Outlook Summary, December 9, 2008
The stresses in the financial markets of the United States that first emerged in the summer of 2007 transformed themselves into a full-blown global financial crisis in the fall of 2008: credit markets froze; stock markets crashed; and a sequence of insolvencies threatened the entire international financial system.
Massive liquidity injections by central banks and a variety of stopgap measures by governments proved inadequate to contain the crisis at first.
The initially hesitant policy response has become increasingly robust.
The United States government introduced a $700 billion rescue package and has taken equity positions in nine major banks and several large regional banks.
Various debt and deposit guarantees have also been introduced.
At the same time, European governments have announced plans for equity injections and purchases of bank assets worth some $460 billion, along with up to almost $2 trillion in guarantees of bank debt.
At the time of this writing, November 20, 2008, markets remain volatile despite the forcefulness of these measures and signs that credit conditions are improving somewhat in high-income countries.
Both private-sector and sovereign interest rate spreads for developing countries have spiked even higher, and a growing list of countries have been forced to seek assistance from the International Monetary Fund (IMF).
During the initial phases of this financial crisis in 2007, the effects of the financial turmoil on developing countries were relatively modest.
However, as the crisis intensified in 2008 and especially since mid-September, risk aversion (the absence of which had been the hallmark of the preceding boom) has increased, and capital flows to developing countries have seized up.
As a result, the currencies of a wide range of developing countries depreciated sharply, and developing-market equity prices have given up almost all of their gains since the beginning of 2008.
Initial public equity offerings have disappeared, and risk premiums have increased to more than 700 basis points on sovereign bonds and to more than 1,000 basis points on the debt of developing- country firms.
Very recent data on bank lending and foreign direct investment inflows are not available, but indications are that these inflows have also declined, but less dramatically.
Virtually no country, developing or high- income, has escaped the impact of the widening crisis, although those countries with stronger fundamentals going into the crisis have been less affected.
The deterioration in financing conditions has been most severe in countries with large current account deficits, and in those that showed signs of overheating and unsustainably rapid credit creation before the financial crisis intensified.
Of the 20 developing countries whose economies have reacted most sharply to the deterioration in conditions (as measured by exchange rate depreciation, increase in spreads, and equity market declines), 6 come from Europe and Central Asia, and 8 from Latin America and the Caribbean.
In this climate, growth prospects for both high-income and developing countries have deteriorated substantially, and the possibility of a serious global recession cannot be ruled out.
Even if the waves of panic that have inundated credit and equity markets across the world are soon brought under control, the crisis is likely to cause a sharp slowdown in activity stemming from the deleveraging in financial markets that has already occurred and that is expected to continue.
In the baseline forecast presented in this chapter, much tighter credit conditions, weaker capital inflows to middle-income countries, and a sharp reduction in global import demand are expected to be the main factors driving the slowdown in developing countries.
Import demand is projected to decline by 3.4 percent in high-income countries during 2009, while net private debt and equity flows to developing countries are projected to decline from $1 trillion in 2007 to about $530 billion in 2009, or from 7.7 to 3 percent of developing-country GDP.
As a result, investment growth in developing countries is projected to slow dramatically, rising only 3.5 percent in middle-income countries, compared with a 13.2 percent increase in 2007.
A pronounced recession is believed to have begun in mid-2008 in Europe, Japan, and most recently, the United States.
This recession is projected to extend into 2009, yielding a decline in high-income country GDP of 0.1 percent that year (see Forecast summary table).
In developing countries, growth is projected to slow to 4.5 percent in 2009, down from 7.9 and 6.3 percent in 2007 and 2008.
Overall, global GDP is projected to expand only 0.9 percent in 2009 (figure 1.1)— below the rate recorded in 2001 and 1991 and indeed, the weakest since records became available beginning in 1970.
Because low-income countries have less access to international capital markets, the slowdown will affect them mainly through indirect mechanisms, including reduced demand for their exports, lower commodity prices, and reduced remittance inflows.
International trade is projected to decelerate sharply, with global export volumes falling by 2.1 percent in 2009—the first time they have declined since 1982 and eclipsing the 1.9 percent falloff that occurred in 1975.
Export opportunities for developing countries will fade rapidly because of the recession in high-income countries and because export credits are drying up and export insurance has become more expensive.
Slower growth in high-income countries is estimated to have reduced remittance flows into developing countries from 2 to 1.8 percent of recipient country GDP between 2007 and 2008. At the country level, the extent of further slowdown will depend critically on exchange rate developments, with recent swings in bilateral exchange rates dwarfing the expected changes in remittances denominated in host-country currencies.
The global growth recession is projected to cause both commodity prices and inflation to ease further, with oil prices averaging about $75 a barrel (bbl) in 2009, and food and metal prices projected to decline by about 23 and 26 percent, respectively, compared with their average levels in 2008.
Nevertheless, commodity prices will remain well above the very low levels of the 1990s. Lower commodity prices should reduce the burden on some segments of the poor (notably urban dwellers), whose purchasing power has declined because of high food and fuel prices (see chapter 3 of Global Economic Prospects 2009).
Lower prices should also help dampen headline inflation.
Indeed, the rapid rise of food and energy prices over the course of 2007 and the first half of 2008, coupled with tight capacity in many countries (following years of very fast growth fueled by ample liquidity) caused headline and core inflation to pick up throughout the world.
Headline inflation increased by 5 percentage points or more in most developing countries, and more than half of developing countries had an inflation rate in excess of 10 percent by the middle of 2008.
This financial crisis and the expected abrupt slowing of global growth comes at a moment when developing countries considered as a whole are more vulnerable than they have been in the recent past.
Higher commodity prices have widened current account deficits of many oil-importing countries to worrisome levels (they exceed 10 percent of GDP in about one-third of developing countries), and after having increased substantially, the international reserves of oil-exporting developing countries are now declining as a share of their imports. Moreover, inflation is high, and fiscal positions have deteriorated both for cyclical reasons and because government spending has increased to alleviate some of the burden of higher commodity prices.
Although the global recession is likely to be protracted, some elements of an eventual recovery can already be discerned.
These include early movement toward stabilization in the housing sector in the United States; continued progress on debt workouts and a strengthening of balance sheets among both banks and households; a gradual easing of credit conditions as government rescue packages take hold and investors begin to return to heavily discounted equity markets; increases in real incomes (stemming from lower food and fuel prices) among individuals with relatively high marginal propensities to consume; and increased space for fiscal and monetary policies as inflationary pressures ease and government outlays on food and fuel subsidies decline in tandem.
Although this sober outlook represents a likely outcome, the situation remains unstable, and a wide range of outcomes are possible, including a scenario where the rebound of growth in 2010 is weaker, held back by continuing banking sector restructuring, and negative wealth effects resulting from lower housing and stock market prices.
An even sharper recession is also possible. If the freeze in credit markets does not thaw as anticipated in the baseline, the consequences for developing countries could be catastrophic.
Financing conditions would deteriorate rapidly, and apparently sound domestic financial sectors could find themselves unable to borrow or unwilling to lend—in both international and domestic markets.
Such a scenario would be characterized by a long and profound recession in high-income countries and substantial disruption and turmoil, including bank failures and currency crises, in a wide range of developing countries.
Sharply negative growth in a number of developing countries with all of the attendant repercussions, including increased poverty and unemployment, would be inevitable.
Although it is a receding concern, high inflation in developing countries remains a problem, especially if the impact from the current crisis on developing-country investment demand is less pronounced, and the stimulus provided by various rescue and fiscal packages in high- income and developing countries feeds a rapid expansion in demand.
Under such a scenario, global growth would still slow in 2009, which would tend to dampen inflationary pressures initially, but growth could be expected to snap back much more sharply in 2010.
Countries that now have large current account deficits and high inflation could suffer from a renewed overheating of their economies.
Policies would have to be very prudent in these circumstances, because the currencies of these countries are likely to remain sensitive to changing market perceptions and increased risk aversion.
The challenge for policy makers is not only to prevent an escalation of the crisis and to mitigate the downturn but also to ensure a good starting position once the rebound sets in.
For developing countries, this means responding rapidly and forcefully to signs of weakness in domestic banking sectors, including resorting to international assistance where necessary.
It also means pursuing a prudent countercyclical policy, relying on automatic stabilizers, social safety nets, and infrastructure investment that addresses bottlenecks that have become binding constraints on long-term sustainable growth in many countries.
In the current circumstances of heightened risk aversion and investor skittishness, policy makers need to be especially wary of taking on excessive levels of debt or creating the conditions for an inflationary bubble by reacting too aggressively to the global slowdown.
Although it is important for policy makers to react quickly to emerging problems, it is also essential that steps and conditions attached to assistance be well focused on overcoming some of the fundamental sources of weakness.
Otherwise there is a risk that governments lose the support of markets and taxpayers in their efforts to limit the extent of near-term disruptions.
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