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South Asia's growth-inflation dilemma

The top priorities for India, Sri Lanka, Pakistan and Bangladesh should be reforms and higher investments to break free of this trap

Dharmakirti Joshi & Aindrilla Roychoudhry 

Dharmakirti Joshi & Aindrilla Roychoudhry

In the previous decade, South Asia was among the fastest-growing regions of the world. But it has been a very different story in the last three or four years. Growth in the region has slowed more than anticipated. And today, it is not only India - the dominant economic force in the region - which is in the grip of low growth and high inflation; other key South Asian economies, too, are preys to this. This is in marked contrast to neighbouring Asian economies, such as Indonesia and Philippines, which enjoy low inflation and better economic prospects, and to African nations that have shown great economic resilience.

Among the four countries in the region that we analysed, the growth-inflation dynamic is far worse in India and Pakistan - the region's two largest economies - compared with Sri Lanka and Bangladesh.

Growth in India and Pakistan during this period has been significantly lower than the pre-crisis years, whereas inflation rates have been substantially higher. Although a weak global environment has been a common growth dampener for the region, domestic macroeconomic imbalances have been primarily responsible for the sharp slowdown and the spike in inflation in both these countries. In Bangladesh, growth did not fall much, buoyed by robust export growth and strong inward remittances, but inflation shot up.

The exception to this regional trend was Sri Lanka, which benefited from the end of the civil war in the country's north and the northeast. Here, growth went up and inflation declined. But the scenario is now reversing in the island nation.

In India and Pakistan, the gross domestic product (GDP) growth fell to 7.2 per cent and 3.4 per cent, respectively, during 2009-2012, from 8.8 per cent and 6.3 per cent during 2004-2009. Inflation, however, shot up 7.2 per cent per year in India and 11.9 per cent in Pakistan, from 5.5 per cent and eight per cent per year, in the respective periods. India's GDP is projected to slip to five per cent in 2012-13, and Pakistan is projected to have grown at 3.5 per cent in the same period.

Domestic factors, such as high interest rates, policy logjam and a consequent sharp slowdown in private investments, led to the growth slowdown in India. Since 2008-09, the government expenditure has focused more on boosting consumption demand in the short term than on improving the economy's productive capacity. The consequent increase in the fiscal deficit and the inadequate focus on expanding productive capacity served as a breeding ground for a high inflation regime. Food inflation, too, has been stubbornly high in India.

The growth situation in Pakistan worsened partly because of the global economic turmoil that affected the export demand, but largely owing to internal issues like shortages of gas supply and security issues, affecting the industry and investments. Inflation in the country was high even in the pre-crisis period, but has risen further on the back of a spike in food inflation.

Bangladesh's growth has been somewhat resilient compared to its counterparts, since remittances from its workers in the Gulf region remained strong. This, together with the strong buoyancy in the export growth (Bangladesh exports low-end items whose demand has not been significantly affected by the global crisis), cushioned the country's GDP growth.

Sri Lanka not only maintained its pre-crisis growth rate, but also managed to keep inflation fairly low during this period. Reconstruction spending in the war-affected northern part of the country supported growth. The unlocking of land for agricultural purposes after the end of the war boosted agricultural productivity and tamed food inflation. However, this dividend from the end of the war, and some of the gains it ushered in, are now beginning to fade.

The outlook for 2013 is somewhat better than the performance in 2012, but the high growth rates seen during the pre-Lehman crisis period are not in sight anywhere in the region, except in Bangladesh. Some improvement is likely in the export growth as a result of the marginal improvement in the global economic scenario. GDP growth in India, Pakistan and Bangladesh could also benefit from an increase in government-welfare spending on the eve of elections: general elections are expected to be held in early 2014 in India, May 2013 in Pakistan, and January 2014 in Bangladesh.

However, these drivers of growth for 2013 are either cyclical or one-off. The region needs to decisively come out of the low growth-high inflation regime to lift its population out of poverty. Although there is no "one shoe fits all" solution for countries in the region, economic reforms that will help clear structural bottlenecks, higher investments and better regional economic cooperation to create a buffer against global headwinds are necessary in all these economies, so that they can raise growth and bring down inflation.

After a brief policy hiatus, India has embarked on a fresh round of economic liberalisation beginning September 2012, to improve its fiscal health and kick-start private investments. But it still has a long way to go. Sri Lanka needs to enhance its export competitiveness and boost private consumption in order to support its growth. Pakistan needs to reverse the trend of falling investment, address infrastructural bottlenecks and tame its deficits. Bangladesh has been resilient and its prospects are relatively healthier, but it surely needs to diversify its exports and address infrastructural constraints to lift growth from around six per cent currently and sustain higher growth rates.

Even as they take steps to boost growth, maintaining low and stable inflation should be a policy priority for all countries in the region. In the near term, inflationary pressure will remain somewhat high in South Asia since fuel and power prices (which are highly subsidised) will have to be increased to trim the fiscal deficit. In the long run, however, taming food inflation via improving agricultural production and the supply chain and removing intra-country restrictions on the movement of food is vital to rein in overall inflation. Food inflation has been persistently high in the region, and constitutes a significant part of household consumption. Its weight in the consumer price index ranges from 35 to 55 per cent in the region.

Last but not the least, improving regional trade can bring in a host of benefits and help South Asian economies to come out of the low growth-high inflation trap. Recent studies by various multilateral agencies have shown that increased trade not only has the potential to boost GDP growth because of the unique geography of South Asia - distance and density - but can also help the region in its fight against food inflation.

Dharmakirti Joshi is Chief Economist and Aindrilla Roychoudhry is Economic Analyst, CRISIL

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First Published: Wed, March 13 2013. 21:42 IST