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Less volatile, but slower growth ahead

Theo Janse van Rensburg's picture
The summer edition of the World Bank’s Global Economic Prospects (GEP) is now out. In this blog posting, I highlight some of the interesting baseline forecast numbers as well as some new risks.

The global economy appears to be transitioning towards a smoother and less volatile period. But, the recovery remains hesitant, and uneven. Although financial conditions in high-income countries have improved and risks are down, growth remains subdued especially in Europe as fiscal consolidation, high unemployment and still weak consumer and business confidence will continue to dampen growth this year.

Growth in the developing world will be solid but weaker than during the boom. Most developing countries have recovered from the crisis, with limited room for additional acceleration. There is more upside potential in developing Europe where activity remains depressed due to ongoing restructuring, and the Middle East & North Africa where growth is weak mainly because of political and social tumult.

Financial conditions in high-income countries have improved and risks are down, but growth remains subdued, especially in Europe

Financial market risk indicators, such as credit default swap rates, sovereign debt spreads, and stock-market volatility indicators have significantly improved since June 2012. Although the challenges faced by high-income countries to restore financial-sector health, reform institutions and get fiscal policy back onto a sustainable path persist, the likelihood that these challenges will provoke a new major crisis has declined markedly.

But despite this progress on the financial side, real-side recovery has been slow and activity remains sluggish, especially in Europe, where it is being held back by weak confidence and continued banking-sector and fiscal restructuring. The recovery is on more solid ground in the United States, where a fairly robust private sector recovery is being held back, but not extinguished, by fiscal tightening. Meanwhile, in Japan, a dramatic relaxation of macroeconomic policy has sparked an uptick in activity, at least over the short term. Overall, high-income country growth is projected to accelerate slowly, from a modest 1.2 percent this year to 2.0 and 2.3 percent in 2014 and 2015, respectively (Table 1). 
 
 


Growth is firming in developing countries, but conditions vary widely across economies

The story for developing countries is, for the most part, rosier. Developing economies have more or less completely recovered from the 2008 crisis and less volatile external conditions are expected to yield a gradual acceleration of activity in developing regions.

Also, less volatile external conditions, a recovery of capital flows to levels that support growth, the relaxation of capacity constraints in some middle-income countries, and stronger growth in high-income countries are expected to yield a gradual acceleration of developing-country growth to 5.1 percent this year, and to 5.6 and 5.7 percent in 2014 and 2015, respectively.

Most developing countries have recovered from the crisis, so room for additional acceleration is limited

Before we take a look at broader region-wide trends, I would like to point out that the overall acceleration is not stronger because the majority of developing countries have more-or-less fully recovered from the 2008 financial crisis.  In fact, for many countries, current and projected growth is broadly in line with underlying potential growth – leaving little room for acceleration.

Put differently, growth in several middle-income countries is being held back by supply bottlenecks and is unlikely to reach pre-crisis levels unless supply-side reforms are completed.

In China growth has slowed as authorities seek to rebalance the economy. As a result growth in the East Asia & Pacific region is projected to remain broadly stable at around 7½ percent in each of 2013, 2014, and 2015.

In Latin America, growth is expected to pick up in 2013 to about 3.3 percent but then to stabilize at just below 4 percent in each of 2014 and 2015. Already, growth in several countries in both regions is being held back by supply-side constraints that are manifesting themselves in inflation, asset-price bubbles, and deteriorating current account balances. 

Many countries in Sub-Saharan Africa are also running at, close to, or above potential output, and risk building up inflationary pressures. Growth in the region is projected to firm over the projection period from 4.4 percent in 2012 to 4.9, 5.2, and 5.4 percent in 2013, 2014, and 2015, respectively (with the big acceleration in 2013 partly reflecting a post-conflict bounce-back in South Sudan).

Growth in South Asia is projected to pick up to 5.2 percent this year, following a very weak 2012 and then to firm only gradually to 6.0 and 6.4 percent in 2014 and 2015 as spare capacity is reabsorbed.
In developing Europe and the Middle East & North Africa, output gaps remain and growth is projected to strengthen

Many countries in developing Europe have still not recovered from the crisis, with unemployment and spare capacity remaining high, because activity has been weighed down by banking-sector, household, and fiscal restructuring (much like high-income Europe). As adjustments are completed, growth in the region is projected to strengthen progressively from 2.7 percent last year to 4.2 percent by 2015.

Growth in the Middle East & North Africa has been disrupted by political and social tensions and Euro Area weakness. Assuming that tensions in the region gradually ease, growth is projected to gradually strengthen from 2.5 percent in 2013 to 3.5 percent in 2014 and 4.2 percent in 2015.

Developing countries face new risks…

Even as the post-crisis risks from the high-income world have declined in importance, a new set of uncertainties and risks are emerging or gaining in stature. For instance:
 
  • The potential effects of the radical relaxation of both fiscal and monetary policy in Japan. This could reduce developing countries’ competitiveness in markets in which they directly compete with Japan, due to the 21 percent real-effective depreciation of the Yen since September 2012, and exacerbate overheating economies, particularly in East Asia, through increased capital flows.
  • A faster than expected decline in commodity prices. Over the past year, energy and metals prices have been easing in response to supply and demand-side substitution induced by high prices (metal prices are down 28 percent since their February 2011 peak). If prices decline to their longer-term equilibrium more quickly than assumed in the baseline, GDP growth among Sub Saharan Africa metals exporters could decline by as much as 0.7 percentage points, while current account and fiscal balances could deteriorate by 1.2 and 0.9 percent of GDP, respectively. Lower oil prices would have similar impacts for oil exporters (-0.4 percent of GDP), but would tend to benefit developing countries as a whole (+0.3 percent).
  • The withdrawal of quantitative easing policies could negatively impact capital flows to developing countries. Quantitative easing (QE) has benefited developing countries by stimulating high-income-country GDP, lowering borrowing costs, and avoiding a financial-sector meltdown. Although the increased liquidity has not generated excessive capital flows to developing countries, capital flows has become more volatile. The recent intensification of monetary easing in Japan could (re)generate large fluctuations in flows over the short run that is difficult to manage.  However, once high-income countries begin to pursue QE less actively or even begin to unwind long-term positions, interest rates are likely to rise, which will increase debt-servicing costs, and raise the cost of capital in developing countries. As investment rates adjust to these higher capital costs, developing-country investment spending and growth can be expected to decline by as much as 0.6 percent per annum after three years.

Domestic solutions hold key to future growth…

Developing countries have navigated the crisis and the immediate post-crisis period very well. As the global economy moves into the new, more stable phase and as acute risks from high income economies diminish, developing countries will have to pay more attention to domestic challenges and look to domestic solutions to boost growth, competitiveness and employment. They will also have to keep a close eye on the nature of evolving external risks, including from shifts in commodity prices and the withdrawal of quantitative by high income economies over the medium term. 

While projected growth rates are satisfactory and well above the growth rates of the 1990s, they are 1-2 percentage points slower than in the pre-crisis boom period. To achieve faster growth on a sustained basis, developing countries will need to redouble efforts to restore and preserve macroeconomic stability and reduce bottlenecks by streamlining regulations; improving their enforcement; and investing in infrastructure, education, and health.