Title page

Contents

Acknowledgements 3

Abbreviations 11

Executive summary 15

CHAPTER I. Opportunities amid lingering challenges 19

Introduction 19

1.1. An uneven recovery amid rising uncertainty 20

1.2. Slow-falling inflation and elevated food prices 26

1.3. External sector pressures meet policy distortions 31

1.4. Rising financial sector vulnerabilities 45

1.5. Monetary tightening and fiscal consolidation 54

Appendix 1.1. Additional tables and figures for Box 1.1 68

Appendix 1.2. Sample and econometric analysis for Box 1.3 70

References 72

SPOTLIGHT: The informal foreign exchange market and capital controls: A South Asian tale 76

S1. The operation of the informal foreign exchange market 77

S2. Suggestive evidence 80

S3. Macroeconomic implications and conclusion 85

Reference 88

CHAPTER II. Navigating economic uncertainties 91

Introduction 91

2.1. Dimmed outlook amid continued external strains 92

2.2. Outlook subject to risks and uncertainties 104

2.3. Climate financing needs and opportunities 115

Appendix 2.1. Methodology for Box 2.1 130

Appendix 2.2. Methodology for Box 2.2 131

Appendix 2.3. Additional table for Section 2.3 132

References 133

CHAPTER III. Expanding opportunities: A map for equitable growth in South Asia 140

Introduction 140

3.1. Social progress in South Asia 141

3.2. Inequality of opportunity and intergenerational mobility in South Asia 149

3.3. Policies 173

Appendix 3.1: Underlying Data, Constructed variables, and Methodology 183

References 190

Table 1.1. Export restrictions on food by South Asian countries and major trading partners 30

Table 1.2/Table 1.3. Intervention policies to restore the balance of payments and stabilize exchange rates 44

Table 1.3/Table 1.4. Monetary policy hikes in South Asia since January 2021 55

Table 1.4/Table 1.5. Food and fertilizer subsidies in South Asian countries 59

Table 2.1. Growth in the region downgraded amid continuing pressures 93

Table 2.2. Private consumption impacted by still-high inflation, while investment outperforms expectation 96

Table 2.3. Assumptions behind alternative scenarios 105

Table 2.4. Selected innovative financial instruments for climate finance 128

Table 3.1. Intergenerational mobility and inequality of opportunity in South Asia 151

Table 3.2. Elasticity of IOp with respect to expansion in Primary Education 154

Table 3.3. Primary education profiles for 'high-opportunity' and 'low-opportunity' groups 156

Table 3.4. Consumption profiles for "high-opportunity" and "low-opportunity" groups 166

Figure 1.1. Global services sector is recovering while energy prices are falling 21

Figure 1.2. Activities in the industrial sector and especially manufacturing have declined 21

Figure 1.3. Construction and services sectors in India expanded in 2022H2, while manufacturing contracted 22

Figure 1.4. Services sector activity was led by a recovery in tourism 23

Figure 1.5. Investment and business confidence remain strong in India, whereas business sentiment is weak in Pakistan and Sri Lanka 24

Figure 1.6. Employment has expanded in India, albeit at a slower pace, and has continued to contract in Sri Lanka 25

Figure 1.7. GDP nowcast suggests continued uneven recovery across countries 26

Figure 1.8. Consumer inflation has fallen but remains sticky in most countries, while wholesale inflation has fallen by more 27

Figure 1.9. Commodity price pass-throughs increased during 2022H2 27

Figure 1.10. Inflation in food items has remained high, while energy-related inflation has trended down 29

Figure 1.11. Local-level supply constraints and exchange rate depreciation have contributed to domestic inflation, while the impact of oil prices has fallen 31

Figure 1.12. Food and fuel inflation in South Asia 32

Figure 1.13. Consumption expenditure share by household decile in South Asia 34

Figure 1.14. Inflation inequality between households in top and bottom deciles 35

Figure 1.15. Falling goods imports have helped improve the goods trade balance in South Asia 37

Figure 1.16. Import share of some capital goods fell in 2022Q3-Q4 in South Asian countries except India 38

Figure 1.17. Financial accounts net outflow increased 39

Figure 1.18. Exchange rate has stabilized in most countries, but the gap between the informal and official exchange rates widened, which led to a decline in official... 40

Figure 1.19. Financial sector conditions are worsening in South Asia 46

Figure 1.20. Asset quality has deteriorated in Bangladesh and Sri Lanka and among microfinance banks in Pakistan 47

Figure 1.21. Bank credit growth continues to outpace deposit growth in South Asian countries 49

Figure 1.22. Sovereign debt and banks' holdings of sovereign debt in South Asia, 2013-2021 50

Figure 1.23. Exposures to sovereign and SOEs (% of total assets) 51

Figure 1.24. Sovereign debt holdings, by bank ownership 52

Figure 1.25. Monetary policy has tightened but real rates remain negative in most countries due to high inflation expectation 55

Figure 1.26. Interest payments have remained high, while spending on subsidies has fallen in most countries 57

Figure 1.27. Tax revenue has been slow to pick up in most countries and fallen in others 58

Figure 1.28. Experts see continuing recovery but views on the future are less optimistic 61

Figure 1.29. While inflation risk is perceived to be receding, experts note financial sector stress and sluggish consumption as rising risks 62

Figure 1.30. Experts believe major risks in the financial sector come from deteriorating asset quality, liquidity, and the sovereign-bank nexus 62

Figure 1.31. Drivers of falling foreign reserves 63

Figure 1.32. Tradeoffs of capital control measures in response to the balance of payment tension 65

Figure 1.33. Hurdles to green development in South Asia 65

Figure 1.34. Inequality and inequality of opportunity are perceived to be high and rising in South Asia 66

Figure 1.35. Inequality of opportunity and policy choices 67

Figure 2.1. Fiscal consolidation will lead to narrowing fiscal deficits, but deficits will remain high in some countries 98

Figure 2.2. Growth of private consumption and investment will drive GDP growth, while on the supply side services sector growth will remain robust 99

Figure 2.3. Inflation will fall more slowly than previously expected 100

Figure 2.4. Prices respond significantly to temperature anomalies in South Asia 102

Figure 2.5. Per capita real GDP will grow at about half of a percentage point slower in 2023 than previously expected 103

Figure 2.6. The number of poor at the low-income threshold of US$2.15/day will only fall below its 2019 level by 2024 104

Figure 2.7. External developments pose uncertainty and risks to South Asia's outlook 107

Figure 2.8. Impact of faster-than-expected US monetary policy tightening 109

Figure 2.9. US interest rates 111

Figure 2.10. Impact of a 25-basis-point increase of US interest rate on South Asia 112

Figure 2.11. Impact of worsening financial sector conditions depends on size of shock and elasticity assumption 114

Figure 2.12. Stronger fiscal response mitigates economic distress but puts pressure on public finance 118

Figure 2.13. Both economic activity and debt are less affected under stronger structural resilience 119

Figure 2.14. Indicative estimation of total investment needs for climate-resilient and low-carbon development in Pakistan for up to 2030 120

Figure 2.15. Explicit fossil fuel subsidies vary widely in the region 123

Figure 2.16. Fiscal revenues from the fossil fuel subsidy reform are significant in some countries 124

Figure 2.17. The fossil fuel subsidy reform leads to progressive distributional outcomes 125

Figure 3.1. Mobility in education is very low in South Asia and lower than any other region 142

Figure 3.2. Regional inequality as measured by the Gini coefficient is moderate in South Asia compared with other world regions 143

Figure 3.3. Inequality at the top end of the income distribution has increased significantly in India since the 1990s 144

Figure 3.4. Wealth concentration by billionaires in the BRIC countries and the United States 144

Figure 3.5. The Great Gatsby Curve of inequality of opportunity versus total inequality 145

Figure 3.6. Inequality of opportunity in years of schooling has decreased for most countries in the region 153

Figure 3.7. Primary education in South Asia: coverage has increased and inequality has decreased 154

Figure 3.8. Opportunity growth incidence of primary education across opportunity groups in Pakistan 158

Figure 3.9. Relative inequality of opportunity of primary education completion goes down faster than that of upper secondary education completion 159

Figure 3.10. Not all circumstances matter the same for IOp in years of education 160

Figure 3.11. There is an urban premium in IOp in years of education 161

Figure 3.12. IOp in consuption goes down but less than IOp in education 162

Figure 3.13. The evolution of IOp in primary education, years of schooling and consumption 163

Figure 3.14. The contribution of the different circumstances to IOp in consumption 164

Figure 3.15. Opportunity growth incidence of consumption across opportunity groups in Pakistan 167

Figure 3.16. Bottom-half mobility has been stagnant across generations in South Asia 168

Figure 3.17. There is a distinct hierarchy of countries in terms of mobility in South Asia 169

Figure 3.18. Geographic heterogeneity in bottom-half mobility at the province level across South Asia 170

Figure 3.19. There is an urban premium in terms of bottom-half mobility across most countries in South Asia 171

Figure 3.20. In most South Asian countries, the urban premium is driven higher upward mobility of women in urban areas 172

Figure 3.21. The demand for a more equal income distribution is higher in South Asia than in any other region 174

Figure 3.22. The demand for a more equal income distribution has increased significantly since the 1990s and more so for South Asia than in other regions 174

Figure 3.23. Support for reducing inequality is higher in India relative to Bangladesh and Pakistan 175

Figure 3.24. Support for state intervention in welfare is high in South Asia 175

Boxes

Box 1.1. Distributional impact of high food and energy inflation in South Asia 32

Box 1.2. Recent changes in exchange rate policy in Bangladesh 41

Box 1.3. The sovereign-bank sector nexus in South Asia 50

Box 1.4. Voices from South Asia 60

Box 2.1. Weather extremes and price stability 101

Box 2.2. Estimating the spillovers from US monetary policy 110

Box 2.3. Fiscal space and disaster resilience 117

Box 2.4. The turning point - fossil fuel subsidy reform in South Asia 123

Box 3.1. Measuring inequality, inequality of opportunity and intergenerational mobility in South Asia 146

Box 3.2. In South Asia, opportunity gaps in primary education have been shrinking but not at the same pace for all countries 155

Box 3.3. Are opportunity gaps closing? A stylized version of the opportunity growth incidence curve 165

Box 3.4. Affirmative action policies in South Asia 179

Spotlight Tables

Table S.1. Common purposes of import mis-invoicing 82

Table S.2. Selected long-term capital controls and other foreign exchange restrictions 87

Spotlight Figures

Figure S.1. Operation model of Hundi/Hawala 77

Figure S.2. Depreciation of the official exchange rate did not narrow the informal exchange rate gap 80

Figure S.3. Import finance restrictions and import mis-invoicing 82

Figure S.4. In Bangladesh, the informal-official exchange rate gap and official remittance inflows are negatively correlated, but no correlation between the official... 84

Figure S.5. Export proceeds inflows into Pakistan during exchange and capital controls 85

Table A.1.1. Data sources and coverage 68

Table A.1.2. Estimation results 71

Table A.2.1. Summary of key data on financial needs contained in South Asian countries' national reports submitted as part of the UNFCCC 132

Table A.3.1. Data harmonized for the underlying analyses in Bussolo et al. (2023); Asher et al. (2023) 183

Table A.3.2. India: Age-birth cohort table (Bussolo et al. 2023) 186

Figure A.1.1. Aggregate consumption pattern over time 69

Figure A.1.2. Contribution to price changes in the bottom and top deciles 69

Figure A.3.1. Education attainment of fathers of sons born in 1971-1980 (Pakistan); Asher et al. (2023) 189