Financial markets

The immediate impact of the crisis on the South Asian economy was most apparent in financial markets, although the banking sector was relatively unscathed—given the region’s minimal exposure to toxic assets and the limited presence of foreign commercial and investment banks.
Stock markets were buffeted largely in line with global equities, especially through the end of 2008.

Since that time, equity markets in the region have stabilized, with some bourses posting gains as of the end of May 2009.

Stock markets in India, for example, advanced in April and May, with a surge following recent elections that boosted market sentiment and underpinned expectations of an accelerated reform program and greater openness to foreign investors.
Markets in Bangladesh witnessed less extreme volatility than other regional stock markets, as its equity market is not highly capitalized, trading is thin, and foreign participation is low (2.5 percent of total assets are held by foreign investors).

Regional bond markets also suffered from the sharp deterioration in investor sentiment and widespread deleveraging by commercial banks in developed countries, which resulted in a withdrawal of investment funds from emerging markets in the fall of 2008.
Bond spreads surged for sovereigns in the region, and spreads for emerging market corporate borrowers effectively barred them from the market—notably for Pakistan and Sri Lanka.

As global markets have begun to thaw, and after Pakistan and Sri Lanka began to work with the IMF on stabilization packages, spreads have narrowed significantly.
As of late May 2009, spreads had declined to 1,298 basis points in Pakistan and 957 points in Sri Lanka from 2,221 and 2,455 in December and October of 2008, respectively.

Nonetheless, spreads remain substantially above the emerging market average of 473 basis points (see figure on previous page).

Gross capital inflows—international syndicated bank lending, equity placements, and bond issuance—to South Asia had surged in recent years, but collapsed in the aftermath of the crisis.
Flows to South Asia fell by 29 percent in 2008, among the sharpest declines posted among developing regions. In the first quarter of 2009, inflows to Bangladesh, Pakistan, and Sri Lanka fell to zero, while in India they were extremely subdued, down 64 percent relative to inflows recorded during the first quarter of 2008.

In India, gross inflows were primarily composed of bank loans, with a trickling of equity inflows for the first quarter of 2009.
Gross financial flows posted a recovery in India during April and May, as international investor confidence improved on early indications of a recovery for global growth and on expectations that the country is well-placed to benefit from an eventual turnaround. Markets have also reacted positively to the decisive election outcomes.

Capital inflows, including recent record-high FDI inflows, had become a significant source of finance for the rapid rise in regional investment (particularly for corporate capital expenditures in India) and a key driver of regional GDP growth over recent years (see table below).
As a consequence, their reversal has contributed to a sharp falloff in regional investment growth.

For example, in Pakistan, FDI represented 13.4 percent of gross domestic investment in 2007 but has since declined by more than half, sapping badly needed capital for investment programs.

In India, FDI inflows fell from 4.6 percent of gross domestic investment in the third quarter of 2008 to only 0.7 percent during the fourth quarter of the year.
In contrast, in Bangladesh, FDI has been relatively resilient. Despite the crisis, inflows between July 2008 and February 2009 were twice as high as in the previous year and are projected to reach 1.4 percent of GDP in the current fiscal year.

On a net basis, total private and official capital flows to the region contracted by one-third in 2008 from a record-high $116.5 billion in 2007.
The contraction was led by a halving of portfolio equity inflows plunging private creditor bond issuance and syndicated bank loans, which contracted 84 percent and 67 percent, respectively.

In contrast, during 2008, net FDI inflows grew 59 percent, coming to represent nearly two-thirds of total net inflows.
This sharp increase in net FDI inflows was driven by surges in FDI to India and Pakistan—largely accumulated prior to the onset of the crisis—which registered gains of 52 percent and 59 percent, respectively.

Although less immediate than the transmission to the financial sector, the crisis has also had a severe impact on trade flows (see figure on previous page).
This has become increasingly evident as the collapse in demand—most pronounced among the high-income countries—led to a falloff in exports that has become more pervasive across the global economy in the first quarter of 2009.

In the six months through March 2009, regional merchandise exports in dollar terms fell by one-third from August 2008 pre-crisis levels.
This stands in stark contrast to the 17 percent boom in export growth posted in the six months through March 2008.

In India, Pakistan, and Sri Lanka, exports are contracting at double-digit annual rates (seasonally adjusted), down 33 percent, 27.5 percent (both as of March 2009), and 11.6 percent (as of February), respectively.
In Bangladesh, exports averaged 3 percent annualized growth during the three months through January 2009, down from a peak of 72 percent in July 2008.

Regional merchandise imports have also contracted sharply, reflecting weakening domestic demand and the steep fall in international commodity prices, particularly oil.
In the six months through March 2009, regional merchandise import values fell 30 percent from August 2008 pre-crisis levels, contracting just slightly less than the 33 percent recorded for exports over the same period.

As the level of imports is significantly larger than exports in most countries, this has led to a general improvement in trade balances.

The marked deterioration in investor confidence, collapse in capital flows and plummeting external demand and trade are translating into a significant falloff in industrial production.
High frequency data for South Asia (where available) show a decidedly sharp slowdown—if not outright contraction—in economic activity in recent months.

Industrial production in India was down 2.4 percent in March 2009 from a year earlier and in Pakistan it was down 20.6 percent.
In India, industrial activity has been generally trending downward since late 2006, recording a halving of growth to 4.4 percent in 2008, compared with outturns of 10 percent growth in both 2006 and 2007.

In Pakistan, industrial production has posted negative readings since July 2008, now down 23 percent on an annualized basis as of March 2009, from an expansion of 5.5 percent during 2007.
In Bangladesh, manufacturing output has slowed markedly, falling to 2.8 percent in December (year-on-year).

During the fourth quarter of 2008, production slowed to 4.4 percent, nearly one-third the 12.6 percent pace recorded in the preceding quarter (see figure on previous page).

Reflecting the collapse in food and fuel prices since the recent peak in mid-2008 and falling domestic demand, regional inflationary pressures have subsided and disinflation is evident across the region.
Indeed, at one extreme, Afghanistan recently registered sharp deflation of 9.7 percent at an annual rate in April 2009.

This compares with a recent high rate of inflation of 47.8 percent in May 2008 and reflects a sharp fall of food prices, as agricultural output has rebounded dramatically following the severe drought of last year.¹¹ 

Elsewhere in the region, the path of disinflation is particularly marked in Sri Lanka, where the consumer price index has come down by 25 percentage points since a recent peak in June 2008, reaching an annual rate of 3.3 percent in May 2009.
Disinflationary pressures are less pronounced elsewhere in the region, although also clearly evident. In India, wholesale producer prices moderated sharply (reaching close to a zero annual rate in March), although consumer price inflation has proven more sticky downward (at just below 10 percent in March).

In Bangladesh, inflation moderated to 5 percent in March 2009, down from a recent peak of 10.8 percent in August 2008.
In the Maldives, inflation has also eased significantly to 11.2 percent in March, compared with a year ago, down from over 17 percent in July 2008.

In Pakistan, notably, inflationary pressures have proven more stubborn.

While the consumer price index in Pakistan is down by a marked 8 percentage points since August 2008, it remains in double digits at an annual rate of 17.2 percent in March 2009—among the highest rates in the world.
Inflation in Nepal also remains at double-digit rates (14.4 percent as of March), with limited pass-through to consumers of lower international commodity prices.

In the immediate aftermath of the crisis, remittance inflows to South Asia rebounded.
However, this was an apparently temporary phenomenon, because migrant workers who have lost foreign jobs are reported to be returning to their home countries with accumulated savings.

More recently, remittance inflows have begun to dwindle, if not contract.
For example, in Bangladesh, although remittance inflows have continued to grow, the rate of increase has declined sharply from an annual rate of 50 percent pace in August 2008 to only 9.6 percent in April 2009.

In Sri Lanka, net remittances inflows declined 3.8 percent in March 2009 over a year ago, posting the fifth consecutive month of decline (on the heels of an 18 percent decline in February)—compared with over 22 percent annual growth rate for the third quarter of 2008.

Tourism, a key source of foreign exchange and economic growth in a number of regional economies, has also been negatively affected by the global crisis.
In Bhutan, where tourism recently contributed 7 percent to GDP growth, tourist arrivals declined 37.8 percent (year-on-year) in March 2009, compared with growth of 40 percent in 2008.

In the Maldives, tourism activity, which represents over one-third of GDP, has declined by about 10 percent.

In Sri Lanka, the recently ended civil war contributed to an 11 percent fall in tourist arrivals during 2008.
In Nepal, tourist arrivals are mixed, shrinking 17.6 percent in March 2009 over the previous year and growing 15.8 percent in April.

Until recently, tourism revenues in Nepal were rising rapidly, up to 2.3 percent of GDP in fiscal 2007/08 (through June 2008), roughly double the outturn of the previous year on the improved security situation and emerging political stability.

¹¹ Wheat production in Afghanistan is projected to rise by 40–50 percent over 2008, given improved weather conditions, and the UN Food and Agriculture Organization has reported that the country is likely to be self-sufficient in wheat this year.