The world economy has entered a very difficult phase characterized by significant downside risks and fragility.
The financial turmoil generated by the intensification of the fiscal crisis in Europe has spread to both developing and high-income countries, and is generating significant headwinds.
Capital flows to developing countries have declined by almost half as compared with last year, Europe appears to have entered recession, and growth in several major developing countries (Brazil, India, and to a lesser extent Russia, South Africa and Turkey) has slowed partly in reaction to domestic policy tightening.
As a result, and despite relatively strong activity in the United States and Japan, global growth and world trade have slowed sharply.
Indeed, the world is living a version of the downside risk scenarios described in earlier editions of Global Economic Prospects (GEP), and as a result forecasts have been significantly downgraded.
- The global economy is now expected to expand 2.5 and 3.1 percent in 2012 and 2013 (3.4 and 4.0 percent when calculated using purchasing power parity weights), versus the 3.6 percent projected in June for both years.
- High-income country growth is now expected to come in at 1.4 percent in 2012 (-0.3 percent for Euro Area countries, and 2.1 percent for the remainder) and 2.0 percent in 2013, versus June forecasts of 2.7 and 2.6 percent for 2012 and 2013 respectively.
- Developing country growth has been revised down to 5.4 and 6.0 percent versus 6.2 and 6.3 percent in the June projections.
- Reflecting the growth slowdown, world trade, which expanded by an estimated 6.6 percent in 2011, will grow only 4.7 percent in 2012, before strengthening to 6.8 percent in 2013.
However, even achieving these much weaker outturns is very uncertain.
The downturn in Europe and weaker growth in developing countries raises the risk that the two developments reinforce one another, resulting in an even weaker outcome.
At the same time, the slow growth in Europe complicates efforts to restore market confidence in the sustainability of the region’s finances, and could exacerbate tensions.
Meanwhile the medium-term challenge represented by high deficits and debts in Japan and the United States and slow trend growth in other high-income countries have not been resolved and could trigger sudden adverse shocks.
Additional risks to the outlook include the possibility that political tensions in the Middle-East and North Africa disrupt oil supply, and the possibility of a hard landing in one or more important middle-income countries.
In Europe, significant measures have been implemented to mitigate current tensions and to move towards long-term solutions.
The European Financial Stability Facility (EFSF) has been strengthened, and progress made toward instituting Euro Area fiscal rules and enforcement mechanisms.
Meanwhile, European Central Bank (ECB) has bolstered liquidity by providing banks with access to low-cost longer-term financing.
As a result, yields on the sovereign debt of many high-income countries have declined, although yields remain high and markets remain skittish.
While contained for the moment, the risk of a much broader freezing up of capital markets and a global crisis similar in magnitude to the Lehman crisis remains.
In particular, the willingness of markets to re-finance the deficits and maturing debt of high-income countries cannot be assured.
Should more countries find themselves denied such financing, a much wider financial crisis that could engulf private banks and other financial institutions on both sides of the Atlantic cannot be ruled out.
The world could be thrown into a recession as large or even larger than that of 2008/09.
Although such a crisis, should it occur, would be centered in high-income countries, developing countries would feel its effects deeply.
Even if aggregate developing country growth were to remain positive, many countries could expect outright declines in output.
Overall, developing country GDP could be about 4.2 percent lower than in the baseline by 2013 — with all regions feeling the blow.
In the event of a major crisis, activity is unlikely to bounce back as quickly as it did in 2008/09, in part because high-income countries will not have the fiscal resources to launch as strong a counter-cyclical policy response as in 2008/09 or to offer the same level of support to troubled financial institutions.
Developing countries would also have much less fiscal space than in 2008 with which to react to a global slowdown (38 percent of developing countries are estimated to have a government deficit of 4 or more percent of GDP in 2011).
As a result, if financial conditions deteriorate, many of these countries could be forced to cut spending pro-cyclically, thereby exacerbating the cycle.
Arguably, monetary policy in high-income countries will also not be able to respond as forcibly as in 2008/09, given the already large expansion of central bank balance sheets.
Among developing countries, many countries have tightened monetary policy, and would be able to relax policy (and in some cases already have) if conditions were to deteriorate sharply.