Europe and Central Asia: Developing Country Growth Is Fastest In Three Decades, But Global Imbalances Pose Risks

WASHINGTON, April 6, 2005 — Economic growth increased in the Europe and Central Asian region by 6.8 percent in 2004, while global growth reached 3.8 percent-the fastest rate in four years, says the World Bank's Global Development Finance 2005: Mobilizing Finance and Managing Vulnerability. In Europe and Central Asia, the growth reflects a positive international trade and capital flows environment, as well as the benefits of continued reform, including improvements in investment climate and governance across much of the region.

The positive impact of EU accession in Central Europe and the Baltics, and progress with candidacy for EU membership in Bulgaria, Croatia, Romania, and Turkey are also contributing to growth. Other factors include continued political stability in Southeastern Europe, and the positive impact of high commodity prices in the Commonwealth of Independent States (CIS).

"Europe and Central Asia's growth is outpaced only by East Asia's," comments Pradeep Mitra, Chief Economist in the World Bank's Europe and Central Asia unit. "Rising oil prices have certainly played a part, but more important are continuing reforms, democratization, and increased political stability, which underpin the continued surge in investment."

Globally, developing countries outgrew high-income countries, and the gains were widespread—all developing regions grew faster in 2004 than their average over the past decade. But global growth momentum has peaked, and developing country gains are vulnerable to risks associated with adjustments to ballooning global imbalances—especially the $666-billion U.S. current account deficit.

Specifically, inflationary pressures are building in Europe and Central Asia, which could lead to tighter domestic monetary policy, which, in combination with expected increases in world interest rates, should mean higher regional interest rates, slowing investment, and a dampening of consumption demand. Coupled with the negative influence of a strong real effective appreciation by a number of the region's larger economies, and a leveling off of oil incomes, regional growth is expected to slow to about 5.5 percent in 2005 and 4.9 percent by 2006.

The strong global performance was underpinned by solid U.S. growth and rapid expansion in China, India, and Russia. Record expansion of 6.6 percent in developing countries was encouraged by favorable global conditions and supported by years of domestic policy improvements. As a result, financial flows to developing countries during 2004 reached levels not seen since the onset of the financial crises of the late 1990s.

Net private capital flows, including debt and equity to developing countries, increased by $51 billion to $301.3 billion in 2004. Of this, net foreign direct investment (FDI) totaled $165.5 billion, up by $13.7 billion in 2004. FDI to Europe and Central Asia has stabilized over the past three years at 23 percent of the developing-world total, significantly above its 9 percent share in 1994. In 2004, FDI to the region reached an estimated $37.6 billion, up from $35.6 billion in 2003.

Developing countries themselves continued to increase their exports of capital in tandem with their strengthening current account balances, which reached an aggregate surplus of $124 billion in 2004. FDI outflows from developing countries rose to an estimated $40 billion in 2004, up from $16 billion in 2002; these outflows are coming, for the most part, from the same countries receiving the bulk of private capital inflows, namely Brazil, China, Mexico and Russia.

"This recovery of financial flows is a welcome sign of renewed market interest in developing countries and a tribute to the substantial strengthening in economic fundamentals achieved in many countries," says François Bourguignon, the World Bank's Senior Vice President for Development Economics and Chief Economist. "But we should also keep in mind that current global financial imbalances pose risks-of disorderly exchange rate movements, or of interest rate increases-that could threaten these gains. Developing countries need to prepare themselves for adjustments, some of which could be sudden."

The report points to a baseline scenario in which tightening of U.S. fiscal policy and higher interest rates-along with strong growth among developing countries-starts to redress global imbalances and reduce the U.S current account deficit. But it also highlights the risks to this outlook, and argues that developing countries need to reduce their vulnerability to shifts in market sentiment prompted by higher-than-expected interest rate hikes, or a greater-than-expected depreciation of the U.S. dollar.