Growth for Low-Income Countries?

  • 2013•05•17

    James Stewart

    LIC Growth

    UN Photo/Kibae Park

    Even the most optimistic analyses accept that many low-income countries (LICs) will remain low income for some time to come. Consequently, when assessing the policy options available to LICs, it is important to take a long-term view.

    In the WIDER Working Paper “Aid, Fiscal Policy, Climate Change, and Growth”, David Bevan highlights some important considerations that should help structure the answer to two crucial questions relating to the long-term policy options of LICs: What determines growth in LICs? and How is the answer conditioned by a country’s history of fiscal policy design?

    Environmental issues and growth

    Two types of environmental issues are particularly important to developing countries. The first concerns environmental degradation and water stress caused by increasing populations and economic development. The second reflects the consequences of global warming, including an increase in climatological disasters in the short term, and changing levels of temperature, rainfall and sea level in the long term.

    Bevan suggests that dealing with climate change will not be as costly for LICs as one might expect. An ambitious World Bank economic research project, “The Economics of Adaption to Climate Change”, suggests that the costs of climate change will fall in the range of 0.12 to 0.17 percent of the aggregate developing country GDP over the period 2010–2050. While this is by no means insignificant, Bevan suggests that it is unlikely to be a “game changer” when compared to the challenges LICs already face.

    Furthermore, though it may seem logical that the problem of water stress will be made worse by climate change, recent studies do not support this. Increased water stress is primarily due to increased withdrawals, while increased precipitation due to climate change actually decreases water stress.

    Bevan is not seeking to deny the gravity of climate change; he is, instead, suggesting that the growth consequences to LICs are likely to be small in relative terms over the next few decades. Consequently, other environmental concerns are more urgent challenges for LICs, at least in the short term.

    What determines growth in low-income countries?

    Having established that climate change is not a major impediment to growth in LICs at this time, Bevan looks at other factors that may determine growth. A LIC with the median per capita income for the group ($440) would have to have a growth rate of seven percent for 17 years to exit the LIC category. If the growth rate were only five percent, it would take 29 years.

    Clearly, Bevan suggests, understanding what determines growth in low-income countries is crucial to understanding how LICs can become middle-income countries. The focus here is on fiscal considerations (other important determinants of growth, such as the quality of institutions and of governance, are not addressed).

    The infrastructure deficit —A key limitation on growth in low-income countries is that many of them have a huge infrastructure deficit. Bevan argues that this deficit exists for three reasons. First, stabilization efforts have required countries to cut costs to reduce fiscal deficits. As it is much harder to reduce current expenditures than it is to reduce expenditure on infrastructure, the bulk of adjustment was consequently borne by the latter. Second, donors have become increasingly focused on social sector spending, and infrastructure has become neglected in aid budgets. Third, infrastructure is very expensive, and the low-income levels of the countries involved mean that even when a higher than average portion of GDP is dedicated to infrastructure, spending is still low.

    These problems are compounded by the sheer scale of spending that would be needed to bring Africa’s infrastructure up to scratch. It is estimated that the region needs to spend around 15 percent of its GDP on infrastructure (a figure that includes the middle-income and resource-rich countries in the region). Bevan suggests that this level of spending is very unlikely to be achieved, and that consequently prioritization will be an important part of selecting policy options for LICs.

    Public debt — Another factor that has the potential to limit growth in LICs is public debt. A particular problem Bevan highlights is that of “debt overhang”, a situation whereby a country’s debt service burden is so high there is little incentive to invest. The level of debt at which this problem starts to be significant is not clear. High estimates put the problematic ratio at around 40 percent of GDP, whereas others estimate that problems could begin to occur with a debt/GDP ratio as low as 15 percent.

    One thing that is clear is that determining a prudent approach to debt is country-specific. LICs need to take into account their own prospects, history, reputation, the costs of borrowing, and the potential for those costs to change in the future when deciding how much debt they can afford to take on.

    The role of government — Bevan notes that as per capita income rises, countries will typically experience structural changes. In particular, income growth typically leads to a shift in the composition of production between agriculture, manufacturing and services.

    There are two options open to a government faced with this type of structural change. First, it could continue to operate as normal, concerning itself only with core government functions and leaving it up to the private sector to implement the structural changes. Second, the government could take an active role in modifying the characteristics of the transition by, for example, investing in training more workers with skills suitable for the service sector or by identifying and addressing potential bottlenecks.

    The size of the state — Another key factor that effects growth in LICs is the size of the state. Bevan points out that a state can either be too big or too small when it comes to assessing economic efficiency. He argues that two important questions need to be answered. What should be the size and functions of the state? and Are the present fiscal arrangements for achieving these functions sustainable? Bevan suggests that the answers to these questions are likely to be country-specific, and that the scale and scope of government expenditure will change over time and be affected by a wide variety of factors.

    Considerations for the future

    Bevan goes on to suggest ways in which developing countries can look to finance their development going forward. He outlines the considerations that both domestic governments and donors should take into account, and in particular looks at the various sources of financing that are available to LICs.

    Aid — One source of financing is aid. Bevan suggests that the long-term prospects for aggregate aid flows may be bleak. The financial crisis has led to many developed countries needing to adjust their fiscal outlays, and as such the availability of aid may diminish in the future. However, he suggests that aid flows to individual LICs may not suffer the same fate. If, as seems likely, some LICs succeed in exiting from this status in the medium term, a smaller pool of aid may simply be distributed to fewer countries, so aid may continue to be an important potential source of financing for the remaining LICs.

    Taxation — Another source of revenue for LICs is taxation. However, it is often difficult to raise taxes in LICs due to a large informal sector, weak and corrupt tax administrations, and habits of non-compliance.

    One obvious consequence of this is that governments tend to be smaller relative to GDP in poorer countries than in richer ones. Another potential consequence Bevan considers is whether this difference is purely due to tax capacity, or whether revenue could be sustainably increased through a greater tax effort. He points out that it appears tax effort does not dramatically differ between low- and high-income countries, and that consequently the lower tax/GDP ratio in LICs is primarily due to lower capacity. Bevan suggests that while there may be some scope for LICs to raise their tax revenue, the fact that the low rates are mostly due to a lower tax capacity means that a dramatic increase in revenue from taxation is unlikely to be achievable over a reasonable horizon.

    Borrowing — Borrowing, from both domestic and international sources, is another form of financing that LICs could pursue. The IMF has suggested that a safe upper bound for the domestic debt/GDP ratio might be 15 percent. A country with such a ratio, which it intended not to increase, could afford a domestic deficit of around 2.5 percent if it achieved real growth of 7 percent and an inflation rate of 5 percent. Such figures are not unreasonable and, consequently, domestic borrowing could be a material source of finance for LICs. However, Bevan does point out that domestic borrowing may drive up interest rates and crowd out private investment. He suggests that while there is little empirical work on this issue, there is a need for caution.

    As LICs have been relieved of some of their previous debt obligations and improved their macroeconomic performance, non-concessional external borrowing has increasingly become a realistic potential source of finance. LIC access to such borrowing has also been improved by the traditional donors relaxing their rules about mixed financing and by the emergence of non-traditional partners.

    However, aside from avoiding taking on too much debt, there are two separate issues for LICs to consider when thinking about taking on external debt. First, LICs may pay a higher rate of interest than is justified by their objective circumstances due to an inability to guarantee the continuation of stable conditions. Second, 100 percent debt financing of uncertain investments is inherently undesirable, as failed investments will lead to heavy losses. Bevan concludes that these considerations, combined with the inherent uncertainty of the future financing climate, make this route of financing one to be treated with extreme caution.

    Fiscal targets — Having looked at various potential forms of revenue for LICs, Bevan poses the question of what the fiscal targets should be for LICs. The IMF suggests a target upper bound for the debt/GDP ratio of 60 percent for advanced economies, and 40 percent for emerging economies. However, Bevan notes, LICs are typically in receipt of at least some concessional loans with very low interest rates and also differ enormously from one another in regard to past performance. Consequently, targets that apply to all LICs are unlikely to be effective.

    Some LICs have instituted fiscal rules. Bevan points to the example of the fiscal rules the IMF informally suggested Tanzania might consider adopting, which included a limit on the debt ratio of 40 percent and targets for net domestic financing of less than 2.5 percent of GDP, for non-concessional external borrowing of less than 2.5 percent of GDP, and for change in the ratio of government spending to GDP of less than 3 per cent per annum.

    However, Bevan argues that setting such rules may be inherently problematic. Fiscal policy has to be able to react to contingencies, and while simple rules may not be able to deal with contingencies very well, flexible rules quickly become too complex to be operational. Furthermore, if there is a political commitment towards fiscal responsibility, then rules are probably unnecessary, while if there is not that commitment, rules are unlikely to be successful. Bevan suggests that adopting an approach based on fiscal indicators and targets would allow more flexibility and provide the opportunity to take into account more criteria than would be possible under any workable system of rules.

    In conclusion

    Bevan finishes by pointing out that LICs face high volatility in the short term and large challenges in the long term. Consequently, deciding on the correct policy options is difficult, as future scenarios are difficult to project.

    Bevan suggests that some of the issues LICs face will be country-specific, but that many will be systematic. Consequently, overcoming these problems requires the involvement of both domestic governments and the wider economic community, including international finance institutions, donors, and academics.

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    Adapted from a two-part article previously published in the WIDER Angle newsletter: see “Growth for Low-income Countries? (part one)” and “Growth for Low-income Countries? (part two)“.