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Prospects Weekly: Industrial production leads to more restrictive policy measures

Global Macroeconomics Team's picture

Industrial production in some developing countries is close to or exceeds full-capacity, which has led them to adopt more restrictive policy measures and begin to emphasize more structural supply-oriented policies to support sustainable long-term growth. As monetary policy in some of these countries tightens, the growing gap between their interest rates and those in high-income countries (where monetary policy remains very accommodative) is prompting an increase in potentially destabilizing short-term capital flows. Despite recent market concerns about long-term fiscal sustainability in some high-income European countries, foreign bond sales in developing countries have reached a record $143bn in 2010 so far.
Industrial production spare capacity varies markedly across developing regions and income groups. It remains elevated in many high-income countries and in Europe and Central Asia. In contrast, output in many developing countries, notably those in Asia, is close to or exceeds full capacity. In these countries policy is being tightened and focus is shifting from demand-stimulus to supply-creation. Even in countries where backward-looking estimates of spare capacity remain high, a transition toward more supply-augmenting rather than demand-stimulating policy may be in order. Such a transition would be particularly desirable, if a significant proportion of the decline in output reflected a crisis-induced destruction of capacity, as is often observed following a financial crisis. 
Rising interest rates following the tightening of monetary policy in some developing countries are creating tensions. Short-term financial assets are becoming more attractive to foreign investors in several developing countries following policy rate hikes. This is leading to higher and potentially destabilizing capital inflows in countries such as Brazil, Indonesia, Turkey and South Africa. Although pressures have been contained so far, if such flows were to build they could prompt currency appreciation, an expansion of domestic credit and a widening of current account deficits (or lower surpluses). Monetary policy is often powerless to neutralize these effects, as interest rate hikes may prompt more inflows. In some cases, tighter fiscal policy and capital controls may be required. 
Despite the intensification of market concerns about long-term fiscal sustainability in some high-income European countries, bond flows to developing countries have reached record levels. So far this year, $143bn in bonds have been issued by developing countries on international financial markets, 48% more than during the same period in 2007. These flows partly reflect a demand-side effect, as firms in developing countries seek to compensate for weak bank lending by going to the bond market. Private-sector bond issues accounted for 48% of sales in 2010 (Q1-Q3), compared with 39% in 2008 and 37% in 2009 (Q1-Q3). Among other international capital flows, IPOs and new share offerings have nearly recovered to pre-crisis boom levels, partly because of world-record deals in China and Brazil. However, total capital inflows remain 27% below the peak of $479bn posted in 2007 (Q1-Q3), as ongoing balance-sheet consolidation continues to impede bank lending, which is likely to be negative in net terms this year. 

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