Simmering risks

ROSY PICTURE: Farming machines reap soybeans on a farm in Brazil. The World Bank expects emerging economies such as Brazil to continue to recover, though their growth rates may slow (XINHUA)

The recovery is mostly complete in developing countries, with prospects in individual countries increasingly dependent on local conditions and medium-term productivity growth rather than the large, global-level forces that dominated economic activity during and immediately after the financial crisis.

There are several potential downside risks. A much more severe slowing of the global economy could come about if the political turmoil in the Middle East and north Africa were to result in a prolonged period of high oil prices—either through increased uncertainty, or an enduring disruption to global oil supply.

Conditions in global food markets represent a more focused risk for the poor in developing countries. Another year of poor harvests could mean prices rise still higher—especially if combined with higher oil prices—with potentially serious consequences for the poor.

The market nervousness over fiscal sustainability in high-income Europe, although less acute than in the past, still has the potential to disrupt growth in developing countries if it begins to weigh on confidence.

The rise in commodity prices, combined with strong capital inflows, has contributed to an acceleration of inflation throughout the developing world. Headline inflation in developing countries neared 7 percent year on year in April 2011, a 3-percentage-point increase since low points in July 2009, when concerns of deflation were paramount. Headline inflation in high-income countries has also picked up, reaching 2.8 percent in April 2011.

Responding to the rise in inflation, authorities in many developing countries have begun the process of adjusting macroeconomic policy, which had been loosened in the wake of the financial crisis, to a more neutral stance.

Efforts to tighten monetary policy and rein in credit growth were complicated in 2010 by strong capital inflows. Some of these flows (mainly short-term debt and equity flows) were perceived as having an important speculative and temporary component. As a result, many countries (notably several large middle-income countries with relatively deep capital markets) sought to resist the associated upward pressures on their currencies, putting into place a wide range of administrative and regulatory measures designed to reduce the attractiveness of short-term financial investments or reduce the extent of credit expansion associated with reserve accumulation.

Looking forward, policymakers in developing countries will need to make fuller use of all of the tools at their disposal to keep inflation under control. While the more unstable capital inflows that characterized the third quarter of 2010 have abated, many of the underlying conditions that attracted those flows remain in place, such as low short-term interest rates in high-income countries; stronger growth prospects in developing countries; strong commodity prices, and a long-run tendency for developing countries' currencies to appreciate. Moreover, countries are now confronted with additional pressures from growing capacity constraints and rising commodity prices.

A more assertive tightening of fiscal policies in developing countries would also allow a given level of macroeconomic tightening to be achieved at lower interest rates. Lower domestic interest rates would both reduce the financial incentive for potentially destabilizing short-term debt inflow, but might also increase investment rates and overall activity by lowering the cost of capital for local entrepreneurs.

Some countries should consider introducing more flexible exchange rate regimes. When countries face temporary or speculative pressures on their currencies, reserve accumulation and other strategies to resist unwarranted exchange rate appreciation, or depreciation, may well be warranted. But when those pressures are persistent and enduring, a policy that resists exchange rate adjustment may well be counter-productive.