Developing countries are more vulnerable than in 2008

Whatever the actual outcomes for the world economy in 2012 and 2013 several factors are clear.  First, growth in high-income countries is going to be weak as they struggle to repair damaged financial sectors and badly stretched fiscal balance sheets. Developing countries will have to search increasingly for growth within the developing world, a transition that has already begun but is likely to bring with it challenges of its own. Should conditions in high-income countries deteriorate and a second global crisis materializes, developing countries will find themselves operating in a much weaker global economy, with much less abundant capital, less vibrant trade opportunities and weaker financial support for both private and public activity. Under these conditions prospects and growth rates that seemed relatively easy to achieve during the first decade of this millennium may become much more difficult to attain in the second, and vulnerabilities that remained hidden during the boom period may become visible and require policy action.

The remainder of this report examines some of these potential vulnerabilities and attempts to offer some policy advice for developing countries to help prepare for what is likely to be a weaker global economy going forward, and what potentially could be a second major global recession.

Conditions today are less propitious for developing countries than in 2008

One of the more positive elements of the recession of 2008/9 was the speed with which developing countries (other than those in Central and Eastern Europe) exited the crisis. Indeed, by 2010, 51 percent of developing countries had regained levels of activity close to or even above estimates of their potential output).

This was in stark contrast to many high-income countries, where, even now, GDP remains well below the levels that might have been expected had pre-crisis trends continued. The good performance partly reflects the healthy fiscal, current account and reserves positions with which most developing countries entered the crisis. This allowed most to absorb a large external shock without serious domestic dislocation (see Didier, Hevia, and Schmukler, 2011).

Today fiscal conditions are still generally better in developing countries than in high-income countries. Only 27 countries for which comprehensive data exist, have fiscal deficits in excess of 5 percent of GDP, and while 14 have gross debt to GDP ratios in excess of 75 percent, only 3 countries (Eritrea, Egypt and Lebanon) combine a deficit in excess of 5 percent of GDP and a gross debt to GDP ratio in excess of 75 percent of GDP in 2011.

Nevertheless, fiscal positions in developing countries have deteriorated markedly since 2008. In particular, government balances have deteriorated by two or more percent of GDP in almost 44 percent of developing countries in 2012. As a result, developing countries have much less fiscal space available to respond to a new crisis.

To a large extent the reduced fiscal space reflects the fact that in 2007 many countries were at the peak of a cyclical boom that had boosted fiscal revenues above normal rates. As a result, fiscal  deficits  were smaller by about 2 percent of GDP than they would have been had activity been in line with underlying potential. Now most developing countries are much closer to normal levels of output, and this cyclical windfall has disappeared.

Fiscal balances have not deteriorated by the whole (windfall) amount because policy reforms and high commodity prices have benefitted fiscal balances. In most regions structural fiscal balances (the balance that would be observed if demand was just equal to potential GDP) have neither increased nor decreased appreciably (see discussion on Structural budget balances).

Europe and Central Asia and South Asia are exceptions in this regard. In Europe and Central Asia the policy reforms necessitated by the very large shock that the region encountered in 2008/9 resulted in a 3.0 percent of GDP reduction in structural deficits, from -3 to 0 percent of GDP. In contrast, a sharp increase in fiscal spending in South Asia contributed to a 3.1 percent deterioration in structural budget balances to -8.0 percent of GDP in 2011.

High commodity prices have also boosted government revenues and served to keep deficits low. For oil exporting developing countries, the increase in commodity prices since 2005 has improved government balances by an average of 2.5 percent of GDP, among metal exporters the improvement has been of the order of 2.9 percent of GDP, while for non-oil non-metals commodity exporters the improvement has been less pronounced.

Independent of whether fluctuations in commodity revenues (and subsidy expenditures) are included in the cyclical or structural deficit, if commodity prices were to fall then fiscal conditions in exporting countries would deteriorate rapidly. Simulations suggest that if  commodity prices were to fall as they did in the 2008/09 crisis, fiscal balances in oil exporting countries could deteriorate by more than 4 percent of GDP. Impacts in metals exporting countries could also be large, with some regional impacts exceeding 4 percent of GDP.

Impact on fiscal balance of a fall in commodity prices like that observed in the 2008/09 crisis
(change in fiscal balance, percent of GDP)