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Prospects Weekly: Demand stimulus to support growth in developing countries since 2007 has substantially eroded policy buffers, Agricultural and metals commodity producers have suffered, Developing country gross capital flows remain volatile

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Demand stimulus to support growth in developing countries since 2007 has substantially eroded policy buffers. Agricultural and metals commodity producers have suffered a large negative terms of trade shock due to sharp declines in food and metal prices since 2011. Together these developments have contributed to rising domestic and external imbalances in developing countries, reducing their capacity to respond to external shocks. Developing country gross capital flows remain volatile, with a sharp drop in October fully reversing September’s rebound.

Demand stimulus in developing countries in the post-crisis period has eroded policy buffers. Automatic stabilizers and policy makers’ efforts to revive growth after the 2007 financial crisis have depleted policy space in developing countries, while adding to domestic and external imbalances. Compared to 2007, fiscal balances have deteriorated by over 4 percentage points of GDP in nearly half of developing countries. Among middle-income countries, fiscal deficits rose to about 4 percent of GDP in 2012 in Malaysia, South Africa and Thailand, and nearly 8 percent in India. Partly reflecting strong capital inflows, monetary policy also remains loose, with most developing country central banks having cut policy rates over the past two years. With output remaining capacity constrained current account deficits are rising, and looser policy has translated into rising or persistently high inflation despite falling food prices over the past two years.

Food and metal commodity price declines over the past year are hurting incomes in resource rich developing countries. The sharp fall in global food and metal prices – these are down by 22 and 12 percent respectively since December 2012 – has led to a steady worsening in the terms of trade of commodity producers hurting export and fiscal revenues. Estimates of the impact of lower commodity prices on export earnings suggest that commodity producers in sub-Saharan Africa and Latin America have suffered (net) losses of over 1 percent of GDP and over 2.5 percent in some cases. Income declines in major middle-income commodity producers are smaller but not insignificant: about 0.4-0.6 percent of GDP in Indonesia, South Africa and Vietnam and nearly 0.2 percent in Brazil. This has added to deteriorating current account imbalances in these economies. With prices expected to decline further on improving supply, commodity producers could suffer further losses.

Gross capital flows to developing countries eased in October, fully reversing the September rebound. At just $23 billion, gross capital flows in October were the lowest since December 2011. They were also lower than the June-August period when market concerns about possible tapering of US monetary stimulus pushed up long-term interest rates, weakening capital flows to developing countries as asset portfolios were readjusted towards high income economies. Syndicated bank lending, which tends to trail bond and equity flows due to lengthy transaction times, dropped sharply to just $3.8 billion after remaining relatively resilient during the summer. Bond issuance which had rebounded strongly in September, dropped by nearly two-thirds. Higher risk borrowers appear to be facing greater difficulties in tapping international bond markets: only 16 percent of total bond issuance since September has been accounted for by non-investment grade borrowers, compared with an average of 48 percent between January and June. Equity flows held up at just above $6 billion in October, but remain about half of the levels reached in the first five months of the year.

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