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In the immediate term, tensions emanating from the Euro Area are the most serious potential risk for developing countries

Significant progress has been made in Europe on the policy front both in terms of the domestic structural and fiscal policies of high-spread European economies; and at the level of Euro Area institutions (renewed commitments to pan-European fiscal rules; enhanced Euro Area and IMF firewalls; and a more pro-active stance taken by the ECB).

Nevertheless, policy makers have yet to find the right mix of structural and macroeconomic policies to turn the vicious circle (whereby market-driven cuts in fiscal spending so dampen growth that they worsen fiscal sustainability and require even more cuts to spending) into a virtuous circle where reduced tensions yield  lower interest rates — and deficits— that allow for stronger private-sector growth and even more rapid progress toward fiscal sustainability. As a result, even if the current bout of tensions pass as is assumed in the baseline, markets are likely to remain nervous and further bouts of turmoil and policy reaction may be in store.

Current conditions in the Euro Area are worrisome. Bond yields on the debt of several countries have reached levels that, in the past, have been associated with interventions by international agencies. At the same time, deposits withdrawals from banks speak to a weakening of domestic confidence in the financial systems of some countries.

As discussed in the January 2012 edition of Global Economic Prospects (World Bank, 2012), if conditions in high-income Europe deteriorate sharply such that one or more countries found themselves frozen out of financial markets, global economic consequences could be severe.

Box 5 updates two scenarios that were presented in the January 2012 edition of Global Economic Prospects.4  The scenarios are not meant to be predictive, but rather illustrative of the magnitude of impacts that might be envisaged if the situation in high-income Europe were to deteriorate sharply.  They are presented, in the spirit of recent stress-tests of banking systems, as a tool that could help policymakers in developing countries prepare for the worst, and they are presented with full recognition of the limitations of the tools that underpin them. If a downside scenario actually materializes, its precise nature, triggers, and impacts will doubtless be very different from these illustrations.

With these caveats in mind, these simulations suggest that if there were a major deterioration in conditions, GDP in developing countries could be much (4.0 percent) weaker than in the baseline.

4. The scenario underlying the simulations is similar to that outlined in the Junauary 2012 edition of Global Economic Prospects (World Bank, 2012). It is assumed that current market tensions escalate, freezing Greece out of international capital markets. In the scenario, market confidence is shaken resulting and contagion to at least four other Euro Area economies ensues. The acute credit squeeze in directly affected economies denies finance that extends to the private sectors of these economies whose GDP declines by 8 or more percent (broadly in line with observations during previous financial crises in high-income countries (see Abiad and others, 2011). Other, economies are affected through reduced exports (imports from the directly affected countries fall by 9 percent), and by increased uncertainty, which raises borrowing costs and increases precautionary savings by households and firms. Direct trade and tighter global financial conditions plus increases in domestic savings by firms and households as a result of the increased global uncertainty impact activity worldwide, with Euro Area GDP falling by 6.2 percent relative to the baseline in 2013. GDP impacts for other high-income countries (-3.6 percent of GDP) and developing countries (-4.0 percent ) are less severe but still enough to push them into a deep recession. Overall, global trade falls by 2.6 percent (7.5 percent relative to baseline) and oil prices by 24 percent (5 percent for food.

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