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`Managing capital flow surge, a challenge to developing nations'

G. Srinivasan

Subsidies imposing heavy burden on Govt purse: World Bank report

Note of caution
While favourable economic performance was backed by good policies, it also reflects external conditions that are likely to weaken.
Most developing nations have exhausted surpluses, other cushions that allowed them to absorb higher oil prices, making them vulnerable to further shocks.

New Delhi , May 31

The unprecedented upheavals in stock markets in the emerging economies in recent times might partly be explained by the surge in portfolio inflows to many developing countries, which together with net private capital flows amounted to a $491 billion in 2005.

"One warning sign of potential troubles has been the surge in portfolio inflows that has been associated with a dramatic escalation of stock market prices and valuations in many developing countries, particularly in Asia, raising the risk of asset price bubbles," cautions the World Bank's Annual 2006 Global Development Finance report released in Washington today.

Even as the record surge in net private capital flows to developing countries were driven by privatisation, mergers and acquisitions, external debt refinancing, as well strong investor interest in local-currency bond markets in Asia and Latin America, the Bank said this coincided with 6.4 per cent economic growth in developing countries last year, more than double the 2.8 per cent growth in developed world.

The bank said the sharp rise in private flows to developing countries came despite uncertainties caused by high oil prices, rising global interests and growing global payments imbalances. Private debt flows to developing countries rose to an estimated $192 billion, up from $85 billion in 2003, driven by abundant liquidity, steady improvement in developing country quality, lower yields in rich countries and expansion of investor interest in emerging market economies.

Vulnerable to shocks

The surge in capital flows also reflects rising trade flows and financial integration among developing countries with much South-South foreign direct investment (FDI) originating from middle-income country firms and is invested in the same region, for instance, Russian and Hungarian firms investing in Eastern Europe and Central Asia and South African companies investing elsewhere in southern Africa.

The Bank said while this favourable economic performance was backed by good policies it also reflects the conducive external conditions that are likely to weaken. Many developing countries have exhausted surpluses and other cushions that allowed them to absorb higher oil prices, while growing quickly. As a result, they remain vulnerable to further shocks, it said.

In this context, it said that though several countries in South Asian region have taken steps to pass on higher oil prices, explicit and implicit subsidies (through state oil companies) are imposing "a heavy burden on the government purse". They have increased government deficits by as much as 0.7 per cent of GDP in India between 2002 and 2005.


"Subsidies appear to have crowded out other development spending on health and education" in India. Besides the fiscal cost, by preventing relative prices from adjusting, these policies eliminate private incentives to conserve fuel and thereby contribute to high current account deficits, the Bank warned.

It said in both India and Pakistan growth was consumption-led, reflecting higher farm incomes on the one hand and a relaxation of fiscal policy in Pakistan, plus an already lax fiscal and monetary policy stance in India. The boost to private consumption signified almost three quarters of the increase in Indian GDP and more than all of the increase in Pakistan.

Industrial production

It said that even in India, industrial production growth slowed from 8.5 per cent in 2004 to 7.8 per cent last year and import growth outstripped exports by a significant margin - suggesting that supply was unable to keep with demand. Hence, the report states that in India and Pakistan, more restrictive macro policies, combined with tighter global credit conditions, and an easing of external demand (in the US) are projected to slow growth by about one percentage point in 2006.

However, India is expected to continue benefiting from strong services sector growth, including foreign demand for IT service and rising private investment, given improving business confidence and progress in market reforms. The Government's recently announced four-year "Build India" (Bharat Nirman) infrastructure programme (equivalent to a total package of about 5 per cent of GDP) would provide an additional spur to growth starting this year, the Bank said.

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