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CHAPTER 2 The Current Slowdown and the Role of Spillover Effects

Author(s):
International Monetary Fund
Published Date:
December 2009
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Explaining the Current Slowdown: Shocks and Channels

Historically, EAC growth has closely tracked global real GDP growth (Figure 1 and Appendix Figures 1a and 1b). Even though growth in the EAC countries seems to have trended upward since the early 1990s—to higher levels than that experienced by the world economy—real GDP growth in the region has generally been susceptible to fluctuations in world output growth. During global slowdowns, the EAC has generally been affected by reduced external demand for its exports and deteriorating the terms of trade prompted by declines in global commodity prices. At times, the region has also been affected by tighter financial conditions abroad, particularly during episodes of financial crisis. However, the magnitude of the impact of past slowdowns has varied greatly, depending on the causes of the decline in world growth and idiosyncratic domestic developments in EAC economies, including economic policy responses. Throughout the 1980s and 1990s, recessions in industrial countries led to more-than-proportional recessions in EAC economies, but this link seem to have been broken in the 2000s (Box 2.1).

Figure 1.Sub-Saharan Africa and the Rest of the World: Real GDP Growth

(Percent)

Source: IMF, World Economic Outlook; and authors’ calculations.

The current global financial crisis is affecting EAC countries through three primary channels. First, as growth in trading partners slows, EAC economies suffer from a decline in external demand for their goods and services. Second, by reducing income, the sharp fall in commodity prices and terms of trade (Figure 2), and the decline in workers’ remittances induced by the crisis are dampening domestic demand growth. Finally, global financial conditions have recently deteriorated to levels not seen in more than two decades. As a result, a reduction or reversal in capital flows to the region, including foreign direct investment (FDI), is constraining investment and dampening growth prospects.

Figure 2.Foreign Demand and Export Prices in the EAC

Source: IMF, World Economic Outlook.

Trade Channel

  • Exports are an increasing greater share of the EAC economies—about 20–25 percent of GDP, on average, compared to 10–15 percent in the 1980s and 15–20 percent in the 1990s. This has made the economy more exposed to declines in external demand. Kenya in particular is much more open than Rwanda, with Tanzania and Uganda right in between.
  • Export destinations have become more diversified in recent years, with more exports now going to other emerging and developing economies (Figure 3). This suggests that trade spillovers are likely to manifest themselves indirectly, to the extent that the relevant trading partners are affected. Exports from the EAC to developing Asia and the rest of Africa (as a percent of GDP) have tripled from 1 percent of GDP in the mid-1980s to 3 percent of GDP in the 2000s, while exports to the United States and the euro area have been stable at close to 1 and 3 percent, respectively, in the same period.
  • Exports to other EAC countries are now as large as exports to the euro area, suggesting that trade spillovers are likely to manifest themselves through intraregional trade.
  • Deteriorating terms of trade have also put downward pressures on national income and thus domestic demand.

Figure 3.EAC Exports by Destination

East African Countries: Total Merchandise Exports by Destinations, 1985 to 2008

Source: IMF, Direction of Trade Statistics.

Box 2.1.Past Declines in World Growth and the EAC

While past declines in world growth have affected EAC countries, the magnitude of the impact varied greatly, partly due to the underlying cause of the decline in world growth, idiosyncratic domestic developments in EAC (e.g., droughts), and economic policy responses (Table 1). Through the 1980s and 90s, recessions in industrial countries led to more-than-proportional recessions in EAC economies, but this link seem to have been broken in the 2000s.

  • The declines in world growth in 1980, 1982, and 1991 were accompanied by growth declines in SSA. In 1980-82, world growth suffered from a large U.S. recession and growth declines in other industrial countries. Due to the global nature of the crisis, and the associated large oil price shock, growth in EAC countries also suffered. And the decline in the EAC growth rates was stronger than experienced elsewhere. In 1991 the decline in world growth was driven by the U.S. recession. The associated Savings and Loan crisis in the U.S. and the resulting credit crunch affected growth in other industrial countries. And the EAC region also suffered.
  • By contrast, the 2001 decline in world growth was not associated with a decline in EAC growth. Indeed, growth in the EAC actually increased. The global slowdown was driven by a U.S. recession associated with the burst of the IT bubble, including the sharp declines in most major stock market indices and drops in business investment around the world. The US recession was accompanied by growth declines in most industrial economies, and non-fuel commodity prices declined, but EAC growth was resilient.
Global slowdowns and EAC Growth
Recessions1Slowdowns2
1974-751980198219912001198619954
Change in GDP growth (median for region; unless otherwise indicated)
World 3-4.5-1.6-1.1-1.3-2.3-0.1-0.1
United States-6.1-3.4-4.5-2.1-2.9-0.7-1.5
Other Industrial countri-5.4-1.50.4-1.3-2-0.1-0.3
Emerging Asia-3.5-0.3-1.5-0.1-1.10.90.3
SSA-0.5?1?0.6-0.61.9
SSA-1.6-0.70.2-1.10.9-1.10.6
SSA 3-1.01.5-2.3-2.51.00.51.5
EAC-2.9-2.95.82.2-0.91.8-0.7
EAC 30.0-3.83.31.2-1.30.01.4
Burundi-8.00.119.02.10.211.62.4
Kenya-3.8-2.5-1.5-0.4-1.82.52.6
Rwanda-2.7-0.46.06.1-1.6-8.6-14.7
Tanzania-0.60.8-2.13.31.63.50.6
Uganda0.8-12.77.30.1-3.00.05.5
Change in percent
Non-fuel commodity pr47.87.1-13.8-9.1-8.56.311.5
Oil prices250.8133.0-7.3-15.7-13.8-48.27.9
Source: World Economic Outlook, April 2007; and IMF staff calculations.

Year during which most of the impact on U.S. growth was recorded.

Periods in which U.S. output was below potential and not considered recessions by the NBER.

Weighted average.

1994 Figures for Rwanda, Tanzania, and Uganda.

Source: World Economic Outlook, April 2007; and IMF staff calculations.

Year during which most of the impact on U.S. growth was recorded.

Periods in which U.S. output was below potential and not considered recessions by the NBER.

Weighted average.

1994 Figures for Rwanda, Tanzania, and Uganda.

Financial Links

  • Flows of private capital have clearly diminished in Kenya, led by weaker FDI and other private flows, and portfolio flows turned negative at the beginning of the crisis is some countries (e.g., Uganda), although most flows to the other countries have been broadly spared (Figure 4). In some countries, however, including Kenya, having a clear picture of private capital flows is made difficult by the bunching of short-term flows with errors and omissions.
  • Remittances declined in some countries (Uganda, Kenya) but by less than expected at the beginning of the crisis.
  • Aid flows are less significant in Kenya than in the other EAC countries but seem to have held up relatively well.

Figure 4.Net Capital Flows to the EAC

Net Capital Inflows in EAC Countries

Source: IMF, World Economic Outlook.

As a result of the crisis, the contributions of both external and domestic demand to GDP growth have declined (Figure 5 and Appendix Figure 2). Both consumption and investment lost steam, partly due to tighter financing conditions as well. Government consumption, which had been slightly expansionary in 2006 and 2007, slipped to neutral for the region as a whole. The contribution of net exports to growth remained negative across all countries. The exact channel of transmission varies across countries depending on each country exposure to financial links abroad, the decline in external demand, and economic policy responses.

Figure 5.Contribution to GDP Growth

Source: IMF, World Economic Outlook and Staff Calculations.

In 2009, growth remained subdued for all the EAC on account of the global economic crisis (Figure 6). Growth in Kenya dropped to below 2 percent in 2008—with the slowdown partly on account of a drought and domestic political crisis—and it is projected to remain below 3 percent in 2009, its lowest rates in the last five years. In the other countries (Rwanda, Tanzania, and Uganda), while growth improved in 2008 in comparison to 2007, it is expected to decline in 2009 with the impact of global spillovers partly moderated by the weight of agriculture and public investment spending in some countries (e.g., Uganda) and by the lower dependence of Tanzania and Uganda on external demand. Policy responses—fiscal stimulus and monetary easing—also helped boost consumption and investment.

Figure 6.Real GDP Growth, by Country

Percent Change in Real GDP

How Does the Current Cycle Compare with Previous Cycles?

A comparison of the current economic cycle in the EAC with previous cycles in the region and cycles elsewhere in the sub-Saharan African (SSA) region provides the following insights (Figure 7 and Appendix Figure 3):

  • The current downturn starts from a more favorable position: precrisis growth was higher than that at comparable times in previous cycles, and fiscal positions and reserve levels were generally stronger. This has not only made the economies structurally less vulnerable to external spillovers but also enabled the authorities to consider countercyclical policies.
  • The growth decline in the EAC has been, on average, less pronounced than that for other SSA countries. However, performance varies significantly across countries, with Kenya suffering a more pronounced downturn than other countries in the EAC region.
  • The pace of the expected recovery suggests it will take about 3-4 years for growth to recover, on average, to precrisis levels. This pace would seem to be broadly similar to that observed in previous EAC cycles.
  • The drop in EAC growth has been partly driven by a fall in exports, in some cases even as a share of GDP. But while the recovery for SSA countries is expected to be clearly export-led, growth in Kenya and the EAC is expected to reflect a combination of positive spillover effects and strong domestic demand in the initial years. Aid is also expected to sustain demand.

Figure 7.The Current Economic Cycle and Historical Cycles: The EAC and the SSA

(Red is historical pattern, black is current pattern)

Source: IMF, World Economic Outlook.

The Role of Spillover Effects

Much of the recent downturn in the EAC can be explained by spillovers. To measure the size of spillovers on individual African countries, we apply estimates from a dynamic panel model for countries in the region (Figure 8). The model relates real growth in domestic output to world growth weighted by trading partner countries and to several control variables: oil prices, non-oil prices, a measure of global financial stress, and country fixed effects (Box 2.2). The median estimates for the region as a whole suggest that the slowdown can be generally explained by spillover effects. The exception is Kenya, where a major slowdown took place in 2008 amid political disturbances, and the current year is set to record a mild recovery. Some offsetting factors seem to be at play, reflecting domestic developments, including strong agricultural growth, and perhaps, policy responses, an issue we turn to next.

Figure 8.Spillover Effects and the EAC; Explaining the Slowdown for 2009 GDP

(Percentage point decline from 2008)

Box 2.2.Quantifying the Impact of a Global Slowdown on Individual African Countries

The following are the key estimates of the impact of a global slowdown on individual African countries, using a series of dynamic panel regressions for countries in the region:

  • A 1 percentage point slowdown in the rest of the world has been found to lead to an estimated 0.4–0.5 percentage point slowdown in sub-Saharan African countries. The effect is partly felt contemporaneously (0.2 percentage points) and partly in the following year (0.2 percentage points).
  • A nonfuel-commodity-prices-induced income reduction by 10 percent tends to reduce growth in sub-Saharan Africa by about 1.9 percentage points after two years.
  • An oil price shock tends to be significant only above a certain threshold (5 percent increase in prices). The impact is calculated as the oil price change (above the threshold) times the share of net oil exports. An SSA country with oil imports of some 20 percent of GDP facing a decline in oil prices on the order of 50 percent, could expect a growth rate some 0.5 percentage points higher than otherwise. The impact is linear on price changes above the threshold and on the oil intensiveness of the economy. It appears symmetric for price increases and decreases in prices.
  • A financial channel is significant when proxied by the spread of 3-month LIBOR vs. US Treasury bills: a 100 basis point increase in the spread reduces growth in SSA countries by an estimated 0.5 percentage points. To our knowledge, this is one of the first applications of such a measure of financial conditions for countries in the region.
Source: Drummond and Ramirez, 2009.

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