Economic developments of the past year have been volatile, punctuated by natural disasters, large swings in investor sentiment, and periods of relative calm and improving prospects. Output in the second half of 2011, was particularly weak, buffeted by flooding in Thailand, the delayed impact of earlier policy tightening and a resurgence of financial market and investor jitters.
In contrast, economic news during the first four months of 2012 was generally positive. Significant structural, fiscal and monetary policy steps in high-income Europe during the fourth quarter of 2011 and the first quarter of 2012 contributed to a significant improvement in market sentiment, and less constraining financial conditions. This combined with monetary policy easing in developing countries was reflected in a strengthening of real-side economic activity in both developing and high-income countries. Annualized growth rates for industrial production, import demand and capital goods sales returned to positive territory with developing countries leading the rebound.
Increased Euro Area jitters have reversed earlier improvements in market sentiment
Most recently, market tensions have jumped up again, sparked by fiscal slippage, banking downgrades, and political uncertainty in the Euro Area. The renewed market nervousness has caused the price of risk to spike upwards globally. In the Euro Area, measures of financial market tension, such as Credit Default Swap (CDS) rates, have risen to levels close to their peaks in the fall of 2011. In other high-income countries, CDS rates have risen somewhat less sharply. Among most developing countries, CDS rates are currently about 65 to 73 percent of peak levels, and between 77 and 90 percent for countries in the Europe & Central Asia region.
Other financial market indicators have also deteriorated, with developing– and high-income country stock markets losing about 10 percent (at their recent trough) since May 1st, giving up almost all of the gains generated over the preceding 4 months. They have since recovered about half that value. Yields on high-spread economies were also driven upwards, while those of safe-have assets declined. Virtually all developing economy currencies have depreciated against the US dollar, while industrial commodity prices such as oil and copper have also fallen sharply (19 and 14 percent respectively).
Renewed tensions will add to pre-existing headwinds to keep GDP gains modest
Assuming that conditions in high-income Europe do not deteriorate significantly, the increase in tensions so far can be expected to subtract about 0.2 percentage points from Euro Area growth in 2012. The direct effect on developing country growth will be smaller (in part because there has been less contagion), but increased market jitters, reduced capital inflows, high-income fiscal and banking-sector consolidation are all expected to keep growth weak in 2012. These drags on growth are expected to ease somewhat, and global growth strengthen during 2013 and 2014, although both developing-country and high-income country GDP will grow less quickly than during the pre-crisis years of this century.
Taking these factors into account, global GDP is projected to increase 2.5 percent in 2012, with growth accelerating to 3.0 and 3.3 percent in 2013 and 2014 (table 1). Output in the Euro Area is projected to contract by 0.3 percent in 2012, reflecting both weak carry over and increased precautionary saving by firms and households in response to renewed uncertainty. Overall, high-income GDP is expected to expand only 1.4 percent this year weighed down by banking-sector deleveraging and ongoing fiscal consolidation. As these pressures ease in 2013 and 2014, rich-country GDP growth is projected to firm to what will still be a modest 1.9 and 2.3 percent pace in each of 2013 and 2014.
GDP in developing countries is projected to expand 5.3 percent in 2012. Still weak, but strengthening high-income demand, weak capital flows, rising capital costs and capacity constraints in several large middle-income countries will conspire to keep growth from exceeding 6 percent in each of 2013 and 2014. The projected recovery in the Middle-East & North Africa is uncertain and is contingent on assumptions of a gradual easing of social unrest during 2012 and a return to more normal conditions during 2013 and 2014.
In the baseline, the slower growth in developing countries mainly reflects a developing world that has already recovered from the financial crisis. Several countries are rubbing against capacity constraints that preclude a significant acceleration in growth, and may even require a slowing in activity in order to prevent overheating over the medium run.
Should global conditions deteriorate, all developing countries would be hit — making the replenishment of depleted macroeconomic cushions a priority
The resurgence of tensions in the high-income world is a reminder that the after effects of the 2008/09 crisis have not yet played themselves out fully. Although the resolution of tensions implicit in the baseline is still the most likely outcome, a sharp deterioration of conditions cannot be ruled out. While the precise nature of such a scenario is unknowable in advance, developing countries could be expected to take a large hit. Simulations suggest that their GDP could decline relative to baseline by more than four percent in some regions, with commodity prices, remittances, tourism, trade, finance and international business confidence all mechanisms by which the tribulations of the high-income world would be transmitted to developing countries. Countries in Europe and Central Asia would be among the most vulnerable to an acute crisis in high-income Europe, with likely acceleration in deleveraging by Greek banks affecting Bulgaria, Macedonia and Serbia the most.
A return to more neutral macroeconomic policies would help developing countries reduce their vulnerabilities to external shocks, by rebuilding fiscal space, reducing short-term debt exposures and recreating the kinds of buffers that allowed them to react so resiliently to the 2008/09 crisis. Currently, developing country fiscal deficits are on average 2.5 percent of GDP higher than in 2007, and current account deficits 2.8 percent of GDP higher. And short-term debt exceeds 50 percent of currency reserves in 11 developing countries.
A more neutral and less reactive policy stance will help even if a crisis is averted
Even in the absence of a full-blown crisis, elevated fiscal deficits and debts in high-income countries (including the United States and Japan), and the very loose monetary policies being pursued in the high-income world, suggests that for the next several years the external environment for developing economies is likely to remain characterized by volatile capital flows and volatile business sentiment.
As a result, sharp swings in investor sentiment and financial conditions will continue to complicate the conduct of macro policy in developing countries. In these conditions, policy in developing countries needs to be less re-active to short-term changes in external conditions, and more responsive to medium-term domestic considerations. A reactive macroeconomic policy runs the risk of being pro-cyclical, with the impact of a loosening (tightening) in response to a temporary worsening (improvement) of external conditions stimulating (restraining) domestic demand at the same time as external conditions recover (weaken).
For the many developing economies that have, or are close to having fully recovered from the crisis, policy needs to turn away from crisis-fighting and re-prioritize the kinds of productivity-enhancing reforms (like investment in human capital and regulatory reform) that will support a durable pickup in growth rates over the longer term.