privileges. In other countries where the distribution of wealth was more equal, more open and inclusive institutions developed that protected the property rights of the many rather than the few. The 2006 WDR calls on a variety of historical examples, including the contrast between the developments of North and South America to illustrate this point. The interaction between inequality and institutions has in many countries undermined growth in the long term, with more-unequal societies with weaker governance ending up poorer than their more-equal and better-governed counterparts.

A vivid illustration of how weak institutions that protect only the property rights of the few can undermine economic growth comes from recent work by Klapper and others.a They construct data on entrepreneurial activity, as measured by rates of new business formation, across a large set of developed and developing countries. They find a strong association between institutional quality and business entry rates that persists after controlling for per capita income and de jure regulatory barriers to firm entry. In particular, weak institutions that protect the property rights of the few shield incumbents from competitive pressure by stifling entrepreneurial activity. This can contribute to the perpetuation of both high inequality and weak institutions. And it can also undermine growth: in a related paper, Klapper, Laeven, and Rajanb find that when weak institutions stifle entrepreneurial activity, growth of incumbent firms thus sheltered from competition is also significantly lower.

High inequality and weak institutions go together across countries

Note: Data on the Gini Index are taken from 2007 World Development Indicators, table 2.7, and refer to the most recent year for which data are available. Data on Rule of Law come from the Worldwide Governance Indicators project, www.govindicators.org, and refer to 2006, the most recent year available.

Entrepreneurial activity is stronger in countries where property rights are protected

Note: Data on new business entry rates are taken from Klapper and others (2007) and refer to the number of newly registered businesses in a year as a fraction of the total number of registered businesses in the previous year. Data are averaged for 2003–05. Data on Rule of Law come from the Worldwide Governance Indicators project, www.govindicators.org, and refer to 2006, the most recent year available.

a. Klapper and others 2007.b.Klapper, Laeven, and Rajan 2006.

Natural capital as a share of total wealth is high for developing countries but falls as income rises. It exceeds produced capital as a share of wealth in these countries, but not in high-income countries. The share of intangible capital tends to rise with income and is particularly important in Europe and Central Asia (72 percent of total wealth). Fragile states are notable for having extremely low levels of produced assets per person.

Agricultural land is an important share of total natural wealth in developing countries. Preserving soil quality in these countries will be particularly important for maintaining wealth and sustaining development. Similarly, fragile states show a relatively large share of forest resources in total natural wealth, suggesting that sound forest management could be important for maintaining the wealth of these countries. Total natural wealth per capita rises with income, reflecting high population-to-land ratios in lower-income countries, and the much greater productivity of agricultural land in higher-income countries.

Net Savings, Environmental Resources, and Sustainable Growth

Recent growth theory suggests a link between current net savings and changes in future consumption.24 Measures of saving should account for the depletion of natural resources and damage to the environment in addition to the depreciation of produced capital. Adjusted net savings” provides such a measure, altering the measure of net saving in the National Accounts to include investment in human capital (an addition to saving); depletion of minerals, energy, and forests; and damages from emissions of particulate matter and carbon dioxide (CO2). Negative adjusted net savings indicates that an economy is potentially on an unsustainable long-term path.

The positive relation between adjusted savings and economic growth is illustrated in figure 1.12. Because there is a lag between investment and growth in output, these figures scatter adjusted net saving rates averaged over 2000–02 against per capita growth rates averaged over 2002–06. As figure 1.12 shows, there is some tendency for higher net saving rates to be associated with higher growth in output per capita over the short run. Robust evidence on the linkage between net savings and growth over the longer term is reported in a forthcoming study, which shows, using historical series in per capita terms from 1970 to 2000, that adjusted net savings is correlated with future changes in consumption in developing countries.25

figure 1.12GDP growth vs. adjusted net savings

Source: World Development Indicators database and World Bank staff estimates.

Note: Includes all countries except major oil producers.

Reflecting high rates of natural resource depletion, adjusted net savings are negative in many developing countries, putting these countries on an unsustainable long-term path (table 1.9 and figure 1.13). In fragile states, adjusted net savings in 2005 were estimated at minus 22 percent of GNI. On average, other developing countries (excluding emerging markets and fragile states) also had negative adjusted saving rates (minus 5 percent of GNI) as a result of high natural resource depletion. Environmental health damages—which measure deductions to the stock of human capital caused by particulate matter pollution—are particularly important in East Asia and the Pacific and in South Asia, as are the damages caused by carbon dioxide pollution. In contrast, emerging markets showed positive rates, reflecting the robust saving efforts in countries such as China and India, but also the much smaller impact of natural resource depletion.

Table 1.9Adjustments to savings, 2005% of GNI
Gross

national

savings
Education

expenditure
Consumption

of fixed

capital
Natural

resource

depletion
Environmental

health

degradation
CO2

damages
Adjusted

net

savings
East Asia & Pacific44.42.210.37.81.21.226.1
Europe & Central Asia23.94.110.417.50.61.2-1.7
Latin America & the Caribbean21.04.312.08.60.40.43.9
Middle East & North Africa33.74.510.932.20.61.2-6.7
South Asia29.43.59.15.50.81.216.5
Sub-Saharan Africa17.33.810.716.10.40.7-6.8
Emerging market economies30.63.510.79.90.81.011.7
Other developing countries30.03.710.227.00.60.9-5.0
Fragile states19.93.410.033.40.91.1-22.2
High-income countries18.64.613.11.40.30.38.2
World22.14.312.34.90.40.58.1
Major oil producers34.63.69.141.70.51.5-14.4
Source: World Development Indicators 2007.
Source: World Development Indicators 2007.

figure 1.13Adjusted net saving trends, 1990–2005

Source: World Development Indicators 2007.

Notes
1.This chapter discusses growth and poverty reduction in emerging market economies, other developing countries, and fragile states. Emerging economies include those developing countries with substantial access to international capital markets. They include mainly middle-income countries, although some low-income countries (such as India) are also included in this group. The “other developing countries” category includes mainly low-income countries.
2.See also IMF 2008.
3.The terms-of-trade changes had a sizable impact on domestic incomes and purchasing power in many developing countries. In countries with large terms-of-trade fluctuations, gross domestic income (GDI) offers a more reliable measurement of changes in purchasing power than GDP. Real GDP measures the value added of physical output in the economy but says nothing about its purchasing power. Changes in output at constant prices may differ from the income generated by this output as a result of shifts in the terms of trade. If the terms of trade improve compared with the base year, income generated by a given level of real GDP increases, and vice versa.
6.See also Dorsey and others, forthcoming.
8.The data on remittances remains patchy, although significant improvements have been achieved recently. The World Bank has developed the most comprehensive database on skilled migration to date.
21.PEFA is a partnership of the World Bank, the IMF, the European Commission, the United Kingdom’s Department for International Development, the Swiss State Secretariat for Economic Affairs, the French Ministry of Foreign Affairs, the Norwegian Ministry of Foreign Affairs, and the Strategic Partnership with Africa. See http://www.pefa.org. It includes 28 indicators covering aspects of budget formulation, execution, and reporting as part of an overall diagnostic Performance Measurement Framework report on the quality of a country’s public financial management (PFM) systems.
23.The estimates are based on the methodology presented in World Bank 2006. Note that China dominates the East Asia figures in table 1.7. The relatively low total wealth and high produced capital share in this region reflect difficulties with the methodology of estimation for China. The negative values for intangible capital reported for fragile states and major oil producers reflect very low returns on total assets in these countries.
25.Ferreira and others, forthcoming. Ferreira and Vincent (2005) show that adjusted net saving is not significantly correlated with future consumption in developed countries, where technological change and knowledge generation are likely to be more important as sources of growth than physical asset accumulation.
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