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UPDATED: July 12, 2010 NO. 28 JULY 15, 2010
Clouded Prospects
Developed countries struggling  

DOWNTURN BITES: A group of people eat at a restaurant on the Canary island of Tenerife, Spain on August 4, 2009. International tourist arrivals in Europe were down 10 percent in the first four months of 2009 (CFP)

As the European debt crisis deepens, the world economy has yet to find its footing despite signs of growth and renewed confidence. While the developed world faces the challenge of fiscal indebtedness, many developing countries are feeling the pinch of capital inflows and trade downturn. Global Economic Prospects 2010, the latest report by the World Bank, discussed these issues. Edited excerpts follow:

Concerns about the sustainability of Greece's fiscal position spilled over into global financial markets in early May 2010. Although there was a sharp increase in risk premium and a steep decline in stock markets worldwide, there are only limited indications of a wider contagion—at least so far.

Financial markets in developing and high-income countries have staged remarkable recoveries. Notwithstanding the recent turmoil, interbank lending rates and developing country bond spreads have almost returned to normal levels; stock markets in high-income and emerging economies have recovered much of the value lost; and most developing country currencies have regained their pre-crisis values against the dollar, with some having appreciated.

The real-side of the global economy is also recovering. In the first quarter of 2010, global industrial production was expanding at an 11 percent annualized rate, while merchandise trade was growing even more briskly.

While the downturn and recovery of the global economy were remarkable for both its depth and its similarity across countries, the character of the recovery—now more than a year old—is changing. Bounce-back factors (including the deep inventory cycle and the growth impetus from fiscal and monetary stimulus) that contributed to very rapid quarterly growth rates are fading. Increasingly, the pace of the recovery on the national and regional level will depend on the extent to which private sector activity recovers and the measures taken to address longer-term structural factors (including fiscal sustainability, banking-sector restructuring, and underling productivity).

Medium-term prospects for both high-income and developing countries face serious headwinds. High-income countries will continue to be plagued by weak financial sectors, waning growth effects from fiscal and monetary stimulus, and an increasingly pressing need to set public finances on a sustainable path.

The need to tighten fiscal policy extends well beyond countries that are frequenting headlines. It also supercedes the immediate challenge of unwinding the crisis-related stimulus measures that were put into place. This is a problem for many high-income countries where fiscal deficits and debt-to-GDP ratios have reached unsustainable levels. The G-7's debt is expected, according to the IMF, to reach more than 113 percent of the group's GDP in 2010, a level not seen since 1950.

Bringing debt levels down will be more challenging now because, in contrast with the war-related debt of the 1950s, today's debt reflects ongoing demands on government coffers that are likely to grow as pension and health liabilities expand with aging populations. The IMF estimates that high-income countries will need to cut government spending (or raise revenues) by 8.8 percent of GDP for a 20-year period in order to bring levels down to 60 percent of GDP by 2030.

The need to unwind stimulus measures among developing countries is generally less pressing because both fiscal deficits and debt-to-GDP ratios are much lower. Overall general government deficits as a percent of GDP in developing countries increased by 4.5 percentage points between 2007 and 2009.

Several developing countries do face fiscal challenges, including India whose fiscal deficit is estimated to have reached 9.5 percent of GDP in the 2009-10 period. India's debt represents 77 percent of its GDP. China also put in place a large stimulus package, but its finances are on a firmer footing, so there is less urgency to wind down stimulus (although overheating could be a strong macroeconomic adjustment for doing so).

Overall, global GDP is expected to expand by 3.3 percent in 2010 and 2011, rising somewhat thereafter to 3.5 percent in 2012. Reflecting much higher productivity and population growth, the economies of the developing world are expected to grow by about 6 percent over the next three years, while high-income country growth is limited to 2.3 percent in 2010 and 2.4 percent and 2.7 percent in 2011 and 2012, respectively. Because of these large growth differentials, developing countries will be a major source of global growth. Close to half of the increase in global demand in 2010 through 2012 will come from developing countries—their rapidly rising imports will be responsible for more than 40 percent of the increase in global exports.

Ripple effect

Although a gradual and smooth resolution of the fiscal issues in high-income Europe is the most likely scenario, should a disorderly adjustment occur it could have serious consequences for both high-income and developing countries. But even in the absence of a disorderly adjustment, developing countries and regions with close trade and financial connections to highly-indebted, high-income countries may face significant repercussions.

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