Developments, during the first four months of 2012 were generally positive and in line with the expectations that underpinned the projections in the January 2012 edition of Global Economic Prospects (World Bank, 2012). High-income Europe appeared to be stepping back from the brink. However, the situation has soured significantly, with financial market tensions in the Euro Area approaching the levels observed in the fall of 2011, although so far there has been less contagion to developing countries.
The renewed tension compounds the headwinds facing developing countries going forward and increases the likelihood of a serious deterioration of conditions in high-income Europe, to which developing countries remain vulnerable. While countries must be prepared to react to a significant downturn should it arise, they must also be careful to ensure that policy does not become too re-active, but is directed by medium-term domestic priorities.
Even if the current phase of tensions passes, the external environment for developing countries is likely to remain volatile and challenging. Loose monetary policies, and, as yet, unresolved fiscal and banking-sector problems in high-income countries are likely to keep international capital flows and business confidence volatile.
If a close to capacity economy finds demand falling (accelerating) at an unexpectedly rapid pace due to changes in global animal spirits, macroeconomic policy can potentially find itself following a similarly volatile path of permanently trying to catch up to what for many developing countries are entirely external and largely unforeseen developments.
In such an environment, perhaps the optimal strategy is to follow a steadier course, keeping policy instruments focused on the domestic forces that policy can expect to influence, while allowing automatic stabilizers such as exchange rates and the tax system to deal with the constant changes of a still febrile international environment.