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GlobalEconomic
Prospects

Crisis, Finance, and Growth
53098

2010

Global
Economic
Prospects

Global
Economic
Prospects
Crisis, Finance, and Growth2010© 2010 The International Bank for Reconstruction and Development / The World Bank
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The cutoff date for the data used in this report was January 8, 2010. Dollars are current
U.S. dollars unless otherwise indicated.

Contents

Forewordxi

Acknowledgments
Abbreviations

xiii

xv

Overview
1
The acute phase of the crisis is over 1
Impact of the boom period on developing-country potential 4
Medium-term implications of the bust for finance in developing countries 8
Medium-term impact on the supply potential of developing countries 12
Conclusion
14
References
14
Chapter 1 Prospects for Developing Economies
15
Recent developments in financial markets 18
Global growth22
Prospects for high-income countries 23
Prospects for developing economies 25
Regional outlooks
26
Commodity markets
31
Inflation
35
World trade36
Narrowing global external payment imbalances 38
Uncertain prospects
39
The impact of the crisis on the very poor 41
Policy implications for developing countries
42
Notes
43
References
44
Chapter 2 The Impact of the Boom in Global Finance on Developing Countries
Financial innovation, high-income finance, and the liquidity boom 47
Novel channels for credit creation 50
Developing-country finance during the boom
53

45

v

C O N T E N T S

Real-side consequences of the surge in global finance
Concluding remarks
70
Notes
71
References
72

61

Chapter 3 Medium-Term Impacts of the Crisis on Finance and Growth in Developing
Countries
75
The impact of post-crisis regulatory and structural changes 77
Implications of a potential developing-country retreat from financial integration
The impact of higher borrowing costs 94
Strategies for dealing with a weaker international finance system 104
Implications for the global balance between savings and investment 107
Conclusion
108
Notes
109
References
112

88

Appendix: Regional Economic Prospects 117
East Asia and the Pacific 117
Europe and Central Asia
123
Latin America and the Caribbean 131
Middle East and North Africa 139
South Asia
146
Sub-Saharan Africa
154
Notes
163
References
164

FiguresO.1
Financial conditions have stabilized 2
O.2
Developments in high-income countries have driven the industrial
production cycle
2
O.3
The downturn in developing countries has been deeper and more broadly based thanduring previous recessions3
O.4
Selected indicators of macroeconomic stability in developing countries, 2007 5
O.5
The cost of risk in high-income countries fell sharply during the boom 6
O.6
Developing-country potential output growth was boosted by low borrowing costs 7
O.7
Foreign participation in selected emerging equity markets 9
O.8
FDI as a share of investment in developing countries, 1995−2008 10
O.9
Very volatile external debt flows pose serious macroeconomic challenges 10
O.10
Indicators of regulatory quality 12
O.11
Private credit provision is strongly correlated with per capita incomes 12
O.12
Higher borrowing costs result in a permanent decline in developing-country
GDP
13
1.1
Financial markets’ stabilization has partially restored pre-crisis financial conditions indeveloping countries
19
1.2
Syndicated bank lending by region, 2008 and 2009 20
1.3
FDI flows to developing countries21
1.4
External financing needs as a share of GDP, 2010 22vi

C O N T E N T S

1.5
1.6
1.7
1.8
1.9
1.10
1.11
1.12
1.13
1.14
1.15
1.16
1.17
1.18
1.19
1.20
1.21
1.22
1.23
1.24
1.25
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
2.10
2.11
2.12
2.13
3.1
3.2
3.3
3.4
3.5
3.6

Growth in industrial production
23
Change in stock building as a contribution to GDP growth in G-3 countries 24
Dispersion of GDP growth results in the first quarter of 2009 25
China’s stimulus program yielded a pickup in import demand 27
Nonperforming loans rise across much of Europe and Central Asia 28
In Latin America EMBI-stripped spreads retreat as investor confidence
returns
28
Lower oil prices and production yield sharp decline in oil revenues during 2009 30
South Asia’s external position improves in most countries on lower oil prices anddecline in domestic demand 30
Quarterly GDP data point to output stabilization in Sub-Saharan Africa
31
Real commodity price indexes
32
OPEC spare capacity 33
Global stock-to-use ratio of key agricultural markets (excluding China) 34
Real commodity prices
35
Inflation in low-, middle-, and high-income countries 35
Core inflation in high-income countries 35
Food prices in low-income countries 36
World trade is recovering 36
International tourist arrivals
37
An easing of global imbalances 39
U.S.-China imbalances have diminished markedly 39
Comparison of 2015 poverty forecast, GEP 2009 versus GEP 2010 43
Since the early 2000s, credit expansion has grown more than twice as fast as
nominal GDP
49
High-income GDP and trade growth do not explain the acceleration in developingcountry economic activity
50
Notional value of derivative transactions, 2002–08 52
Share of commercial bank and securitized assets in total credit held by U.S. financial
sector, 1995–2008
52
The cost of risk in high-income countries fell sharply during the boom 55
Developing-country interest rates fell substantially during the boom period 56
Total capital inflows to developing economies 58
Portfolio equity flows to developing countries 59
FDI inflows to developing countries, 1980–2008 60
Distribution of capital flows as a percentage of GDP in 2007 61
The determinants of private finance 62
Private credit from banks and other financial institutions relative to per capita
income, 2007
63
Rising investment rates contributed to an acceleration in potential output 70
Foreign participation in selected emerging equity markets 84
Debt financing of M&A transactions, 1995–2008 85
FDI as a share of investment in developing countries, 1995−2008 86
Net external debt flows from private sources, 1980–2008 88
The recent buildup in reserves was concentrated in East Asia and among oil
exporters
89
Developing countries’ average financial openness, 1990–2006 91

vii

C O N T E N T S

3.7
3.8
3.9
3.10
3.11
3.12
3.13
3.14
A1
A2
A3
A4
A5
A6
A7
A8
A9
A10
A11
A12
A13
A14
A15
A16
A17
A18
A19
A20
A21
A22
A23
A24
A25
A26
A27

viii

The global synthetic price of risk versus the portion explained by economic
fundamentals
95
Yields on selected U.S. government securities 97
Government debt is projected to rise in high-income, but not developing,countries
97
Falling capital costs were reflected in rising capital-output ratios 99
Impact of 110-basis-point shock on the capital-output ratio of a typical country 102
Higher borrowing costs result in a permanent decline in developing-countryGDP
102
The effect of higher borrowing costs on the ratio of private-source debt to grossnational income
104
Higher intermediation costs will reduce the risk-free interest rate relevant to savings
decisions
108
East Asian exports and production hard hit by downturn in capital goods demand 118
Malaysia: A profile of recovery 119
China’s stimulus program supports exports from regional partners 119
Equity markets have nearly recovered from earlier declines 120
East Asian currencies continue to recoup against U.S. dollar 120
Stimulus measures yield widening fiscal shortfalls across the region 121
East Asia will enjoy a moderate rebound in 2010–11 122
Gross capital flows to Europe and Central Asia picked up in mid-2009 125
Many European and Central Asian economies post sharp current accountadjustments
125
Pace of contraction in industrial production moderates in Europe andCentral Asia
126
Nonperforming loans rise across much of developing Europe and Central Asia 130
Industrial production and trade volumes are gaining momentum in Latin America andthe Caribbean
132
Central banks across Latin America eased monetary policy aggressively 134
Real effective exchange rates depreciated in more integrated economies 134
Quarterly GDP points to output stabilization in Latin America 134
Capital flows return to Latin America 135
Equity markets in the Middle East dropped quickly, and GCC recovery has been
muted
140
Oil prices, 2004–09
141
Lower oil prices and lower Middle Eastern output yield sharp decline in oil revenues
in 2009
141
Reduced oil revenues reduce current account surplus positions in 2009 142
Middle Eastern exports declined sharply as European demand fell 142
Worker remittances fell by a moderate 6.3 percent in 2009 143
Tourism receipts fall from record 2008 performance, but modest recovery likely 143
Oil price and export revival hold key to recovery in the Middle East andNorth Africa
144
Gross capital inflows to South Asia are recovering but remain below pre-crisis
levels 147
Local equity markets have generally returned to pre-crisis levels 147
Recovery in industrial production has taken hold in South Asia ahead of most otherregions148

C O N T E N T S

A28
A29
A30
A31
A32
A33
A34
A35
A36
A37
A38

Current account balances improve across much of South Asia in 2009 149
International flows to South Asia 149
Budget deficits in most South Asian countries outstrip developing-country
average
150
Interest payments represent a significant burden in South Asian economies 153
Middle-income and oil-exporting countries of Sub-Saharan Africa hit hardest
by global crisis
154
Private consumption and trade contracted markedly in South Africa 155
Current account balances of middle-income and oil-exporting countries deteriorated themost, while low-income countries remained aid-dependent 155
EMBI-stripped spreads retreat as investor confidence returns 156
Inflation in Sub-Saharan Africa down to low single digits on lower food prices 156
Quarterly GDP readings point to output stabilization in Sub-Saharan Africa 157
Growth in middle-income and oil-exporting countries in Sub-Saharan Africa will
accelerate faster
162

TablesO.1
A modest recovery
3
O.2
Regional distribution of changes in financing conditions, 2000–07 6
O.3
Decomposition of increase in potential output growth directly attributable tocapital deepening
7
O.4
Contribution of private-source debt inflows to external finance of developing countries
with current account deficits, average 2003–07 9
1.1
The global outlook in summary 17
1.2
Prospects remain uncertain
40
1.3
Poverty in developing countries by region, selected years 42
2.1
Interest rates and inflation in industrial countries, January 2002–June 2007
49
2.2
Changes in domestic intermediation, 2000–07
56
2.3
Net capital inflows by region 60
2.4
Intertemporal changes in financial variables mainly reflected the cost of capital, butacross countries institutional quality was most important 63
2.5
Regional distribution of changes in financing conditions, 2000–07 65
2.6
Rising investment rates by region 66
2.7
Intertemporal and cross-country influences on investment 67
2.8
Decomposition of increase in potential output growth directly attributable to capital
deepening70
3.1
Credit growth by foreign banks versus total credit growth, developing countries 82
3.2
Contribution of private-source debt inflows to external finance of developing countries
with current account deficits, average 2003–07 88
3.3
Indicators of the quality of domestic financial systems 93
3.4
Historical and prospective costs of capital for developing countries 98
3.5
Possible impact of tighter financial conditions on developing-country capital costs
99
3.6
Impact on potential output of a return to normal pricing of risk and higher base
rates
101
3.7
Higher borrowing costs and slower population growth imply slower growth inpotential output over the longer term
103
3.8
The crisis could increase poverty by 46 million in the long term 104
3.9
Selected indicators of banking sector efficiency 105

ix

C O N T E N T S

3.10
A1
A2
A3
A4
A5
A6
A7
A8
A9
A10
A11
A12
Boxes
1.1
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
3.1
3.2
3.3
3.4
3.5
3.6
3.7

x

Potential impact of improved fundamentals on long-term growth prospects
East Asia and Pacific forecast summary 118
East Asia and Pacific country forecasts 123
Europe and Central Asia forecast summary 124
Europe and Central Asia country forecasts 129
Latin America and the Caribbean forecast summary 131
Latin America and the Caribbean country forecasts 137
Middle East and North Africa forecast summary 141
Middle East and North Africa country forecasts 145
South Asia forecast summary 151
South Asia country forecasts 152
Sub-Saharan Africa forecast summary
154
Sub-Saharan Africa country forecasts
159

Prospects for remittances
38
Comparing this boom-bust cycle with other major cycles 48
Recent and systemically important financial innovations
51
Financial intermediation and economic development 54
The role of foreign banks in domestic intermediation 57
Capital flows can boost investment and efficiency 59
Determinants of cross-country differences in domestic and international
financial intermediation
64
Understanding the increase in investment rates 68
Estimating potential output in developing countries 69
Likely directions of financial sector reforms
78
The impact of foreign bank participation on stability 81
Survey evidence on the decline in trade finance during the crisis 83
FDI and debt flows during crises 86
The debate over capital account liberalization 92
The synthetic price of risk 95
Higher borrowing costs will constrain domestic and external finance
100

106

ForewordT

HIS YEAR, Global Economic Prospects
is being released at a critical juncture
for the world economy. A recovery
from the financial crisis that rocked the worldin the fall of 2008 is under way, but many
challenges remain and much uncertainty continues to cloud the outlook.
In many respects, recent economic news
has been encouraging. Industrial production
and trade, after falling by unprecedented
amounts worldwide, are growing briskly;
financial markets have recovered much of thesteep losses they incurred in late 2008 andearly 2009; and developing countries are once
again attracting the interest of international
investors. However, the depth of the recession has left the global economy seriously
wounded. Even as profitability returns tomany of the firms that were at the heart of thecrisis, industrial production and trade levels
have yet to regain their pre-crisis levels, andunemployment has reached double digits inmany countries and continues to rise.
Given the depth of the crisis and the continued need for restructuring in the global
banking system, the recovery is expected tobe relatively weak. As a result, unemployment and significant spare capacity are likely
to continue to characterize the economic
landscape for years to come. This poses areal challenge for policy makers, who must
cut back on unsustainably high fiscal deficits
without choking off the recovery. Similarly,
the extraordinary monetary stimulus needs tobe scaled back to avoid the creation of new

bubbles. The medium-term strength of therecovery will depend both on how well thesechallenges are met and on the extent to which
private-sector demand picks up. If policies areadjusted too slowly, inflationary pressures andadditional bubbles could develop; too quick ofan adjustment could stall the recovery.
Whatever the relative strength of the recovery in the next few months, the human costs ofthis recession are already high. Globally, andnotwithstanding upward revisions to growth
projections for 2010, the number of people
living on $1.25 per day or less is still expected
to increase by some 64 million as comparedwith a no-crisis scenario. The recession has
cut sharply into the revenues of governments
in poor countries. Unless donors step in to fill
the gap, authorities in these countries may beforced to cut back on social and humanitarianassistance precisely when it is most required.
In addition to analyzing the immediate challenges for developing countries posed by thecrisis, this year’s Global Economic Prospects
describes some of the longer-term implicationsof tighter financial conditions for developingcountry finance and economic growth. While
necessary and desirable, tighter regulation in
high-income countries will result in less abundant capital (both globally and domestically)
and increased borrowing costs for developing
countries. As a result, just as the very loose conditions of the first half of this decade contributed
to an investment boom and an acceleration indeveloping-country growth, so too will higher
capital costs in coming years serve to slowxi

F O R E W O R D

growth in developing countries and provoke adecline in potential output.
Countries should not respond passively. Efforts to strengthen domestic financial systems
and expand regional cooperation (including
regional self-insurance schemes) can help toreduce the sensitivity of domestic economies
to international shocks and counteract someof the longer-term negative effects of tighterinternational financial conditions. Such initiatives are most likely to benefit middle-income
countries that already have reasonably welldeveloped regulatory and competitive environments and healthy financial sectors. Finally, both low- and middle-income countries
should strengthen domestic financial regulations. Over time, such steps can improve domestic financial-sector efficiency and reducexii

borrowing costs—more than offsetting any
negative impacts from tighter international
conditions.
Overall, these are challenging times. The
depth of the recession means that even though
growth has returned, countries and individuals will continue to feel the pain of the crisis
for years to come. Policy can help mitigate theworst symptoms of this crisis. However, there
are no silver bullets, and achieving higher
growth rates will require concerted efforts toincrease domestic productivity and lower thedomestic cost of finance.
Justin Yifu Lin
Chief Economist andSenior Vice President
The World Bank

AcknowledgmentsT

HIS REPORT WAS produced by staff from the World Bank’s Development Prospects Group.

The report was managed by Andrew Burns, with direction from Hans Timmer. The
principal authors of the report were Andrew Burns, William Shaw, and Theo Janse van
Rensburg. The report was produced under the general guidance of Justin Yifu Lin.
Several people contributed substantively to chapter 1. Theo Janse van Rensburg was its main
author. The Global Macroeconomic Trends team, under the leadership of Andrew Burns, wasresponsible for the projections. The projections and regional write-ups were produced by Dilek
Aykut, Ivailo Izvorski, Eung Ju Kim, Annette De Kleine, Oana Luca, Israel Osorio-Rodarte,
Theo Janse van Rensburg, Elliot (Mick) Riordan, Cristina Savescu, and Nadia Islam Spivak.
These were produced in coordination with country teams, country directors, and the offices of
the regional Chief Economists and PREM directors. The short-term commodity price forecasts
were produced by John Baffes, Betty Dow, and Shane Streifel. The remittances forecasts were
produced by Sanket Mohapatra, while Shaohua Chen from the Development Research Groupand Dominique van der Mensbrugghe generated the long-term poverty forecast.
Andrew Burns, William Shaw, and Nikola Spatafora were the main authors of chapter 2,
with written contributions from Mike Kennedy, Oana Luca, and Angel Palerm. Chapter 3 waswritten by Andrew Burns and William Shaw, with written contributions from Dilek Aykut,
Jean-Pierre Chauffour, and Mariem Malouche. Both chapters 2 and 3 benefited from theexpert research assistance of Augusto Clavijo, Yueqing Jia, Eung Ju Kim, Irina Kogay, Sergio
Kurlat, Sabah Mirza, and Nadia Islam Spivak.
The accompanying online publication, Prospects for the Global Economy (PGE), was produced by a team led by Cristina Savescu and composed of Cybele Arnaud, Augusto Clavijo,
Sarah Crow, Betty Dow, Ernesto McKenzie, Kathy Rollins, Ziming Yang, and Ying Yu, withtechnical support from Gauresh Rajadhyaksha. The translation process was coordinated byJorge del Rosario (French and Spanish) and Li Li (Chinese). A companion pamphlet highlighting
the main messages of the commodities section of the report was prepared by Kavita Watsa andRoula Yazigi.
Martha Gottron edited the report. Hazel Macadangdang managed the publication process,and Rebecca Ong and Merrell Tuck-Primdahl managed the dissemination activities. Book production was coordinated by Aziz Gökdemir along with Stephen McGroarty and Andrés Meneses,
all from the World Bank Office of the Publisher.
Several reviewers offered extensive advice and comments throughout the conceptualization
and writing stages. These included Shaghil Ahmed, Daniel Benitez, Cesar Calderon, Otaviano
Canuto, Kevin Carey, Rodrigo Chavez, Jeff Chelsky, Mansoor Dailami, Jeff Delmon, Shahrokh
Fardoust, Alan Gelb, Jack Glen, Arvind Gupta, Fernando Im, Jacqueline Irving, Ada Karinaxiii

A C K N O W L E D G M E N T S

Izaguirre, Ivailo Izvorski, Prakash Kannan, Auguste Tano Kouame, Robert Kahn, Doreen
Kibuka-Musoke, Jean Pierre Lacombe, Atushi Limi, Justin Yifu Lin, Dominique van der
Mensbrugghe, Celestin Monga, Mustapha Nabli, Fernando Navarro, Il Young Park, Maria
Soledad Martinez Peria, Zia Qureshi, Hartwig Schafer, Luiz Pereira da Silva, Claudia Paz
Sepulveda, Hans Timmer, and Augusto de la Torre.

xivAbbreviations

ASEAN
BIS
CDOs
CDSs
CPI
DECPG
ECB
EMBI
EMBI+
FDI
GCC
GDP
GIDD
GNFS
GNI
IBRD
IDA
IMF
IPO
Lao PDRLCU
LIBOR-OIS
M&A
MDG
MSCI
NIEs
ODA
OECD
OPEC
PPP
saar
T-billTFP
UAE

Association of Southeast Asian Nations
Bank for International Settlements
collateralized debt obligations
credit default swaps
consumer price index
Development Economics Prospects Group (World Bank)
European Central Bank
Emerging Markets Bond Index
Emerging Markets Bond Index Plus
foreign direct investment
Gulf Cooperation Council
gross domestic product
Global Income Distribution Dynamics model
goods and nonfactor services
gross national income
International Bank for Reconstruction and Development
International Development Association
International Monetary Fundinitial public equity offering
Lao People’s Democratic Republic
local currency unit
London Interbank Offered Rate-Overnight Indexed Swap rate
mergers and acquisitions
Millennium Development Goal
Morgan-Stanley Composite Index
newly industrializing economies
official development assistance
Organisation for Economic Co-operation and Development
Organization of the Petroleum-Exporting Countries
purchasing power parity
seasonally adjusted annualized rate
Treasury bill (U.S.)
total factor productivity
United Arab Emirates

xv

OverviewT

he world economy is emerging from thethroes of a historically deep and synchronized recession provoked by the bursting of a
global financial bubble. The consequences of theinitial bubble and the crisis have been felt in virtually every economy, whether or not it participateddirectly in the risky behaviors that precipitatedthe boom-and-bust cycle. And while growth rates
have picked up, the depth of the recession meansthat it will take years before unemployment andspare capacity are reabsorbed.
This year’s Global Economic Prospects examines the consequences of the crisis for boththe short- and medium-term growth prospects ofdeveloping countries. It concludes that the crisisand the regulatory reaction to the financial excesses of the preceding several years may havelasting impacts on financial markets, raising borrowing costs and lowering levels of credit andinternational capital flows. As a result, the rateof growth of potential output in developing
countries may be reduced by between 0.2 and0.7 percentage points annually over the next five
to seven years as economies adjust to tighter financial conditions. Overall, the level of potential
output in developing countries could be reduced
by between 3.4 and 8 percent over the long run,compared with its pre-crisis path.
The report further finds that the very liquidconditions of the first half of the decade contributed to the expansion in credit available in developing countries and that this expansion was
responsible for about 40 percent of the approximately 1.5 percentage point acceleration of thepace at which many developing-country economies could grow without generating significant
inflation.
While developing countries probably cannot
reverse the expected tightening in international
financial conditions, there is considerable scopefor reducing domestic borrowing costs, or increasing productivity and thereby regaining thehigher growth path that the crisis has derailed.

The acute phase of the crisis
is overT

he immediate impacts of the crisis (including a freezing up of credit markets, a sharp
reversal of capital flows, and the precipitous
equity market and exchange rate declines thatensued) are largely in the past. Since March
2009, stock markets in high-income and emerging economies have recovered roughly half thevalue they lost, with developing economies rebounding somewhat more strongly than highincome ones. Interbank lending rates havereturned to normal levels, developing-country
sovereign interest rate premiums have declined
from a peak of more than 800 to around 300
basis points and stock market volatility has
receded (figure O.1). In addition, bond flows
to high-income corporate and emerging-market
sovereigns have returned to more normal levels,and most developing-country currencies haveregained their pre-crisis levels against the dollar.
However, bond markets and bank lending have1

2 0 1 0

Figure O.2 Developments in high-income
countries have driven the industrial
production cycle

12

400

8

250

⫺8

200

⫺12
⫺20

Vix index

Maximum: Oct. 2008
index point

Q
09

LIBOR-OIS
High-income countries

Maximum decline:
Oct. 2007 toMar. 2009 (%)

20

1
07

0
MSCI EM index

20

20

3

⫺24

50

1

100
30

⫺16

Q

150

40

09

50

20

60

0
⫺4

3

300

4

Q

70

08

350

20

80

16

450

1

right axis

Qleft axis

08

90

Contributions to global industrial production growth (% saar)

20

Basis points

3

Change from recent peak to current levels

Q

Figure O.1 Financial conditions havestabilized07

P R O S P E C T S

20

E C O N O M I CQ

G L O B A L

Decline as of
Sep. 2009
Current
Maximum: Oct. 2008
basis point

China

Developing countries
except China

Source: World Bank.

Source: JP Morgan and Morgan-Stanley.

begun only recently to reopen themselves to private sector borrowers in developing countries,
with syndicated loans to developing countries
totaling only $123 billion in 2009, comparedwith $236 billion during 2008.
The real side of the global economy is also
recovering, with industrial production at the
global level growing at more than 12 percent
annualized pace in the third quarter of 2009.
The recovery, which was initially concentrated
in developing countries, has become more balanced recently as the drawdown of inventories
in high-income countries slows and activity
catches up to underlying demand trends (figureO.2). Nevertheless, the level of output remains
depressed worldwide, with industrial production still 5 percent below pre-crisis peaks in
October 2009.
Trade, which initially fell sharply, is also
recovering; the exports of developing countries were expanding at a 36 percent annualized pace in October, but the volume of world
trade remained 2.8 percent lower than its
pre-crisis level and some 10 percent below the2

level consistent with its pre-crisis trend growthrate. Overall, considerable slack remains in
the global economy, with unemployment continuing to rise, disinflation widespread, andcommodity prices between 50 and 25 percent
lower than their levels in mid-2008.

A subdued recovery
Overall, after falling for two to three quarters,
global GDP has begun recovering; output grew
rapidly during the second half of 2009 and is expected to continue to do so during the first halfof 2010. However, as the positive contribution
to growth from fiscal stimulus and the inventory
cycle wanes, growth will slow, in part because
spending by households and the banking sector
will be less buoyant as they rebuild their balance
sheets. As a result, global GDP growth, which is
projected to come in at 2.7 percent in 2010 (after
an unprecedented 2.2 percent decline in 2009), is
expected to accelerate only modestly to 3.2 percent in 2011 (table O.1).
A weak recovery is also anticipated in developing countries. Arguably the inventory cycle issomewhat more advanced in East Asia and thePacific, and there are signs that the growth impactof fiscal stimulus in China may already be waning

O V E R V I E W

Table O.1 A modest recovery(real GDP growth, percentage change from previous year)
Region

2007

2008

2009e

2010f

2011f

World
High-income countries
Euro Area
Japan
United States
Developing countries
East Asia and Pacific
Europe and Central Asia
Latin America and the Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa
Memorandum items
Developing countries
excluding transition countries
excluding China and India

3.9
2.6
2.7
2.3
2.1
8.1
11.4
7.1
5.5
5.9
8.5
6.5

1.7
0.4
0.5
⫺1.2
0.4
5.6
8.0
4.2
3.9
4.3
5.7
5.1

⫺2.2
⫺3.3
⫺3.9
⫺5.4
⫺2.5
1.2
6.8
⫺6.2
⫺2.6
2.9
5.7
1.1

2.7
1.8
1.0
1.3
2.5
5.2
8.1
2.7
3.1
3.7
6.9
3.8

3.2
2.3
1.7
1.8
2.7
5.8
8.2
3.6
3.6
4.4
7.4
4.6

8.1
6.2

5.6
4.3

2.5
⫺2.2

5.7
3.3

6.1
4.0

Source: World Bank.
Note: e ⫽ estimate; f ⫽ forecast; growth rates aggregated using real GDP in 2005 constant dollars.

(industrial production and import growth in theregion are already slowing). Output is estimatedto have picked up in virtually every other developing region in the final quarter of 2009 and should
continue to do so early in 2010, before slowing
toward more sustainable rates later in the year.
The pace of the recovery is expected to be mostsubdued in the Europe and Central Asia region,
partly because the pre-crisis level of demand in
the region was well above potential and partly because the financial system in the region has been
more acutely affected by the crisis.
Combined, GDP growth in developing
countries is projected to grow by some 5.2 percent in 2010, after a modest 1.2 percent rise in2009 (⫺2.2 percent if India and China are excluded), and by a relatively weak 5.8 percent
in 2011. Despite these relatively robust growth
rates, the unusual depth of the recession will
mean that spare capacity and unemployment
will continue to plague economies in 2011 andsome sectors may well still be shrinking. Overall, the output gap (the difference between actual GDP and what GDP would be if capitaland labor were fully employed) in developing
countries will remain elevated at about 4 percent of potential output in 2011 (figure O.3).
The depth of the recession and the relative
weakness of the expected recovery suggest that

Figure O.3 The downturn in developing
countries has been deeper and more broadly
based than during previous recessions
Percent
0
ⴚ1
ⴚ2
ⴚ3
ⴚ4
ⴚ5
ⴚ6
1982–83

1991–93

Change in GDP growth

2001

2009
Output gap

Source: World Bank.
Note: Change in GDP growth is the percentage change in thegrowth rate of developing-country GDP between the crisis year(s)and the previous year. The output gap is the percentage difference
between GDP and potential output during the crisis year(s).

significant spare capacity, high unemployment,
and weak inflationary pressures will continue tocharacterize both high-income and developing
countries for some time. Already, the slowdown
in growth is estimated to have increased poverty.
Some 64 million more people around the world
are expected to be living on less than $1.25 a dayby the end of 2010 than would have been the3G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 1 0case without the crisis, and between 30,000 and
50,000 children may have died of malnutritionin 2009 in Sub-Saharan Africa because of thecrisis (Friedman and Schady 2009). Moreover,the slowdown is expected to cut heavily into
government revenues in poor countries. Countries eligible for soft loans and grants from theInternational Development Association of theWorld Bank may require as much as $35 billion to$50 billion in additional funding just to maintain2008 program levels, never mind the resources
necessary to fund additional demands brought
upon by the crisis.

The outlook remains clouded byuncertainties and the challenge ofunwinding the stimulus
Many uncertainties continue to surround theshort-term outlook for developing countries.
Principal among these is the extent to which
private sector consumption and investment
demand will respond to the pickup in activity
prompted by fiscal and monetary stimulus
and the inventory cycle. Should the response
be weaker than expected in the baseline
projection or should the stimulus be withdrawn too quickly, the recovery could stall.
Although a double-dip recession in the senseof a return to negative global growth rates isunlikely, developing-country growth could
come in as low as 5.1 percent in 2010 and
5.4 percent in 2011, with some countries
potentially recording negative growth for
one or more quarters.
A related but opposite risk is that the stimulus is not retracted quickly enough. In the caseof fiscal policy, the risk is mainly one of increased indebtedness and unnecessary crowdingout of private sector investment. On the monetary policy side, the risk is that the vast monetary expansion that has been undertaken begins
to gain traction, potentially overinflating the
global economy. This could recreate liquidity
conditions similar to those that created the bubbles that precipitated the crisis, causing global
imbalances to reemerge and forcing a much
more abrupt tightening of policy—possibly even4

a second recession. Indeed, in some middle-income countries, very loose monetary conditions
may already be generating asset price bubbles inlocal real-estate and other asset markets.

Impact of the boom period ondeveloping-country potentialI

n some ways, the crisis and recession fromwhich the world economy is currently emerging resemble previous boom-bust cycles. Like
many other major crises, the current one ischaracterized by a sharp reduction in economic
activity following an extended period of rapid
and ultimately unsustainable credit expansion,accompanied by excessive risk taking by financial institutions.
At the same time the current crisis differsfrom previous ones in fundamental ways. Froma global perspective, this crisis is the most severe
and widespread downturn since 1945. Global
GDP is estimated to have contracted by 2.2 percent in 2009 (the first absolute decline in global
GDP among the postwar crises). Even in 2011
demand is projected to remain 5 percent below
the global economy’s productive potential,
which is almost twice the output gap during thenext most severe recession (1982–83).
Moreover, in contrast with earlier downturns, the current crisis struck virtually every
developing country hard, even though, with
the important exception of many in Europe andCentral Asia, most countries did not exhibit
unsustainable macroeconomic imbalances(figure O.4). Outside of Europe and Central
Asia, regional inflation rates averaged about
6 percent or lower (well below the doubledigit rates in most regions during the early
1990s); most regional current account balances were near zero or strongly positive;
and ratios of debt to gross national income
were modest. The importance of prudent
macroeconomic policies was revealed during
the crisis, as the countries with the largest
imbalances suffered the biggest declines in
output (see chapter 3).
That the acute phase of the crisis was deeper
than past ones may have important longer-term

O V E R V I E W

Figure O.4 Selected indicators of macroeconomic stability in developing countries, 2007
Debt/GDP (percent)
45
40
35
30
25
20
15
10
5

an Eas
d tA
Pa s
ci ia
fic
Eu
C ro
en p
tra e
l A and
si
La
a
an ti
d nA
C m
ar e
ib ric
be a
M
an
id
dl
N eE
or as
th t
Af an
ric d
a
So
ut
h
As
ia
Su
bSa
h
Af araric na0Current account/GDP (percent)
10
8
6
4
2
0
ⴚ2

an Eas
d tA
Pa s
ci ia
fic
Eu
C ro
en p
tra e
l A and
si
La
a
an ti
d nA
C m
ar e
ib ric
be a
M
an
id
dl
N eE
or as
th t
Af an
ric d
a
So
ut
h
As
ia
Su
bSa
h
Af araric naⴚ4Inflation (percent)
12
10
8
6
4
2

an Eas
d tA
Pa s
ci ia
fic
Eu
C ro
en p
tra e
l A and
si
La
a
an ti
d nA
C m
ar e
ib ric
be a
M
an
id
dl
N eE
or as
th t
Af an
ric d
a
So
ut
h
As
ia
Su
bSa
h
Af araric n
a0so many countries are affected, unemployment
will remain high longer, skills will deteriorate,otherwise healthy firms may go bankrupt, andthe overall level of economic dislocation and associated economic costs will remain high. Just
passing through the crisis may have a sustained
negative impact on productivity and the future
path of economic growth. In some economies,
prolonged weakness in demand could provoke
the disappearance of whole sectors instead ofjust some companies. This could be especiallythe case for declining sectors. Similarly, an uneven recovery with growth and economic dynamism concentrated in one region versus another
could sway the path of investment, making lagging countries look weaker and possibly creating
new comparative advantages in the leading regions. Global trade patterns may be irrevocablyaltered.
How these forces will play out and the policies that should be put in place to respond tothem merit in-depth exploration. However,dealing with all of the potential consequencesof the crisis for developing countries lies outside of the scope of this publication.
The approach to the medium-term consequences of the crisis described in the pages that
follow is more narrowly oriented toward theconsequences for developing countries of thechanges in financial conditions observed overthe past decade and those that can be expectedin the next 5–10 years. Initially, the focus is on
how the boom in global financial markets affected credit conditions, investment, and growthprospects in developing countries and on thefactors that help to explain which countries
benefited most from the boom. It then switches
to an examination of how changes in the regulatory environment, risk aversion, and the policy
environment are likely to affect financial conditions, investment, and growth in developing
countries.

Source: World Bank.

consequences for growth, productivity, and eventhe structure of the world economy going forward. Because the shock is so deep and because

Not all countries benefited fully
from the liquidity boom
The liquidity boom in high-income countries
during the first seven years of the 21st century

5

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 1 0created favorable financial conditions in both
high-income and developing countries. Much
more intensive use of a range of financial innovations, including the securitization of loans
and the development of off-balance-sheet
vehicles, allowed banks to off-load an important portion of their loan portfolios onto
capital and money markets. Effectively, these
innovations allowed unregulated securities tosupport a portfolio of loans much like the traditional banking sector—but without capitalrequirements and under a much less stringent
regulatory framework. That permitted an unprecedented leveraging of equity capital, andthe rapid expansion of liquidity that ensued
helped to drive down interest rates, interest rate premiums, and the cost of capital inboth high-income and developing countries(figure O.5).
As a result, domestic banking sectors andthe quantity of domestic credit available
within developing countries increased quickly.
At the global level, international banking sector credits grew twice as fast as nominal GDP,and the quantity of capital flowing to low- andmiddle-income economies surged. Overall private sector lending increased by 5.5 percent
of GDP; the ratio of international capital inflows to GDP increased by about 5 percentage
points; and stock market capitalization increased by 79 percent of GDP (table O.2).
Table O.2

Figure O.5 The cost of risk in high-income
countries fell sharply during the boom
Percentage Points
16

Merrill high-yield corporate (US)

Lehman investment
grade (Euro)

14
12

Lehman investment
grade (US)10
US 10-year government bond8
6
4Euro 10-year government bond2
Jan. 1998 Jan. 2000 Jan. 2002 Jan. 2004 Jan. 2006
Source: Datastream.

The ensuing investment boom
boosted the supply potential ofdeveloping countries
The liquidity boom fed an investment boom
in developing countries that prompted a rapid
expansion in the supply potential of low- andmiddle-income countries but with limited impact on goods inflation in most countries. On
average, investment-to-GDP ratios in developing countries increased by 5.5 percentage
points, ranging from a 1.4 percentage point
increase in Latin America and the Caribbean
to an 8.1 percentage point rise in South Asia.
As a result, between 2000 and 2007
capital-to-output ratios in developing countries

Regional distribution of changes in financing conditions, 2000–07
Change between 2000 and 2007 in:RegionCost of capital

Capitalinflows

Stock market
capitalization(basis points)

Private credit bydeposit money banks(percent of GDP)

Developing countries
Low-income countries
Middle-income countries

⫺400

5.0

79

5.5

5.5
2.3
5.6

East-Asia and Pacific
Europe and Central Asia
Latin America and the Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa

⫺134
⫺866
⫺471
269
⫺142
⫺685

2.0
12.0
2.0
2.0
7.0
4.0

118
60
40
36
107
59

⫺10.7
15.7
2.2
6.2
14.8
6.8

5.5
4.9
1.4
5.0
8.1
3.6

Sources: World Bank; Beck and Demirgüç-Kunt 2009.
Note: Regional values are simple averages of countries, except for investment rates, which are weighted averages.

6

Investment

O V E R V I E W

Figure O.6 Developing-country potential
output growth was boosted by low
borrowing costs

Table O.3 Decomposition of increase inpotential output growth directly attributableto capital deepening
Change in growth rate of potential
output (2003–07 versus 1995–2003)

Percent growth in potential output
8
Actual7
6

Regions5

Without capital
deepening

4

Developing
Middle-income
Low-income

3
2
1
0
1995

1997

1999

2001

2003

2005

2007

Source: World Bank.

were about 10 percentage points higher thanthey would have been had investment rates
held stable at their 2002 levels. The increase incapital services provided by the additional capital contributed to about 40 percent of the 1.5
percentage point increase in the rate of growthof potential output (the level of output if capital and labor were fully employed) during thisperiod (figure O.6 and table O.3). In so far as therising share of new capital embodying the latest
technology contributed to the observed increase
in total factor productivity growth during thisperiod, the actual contribution of the boom todeveloping-country potential was even higher.
The notable exception was in the Europe andCentral Asia region. Despite experiencing thelargest increase in intermediation, much of theadditional resources went into consumption. As
a consequence, investment-to-GDP ratios in theregion increased by only 4.9 percent, less than
the 5.5 percent average for all developing countries considered as a whole. And in contrast withother regions, the expansion in domestic credit
fueled a consumption binge that generated significant domestic and external imbalances andultimately unstable macroeconomic conditions.

Economic policies are criticalto understanding cross-country
differences in intermediation
Lower borrowing costs were the largest
identifiable factor behind the increase in

East Asia and Pacific(excluding China)
China
Europe and Central Asia
Latin America and the
Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa

Total

Due tocapitaldeepening(percentage points)
1.5
0.6
1.5
0.6
1.3
0.8

Share due tocapitaldeepening(percent)
40.3
39.8
63.7

0.4
0.3
3.1

⫺0.1
0.9
0.6

⫺19.8
283.5
18.7

0.3
0.8
1.4
1.9

0.1
0.5
1.1
1.5

46.6
66.7
78.5
79.5

Source: World Bank.

intermediation in developing countries between
1998 and 2008. Nevertheless, other factors remain critical in understanding the cross-country differences in the level of intermediation(and in the increases observed since the 1980s).
The quality of institutions and levels of market
openness are associated with 56 and 37 percentof the variaion in the average level of intermediation between developing countries in the top
and bottom quartiles according to the ratio ofdomestic credit to GDP, respectively. In practical terms, this finding suggests that an improvement in institutional quality in Sub-SaharanAfrica to roughly the level observed in Latin
America could generate an increase in the stockof domestic credit to the private sector of about
12 percent of GDP and in international financeof about 2 percent of GDP.
Countries with relatively open economies,
strong institutions, and supportive investment
climates enjoyed the largest increases in external
flows during the boom. Resource-rich countries
also fared well in attracting external capital, inpart because their resources provided relatively
secure collateral that partially compensated forthe weak quality of their institutions.

7

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 1 0Countries with good regulatory environments were also more successful in transforming increased financing into increased investment
and, as a result, increased long-term supply potential. Inflows of foreign direct investment anddomestic credit creation were associated withlarger investment and growth effects than wereequity or debt-creating inflows.

Medium-term implicationsof the bust for finance indeveloping countries

T

he short-term costs of the financial crisis have been severe and discouraging.
In many countries, the sharp contraction in
activity wiped out several years worth of theadditional GDP gains that the above-average
growth of the preceding years had produced.
That a crisis rooted in regulatory failure inhigh-income countries has had such pronounced effects on developing countries may
have caused a backlash against financial andtrade liberalization, particularly among themany developing countries that implemented
stricter fiscal policy regimes, improved regulatory institutions, and introduced more flexible
exchange rates during the 1990s and 2000s.
Although these measures likely prevented thebuildup of domestic vulnerabilities during theboom period, which would have made the crisis much more serious, they did not entirely
insulate developing countries from its effects.

Tighter financial conditions are in
the offing, implying reduced levelsof finance
The lessons and fallout from the crisis arelikely to shape financial policies and market
reactions for years to come. Beyond the immediate and unprecedented global recessionthat it has provoked, the crisis can be expected
to significantly alter the global financial landscape over the next 5 to 10 years.
These changes may include:• a tightening and broadening of the scopeof financial market regulation;8• the introduction of rules and policies
designed to isolate developing countries from excessive financial market
volatility;• increasing reliance on domestic intermediation and efforts to deepen regional
financial markets;• a generalized increase in risk aversion;and• a step backward from some of the innovative financial instruments that weremost associated with the financial crisis.
Anticipated regulatory changes in highincome countries are expected to broaden
the range of financial institutions and activities that come under supervision, increase reporting criterion, reduce the scope for using
derivatives and other innovative financial instruments, and pay greater attention to interbank dependencies and cross-border activities.
These changes, plus increased risk aversion
and the necessity for banks in high-income
countries to rebuild their capital, suggest thatliquidity will be more scarce and expensive inthe years to come.

Possible impacts of scarcer andmore expensive finance
The extent to which international financial
conditions impinge on developing-country finance goes well beyond the traditional current
account financing of developing countries (seebelow). Indeed, in aggregate, developing countries are net lenders to high-income countries.
Once cross-border flows have been netted out,developing countries invested more of theirsavings into high-income countries than highincome countries invested in them between
2000 and 2008.
However, for many countries with capital
shortages, external savings are still a criticalsource of finance for investment. Excluding
China and the oil exporters, the remaining developing countries are, on average, net importers of capital. Of the 53 developing countries
that faced an external financing gap in 2009,
most had current account deficits of 5 percent

O V E R V I E W

Table O.4 Contribution of private-source
debt inflows to external finance ofdeveloping countries with current accountdeficits, average 2003–07

All countries
Low income
Lower middle income
Upper middle income
Of which: ECA

Number ofcountries
with current
account
deficits

Current
account
deficit(% ofGDP)

Net debt
inflows
fromprivatesources
(% of
GDP)

53
16
20
17
8

6.3
5.8
6.1
7.1
8.5

2.2
0.8
0.8
5.3
8.1

Source: World Bank.
Note: Data on current account deficits and debt inflows are
simple averages of country numbers. Excludes small island
economies.

of GDP or more, with private-source net debt
inflows equal to about 2.2 percent of GDP (oralmost half the deficit)—0.8 percent if the countries in Europe and Central Asia are excluded
from the mix (table O.4). For these countries asignificant withdrawal of external financing
could have serious consequences for domestic
investment and long-term potential output.

Weaker and more expensive capital at the
global level also will affect financial conditions
in developing countries indirectly by influencing conditions in domestic financial markets(changes in the cost of and rate of return on
external investment and borrowing, increased
competitive pressure, technology, and knowledge transfers).
Tighter regulations, along with the transformation of many investment banks into traditional banks, may reduce the supply of financial
services, including the intermediation of developing countries’ capital issuances (figure O.7).
Over the past 10 years, American investmentbanks participated in 86 percent of the valueof developing-country initial public offerings,
or 32 percent of the number of deals, and theoperation of mutual funds and other investment
vehicles allowed individual and institutional investors in high-income countries to place money
in developing markets. While developing-country competitors could pick up some of these activities and while high-income firms will almost
certainly continue their involvement in this business, the likely result is that developing-country
firms will have less access to capital. Moreover,Figure O.7 Foreign participation in selected emerging equity markets(portfolio equity inflows divided by stock market capitalization, percent)% of local stock market capitalization
50

2003

2007

45
40
35
30
25
20
15
10
5

Es

to
n
M ia
ex
H ico
un
g
Th ary
ai
la
n
Tu d
ni
si
Ka Br a
za az
kh il
st
a
Tu n
rk
Jo ey
rd
C
R ze Mal an
us ch aysi
an Re sia
Fe pubde lic
ra
tio
n
Pe
Po ru
In land
So on d
ut es
h ia
Af
ric
a
L
Sl Ph atv
ov ilip ia
ak pi
R nes
ep
Ar ublge ic
n
Li tin
th a
ua
ni
a
In
Bu dia
lg
R ari
om a
a
Pa niaki
stanC
M hile
or
oc
c
C o
C hin
ol
om a
U bia
kr
ai
ne

0

Source: IMF.

9

2 0 1 0

overall productivity will be affected if less active
foreign investment banks have a comparativeadvantage in identifying firms and products withstrong potential in global markets.
Tighter regulation in high-income countries and the need for parent banks to build up
their capital may also impede foreign banks’participation in developing countries, which
could have negative consequences for theirdevelopment—especially for poorer countries
with good regulatory regimes. Foreign banks
can serve as a conduit for foreign savings intoa developing country and can contribute to
greater intermediation at lower cost by increasing competition. This can be especially important in less developed countries. However, thequality of domestic institutions is important.
In the presence of weak institutions, foreignbanks’ participation may have no or even a net
negative effect on intermediation and cost saving, if, as has happened in some regions, theycherry-pick the best clients and merely displace
domestic banks.
Foreign direct investment (FDI) should beless constrained than debt flows by the rise inrisk aversion and more stringent regulation.
However, parent firms will face higher capital costs, and these are likely to reduce theirability to finance individual projects. As a result, FDI inflows are projected to decline fromrecent peaks of 3.9 percent of developingcountry GDP to around 2.8–3.0 percent of
GDP. The real-side consequences of such a
decline could be serious because foreign direct
investment represents as much as 20 percent
of total investment in Sub-Saharan Africa,
Europe and Central Asia, and Latin America(figure O.8).
Of course, access to foreign capital is not anunmixed blessing, as both this crisis and pastcrises serve to remind us. Historically, private
capital flows into developing countries, notably debt flows such as bank and bond lending,have been very volatile (figure O.9). Becausesuch capital flows can stop, or even reverse
abruptly, countries that become heavily reliant
upon them can be very vulnerable. From thispoint of view, a less integrated global financial

10

Figure O.8 FDI as a share of investment indeveloping countries, 1995−2008
Percent of fixed investment25
2000−0920
1995−99

2005−08

15
10
5
0

lo A
pi ll
E ng
an astd A
Pa siaE cif nC uro ice
La ntr petin al an
A A d
th m siae er
ca icaM ribb an
idea dd
N le E n
or a
th st
Af an
ric d
So a
ut
h
As
ia
Su
bSa
ha
Af ra
ric n
a

P R O S P E C T Sve

E C O N O M I CdeG L O B A L

Source: World Bank.

Figure O.9 Very volatile external debt flows
pose serious macroeconomic challenges
US$ billion

Share of GDP %

600

4.0

Net external debt flows
from private sources/GDP

500

3.5
3.0

Net external debt flows
from private sources(in $US billion)

400

2.5

300

2.0

200

1.5
1.0

100

0.5
0

0.0

⫺100

⫺0.5
1980

1985

1990

1995

2000

2005

Source: World Bank.

system could have some benefits if it reduced
developing countries’ dependence on volatile
capital flows.
Indeed, a central lesson from this boom-bust
cycle is that although the very loose financial
conditions contributed to the growth boom indeveloping countries, the boom was not sustainable and the crisis, loss in output, and associatedsocial dislocation were essential and arguably
inevitable consequences of the boom. If better

O V E R V I E W

regulation of financial flows going forward succeeds in reducing volatility and the frequency ofboom-bust cycles, the benefits of more stable
and sustainable conditions could outweigh thecosts (see below) of more expensive and lessabundant capital.

Countries may seek to insulatethemselves from global financial
markets. . .
Of course, the extent to which a given country
experiences volatility in financial markets, aswell as the consequences for the real economy,
also depends on domestic policies. Despite
the fact that countries with prudent and open
policies tended to benefit from the boom andsuffer least in the bust, the negative impactsof this crisis, which encompassed many developing countries that had managed the inflows
associated with the boom period in a very
prudent manner, may induce authorities in developing countries to take additional steps toreduce their economies’ vulnerability to largechanges in conditions outside their control.
In the past, developing countries have reacted to crises by increasing their official reserves or imposed capital controls as a meansof reducing the domestic consequences of external shocks. Such self-insurance mechanisms
can be expensive. By some estimates, recent
reserve holdings of developing countries havecost as much as 1 percent of GDP to maintain.
Nor are such reserves necessarily effective. For
example during the recent crisis, there wasonly a limited correlation between the severity of the real-side downturn experienced bydeveloping countries and the level of reserves
they held going into the crisis period. This lackof correlation does not mean that reserves did
not help cushion the shock—indeed, countries
with low reserves and high current accountdeficits tended to be hardest hit by the crisis.
However, it does suggest that beyond a point,
additional reserves offer little additional protection from this kind of international shockobserved and that countries should carefully
weigh the additional costs associated withaccumulating and maintaining even higher
reserves.
Another strategy that has been followed
after earlier crises has been the imposition ofcapital controls or a slowdown in liberalization. While such steps may reduce the risk thatan economy develops a level of external indebtedness that makes it vulnerable to a rapid
shift in sentiment, it does so at the expenseof the longer-term benefits (such as technology transfers, increased investment, and further integration into the global economy) thatmight have accompanied the excluded capital
inflows. In addition, controls on capital areoften ineffective, particularly when they areused to support substantial exchange rate
misalignment.

. . . and increase the role ofdomestic and regional alternatives
Faced with a less active external financing system, authorities and entrepreneurs in developing
countries may take steps to promote domestic
financial intermediation as an alternative to reliance on foreign capital. Given the importancethat intermediation has for development, such a
strategy could have significant benefits for those
middle-income countries that already have astrong framework for financial intermediation,by increasing the efficiency of domestic financial
intermediaries through learning by doing andeconomies of scale.
For low-income countries, the longer-run effects of a weaker international system may be
more serious. In the short run, low-income countries may be less directly affected by the crisisinduced increase in borrowing costs—simply
because their economies are not well intermediated. However, a weaker international financial
system could deny them investments critical totheir development, particularly because deficiencies in domestic intermediation systems arelikely to prevent them from compensating for a
reduced foreign presence (figure O.10).
The crisis is also likely to result in greater
regional cooperation, which could strengthen
financial services by capturing economies
of scale and facilitating risk sharing by

11

G L O B A L

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P R O S P E C T S

2 0 1 0Figure O.10 Indicators of regulatory quality
Index
2.0
Rule of law
1.5
Control of corruption

1.0

0.5

Regulatory quality

0.0
⫺0.5

an Easd tA
Pa sia
Eu cific
C ro
en p
tra e
a
L lA nan ati sia d
d nA
C m
a
M rib eriid be cadl ae
N -E n
or as
th t
Af an
r d
So ica
ut
h
As
Su
ia
bSa
ha
A r
H fric anig
h- a
co inc
un om
tri e
es

⫺1.0

Sources: World Bank, Worldwide Governance Indicators Project.

pooling reserves. Such cooperation may also
help strengthen South-South financial flows,which are likely to be important in sustaining FDI flows to many developing countries.
However, progress in regional financial cooperation has been slow in developing countries. Further, such arrangements are likely to
be of greatest benefit to regions that alreadyhave relatively robust domestic financial systems, such as East Asia and the Pacific. Poor
countries with weak institutions can benefit
through integration with stronger regional
economies, but the promotion of regional integration with other countries with weak institutions is unlikely to be beneficial.

management strategies that contributed toboosting liquidity are all factors that are likely
to increase borrowing costs in both highincome and developing countries.
The overall expansion of investment andgrowth during the boom period, without thecreation of significant inflationary pressures
or external imbalances in many developing
countries, suggests that in these countries theboom relieved what may have been a binding
capital constraint on growth, albeit in whatproved to be a temporary and unsustainable
manner. The necessary and desirable tightening of regulations will hopefully reduce thefrequency of boom-bust cycles and provide amore stable financial environment for developing countries. However, higher borrowing
costs are likely to mean a temporary decline
in the rate of growth of developing-country
potential output. Financial services are critical to the smooth functioning of an economy,
and the level of domestic intermediation (forexample, the ratio of domestic bank credit toGDP) is strongly correlated with economic development (figure O.11).
The extent to which anticipated changes
in financial markets will increase borrowing

Figure O.11 Private credit provision isstrongly correlated with per capita incomes
GDP/capita in US$
70,00060,00050,00040,00030,000Medium-term impact on the
supply potential of developing
countriesI

ncreased risk aversion, the necessity for banks
to recapitalize, increased borrowing requirements from high-income governments, andthe falling into disrepute of many of the risk-

12

20,00010,0000⫺10,000
0.5

1.0

1.5

2.0

Private Credit/GDP
Sources: International Financial Statistics; World Bank.

2.5

O V E R V I E W

costs in developing countries will depend on
many factors, including the level of interest
rates in high-income countries. Currently,
under the influence of the extraordinary
steps taken by the U.S. Federal Reserve Bankand other central banks, medium (1-year)
and long-term (10-year) interest rates on U.S.
government securities are 0.4 and 3.8 percentage points, respectively—some 290 and
60 basis points lower than during the boom
period. Similarly, developing-country risk
premiums have fallen and appear to have stabilized at close to their pre-crisis levels or
about 150 basis points higher than during
the boom period. If real interest rates inhigh-income countries return to their preboom levels and if the historical relationshipbetween these base rates and interest rate
spreads remain unchanged, the borrowing
costs developing countries face could rise by
between 110 and 220 basis points comparedwith their boom-period levels.
Just as the decline in borrowing costs during the first few years of this decade was associated with a marked pickup in investment
activity and potential growth rates, higher
borrowing costs going forward will tend to reduce investment rates and result in lower levels of potential output than would have been
observed otherwise. Firms can be expected toreact to higher capital costs by employing lesscapital and more labor and natural resources
per unit of output, so economy-wide capital-to-output and investment-to-GDP ratios
will decline. During the transition period tothe new, lower capital-output ratio, the rateof growth of potential output could slow by
between 0.2 and 0.7 percentage points fromthe average of 6.2 percent rate observed during the 2003–07 period (figure O.12). Overthe long run, unless offset by other factors(notably improved domestic policies, see
below), this substitution away from capitalintensive techniques could reduce the supply
potential in developing countries by between
3 and 5 percent and potentially by as much as
8 percent.

Figure O.12 Higher borrowing costs resultin a permanent decline in developingcountry GDP
Trillions of real 2005 US$
3Pre-crisis path of potential output
3
2
2

Post-crisis path of potential output

1
1
2005

2010

2015

2020

2025

2030

Source: World Bank.

Developing countries can mitigate
the effects of weaker international
conditions
Although there is little that developing countries can do to prevent a deterioration in global
financial conditions, they should not stand bypassively. Much can be done to mitigate thecosts of a tightening of global financial conditions by reducing the domestic cost of intermediation through strengthening regional anddomestic institutions or by improving longterm productivity growth.
Inefficiency of domestic financial sectors resulting from corruption, weak regulatory institutions, poor protection of property rights, andexcessive limits on competition can make borrowing costs in developing countries 1,000 basis
points higher than in high-income countries(even more so if the even higher costs imposedby informal lenders are taken into account).
Improvements in the policies and institutions governing the financial sector can thus
have a significant impact in boosting domestic financial intermediation, one that can outweigh any potential negative impact of higher
global risk premiums. Simulations suggest that
if developing countries continue to improvepolicies and other fundamentals, so that theirinterest spreads fall by an average of 25 basis
points a year, they would more than offset

13

G L O B A L

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P R O S P E C T S

2 0 1 0the long-term effects of the financial crisis—
producing a 13 percent increase in long-term potential output and increases in potential output
growth of about 0.3 percent per year by 2020.
Efforts to increase domestic financial intermediation should focus on strengthening
institutions, not on discriminating against foreign capital. Especially in countries with poor
regulations or weak enforcement capacities,
discouraging foreign capital could have thedetrimental effect of forcing firms to rely on
more expensive domestic sources of financeand potentially reducing the overall level of intermediation. Suppressing foreign capital also
could reduce firms’ access to new technology,
expertise, and international market contacts.

ConclusionT

he international financial conditions of
the boom period were unsustainable andresulted in the extremely disruptive and costly
crisis from which the global economy is only
now emerging. At the same time they demonstrated that, when exposed lower capital costs,
developing countries were capable of sustaining significantly higher growth rates without
generating higher inflation.
Over the medium term, international capitalcosts are going to be higher than they were during
the boom period. As a result, developing-country
growth potential will remain well below recent

14highs, which is likely to be a source of frustration for many countries. While some prudent
reforms to reduce the sensitivity of domestic
economies to some of the more volatile forms
of international capital may be advisable,
policy makers need to remain mindful of thebenefits that financial openness and improved
intermediation can bring.
Looking forward, it is not desirable torecreate the unstable and unsustainable international conditions of the boom period.
However, the domestic savings in developing
countries represent an enormous growth potential that is waiting to be released throughreforms aimed at reinforcing and growing domestic intermediation. Although such reforms
will take time to bear fruit over the longer
term they may once again place developing
countries on the higher growth path that thecrisis has derailed.

References
Beck, Thorsten, and Asli Demirgüç-Kunt. 2009. “Financial Institutions and Markets across Countries and over Time: Data and Analysis.” Policy
Research Working Paper 4943. World Bank,
Washington, DC.
Friedman, Jed, and Norbert Schady. 2009. “HowMany More Infants Are Likely to Die in Africa asa Result of the Global Financial Crisis?” Policy
Research Working Paper 5023. World Bank,
Washington, DC.

1
Prospects for Developing
EconomiesThe acute phase of the financial crisis has
passed and a global economic recovery
is under way. Moreover, the recovery is fragile and expected to slow in the second half of2010 as the growth impact of fiscal and monetary measures wane and the current inventory cycle runs its course. Indeed, industrial
production growth is already slowing (albeit
from very high rates). As a result, employment
growth will remain weak and unemployment
is expected to remain high for many years.
The overall strength of the recovery and its
durability will depend on the extent to whichhousehold- and business-sector demandstrengthens over the next few quarters. Whilethe baseline scenario projects that global
growth will firm to 2.7 percent in 2010 and
3.2 percent in 2011 after a 2.2 percent decline in 2009, neither a double-dip scenario,
where growth slows appreciably in 2011, or astrengthening recovery can be ruled out.
Financial markets have stabilized and arerecovering, but remain weak. Interbank liquidity as measured by the difference between
the interest rates commercial banks charge one
another and what they have to pay to central
bankers have declined from an unprecedented
peak of 366 basis points in dollar markets toless than 15 basis points—a level close to its“normal” pre-crisis range. Currencies, whichfell worldwide against the U.S. dollar in theimmediate aftermath of the crisis, have largely
recovered their pre-crisis levels. And international capital flows to developing countries

have recovered—with a rapid run-up during
the last months of 2009. Also, borrowing costs
for emerging market borrowers have stabilized
over the last few quarters, but remain elevated.
However, private sector firms remain shutout from international banking markets.
Moreover, the Dubai World event and ripple
effects to credit downgrades for Greece andMexico can be expected to once again raise
concerns about sovereign debt sustainability and will impact risk assessments, capital
flows, and financial markets in 2010.
The real economy is recovering as well.
Although global industrial production in
October 2009 remained 5 percent below its
level a year earlier, it is recovering, with output in both high-income and developing
countries expanding at more than a 12 percent
annualized rate (or saar) in the third quarter of2009. Just as a sharp drop in inventories
contributed to a precipitous initial decline inindustrial production, the stabilization of
inventory levels has contributed to a strong rebound in production, and this factor is expected to support industrial production, evenas growth rates start to come down.
Trade too is recovering but remains depressed. Quarterly growth rates have moved
into positive territory in recent months, but
the U.S. dollar value of trade was still off
17 percent from its September 2009 level.
Lower commodity prices mean that the volume of trade has fared better, but it is nevertheless down by 3 percent from a year ago.

15

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2 0 1 0The most marked increases have been in developing East Asia, and reflect, at least partly,
the 4 trillion renminbi (or 12 percent of GDP)fiscal stimulus put into place by the Chinese
authorities extending through 2010 (roughly
half spent).
Much of that stimulus has found its way
into imported raw commodities and investment
goods. Indeed, partly because of restocking,Chinese demand for key metals has been supportive of commodity prices, which have recovered about one-third of their earlier declines.
Nevertheless, international metal prices, measured in U.S. dollars, are 20 percent below their
July 2008 levels, oil prices are 44 percent lower,
and food prices 24 percent lower, with global
oil demand some 2 percent lower than its peaklevel of 87 million barrels a day in 2007.
The combination of the abrupt fall in commodity prices and ample spare capacity worldwide has resulted in median inflation indeveloping countries falling from more than
10 percent in August 2008 to about 1 percent
in October 2009.
Global imbalances narrowed further during
the crisis. This trend may be largely cyclical, as
it relates to substantial declines in the U.S. trade
deficit, the Chinese trade surplus, and the priceof oil. The durability of the narrowing will depend on the speed with which the United States
can unwind its fiscal and monetary stimulus
and the extent to which stimulus-based infrastructure investment in China contributes tohigher domestic demand rather than additional
export capacity.
Although the real-side effects of the crisis
have been large and serious, economic activity
in most developing countries is recovering andoverall growth is expected to pick up from theanemic performance of 1.2 percent in 2009 to
5.2 percent in 2010 and to 5.8 percent in 2011(table 1.1). Although much lower than the
6.9 percent growth rate that developing countries averaged between 2003 and 2008, these
rates are well above the 3.3 percent average
performance during the 1990s. Excluding
China and India, the remaining developing
countries are projected to grow at a 3.3 and

16

4.0 percent rate in 2010 and 2011, respectively, compared with 5.4 percent growth on
average between 2003 and 2008. Countries indeveloping Europe and Central Asia have been
hardest hit by the crisis and are expected tohave the least marked recovery, with GDP expanding by only 2.7 percent in 2010 and by
3.6 percent in 2011.
The combination of the steep decline inactivity in 2009 and the relatively weak projected recovery means that developing economies will still be operating about 3 percent
below their level of potential output1—and
unemployment, although on the decline will
still be a serious problem. Moreover, the impacts on poverty and human suffering in thesecountries will be very real. Some 30,000–
50,000 additional children may have died ofmalnutrition in 2009 in Sub-Saharan Africa
because of the crisis (UNSCN 2009; Friedman
and Schady 2009), and globally by the end of
2010, 90 million more people are expected tobe living in poverty than would have been thecase without the crisis.
Few of the poorest countries will have thefiscal space to respond to the economic dislocation caused by the crisis without significant
additional financial assistance. It is estimatedthat IDA countries (those eligible for soft
loans and grants from the International Development Association of the World Bank) will
require an additional $35 billion to $50 billion in funding just to maintain current levelsof programming, let alone come up with theadditional funding required to meet the needsof those additional individuals thrown intopoverty.2 Worse, the recession may cause donors to reduce aid flows precisely at the moment the flows need to rise.
Great uncertainty continues to surroundfuture prospects. Even the weak recovery
outlined above is not certain. If the private
sector continues to save in order to restore
balance sheets, a double-dip, characterized bya further slowing of growth in 2011 is entirely
possible—especially as the growth impact offiscal stimulus wanes. A stronger recovery is
also possible, if the massive traditional andP R O S P E C T S

F O R

D E V E L O P I N G

E C O N O M I E STable 1.1 The global outlook in summary(percentage change from previous year, except interest rates and oil price)
2007

2008

2009h

2010i

2011i

7.2

3.0

⫺14.4

4.3

6.2

2.0
2.9

3.1
3.8

⫺0.2
⫺0.5

1.1
1.6

1.7
2.4

17.1
71.1
10.6
5.5

21.0
97.0
36.4
6.0

⫺21.6
61.8
⫺36.3
⫺4.9

5.3
76.0
23.1
1.5

0.7
76.6
0.8
0.7

5.2
4.3

3.2
4.8

1.2
1.5

1.8
2.2

2.8
3.0

Real GDP growthe
World
Memo item: World (PPP weights)f
High incomeOECD Countries
Euro Area
Japan
United States
Non-OECD countries
Developing countries
East Asia and Pacific
China
Indonesia
ThailandEurope and Central Asia
RussiaTurkeyPolandLatin America and Caribbean
BrazilMexicoArgentina
Middle East and North Africa
Egyptg
Irang
AlgeriaSouth Asia
IndiagPakistang
Bangladeshg
Sub-Saharan Africa
South Africa
Nigeria
Kenya

3.9
5.0
2.6
2.5
2.7
2.3
2.1
5.4
8.1
11.4
13.0
6.3
4.9
7.1
8.1
4.7
6.7
5.5
5.7
3.3
8.7
5.9
7.1
7.8
3.0
8.5
9.1
5.7
6.4
6.5
5.5
6.3
7.1

1.7
2.7
0.4
0.3
0.5
⫺1.2
0.4
2.6
5.6
8.0
9.0
6.1
2.6
4.2
5.6
0.9
4.9
3.9
5.1
1.4
6.8
4.3
7.2
2.5
3.0
5.7
6.1
2.0
6.2
5.1
3.7
5.3
1.7

⫺2.2
⫺1.0
⫺3.3
⫺3.3
⫺3.9
⫺5.4
⫺2.5
⫺2.3
1.2
6.8
8.4
4.5
⫺2.7
⫺6.2
⫺8.7
⫺5.8
1.6
⫺2.6
0.1
⫺7.1
⫺2.2
2.9
4.7
1.0
2.1
5.7
6.0
3.7
5.9
1.1
⫺1.8
4.3
2.8

2.7
3.5
1.8
1.8
1.0
1.3
2.5
2.9
5.2
8.1
9.0
5.6
3.5
2.7
3.2
3.3
2.2
3.1
3.6
3.5
2.3
3.7
5.2
2.2
3.9
6.9
7.5
3.0
5.5
3.8
2.0
4.8
3.7

3.2
4.0
2.3
2.3
1.7
1.8
2.7
3.9
5.8
8.2
9.0
5.8
4.0
3.6
3.0
4.2
3.4
3.6
3.9
3.6
2.4
4.4
6.0
3.2
4.0
7.4
8.0
4.0
5.8
4.6
2.7
5.1
4.8

Memorandum items
Developing countries
excluding transition countries
excluding China and India

8.1
6.2

5.6
4.3

2.5
⫺2.2

5.7
3.3

6.1
4.0

Global Conditions
World trade volume
Consumer prices
G-7 countriesa,bUnited States
Commodity prices (US$ terms)
Non-energy commodities
Oil price (US$ per barrel)c
Oil price (percent change)
Manufactures unit export valued
Interest rates$, 6-month (percent)€, 6-month (percent)2008 2009h 2010i 2011i
Source: World Bank.
Note: PPP ⫽ purchasing power parity; h ⫽ estimate; i ⫽ forecast.
a. Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States.
Egypt
6.8
5.7 5.1
5.6
b. In local currency, aggregated using 2005 GDP Weights.
Iran
2.5
1.0 2.2
3.2
c. Simple average of Dubai, Brent, and West Texas Intermediate.
India
7.3
6.4 7.6
8.0
d. Unit value index of manufactured exports from major economies, expressed in USD.
Pakistan
3.8
2.9 3.3
3.5
e. Aggregate growth rates calculated using constant 2005 U.S. dollar GDP weights.
Bangladesh 6.3
6.1 5.7
5.7
f. Calculated using 2005 PPP weights.
g. In keeping with national practice, data for Egypt, Iran, India, Pakistan and Bangladesh
are reported on a fiscal year basis. Expressed on a calendar year basis, GDP growth in these countries is as in the table just above.

17

G L O B A L

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2 0 1 0

untraditional monetary stimulus that has been
put into place in high-income countries begins
to gain traction.

Recent developments infinancial marketsT

he unprecedented steps that were taken
by policy makers in both developed anddeveloping countries following the collapseof Lehman Brothers in September 2008 havegone a long way toward normalizing financial
markets and restoring capital flows to developing countries (see World Bank, 2009c for asummary of such measures).
The immediate outflow of international
capital from developing countries to safe havens in the United States and Europe has reversed itself. As a result, a large number of
emerging-market exchange rates have recovered their pre-crisis levels vis-à-vis the U.S.
dollar, equity markets have recovered much of
their initial losses, and, capital flows to developing countries have begun to recover.
Toward the end of 2009, gross capital inflows to developing countries began to gain
momentum as uncertainty subsided and risk
aversion declined. On an annualized basis,
total gross inflows to developing countries
reached a $435 billion pace in the five months
ending November 2009, up from $218 billion
in the first half of the year. Although capital
flows for the year as a whole remain 20 percent below their 2008 levels and well below
their peaks in 2007, this recent surge in portfolio flows has raised concerns that if sustained,
it could reinflate some of the asset bubbles
in stock, currency, and real estate markets
among developing countries that the crisis had
only just begun to unwind. However, risk appetites may have been tempered by the Dubai
World event and the credit rating downgradesof Greece and Mexico at the end of 2009.
Policy interest rates around the globe remain very low, although some central banks
have begun tightening (e.g., Australia has already tightened by 75 basis points) or signaled

18

their intention to begin to do so soon. In the
United States, the Federal Reserve Board’s
federal fund rate has been hovering around12 basis points, compared with close to 550
basis points in mid 2007. The European
Central Bank’s (ECB) policy rate remains in
the 100-basis-point range, compared with alevel of more than 400 basis points in 2008.
Short-term market rates are also very low,
reflecting the reduced opportunity cost of borrowing money from the monetary authority andincreased confidence in the creditworthiness ofcounterparties within the international banking
system. Reflecting policy steps to recapitalizebanks and restore confidence in the international financial system, the spread between theprice that commercial banks charge one anotherfor overnight lending and the overnight rate
charged by central banks—a common measureof banks’ confidence in one another—has fallenfrom an unprecedented 365 basis points at thepeak of the crisis to a more normal level of lessthan 15 basis points (figure 1.1, panel a). As apart of these efforts, central banks have taken anumber of extraordinary steps including lending directly to private firms and intervening insecondary mortgage markets. As a result, theirbalance sheets have ballooned.
As a result of these and other measures,the freeze-up of financial markets that characterized the autumn of 2008 has eased
considerably, and the spreads facing emergingmarket borrowers have declined as well (figure 1.1, panel b), with commercial borrowers able to access funds for a premium of 359
basis points and sovereign borrowers at a premium of about 300 basis points. While these
spreads are higher than the pre-Lehman average of about 180 basis points, they remain
substantially lower than their long-term averages, the fruit of improved fundamentals of
many developing countries and years of policy
reform.
As spreads declined and the acute risk
aversion of the immediate post-crisis period
eased, investors started moving back some of
the money that had been withdrawn fromdeveloping-country capital markets. As a

P R O S P E C T S

F O R

D E V E L O P I N G

E C O N O M I E S

Figure 1.1 Financial markets’ stabilization has partially restored pre-crisis financial conditions
in developing countries
a. Liquidity in interbank markets has normalizedb. Developing-country spreads have come down

LIBOR-OIS spread key policy and regulatory responses;

Basis points

400

1,200
G-7 meeting
1,000

300
800
200

600
400

100
200
0
Oct. 2008
Dollar

Feb. 2009
Euro

Jun. 2009

Oct. 2009

Pre-crisis US$ average

Ja
n.
20
07
M
ay
20
07
Se
pt
.2
00
7
Ja
n.
20
08
M
ay
20
08
Se
pt
.2
00
8
Ja
n.
20
0
9
M
ay
20
0
9
Se
pt
.2
00
9
Ja
n.
20
10

0
Jun. 2008

EMBI global
CEMBI global
Pre-Lehman collapse averagec. Most emerging currencies have recovered against
the dollar

d. Equity markets have rebounded

percentage change (USD per LCU) (%)

Equity market indexes (Jan. 2007 = 100)

US reer

200

yen

180

US neer160

sterling
Mexican peso

140

Turkish lira
120

euro
Canadian $100

Russian ruble
Idonesian rupiah

80

Polish zloty

60

Korean won
Hungarian forint

40

Brazilian real
20

South African rand
Australian $
0

10

20

30

40

50

Percentage change (USD per LCU)

Ja
n.
20
07
M
ay
20
07
Se
p.
20
07
Ja
n.
20
08
M
ay
20
08
Se
p.
20
08
Ja
n.
20
09
M
ay
20
09
Se
p.
20
09
Ja
n.
20
10

0

⫺20 ⫺10Stronger local currency
Gain since Mar. 2009
NET since Sep. 2008

Emerging markets Asia
Emerging markets Europe
Latin America
Mature markets

Sources: Thomson/Datastream; World Bank.

result, beginning roughly in March 2009
developing-country currencies began appreciating against the dollar (figure 1.1, panel c),their stock markets began rebounding, recovering between one-third and one-half of theirinitial losses (figure 1.1, panel d), helping torestore global confidence by restoring some of
the wealth initially destroyed in the crisis.
The revival in stock market activity has
supported new equity placements by emerging
economies, which totaled $98 billion in thefirst eleven months of 2009, up sharply from19

E C O N O M I C

P R O S P E C T S

2 0 1 0$66 billion during the same period in 2008.
Although initial public offering (IPO) activity remained subdued during the first half of2009, there were signs of a sharp rebound in
the third quarter, on the strength of large deals
by China, Brazil, and India, which together accounted for about 85 percent of all emergingmarket transactions year-to-date, comparedwith an average share of 65 percent in the five
years through 2007. The relatively strong fundamentals in these countries appear to haveraised investor preference for these economies. Gross equity flows to the remaining
developing countries were still compressed at
0.15 percent of their GDP in 2009, versus
0.42 percent (of GDP) on average during thefive years ending 2007.
Developing countries’ access to international capital markets has also revived. Bothsovereign and corporate borrowers have benefited from rising global liquidity, improved
market conditions, and better long-term fundamentals of emerging economies vis-à-vis advanced economies. The recovery in corporatebond issuance by developing countries reached$109 billion during 2009, up almost $45 billion compared with 2008. During the first
trading week of 2010, Turkey and thePhilippines tapped international bond markets for $2 billion and about $1.5 billion,
respectively, taking advantage of continuing
favorable conditions. The improved bond andequity markets reflect a normalization of financial markets and, to an unknown extent, theopening up of a carry trade precipitated by low
real interest rates in high-income countries.
Some middle-income countries (notably Chile
and Brazil) are attracting very large inflows,which if sustained at current rates, pose realpolicy challenges and could generate significant stress. Some countries have sought to use
increased intervention or other measures suchas a financial operational tax (Brazil)—even as
the effectiveness of these measures is unknown.
In stark contrast to the recovery in bondand equity markets, cross-border bank lending remains weak as global banks continue
to consolidate and deleverage in an effort to20

Figure 1.2 Syndicated bank lending byregion, 2008 and 2009
US$ (billions)
120
100
80
60
40
20
0

an Ea
d st A
Pa s
ci ia
f
Eu ic
C ro
en p
tra e al A ndsiLaan ati
n
d
C Am
ar e
ib ri
be ca
M
id
an
dl
N eE
or as
th t
Af an
ric d
So a
ut
h
As
ia
Su
bSa
h
Af araric naG L O B A L

2008

2009

Sources: World Bank; Bankscope.

rebuild their balance sheets. In 2009, syndicated loan deals involving developing countries amounted to $123 billion, comparedwith $236 billion in 2008. There was a surprising jump in December 2009, when loans
amounted to $27 billion, mostly led by $10 billion lending for energy-related projects in
Papua New Guinea and $6.5 billion tradefinance loan to the Brazilian government(figure 1.2). Overall, banks’ external claims
on developing countries reported to the Bankof International Settlements (BIS) expanded
by only $10 billion in the second quarter of2009 (exchange rate adjusted), after contracting $126 billion in the first quarter of 2009
and $279 billion in the fourth quarter of 2008.
Prospects for a resurgence in bank lending in
the near term are likely to be muted (longerterm prospects are discussed in chapter 3), especially in regions such as Europe and Central
Asia where mounting nonperforming loans andlarge domestic adjustments are likely to restrain
both the demand and supply side for lending.
At the same time, lending to natural-resourcerich countries is likely to remain robust.

P R O S P E C T S

Figure 1.3 FDI flows to developing countries
US$ (billions)
140
123

121

120
106
100

86
73

80

D E V E L O P I N G

E C O N O M I E S

these stronger inflows have only partially offset the sharp reduction in flows following thecrisis and have not re-created bubble conditions. However, should these strong inflows
persist or strengthen, asset bubbles could
begin to reinflate, leaving countries vulnerable
to a second sudden stop in external finance.

77
69

Prospects and implications fordeveloping-country financing needs

60
40
20

20
09
Q
3

20
09
Q
2

20
09
Q
1

20
08
Q
4

20
08
Q
3

20
08
Q
2

0

20
08
Q
1

F O R

Source: World Bank.
Note: Countries include Brazil, Bulgaria, Chile, China (excluding
some sectors), Croatia, the Arab Republic of Egypt, India,
Indonesia, Jordan, Kazakhstan, Malaysia, Mexico, Pakistan,Philippines, Poland, Romania, the Russian Federation,
South Africa, Thailand, Turkey, Ukraine, and R. B. de Venezuela.

In contrast with debt-creating flows, foreign direct investment (FDI) has yet to show
signs of rebounding. FDI tends to be themost stable source of international capital,
but inflows nevertheless have declined by
40 percent since the first quarter of 2008 andstood at $69 billion in 2009Q3 (figure 1.3).
Although these flows are expected to have recovered during the last quarter, inflows to all
developing countries for the year as a wholeare expected to come in at $385 billion, only
30 percent of their 2008 values. While resource-related investment has picked up in2009 after the pause in late 2008, investmentin the banking sector, which led the surge inrecent years, remains limited.
The recent decisions of the Dubai World
holding company to ask its creditors for a
six-month standstill on debt payments, andof rating agencies to downgrade Greece andMexico’s credit rating, remind that the echoesof the crisis continue to be felt. Global markets
have largely been unaffected by these developments and capital flows to emerging markets
have strengthened in recent months. So far,

Overall, net private capital flows to developing countries in 2009 are estimated to havefallen by $795 billion (relative to their high in2007), or by almost 70 percent. Even with recovery on the horizon, projected flows in 2010
are only $517 billion, or 3.2 percent of GDP.
Lower-income countries will suffer the mostfrom this shrinkage, because their alreadyminiscule share of total private capital flows(i.e., 2.6 percent in 2007) is expected to dwindle to almost nothing in 2010. Even thoughsmall in absolute terms, the capital inflows tothese low-income countries represent a significant share of national income and investment,
and their loss will certainly have a severe impact on the ability of these countries to meettheir financing needs in the short to medium
term (see chapter 3).
While capital inflows have declined sharply,
the ex ante financing needs of developing
countries have not changed significantly. Basedon the current account deficit projections for
2010, along with schedules of private foreign
debt coming due, the total external financing
needs of developing countries are expected to
be on the order of $1.1 trillion in 2010, compared with an estimated $1.2 trillion in 2009.3
Countries in Europe and Central Asia andLatin America and the Caribbean face the largest external financing needs in 2010, projected
at $447 billion and $280 billion, respectively(figure 1.4). Although smaller in magnitude,
Sub-Saharan Africa’s financing needs are also
large, standing at nearly 12 percent of GDP.
Combining these projections with countryspecific estimates of the amount of private sector financing likely to be forthcoming suggests

21

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 1 0Figure 1.4 External financing needs as ashare of GDP, 2010
Percent
16

However, since SDRs are allocated according to country quotas, the benefits of thismove for the neediest developing countries are
small.

14
12

Global growth

10
8

A

6
4
2

E
C uro
en p
tra e
l A and
si
Su
a
bSa
h
Af ara
M
ric n
id
a
dl
N eE
or as
th t
Af an
ric d
a
an Eas
d tA
Pa s
ci ia
L
fic
an ati
n
d
A
C m
ar e
ib ri
be ca
an
So
ut
h
As
ia

0

Maturing foreign debt

Current accountSource: World Bank.
Note: The figure shows the external financing needs as a share of
GDP of those countries with a financial need.

that developing countries could face a total financing gap of as much as $315 billion in 2010.
In 2009 those countries whose ex ante
financing needs exceeded private capital inflows
were forced to bridge the gap either by cutting into domestic demand and via exchange
rate depreciation—thereby reducing their trade
deficits via lower imports, or by using otherresources such as drawing down international
reserves or drawing upon official assistance(or both). Overall, developing countries consumed some $362 billion worth of their international reserves during the initial phasesof the crisis, while a wide range of countries
increased borrowing from the International
Monetary Fund (IMF), the World Bank, andvarious regional and bilateral development
agencies. Currently, an overall count of the increase in official flows is unavailable, but theWorld Bank (International Bank for Reconstruction and Development, or IBRD, and IDA) alone
increased its lending commitments by some
$12.8 billion, while the IMF made an additional
commitment of $70 billion by October 2009.
The IMF’s lending resources are being tripled, to $750 billion, including a new special
drawing right (SDR) allocation of $283 billion.

22

fter a deep global recession, economic
growth has turned positive, as a wide
range of policy interventions has supported
demand and reduced uncertainty and systemicrisk in financial markets. However, the recovery is expected to be slow, as financial markets
remain impaired, stimulus measures will need
to be withdrawn in the not too distant future,and households in countries that suffered assetprice busts are forced to rebuild savings while
struggling with high unemployment. Although
global growth is expected to return to positive
territory in 2010, the pace of the recovery will
be slow and subject to uncertainty. After falling by an estimated 2.2 percent in 2009, global
output is projected to grow 2.7 and 3.2 percent
in 2010 and 2011, respectively (⫺1.0, 3.5, and
4.0 percent when aggregated using purchasingpower-parity weights).
The main drag on global growth is comingfrom the high-income countries, whose economies are expected to have contracted by 3.3 percent in 2009. Japan, which felt the consequencesof the global crisis more severely than otherhigh-income countries, experienced the sharpest
growth contraction (⫺5.4 percent). Growth
rates of 2.5 and 2.9 percent are expected in2010 for the United States and for high-income
countries that are not members of the Organisation for Economic Co-operation and Development (OECD), respectively.
The global economic crisis affected developing countries first and foremost through asharp slowdown in global industrial activity
due to a sudden cut in investment programs,
consumer durable demand, and a widespread
effort to reduce inventories in the face of uncertain future conditions. Falling export demand,commodity prices, and capital flows exacerbated and extended the downturn. Overall,
growth in developing countries declined to an

P R O S P E C T S

D E V E L O P I N G

E C O N O M I E S

Figure 1.5 Growth in industrial production
Industrial production (percent change, saar)
40
30
20
10
0
⫺10
⫺20
⫺30

00

9

09
ct

.2

20
O

l.
Ju

r.
2

00

9

09
20
n.
Ja

.2
ct
O

Ap

00

8

08

8
l.

20

00
Ju

r.
2
Ap

n.

20

08

⫺40

Ja

estimated 1.2 percent in 2009, down from
5.6 percent in 2008.
Among developing-country regions, economies in Europe and Central Asia were hit
hardest by the crisis, with GDP falling 6.2 percent (with the Russian Federation contracting 8.7 percent). The main causes were lower
oil prices (Russia) and difficulties in fundinglarge current account deficits in a risk-adverse
environment.
Growth in the East Asia and Pacific region(particularly in China) as well as in South Asia
(particularly India) has been resilient, buoyed
by a massive fiscal stimulus package in China
and by India’s skillful macroeconomic management. Between 2008 and 2009, growth in the
East Asia and Pacific region is estimated to haveeased by only 1.2 percentage points to 6.8 percent, while South Asian growth has remained
stable at 5.7 percent. GDP growth in China isestimated to have slowed from 9 percent in2008 to 8.4 percent in 2009, but is expected torecover toward 9 percent over the remainder ofthe forecast period.
These developments have also been reflected
in global industrial production, which declined
sharply in the aftermath of the global financial
crisis. In February 2009, world industrial production was falling at a 27 percent annualized pace,but by the beginning of April/May, production
began recovering (figure 1.5), initially led by accelerating growth in China following the implementation of the $575 billion (over five quarters)
fiscal stimulus package. Increased import demand
from China quickly spread to other countries,
with industrial production registering positive
growth in emerging countries (excluding China)
by March 2009 and high-income countries by
May 2009. As the benefits of the stimulus measures and inventory restocking began to wane,
industrial production growth rates have started
to moderate. Whether this deceleration signals atransition to slower growth, more in line with underlying demand patterns, or the beginnings of adouble-dip growth recession will largely dependon the extent to which consumer and business demand picks up in the months ahead (see the Risks
section below).

F O R

China
Developing countries excluding China
High-income countries
World total
Source: World Bank calculations based on Thomson Datastream
data.

Prospects for high-income
countriesO

utput among high-income economies in2009 is estimated to have contracted by
3.3 percent, the first time since 1960 that theaggregate GDP of these countries has declined.
Industrial production and trade flows among
high-income countries were particularly distressed, with the former registering peak-totrough declines in excess of 20 percent incountries such as the United States, the United
Kingdom, Germany, and Japan.
A pronounced growth rebound is underway. The initial turnaround was driven by aninvestment rebound in developing countries,
particularly China and the newly industrialized economies of East Asia, which has spreadto high-income capital-equipment-exporting
countries such as Germany and Japan. Highincome countries have now started making
larger contributions to world output and trade
growth, as the effects of stimulus measuresbear fruit in fostering domestic demand andimports, and a turn in the inventory cycle underpins production gains.

23

G L O B A L

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P R O S P E C T S

2 0 1 0Supported by large stimulus programs,
Japan, Germany, and France all started growing in the second quarter of 2009, while GDP
in the United States expanded 2 percent in thethird quarter. Recent data releases also indicate
a continued rise in output in Japan, growing by
1.3 percent during the third quarter (seasonallyadjusted rate).
The growth rebound in high-income countries is projected to remain relatively strong
over the next several months but should lose
strength during the course of 2010 as thegrowth impact of stimulus measures and therebuilding of depleted inventories cease tobolster growth. During the depths of the recession, changes in stock building shaved off
2.4 percent (first quarter of 2009) from annualized growth (figure 1.6). The inventory
cycle is expected to be an especially importantelement feeding the recovery in the UnitedStates and the newly industrialized economies
because the destocking during the acute phaseof the crisis was particularly strong in these
economies. In Europe, although slower inventory accumulation had acted as a drag on
growth, inventories continue to build up,

Figure 1.6 Change in stock building as acontribution to GDP growth in G-3 countries
Percentage point contribution to growth
4
3
2
1
0
⫺1
⫺2
⫺3
⫺4
United States

2008 Q4
2009 Q2
Source: World Bank.

24

Euro Area

Japan

2009 Q1
2009 Q3

albeit slowly. As a result, the inventory cyclein Europe is expected to be shallower andshorter-lived.
In the United States, notwithstanding therecovery of growth in the second half, wholeyear GDP is estimated to have declined by
2.5 percent in 2009. The recovery is expected
to continue into 2010, supported by the inventory cycle, the bottoming out of the housing
sector downturn, and fiscal and monetarystimulus. However, the pace of recovery shouldslow toward the middle of 2010 as the growth
impact of these forces wanes and as banking
sector balance sheet consolidation, and stilllarge negative wealth effects weigh on domestic
demand. Overall, growth is projected to comein at 2.5 percent in 2010 and stabilize at a relatively modest 2.7 percent in 2011.
The IMF estimates that even though
global bank write-downs amounted to$1.3 trillion through the first half of 2009,
further write-downs of some $1.5 trillion
may be required as U.S.-domiciled banks
have recognized only about 60 percent of
anticipated write-downs.
In high-income Europe, GDP is expected to
decline by 3.9 percent in 2009 and to increaseby only 1.0 percent in 2010. The support fromfiscal and monetary policy for domestic demand, as well as improving global demand islikely to support growth in the region. However, ongoing balance-sheet problems of EuroArea banks are likely to remain a drag on financing conditions. So far, commercial banks
have made little use of the governments’ rescue
packages, and governments have yet to amend
rescue plans. As a result lending restrictions
are likely to remain a drag for capital expenditure. According to the latest ECB Financial
Stability Review (2009) only two-thirds of potential losses in major European banks havebeen provisioned or written off so far, withsome 187 billion euros of potential losses still
remaining.
Outturns in Germany have been key todevelopments in the Euro Area more generally. The German economy grew at an

P R O S P E C T S

D E V E L O P I N G

E C O N O M I E S

Prospects for developing
economiesM

ost developing countries were not directly involved in the risky behaviors
that precipitated the financial crisis, and thebanking systems in most regions carried only
limited exposure to subprime loans. Nonetheless, economic activity in virtually all countries
were sharply affected. By the first quarter of2009, 25 of 31 developing countries (for whichquarterly national account data are available)
had reported negative growth rates (figure 1.7).
Domestic demand in developing countries
was particularly affected by the sharp slowdown
in fixed investment growth, which fell from
13.4 percent in 2007 to 8.5 percent in 2008
and to an estimated 1.3 percent in 2009. In response to falling domestic and external demand,
industrial production came under pressure. By
the end of the first quarter of 2009, industrial
production was down by 12.9 percent fromits level a year earlier, the volume and valueof developing-country exports had declined by
30.2 percent and 17.6 percent, respectively,
and the commodity prices that had supported
growth in the boom years in many countries
had fallen sharply. Moreover, the freezing of
capital flows in high-income countries andFigure 1.7 Dispersion of GDP growth
results in the first quarter of 2009
10
8
6
4
2

Negativedev O
co elo th
un pi ertri ng
es
N
hi on
gh -O
co -inc EC
un om D
tri e
es

E
C uro
en p
tra e
l A and
La
si
tin
a
th Am
e er
C ic
ar a
ib an
be d
an

0

an Eas
d tA
Pa s
ci ia
fic

annualized pace of 2.9 percent in the third
quarter of 2009, with growth largely driven
by corporate investment and construction,
while private consumption waned. Looking
forward, the strong recovery in foreign orders for manufactured goods suggests thatnet exports will come to support growth. In
addition, increasing public capital expenditures will support activity in the second halfof 2009 and most of 2010. However, rising unemployment will be a drag on private
consumption.
In France output in the third quarter benefited from a rise in exports even as private
spending remained stagnant and fixed investment continued to fall. In general, France suffered less than other rich nations, because it
was neither a large supplier of international
credit nor reliant on borrowing, and when
private demand suddenly plunged, the Frenchgovernment stepped in. Although the recession
in the United Kingdom has been deeper thanmost initially expected, positive GDP growthis expected to resume in the fourth quarter,
thereby ending six consecutive quarters of falling GDP.
Japan’s economy grew by a revised 1.3 percent (saar) in the third quarter. The recovery
results mainly from stimulus efforts at home
and abroad. Tax incentives, as well as a reward program for purchasing green products,
are encouraging Japanese consumers to switch
to low-emission cars and energy-saving home
appliances. At the same time, export volumes
have benefited from increased demand forJapanese products from abroad, such as carsand related products in the United States andelectronic goods in China.
Over the next few quarters, growth is forecast to benefit from an end to the sharp inventory liquidation in both domestic and overseas
markets and the continued support emanatingfrom the stimulus packages. Growth may comeunder renewed pressure later in 2010/11, as
the effect of the stimulus package ebbs and theanticipated recovery in major trading partners
remains modest.

F O R

Positive

Sources: World Bank.

25

G L O B A L

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P R O S P E C T S

2 0 1 0increased borrowing costs generated a huge
$690 billion financing gap that had to be met by
reduced imports, layoffs, and in some instances
substantial injections of foreign capital throughofficial agencies such as the IMF, World Bankand various regional development banks.
As a result, GDP growth in developing countries decelerated sharply, coming in at only
1.2 percent for the year as a whole. Developing
Europe and Central Asia, which went into thecrisis period with large current account deficits
due to a consumption boom financed by international credit and FDI, was hardest hit. GDP
there fell an estimated 6.2 percent in 2009. Excluding these countries and China and India,
which were able to weather the worst effects ofthe turmoil through large fiscal and monetarystimulus packages, GDP in the remaining developing countries fell by an estimated 2.2 percent in 2009—well below the 3 percent trend
growth rate of these countries going into thecrisis. While overall developing-country growth
remained positive, the deceleration and dislocation that it has caused has been brutal. Unemployment is rising, an additional 90 million
people are expected to remain in poverty (lessthan $1 a day) by the end of 2010 as a result of
the slower growth, and as many as 30–50 thousand additional children are expected to havedied of malnutrition in 2009 in Sub-SaharanAfrica (Friedman and Schady 2009).
Prospects for developing countries are for a
relatively robust recovery in 2010, with growthof 5.2 percent in aggregate or 3.7 percent if
China, India, and Europe and Central Asia are
excluded. Output should strengthen further in
2011, but only modestly, rising to 5.8 percent
for the developing aggregate as a whole and
4.1 percent for developing countries excluding
China, India, and Europe and Central Asia.

Regional outlooksM

ore detailed descriptions of prospects fordeveloping regions, including countryspecific projections, are available in the regional
appendix to this report and online at http://
www.worldbank.org/globaloutlook.

26

East Asia and the Pacific
East Asian economies were less adversely affected by the crisis than other regions, although
as a key durable- and investment-goodsproducing region it experienced dramatic
declines in trade and production between
September 2008 and March 2009.
The direct fallout from the financial crisis in high-income countries was limited.
Although equity markets declined steeply andrapidly, the region’s financial system held relatively few toxic assets and its overall resilience
had been improved by banking reforms following the East Asian financial crisis of the
1990s.
Regional industrial production was declining at a 9 percent annualized pace toward
the end of 2008, but started recovering earlyin 2009 under the influence of the 4 trillion
renminbi (12 percent of GDP) fiscal stimulus
package and monetary easing introduced by
the Chinese government. Regional exports
plummeted more sharply still, falling at a
50 percent annualized pace in the first quarterof 2009. Since then export volumes have been
recovering, up 18 percent during the third
quarter. Beginning in March 2009, regional
trade partners started to benefit from thesurge in Chinese imports associated with its
fiscal stimulus (figure 1.8), and overall export
volumes have been growing at a 10 percent
annualized pace in recent months.
Overall, GDP resisted the global recession
to a fair degree, expanding by 6.8 percent in2009. Excluding China, the decelerationin growth was sharper. GDP in these countries
grew at an estimated 1.3 percent, down from
4.8 percent in 2008. Regionwide fiscal andmonetary stimulus plus the weakness of external demand have raised the contribution ofdomestic demand to overall growth.
Looking forward, the stabilization of international financial markets and renewed capital
inflows, coupled with a strong inventory cycle,
particularly among the newly industrialized economies in the region, are expected to boost growthin 2010 to 8.1 percent, with China leading therecovery with growth of 9 percent. Continuing

P R O S P E C T S

Figure 1.8 China’s stimulus program yieldeda pickup in import demand
Export values (US$) seasonally adjusted, annual percentagechange
80
60
40
20
0
⫺20
⫺40
⫺60

09

09

20
p.
Se

M

n.
Ja

East Asian exports
Chinese imports

ay

20

20

09

08
20
Se

p.

20
ay
M

Ja

n.

20

08

08

⫺80

Japanese exports

Sources: Haver Analytics and World Bank.

excess capacity in manufacturing and only moderate advances in world trade growth (in historiccontext) will restrain GDP growth from accelerating much faster than 8.2 percent in 2011.

Europe and Central Asia
Preexisting vulnerabilities in developing Europe
and Central Asia, including large current account deficits, excessive reliance on foreign
capital to finance domestic consumption, andsizable fiscal deficits in some countries, exposed the region to a particularly sharp adjustment when international sentiment reversedwith the onset of the crisis.
Faced with the dramatic tightening of external financing conditions, authorities respondedwith a mix of domestic macroeconomic adjustment initiatives and extensive resort to official
financing from the IMF, the World Bank, andthe European Union to replenish foreign reserve
holdings, support budget initiatives, and resist
downward pressure on local currencies.
Notwithstanding these efforts, the crisis hit
the region hardest of all developing regions.
GDP is estimated to have fallen 6.2 percent

F O R

D E V E L O P I N G

E C O N O M I E S

regionwide. In Russia, GDP in the third quarter
was 9.0 percent lower than a year earlier, as thedrop in commodity prices (particularly oil) andthe sudden reversal of capital flows led to a substantial decline in revenues and fixed investment. Industrial activity is now recovering,growing at a 9.3 percent annualized pace in thethree-month period ending November 2009. In
November, industrial output shifted to positive
annual growth of 1.3 percent following 12 consecutive months of decline over prior year levels. In Poland industrial production was morerobust and GDP growth remained positive,
supported by relatively resilient domestic demand and recent cuts to income taxes andimproved retirement benefits. Production in
Turkey, while down 1.8 percent as of November 2009 from a year earlier, has also been resilient and is recovering. In the Baltic States,industrial production declined between 15 and20 percent. Among other smaller countries,
such as Armenia, Kyrgyz Republic, and Tajikistan, the depth of the slowdown in Russia has
cut into remittances, whose U.S. dollar value
declined by between 15 percent and 33 percent
in the first half of 2009.
The recovery in the region is expected toremain weak, given the substantial adjustment in domestic demand levels required andextensive financial weakness. Because of thedepth of the crisis, the number of nonperforming loans has increased substantially andcan be expected to continue to rise for sometime. This, in combination with higher interest rates and weak international capital flows,
may dampen investment growth (figure 1.9).
Overall, the recovery is projected to be anemic, with GDP growth of only 2.7 percent
in 2010 and 3.4 percent in 2011. Moreover,given substantial weaknesses and remaining
needs for balance-sheet consolidation, substantial downside risks persist, including thepossibility of a secondary regional financial
crisis or a double-dip recession.

Latin America and the Caribbean
Owing to sound macroeconomic fundamentals, the Latin America and Caribbean region27

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 1 0Figure 1.9 Nonperforming loans rise acrossmuch of Europe and Central Asia

Figure 1.10 In Latin America EMBI-stripped
spreads retreat as investor confidence
returns% share of nonperformng loans in all loans
Basis points
Belarus2,000

Estonia

1,750

Bulgaria

1,500

Slovak Republic
Bosniaand Herzegovina
Czech Republic

1,250
1,000

Hungary
Turkey750

Poland250

Croatia

0

9

9
.2
ec
D

O

ct

.2

00

00

09

09

20
g.
Au

Ju

Ap

r.

n.

20

20

09

09

8

20

00
Fe

b.

.2

00

ec
D

.2
ct
O

Au

g.

20

Macedonia, FYR
RussianFederation
Moldova

8

08

500

Montenegro

Argentina

BrazilChile

SerbiaColombia

Dominican Republic

PanamaLatviaLatin America

MexicoUruguayPeru

El Salvador

Lithuania
Ukraine
0

5

10

15

20

25

30

Share of total loans (percent)2007
2009 (most recent observation)

Source: JP Morgan.
Note: Spreads measure the credit risk premium over U.S. Treasury
bonds. A stripped spread is a better measure for these comparisons
as it accounts for collateral. In the calculation of the stripped
spread, the value of collateralized flows (if any) is “stripped” fromthe bond.

Source: IMF Global Financial Stability Report, October 2009
Update, and World Bank.

has been able to weather the crisis much better
than earlier ones. Indeed, risk spreads in theregion have declined to near pre-crisis levels as
investor confidence returned (figure 1.10). As
elsewhere, both industrial production andinternational trade volumes declined sharply
in the face of the abrupt contraction in global
demand. By October 2009 industrial production was 5.3 percent below its August 2008
level, even as it has been recovering at a
9.8 percent annualized pace in recent months.
Similarly, the volume of regional exports fellby 25 percent in the first several months of thecrisis and is only now beginning to recover.
Falling commodity prices meant that the valueof exports fell even more sharply, contributing to lower incomes in many countries in theregion.
Notwithstanding these circumstances, exchange rates have held up well, with virtually28

all of the countries in the region having
regained their pre-crisis exchange rate level
relative to the U.S. dollar. Equity markets too
have been recovering, and spreads on regionalsovereigns have come down. Partly as a result,many countries in the region have successfully
accessed international capital markets.
However, stronger capital inflows, in part
attributable to still high interest rate differentials, have put upward pressure on real effective
exchange rates in some countries. In the caseof Brazil the government levied a 2 percent financial transaction tax on foreign portfolio inflows, but that action may not be able to stem
capital inflows or the real appreciation of thereal. Some economies may be faced with appreciating real currencies, because of a weaker U.S.
dollar, higher commodity prices, and strong
capital inflows, losing external competitivenessat a time when external demand recovery is stillfragile.

P R O S P E C T SWithin the region, the Mexican economy
suffered the deepest contraction, with quarterly GDP down 9.7 and 6.3 percent in thesecond and third quarters of 2009. The depthof the fall in activity reflects Mexico’s close
ties to the U.S economy and its specializationin those sectors most deeply affected by thecrisis (construction, automotive manufacturing, and electric appliances). Moreover, it isestimated that the outbreak of the AH1N1
flu virus, which caused declines in air transport volumes of 80 percent in some months
and hotel vacancies in tourist areas of 80 or
more percent, shaved 0.7 percentage point off
GDP.
In Brazil, GDP fell by 0.2 percent year-onyear in the first two quarters of the crisis period,
but rebounded in the second and third quarterof 2009. A robust fiscal policy package, including support for the automotive sector and a reversal of the inventory cycle, boosted industrial
production, which was strong at a 22.2 percent
annualized pace in October 2009. At the sametime, lower policy interest rates and a decline
in interest rate spreads helped prompt a recovery in private credit that has bolstered domestic
demand.
In Argentina, GDP increased by 0.5 and0.2 percent on an annualized basis in the second and third quarters of 2009. Policy-related
uncertainties, including export restrictions,contributed to a sharp 17.3 percent decline inindustrial production and trade. The pace ofrecovery has also been held back by a severe
drought, which caused agricultural output toplunge.
Output in the region is expected tocontinue strengthening into 2010. Industrial
production is currently growing at a 22.2 percent annualized pace in Brazil and the contraction in Mexico is beginning to moderate.
This should be further supported by ongoingfiscal stimuli, the lagged benefits of strong
monetary policy support, a shift in the inventory cycle and improvements in the terms oftrade. But many of the smaller countries inCentral America, which are highly dependenton migrant workers’ remittances are likely to

F O R

D E V E L O P I N G

E C O N O M I E S

lag the overall recovery in output. As a result, regional GDP is projected to increase by
3.1 percent in 2010, and 3.6 percent is expected in 2011.
Key challenges facing the region include
winding down of monetary and fiscal stimulus without undermining the recovery, providing adequately for the unemployed in a
fiscally sustainable manner, and maintaining
an open attitude toward international tradeand investment.

The Middle East and North Africa
The developing economies of the Middle Eastand North Africa region were adversely affected by the crisis to varying degrees. At theonset of crisis, equity markets among the highincome Gulf Cooperation Council (GCC)
economies and several bourses in the developing region plummeted—by more than the average for emerging markets. Recovery in thesemarkets has been hesitant, given uncertainties
surrounding financial conditions in Dubai andthe United Arab Emirates that have played amajor role in funneling FDI into the developing region.
GDP growth in 2009 for the developing
economies is estimated to have eased from
4.3 percent in 2008 to 2.9 percent. Despite
continuing large infrastructure development
programs, the growth rate of developing oil
exporters effectively halved from 2.9 percent
in 2008 to 1.6 percent in 2009, mainly because of oil production cutbacks to support
OPEC (Organization of Petroleum-ExportingCountries) price floors (figure 1.11).
Growth for the diversified economies faltered by almost 2 percentage points in the year,
from a strong 6.6 percent outturn in 2008
(powered by growth of more than 7 percent
in the Arab Republic of Egypt), to 4.7 percent.
The virtual collapse of key export markets (notably the Euro Area), yielded sharp declines ingoods exports from countries such as Egypt,
Jordan, Morocco, and Tunisia. At the sametime, remittances in 2009 dropped by 6.3 percent and tourism revenues by 5 percent—both

29

G L O B A L

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2 0 1 0Figure 1.11 Lower oil prices and production
yield sharp decline in oil revenues during 2009
Oil revenues, US$ billion
800

600

400

200

0
2004

2005

2006

2007

Other countries in region
Saudi Arabia

2008

2009

Other GCC

Sources: World Bank and International Energy Agency.
Note: Revenues are for oil exporters in the Middle East andNorth Africa region.

important sources of foreign income that support household consumption and job creation
for these countries.
Looking forward, economic recovery will
depend on global demand for oil and gas,
which may not gain momentum until late in
the forecast period. On balance, growth amongdeveloping countries in the region is anticipated to move moderately higher, to 3.7 percent during 2010, before firmer recovery setsin the following year. Nonetheless GDP gainsof 4.4 percent in 2011 will remain below the
5 percent growth attained earlier in the 2000s.
The recent difficulties of Dubai World holding company, an entity of the government of
Dubai, indicate that institutions in the region
were not entirely unaffected by the global financial crisis. Given the very high investment
levels of the past several years, as well as asset
inflation (property prices increased particularly
sharply in Egypt and Morocco), there may belarge-scale financial losses within the region
that have yet to be realized. Should these materialize, they could adversely affect market confidence, financial conditions, and employment
and investment in the region, to the detrimentof medium-term growth prospects.

30

South Asia
South Asia appears to have escaped the worst
effects of the crisis, with GDP growth in theregion estimated at 6.0 percent in 2009, downfrom 6.9 percent in 2008. The slowdown in
GDP growth mainly reflected weaker investment and private sector demand, which were
only partially offset by an increase in public
expenditures. Several countries (Maldives,
Pakistan, and Sri Lanka) faced serious challenges financing large current account deficits.
Despite enduring a 5 percent decline in goods
and services export volumes, an even sharper
decline in import demand (partly explained byweaker investment demand) and lower food andoil prices meant that trade and current accountbalances improved in 2009 (figure 1.12). Remittance flows to the region, which equal some
4.7 percent of GDP, fell an estimated 1.8 percent, representing a significant drop in household incomes and foreign currency earnings.
The region experienced sizeable capital outflows at the onset of the crisis, particularly inPakistan and Sri Lanka, where outflows were
driven by investor concerns about rising domestic and external imbalances. Improved
investor sentiment, particularly related torelatively strong growth outturns (India) andongoing or new IMF stabilization programs

Figure 1.12 South Asia’s external position
improves in most countries on lower oil
prices and decline in domestic demandCurrent account balances as percent of GDP
6
4
2
0
⫺2
⫺4
⫺6
⫺8
⫺10
Pakistan

Source: World Bank.

Sri Lanka

India

2008

2009

Bangladesh

P R O S P E C T S(Pakistan and Sri Lanka) as well as improved
political stability (with the ending of thedecades-old civil war in Sri Lanka) led to renewed capital inflows during the second andthird quarters of 2009. Partly as a result, exchange rates and local equity markets have regained strength as both domestic and foreign
investors have become less risk averse.
The recovery in the region is expected to beless marked than elsewhere, partly reflecting therelative shallowness of the downturn. Growthis expected to rebound to 7.0 and 7.4 percent
in 2010 and 2011, respectively, compared with
6.0 percent in 2009.

D E V E L O P I N G

E C O N O M I E S

Figure 1.13 Quarterly GDP data point to
output stabilization in Sub-Saharan Africa
Percent change (saar)
20
15
10
5
0
⫺5
⫺10
⫺15
South Africa
2008 Q1
2008 Q4
2009 Q3

Sub-Saharan Africa
The collapse of global trade slowed growth in
Sub-Saharan Africa markedly, to 1.1 percent
in 2009 from an average of 5 percent in thepreceding five years. Initially, as global capital inflows reversed, the impact of the global
crisis was felt most acutely by countries suchas South Africa, whose financial markets are
more integrated into global financial markets.
Subsequently, as trade collapsed, the impact
spread to oil exporters (such as Angola) andcommodity exporters (such as Botswana andZambia). Lower tourism volumes, falling remittances, and lower levels of official development assistance also affected the region
adversely. Overall, GDP growth is estimated tohave decelerated by 4 percentage points, andgross national income (a measure that includes
terms-of-trade effects) fell by 3.7 percentage
points between 2008 and 2009.
South Africa recorded three consecutive
quarters of negative growth, with output declining at a 2.8 percent annualized pace in thesecond quarter of 2009. But South African
growth rebounded to positive territory in thethird quarter, rising 0.9 percent, while in Kenya
GDP increased by 5.8 percent (saar) in the second quarter of 2009, suggesting that recovery
is under way (figure 1.13). Nigeria’s growth
performance has been helped by a relatively
strong performance in the agriculture sector aswell as in gas and oil. Given the high level ofnonperforming loans, however, the financial

F O R

Kenya
2008 Q2
2009 Q1

2008 Q3
2009 Q2

Source: Haver Analytics.

sector is likely to be a drag on Nigeria’s growthin the near future.
The sharp decline in oil prices that accompanied the recession has caused current account balances in the region’s oil exporters tofall (by more than 10 percent of GDP in countries such as Angola, Gabon, and Nigeria).
The recovery is expected to be modest,with GDP expanding by 3.8 and 4.6 percent
in 2010 and 2011, respectively. However, theoutlook is very uncertain and the strength of
the recovery will depend to a large extent on
growth performance in key export markets.
A growth rebound there should translate into
stronger external demand, while also triggering a recovery in FDI flows. Incomes in countries dependent on workers’ remittances are
expected to remain subdued, largely owing tocontinued high unemployment in the UnitedStates and the European Union.

Commodity markets

An extended period of strong developingcountry growth, coupled with specificsupply-side factors, resulted in uncomfortably
low levels of spare capacity in the oil sector

31

G L O B A L

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2 0 1 0and low stocks of many grains and limited
stockpiles of many traded metals in the mid2000s (see World Bank 2009b for an in-depth
discussion of the commodity boom and bust).
These fundamental factors were also supported by financial investments associatedwith the global liquidity boom (see chapter 2),
which may well have exacerbated the effectof the tight supply situation on commodity
prices. Consequently, between 2003 and 2008
real non-energy commodity prices doubled,
while real energy prices rose 170 percent.
Although commodity prices began falling before the onset of the acute phase of thefinancial crisis, both the financial contraction associated with the crisis itself and thespectacular contraction in economic activity
that it provoked generated a sharp decline
in global demand for commodities. Between
July 2008 and February 2009, the U.S. dollar price of energy plummeted by two-thirds,
and that of metals dropped by more than
50 percent, from earlier highs. Dollar pricesof agricultural goods retreated by more than
30 percent, with the prices of fats and oils
dropping 42 percent.
Dollar prices of energy and metals commodities began to recover in March 2009 broadly
in tandem with global economic activity. The
price increases partly reflect the depreciationof the dollar that has since reversed almost allof the appreciation that was associated with
the immediate flight of capital from the rest of
the world to the United States. Indeed, the real
local-currency price of international commodities (a measure that corrects for currency fluctuations and inflation differentials) increasedmuch less than dollar prices (figure 1.14). For
instance, although energy prices measured in
U.S. dollars rose 57 percent between Februaryand October 2009, the increase over the same
period in trade-weighted real local-currency
terms was only 33 percent.

Crude oilWorld oil demand, which grew on average by
1.7 percent a year over the 2000–2007 period,
declined by nearly 3 percent during the last

32

Figure 1.14 Real commodity price indexes
Constant 2000 prices, trade-weighted and adjusted for currency
fluctuations and inflation differentials (Jan. 2000 = 100)
350
300
250
200
150
100
50
0
Jan.
2000

Jul.
2001

Energy

Jan.
2003

Jul.
2004

Jan.
2006

Metals and minerals

Jul.
2007

Jan.
2009

Agriculture

Source: World Bank.

quarter of 2008 and the first quarter of 2009—a
result of reduced economic activity and induced
conservation and substitution toward other energy sources in response to high oil prices. Oil
demand in OECD countries began declining
in the fourth quarter of 2005 (when oil prices
surged above $50 a barrel) and has been falling for more than four years now, with little
or no growth expected in 2010. Demand in
non-OECD countries also declined in the firstquarter of 2009, but has since increased andis projected to resume its trend growth rate in2010.
OPEC responded to the fall in global demand by reducing its production by nearly
4 million barrels a day in an effort to maintain prices at around $75 a barrel. As a result,
OPEC spare capacity—one measure of global
slack in oil markets—has increased to around
6.5 million barrels a day, equivalent to about
five years of demand growth, and roughly thesame level as in 2003 when oil prices were $20
a barrel (figure 1.15). Moreover, inventoriesof already extracted oil and oil products remain very high with some 150 million barrels
currently being stored on ships at sea owing
to weak demand and saturation of some landbased storage facilities.
While immediate-term supply is ample, thelonger-term prospects are more clouded. OverP R O S P E C T S

F O R

D E V E L O P I N G

E C O N O M I E S

Figure 1.15 OPEC spare capacity
Million barrels a day
7
6
5
4
3
2
1
0
Jan. 2001

Jan. 2002

Jan. 2003

Jan. 2004

Jan. 2005

Jan. 2006

Jan. 2007

Jan. 2008

Jan. 2009

Jan. 2010

Sources: International Energy Agency; World Bank calculations.

the past decades non-OPEC supply (outside theformer Soviet Union where output rose strongly
in the early 2000s) has been fairly stagnant, withincreased production in Brazil, Canada, and West
Africa offset by large declines in U.S. and North
Sea output. Although much higher prices now
have prompted increased investment, growthfrom new developments has been sluggish,
partly because of high costs in 2007–08 causedby shortages of equipment and skilled labor,
and because of numerous project delays. Moreover, some three-fourths of known reserves arein the control of national oil companies (OPECcontrolled or otherwise), which forces major international oil companies to invest in higher-costdevelopments (such as oil sands and deepwater),increasing their costs and the amount of lead timeneeded before projects come on stream.
Given the large inventory overhang andthe modest increases in oil demand expected
over the next few years, real oil prices are notexpected to rise substantially. However, thesector remains sensitive to both demand andsupply developments, and a significant disruption to global supply could result in a sharp, if
temporary, rise in prices once again.
Unless significant additional reserves are
discovered over the longer term, OPEC’s
pricing power will continue to increase. Ultimately, however, alternative energy sources
such as coal, natural gas, nuclear power, andvarious renewables are likely to prevent realoil prices from rising without end. Industry

estimates suggest that at current real oil prices,demand and supply should remain in balance
for the foreseeable future.

MetalsThe global recession prompted a sharp decline
in demand for metals. During the first half of2009, global consumption of aluminum andcopper, the most important metals in termsof volume, fell by 19 percent and 11 percent,respectively. Restocking by Chinese companies (China is the world’s largest consumer ofmetals) and the government’s State Reserves
Bureau resulted in strong demand growth in
the first half of the year, but during the second
half of the year the restocking waned, and asimilar restocking in industrial countries has
yet to materialize. As a result, global demand
for aluminum and copper in 2009 is estimatedto have declined by 11 percent and 9 percent
respectively from 2007 peaks, with world
demand outside China down by more than
20 percent for both metals.
On the supply side, cutbacks at mines andsmelters were significant early in the downturnof the cycle. In addition, project cancellations,tight scrap markets, and numerous strikes (inCanada and South America, for example) havehelped tighten markets. Over the next two
years, metals prices are expected to continue
to rise moderately as the global recovery progresses and metal demand expands. Prices are,however, not expected to rise substantially,33

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 1 0partly because of the large price appreciation
to date, but mainly because of substantial idle
capacity in many sectors that can be profitably brought back into production at current
prices. Once demand growth returns to trend
and idle capacity is eliminated, the industry
will again be challenged to add sufficient capacity in the face of strong growth in developing countries—partly because new mines will
be more expensive (underground versus open
pit, for example) and often in geopoliticallydifficult regions. The mining industry will also
have to contend with declining ore grades, environmental and land rehabilitation, as wellas water, energy, and labor pressures. However, metals prices are not expected to reachthe nominal peaks attained earlier this decade
over the forecast period.

Agriculture
Although agricultural prices have declinedby 22 percent since their peak in June 2008,
they nevertheless remain almost twice as highas the lows reached in the early 2000s. The
recent fall in agricultural prices (relative toprevious peaks) reflects lower oil prices—a
key cost component—and larger stockpiles ofkey agricultural commodities, including rice,maize, and wheat (figure 1.16), resulting fromfavorable harvests and area expansion of key
agricultural commodities.

Barring unforeseen production problems,
agricultural markets are likely to remain well
supplied. As a result, agricultural prices areprojected to decline by 13.8% in 2009, compared with 2008. Over the medium- to longer terms, agriculture prices are expected toremain broadly stable in real terms, reflecting two opposing forces. On the one hand, astronger link between energy and agricultural
prices (higher costs of production plus demand for biofuel) will exert upward pressure
on prices; on the other hand, continued gains
in total factor productivity (which tends to bestronger in agriculture than in manufacturing)should constrain production costs.
Short-term food security concerns havesubsided, and most countries have reduced oreliminated the export bans and other export
restrictions that were put in place during thecommodity price spike of 2008. However, thepoverty challenges posed by higher food prices
remain. Over the longer term, productivity gains
at the global level should ensure long-term foodsupply. However, advances in agricultural productivity in many poor countries is not keeping
pace with population growth. As a result, there
is a rising risk of increasing dependence on imported food to meet basic needs. For example,
between 1980 and 2004, per capita agricultural
GDP in Sub-Saharan Africa grew by less than
1 percent a year (versus more than 3 percent per
year in East Asia).

Prospects
Figure 1.16 Global stock-to-use ratio of key
agricultural markets (excluding China)
Stock-to-use ratio (percent)
35
30
25
20
15
10

19
60
19
64
19
68
19
72
19
76
19
80
19
84
19
88
19
92
19
96
20
00
20
04
20
08

5

Sources: World Bank calculations based on U.S. Agriculture
Department data.

34

Over the medium term, real commodity prices
are projected to remain relatively stable, with
up- and downside risks more or less in balance (figure 1.17). Recent price rises reflect
dollar weakness and some overshooting associated with the slowdown in global economic
activity. Long term there is some concern that
non-industrial commodities may become moreprocyclical and volatile than in the past. If theinfluence of financial investors in commodity
markets rises, then the procyclical nature of
their activity could raise volatility in affectedmarkets. Similarly, the use of agricultural products as an alternative fuel source may introduce

P R O S P E C T S

Figure 1.17 Real commodity prices
Constant 2000$—manufacturing unit value (MUV) deflator

F O R

D E V E L O P I N G

E C O N O M I E S

Figure 1.18 Inflation in low-, middle-, andhigh-income countries

350

Percent

300

20

250

15

200

10

150
5

100

0

50

High-income countries

an element of cyclicality into some food pricesthat was not previously there.

9
00

09

.2
ct

O

08

20

20

ay
M

De

c.

20
l.
Ju

b.

08

08

07

Low-income countries

Note: MUV deflator is the unit value index in U.S. dollar termsof manufactures exported from the G -5 countries (France,
Germany, Japan, United Kingdom, and the United States),
weighted proportionally to the countries’ exports to developing
countries.

20

20
p.

Se

Source: World Bank.

Fe

6

00

00

r.
2

Ap

n.

n.

Agriculture

Ju

MetalsJa

Energy

7

–5

2020

06

2010

v.
2

2000

No

1990

06

1980

20

1970

20

0
1960

Middle-income countries

Source: World Bank.

Figure 1.19 Core inflation in high-income
countries
Percent

InflationJ

ust as the sharp rise in food and fuel prices
generated a rapid acceleration of headline
inflation in both high-income and developing
countries during 2008, the fall of commodity
prices during the course of 2009 and the unprecedented slowdown in the global economy
has led to a dramatic fall in headline inflation(figure 1.18). The median rate of year-over-year
consumer price inflation in high-income countries, which peaked at 5.2 percent in mid-2008,
turned negative in July, but was 0.6 percent inNovember 2009. The median inflation rate indeveloping countries has declined from a peakof 12.4 percent in mid-2008 to only 2.6 percent. Notwithstanding the declines in headline
inflation, core inflation has remained relatively
stable in high-income countries (figure 1.19).
Only in Japan has core inflation dropped
below zero. The bulk of the commodity pricedeflation has now passed through the system;
therefore headline inflation can be expected
to rise toward core inflation rates in coming
months. Headline inflation in the United States

3
2
1
0
Jan. Jun. Nov. Apr. Sep. Feb. Jul. Dec. May Oct.
2006 2006 2006 2007 2007 2008 2008 2008 2009 2009
Euro Area

United States

Source: World Bank.

and Group of Seven countries is expected toaverage 1.6 percent and 1.1 percent in 2010,
respectively.
Inflation developments have changed
drastically among middle- and low-income
countries. Median inflation in low-income
countries peaked at 15.4 percent in the middleof 2008, but as of October 2009 it was
1.2 percent—well below the levels observed
before the food and fuel boom. However, foodinflation in developing countries has not been

35

G L O B A L

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2 0 1 0benefiting from lower international foodprices to the same degree as the poor in richer
countries and that a significant portion of the
130 million pushed into extreme poverty during the food-price spike (World Bank 2009b)
may not have exited poverty as might havebeen expected given the fall in international
food prices.

Figure 1.20 Food prices in low-income
countries
Index, 2003 = 1.0
1.12
1.10
1.08
1.06
1.04
1.02
1.00
0.98
Jan. Sep. May Jan. Sep. May Jan. Sep. May Jan.
2003 2003 2004 2005 2005 2006 2007 2007 2008 2009
Low-income countries

Limited sample

Sources: World Bank with data from the International Labour
Organization (ILO).

falling as rapidly as overall prices in the twothirds of developing countries for which data
are available through May 2009 (figure 1.20).
As a result, by the end of May 2009, foodprices in developing countries had risen about
8 percent faster than nonfood prices, whencompared with January 2003. This suggeststhat the poor in these countries may not be

World tradeIn general, global trade has followed abroadly similar pattern similar to industrial
production, albeit the fall was deeper and therecovery lagged somewhat. The dollar valueof world trade plummeted 31 percent between
August 2008 and its low point in March 2009
(figure 1.21). The decline in volume terms was
somewhat less pronounced when falling commodity prices and exchange rate fluctuations
were taken out of the equation; nevertheless,by March 2009 global trade volumes were
down by 22 percent. Although global trade
has recovered from these troughs, as of
October 2009 it was still 2.8 percent below its
pre-crisis level.

Figure 1.21 World trade is recoveringa. Annualized quarterly increase in import volumes

b. Annualized quarterly increase in export volumes

Percent growth

Percent growth

100

80

80

60

60

40

40

20

20
0
0

Source: World Bank.

36

9
00

09

9

O

ct

.2

20

00

l.

r.
2
Ap

High-income countries
Other developing countries

Ju

8
Ja

n.

20

00

8
00

.2
O
ct

r.

20

20
n.
Ja

.2
ct
O

East Asia and Pacific

08

9
00

09

9
l.
Ju

.2
Ap
r

20

00

00

8

.2

00

20

.2
O
ct

Ja
n

08

08
l.
Ju

r.

20

20
Ap

n.
Ja

High-income countries
Other developing countries

.2

⫺80

Ju
l

⫺60

⫺80

08

⫺60

9

⫺40

08

⫺40

Ap

⫺20

09

⫺20

East Asia and PacificP R O S P E C T S

The lag in the trade rebound does not appear
to be wholly a reflection of weak trade finance(although doubtless it has played some role).
Rather, the lag appears to reflect the stilldepressed level of investment activity (investment goods generally are heavily traded). Global
investment fell by an estimated 9.7 percent in2009 and even in 2010 investment is forecast to
grow by only 4.9 percent.
The initial fall-off in import volumes was
relatively stronger in high-income countries, partly reflecting the growth slowdown
that had already begun before the failure ofLehman Brothers. With the crisis, the decline
accentuated and broadened, with global import volumes falling at a 40 percent annualized pace in the first quarter of 2009. At thetrough, imports in high-income countries were
24 percent off their August 2008 level; in developing countries they were also down by
25 percent.
The trade slump was less marked in Asian
countries, in part because of fiscal stimulus in
China. Most Chinese trade partners benefited
from the rebound in Chinese imports. By thethird quarter, import demand had strengthened among most countries. After a period ofsome weakness, reflecting faltering domestic
demand, the United States’ import volume
growth jumped to 29 percent in October(saar), in Germany to 27 percent, and in Japan
to 31 percent as of November.
In general, services trade has been more
resilient than merchandise trade, in part because a larger share is destined for personal
consumption rather than investment expenditures. Tourism represents something ofan exception—such expenditures tend to beluxury goods and therefore more volatile.
The World Tourism Organization reportsthat compared with 2008, tourism arrivals
were off 7 percent in the first six months of2009 (figure 1.22). Regionally, Central andEastern European nations recording the largest fall in tourism (11 percent), while Africa
registered a modest increase in tourist arrivals. Mexico was particularly hard hit, witharrivals down 19 percent (year-over-year) in

F O R

D E V E L O P I N G

E C O N O M I E S

Figure 1.22 International tourist arrivals
Percent change in volumes, year over year
10
5
0
⫺5
⫺10
⫺15
2008 Q1 2008 Q2 2008 Q3 2008 Q4 2009 Q1 2009 Q2
Source: World Tourism Organization.

the second quarter, where the effects of the
global recession were magnified by the outbreak of AH1N1 in that country and efforts
by individuals worldwide to avoid infection. Most recently, global tourism arrivals
appear to be picking up, with July volumes
only 4 percent lower than a year earlier.
Notwithstanding widespread efforts to support tourism through special tax deductions,the easing of visa restrictions, and investment plans, the World Tourism Organization expects global tourist volumes to havedeclined by between 4 and 6 percent during
2009.
Overall, world merchandise trade volumes
are estimated to have contracted by 17.6 percent in 2009, with goods and services downsome 14.4 percent. Given the expected weak
recovery and weak base effects, trade is projected to expand by only 4.3 percent in 2010
and by 6.2 percent in 2011. As a result even
two years into the recovery, the overall volumeof goods and services traded is forecast to be
5 percent lower than its 2008 peak.
Remittances are another important sourceof external currency for developing countries,
representing as much as 20 percent of GDP insome countries. Remittances have been morestable than capital flows and merchandise trade,but have nevertheless declined by an estimated
6.1 percent in 2009 (box 1.1).

37

G L O B A L

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Box 1.1

P R O S P E C T S

2 0 1 0

Prospects for remittancesO

fficially recorded remittance flows to developing countries reached a peak of $338 billion in
2008, up 16.7 percent from 2007, despite a slowdown in several remittance corridors during the final
quarter of 2008. Based on monthly and quarterly
data released by some central banks and in line with
the World Bank’s global economic outlook, it is estimated that remittance flows to developing countries
will fall by 6.1 percent in 2009, before recoveringin 2010. Weaknesses in the U.S. job market led to asignificant decline in recorded remittances to Latin
America, particularly Jamaica and Mexico, where
year-to-date remittances fell by 16 and 13 percent,respectively. In contrast, remittances to some South
Asian countries such as Bangladesh and Pakistan
have continued to record positive growth in 2009,
where year-to-date remittances have increased 16
percent and 27 percent respectively. The latter is inpart a result of measures by the Pakistani authorities
to increase flows through formal channels including subsidies for marketing expenses to providersof remittance services (see the Pakistan Remittance
Initiative); in addition, some migrants are returningwith accumulated savings.a
However, in all regions, remittance flows are expected to weaken from 2008 levels, with Europe andCentral Asia likely to record the largest deteriorationin flows (⫺15 percent), while remittances to South
Asia are expected to drop by a more modest 2 percent. Remittance flows to South Asia grew strongly
in 2008 despite the global economic crisis, but now
there are risks that they may slow in a lagged response to a weak global economy. East Asia and SubSaharan Africa also face similar risks. In contrast,
remittance flows to Latin America and the Caribbean
and to the Middle East and North Africa have been
weaker than expected in 2009; however, they appear
to have reached a bottom already, with the expectation of a recovery in 2010 and 2011.
Overall, migration and remittance flows are
expected to recover in 2010 and 2011, but the recovery is likely to be shallow, with remittances notexpected to reach the level of 2008 even in 2011. In
all developing regions, remittance flows are likely
to face three downside risks: a jobless economic recovery, tighter immigration controls, and unpredictable exchange rate movements. Despite these risks,
remittances are expected to remain more resilient
than private capital flows and will become even more
important as a source of external financing in many
developing countries. Policy responses could involve
efforts to facilitate migration and remittances tomake these flows cheaper, safer and more productive
for both the sending and the receiving countries.ba. See http://www.pri.gov.pk/.
b. Ratha 2009.

Narrowing global external
payment imbalancesIn aggregate, the crisis has prompted a narrowing of global imbalances attributable toan overall decline in the volume of trade (fora given percentage imbalance between imports and exports, weaker trade will reduce
the global imbalance), falling oil prices, anda narrowing of China’s and the United States’
trade imbalances. Overall, the absolute valueof global current account balances (the sum of
all surpluses plus the absolute value of all deficits) is estimated to have declined from a peakof 5.9 percent of world GDP in 2008 to around38

3.9 percent in 2009. Given continued relatively
large gaps in global output and the absence ofstrong excess demand pressures (particularly
in high-income countries)—which should keep
oil prices in check—this narrowing is projected
to be broadly stable, with imbalances rising
only slightly to around 4.1 percent of GDP in2011 (figure 1.23).
The decline in the U.S. current accountdeficit reflects the continuation of a preexisting narrowing of the non-oil trade balancethat was masked by rising oil prices. It also
reflects a sharp increase in household savings
rates as the wealth effect of the housing bubble ceased to support high levels of consumer

P R O S P E C T S

Figure 1.23 An easing of global imbalances
Percent of world GDP
7
6
5
4
3
2
1

05

06
20
07
20
08
20
09
20
10
20
11

20

04

20

03

China

20

02

20

01

20

20

20

00

0

Rest of world

United States

Source: World Bank.

demand. The most recent small increase in
the U.S. trade deficit mainly reflects high oil
prices as public sector deficits have only partially offset the increase in consumer saving.
The sharp narrowing of the Chinese surplus
is more directly related to the drop in global
trade and China’s large fiscal package, which
has bolstered imports at a time that global export demand was weaker (figure 1.24).
Whether the narrowing of these trade balances persists will depend importantly on how

Figure 1.24 U.S.-China imbalances havediminished markedly
Total goods trade balance, US$ billion, saar
450
250
50
ⴚ150
ⴚ350
ⴚ550
ⴚ750
ⴚ950
ⴚ1,150
Jan.
2000

Aug.
2001

Mar.
2003

Oct.
2004

China excluding oil
USA excluding oil
Source: World Bank.

May.
2006

Jan.
2008

Aug.
2009

China total balance
USA total balance

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E C O N O M I E S

the fiscal and monetary stimuli in both of thesecountries are unwound. In the case of the UnitedStates, if household savings rates fall as the recovery takes hold, but public sector spending is
not cut back, the trade deficit can be expected torise once again. Although growth in the UnitedStates is still in the early stages of recovery, recent improvements in the current account havebeen maintained in the third quarter of 2009,as the marginal increase in the current accountdeficit from 2.8 to 3 percent of GDP is largely
related to higher oil import costs.
In China, the success of the authorities instimulating domestic demand will determine
whether or not its trade surplus begins to rise
as world trade recovers. So far, most of thestimulus has gone into additional infrastructure investment. If, as some fear, this merely
bolsters the economy’s export competitivenesswithout promoting an expansion of domestic
spending, then as global trade revives, China’s
trade surplus could reemerge. While additional
exchange rate flexibility could help increase theattractiveness of domestic markets for Chinese
producers, such a move is unlikely to eliminate
China’s tendency toward large trade surpluses
unless it is accompanied by structural changes
to decrease household and firm savings rates.
In the baseline forecast, a further modest
unwinding of global imbalances is projected
over the medium term. China’s current account surplus is expected to decline from anestimated 5.6 percent of GDP in 2009 to 4 percent of GDP by 2011, while the U.S. current
account deficit is projected to rise only
marginally from an estimated 2.9 percent in2009 to 3.1 percent of GDP by 2011.
Overall, the extent of global imbalances, measured as the absolute value of current accountbalances as a percent of world GDP, is projected to decline from its peak of 5.9 percent in2008 to 4.5 percent in 2011.

Uncertain prospectsAs emphasized above the economic rebound that is currently under way is likely
to continue for several months, supporting39

G L O B A L

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P R O S P E C T S

2 0 1 0relatively rapid growth. However, a great dealof uncertainty clouds the outlook for the second
half of 2010 and beyond. The waning growth
impact of the fiscal stimulus, a progressiveend to the inventory cycle, uncertainty about
the extent to which private sector confidence
will step in and sustain the recovery, and thepossibility of a second round of bank failureseither in developed or developing countries areamong the factors that could contribute to amore pronounced slowdown of growth in thesecond half of 2010 and into 2011—potentiallyyielding a double-dip growth recession.
On the upside, if private sector confidence
does return, there is a risk that the huge traditional and nontraditional monetary stimulus that has been put into place will begin togain traction, potentially reflating some of the
bubbles that have only recently burst. Indeed,some (Roubini 2009) are already arguing thatvery loose monetary policy in high-income
countries has produced a carry-trade opportunity that is underpinning in an unsustainable manner the resurgence of capital flows
to developing countries, which may ultimately
regenerate the kind of global imbalances thatprecipitated the crisis in the first place.
The following pages address some of theseissues and present simulations designed to illustrate potential alternative outcomes should
these pressures, which exist in the baseline,
hold greater or lesser sway in the months tocome. These alternative scenarios are notmeant to quantify the result of worst- or bestcase scenarios, but to illustrate a reasonable
range of possible outcomes given the uncertainties prevailing today.

A deeper growth recession
Table 1.2 reports the results of two scenarios.
The first outlines growth prospects for GDP
under the assumption that the progressive improvement in global financial markets implicitin the baseline scenario is not as strong as
projected and is exacerbated by the beginningof efforts to unwind the fiscal and monetarystimulus already in place. In this scenario, the40

Table 1.2 Prospects remain uncertain
Real GDP growth
Region

2008

2009

2010

2011

1.7
0.4
5.6
8.0
4.2
3.9
4.3
5.7
5.1

⫺2.2
⫺3.3
1.2
6.8
⫺6.2
⫺2.6
2.9
5.7
1.1

2.7
1.8
5.2
8.1
2.7
3.1
3.7
6.9
3.8

3.2
2.3
5.8
8.2
3.6
3.6
4.4
7.4
4.6

1.7
0.4
5.6
8.0
4.2
3.9
4.3
5.7
5.1

⫺2.2
⫺3.3
1.2
6.8
⫺6.2
⫺2.6
2.9
5.7
1.1

2.5
1.6
5.1
7.9
2.6
3.0
3.7
6.9
3.8

2.7
1.8
5.4
7.5
3.2
3.2
4.4
7.3
4.4

1.7
0.4
5.6
8.0
4.2
3.9
4.3
5.7
5.1

⫺2.2
⫺3.3
1.2
6.8
⫺6.2
⫺2.6
2.9
5.7
1.1

3.1
2.2
5.8
9.0
3.1
3.6
4.1
7.4
4.0

3.4
2.4
6.3
8.8
4.0
4.2
4.6
7.6
5.1

Baseline scenario

World
High-income countries
Developing countries
East Asia and Pacific
Europe and Central Asia
Latin America and the Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa
Deeper recession scenario

World
High-income countries
Developing countries
East Asia and Pacific
Europe and Central Asia
Latin America and the Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa
Stronger growth scenario

World
High-income countries
Developing countries
East Asia and Pacific
Europe and Central Asia
Latin America and the Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa
Source: World Bank.

combination of a modest tightening of monetary and fiscal policy and ongoing restructuring in the banking sector causes investment
growth to be more subdued than in the baseline. The results in the second panel of the table
are based on a simulation that assumes that
10 percent of the 2009 increase in structural
deficits is withdrawn4 in 2010 and a further
20 percent in 2011 and that the rebound in investment is only 80 percent as strong as in thebaseline.
In this scenario, global growth comes inabout 0.2 percentage points lower in 2010
and 0.5 percentage points lower in 2011
than in the baseline forecast. Growth rates
in high-income countries decline by 0.2 and
0.5 percentage points in 2010 and 2011,
respectively. This is more than the 0.1 andP R O S P E C T S

0.4 percentage points decline projected fordeveloping countries, mainly because thefiscal stimulus in high-income countries wasmuch bigger than in developing countries.
Indeed in many developing countries financial
constraints precluded any real countercyclicalincrease in spending.
Global imbalances narrow in this scenario
mainly because of weaker consumer demandin high-income countries, and disinflation,
unemployment and high output gaps become
even more pronounced problems.

A more buoyant private sector
reaction
The reaction of the private sector to the recovery is one of the major uncertainties underlying the outlook. In the baseline scenario, thenegative wealth effect from the crash plus theindebtedness incurred during the boom period
are expected to dampen consumer demand forseveral years. In addition, the weakened banking sector is not expected to be able to support
the kind of investment rebound that normallyfollows a serious recession.
However, with monetary policy as loose as
it currently is in high-income countries, there
is a reasonable probability that householdsaving rates will decline more quickly than isassumed in the baseline. By the same token,
investment may react more forcefully to lowinterest rates and improved confidence.5
The third panel of table 1.3 reports the resultsof a simulation that assumes that the savings ratein the United States declines over time from its
current level of 3.4 percent of household income
to about 2.7 percent of household income—close
to its average level in the 2000s. Savings rates inhigh-income European countries are assumed tofall by about the same amount.
In this scenario, the combination of stronger consumption and investment throughout
the global economy increases GDP growth byabout 0.4 percentage points for high-income
countries and 0.6 percent for developing countries in 2010. As a result global trade is close to
0.2 percentage points higher in 2011 thanin the baseline, and output gaps are about

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E C O N O M I E S

0.6 percentage points lower. Lower savings in
the United States serve to push up its current
account deficit by about 0.2 percent of GDP.

The impact of the crisis on thevery poorThe financial crisis has taken its toll on
achieving the 2015 poverty Millennium Development Goal (MDG). Newly updated WorldBank estimates suggest that the crisis will leavean additional 50 million people in extreme poverty in 2009 and some 64 million by the endof 2010 relative to a no-crisis scenario.6 These
depressing statistics notwithstanding, the relatively rapid rebound in developing countries,
their future medium term prospects as describedin the first part of this chapter combined withthe significant progress in most regions since
1990, the poverty MDG is likely to be met atthe global level.
The current projection of the percentage of developing-country population living
on $1.25/day or less (a standard measure ofpoverty) in 2015 is 15 percent (table 1.3), well
below the target rate of 20.8 percent (one-halfthe 1990 headcount index). This translates intoaround 920 million people living under the international poverty line, which coincidentallyis around 50 percent of the estimated numberof poor in 1990. There is significant regionalvariation. East Asia and the Pacific will largely
surpass its regional target, in large part becauseof the significant success in reducing poverty in
China, by far the region’s most populous country. Sub-Saharan Africa is projected to missits target (by over 9 percentage points) as will
Europe and Central Asia. Africa’s poor performance reflects mainly weak growth in the
1990s. The economic adjustments required by
the transition from planned economies to market economies led to a rise in poverty in Europe
and Central Asia, albeit from a low level. Significant progress in reducing poverty is anticipated in both regions between 2005 and 2015.
Progress on poverty using the broader $2/
day definition is projected to be somewhat lesspromising, with the headcount index dropping

41

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2 0 1 0

Table 1.3 Poverty in developing countries
by region, selected years
Region or country

1990

2005

2015f

2020f

Percentage of the population living on less than $1.25/day
East Asia and Pacific
China
Europe and Central Asia
Latin America and the Caribbean
Middle East and North Africa
South Asia
India
Sub-Saharan Africa
Total

54.7
60.2
2.0
11.3
4.3
51.7
51.3
57.6
41.7

16.8
15.9
3.7
8.2
3.6
40.3
41.6
50.9
25.2

5.9
5.1
1.7
5.0
1.8
22.8
23.6
38.0
15.0

4.0
4.0
1.2
4.3
1.5
19.4
20.3
32.8
12.8

Percentage of the population living on less than $2.00/day
East Asia and Pacific
China
Europe and Central Asia
Latin America and the Caribbean
Middle East and North Africa
South Asia
India
Sub-Saharan Africa
Total

79.8
84.6
6.9
19.7
19.7
82.7
82.6
76.2
63.2

38.7
36.3
8.9
16.6
16.9
73.9
75.6
73.0
47.0

19.4
16.0
5.0
11.1
8.3
57.0
58.3
59.6
33.7

14.3
12.0
4.1
9.7
6.6
51.0
51.9
55.4
29.8

Number of people living on less than $1.25/day (millions)
East Asia and Pacific873 317China
683 208
Europe and Central Asia
916
Latin America and the Caribbean 50
45
Middle East and North Africa
1011South Asia
579 595
India
435 456
Sub-Saharan Africa
296 387
Total
1,817 1,371

120
70
7
30
6
388
295
366
918

83
56
5
27
6
352
268
352
826

Number of people living on less than $2.00/day (millions)
East Asia and Pacific
1,274 730 394 299
China
961 473 220 168
Europe and Central Asia
32
39
22
18
Latin America and the Caribbean 86
91
67
62
Middle East and North Africa
44
52
30
26
South Asia
926 1,091 973 926
India
702 828 728 686
Sub-Saharan Africa
391 555 574 595
Total
2,754 2,557 2,060 1,926
Source: World Bank.
f: Forecast.

to a still high one-third of the total developingcountry population and more than 50 percent of
the 1990 level, leaving some 2 billion people living with $2/day or less.
As is the case each year, the new poverty
forecast is a combination of two changes—
new and more recent household surveys and42

a new forecast of per capita income growth.
Beyond the methodological advances in more
recent surveys, they also reflect changes in theunderlying distribution of income that are notmeasured by changes in mean income (or consumption). Since last year’s report, the newpoverty forecast integrates 31 new household
surveys. Combining these new surveys with lastyear’s growth forecast implies a 0.5 percentage
point decline in the aggregate headcount index
from 15.5 percent to 15.0 percent (figure 1.25).
The largest single change is for China where
the new survey causes the projected 2015 headcount index to drop by about 2 percentage
points. Sub-Saharan Africa shows a small riseof 0.3 percentage point for the same reason.
The new economic forecast, compared with
2008, has no net effects at the aggregate level,
but raises slightly the headcount index for SubSaharan Africa and East Asia and the Pacific.7
As 2015 is rapidly approaching, it is useful
to look a bit further ahead and assess the needsof developing countries 10 years forward. This
year’s forecast for 2020 suggests that 826 million or 12.8 percent of developing-country
citizens will be living on $1.25/day or lessand that there will be almost 2 billion poor
people using the $2/day poverty line. The five
additional years would still leave Sub-SaharanAfrica short of the poverty MDG.

Policy implications fordeveloping countries

Although the financial crisis has passed
and the global economic recovery seems
to be under way, many challenges for policy
makers and international financial institutions remain. Paramount among these is the
management of the unwinding of the fiscal
and monetary stimulus that has played such a
critical role in avoiding a much more serious
downturn.
Timing the tightening of fiscal and monetary policy to avoid killing off the recovery
is one clear consideration. But so too is therisk that the very loose monetary and fiscal
conditions in high-income countries could

P R O S P E C T S

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E C O N O M I E S

Figure 1.25 Comparison of 2015 poverty forecast, GEP 2009 versus GEP 2010$1.25/day headcount index, percent
40
35
30
25
20
15
10
5
0
East Asia andPacific

China

Europe and Latin America Middle East
Central Asia
andandthe Caribbean North Africa
GEP 2009

South Asia

GEP 2009 and new surveys

India

Sub-SaharanAfricaTotal

GEP 2010

Source: World Bank.

create dangerous conditions for developing
countries. Already very low interest rates inhigh-income countries are promoting carrytrades that may be promoting destabilizing
capital inflows into developing countries that
could create new asset bubbles and the potential for future crises. For developing countries,
the management of the recovery in capital flows
is a critical challenge. Warding off new asset
price bubbles may call for greater exchange
rate flexibility. If these inflows are enduring
and effectively channeled into productive investment, they could present a major boon
to developing countries (see the analysis in chapter 2). However if they exceed the absorptive
capacity of countries or are cut off abruptly, thecosts could be very high.
Given the slow growth and associated realside adjustments that are expected over the medium term (see chapters 2 and 3), government
policies should focus on productivity-enhancing
growth strategies. For low-income countries,
these strategies may involve simultaneously addressing underlying structural problems such as
the quality of institutions, regulatory reform, andopenness—all critical factors in promoting fasterproductivity growth. To the extent that thesemeasures succeed in generating additional output
and government revenues, associated expenditures will be more sustainable than more traditional expenditure-oriented ones. Countries with
sufficient fiscal space may seek to target measures
to reduce (infrastructure) bottlenecks. Invested
wisely in human and physical capital, such steps
can position a country to take better advantageof the global recovery when it comes, by more effectively exploiting existing comparative advantages and helping to generate new ones.

Notes
1. Potential output is the level of output commensurate with the level of production when all factors of
production, i.e., labor, capital, and technology, arefully employed.
2. Total revenues in IDA countries is estimated(based on IMF 2009) to have fallen from an averageof 26.2 percent of GDP over the 2000–08 period to
21.9 percent of GDP in 2009. This 4.3 percent (asa share of GDP) decline in revenues is equivalent tonearly $35 billion. When 2009 revenues are comparedto the year before (when total revenues were equivalent
to 28.1 percent of GDP), the fall in revenue is equivalent
to nearly $50 billion.
3. The external financing need and gap projections are based on the methodology developed in43

G L O B A L

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2 0 1 0World Bank (2009a) and assess the extent to which
capital flows from private sources will meet developing countries’ external financing needs defined as current account deficit and scheduled principal payment
on private debt. Private short-term debt is projected to
decline further in 2010, while medium and long term
debt increase slightly.
4. The fiscal stimulus for the G-20 countries was
taken as the change in the discretionary measure of the
fiscal deficit from Horton, Kumar, and Mauro (2009).
For the remainder of developing countries, it was estimated as the change in the structural deficit (in thosecountries where structural expenditures increased asa percent of GDP)—using IMF estimates for general
government expenditures and revenues.
5. In the early 2000s investment grew about 1.6
times as quickly as GDP in developing countries, but
the elasticity has occasionally been as high as 2 during upswings. In the baseline, this investment-GDP
elasticity is roughly consistent with the trends earlier
in this decade—about 1.4 times GDP growth in mostcountries. Applying the larger historical elasticity of 2during upswings suggests that investment could growas fast as 10.9 percent on average over 2010–11 versus
the 7.8 percent in the baseline scenario.
6. These calculations update those in Ravallion(2009) and World Bank (2009c) and are consistent
with new survey evidence and the revised forecasts for
growth presented in this report.
7. We have not decomposed these changes intochanges in the growth forecast itself and changes tothe poverty elasticity with respect to growth as emerges
from the new surveys.

References
Agriculture, U.S. Department of. 2009. “Production,
Supply and Distribution” [online], available at
http://www.fas.usda.gov/psdonline/ [Accessed:
December 9, 2009].
Chen, S., and M. Ravallion. “The Impact of the
Global Financial Crisis on the World’s Poorest.” Vox: Research-based policy analysis andcommentary from leading economists [Accessed:
December 9, 2009], www.voxeu.org/index.php?q=node/3520.
ECB (European Central Bank). 2009a. “What Triggers
Prolonged Inflation Regimes? A Historical Analysis,” by Isabel Vansteenkiste. Working Paper Series.
______. 2009b. December 2009 Financial Stability
Review. Frankfurt, Germany. http://www.ecb.europa.eu.

44Friedman, Jed, and Norbert Schady. 2009. “HowMany More Infants Are Likely to Die in Africa asa Result of the Global Financial Crisis?” Policy
Research Working Paper 5023, World Bank,
Washington, DC.
Horton, Mark, Manmohan Kumar, and Paolo Mauro.
2009. “The State of Public Finances: A CrossCountry Fiscal Monitor.” IMF Staff Position
Note SPN/09/25, International Monetary Fund,
Washington, DC.
IMF (International Monetary Fund). 2009. World
Economic Outlook. Washington, DC.
International Energy Agency. 2009. Oil Market
Report. Paris.
Ratha, Dilip. 2009. “Dollars without Borders: Can
the Global Flow of Remittances Survive the
Crisis?” Foreign Affairs, October 16. http://www.foreignaffairs.com/articles/65448/dilip-ratha/
dollars-without-borders.
Ratha, Dillip, Sanket Mohapatra, and Ani Silwal. 2009.
“Migration and Remittance Trends 2009: A Better-Than-Expected Outcome So Far, But Significant Risks Ahead.” In Migration and Development
Brief. World Bank, Washington, DC.
Ravallion, Martin. 2009. “The Crisis and the World’s
Poorest.” Development Outreach, World Bank,
Washington, DC. December.
Roubini, Nouriel. 2009. “Mother of All Carry Trades
Faces an Inevitable Bust.” The Financial Times,
November 1.
UNSCN (United Nations Standing Committee on
Nutrition). 2009. “Global Recession Increases
Malnutrition for the Most Vulnerable People
in Developing Countries. Pregnant Women andChildren Are Hardest Hit.” In Nutrition Impacts of the Global Food and Financial Crises.
Geneva.
World Bank. 2009a. Global Development Finance2009. Washington, DC: World Bank.
______. 2009b. Global Economic Prospects: Commodities at the Crossroads. Washington, DC.
______. 2009c. “Protecting Progress: The Challenge
Facing Low-Income Countries in the Global
Recession,” Background paper prepared for the
G-20 Leaders’ Meeting, Pittsburgh, PA, Sept
24–25, 2009. http://siteresources.worldbank.org/
NEWS/Resources/WorldBankG20PaperonLICsSept2009.pdf.
World Bureau of Metal Statistics. World Metal Statistics Yearbook. London.

2
The Impact of the Boom in Global
Finance on Developing Countries

T

he first seven years of the 21st century
were very good for developing countries.
GDP growth continued to accelerate as it had
done in the 1990s but at an even faster pace,
while economic volatility was far lower thanin previous periods of rapid growth (IMF
2007). And while large countries with very fast
growth rates, such as China and India, tended
to attract the most attention, most of the acceleration in developing-country growth during
this period occurred among smaller countries
that in the past had been growing much lessquickly.
Somewhat surprisingly and in contrast to
popular perceptions, this growth spurt occurred during a period in which external demand conditions for developing countries
were not that strong. Growth in high-income
countries was actually slower during the boom
years 2003–07 than during the preceding
13 years. Moreover, import demand fromhigh-income countries was growing only 5.6
percent a year, marginally slower than during the preceding 13 years. More than all of
the acceleration in developing-country exports came from an expansion in their share inhigh-income country imports and very rapid
growth in South-South trade.
Financial conditions were, however, very
favorable. Interest rates and interest rate
premiums were low (for example, the average secondary market spread on developing countries’ sovereign bonds fell to about
200 basis points by mid-2007, down fromabout 700 basis points in January 2003), andglobal credit expanded twice as fast as nominal GDP.1 A range of financial innovations,
including the securitization of loans and thedevelopment of off-balance-sheet vehicles,
allowed banks to fund an important portionof their loan portfolios through capital andmoney markets, leveraging equity capital in a
way never before possible. Partly as a result,the amount of finance—both domestic andinternational—available to developing countries expanded very rapidly, and countries enjoyed a sustained investment boom.
That boom came to an abrupt end in thefall of 2008 with the failure of Lehman Brothers and the financial crisis that ensued (seechapter 1). Although clouded by uncertainty,
the longer-term consequences of the crisis
could be far-ranging. The sharp scaling backof global production may result in permanentand long-lasting adjustments in global production patterns. Firms and regional specializations may fail and disappear in a way thatthey would not have had adjustment occurred
more gradually. Global trade patterns may beirrevocably altered, and the depth of the recession in some regions and countries relative
to others may change the future pattern ofgrowth in the world. The temporary weaknessof the financial sector in high-income countries may create opportunities for financial
firms in developing countries, allowing themto grow and expand in ways that might nothave been possible otherwise. Although each45

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2 0 1 0of these possible consequences merits in-depth
exploration, dealing with all of the potential
consequences of the crisis for developing countries lies outside the scope of this publication.
The analysis presented in this and the next
chapter focuses more narrowly on the mediumterm consequences of recent and anticipatedchanges in financial conditions for developingcountry finance, investment, and supply potential, both over the past decade and thatcan be expected in the next 5 to 10 years. Thisorientation was chosen partly because, contrary to popular perceptions, real-side external
factors do not appear to have played a majorrole in the boom. Most important, this focus
on the financial aspects of the crisis was chosen because of the important role that financeplayed in causing the crisis and because thelikely regulatory and market-based changes inthe sector are somewhat less speculative thanthose that might surround other importantelements of the post-crisis world.
Within this overall context, this chapter examines the link between the global expansionof liquidity and the improvement in developing
countries’ growth before the financial crisis. It
begins with a review of the credit boom and its
implications for the pricing of risk and borrowing costs. It then describes how the global boom
contributed to the rapid expansion of domestically supplied credit and international capital
flows in developing countries, discusses the factors that helped to determine which countries
most benefited from the liquidity glut, and examines the extent to which different countries
were able to translate these more liquid conditions into increased investments. The chapter
concludes with some model-based measurements of the impact of the investment boomon growth and potential output in developing
countries. All of this serves as a prelude to chapter 3, which analyzes the extent to which, in the
future, tighter financial regulation, increased
risk aversion, and higher interest rates andinterest rate premiums are likely to constrain
investment and potential growth in developing
countries and the scope for developing countries
to pursue policies to mitigate these impacts.

46

A number of key messages emerge from thediscussion in chapter 2:●●●

The acceleration in developing-country
growth during the 2003–07 period arose
despite relatively lackluster GDP and import growth among high-income countries. Developed-world GDP grew on
average 0.2 percentage point slower thanduring the 1990s and import demand increased 0.4 percentage point less quickly.
The fall in borrowing costs during the
2003–07 period was associated with almost 70 percent of the increase in capital flows into developing countries and80 percent of the increase in domestic
intermediation.
While the biggest apparent contribution
to the changes in the extent of intermediation in developing countries was driven bylower borrowing costs and the overall expansion of global liquidity, cross-country
differences in the level of intermediation
remain very large and are best explainedby fundamental factors such as the quality of regulatory frameworks and thebusiness environment, inflation rates, andlevels of government debt.
Country-specific differences in thequality of institutions and the degreeof market openness of the top andbottom performing 25 percent ofcountries are associated with 56 and37 percent of the cross-country variation in levels of domestic intermediation, respectively, and 1/3 and 1/5 ofthe cross-country difference in international capital flows.
Countries with good regulatory environments were also more successfulin transforming increased financing
into increased investment and GDP
growth. More than one-quarter of the
11.5 percent of GDP difference between the investment rates of the top
and bottom 25 percent of developing
countries appears to reflect differencesin the quality of institutions.

T H E●●●I M P A C T

O F

T H E

B O O M

I N

Countries with high levels of financial openness and well-developed domestic intermediation systems also
had higher investment rates. About 3
percentage points of the difference between the investment-to-GDP ratio of
the top 25 percent of developing countries and the bottom 25 percent is associated with differences in the size of
foreign capital inflows. For domestic
intermediation, the same figure is justunder 2 percent of GDP.
These results suggest that if SubSaharan Africa could improve its institutions to roughly the levels observedin Latin America, the overall extent
of financial intermediation would
rise substantially, perhaps by as muchas 12 percent of GDP in the case ofdomestic credit to the private sector
and 2 percent of GDP in the case ofinternational financial flows.
Different forms of finance had different
effects on investment.
Bond flows had significant impacts on
investment in middle-income countries.
Bank lending, which dominated flows
into Europe and Central Asia, wereassociated with a larger increase incurrent account deficits and consumer
demand.
Foreign direct investment (FDI)
funded as much as 20 percent of total
investment in some regions, with lowincome countries tending to be morereliant on this form of financing thanricher countries.
Overall, more than half of the 1.4 percentage point increase in potential output growth rates in developing countries
between 2003 and 2007 is directly attributable to the capital deepening thatwas observed during this period, evenunder the conservative assumption thathigher investment had no role in the risein productivity.
The expansion of investment and growthduring the boom period, without theG L O B A L

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creation of significant inflationary pressures or external imbalances in many developing countries, suggests that in thesecountries the boom relieved what may
have been a binding capital constraint on
growth. That in turn implies that suchstronger growth rates for developing
countries may be achievable over the longterm if sufficient finance (domestic or
external) is forthcoming. Of course there
were exceptions, notably in the Europe
and Central Asia region, where the strongest expansions in credit boom contributed to macroeconomic instability.

Financial innovation, highincome finance, and theliquidity boomT

he liquidity boom that preceded thefinancial crisis of 2008 was broadly
based and rooted in a number of factors.
Like other booms and busts, this one wasprompted by a rapid increase in credit andinvestment that ultimately proved unsustainable and the ensuing bust provoked asudden contraction in GDP (box 2.1).
Data from the Bank of International Settlements (BIS) indicates that from 2002 through2007 international bank credit expanded
about twice as fast as nominal GDP and morethan twice as fast as it had during the previous decade (figure 2.1). Long-term interest
rates were only between 1.5 and 2 percentage
points higher than inflation in the major industrial countries (table 2.1), compared with
about 3.5 percentage points (in the UnitedStates) during the global expansion in the second half of the 1990s.
The proximate cause of the credit boom isa question of considerable debate—a debatethat is unlikely to be resolved anytime soon.
Among the competing and not necessarily contradictory explanations are:
A savings glut. According to this argument(see Bernanke 2005, among others), high47

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2 0 1 0Box 2.1 Comparing this boom-bust cycle with othermajor cyclesT

his boom-bust cycle shares many characteristics
with earlier financial crises: an extended periodof rapid and ultimately unsustainable credit expansion, accompanied by excessive risk taking by financial institutions, followed by a sharp reduction ineconomic activity. However, this crisis differs in threeimportant respects from earlier crises.
First, this crisis is the most severe and widespread
downturn since 1945. Global GDP is estimatedto have declined by 2.2 percent in 2009 (the only
absolute decline in global GDP during the postwar
period), and GDP is projected to remain well below
potential output for years to come, with estimatesof the developing-country output gap peaking at
4.8 percent of GDP—almost 50 percent larger thanduring the next most severe modern-day recession(1982–83).
Second, for the majority of developing countries this is a crisis that originated in high-income
countries. Moreover, with the notable exception ofmany countries in Europe and Central Asia, it was

Box figure 2.1.2 Indicators of macroeconomic stability in developing countries, 2007
a. Low inflation
Annual percent change in consumer prices
12
10
8
6
4
2
0
East Asia Europe
Latin
MiddleandandAmerica East
Pacific Central
and and North
Asia Caribbean Africa

South
Asia

SubSaharanAfricab. Generally modest current account deficits
Percent of GDP
10
8
6
4
2
0

Box figure 2.1.1 GDP growth and output
gaps in global crises since 1970

–2
–4

Percentage

East Asia Europe
Latin
MiddleandandAmerica East
Pacific Central
and and North
Asia Caribbean Africa

–6

South
Asia

SubSaharanAfrica–5c. Relatively low debt levels
Gross external debt/gross national income, percent–445

Output Gap

40

–3

35
30

–2

25

GDP growth

20
–1

15
10

0

5
1982–03

1991–93

2001

2009

Source: World Bank.
Note: GDP growth is the percentage change in GDP growth in thecrisis year(s) compared with the preceding year. The output gap
is the percentage difference between GDP and potential output
during the crisis year(s).

480East Asia Europe
Latin
MiddleandandAmerica East
Pacific Central
and and North
Asia Caribbean Africa
Source: World Bank.

South
Asia

SubSaharanAfricaT H EI M P A C T

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not preceded by the buildup of serious domestic andexternal imbalances, and domestic actors largely did
not participate directly in the unsustainable activities
that precipitated the crisis.
During earlier global or large-scale crises triggered by changes in high-income countries, major
impacts tended to be limited to developing countries
with preexisting vulnerabilities. The tightening of
U.S. monetary policy in 1979–80 boosted real interest rates and brought on a global recession, which
hit hardest those developing countries with excessive
levels of private-source debt. The depreciation of the
yen against the dollar in the mid-1990s reduced thecompetitiveness of East Asian economies that pegged
their currencies to the dollar, which may have contributed to the onset of the 1997 crisis. By contrast,
the current crisis struck virtually every developing

savings relative to investment in East Asia
kept global interest rates low, fueling rapid
increases in investment and consumption in
high-income countries.
An extended period of loose monetary policy. Very loose monetary conditions in the
United States, Japan, and Europe over an extended period of time bled through into longer maturities, provoking an unprecedented
expansion in global credit (BIS 2006).

Figure 2.1 Since the early 2000s, credit
expansion has grown more than twice as
fast as nominal GDP

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country hard, even though, outside Europe andCentral Asia, most countries did not exhibit unsustainable macroeconomic balances (box figure 2.1.2).
In most countries regional inflation rates averaged
about 6 percent or lower (well below the double-digit
rates in most regions during the early 1990s); mostregional current account balances were near zero orstrongly positive; and ratios of debt to gross national
income were modest. However, the quality of policies
still affected the impact of the crisis—the countries
with the largest imbalances suffered the most (seechapter 3).
Third, this crisis has struck many more countries
than earlier recessions did, a factor that complicatesrecovery for individual countries because there arefew fast-growing external markets with which toengage in an export-led recovery strategy.

An excessive loosening of regulatory oversight. The reduction of regulatory barriers to speculation and excessive relianceon self-regulation of the banking sector inindustrial countries generated and failed tocurb excessive risk taking by financial institutions (Crotty 2009).
Financial innovations. In this loosely controlled environment, the use of new financial innovations expanded rapidly; these
innovations increased risk taking andhelped to circumvent those regulatory barriers that remained (Calvo 2009).
Finally, in contrast to popular thinking,unusually strong developed-country demand

Index, June 1990 = 100
600
500
400

Global Banking Assets

Table 2.1 Interest rates and inflation inindustrial countries, January 2002–June 2007
(percent)

300

Consumerprice inflation

Average long-term
interest rate

2.2
0.1
3.0

4.1
1.4
4.4

200
100

World nominal GDP

01990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Sources: Bank of International Settlements; World Bank.

Euro Area
Japan
United States

Source: OECD.
Note: CPI inflation is expressed as the average annual percentage change over the period, and the average long-term rate isin percent.

49

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2 0 1 0was not a major factor behind the accelerationin developing-country growth or exports.
Indeed, the boom period 2003–07 wasactually one of relatively slow growth for
high-income countries in terms of both GDP
and imports. Developed-country GDP grew on
average 2.3 percent during the period versus
an average of 2.5 percent between 1990 and2003 (figure 2.2). Moreover, notwithstanding
the somewhat heated rhetoric surrounding
trade issues, high-income-country importdemand, which grew an average of 5.6 percent
during the boom period, actually expanded
less quickly than during 1990–2003, when it

Figure 2.2 High-income GDP and trade
growth do not explain the acceleration indeveloping-country economic activity
a. High-income GDP was slower than normal
Annual percent change
9
Developing countries

8
7

Period averages

6
5
4
3
2
1

High-income countries

0
1990

1995

2000

2005

b. High-income import demand was slower than during
the 1990s
Annual percent change
20
Developing-country exports
15

Period averages

1050High-income imports
–5
1990

1995

Source: World Bank.

50

2000

2005

rose an average of 6.0 percent annually. The
strong performance of developing-country
exports during this period reflected three main
factors: rapidly expanding supply capacity indeveloping countries, an increase in their shareof the imports of high-income countries, andrapidly expanding South-South trade.

Novel channels for credit
creationW

hatever the fundamental reason forthe long credit boom, the increased
availability of a number of new financial
instruments (box 2.2) gave investors what
ultimately proved to be a false sense thatthe risks of rapid credit expansion had
been reduced. This false sense of security
contributed to the reductions of interest rates
and interest rate spreads, thus facilitating the
expansion of credit.
The expanded use of a number of thesefinancial innovations boosted the growth ofwhat has been called the “shadow banking
system”—comprising institutions that do nothave access to deposit insurance or central
bank rediscount operations and that are notsubject to the same prudential regulations asbanks (Farhi and Cintra 2009). These institutions nevertheless actively sold and marketed instruments that leveraged the savingsof households in a manner akin to the credit
creation process of more traditional banks.
The institutions involved included investmentbanks, hedge funds, investment funds, private
equity funds, special investment vehicles (including those operated off balance sheet bybanks), pension funds, and insurance companies. The quasi-banking activities of these
entities were actively supported by ratings
agencies, which markedly increased their revenues by rating the structured products these
entities sold.
It is difficult to measure the contributionof the shadow banking system to the financial boom, compared with more traditionalbalance-sheet transactions of the commercial

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Box 2.2 Recent and systemically important financial
innovations

Securitization is not a recent innovation, but its
use skyrocketed during the boom. It refers to theissuance of new securities backed by a pool of debt
instruments. By this mechanism, a relatively illiquid
stream of future cash flows (such as a standard loan
with fixed repayment terms) is converted into a security that can be traded in the marketplace.
Credit default swaps (CDSs) are agreements inwhich the buyer makes a series of payments to theseller, in return for which the seller is obligated tocompensate the buyer if the underlying bond or loan
goes into default. Effectively, these instruments provided insurance against default—although the regulatory environment for such swaps and insurance arevery different. More extensive use of credit default
swaps also increased arbitraging opportunities bymaking it easier for speculators to take positions insecurities that they did not own (Guttmann 2009).
Interest rate and currency swaps are instrumentsthat allow investors to effectively change the payment
scheme associated with a loan or an asset. For example, interest rate swaps often involve contracting to
make a fixed series of payments by one counterparty
in exchange for receiving a second series of payments based on a floating rate. Other swaps involvebanking system—in large part because it
faced much less comprehensive reporting requirements and oversight. One indication of
its importance can be gleaned from the risein the share in total U.S. domestic credit ofmortgage pools (issued by Fannie Mae andFreddie Mac) and asset-backed securities. In
1995 these securities accounted for 16 percent of credit assets held by the U.S. financial
sector or 30 percent of GDP. By 2007 thevalue of these securities had increased morethan fivefold, reaching 23 percent of credit
assets and 63 percent of GDP—almost as
large as the total of commercial bank assets(figure 2.3).
The credit expansion was also reflectedin the phenomenal rise in derivative swap

swapping payment obligations from one currency toanother. These transactions are often used to protect
a portfolio in the face of uncertain changes in interestor exchange rates or to speculate on such changes.
Collateralized debt obligations (CDOs) are securities backed by collateral in the form of a portfolioof bonds, bank loans, or other debt (such as credit
card debt). Repayments to the pool of investors are
typically allocated according to some prioritization;for example, senior CDO notes are paid first. Other
tranches earn higher returns but are only paid out
if funds are remaining. This structure permits issues
that satisfy differing trade-offs between risk andreturn: more speculative investors can purchase thelower-rated tranches, while more risk-averse investors can purchase higher-rated tranches.
Other credit derivative products. U.S. financial
markets have generated several, more exotic approaches to securitizing debt transactions. For example, credit-linked notes are sold with an embedded
credit default swap, where the issuer is not required
to repay the debt if a specified event occurs (essentially eliminating the need for third-party insurance).
Specialty finance companies have been created wheretransactions involve both securitization and lending.

transactions, the notional value of which quadrupled between 2002 and 2008 (figure 2.3),
reaching more than 25 times U.S. GDP (figure2.4). The gross notional value of the derivative
market involves considerable double counting(the net exposure of counterparties is muchsmaller because of offsetting transactions);
moreover the actual associated flows involvedin these transactions are typically a very small
percentage of the notional values. Nevertheless,the notional value provides a sense of how pervasive and far reaching these instruments had
become in intermediating economic activity.
Moreover, the notional values provide asense of the systemic vulnerability represented
by these instruments, especially during theacute phase of the crisis when the ability of51

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2 0 1 0Figure 2.3 Notional value of derivativetransactions, 2002–08
US$, trillion
450Interest rate and currency swaps
Credit default swaps
Equity derivatives

400
350
300
250
200
150
100
50
0
2002

2003

2004

2005

2006

2007

2008

Source: International Swaps and Derivatives Association.

counterparties to meet their commitments
was called into question and default payments
under derivative contracts mushroomed.
The impact of the expansion of the shadowbanking system was to greatly expand theamount of credit available and reduce its
cost. Shadow banking effectively performed
the same functions as banks, increasing assets to several times their equity by funding
long-term assets with short-term liabilities (byFigure 2.4 Share of commercial bank andsecuritized assets in total credit held by
U.S. financial sector, 1995–2008
US$, trillion
30

Commercial banks

Securitized transactions

25
20
15
10
5
0
1995

2002

2003

2004

2005

2006

2007

2008

Sources: U.S. Flow of Funds Data, Federal Reserve accounts.
Note: Securitized transactions include mortgage pools issued by
U.S. government-sponsored enterprises (principally Fannie Maeand Freddie Mac) and asset-backed securities.

52

raising funds in the commercial paper market,
for example). The instruments it employed(such as collateralized debt obligations—seebox 2.2) had the perceived virtue (comparedwith bank loans) of spreading the risk of lending. Large, risky investments could be divided
efficiently among investors and thus increase
the feasibility of such projects. And investors
could more easily diversify their risk portfolio,
allowing them to undertake higher risk and return projects.
However, these instruments were either
loosely or not at all regulated and may haveinduced banks to reduce their lending standards more than they would have otherwise
because the long-term risk associated withloans was being held by others. Moreover,in the event, ownership was concentrated insome systemically important hands. Banks
were left with large holdings—often the lowerquality, higher-yielding tranches. In addition,banks that relied on secondary markets to buy
and sell loans tended to increase their leverage(Duffie 2007), which contributed to increasing systemic risk to the extent that the buyers of these securitized loans lacked sufficient
information to accurately evaluate the risks
involved.2 The extreme complexity of some ofthese instruments and the lack of standardized
exchanges made it difficult for both purchasers
and sellers to evaluate them and exacerbatedthe difficulties in debt renegotiations in thecase of financial distress. Ex post, it appears
clear that these instruments generated substantial further systemic risks by multiplying in a
nontransparent manner the interdependencies
in the financial system.
On balance, the growth of the shadowbanking system and the expanded use of
securitization and derivatives products
worldwide (see box 2.2) contributed to the
expansion of credit in developing countries during the boom period. Several factors underpinned the increased use of these
instruments in developing countries. Their
expanding use in high-income countries
made more investors familiar with their benefits, while efforts to standardize derivative

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contracts (by the International Securities
Dealers Association, for example, to develop standard documentation for credit
default swaps) helped reduce their costs andimproved confidence in derivative transactions. Growth in spot markets also encouraged greater use of derivatives for hedging
purposes. In addition, the expansion of thesize and length of maturities in local currency
bond markets facilitated the creation andpricing of developing-country interest rate
derivatives (Saxena and Villar 2008).
The expanded use of these products helped
to disperse risk, improve diversification among
investors, and increase the pool of developingworld investors, thereby increasing capital flows
to developing countries. For example, banks
were able to expand lending to developingcountry borrowers—even high-risk borrowers—and transfer the risk to capital markets
through credit default swaps (World Bank
2007) and by pooling loans and selling themto investors in high-income countries. Between 2003 and 2008, CDS spreads werequoted widely for 40 developing countries,
in addition to a number of privately negotiated deals that were not widely reported.3
The proliferation of securitized and derivative
products enabled pension funds and insurance companies, many of which face regulatory restrictions on the kinds of investments
they can make, to take indirect positions indeveloping-country loans by purchasing themore highly rated tranches of securitizedloans.
The secondary sale of developing-countryloans to nonbank investors, or the banks’
own off-balance-sheet vehicles, contributed
to overall credit expansion by replenishingbanks’ reserves and allowing them to provide
new additional loans to developing countries. Increased availability of derivatives also
boosted the supply of FDI by providing investors with a mechanism to hedge the short-term
foreign exchange risk involved in projects,
particularly in those targeting production forthe domestic market (Griffith-Jones and Leape2002).

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Not all derivative transactions involving
developing-country instruments increased theavailability of capital to developing countries.
For example, synthetic collateralized debt obligations were mainly a vehicle to facilitate
speculation on developing-country returns.
Investors purchase a synthetic CDO, the return on which was tied, say, to changes in thecredit default swap spread on bonds issued by
the Brazilian government. Because these synthetic CDOs did not involve the repackaging
of existing bank loans, they did not reducebanks’ exposure to developing-country debt
and therefore did not enable them to increase
lending. Indeed, some observers argue that byfacilitating speculation, these instruments increased volatility in developing-country financial markets.4

Developing-country financeduring the boomThe expansion of liquidity in high-income
countries, the financial innovations, andthe consequent fall in the price of risk dramatically changed developing-country finance. Net
capital inflows quintupled, and spreads on foreign debt fell from 656 basis points in 2000 to
168 basis points at the end of 2007. Equallyimportant, domestic credit as a share of GDP
increased by 5 percentage points on average,
with much larger increases in several regions,while domestic interest rates declined acrossthe board. These developments were accompanied by an unprecedented tripling in the valuation of equities traded on developing-economy
stock markets.
The rise in financial intermediation increased the supply of finance available to entrepreneurs to undertake productive investment,
thereby contributing to capital accumulationand the expansion of potential output. Moreover, the influx of new investments, embodying newer technologies, facilitated an overall
acceleration in technological progress in developing countries that was also supported bymacroeconomic and institutional reforms in

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2 0 1 0many countries.5 Finally, the acceleration in
growth itself likely triggered a further deepening of financial markets (see box 2.3 for the
positive interaction between financial intermediation and growth).
Of course, while a rapid increase in global
liquidity can facilitate economic growth, insome circumstances it can also cause macroeconomic instability. Easy access to financecan lead to excessive consumption and unsustainable current account deficits, as was thecase in many countries in emerging Europe
and Central Asia. More generally, international finance tends to be especially procyclical for developing-country borrowers. Weakinstitutions (including protection of property
rights) and low-income levels make them lesscreditworthy on average. As a result, whenboth global and domestic conditions are good,

middle-income borrowers (and those lowincome borrowers with market access) may
see a surge of inflows that reverse especiallysharply when prospects deteriorate.
Historically, this “stop-go” quality of finance, particularly external debt and portfolio equity flows, has exacerbated booms andpainful busts in many developing countries.
The source of instability is not always foreign,
however. In many instances, large swings ininternational capital flows have been ascribedto the behavior of domestic investors.6 In the
East Asian financial crisis, much of the capitalflight that contributed to the large currency
depreciations and macroeconomic instability
was the result of domestic investors fleeing
local currency instruments in favor of foreigndenominated instruments that were expected
to be better stores of value (Kawai, Newfarmer,

Box 2.3 Financial intermediation and economic
development

S

everal empirical studies find that the size andefficiency of financial intermediation has a causal
affect on growth: Measures of financial development
are found to be correlated with growth in a subsequent period in a cross-section of countries (Kingand Levine 1993, Levine and Zervos 1998 for developed economies). Financial market deepening is foundto be related to productive efficiency in cross-section
data, including both developed and developing countries (Nourzad 2002). Financial development is associated with poverty reduction (Jalilian and Kirkpatrick
2002; Beck, Demirgüç-Kunt, and Levine 2007) andis found to precede growth in tests of Granger causation on time series data (Neusser and Kugler 1998;
Rousseau and Wachtel 1998). Instrumental variables(English, French, German, or Scandinavian legal origin) as well as other econometric techniques are used
to isolate the causal impact of financial development(Levine, Loayza, and Beck 2000). Financial development also is found to raise growth principally throughits effects on total factor productivity (Beck, Levine,and Loayza 1999). Several country studies also showthat financial development has a major impact on
growth over time (Levine 1997).

54

But the literature is not unanimous in identifying
a causal relationship between financial development
and growth. Growth also has an impact on financial development. Moreover, third factors (such astechnological innovations in communications anddata processing, as well as the quality of institutions) affect both growth and financial development.
Several economists find a bidirectional relationshipbetween financial development and growth (Luintel
and Kahn 1999; Al-Yousif 2002; Demetriades andHussein 1999). Hurlin and Venet (2008) find a robust causality from growth to financial development
in a sample of developed and developing countries
but little evidence of causality from financial development to growth. Arestis and Demetriades (1997) findthat financial development causes growth in only a
few countries in their sample; Shan (2005) and Shanand Morris (2002), using time series data (covering
OECD countries plus China), find little evidence that
financial development leads economic growth; andAl-Taimimi and others (2001) find no evidence ofGranger causation between financial development or
economic growth in either direction from a sample ofArab countries.

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and Schmukler 2001; World Bank 1998). A
similar dynamic underlay the crisis in Mexico
in 1994–95 (Frankel and Schmukler 1996).
In the case of Chile following the East Asianand Russian crises, however, foreign investors
were the main sources of capital flight (Cowan
and others 2005).
As discussed in chapter 1, during the recent
crisis a rapid reversal in capital flows adversely
affected virtually every developing country,
even those that had pursued prudent macroeconomic policies and accumulated large
stocks of foreign currency reserves. That said,
the countries (notably many in the Europe andCentral Asia region7) that were hardest hit
were precisely those in which the additionalliquidity had been channeled into domestic
consumption and that had accumulated significant domestic and external imbalances during
the boom period.

The reduction in the price of risk
The rapid expansion of global credit and the
low interest rates that accompanied it werereflected in a sharp fall of secondary-market
spreads on investment grade and high-risk
debt in industrial countries. For example, therisk premium on AAA corporate bonds in the
United States fell from 490 to 65 basis points
between 2002 and 2007, while that on BBB
grade European corporate debt fell from 390
to 55 basis points. The simultaneous fall of
spreads on a wide variety of risky assets is consistent with a significant reduction in the priceof risk itself, either because of a decline in risk
aversion on the part of investors or because of
the emergence of a view that derivatives andother hedging mechanisms had lowered thelikely financial cost of holding a given level ofrisk (figure 2.5).
The decline in interest rates and the fall in
the price of riskier assets at the beginning of
the decade were initially treated as a temporary cyclical phenomenon. However, as theboom period continued, commentators increasingly began to argue that financial market innovations such as credit default swaps
and the securitization of loans in secondaryG L O B A L

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Figure 2.5 The cost of risk in high-income
countries fell sharply during the boom
Percentage points

16

Merrill high-yield corporate (US)14
Lehman investment
grade (Euro)

12
10
8

Lehman investment
grade (US)US 10-year govt. bond

6
42Euro 10-year govt. bondJan. 1998 Jan. 2000 Jan. 2002 Jan. 2004 Jan. 2006
Source: Datastream.

markets had permanently reduced long-term
interest rates and risk premiums.
Falling interest rates internationally, lower
risk premiums, and, especially toward the endof the boom period, rising commodity prices
also meant that financial conditions withindeveloping countries relaxed. Reflecting boththese developments and the influence of policy
improvements and political factors, interest
rate premiums and the interest rates paid bydeveloping-country borrowers fell sharply inseveral regions (figure 2.6).

The expansion in domestic credit
The decline in borrowing costs was associated with a rapid increase in financial flows,
domestic intermediation, and capital market
valuations throughout the developing world(table 2.2). Banking intermediation, as measured by claims of deposit money banks on
the private sector, expanded on average from
29 percent of GDP in 2000 to 35 percent
in 2007—greatly boosting the funds available to firms for investment (see table 2.2).
In some regions, a growing participation byforeign banks in domestic financial systems

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2 0 1 0Figure 2.6 Developing-country interest rates
fell substantially during the boom period

financial intermediation and the levels reachedvaried significantly:●

Percentage points
25
Jan. 2000

Jul. 2007

20

15

10

5

●

U

ni
t
of ed
Am Staer tesic
aan Eas
d tA
Pa s
c ia
E ifi
C uro c
en p
tra e
a
L lA nan ati sia d
d nA
C m
ar e
ib ri
be ca
an
an
M
d
i
N dd
or le
th E
Af as
r
So ica t
ut
h
As
ia
Su
bSa
ha
Af ra
ric n
a

0

Source: World Bank.

supported the rapid rise in domestic financial
intermediation (box 2.4). Firms in developing countries also benefited from a surge instock market capitalization, which rose from35 percent of GDP in 2000 to 114 percent
in 2007.8 Moreover, lower interest rates andinterest rate spreads reduced the cost of capitalfacing investors in developing countries. Partly
as a consequence, ratios of investment to GDP
adjusted for inflation jumped by 5 percent of
GDP on average, with an 8 percent GDP jumpin South Asia.
All regions participated in the financial
boom to some extent, although the increase in
Table 2.2●

In Europe and Central Asia, bank credit
almost doubled and stock market capitalization more than quadrupled (relative toGDP), reflecting very low initial levels attributable to the region’s communist past
(despite 10 years of transition), the prospects for accession of several countries tothe European Union, and the boom in oil
prices. Of the 25 countries with sufficientdata, 12 registered increases in credit to theprivate sector of more than 10 percent ofGDP.
Financial intermediation also rose strongly
in South Asia. In India the ratio of bankcredit to GDP increased by 15 percentage
points and the stock market capitalization
nearly quintupled relative to GDP. Other
countries in the region had more moderate increases (for example, the ratio ofbank credit to GDP increased 12 percentage points in Bangladesh and 6 percentage
points in Pakistan).
The increase in credit to the private sector in the Middle East and North Africa
was smaller but still robust—partly reflecting the fact that as measured the cost ofcapital in the region actually increased (seetable 2.2). Credit in Algeria, Morocco, andTunisia registered gains of 5–6 percentage
points of GDP. Despite the near tripling ofstock prices, the increase as a percentage

Changes in domestic intermediation, 2000–07
Private credit by banks

Region2000

Developing countries
East Asia and Pacific
Europe and Central Asia
Latin America and the Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa

29.3
66.1
16.8
24.9
33.0
25.6
34.8

2007

(percent of GDP)

34.8
55.4
32.5
27.1
39.2
40.4
41.6

Stock market capitalization
Change(% points)

5.5
10.7
15.6
2.2
6.2
14.8
6.8

2000

2007

Change(percent of GDP)(% points)

35.3
47.1
17.5
31.6
19.9
26.1
89.9

78.6
118.0
59.8
39.8
36.2
107.2
59.1

113.9
165.1
77.3
71.4
56.1
133.4
149.0

Source: World Bank calculations using Beck and Demirgüç-Kunt 2009.
Note: For private credit, the regional numbers are simple averages of available country data. For stock market capitalization,
the averages are weighted by GDP.

56

T H EI M P A C T

O F

T H E

B O O MI N

G L O B A L

F I N A N C E

O N

D E V E L O P I N GC O U N T R I E S

Box 2.4 The role of foreign banks in domestic
intermediation

F

oreign banks play an important and growing rolein domestic intermediation among developing
countries. As of 2005, their share in total banking
assets in developing regions ranged from a low of
7.4 percent in South Asia to a high of 54.4 percent
in Europe and Central Asia (box table 2.4.1). Moreover, during the boom period foreign banks increased
their share in total assets in all of the regions where
they already had relatively large presences. Indeed,
the extent of the expansion in domestic credit isloosely related to the extent to which foreign banks
increased their market shares. The two regions withthe smallest foreign presence (East Asia and thePacific and South Asia) actually saw the market shareof foreign banks decline.
The contribution of foreign banks to intermediation in developing countries is not straightforward.
In some countries they can serve as an important
conduit that facilitates the importation of external

Box table 2.4.1 Foreign bank participationand credit expansion

RegionEast Asia andPacific
Europe andCentral Asia
Latin America
and Caribbean
Middle Eastand North Africa
South Asia
Sub-SaharanAfricaShare ofassetsowned
by foreignbanks,
2001

Share ofassetsowned byforeignbanks,
2005

Change inratio of bankcredit to theprivatesectorover GDP,
2000–07

13.0

11.1

10.7

42.0

54.4

15.7

30.4

35.6

2.2

8.3
8.9

10.9
7.4

6.2
14.8

46.2

49.5

6.8

Source: World Bank database on Financial Institutions andStructure.

capital to expand lending, and if they are more efficient and improve domestic bank efficiency (seebelow), they can reduce the cost of financial intermediation and encourage higher volumes. In these instances, foreign banks by stimulating intermediation
may, in turn, encourage more rapid development. For
example, in Europe and Central Asia, the acquisition of local banks by foreign banks was associatedwith increased lending to small and medium-size
enterprises and retail markets (de Haas and Naaborg
2006), even though foreign banks lent predominantly
to multinational corporations, large domestic firms,
and governments—potentially squeezing out smaller
players (see Gormley 2005 for the theoretical model).
Indeed, the entrance of foreign banks in a market
tended to cause local banks to increase lending tosmall enterprises in part because of increased competition in lending to larger firms (Jenkins 2000).
In some cases foreign banks may reduce the levelof financial intermediation. Research suggests that
especially among low-income countries with weakregulatory frameworks and competition law, foreignbanks may enter into a market and cherry-pick thebest local clients (Detragiache, Tressel, and Gupta
2006). In such circumstances, a larger presence of
foreign banks may be associated with less credit to
the private sector.
Overall, the evidence is mixed. Survey data indicate that entrepreneurs in countries with larger
participation by foreign banks face less binding
credit constraints (Clarke, Cull, and Martinez Peria
2001). Moreover, when domestic conditions are
propitious (a solid local banking sector, and good
regulatory and competitive protections), foreignbanks can contribute to an overall expansion of
credit and a lowering of costs for borrowers. However, foreign bank participation is not critical toincreasing financial intermediation in developing
countries and can, in some regions with weakly
contested and poorly regulated markets, result in
the crowding out of local providers and no net increase in intermediation.

57

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●

●

58

P R O S P E C T S

2 0 1 0of GDP and the level in 2007 were smaller
than in the other developing regions
The 7 percentage point increase in bankcredit (relative to GDP) in Sub-SaharanAfrica mainly reflects a 12 percentage point
rise in South Africa, rather than a moregeneralized increase in domestic financial
intermediation. Of the 30 countries withcomplete data, 9 experienced declines in domestic intermediation relative to GDP, and12 countries experienced increases of lessthan 5 percentage points. Sufficient dataon stock market capitalization are reported
for only 13 countries. The strong increase
is attributable to capitalization more thantripling relative to GDP in Côte d’Ivoire,
Kenya, Mauritius, and Nigeria. The highlevel of stock market capitalization relative to output, however, is attributable
to South Africa, where the level reachednearly three times output in 2006. Because
South Africa attracts investment from othereconomies in the region that lack stock
markets and are hence not included in the
average, the average tends to overstate
the level of capitalization for the South
African economy per se. Excluding South
Africa, the region has the lowest level ofstock market capitalization relative to output of the six developing regions.
The small average increase in credit to theprivate sector relative to output in Latin
America and the Caribbean reflects very different outcomes across countries, ranging
from a decline of more than 26 percentage
points in Bolivia and Uruguay to an increase of 17 percentage points in Colombia
and Costa Rica. Macroeconomic policies in
Latin America have improved greatly since
their boom-and-bust experiences over thelast decades of the 20th century, and many
countries avoided an excessive buildup of
private credit and achieved steady growth
in incomes. Compared with most other regions, the doubling of stock market capitalization was modest and may have reflected
policy prudence by authorities in the region
seeking to avoid an asset-price bubble.

●

The drop in private credit relative to GDP
in East Asia and the Pacific stems in partfrom adjustments following the East Asia
crisis, with particularly significant declines
in Malaysia (27 percentage points) and
the Philippines (14 percentage points).
However, East Asia is the developing region with the deepest domestic financial
systems, and the region’s ratio of bankcredit to GDP exceeded that of the UnitedStates (although remaining below that of
the more bank-based systems in Western
Europe). The further deepening of financial markets was reflected in the more thantripling of stock market capitalization overthe period.

The rise in foreign flows
The increase in domestic financial intermediation during the liquidity boom was accompanied by a rapid expansion of capital inflows(figure 2.7). Similar to increases in domestic
credit, higher capital inflows can boost investment and efficiency (box 2.5).
While virtually every country saw inflows
rise, they did not rise by the same amountin all countries, and not all forms of international capital flow increased to the same
degree. Portfolio equity flows to developing
countries increased rapidly before the financial

Figure 2.7 Total capital inflows to developing
economies
US$ billion

Share of GDP, %

1,200

9
8

1,000
800

7
Share of GDP

5

600

4

400

3
2

200
Total capital inflows
01990 1992 1994 1996 1998 2000 2002 2004 2006
Source: World Bank.

6

10

T H EI M P A C T

O F

T H E

B O O MI N

G L O B A L

F I N A N C E

O N

D E V E L O P I N GC O U N T R I E S

Box 2.5 Capital flows can boost investment
and efficiencyM

ost developing countries relied on externalfinance during the 2003–07 boom. Developing countries’ aggregate current account surplus(which averaged almost $243 billion during this period) mainly reflected large surpluses of savings overinvestment in a few countries, notably China, anddeveloping oil and mineral exporters. Three-fourthsof the remaining developing countries for whichdata are available were net importers of capital, withcurrent account deficits that averaged more than
6 percent of their GDP and 28 percent of their total
investment spending (box table 2.5.1).
Box table 2.5.1

External finance can improve efficiency by enhancing the transfer of technology from moredeveloped economies, helping firms achieve larger
size and thus benefit from economies of scale, building reputations in global markets, and establishingbusiness and marketing contacts for developing countries’ exports (World Bank 2006). These effects canbe indirect or arrive more directly, as can be the casewith some forms of foreign direct investment, if theresult is the importation of more sophisticatedmachines or business techniques.

Developing countries with current account deficits, 2003–07
Number of countries withcurrent account deficits

Current accountdeficit (% of GDP)

Current account deficit(% of investment)

53
16
20
17

6.3
5.8
6.1
7.1

26.8
29.1
23.4
28.3

All countries
Low income
Lower middle income
Upper middle income

Source: World Bank.
Note: Data on current account deficits are simple averages of country numbers. Small island economies are excluded.

crisis, from near zero in 2001 to $160 billion
in 2007, followed by a total collapse in 2008
(figure 2.8).

Figure 2.8 Portfolio equity flows todeveloping countries
Portfolio investment, equity (US$ billion)

Share of GDP, %

160
140

1.0
Share of GDP

0.8

120
100

0.6

80

0.4

60
40

0.2

20

0

0
–20
1980

Portfolio investment
1985

1990

1995
Years

Source: World Bank.

–0.2
2000

2005

Developing countries’ access to external bond markets and foreign bank lending increased markedly during the liquidity
boom, reaching a peak of 4 percent ofdeveloping-country GDP in 2007. Net FDI
inflows increased from about 2.5 percent
of GDP in 2001 to 3.9 percent in 2007 before falling slightly in 2008, along with the
reduction in global investment in general(figure 2.9). Official flows, in contrast, reversed from net inflows of $26 billion in 2001
to net outflows of $0.1 billion in 2007.
At the regional level, Europe and Central
Asia, East Asia and the Pacific, and Latin
America were the largest recipients of capital
inflows, receiving more than 80 percent of net
inflows over 2001–07, with the first two regions together accounting for 65 percent of thetotal. However, expressed as a share of GDP,the differences in inflows across regions were59

G L O B A L

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P R O S P E C T S

2 0 1 0Figure 2.9 FDI inflows to developing
countries, 1980–2008
FDI net inflows (US$ billion)

Share of GDP, %

700

4.0

600

3.5
3.0

500

Share of GDP

2.5

400

2.0
300

1.5

200

1.0

100

0.5
FDI

0
1980

0
1985

1990

1995

2000

2005

Years
Source: World Bank.

less pronounced—both in 2001, and in 2007
when flows peaked. Flows to East Asia andthe Pacific, relative to GDP, were only slightly
above the developing-country average in 2001
and were actually below average in 2007. In
contrast, while flows to developing Europe
and Central Asia as a share of GDP were below
average in 2001, they grew about fivefold by
2007. South Asia also saw inflows increase
very rapidly, from only about 1 percent of
GDP in 2001 to more than 8 percent in 2007.
Contrary to accepted wisdom, Sub-SaharanAfrica actually received close to average flows(relative to GDP) both in the pre-boom andend-of-boom periods. Both middle-income
and low-income countries benefited fromthe surge in capital flows. The flows to lowincome countries more than quadrupled, from
Table 2.3

1.5 percent of their GDP in 2001 to almost
7 percent in 2007, largely supported by therise in resource-related FDI.
Across regions, the relative importance ofdifferent types of capital flows varied somewhat. In most regions equity (especially FDI)
accounted for both the bulk of capital inflows
in 2007 and most of the increase in inflows
over 2001–07 (table 2.3). In developing
Europe and Central Asia, however, net debt
flows grew from almost nothing in 2001 to
almost 10 percent of GDP. As such they represented about two-thirds of total inflows in
2007. Had Europe and Central Asia received
the same increase in debt flows as other developing regions, its overall inflows would havebeen closer to 8 percent of GDP, similar to
those received by East Asia, South Asia, and
Sub-Saharan Africa. Although many factors
underpin the strength of debt inflows to theregion—including enthusiasm for the region’s
long-term prospects within the European
Union and the high share of foreign banks inthe overall banking sector—the population’s
willingness to take on exchange rate risk byborrowing in foreign currencies helps to explain
why bank lending—including to private individuals—played such a prominent role.
At the country level, absolute flows are
extremely concentrated, with China, India,
the Russian Federation, and Brazil accounting for about 50 percent of net inflows bothin 2007 and, on average, over 2001–07; thefour also account for 73 percent of all flows

Net capital inflows by region
2001

2007

Avg.
2001–2007

Source: World Bank.

60

2007

(% of total flows todeveloping countries)(US$ billion)

Developing countries
East Asia and Pacific
Europe and Central Asia
Latin America and the
Carribean
Middle East and North
AfricaSouth Asia
Sub-Saharan Africa

2001

2001

2007

(% of region’s GDP)

223
83
29

1,143
277
454

470
141
164

37
13

24
40

4
5
3

9
7
15

87

215

87

39

19

4

6

5

21

12

2

2

1

3

8
11

116
60

39
27

4
5

10
5

1
3

8
7

T H EI M P A C T

O F

T H E

B O O M

I N

Figure 2.10 Distribution of capital flows as apercentage of GDP in 2007
Percent of countries
35
30

32.1
28.4

25
20
16.5
15
9.2

10

5.5
5

2.8

0.9 1.8 0.9

0.9 0.9
0
–20

0

20

40

60

Capital flows as % of GDP
Source: World Bank.

(figure 2.10). However, relative to GDP, boththe flows and the change in flows are more
evenly distributed, with about 60 percent ofcountries receiving flows of between 0 and
10 percent of GDP in 2007 (figure 2.10).

Real-side consequences of thesurge in global financeT

he extent to which a given developing
country benefited from the surge in global
liquidity depended on a wide variety of factors,
many of which are impossible or at best very
difficult to measure in a consistent manner
across countries.
Figure 2.11 reports simple correlations between private finance (as represented by domestic intermediation in the first column andforeign capital inflows in the second column)
and borrowing costs, the quality of institutions, and the extent of real-side openness(all data are expressed in terms of the average
from 2001 through 2007). Unsurprisingly, thelevels of both domestic intermediation and private capital inflows are negatively correlatedwith borrowing costs—although the simple bivariate correlation illustrated here is not verystrong, mainly because of the interaction ofother factors (see below).

G L O B A L

F I N A N C E

O N

D E V E L O P I N GC O U N T R I E S

The quality of domestic institutions (proxied here by the Kaufmann–Kraay–ZoidoLobaton index) is also correlated with both
domestic and external finance. Demand forcapital will depend on the potential revenues
from a physical investment. Both domestic andinternational investors operating in countries
with strong institutions and a well-functioning
regulatory environment, including reasonable
protection of property rights, will likely earnhigher real-side returns and therefore, all else
equal, be willing to take on more debt. Similarly, lenders providing finance to borrowers
in countries with strong institutions and protection of property rights would be more likely
to be able to enforce their claims for repayment and hence would be willing to lend more.
Finally, the extent of real-side integrationof an economy is also a good predictor of theextent of financial intermediation and private
capital inflows that a country receives (Figure 2.11 panel C. In the recent boom period,
external factors such as the high price of commodities were also at play. Interestingly, while
per capita income levels are highly correlatedwith the level of domestic intermediation(figure 2.12), the size of capital flows is only
weakly related to income.
Although these correlations provide someinsight into the differences in intermediationlevels at a given point in time, they do not
speak to what drove the changes observed during the boom (table 2.4).
By far the biggest drivers of the observedchanges in the availability of domestic andinternational finance were changes in the costof capital, here operating through the reduction of interest rates in high-income countries and interest rate spreads in developing
countries. Cross-country regressions (box 2.6)
suggest that for the average developing country
a 500 basis point decline (roughly the mean decline observed over the estimation period—aswell as a standard deviation across the sample
of countries for which comparable data are
available) in borrowing costs resulted in an increase in the level of domestic intermediation
equal to 4.5 percent of GDP and an increase in61

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2 0 1 0Figure 2.11 The determinants of private financeDomestic intermediation

International private capital flows

Panel A: vs. the cost of capital
Domestic credit to private sector, % of GDP (avg. 2001–07)

Private capital flows as % GDP (avg. 2001–07)

140

35

120

30

100

25
20

80
60

y = ⫺1.56x ⫹ 55.90
R2 = 0.0440

15

y = ⫺0.22x ⫹ 10.03
R2 = 0.02

10
5

20
0

0

⫺20
10

⫺5
10

12

14

16

18

20

22

24

12

Cost of capital (avg. 2001–07)

14

16

18

20

22

24

Cost of capital (avg. 2001–07)

Panel B: vs. institutional quality
Domestic credit to private sector, % of GDP (avg. 2001–07)
140

Private capital flows as % GDP (avg. 2001–07)
30

120

25

y = 0.86x ⫺ 0.93
R2 = 0.34

100

y = 0.13x ⫹ 1.79
R2 = 0.13

20

80

15

60

10

40

5

20

0
⫺5

0
0

20

40

60

80

0

100

10

KKZ index (avg. 2001–07)

20

30

40

50

60

70

80

90

KKZ index (avg. 2001–07)

Panel C: domestic credit and foreign private capital inflows vs. trade openness
Domestic credit to private sector, % of GDP (avg. 2001–07)

Private capital flows as % GDP (avg. 2001–07)

Domestic credit and exports

140

Private capital flows and exports

30
25

100
120
80

15

60

10

40

5

20

0

0

⫺5
0

20

40

60

80

100

120

y = 0.13x ⫹ 1.50
R2 = 0.15

20

y = 0.50x ⫹ 11.26
R2 = 0.13

140

Exports of goods and services as % of GDP (avg. 2001–07)

0

20

40

60

80

100

120

140

Exports of goods and services as % GDP (avg. 2001–07)

Source: World Bank.

foreign capital inflows of 0.5 percent of GDP.
Likewise, panel estimates suggest that financial
conditions in developing countries were evenmore sensitive to international financial conditions. According to these estimates, a 1 point

62

decline in the price of global risk (about the
decline observed between 2003 and 2007)
could result in an increase of 3.5 percent of
GDP in foreign capital flows and an increase of
7.5 percent of GDP in domestic intermediation

T H EI M P A C T

O F

T H E

B O O M

I N

Figure 2.12 Private credit from banks andother financial institutions relative to percapita income, 2007
GDP per capita in $US
70,00060,00050,00040,00030,00020,00010,0000⫺10,000
0.5

1.0

1.5

2.0

2.5

Share of private credit in GDP
Sources: International Financial Statistics; World Bank.

(amounting to, respectively, more than twothirds and more than three-fourths of the mean
increase observed over the estimation period).
The association is especially strong for debt inflows, and, not surprisingly, it does not holdfor official aid.
Changes over time in other important determinants of domestic and international financial
intermediation were not as large as the changes
in international capital conditions and the cost

G L O B A L

F I N A N C E

O N

D E V E L O P I N GC O U N T R I E S

of capital. As a result, changes in the cost ofcapital (broadly understood to include the international price of risk) on average accounted
for almost one-half of the observed fluctuation in capital inflows and about 60 percent of
the increase in domestic intermediation (seetable 2.4), with domestic intermediation being
the only other quantitatively important factor
in the determination of net capital inflows.
However, other factors, including institutional quality, overall economic openness,and the extent of domestic financial sector intermediation (in the case of the capital flows
equation), were critical in explaining the wide
differences in the levels of intermediationand inflows across countries both before andduring the boom (lower panel of table 2.4).
Cross-country differences in institutional
quality (as measured by the Kaufmann–
Kraay–Zoido-Lobaton Index) explained almost six-tenths of the variance in the levelof domestic intermediation across countries
and about one-third of the difference in net
capital inflows. Indeed, a one-standarddeviation improvement in institutional quality(roughly equivalent to the average difference
in institutional quality between Sub-SaharanAfrica and Latin America) could generate a
12 percentage point increase in the ratio ofprivate sector domestic credit to GDP, and an

Table 2.4 Intertemporal changes in financial variables mainly reflected the cost of capital,
but across countries institutional quality was most importantFinancial variables

Net capital flows

Domestic intermediation(As a percent of GDP)

Change over 2001–07 in sample mean of dependent variable
Contributions of changes in (sample mean of):Global cost of risk
Institutional quality
Domestic intermediation
Difference in 2007 between top and bottom quartile in dependent variable
Contribution of differences in:
Cost of capital
Institutional quality
Exports of GNFS

4.9

8.6

2.2
...
1.8

5.1
0.08
...

1.61
...
3.7
5.2

34.5
2.1
19
12.8

Source: World Bank.
Notes: Calculations based on estimates reported in box 2.6.
. . . Not estimated.

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2 0 1 0Box 2.6 Determinants of cross-country differences indomestic and international financial intermediationD

ata limitations among other constraints prevent a comprehensive modeling of the factorsthat explain the extent of the expansion of domestic
and international finance in developing countries in
response to the global loosening of monetary conditions. However, cross-country regressions that seek
to explain the average change in domestic intermediation (credit to the private sector) and international
capital flows as a percentage of GDP provide important insights into the role of the country-specificpotential explanatory variables (including changes
in the cost of capital, institutional quality, financial development, exports, the budget surplus, andinflation).
These regressions confirm a statistically significant
association between the level of domestic intermediation in developing countries and institutional quality,
the share of exports in GDP, and their rate of growth(box table 2.6.1, column 2). The results also indicate
a significant association between the level of international capital flows and institutional quality andexports (box table 2.6.1, column 3).

Both as a robustness check and to explore the roleof the country-invariant risk-premium variable (discussed in chapter 3), panel regressions were also run
for the period 2001–07, with net capital inflows anddomestic intermediation as the dependent variables,
and the risk premium plus the full set of regressors
from the cross-sectional analysis as the independent
variables. All independent variables were lagged, todiminish endogeneity concerns. These regressions
confirm a statistically significant association between
both domestic intermediation and capital inflows on
the one hand and the international price of risk andfinancial development on the other (box table 2.6.2,
columns 2 and 3). While the variation in the level ofdomestic financial intermediation was significantly
associated with institutional quality, the variation ininternational capital flows was not. Nor did the costof capital have an independent influence on either
domestic or international intermediation beyond thatof the price of international risk, likely reflecting thestrong link between variations in the two variables(see chapter 3).

Box table 2.6.1 Cross-sectional regressions results
Dependent variable

Domestic intermediation(Private sector credit, % of GDP,
Average 2001–07)

Net capital inflows(% of GDP,
Average 2001–07)

Explanatory variables

Coefficient

Coefficient

Cost of capitala
Institutional quality (Kaufmann–Kraay–Zoido-Lobaton index)b
Financial development (private sector credit, % of GDP)
Export of goods and nonfactor services (% of GDP)
Export growth
Budget surplus (% of GDP)
Inflation (logs, percent)R20.56*
0.69***—
0.28**
0.53**
1.23***
2.38
0.46

0.02
0.13***
0.05
0.13***
0.244***
0.12
0.52
0.36

Source: World Bank.
Note: All regressions estimated using average values over the period 2001–07 for the dependent variables, and initial values for the
independent variables; number of countries  103. Other controls include export growth, 1990–97 (percent, average annual rate); andindicators for countries in the upper quartile of both the fuel exports/GDP and the metals exports/GDP distribution.
*, **, and *** denote significance at, respectively, the 10 percent, 5 percent, and 1 percent level. Significance is evaluated using robust
standard errors.
a. Measured as the U.S. T-bill rate, plus the country-specific spread, plus depreciation.
b. Measured on a scale of 0 to 100, with a cross-sectional standard deviation of 19.
— Not applicable.

64

T H EI M P A C T

Box table 2.6.2

O F

T H E

B O O MI N

G L O B A L

F I N A N C E

O N

D E V E L O P I N GC O U N T R I E S

Panel regression results

Dependent variable

Domestic intermediation(private sector credit, % of GDP)Net capital inflows(% of GDP)

Explanatory variables

Coefficient

Coefficient

Global cost of riska
Cost of capitalb
Institutional quality (Kaufmann–Kraay–Zoido-Lobaton index)cFinancial development (private sector credit, % of GDP)
Exports of goods and non-factor services (% of GDP)
Budget surplus (% of GDP)
Inflation (logs, %)R2

3.49***
0.03
0.30**
—
0.08
0.07
0.12
0.16

1.47*
0.03
0.01
0.27***
0.02
0.03
0.13
0.10

Source: World Bank.
Note: All regressions estimated using annual data over the period 2001–07, with all independent variables lagged once; number of observations  498, 493. Other controls include indicators for countries in the upper quartile of both the (fuel exports/GDP and the metals
exports/GDP distribution; and a full set of country-specific fixed effects.
*, **, and *** denote significance at, respectively, the 10 percent, 5 percent, and 1 percent level. Significance is evaluated using robust
standard errors.
a. See above for details.
b. Measured as the U.S. T-bill rate, plus the country-specific spread, plus depreciation.
c. Measured on a scale of 0 to 100.
— Not applicable.

increase of 2 percent of GDP in private capital flows after controlling for all other factors. Countries with large export sectors andtherefore a proven track record with foreign
partners also tend to receive more foreign financing than those with weaker external ties.
A country whose export sector was 5 percentage points larger than another’s received, on
Table 2.5

average over 2001–07, an extra 0.5 percent
of GDP in foreign capital inflows, and its
total domestic intermediation amounted toan extra 1.5 percent of GDP. Cross-country
differences in the extent of real-side openness
were associated with about one-third of thedifferences in net capital flows and in domestic intermediation.

Regional distribution of changes in financing conditions, 2000–07
Change between 2007 and 2000 in:
Cost ofcapitalCapitalinflows

Stock market
capitalization(Basis points)

Private credit bydeposits money banks

Investment(% of GDP)

Developing countries
Low-income countries
Middle-income countries

400

5.0

78.6

5.5

5.5
2.3
5.6

East Asia and Pacific
Europe and Central Asia
Latin America and the Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa

134
866
471
269
142
685

2.0
12.0
2.0
2.0
7.0
4.0

118.0
59.8
39.8
36.2
107.3
59.1

10.7
15.7
2.2
6.2
14.8
6.8

5.5
4.9
1.4
5.0
8.1
3.6

Sources: World Bank; Beck and Demirgüç-Kunt 2009; World Bank 2009.
Note: Regional values are simple averages of countries, except for investment rates which are weighted averages.

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2 0 1 0

The association between capital inflows andmacroeconomic stability (as represented by thebudget surplus and inflation) was in general
not statistically significant, after controlling forthe cost of capital, institutional quality, export
intensity, and the extent of financial sector intermediation. Although one would expect thatmacroeconomic stability would be an important determinant of credit worthiness and as aresult the size of capital flows, the data suggestthat the relationship is relatively weak.
Overall, ample global liquidity was a determining factor in the surge in global capital
flows to developing countries, but where thoseflows went and in which form depended importantly on the characteristics of individual
developing countries. Country-specific “pull”
factors, such as the quality of the institutional
environment and overall economic openness,shaped the direction of capital flows and theextent to which the domestic intermediation responded by increasing the availability of credit.
It follows that even in an international
environment in which capital may become
scarcer and more expensive, countries cantake steps that can deepen their domestic
capital markets and increase their accessto international capital. In particular, theevidence suggests that improvements in theregulatory environment, increased market
openness, and more generally reforms that
improve the business environment and reduce the cost of capital can substantiallyinfluence the level of capital inflows andfinancial intermediation in a given country,
especially in Africa where the quality of institutions remains well below the averageelsewhere. Indeed, in the expected tougher
global environment, such factors are likely
to be even more critical in determining thedirection of future flows—placing evenmore value on forging ahead with further
reforms. Sufficient progress in these areas
across enough countries could well mitigate
to a large degree the expected increase in risk
aversion, potentially allowing capital flows
in the longer run to regain more recent levels(see discussion in chapter 3).

66

The liquidity boom andmacroeconomic performance
The sharp increase in capital inflows to developing countries and the rapid expansion of domestic finance were associated with a generalized
investment boom, although some countries weremore or less successful in transforming additional finance into productive investments.9 On
average, between 2000 and 2007 investment-toGDP ratios in developing countries increased by
5.2 percentage points, or 23 percent, comparedwith their 2000 levels (table 2.6).
Investment rates rose in all regions, mostmarkedly in South Asia, the Middle East, and
Sub-Saharan Africa. The very marked increase
in investment rates in South Asia (up by morethan 10 percentage points) partly reflects deep
structural reforms that were undertaken during
the 1990s, the influence of which on investment
was redoubled by falling borrowing costs. In
the rest of the developing world the rise in investment rates was more modest. Rates in lowincome countries rose by 6 percentage points
versus 5.2 percentage points in middle-income
countries (inclusive of India). Despite the verystrong capital inflows received by countries in
Europe and Central Asia, investment rates inthat region rose by only 3.5 percentage points—
much less than the overall average for middleincome countries. By 2007, just before the onsetof the crisis, investment rates in East Asia andTable 2.6
regionRising investment rates by
Investment rate
2000
(%)

2007
(%)

Change(% points)

Developing countries
Middle-income countries
Low-income countries

22.7
22.8
21.1

28
28
27.1

5.2
5.2
6.0

East Asia and Pacific(excluding China)
China
Europe and Central Asia
Latin America and the Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa

22.1
34.1
19.9
18.6
22.4
22.0
16.9

26
38.8
23.4
22.1
27.0
32.8
20.9

3.9
4.7
3.5
3.5
4.6
10.8
3.9

Source: World Bank.

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Table 2.7 Intertemporal and cross-country
influences on investment
Change over 2001–07 in investment/GDP(sample mean)aContributions of changes in:
Global cost of risk
Domestic intermediation
Terms of trade
Difference in 2007 between top and bottom
quartile in investment/GDPb
Contributions of differences:
Cost of capital
Net capital inflows/GDP

5.4
1.9
0.6
1.4
11.5

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Investment does not, of course, mechanically translate into greater output and living
standards: its efficiency must also be taken into
account. In this context, additional econometrics suggest that increased financing was most
likely to lead to increases in growth in thosecountries where the quality of institutions washigh, a result that is consistent with the recent
literature (Frankel 2009).10

3.3
3.0

Source: World Bank.
a. Based on panel regressions.
b. Based on cross-sectional regressions.

Impact of the investment boom on
growth and potential output

the Pacific exceeded 26 percent of GDP. Thosein Sub-Saharan Africa were much more modest(about 21 percent of GDP) but were nevertheless 3.9 percentage points higher than in 2000.
Many factors help explain the extent towhich investment rates differ across countries and rise in some countries but not others(table 2.7; box 2.7). On average, about onethird of the increase in investment rates observed between 2001 and 2007 is accounted
for by the reduction in the global cost of risk, afurther 11 percent by increased domestic intermediation, and about one-fourth by improvements in the terms of trade in some countries.
Cross-country differences were more than
twice as large as the changes over time, with
about 30 percent of the variation accounted
for by differences in the cost of capital and afurther 30 percent by the level of capital inflows a country attracts. The impact of domestic intermediation and institutional quality
was not statistically significant here, possiblyreflecting difficulties in disentangling theireffect from that of the cost of capital. Concretely, these results suggest that a reductionin the cost of capital from the average level
found in Sub-Saharan Africa to that prevailingin Latin America would be associated with anincrease in investment equal to almost 2 percent of GDP. This reinforces the importanceof continuing with structural reforms aimed
at expanding still-underdeveloped financial
sectors (a point confirmed by the simulations
discussed in chapter 3).

The prolonged reduction in interest rates during
the liquidity boom was associated with a rise inpotential output. Normally, the increase in investment from a fall in interest rates would be
relatively short-lived (as would be the period of
low interest rates). During this most recent bubble, however, interest rates remained low fora very long time, and as a result investors andeconomists alike began to talk of a new regime
likely to be characterized by low interest rates.
If investors’ expected interest rates (and withthem the cost of capital) had decreased on a permanent basis,11 then economic theory suggeststhat investors would have sought to increase theamount of capital they employed to produce agiven level of output. As predicted by theory,during this transition period to a higher capital
output ratio, investment grew faster than usual
and the ratio of the stock of capital to GDP rose
(figure 2.13). As a result, the rate of growth ofpotential output increased—see box 2.8 for abrief description of the model of potential output employed here; the online technical annex(available at www.worldbank.org/GEP2010) tothis chapter provides further details—more rapidly than normal during this period.
Overall, the rate of growth of potential
output among developing countries increasedby an average of 1.5 percentage points between 2003 and 2007 as compared with the
pre-boom period 1995–2002, with 40 percentof that increase attributable to increased capital services as a result of higher investment
rates.12 Table 2.8 breaks down this aggregate
result across different regions. Although both67

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2 0 1 0Box 2.7 Understanding the increase in investment rates

B

ox table 2.7.1 reports cross-sectional regression results that seek to describe differences ininvestment across developing countries in terms ofdifferences in the cost of capital, institutional quality,
domestic intermediation, and international capital
inflows, among other explanatory variables. These
regressions confirm a statistically significant association between investment ratios on the one hand andinitial values of the cost of capital and international
capital inflows on the other. Both as a robustness
check and to explore further the changes in investments observed over time, including the role of thecountry-invariant global risk premium, panel regressions were also run for the period 2001–07, withinvestment ratios as the dependent variables, andthe risk premium, plus the full set of regressors fromthe cross-sectional analysis, as the independent variables. Also included as possible explanatory variables
were interactions between capital inflows, financial

development, and institutional quality, to capture thenotion that domestic conditions may affect the efficiency of investment. All independent variables were
lagged, to diminish endogeneity concerns.
The results (box table 2.7.2) confirm a statisticallysignificant association between investment on the one
hand and both the global price of risk and domestic
intermediation on the other. Even after controlling
for the latter factors, the terms of trade have a significant impact on investment. In contrast, the impactof the cost of capital, institutional quality, and international capital flows is not statistically significant,possibly reflecting difficulties in disentangling theireffect from that of other variables. Additional regression analysis, not reported here, indicates that equity
capital inflows, notably FDI flows, have a stronger
effect on investment rates than on international debt
flows (bonds and bank lending).

Box table 2.7.2 Investment to GDP
ratio, panel regression results
Coefficient

Box table 2.7.1 Investment-to-GDP ratio,
cross-sectional regression results
Coefficient

Cost of capital
Institutional qualitya
Financial development
Net capital inflows
Change in terms of tradeR2

ⴚ0.59***
0.00
0.04
0.45*
0.01
0.22

Source: World Bank.
Note: All regressions estimated using average values over theperiod 2001–07 for the dependent variable, and initial values forthe independent variables; number of countries  106. Other
controls include trade-weighted export market growth (percent)and indicators for countries in the upper quartile of both the fuelexports / GDP and the metals exports / GDP distribution. *, **,and *** denote significance at, respectively, the 10, 5, and 1 percent level. Significance is evaluated using robust standard errors.
a.Measured on a scale of 0 to 100.

68

Global cost of risk
Cost of capital
Institutional quality(Kaufmann–Kraay–Zoido-Lobaton index)aFinancial development(private sector credit, percent of GDP)Net capital inflows/GDP (percentage points)
Terms-of-trade index, weighted by trade ratio
R2

1.33*
0.10
0.08
0.08*
0.34
0.06**
0.24

Source: World Bank.
Note: All regressions estimated using annual data over the period
2001–07, with all independent variables lagged once; numberof observations  430. Other controls include trade-weighted
export market growth (percent); indicators for countries in theupper quartile of both the fuel exports/GDP and the metals
exports/GDP distribution; and a full set of country-specific fixed
effects. *, **, and *** denote significance at, respectively, the10, 5, and 1 percent level. Significance is evaluated using robust
standard errors.
a.
Measured on a scale of 0 to 100.

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Box 2.8 Estimating potential output indeveloping countries

T

his Global Economic Prospects introduces new
estimates of potential output based on a hybrid
production-function model of potential output similar to that used by the Congressional Budget Office(CBO) in the United States, the OECD, the European Commission and the Federal Reserve Board(CBO 2001; OECD 2008; Cournède forthcoming;
Denis and others 2006). In this model, which is
described in more detail in the online annex to thispublication, the supply side of GDP is described by asimple Cobb-Douglas function of the form
GDP  AKaL1a,where GDP is gross domestic product, K is the capital stock, and L is labor employed. Potential output
is the level of output attained when the entirety of thecapital stock and effective labor supply is employed.
Replacing L with the working-age population (P1565),
the labor force participation rate (Pr), and the unemployment rate (UNR) gives
GDP  AKa(P1565 * Pr *(1  UNR))1a.
And stating everything in growth terms givesẏ  TḞP  a K̇  (1a) * (Ṗ1565  Ṗr  (1UṄR))
Assuming that all of the capital stock and all of
the labor force are fully employed (UNR and Pr
equal their equilibrium values), that all of the servicesof the available capital stock are used, and that totalfactor productivity (TFP) is growing at its trend rate
gives an expression for the rate of growth of potential. For most developing countries, we do not havereliable economy-wide data for Pr and UNR, so forthe purposes of calculating the rate of growth ofpotential, it suffices to assume that the equilibrium
unemployment and participation rates are constant,which leaves us withẏ  TḞP  a K̇  (1a) * (Ṗ1565)

as an expression for the rate of growth of potential
output.
For the purposes of this study, the capital stock
was estimated using the perpetual inventory methodfrom investment data (running from 1960 in thecase of most countries) and assuming a depreciation rate of 7 percent (IMF 2005). Trend TFP was
calculated using an Hodrik-Prescott filter throughspot estimates of TFP calculated by inverting theabove equation in level terms. The end-point problem was resolved by assuming that TFP growth from2008 through 2009 was equal to the average rate of
growth of TFP during the period 1996–2006. The
share of capital income in total output (alpha) was
assumed to be a uniform 40 percent in all developing
countries.
An alternative approach used until recently by theOECD (it was recently abandoned in favor of one
similar to that described here) calculates the capitalstock on the basis of a smoothed investment rateseries. This results in an estimate of potential that isless sensitive to cyclical changes in investment behavior but has the disadvantage that full employment
capital services are disconnected from the actual observable capital stock. In the words of the U.S. Congressional Budget Office, which also eschews using
the smoothed investment method, “unlike the labor
input, the capital input does not need to be cyclicallyadjusted to create a ‘potential’ level—the unadjusted
capital input already represents its potential contribution to output. Although use of the capital stock
varies greatly during the business cycle, the potential
flow of capital services will always be related to thetotal size of the capital stock, not to the amount currently being used” (CBO 2001).
The use of actual rather than a smoothed capitalstock means that the output gap fluctuates less overthe cycle.

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2 0 1 0Figure 2.13 Rising investment rates contributed to an acceleration in potential output
Growth of potential output, %Investment to GDP ratio, %
33

8

31

7

29
27

6
Growth of potential output

25

5

23

Investment to GDP ratio

21

4

19

3

17

2

15
1995

1997

1999

2001

2003

2005

2007

Source: World Bank.

middle- and low-income countries saw theirpotential growth rates increase by about thesame amount, with capital deepening accounting for a larger share of the total among lowincome countries, with the remaining 60 percent increase attributable to growth in population and in total factor productivity. In
the case of China, almost all of the increasein output during this period can be ascribedto increases in the capital stock. While these
Table 2.8 Decomposition of increase inpotential output growth directly attributableto capital deepening
Change in growth rate of potential output(2003–2007 vs 1995–2003)

Developing countries
Middle-income countries
Low-income countries
East Asia and Pacific(excluding China)
China
Europe and Central Asia
Latin America and the
Caribbean
Middle East andNorth Africa
South Asia
Sub-Saharan Africa
Source: World Bank.

70

results are sensitive to the level of investment
rate used in the counterfactual exercise, thebroad result that capital deepening accounted
for almost half of the acceleration in potential
output observed during this period is robust todifferent specifications.13

Total

Due tocapitaldeepening

Share due
to capital
deepening

1.5
1.5
1.3

0.6
0.6
0.8

40.3
39.8
63.7

0.4
0.3
3.1

0.1
0.9
0.6

19.8
283.5
18.7

0.3

0.1

46.6

0.8
1.4
1.9

0.5
1.1
1.5

66.7
78.5
79.5

Concluding remarks

F

inance, whether it is delivered throughthe domestic banking system or originatesfrom abroad, is an important enabler of economic development. At its best, it improves
efficiency by funding potential-enhancing investment projects that would otherwise nothave been funded and by promoting and facilitating the transfer of technologies and the
spread of best practices within an economy.
However, the extent to which an increase inintermediation is able to achieve these results
depends importantly on the quality of domestic
institutions, regulations, and overall absorptive
capacity of an economy. Where the supply ofcredit, whether domestic or foreign in origin,exceeds the absorptive capacity of an economy,
it can lead to macroeconomic instability andthus make a negative contribution to long-term
growth and potential output.
For the vast majority of developing countries, the period of 2000–07 was one of veryliquid financial conditions. Both domestic andinternational finance expanded rapidly, withthose countries most open to world tradeand finance receiving the largest shares of
the increase in credit. For most countries thisexpansion fueled an investment boom that
contributed to faster productivity growth andincreased potential output through capital
deepening—without generating domestic inflation or serious external imbalances. That inturn suggests that for these countries a preexisting capital constraint was at least temporarily relieved, ushering in a golden age of rapid
and, at least at the country level, sustainablegrowth. For a few countries, most notably anumber in the Europe and Central Asia region,
inflows and domestic credit creation either

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exceeded the domestic economy’s absorptive
capacity or found its way into nonproductive hands, helping to feed an unsustainable
increase in consumer demand that generated
large and ultimately unsustainable internaland external imbalances.
The financial crisis has brought an end tothese favorable conditions for both groupsof developing countries. For the moment, themost serious impacts have been felt in thosecountries where the largest imbalances accrued.
Going forward as financial conditions improve,conditions in developing countries should also
improve. But growth rates are unlikely to regain their boom-period levels, if global liquidity is both more expensive and less abundant incoming years, particularly over the next several
years as countries adjust to tighter international
conditions. International capital flows to developing countries are not expected to reach theirpre-crisis levels in the medium term. Competition among developing countries to attract investment flows (such as FDI) will be tougher
than in previous years. Factors such as institutional quality, trade openness, and regulatory
framework will play an increasingly importantrole in attracting these cross-border investments
and financial intermediation. To what extent
financial conditions and developing-country
growth potential will be affected will depend
importantly on the nature of the changes tocome in the international financial architecture, the extent that these changes impingeon financing conditions for developing countries, and the success with which developing
countries are able to offset the less propitious
external conditions by improving domestic financial conditions. The nature of these changes
and their expected impact on growth and thegrowth potential of developing countries are
explored in more detail in chapter 3.

Notes
1. Total claims on BIS-reporting banks increased by
21 percent a year on average between 2002 and 2007,
compared with a 10 percent annual increase in nominal
world GDP.

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2. The lack of information available to buyers ofthese instruments also should reduce their price. However, sustained low interest rates during the 2002–07
boom appear to have eroded concerns over risk taking
on the part of many investors. Information asymmetries may also be mitigated by more stringent covenants
on loans sold on secondary markets than on loans heldby the originating bank, although it is difficult for covenants to anticipate all potential repayment issues.
3. Data on reported CDS spreads are taken from
Datastream.
4. Over-the-counter derivatives played an important role in the excessive volatility affecting foreign
currency and asset markets during the East Asian crisisof 1997–98 (Kregel 1998).
5. Firms operating in countries at low levels of financial development are constrained from making theinvestments required to assimilate new technologies(Aghion and others 2004). Moreover, the intermediation services of a healthy financial sector also contribute to development, efficiency, and economic growthby enabling arms-length transactions that increase
competition and the range of options available for bothsuppliers and buyers. Financial intermediation also
helps to move resources from less productive uses tomore productive ones, and to reduce information andtransactions costs, such as the cost of acquiring information on investments, monitoring of firms’ managers,
and enforcing contracts (Levine 1997).
6. Rothenberg and Warnock (2006) find that nearly
half the “sudden stop” crises in emerging markets canbest be attributed to capital flight by local investors,
while Cowan and others (2008) find that one in fiveepisodes are driven by surges in outflows rather thanstops in inflows.
7. During the recent boom, the biggest expansion in
finance (both domestic and external) among the developing regions was in Europe and Central Asia, largely
reflecting optimism about long-term prospects for theregion given its quality labor force and its increasing
political and economic integration with high-income
EU economies. Unlike other regions, the expansionin finance (increases of 12 percent of GDP in external
flows and 15.6 percent in domestic intermediation)exceeded the absorptive capacity of many countries,
spilling over into increased consumption, inflation, andrising current account deficits.
8. Bond markets also increased significantly in someof the middle-income countries, as discussed in WorldBank 2009.
9. At first blush, this appears to contradict someof the evidence outlined in box 2.3 suggesting that
increased intermediation increases GDP and investment mainly by contributing to increased total factor

71

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2 0 1 0productivity. However, they are consistent but here theexpansion in potential output that drives an increase
in investment derives (principally) not from increased
TFP but from a fall in the cost of capital. Although
TFP growth did increase during the 2000s, the sharpest change observed was the decline in borrowing
costs and with them the cost of capital. As a result, thequantity of capital that could be supported by a given
level of productivity and labor increased, inducing an
increase in investment, an acceleration in GDP growth,and an increase in potential output.
10. These regressions also suggested a negative
relationship between growth and the global price ofrisk and the cost of capital. However, this link may be
spurious: the estimated negative relationship between
growth and domestic credit expansion suggests that thedata may be finding it hard to disentangle the impactof the domestic credit expansion from that of some ofits underlying determinants.
11. Indeed, some argue that long-term forces will
yet force interest rates back down to the levels observed
during the first half of the 2000s.
12. Calculations based on the results of counterfactual simulations were conducted by assuming
investment-to-GDP ratios between the period 2002 and2007 held constant, instead of increasing significantly,
as they did in many countries. This has the effect of
reducing the level of the capital stock and therefore theservices of capital in the calculation of potential output.
See box 2.8 for more on the model of potential output
employed here.
13. The share attributable to capital deepening
ranges from a high of 57 percent when assuming a baseyear of 2000 to a low of 42 percent when assuming abase year of 2003.

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ment Discussion Paper 741, Harvard Institute forInternational Development, Harvard University,
Boston, MA.
Kawai, Masahiro, Richard Newfarmer, and Sergio
Schmukler. 2001. “Crisis and Contagion in East
Asia: Nine Lessons.” Policy Research Working
Paper 2610, World Bank, Washington, DC.
King, Robert G., and Ross Levine. 1993. “Finance and
Growth: Schumpeter Might Be Right.” Quarterly
Journal of Economics 108 (3): 717–38.
Kregel, J. A. 1998. “Derivatives and Global Capital
Flows: Application to Asia.” Cambridge Journalof Economics 22: 677–92.
Levine, Ross. 1997. “Financial Development and Economic Growth: Views and Agenda.” Journal of
Economic Literature 35 (2): 688–726.
Levine, Ross, Norman Loayza, and Thorsten Beck.
2000. “Financial Intermediation and Growth:Causality and Causes.” Journal of Monetary Economics 46: 31–77.
Levine, Ross, and Sara Zervos. 1998. “Stock Markets,
Banks, and Economic Growth.” American Economic Review 88 (3): 53758.
Luintel, Kul. B., and Mosahid Kahn. 1999. “A Quantitative Reassessment of the Finance-Growth
Nexus: Evidence from a Multivariate VAR.”
Journal of Development Economics 60 (2): 381–
405.
Neusser, Klaus, and Maurice Kugler. 1998. “Manufacturing Growth and Financial Development:
Evidence from OECD Countries.” Review of
Economics and Statistics 80 (4): 638–46.
Nourzad, Farrokh. 2002. “Financial Development
and Productive Efficiency: A Panel Study of Developed and Developing Countries.” Journal of
Economics and Finance 26 (2): 138–49.
OECD. 2008. “Beyond the Crisis: Medium-Term
Challenges Relating to Potential Output Unemployment and Fiscal Positions.” Chapter 4 inEconomic Outlook, No. 85. Paris.
Rothenberg, Alexander D., and Francis E. Warnock.
2006. “Sudden Flight and True Sudden Stops.”
Working Paper 12726, National Bureau of Economic Research, Cambridge, MA.
Rousseau, Peter L., and Paul Wachtel. 1998.
“Financial Intermediation and Economic
Performance: Historical Evidence from Five
Industrial Countries.” Journal of Money, Credit,and Banking 30: 657–78.
Saxena, Sweta and Agustin Villar. 2008. “Hedging
Instruments in Emerging Market Economies.”
In Financial Globalisation and Emerging Market
Capital Flows. BIS Paper 44, Bank for International Settlements, Basel.

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2 0 1 0Shan, Jordan. 2005. “Does Financial Development‘Lead’ Economic Growth? A Vector Autoregression Appraisal.” Applied Economics 37:
1353–67.
Shan, Jordan, and Alan Morris. 2002. “Does Financial Development ‘Lead’ Economic Growth?”
International Review of Applied Economics 16(2): 153–68.

74

World Bank. 1998. Global Development Finance.
World Bank. Washington DC.
———. 2006. Global Development Finance.
Washington, DC.
———. 2007. Global Development Finance.
Washington, DC.
———. 2009. Global Development Finance.
Washington, DC.

3
Medium-Term Impacts of the
Crisis on Finance and Growthin Developing Countries

T

he lessons of the financial crisis are likely
to shape financial policies and market
reactions for some time to come. Beyond theimmediate and unprecedented global recessionthat it has provoked the crisis can be expected
to alter the global financial landscape significantly over the next 5 to 15 years in at least
three important ways.
First, authorities in high-income countries
will almost certainly strengthen financial
regulation to reduce excessive risk-taking byfinancial intermediaries, which will involve
broadening the coverage of regulation and theimposition of higher capital requirements andother limits on excessive and risky lending.
Second, authorities in developing countries
are likely to introduce rules and policies that
insulate them from excessive financial volatility, by placing greater emphasis on domestically managed risk management strategies suchas capital controls and reserve accumulation.
Third, market participants will likely bemore risk averse than they have been over the
past decade, and the extent to which today’srisk management instruments are used to increase leverage and global liquidity is likely toshrink.
Stronger regulation in high-income countries
is likely to reduce volatility in financial markets,
which should contribute to more stable and sustained growth over the longer term. At the sametime, better regulation and higher risk aversion
also imply that firms and governments in developing countries will face higher borrowing

costs, less abundant domestic finance, reduced
availability of external finance, and a moreconstrained environment for domestic financial
intermediation than during the boom. Efforts
by developing-country governments to reduce
dependence on foreign capital may also reduce
firms’ access to finance and perhaps the efficiency of domestic intermediation.
As businesses adapt to higher capital costs,
the rate of growth potential output in developing countries can be expected to slow by
between 0.2 and 0.7 percentage points for
between five and seven years. And, unlessoffset by policy reforms to reduce domestic borrowing costs, these constraints could
result in as much as an 8 percent decline inlong-term potential output (the level of output
if the available labor and capital were fully
employed). This chapter outlines these expected changes and their consequences for finance, investment, and economic activity overthe medium term. The main conclusions are:Necessary and desirable steps to rein inexcessive risk taking by financial intermediaries, together with increased risk aversion as a result of the financial crisis, will
constrain global liquidity going forward.
Tighter regulations, an increase in the rangeof financial activities and firms that comeunder regulatory scrutiny, increased crossborder supervision, the necessity of banks torebuild their balance sheets, and increased risk
aversion on the part of investors will contributeto a more stable global financial environment75

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2 0 1 0but also result in less abundant and more expensive capital. Although developing-country
borrowing costs have declined from their immediate post-crisis highs, spreads appear tohave stabilized at levels that are about 150
basis points higher than during the boom period. Currently, the price of risk in both highincome and developing countries is being held
down by very low policy rates and quantitativeeasing. As monetary easing is withdrawn, baseinterest rates in high-income countries are expected to rise and with them the risk premiums
and interest rates paid by developing-country
borrowers. Interest rates charged developingcountry borrowers could rise 70 to 270 basis
points above boom-period levels.
As a result of the crisis, external capital
flows will decline over the medium term, withthe extent of the decline dependent on the typeof capital flow. Unsecured bond and bank lending, as well as portfolio equity flows, are likely
to be severely constrained by the new global
financial environment. Trade finance, which
often carries lower risk than other forms ofbank lending because it is directly tied to collateral, should be less affected. The rise in risk
aversion and more stringent regulation is notexpected to hit foreign direct investment (FDI)
to the same degree as debt flows, partly because in the future, investors can be expected
to privilege less risky investment forms such as
FDI. Nevertheless, FDI inflows are projected to
decline from recent peaks of 3.9 percent ofdeveloping-country GDP to 2.8–3.0 percent
of GDP. And foreign bank participation in developing countries’ domestic financial systems
may decline (or rise less quickly) because bothrecent losses and tighter regulation will force
parent banks to build up their capital. How
quickly and how durably these impacts will be
felt depends critically on how long it takes toachieve sound, well-functioning financial systems in high-income countries and on the policy
reactions to the crisis in developing countries.
Higher borrowing costs and tighter
rationing of credit will reduce potential output
and growth in developing countries. Higher
borrowing costs will reduce firms’ desired

76

capital-to-output ratios, as firms economize on
capital relative to labor and natural resources.
Because entrepreneurs will be working withless capital than they would have had interest rates remained stable, the level of output
that developing economies will be able to sustain could fall by between 2 and 8 percent of
GDP. Moreover, during the transition period
to the new, lower capital-output ratio, the rateof growth of potential output could decline by
between 0.2 and 0.7 percentage points annually for about seven years.
Despite higher borrowing costs than during
the boom period, borrowing costs will remain
as much as 500 basis points lower than they
were in the 1990s (depending on the region),reflecting years of policy reform and improved
economic fundamentals. Better debt management, more flexible exchange rates, and morestable political regimes are among the factorsthat mean borrowing costs will not return topre-boom levels. The biggest projected improvements in borrowing costs comparedwith the 1990s are in Latin America and the
Caribbean, Europe and Central Asia, and SubSaharan Africa.
Developing countries are likely to rely
more on domestic financial intermediation.
Given the severity of the crisis in high-income
countries, the global financial system’sability to provide ample credit is likely
to be impaired for an extended period oftime. Moreover, authorities in developing
countries may take a more skeptical view
toward globalization and seek to promote
domestic financial intermediation as an alternative to reliance on foreign capital. This
strategy could ultimately benefit some of the
middle-income countries that have a strong
framework for financial intermediation, byincreasing the efficiency of domestic financial intermediaries through learning by doing
and economies of scale. However, a weaker
international system may have undesirable
effects in many low-income countries, where
deficiencies in domestic intermediation systems are likely to prevent them from compensating for a reduced foreign presence.

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The traumatic impact of the financial crisis
will encourage developing countries to takesteps to insulate their economies from external
shocks. Further efforts to raise international
reserves are understandable in this context,
partly because high reserve levels may be useful in deterring speculators and reducing theamplitude of smaller shocks. However, thebenefits from holding reserves are subject todiminishing returns. This, combined with low
returns and risks from the concentration of reserves in dollars will make increasing reserves
and holding high reserve levels costly. And evensubstantial reserves cannot prevent a country
from feeling the effects of a massive shock.
Similarly, some countries may be tempted topursue slower capital account liberalization oreven to reverse past reforms, which could haveheavy long-term consequences.
The financial crisis is likely to encourage
moves toward greater regional cooperation.
Such cooperation holds some potential tohelp strengthen financial services by capturing
economies of scale and facilitating risk sharing through pooled reserves. It may also help
strengthen South-South financial flows, suchas FDI, which are likely to be of increased importance for low-income countries. However,progress in regional financial cooperation has
been slow in developing countries. Further,such arrangements are likely to be of greatest
benefit to regions that already have relatively
robust domestic financial systems, such as East
Asia and the Pacific. Poor countries with weak
institutions are unlikely to strengthen their financial systems by promoting integration withother poor countries with weak institutions.
Developing countries can mitigate the costsof tighter global financial conditions by reducing the cost of intermediation domestically.
Inefficiency of domestic financial sectors, corruption, weak regulatory institutions, poor
protection of property rights, and excessive
limits on competition can push borrowing costs
in developing countries as much as 1,000 basis
points higher than in high-income countries.
Improvements in the policies and institutions
governing countries’ domestic financial sectors

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may significantly boost domestic financial intermediation, potentially more than offsetting any potential negative impact of higher
global risk premiums. For example, if the poor
institutional framework in many Sub-SaharanAfrican countries could be improved to thelevel of South Asia, borrowing costs would fallby an estimated 275 basis points, more thanthe most pessimistic estimate of the increasein developing-country borrowing costs comingfrom tighter global financial conditions. Were
countries in Europe and Central Asia, Latin
America, and Sub-Saharan Africa to reduce
intermediation costs to the levels observed in
Asia, they could see increases in potential output of 8 percent or more.
The remainder of this chapter analyzes inmore detail the qualitative and quantitative
impact of the expected changes in global regulations, risk aversion, and developing-country
attitudes toward financial volatility on intermediation, international capital flows, investment, and growth.

The impact of post-crisis
regulatory and structuralchangesT

he financial crisis exposed a wide range of
weaknesses in financial markets in highincome and some developing countries. A
laissez-faire implementation of the revised
Basel II prudential guidelines that relied uponlarge banks in some high-income countries touse internal risk assessments to help determine
the necessary level of loan provisioning, combined with very strong incentives to maximize
short-term profits, resulted in many of these
institutions taking on far too much risk. They
may also have placed excessive confidence in thecapacity of their hedging and risk-management
strategies to deal with their highly leveraged
portfolios.
In addition, banks reduced their capitalrequirements by selling loans to subsidiaries,
thus moving the loans off the banks’ balance
sheets. While some of these loans were sold77

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Box 3.1

P R O S P E C T S

2 0 1 0Likely directions of financial sector reforms

T

he precise nature of the reforms that eventually
will be instituted are as yet unclear. However,there is broad agreement on the directions that reform should take. Any eventual reform should:••• Expand the perimeter of financial sector surveillance to ensure that the systemic risks posed byunregulated or less regulated financial sector
segments are addressed and introduce mechanisms to discourage regulatory arbitrage andensure effective enforcement of regulation.
• Bring on-book the off-balance-sheet transactions of major banks.
• Recognize that a more systemwide approach tofinancial sector regulation is needed, notably
one that extends beyond the health of individual••

banks and firms and that encompasses the interdependencies among them.
Ensure that existing regulations are effectively
enforced.
Eliminate the pro-cyclicality of existing capitalrequirements and prudential norms, possibly
even making these rules countercyclical.
Recognize the central role played by private
sector ratings agencies and bring them into theregulated sphere.
Resolve the political and legal impediments
to the effective regulation of cross-border
institutions, develop special insolvency regimes
for large cross-border financial firms, and harmonize remedial action frameworks.

Source: This box draws heavily on Cortavarria and others (2009) and Brunnermeier and others (2009).

to outside investors, banks often retained atleast a portion of the risk through such mechanisms as “implicit recourse,” whereby banks
essentially reduced potential investors’ losses
in securitized issues to preserve the banks’ reputation and retain access to the market. The
exposure inherent in implicit recourse was not
subject to capital requirements.1 The combination of securitization and implicit recourse
increased banks’ leverage (implicit loan torisk-weighted capital ratios) and short-term
profits (because investors would pay a higher
price to buy loans where banks were willing to
make good a portion of subsequent losses), but
it also increased their vulnerability to a downturn by effectively eroding capital adequacy.2
Finally, neither public nor private sector
quasi-regulators such as security exchangecommissions and ratings agencies foresaw thefragility of the overall global financial system.
This failure arose in part because these agencies’
regulatory remit failed to provide adequately
for the interdependencies that had crept into thesystem. As a result, the failure of one financial
institution could, and did, lead to a rapid deterioration in the balance sheets of other seemingly78

healthy companies.3 Essentially, no regulator
had the responsibility for overseeing all systemically important financial institutions (Jickling2009), and therefore none had the responsibility
to focus on how failures in one institution could
affect the system as a whole.
The broad outline of measures to be adopted
can already be seen in the changes to financial
sector regulation proposed by authorities in the
United States and Europe.4 Both a tightening of
regulatory requirements (box 3.1) and the more
effective enforcement of existing regulations
will be required. Regulators can be expected toincrease capital requirements for deposit-taking
institutions, in particular requiring higher capital levels during booms to reduce the degree ofprocyclical lending. Regulators may also set
maximum leverage ratios and minimum levelsof liquidity, undertake more vigorous review
of risk assessment procedures, and tighten requirements governing off-balance-sheet transactions and nonbank subsidiaries. Authorities
also are likely to increase scrutiny and prudential requirements for nonbank financial
institutions, particularly those that are large
enough to pose a systemic risk, and ensure that

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supervision takes into account the interdependencies among financial institutions.
Supervisors may devote more scrutiny to
how the structure of compensation affects
risk taking and accountability and may establish stronger firewalls within institutions
where the potential for conflicts of interest is
high. More attention is likely to be placed onwhether authorities have the appropriate tools
and contingency plans for taking over insolvent institutions and responding to a financial
crisis. Markets for derivatives and other innovative financial products will be subject togreater transparency requirements, and efforts
to protect consumers of financial products
from fraud and excessive risk will be redoubled. Finally it is likely that any new regime
will include enhanced cross-border monitoring, regulation, and coordination mechanisms.
In addition, regulators are likely to take amuch closer look at industry self-regulation
mechanisms such as securities exchanges andprivate ratings agencies, which are rightly or
wrongly blamed by many for failing to identify the elevated and dangerously unsustainable level of risk that was being undertaken.
For example, some observers claim that thescandals earlier in this decade surrounding
Enron, WorldCom, and some mutual funds, aswell as failures of oversight tied to the current
banking crisis, have undermined public confidence in self-regulation by stock exchanges(Ellis, Fairchild, and Flether 2008). Some ratings agencies failed to implement required
procedures (for example, the rule that analysts
should not participate in discussions of feeswith issuers) to limit the conflict of interest involved in relying on fees from the institutions
that issued the rated financial instruments(SEC 2008). Any erosion of the accuracy ofratings because of these conflicts had systemic
implications, because many laws and regulations mandate the use of ratings to determine
permissible investments (for example, by insurance and pension companies) and bankcapital requirements (Jickling 2009).
The financial crisis has brought on large,
endogenous structural changes, including a

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significant further consolidation in the banking sector in high-income countries, and thetransformation of leading investment banksfrom loosely regulated institutions to more traditional banks. The first change may increase
monopolistic tendencies within the sector, raising costs for borrowers and reducing returns
for savers, while the second may reduce thesupply of funds to developing-country firms
seeking additional equity financing.
In addition, the financial crisis demonstrated
that the ability of securitization and other exotic
financial transactions to manage and reducethe cost of risk had been grossly overstated.
The complexity of these products and the intricate interdependencies between financial
agents made individual risk exposures very difficult to evaluate correctly—particularly because
these exposures depended to a large degree on
the even-less-well-understood risk exposure ofcounterparties. As a result, these products can be
expected to play a much more modest role in theevolution of global finance in the years to come.
The following subsections attempt to assess
how these changes are likely to affect financial
conditions, investment, and growth prospects
for developing countries in the years ahead.

Impact on developing countries oftighter financial sector regulations
in high-income countries
Although the financial crisis was centered in
the banking sectors of high-income countries,
it has affected near-term real-side prospects
throughout the world, including countries
that have followed very prudent micro- andmacroeconomic policies. The banking sectorsof most developing countries have not comeunder the same kind of stress, nor required
the extensive national and international assistance, as have those of the high-income countries—with the notable exception of those in
the Europe and Central Asia region.
Several features of the expected tightening of regulation in high-inome countries is
expected to benefit developing countries.
Improved transparency requirements (for79G L O B A L

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2 0 1 0over-the-counter derivatives and commercialbank off-balance-sheet liabilities, for example) could ease investors’ concerns over therisks involved, thus moderating the decline inflows. Regulatory changes intended to control the market segments that loomed large
in the boom-and-bust cycle, such as subprime
mortgages in the United States, could encourage greater investment in markets where suchproblems were much less important, such as
developing countries. Tougher disclosure rulesthat reduce the attractiveness of using offshore
centers for tax evasion could shift flows to developing countries. Higher capital requirements
in high-income countries may increase the relative attractiveness of setting up subsidiaries indeveloping countries, where there is likely tobe less pressure to raise capital requirements(because most developing-country banking systems did not suffer from the same weaknesses
as banks in the high-income countries that were
the source of the crisis). Developing countries
may also benefit from a perception of increased
risk in high-income countries, both because
they were the center of the crisis and becauseof the rise in public debt from efforts to support
demand (see below).
However, the tightening of financial regulations in high-income countries will also havenegative consequences for finance in developing
countries. Tighter rules will also increase borrowing costs and reduce liquidity in developing
countries as compared with the boom period.
New regulations may affect the conditions underwhich foreign banks establish branch-bank activities in developing countries and may change
the nature and basis upon which trade finance isarranged. Finally, the structural changes in thehigh-income financial world may have implications for equity markets in developing countries
and the ability of companies in the developingworld to raise equity in the high-income world.
On balance, while tighter regulation willcontribute to a more stable international environment and promote sustainable growth,tighter regulation also is likely to reduce loans
to all high-risk borrowers, including governments and firms in developing countries.

80

Consequences for the role offoreign banks in developing-worldintermediation
The financial crisis could lead to lower foreign bank participation over the medium term
because stricter cross-country regulation andhigher capital requirements (or the need to build
up capital after the huge losses during the crisis)
will reduce not only banks’ ability and willingness to lend but also the attractiveness of foreign
operations. The implications for financial conditions, investment, and output in developing
countries extend beyond the direct impact that
reduced activity might have on international
capital flows. The reliance by foreign banks on
home-country deposits to fund lending implies a
net inflow of capital. However, loans by foreignbanks are also funded from domestic deposits
that do not involve net capital inflows. Moreover, the benefits of foreign bank participation
extend beyond the impact it might have on
credit creation and may include improved stability and economic efficiency.
A reduced presence of foreign banks could
impair growth and efficiency in developing
countries’ banking systems. In an appropriate
institutional environment, foreign banks tend
to generate additional competitive pressures,
which induce cost reductions and quality improvements in domestic banks; improve accounting, auditing, and rating institutions; andincrease pressures on governments to improve
the overall legal framework governing the financial system (Levine 1996). Except for Latin
America, where results are mixed, foreign banks
in developing countries generally tend to be
more efficient than domestic banks, and competition from foreign banks helps to improve theefficiency of domestically owned banks, as measured by reduced costs and spreads (Cull andMartinez Peria 2007).5 As a result, a reduced
foreign bank presence can be expected to raise
the cost of borrowing and lower the supply of financial intermediation, thereby reducing firms’
access to resources for investment.
A decline in foreign bank participation
could be less important for countries whereM E D I U M - T E R M

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Box 3.2 The impact of foreign bank participation
on stabilityIn general foreign bank participation tends to reduce
volatility in developing economies, depending on
individual country (or bank) circumstances. Foreignbanks are likely to be more diversified than domestic
banks. Partly reflecting the internal resources ofinternational banking organizations and their greater
access to capital markets, they tend to fund more of
their lending operations from deposits held abroad,and their lending operations tend to be less procyclicalthan domestic banks (Cetorelli and Goldberg 2009).
At the same time, foreign banks may import instability
as they reduce lending in response to shocks in theirhome countries. And foreign banks may reduce thefranchise value of domestic banks by cherry-picking
the top clients, thus forcing domestic banks into lowerreturn and riskier market segments (Hellman, Murdock,
and Stiglitz 2000). Thus the impact of foreign banks onstability is an empirical question.
The weight of evidence indicates that foreignbanks tend to be more stable lenders than domestic

barriers to competition—high bank concentration, rules that strictly limit banks’ activities, or excessive regulatory barriers to entry
and exit—are significant. In such circumstances, foreign bank entry may fail to exertcompetitive pressures on domestic banks. Indeed, research suggests that, faced with barriers to competition, high bank concentration,and profitability, foreign banks may invest
expressly to reap the rents available from thedistorted environment for financial intermediation. In these environments, reduced foreignbank participation would have limited implications for efficiency.
However, a lower foreign bank presence
could increase instability in developing-country
financial systems. Foreign banks tend to be lessdependent on domestic deposits and therefore
less affected by domestic economic instability than domestically owned banks (box 3.2).
That said, the effect of foreign banks on stability depends on the source of the shock: foreign banks may increase instability if they arebanks (Cull and Martinez Peria 2007). DemirgüçKunt, Huizinga, and Claessens (1998) find that
foreign bank participation reduces the likelihoodof a banking crisis. Martinez Peria, Powell, and
Vladkova-Hollar (2002) find that foreign bank lending is not significantly curtailed during crises, a viewsupported by case studies for Malaysia (Detragiacheand Gupta 2004), Argentina and Mexico (Goldberg,
Dages, and Kinney 2000), Latin America (Peek andRosengreen 2000), and 10 Central and Eastern European countries (De Haas and van Lelyveld 2006). In
studies of selected Latin American countries, Goldberg, Dages, and Kinney (2000) and Crystal, Dages,
and Goldberg (2002) show that credit growth in foreign banks that had a long history in the host country
was less volatile than in domestic banks. Arena,
Reinhart, and Vazquez (2007) find weak evidence
that foreign banks in 20 developing countries wereless sensitive to monetary conditions than domestically owned banks.

constrained by adverse conditions in their homecountries. This appears to be happening in
the current context, where huge bank losses inindustrial countries are reducing lending fromparent and other overseas affiliates of foreignowned banks in developing countries (Cetorelli
and Goldberg 2009).
Preliminary data indicate that between Juneand December 2008 lending by foreign-ownedbanks (at least those reporting to the Bank ofInternational Settlements, or BIS) fell by 13.6
percent, much more than the 4 percent decline
in total bank lending in developing economies (table 3.1).6 In some regions, however,foreign banks have been a source of stability.
In Latin America and the Caribbean lendingby foreign banks declined by less than total
lending, and in the Middle East and North
Africa (where foreign banks have a small shareof total claims) foreign bank claims rose more
rapidly than total bank claims. In the otherfour regions, however, claims by foreignowned banks fell considerably faster than did81

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2 0 1 0

Table 3.1 Credit growth by foreign banks
versus total credit growth, developing
countries(Percent)

RegionEast Asia and Pacific
Europe and Central Asia
Latin America and the
Caribbean
Middle East andNorth Africa
South Asia
Sub-Saharan Africa
All developing countries

Foreignbankclaims as
a % oftotal
claims,June 2008

Growthrate offoreign bankclaims,June–
December
2008

Growthrate oftotal bankclaims,June–
December
2008

3.8
30.6

3.6
12.2

4.2
8.8

27.3

19.9

21.4

9.7
10.2
26.1
14.4

11.7
7.7
15.1
13.6

5.0
2.4
6.5
4.0

Source: Bank for International Settlements and International
Financial Statistics.

total bank claims (or total bank claims actually rose, as in East Asia and the Pacific). The
more rapid decline in lending by foreign banks
is attributable not to just a few large countries
with substantial weight in the total. Of the 89
developing countries with complete data on
both foreign bank claims and total claims, foreign bank claims fell by more (or rose by less)than total claims in 59. Despite these declines,
as of December 2008 foreign bank claims remained 40 percent above the level in December 2006, so although foreign bank presence
has declined, that decline has yet to undo thesubstantial increase that preceded it during theboom period.
Trade credit is critical to sustaining theinternational trading system.7 In the acutephase of the financial crisis, a sharp decline
in the access of developing-country firms totrade finance exacerbated the decline in exports that reflected the fall in global demand(box 3.3). As the crisis intensified, the availability of trade finance tightened and its cost rose
for four main reasons: growing liquidity pressure in mature markets; a perception of heightened country and counterparty risks, resulting
in increased demand for letters of credit, insurance, and guarantees because exporters needed82

greater assurance that importers would pay
on schedule; market disruption caused whencritical market participants either collapsed(Lehman Brothers and others) or encountered
severe difficulties (many commercial banks);
and a drying up of the secondary market for
short-term exposure because of deleveraging
by banks and other financial institutions.
Insofar as the decline in trade finance represented a typical short-term crisis response,
exacerbated (compared to previous developing-country crises) by the breakdown offinancial systems in high-income countries,
trade finance should recover over the medium
term. However, the exact terms under which
it will recover and at what cost remain to be
determined (see the following section on borrowing costs). The extent of the recovery will
depend on the precise rules adopted for banking regulation. In particular, the Basel II Accord on banking laws and regulations does notdiscriminate among different forms of shortterm credits (maturities of a year or less) withrespect to maturity or risk profile. Thus a rigid
application of the Basel II rules would imply
that banks would have to allocate as muchcapital for trade finance as for other shortterm loans, even though trade finance often
has a relatively short maturity (perhaps a few
weeks) and is lower risk (because the goods
being financed serve as collateral) than manyother forms of short-term exposure.
Going forward, policy makers will need totake care that regulatory changes are sensitive
to the importance of credit to trade, and that
restrictions on the use of secondary markets
for securitized loans do not combine withblunt restrictions on country-specific loan exposure limits to restrict trade in a permanentmanner. To overcome this possibility, capitalrequirements for secured trade transactions
should be made less onerous than those on
unsecured loans. Until such time as Basel IIregulations are revised, national authorities
should take advantage of existing flexibility
that allows them to establish different categories of short-term credit with different reserve
requirements.

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Box 3.3 Survey evidence on the decline in tradefinance during the crisisSurvey data clearly indicate the deterioration indeveloping-country firms’ access to trade financeduring the financial crisis. In a World Bank survey of
60 global buyers and suppliers in early 2009, 30 percent attributed the postponement or cancellation offoreign sales to difficulties in obtaining trade finance(Shakya 2009). Another set of firm-level surveys undertaken in 2009 found that most firms, in particularsmall and medium-size enterprises and new firms,
have been affected by increased costs of trade financeand more stringent requirements, including guarantees, to obtain more trade finance (Malouche 2009).a
Higher down payments, more stringent collateral requirements, and higher interest rates have reduced access to preexport financing and become a particularly
important obstacle for exporters.
Banks have tightened counterparty bank criteria,
excluded certain banks and countries from lending
portfolios; demanded additional insurance and confirmation from banks; carried out more detailed due diligence to preselect counterparties; adopted additionalsafeguards to loans through guarantees and higher
confirmation fees; and taken more restrictive attitudes
toward new markets, new clients, and new products.

As a result, the cost of letters of credit was reported tohave doubled or tripled for buyers in emerging countries, including Argentina, Brazil, Bangladesh, China,
Pakistan, and Turkey (IMF/BAFT 2009).
By the end of 2008, trade finance deals were offered at 300–400 basis points over interbank refinance rates—two to three times more than the ratea year earlier. More than 70 percent of respondents
indicated that the price of various types of lettersof credit increased because of an increase in theirown institution’s cost of funds (80 percent ofrespondents), an increase in capital requirements(60 percent of respondents), or both. In the IMF/BAFT survey of global banks (IMF/BAFT 2009)71 percent of banks reported a decline in the valueof their letter-of-credit business, with an overall
8 percent decline in the first nine months of 2008
(compared with the same period in 2007), accelerating to 11 percent during the period October 2008 to
January 2009. While 73 percent of banks recognized
the role falling trade demand played in the decline intrade finance lines, more than half also attributed thetrade finance decline to a decline in available credit(that is, a decline in supply).

a. This survey covered 425 firms and 78 banks in 14 developing countries across Asia, Europe, Latin America, and Africa.

Higher cost and reduced access to trade finance have particularly affected firms that arehighly dependent on external finance, notably in several upper-middle-income countries
such as Brazil that have enjoyed relatively
easy access to international credit markets.
Also affected have been firms that are highly
integrated in global supply chains and marginally creditworthy firms such as small andmedium-size enterprises. By contrast, less affected firms may include those that are lessreliant on the banking system for trade finance (firms in a few low-income Africancountries, for example, that primarily rely on
self-financing or cash in advance) and firms ina few middle-income countries (such as South

Africa) where the banking system is comparatively insulated from the international financial market.

Impact of re-regulation on
developing-country equity markets
Tighter financial market regulation and therestructuring of investment banking activity in high-income countries, while reducing
the likelihood that these firms contribute tofinancial instability, also may reduce the supply of equity investment to firms in developing countries. This could directly affect thecapacity of innovative firms to expand or
start up new product lines. Weighted by value,83

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2 0 1 0Figure 3.1 Foreign participation in selected emerging equity markets(Portfolio equity inflows divided by stock market capitalization, percent)% of local stock market capitalization
50

2003

2007

45
40
35
30
25
20
15
10
5

M

Es

to
ni
a
ex
H ico
un
g
Th ary
ai
la
n
Tu d
ni
si
a
Ka Br
za az
kh il
st
a
Tu n
rk
e
Jo y
r
C
M dan
z
R ec alus h aysi
an Re sia
Fe pubde lic
ra
tio
n
Pe
r
Po u
In landd
So on
ut esi
a
h
Af
ric
a
L
Sl Ph atv
ov ilip ia
ak pi
R nes
ep
Ar ublge ic
n
Li tin
th a
ua
ni
a
In
Bu dialg
R ariaom
aPa niaki
stanC
M hile
or
oc
co
C
C hin
ol a
om
U bia
kr
ai
ne

0

Source: IMF.

approximately 86 percent of all developingcountry initial public offerings (IPOs) overthe past 10 years have been at least partiallyintermediated by American investment banks(accounting for 32 percent of the total numberof deals).8 Moreover, investment banks havebeen instrumental in the creation of mutual
funds9 and other instruments that have allowed individuals and regulated institutional
investors in high-income countries to include
firms in developing countries in their overall
portfolio of assets.
Comprehensive data on the contribution offoreigners to developing-country equity markets are not available. However, portfolio investment inflows as recorded in the balance of
payments accounted for as much as 40 percentof the market capitalization in some developing countries in 2007 (figure 3.1). Of course,
inflows of funds to purchase stocks may be balanced by outflows from the sale of stocks, so
the figure on inflows certainly overstates the
net new purchases of stocks by foreigners onthese markets. At the same time, the share ofstocks traded in any one year in many emerging
equity markets is low, so high levels of inflows

84

relative to total market capitalization may represent very high levels of inflows relative to themarket value of traded stocks. Despite theseweaknesses, the data in figure 3.1 do suggestthat in many markets foreign equity has played
an important role in financing firms’ activities.
The developmental impact of portfolio
equity inflows goes beyond the purely financial aspect of the transactions. Empiricalstudies tend to find a positive impact of net
portfolio equity flows on growth, both inmacroeconomic terms10 and in industry- andfirm-level data (Kose and others 2006).11 Foreign participation in equity markets increases
their overall liquidity, which improves their
attractiveness to other investors (because liquidity increases an investor’s ability to divest
in a timely manner) and encourages greater
investment in projects with a long time horizon, because individual investors can easily sell their holdings before the benefits are
realized.12 Moreover, well-developed equity
markets contribute to transparency, because
firms release information to attract capital,
a process that ultimately improves the efficiency with which investment is allocated.13

M E D I U M - T E R M

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The participation of globally savvy investors
can also improve the identification of projects
with global potential and lead to demonstration effects that might otherwise be missed.
Openness to external financial flows can spurequity market development by increasing liquidity and pressures for improvements in essential infrastructure.14

Impact on FDI
The sharp increase in global FDI flows before the financial crisis partly reflected a surge
in inexpensive debt financing: the value ofcross-border syndicated bank borrowing andinternational bond issuance for the purposeof acquisition (including both domestic andcross-border) rose to almost $1 trillion in 2007,
from $131 billion in 2003 (figure 3.2).15 In addition, almost 30 percent of global merger andacquisition (M&A) deals between 2003 and2008 were carried out by high-income investment banks, hedge funds, and other private
equity firms (UNCTAD 2009).
The tightening of financial conditions
may thus affect firms’ ability to finance FDI.
Similarly, changes in the legal status of these
institutions and the expected expansion ofregulation to encompass more of their activities could further depress developing-country
M&A deals. However, crises tend to affect
FDI to developing countries less than they affect debt flows (box 3.4), and the anticipated
30 percent fall in FDI flows in 2009 is wellFigure 3.2 Debt financing of M&A transactions, 1995–2008
US$, billions
1.8
1.6
Cross-border M&A

1.4
1.2
1.0
0.8
0.6
0.4

International
debt foracquisition

0.2
0
1995

1997

Source: World Bank.

1999

2001

2003

2005

2007

O F

T H E

C R I S I S

O NF I N A N C E

A N D

G R O W T H

below the 90 percent decline projected for net
private debt flows.
The 1990s offer some insight into how
the tighter financial environment could affect FDI. For example, during that period,banking sector difficulties in Japan translated
into a sharp decline in Japanese investmentsin the United States. A single downgrade incredit ratings of Japanese banks resulted in a
30 percent decline in the number of projects
initiated by Japanese investors in the UnitedStates (Klein and others 2002). And domestic financial markets and the availability ofcredit were found to be important factors
in explaining investment outflows throughcross-border M&As during the late 1990s(Di Giovanni 2005).
Despite their sensitivity to financial conditions, FDI inflows to developing countries areunlikely to be as constrained as debt flows
over the medium term. South-South FDI flows
may be more resilient than flows from highincome to developing countries, owing to thesignificant role of state-owned enterprises withsofter budget constraints, limited reliance ofSouthern multinationals on international debt
markets, and continued efforts (particularly
by China) to gain access to energy and minerals.16 In addition, tighter access to equity
and debt-creating credit for firms in marginally creditworthy developing countries may
increase their willingness to enter into FDIbased mergers and acquisitions. Overall, FDI
inflows to developing countries are expected
to be sharply lower than they were during theboom period when they reached just under 4
percent of developing-country GDP, although
they should recover to levels around 3 percent
of GDP, around the same levels observed during the preboom period.
The effect of lower FDI inflows on growthprospects for individual developing countries
will depend partly on the share of FDI in total
investment. While FDI represents less than
5 percent of total investment in some regions,in others, notably Europe and Central Asia,
Latin America, and Sub-Saharan Africa, it
can account for as much as 20 percent of all

85

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2 0 1 0Box 3.4 FDI and debt flows during crises

F

DI inflows tend to be less subject to sharp upswings and downswings during crises than debt
flows. For example, net private-source debt flows to
Latin America and the Caribbean fell from 5.7 percent of GDP the year before the onset of the 1980s
crisis to 1.6 percent the year after (and would havefallen by more if not for concerted lending), while
FDI flows only fell from 1 percent of GDP to 0.8

percent of GDP (box table 3.4.1). Net private debt
flows continued to be negative four years after thecrisis, while FDI remained stable. Similarly, during
the East Asian crisis net private debt flows to themost affected countries plummeted the year of thecrisis while FDI was little affected, in part becauseof the buying opportunities generated by the steep
exchange rate depreciations.

Box table 3.4.1 Net private-source debt flows versus FDI before and after crisis episodes(Percent of GDP)
Crisis  4

Crisis  3

Crisis  2

Crisis  1

CrisisCrisis  1

Crisis  2

Crisis  3

Crisis  4

Latin American 1980s crisis
Net private-source debt flows
FDI

4.50
0.75

5.39
0.89

5.57
0.87

5.67
1.01

3.88
0.85

1.63
0.76

0.24
0.60

0.38
0.79

0.57
0.61

East Asian crisis countriesa
Net private-source debt flows
FDI

1.91
1.05

3.52
1.27

3.16
1.49

0.56
1.68

4.23
2.34

2.78
2.22

1.99
1.33

1.35
0.72

0.70
0.94

Mexico pesos crisis
Net private-source debt flows
FDI

2.79
1.51

0.59
1.21

3.54
1.09

1.98
2.60

1.09
3.32

1.43
2.76

0.79
3.20

2.61
2.95

2.55
2.85

Argentina
Net private-source debt flows
FDI

5.89
3.13

3.57
2.44

1.07
8.46

1.11
3.67

5.83
0.81

10.26
2.11

0.42
1.27

1.49
2.69

9.91
2.87

Source: World Bank.
a. Indonesia, Republic of Korea, Malaysia, and Thailand.

86

Figure 3.3 FDI as a share of investment indeveloping countries, 1995−2008
Percent of fixed investment25

1995−99

2000−042005−08

20
15
10
5
0

de
v
co elo A
un pin ll
tri ges
an Easd tAPa s
E ci ia
C uro fic
en p
La
t e
tin ral an
A dth Am sia
e er
C ic
a a
M ribb an
iddl ean d
N eE
or a
th st
Af an
ric d
So a
ut
h
As
ia
Su
bSa
ha
Af ra
ric n
a

investment (figure 3.3). And in low-income
countries, FDI represents an even larger sharein total investment. In such countries, a 30 percent decline in FDI could represent as much asa 6 percent of GDP decline in investment unless domestic investment steps in to pick up theslack.
Of course not all FDI constitutes investment in the national accounting sense of anaddition to the productive capacity of a country, because much of what is recorded as FDI
in the balance of payments represents merger
and acquisition of already existing firms. Nevertheless, a significant portion of FDI flows
do represent both greenfield and brownfield extensions of productive capacity—apoint that is supported by the regression

Source: World Bank.

M E D I U M - T E R M

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analysis in chapter 2, which found that FDI
tended to have a greater impact than othercapital flows on investment rates in developing countries. Moreover, as described in the2008 edition of Global Economic Prospects(World Bank 2008), FDI can be an importantsource of technology transfer in the form ofcapital goods but also in the form of business processes, which can have large spillover
effects in developing countries.17 Finally, FDI
can provide the impetus for important regulatory and governance changes that can havespillover effects throughout the economy, reducing both the costs of doing business andthe effective cost of capital—thereby spurring
further investment (domestic and foreign).

Impact on private-source debt flows
The tighter financial environment expected in
the post-crisis period, while reducing volatility
in financial markets, is also likely to constrain
developing countries’ access to international
debt markets over the longer term as well as
in the short run (see chapter 1). The necessity
to rebuild banks’ capital and greater concern
over risky loans will reduce both cross-border
lending and foreign bank participation in developing countries. Restrictions on financial institutions’ ability to assume risk may also limit
developing-country borrowers’ ability to issue
bonds in international markets, as regulatory
strictures are extended to many of the institutions (such as hedge funds) that participate inthis market. Finally the elimination of some instruments may reduce the ability of some regulated institutional investors, notably public andprivate sector pension funds, from taking both
direct and indirect positions in some forms ofdeveloping-country debt.
However, some aspects of the reaction to
the crisis could moderate the decline in debt
flows to developing countries. For example, if
risk aversion among borrowers in high-income
countries increases and they decide to repay
rather than roll over debt (as happened during
Japan’s prolonged recession), room could befreed up for banks to lend to developing countries. Moreover, a more stable and transparent

O F

T H E

C R I S I S

O NF I N A N C E

A N D

G R O W T H

global financial system could encourage somelending to high-risk borrowers, which could
limit the decline in flows.
The restructuring of high-income countries’ financial systems and tighter constraints
on risk taking may also reduce interest in
project finance transactions, where the involvement of foreign institutions (such as
syndicated commercial banks, bond underwriters, firms involved in leasing equipment,
dedicated equity funds, and official export
credit agencies) has helped to ensure accessto international capital markets, to reduce
financing costs through innovative financing
techniques that tie debt service obligations
to the timing of expected project proceeds,
to tap extended debt maturities (consistent
with the extended time required for construction of many projects) that may not
be available in the domestic market, andto obtain expertise necessary to constructcomplex financial arrangements.18 Because
the lead arrangers of project finance transactions are largely financial institutions inindustrial countries, a smaller profile of foreigners could make it more difficult to arrange these complex financial transactions.
However, this constraint is unlikely to be toobinding. Institutions in developing countries
have begun to take a more significant rolein arranging project finance transactions.19
Moreover, even if regulatory constraints
limit industrial-country firms’ participationin project finance, they could still provide
financial expertise on a fee-for-service basis.
Countries that have relied heavily (in relative terms) on debt financing to meet theircurrent account obligations and finance investment may be most vulnerable to a change
in the extent to which such financing is forthcoming. Notwithstanding that developing
countries were net exporters of private capital during the boom period, among developing countries with current account deficits,
net debt inflows on average financed about
one-third of the overall deficit (table 3.2),
a ratio that rose to 90 percent in the caseof countries in Europe and Central Asia.

87

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2 0 1 0

Table 3.2 Contribution of privatesource debt inflows to external finance ofdeveloping countries with current accountdeficits, average 2003–07

Income category

All countries
Low income
Lower-middle income
Upper-middle income
Of which: Europe
and Central Asia

Number ofcountries
withcurrent
account
deficits

Current
account
deficit (%of GDP)

US$ billion

Share of GDP %Net debt
inflows
fromprivatesources(% of GDP)

600

300

2.0
1.5

6.3
5.8
6.1
7.1

2.2
0.8
0.8
5.3

8

8.5

8.1

100

Impact on macroeconomic
stability
A more closely regulated international financial sector—especially if provisions to reduce
the procyclical nature of prudential requirements are adopted—may help to reduce thevolatility of private debt flows. In addition to
the vertiginous drop in private debt flows during the current crisis, such flows also dropped
from almost 3 percent of developing-country
GDP just before the Latin American debt crisisin the 1980s to 1 percent of GDP in the depthof the crisis in 1983 (figure 3.4). Arguably
their rapid increase during the recent boom
period was a principle cause of the imbalancesthat arose in some countries, notably those in

3.5
3.0

% of GDP

400

53
16
20
17

Unsurprisingly, it is the upper-middle-income
countries (excluding minerals exporters) that
relied most on debt inflows from private
sources; such inflows financed three-quartersof their current account deficits, on average.
Of these countries, those in the Europe andCentral Asia region account for the largest
private-source debt inflows (averaging 8 percent of GDP); private-source debt inflows forthe other countries in this group averaged 2.5
percent of GDP.

4.0

500

200

Source: World Bank.
Note: Data on current account deficits and debt inflows are
simple averages of country numbers. Excludes small island
economies.

88

Figure 3.4 Net external debt flows fromprivate sources, 1980–2008

2.5

1.0

100

0.5
0

0
Net external debt flows
1980

1985

1990

1995

2000

0.5
2005

Source: World Bank.

developing Europe and Central Asia—where,
at least in ex post terms, the inflow of capital
exceeded these countries’ capacity to absorb
or manage it. More generally, debt-creatingflows tend to contribute to volatility in developing-country consumption rather thanfacilitating consumption smoothing, as might
be expected from a theoretical point of view
(Kose, Prasad, and Terrones 2005; Kose andothers 2006).20

Implications of a potential
developing-country retreat fromfinancial integration

Although the global liquidity expansion
in the early 2000s ushered in a lengthy
period of rapid and arguably sustainable expansion of the supply potential of most developing countries, the financial crisis broughtthat boom period to an end—generating asubstantial, sharp, and painful decelerationin economic activity throughout the developing world. The speed of the global downturnand the costs that it has imposed on countries
that otherwise had followed exemplary policies and whose own financial systems did not
engage in unsustainable practices has quiteM E D I U M - T E R M

I M P A C T S

naturally led many observers to question therelative benefits and costs of global financial
integration.
Policy and behavioral changes following
earlier crises suggest that this crisis may generate a number of important changes in thenature and behavior of financial markets indeveloping countries over the next 5 to 10
years. For example, countries and national
authorities can be expected to be much morecautious in the management of their reserves.
Following the Asian crisis of 1998, many
Asian economies placed a greater emphasis on
reserve accumulation as a self-insurance strategy against external instability. A more skeptical and slow approach to capital accountliberalization, or even a reversal of reforms
made to date, is also possible. Countries inboth Latin America and East Asia took such
steps following crises in their regions in the
1970s and 1990s. Finally, countries may
seek to reduce their vulnerability to externalfinance by developing their own domestic financial sectors or seeking to establish regional
financial mechanisms.

Reserves policies
Developing countries may decide to increase
their reserves to provide themselves some insurance against future fluctuations in global
financial conditions. An ample supply of international reserves can help countries compensate temporarily for a sudden reversal
in external capital flows, thereby avoiding a
sharper real-side adjustment than might otherwise be required. Large reserves can also
dissuade speculators from provoking a capital crisis by demonstrating the authorities’
capacity to prevent a disruptive adjustment.
Following the East-Asian crisis, oil-importing
countries in the region (excluding China) increased their reserves from an average ofabout 3 months worth of imports before thecrisis to more than 9 months worth in 2007.
In China the increase was even more marked,
from about 7 months worth of import coverin the pre-crisis period to almost 18 months

O F

T H E

C R I S I S

O NF I N A N C E

A N D

G R O W T H

Figure 3.5 The recent buildup in reserves
was concentrated in East Asia and among oil
exporters
Months of import cover
16
14
12
10
8
6
4
2
0
1990 1992 1994 1996 1998 2000 2002 2004 2006
Oil exporters

Middle East andNorth Africa

East Asia andPacific

Latin America andthe Caribbean

East Asia and Pacificexcept China
Sub-Saharan Africa

Europe andCentral Asia
South Asia

Source: International Finance Statistics, IMF.

in 2007. Other developing countries also increased reserves during this period but to alesser extent (figure 3.5).
In some of these countries, a desire to have alarger cushion against a financial reversal was
one motivation for increasing reserves (Jeanne2007). Issues of sound macroeconomic management also played an important role inreserve increases in many countries. Sharp increases in capital inflows (see chapter 2) andvery strong commodity revenues during theboom period may have exceeded the domestic
economy’s capacity to invest productively. Insuch cases, a sterilized accumulation of excess
capital inflows may have been the main reason
for reserve accumulation.
Although the existence of high reserves
might prevent a run on a country’s currency,
the extent to which reserves actually helped
lessen the real-side impact of this crisis is
not clear. In fact, although accumulation ofreserves stopped at the peak of the crisis,
relatively few countries actually used theirreserves to smooth adjustment. Thus, whiledeveloping-country reserves fell from $3.7
trillion in December 2007 to $2.2 trillion in89

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2 0 1 0December 2008 (in part owing to the appreciation of the dollar), the precipitous fall inimports meant that import-cover ratios actually rose.
Moreover, countries with large reserves
suffered downturns almost as severe as did
countries with small reserves. The correlationof the slowdown in GDP growth in 2008 withratios of reserves to imports in 2007 is only
0.15, which is not significantly different fromzero at the 5 percent level.21 Reserves levels
also played no role in supporting exchange
rates: the correlation between reserves to imports and the change in exchange rates during
2008 is 0.04 (the same result is obtained if
one excludes countries in Europe and Central
Asia, which suffered very large exchange ratechanges). Finally, there is little relationshipbetween reserves levels and output declines,
even if one controls for other determinantsof the impact of the crisis on growth, including trade and financial openness, exposure
to falling commodity prices, initial current
account imbalances, and other financial vulnerabilities (Blanchard, Faruqee, and Klyuev2009). At least in the case of a generalized financial crisis, very high reserve levels appear
to make little contribution to easing real-side
adjustment.
Significant costs are associated with maintaining higher reserves. Most reserves are heldin the form of low-yield securities that areissued by high-income-country governments. To accumulate foreign currency reserves, central banks must issue debt in local
currencies—usually at much higher interest
rates than can be earned on the foreign currency being purchased, with the difference
between the two (after exchange rate movements) having to be paid by the treasury. The
cost of holding reserves can be disaggregatedinto the forgone return from alternative uses,
typically increasing public investment or reducing debt; minus the financial return on
reserves and lower spreads on foreign debt
if higher reserves improve creditworthiness;plus the current cost of past sterilizations.22
During the 1990s when reserves averaged

90

about 8 percent of GDP, most developing
countries enjoyed a net benefit from reserves(Hauner 2005). By 2004, however, with reserves equal to 19 percent of GDP on average,
most developing-country groups were losing
money—as much as 0.2 percent of GDP in the
Middle East and Central Asia, and 0.6 percent
of GDP in Sub-Saharan Africa and emerging
Europe. And the cost must have increased substantially by 2007, when reserves represented
26 percent of developing-country GDP.23
Jeanne (2007) estimates the annual cost ofreserves holdings for 20 emerging markets at
about 1 percent of GDP over 2000–2005, andRodrik (2006) obtains roughly the same resultfor developing countries.
Exchange rate movements represent a further
potential cost for developing countries thatreact to the financial crisis by increasing theirreserve holdings. As of the second quarter of2009, the U.S. dollar accounted for 63 percentof the known composition of official international reserves,24 with the euro representing
27 percent, and other smaller currencies andspecial drawing rights the remainder. Largecurrency swings in exchange rates can be extremely expensive for countries with extensive
reserves. For example, if developing countries
in East and South Asia hold the same proportion of reserves in dollars as the global average, a not unusual 20 percent decline in thedollar would reduce the value of their international reserves by approximately 10 percent of
their GDP.

Capital account restrictions
The financial crisis may also cause countries
to reconsider plans or recent moves to liberalize their capital accounts. As discussed inchapters 1 and 2, the abrupt reversal of international capital flows at the onset of thecrisis caused not only local equity markets tocrash (losing as much as 50 percent of theirvalue in days) but also virtually every nonpegged currency in the world to depreciate by
between 10 and 30 percent against the dollar. Imposing some sort of capital controls
might have prevented or at least moderated

M E D I U M - T E R M

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the pace of the outflows, reducing the domestic disruption and wealth loss that ensued.
Of course, tighter controls, had they been inplace, might well have reduced the benefits
that countries enjoyed from the boom period(see chapter 2).
The empirical evidence on the effectiveness of these controls is mixed. Controls have
had little success in reducing capital outflows(except in Malaysia during the East Asian crisis), although controls on inflows have hadsome effect in increasing the independence ofmonetary policy (Magud and Reinhart 2006).
Moreover, with the exception of a few countries with unsustainable current account positions, large capital outflows do not appear tohave been a major cause of financial distressduring the current crisis. Indeed, developing countries reduced their deposits in BISreporting banks by about $260 billion (adjusted for exchange rate changes) during thelast quarter of 2008—suggesting a repatriation of capital rather than flight.25 Nevertheless, developing-country policy makers may
take a more skeptical stance toward large external debt inflows during booming economic
conditions and toward allowing domestic
banks and firms to take speculative positions
in foreign currencies.
Indeed, one of the effects of the Asian crisis was to slow the pace of capital accountliberalization. Following that crisis, some of
the most affected countries tightened restrictions on capital account transactions. The
Chinn-Ito index of capital account liberalization declined in Malaysia and Indonesia
following the crisis, and the pace of improvement in Thailand and the Philippines slowedmarkedly. More generally, even countries notdirectly involved in that crisis slowed or reversed the pace of liberalization (figure 3.6).
While the pace of liberalization eased for
middle-income countries in the middle 2000s,
it came to an almost standstill among lowincome countries.26
How a tightening of restrictions on capital
account transactions would affect growth andstability in individual developing countries will

O F

T H E

C R I S I S

O NF I N A N C E

A N D

G R O W T H

Figure 3.6 Developing countries’ average
financial openness, 1990–2006
Index
0.8
0.6
0.4
0.2
0
–0.2
–0.4
–0.6
–0.8
–1.0
–1.2

Middle-income

Developing countries

Low-income
1990 1992 1994 1996 1998 2000 2002 2004 2006

Source: Chinn and Ito 2007.
Note: Simple average of countries in each group. Excludes all
countries that have missing data within time period, as well as
economies with population of less than 1 million.

depend on the type of restrictions introduced,
the international economic environment, investors’ views on economic prospects for thecountry, and the quality of macroeconomic
policy and institutions. In general, evidence
tying economic growth or real-side investment to capital account openness is weak bothbecause of technical reasons surrounding estimation methods and because of complex interactions that make generalizations difficult(box 3.5). Some studies point to beneficial
effects from increased competition and better
economic policies, while others focus on theincreased instability that can accompany capital account openness, particularly with rapid
liberalization in a context of weak domestic
institutions.

Increased reliance on domestic andregional financial arrangements
A weaker international financial system willalmost certainly result in a movement toward
increased reliance on domestic and regionalsources of capital. Indeed, a weaker international intermediation system will increase reliance on other sources of intermediation, even
if the domestic or regional markets do not
grow in size. However, the reduced competitive pressure from abroad can be expected toincrease the potential private economic return91

G L O B A L

E C O N O M I C

Box 3.5

P R O S P E C T S

2 0 1 0The debate over capital account liberalization

M

aintaining an open capital account can contribute to increasing financial depth, and hence
spur development, but mostly in industrial countries
and developing counties with high institutional quality (Klein and Olivei 2008). Open capital accounts
can strengthen domestic financial systems by promoting competition and economic policies throughmarket discipline (Kaminsky and Schmukler 2002),
as well as improve returns and diversification fordeveloping country residents’ savings. Despite these
theoretical benefits, empirical studies of the relationship between capital account openness and growth
have shown decidedly weak results.a
Several reasons are offered for the limited empirical support for the theoretical benefits of capital
account openness. The efficiency effects can be hardto measure and thus may not be detected by panel
regressions (Kose and others 2006). It is difficult todefine exactly how open economies are to capital
account transactions, given the myriad forms of controls that are possible and their varied effectiveness.
These benefits provide only a temporary, but not
permanent, impact on growth, so the effect may not
be found in cross-section analyses (Henry 2007). The
endogeneity of financial integration with respect togrowth also can complicate measurements of the relationship of the two. The benefits of capital accountopenness may be greater in environments with strong
policies and institutions (for example, external competition may strengthen sound financial intermediaries, but destroy weaker ones). However, it is difficult

to define the quality of institutions, or how “strong”
they would need to be to benefit from capital accountliberalization.b
Capital account openness may also promote
instability. The East Asian crisis of 1997–98 andsubsequent episodes increased concerns over the
potential for open capital accounts to raise instability. Calvo (1996) emphasizes the risk that investors’
herd behavior leads to excessive volatility in crossborder capital flows, and Furman and Stiglitz (1998)
emphasize the important role that contagion playedin exacerbating capital flight from open financial systems during the East Asian crisis. Some cross-country
empirical tests find little evidence that open capital
accounts increase the incidence of crises (Glick andHutchison 2001; Edwards 2005), while others findthat capital controls help insulate countries from thenegative impact of widespread financial instability
on growth (Eichengreen and Leblang 2002) and that
capital account liberalization increases output volatility in less financially developed economies, but not in
more developed economies (Mukerji 2008).
Whatever the average relationship between capital
account liberalization and crises, or between liberalization and long-term growth, crises are traumaticand costly, both in terms of welfare and politicians’
careers. It is fair to say that the economic literaturedoes not provide a convincing argument that thewelfare benefits of liberalization are extremely large,or that the risks of crises are extremely small, indeveloping-country environments.

a. Kose and others (2006) summarize the results of 25 empirical studies, in which the majority find that international financial integration
has either no effect on growth in developing countries or mixed effects
depending on model specifications.

b. Kose, Prasad, and Taylor (2009) define threshold levels of financial
development, openness to trade, institutional quality, and macroeconomic stability that make it possible to realize the benefits of financial
openness, while recognizing that some of these threshold levels haverelatively wide confidence intervals.

from these activities and from public incentives
to strengthen the surrounding infrastructure—including the domestic and regional competitive environment. As a result, domestic andregional financial intermediation may well expand compared with a no-change scenario.
The severity of the financial crisis and its
transmission through global capital markets
is likely to turn policy makers’ interest toward

92

regional cooperation in an effort to buffer
shocks originating in high-income countries.
Indeed, in the period following the financial
crises in both Latin America and East Asia,
there was a concerted effort to build regionaland domestic institutions that could complement or even replace international financial
institutions and thus reduce reliance on what
was perceived to be an excessively volatileM E D I U M - T E R M

I M P A C T S

source of intermediation services. Among these
efforts were the pooling of financial resources
and reserves (for example, currency swaps
under the Asian Chiang Mai Initiative and theLatin American Reserve Fund), initiatives topromote or create a new reserve currency, andthe closer integration of local financial markets. The latter included the harmonization ofbond market standards and conventions across
ASEAN (Association of Southeast Asian
Nations) countries (Miyachi 2007) and theManila Framework to monitor domestic
policies, to provide technical assistance forstrengthening domestic financial sectors, andto establish cooperative arrangements to stabilize Asian currencies (Jeon 2002).
To the extent that efforts to promote regionally based intermediation solutions are
successful—and assuming that regional investors understand better than international
investors the differences across countries
within regions—regional capital markets
should help reduce domestic borrowing costs,
both by reducing transaction costs27 and by
reducing risk, notably by lowering the likelihood of contagion (when investors withdraw from countries based on problems inother countries that are perceived to sharesimilar features) affecting all countries in aregion when one runs into fundamental difficulties. Regional financial integration could
also support regional trade integration; help
reap the benefits of scale economies achievable through the amalgamation of regional

Table 3.3

O F

T H E

C R I S I S

O NF I N A N C E

A N D

G R O W T H

exchanges, along with attendant standardization of requirements and regulatory cooperation; and improve coordination of fiscal andmonetary policies among closely linked regional economies.
To what extent these potential benefits canbe realized is uncertain. In countries or regionswith strong domestic institutions and intermediation, greater reliance on domestic andregional intermediation may have long-run
positive effects. In others, where local institutions are weak, the absence of a foreign option
may reduce investors’ overall access to savings
and reduce competitive forces that serve tokeep borrowing costs low.
Because of a poor legal and institutionalframework for the financial sector or limited financial sector development, many domestic (and regional) financial systems arepoorly prepared to substitute for foreign financial services. As discussed in chapter 2,
domestic intermediation in much of the developing world remains low; equity markets,
although growing, are thinly traded and dispersed; and significant domestic debt markets
are restricted to just a few countries (WorldBank 2006). Sub-Saharan Africa, for example, has the weakest domestic frameworkfor financial intermediation—the worst levels of corruption, poorest legal framework,
lowest regulatory quality, largest levels ofcapital flight, and smallest banking sectorsof the developing regions (table 3.3). The
development of regional equity markets in

Indicators of the quality of domestic financial systems

RegionEast Asia and Pacific
Europe and Central Asia
Latin America and Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa
High-income countries

Control ofcorruption

Rule of law

Regulatory
quality

Liquid liabilities
as a % of GDP

Private credit
as a % of GDP

Offshoredeposits as a
% of domesticbank deposits

0.6
0.3
0.4
0.3
0.6
0.6
1.5

0.4
0.3
0.6
0.2
0.4
0.6
1.4

0.1
0.2
0.1
0.2
0.5
0.5
1.4

70.3
42.7
38.2
76.3
56.9
27.3
94.8

54.1
36.9
32.5
45.5
36.0
21.4
122.9

4.5
6.5
60.2
13.7
4.7
82.1
13.4

Source: World Bank databases: Governance Matters and Financial Institutions and Structure.
Note: Values for the first three indicators range from 2.5 to 2.5, with higher values indicating better performance.

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2 0 1 0Sub-Saharan Africa could boost liquidity andreap economies of scale in the provision ofservices and supervision, particularly if theweaker economies can integrate with moredeveloped regional financial markets (such as
South Africa). However, pursuing integration
among the poorest African countries withweak institutions could simply create a large,
illiquid, and poorly functioning market. Thus
it is important for these countries to reachout beyond the region to the international investment community.
In any event, increasing regional cooperation and integration will require time.
For example, progress on the pooling of international reserves in Asia has been slow,
although in May 2008 the ASEAN  3 ministers reached agreement to set up the poolwith $120 billion in reserves by the end of
this year.28 Regional integration of Asianbond markets appears to have slowed since
2002, at least as shown by the correlationof returns across countries (Fung, Tam, andWoo 2008). Low levels of liquidity and insufficient administrative expertise have limited steps toward integration in Sub-SaharanAfrica. The Caribbean Community has failed
to implement its commitment to a monetary union (Ocampo 2006). While several
regional financial institutions have emergedin the Arab world, these have largely been
devoted to the provision of aid to low-income countries (Corm 2006). And even thecreation of procedures to enhance macroeconomic dialogue in Latin America has madeonly limited progress (Machinea and Rozenwurcel 2006).

The impact of higher borrowing
costs

T

he preceding discussion suggests that overthe medium term the supply of both domestic and international finance could be significantly lower (relative to economic activity)
than it was during the pre-crisis boom period.
With a reduced supply of credit, borrowing

94

costs and the premiums associated with agiven level of risk can be expected to rise. In
addition, the discrediting, disappearance, or
reduced scope for many of the financial instruments that contributed to the credit boom (seechapter 2), as well as the large losses sustainedby investors throughout the world, are likely
to reduce demand for speculative financial instruments going forward. As a result, banks,
firms, and individuals can be expected tocarry less leverage, reduce their exposure to
currency and maturity mismatches, and takegreater care in evaluating counterparty risk.
A sharp increase in risk aversion on the partof investors was apparent in the immediatewake of the crisis, and the spread on riskier
assets such as corporate bonds and equities
spiked sharply in both high-income and developing countries—as did the premium requiredof developing-country sovereign borrowers.
Since then, borrowing costs in high-income
countries have been suppressed by monetaryand fiscal actions, notably the efforts by the
U.S. Federal Reserve to keep securitized mortgage markets liquid and to make direct purchases of corporate bonds. Risk premiums on
many assets have declined as the crisis has stabilized. The fall in risk premiums partly reflects
the very loose monetary conditions in highincome countries, which have lowered yields
there and prompted the kind of search for yield
behavior that characterized the boom period itself. Developing-country risk premiums appear
to have reached new “normal” levels that areabout 150 basis points higher than during theboom period. Some further moderation may bepossible, but this tendency will be counteredas today’s loose conditions tighten, and highincome-country yields rise. Assuming past relations continue to hold, developing-country risk
premiums can be expected to rise with them.
The remainder of this section suggests thatthe balance of these competing forces will
likely cause borrowing costs in developing
countries to be higher than during the boom
period, and it explores the implications that
increase may have for investment and growthin these countries.

M E D I U M - T E R M

I M P A C T S

Weaker financial intermediationand increased risk aversion in highincome countries
Changes in risk management techniques, low
short-term interest rates (which reduce the costof financing a given level of risk and tend, atleast temporarily, to reduce the likelihood of
default), and an increasingly held but ultimately
misplaced view that overall risk had declined
contributed to a significant decline in the priceof risk worldwide during the early 2000s. As
a result, interest rates and spreads on a wide
range of riskier assets in both developed and developing countries fell sharply (see discussion inchapter 2, including figures 2.5 and 2.6).
Econometric work first undertaken by theOrganization for Economic Co-operation andDevelopment (OECD 2004; Sløk and Kennedy2005) demonstrated that as much as 82 percent of the decline in risk premiums during thefirst half of the 2000s for a wide range of assets(high-income investment grade and below-investment grade corporate bonds, equities, anddeveloping-country sovereign and corporate
bonds) could be explained by a single common
factor, which the authors termed a synthetic
price of risk (box 3.6).
This synthetic-price-of-risk measure, which
continues to be updated by the OECD (2009),
is used to monitor financial conditions in highincome markets. It suggests that the cost of aBox 3.6

T

O F

T H E

C R I S I S

O NF I N A N C E

A N D

G R O W T H

Figure 3.7 The global synthetic price of risk
versus the portion explained by economic
fundamentals
Synthetic price of risk
6
5
4
Risk measure
3
2
1
0
⫺1
⫺2
Jan.
1998

Predicted risk
measure
Jan.
2000

Jan.
2002

Jan.
2004

Jan.
2006

Jan.
2008

Jan.
2010

Source: Kennedy and Palerm forthcoming.

given level of risk in high-income countries
declined sharply between 2002 and late 2003
and remained depressed straight through to
mid-2007 before it spiked with the onset ofthe financial crisis (figure 3.7).
Since then, the price of risk has declined; anupdate of the measure commissioned for thisstudy (Kennedy and Palerm forthcoming) put
it at about 0.2 points in September 2009, or
about 1 point (a full standard deviation) higher
than its average rate during the boom period.

The synthetic price of risk

he synthetic price of risk was calculated as thefirst principal component computed from a setof returns on corporate bonds (high grade and highyield) for the United States and the Euro Area versus their respective government bonds, the implied
risk on equities for each economy, and the global
EMBI (Emerging Markets Bond Index Plus) spread(versus U.S. Treasury bonds). This synthetic priceof risk is a purely statistical measure of the cost of

risk.a which is constructed to have mean zero andstandard deviation one. Thus an increase in thismeasure of 1 unit does not represent a 100 basis
point increase in risk premiums. One goal in constructing this statistical measure is to explore howmuch of the change in the price of risk can be explained by economic fundamentals, and how much
may result from changes in investors’ appetite forrisk.

a. The first principal component is a statistical technique that analyzes the covariance of a group of data series by decomposing theseries into orthogonal subgroups composed of weighted averages of the original series. The first principal component is the index of
the weighting scheme that explains the largest share of the overall variance of the series being examined.

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G L O B A L

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2 0 1 0

Despite being a purely statistical construct,
the OECD’s synthetic-price-of-risk measurecan be modeled as a function of fundamental
economic factors, including real policy interest
rates in the United States and the Euro Area, theoutlook for the cyclical position of the OECD(measured as the 12-month rate of change in
the OECD’s leading economic indicators);
and global bond default rates. In normal times
changes in these economic determinants do areasonable job of explaining changes in thesynthetic-price-of-risk measure. However, they
were unable to explain much of the fall in thesynthetic risk premium during the early 2000s.
The difference has been attributed to reduced
risk aversion among investors stemming fromfinancial innovations and “animal spirits” during this period (Sløk and Kennedy 2005). Fundamentals only explain about half of the increasein the synthetic price of risk in the immediate
post-crisis period, with the remainder explainedby an increase in risk aversion.29 Similarly, theanalysis of Kennedy and Palerm (forthcoming) suggests that—through September 2009—
the global price of risk fell further than was
warranted by fundamentals.

The influence of the global priceof risk
Kennedy and Palerm (forthcoming) extend theearlier OECD work by linking changes in the
global price of risk to changes in the risk premiums of specific developing countries.30 Theyshow that much of the increase in developingcountry risk premiums during the postcrisis period can be explained by this updated
synthetic-price-of-risk measure. Simple correlations indicate that for a sample of 17 developing countries, between 10 and 80 percent of
the changes in these countries’ risk premiums
between 1998 and 2008 can be explained byfluctuations in the OECD’s synthetic-price-ofrisk measure, with 40 percent or more of thevariation explained in half of the countries inthe sample. A more comprehensive modelingof country-specific factors (including foreign
indebtedness, macroeconomic stability, political risk, and economic growth) explains more

96

than 45 percent of the changes in countryspecific risk premiums over the period January
2002 to April 2009.
Although changes in these country-specificfactors contributed to the rise in countryspecific interest-rate spreads, by far the largest source of the rise resulted from the moregeneralized repricing of risk: the increase in
the synthetic price of risk explains 75 percent
or more of the rise in interest-rate spreads between July 2007 and December 2008 for all
but two of the developing countries in thesample (Kennedy and Palerm forthcoming).31
The estimated relationship between
developing-country risk premiums and theglobal-price-of-risk measure suggests that when
global conditions tighten, developing-country
risk premiums tend to rise faster than risk premiums in high-income countries. Among themain determinants of the global price of risk
are monetary and fiscal conditions. The OECDestimates that an increase of 100 basis points
in policy interest rates in high-income countries will result in a 0.41 increase in the globalprice-of-risk measure. Combining this with theresults for developing countries, a 100 basis
point increase in the base interest rate would
increase the risk premiums of countries withgood credit histories by a further 11.1 basis
points and of countries with less good recordsby an additional 57 basis points. These results
are somewhat higher than the estimates derived
by Dailami, Masson, and Padou (2008) in aslightly different context.32

Medium-term developing-country
interest rates
The rapid decline in the synthetic-cost-ofrisk measure and in developing-country risk
premiums since they peaked in early 2009
has reduced borrowing costs substantially.
However, as monetary policy in high-income
countries tightens from its currently very loose
state, interest rates and interest premiums canbe expected to rise. To what extent they increase in the long run is uncertain.
Several factors point to higher borrowing
costs for developing countries in the future.

M E D I U M - T E R M

I M P A C T S

Figure 3.8 Yields on selected U.S. government
securities
Yields, %
9

O F

T H E

A N D

G R O W T H

High-income countries

100

6

80

5

Middle-income countries

60

4
3

F I N A N C E

120
10-year government bond

7

O N

Figure 3.9 Government debt is projected torise in high-income, but not developing,countries
Percent of GDP

1-year T-bill

8

C R I S I S

40

3-month T-bill

2

20

1

Low-income countries02005 2006 2007 2008 2009 2010 2011 2012 2013 2014

0Jan. 1
1995

Jan. 1
1997

Jan. 1
1999

Jan. 1
2001

Jan. 1
2003

Jan. 1
2005

Jan. 1
2007

Jan. 1
2009
Source: IMF.

Source: Datastream.

• The global price of risk is currently suppressed by very loose monetary policy
conditions (see figure 3.7).
• Base rates used to calculate developingcountry borrowing rates are also low
because of post-crisis flight to quality(figure 3.8), and this effect can be expected to dissipate over time.
• Base rates are likely to rise further
because of the sharp increase in highincome countries’ government debt,
from under 80 percent of GDP in 2007
to perhaps as much as 109 percent of
GDP by 2014 (figure 3.9). Reducing
these debt levels will take some time;and as long as they and deficits remain
high, so too will governments’ demand
for funds to cover interest payments.
Moreover, high debt levels will increase
investors’ concern over the sustainability of fiscal policy, which also will tend
to increase base interest rates.
At the same time, several factors suggestthat developing-country borrowing costs may
not rise as much as otherwise might have been
expected.
• Improved regulation, by increasingtransparency, may lower the uncertainty
surrounding investment instruments byenough to lower risk premiums by morethan the increased costs the regulations
impose, resulting in a net reduction inborrowing costs.
• Increased indebtedness in high-income
countries is likely to raise their borrowing costs and developing-country baserates, but it also may result in lower
interest rate premiums for developing
countries. Developing countries’ government debt is not expected to increase
as much as in high-income countries,
largely because of a limited access tofinance (see chapter 1). As a result, relative to high-income-country debt, theinherent riskiness of developing-country
debt may decline, along with their risk
premiums, although probably not by
as much as they rise in high-income
countries. Overall, developing-country
borrowing costs would still be higher
but the relative attractiveness of investments in developing countries would beenhanced, and they could be expected
to attract a larger share of a reduced
quantity of total lending (see McKibbin
and Stoeckel 2009 for a modeling of thiseffect in a slightly different context).
In the modeling work that follows, neither
the negative nor positive implications of these97

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P R O S P E C T S

Table 3.4

2 0 1 0

Historical and prospective costs of capital for developing countries

Costs

Base
rate

Real baserate (deflated
by coreinflation)

Real
FederalFunds rate
(deflatedby coreinflation)

East
Asia
and
Pacific

EuropeandCentralAsia

Latin
Americaand
Caribbean(Percent)
Interest rates and spreads
Average 1995–2003
Average 2004–May 2007
Level in August 2008
Current (Oct. 2009)
Consistent with long-term priceof risk

5.8
4.5
3.9
3.0

2.7
2.4
1.4
1.6

MiddleEast andNorth
AfricaSouth
Asia

SubSaharanAfrica(Basis points)

2.0
0.1
3.3
0.4

274
224
286
304

1135
196
273
412

802
384
350
362

434
351
474
419

276
215
287
286

832
289
301
408

2.0

318

523

478

496

363

470

2.0
0.1
3.3
0.4

12.4
11.7
11.2
11.7

21.1
11.4
11.1
12.7

17.7
13.3
11.9
12.3

14.0
13.0
13.1
12.8

12.5
11.6
11.2
11.5

18.0
12.3
11.4
12.7

Cost of capital(Percent)

Average 1995–2003
Average 2004–May 2007
Level in August 2008
Current (Oct 2009)

9.7
9.4
8.4
8.6

Spreads constant at October 2009 level
U.S. base rate at avg 04-07H1 level
U.S. base rate at avg 95-03 level

9.4
9.7

12.5
12.7

13.6
13.8

13.1
13.3

13.6
13.9

12.3
11.9

13.5
12.6

Spreads at level consistent with average price of risk
U.S. base rate at avg 04-07H1 level
9.4
U.S. base rate at avg 95-03 level
9.7

12.6
12.9

14.7
14.9

14.2
14.5

14.4
14.7

13.1
13.3

14.1
15.4

Source: World Bank.

factors on borrowing costs are taken into account explicitly. Rather, a range of estimatesfor future borrowing costs is presented, based
upon different historical “norms” for real baseinterest rates and recent relationships between
developing-country spreads and the price of
global risk.
The top panel of table 3.4 reports historical real interest rates and interest rate spreads
for selected developing-country regions. During the boom period 2004–May 2007 the real
yields on long-term U.S. treasury bills were
30 basis points lower than during the previous nine-year period. Spreads on developingcountry debt were about 370 basis points
lower, implying that during the pre-crisis period, borrowers coming to international markets were paying some 400 basis points lessfor U.S. dollar loans than in the precedingnine-year period. As of early October 2009,
risk premiums remain on average about 110
basis points higher than they were during the98

pre-crisis period, notwithstanding significant
declines from their peak levels during the mostacute phase of the crisis.
As discussed in chapter 2, the widespread
fall in borrowing costs before the crisis was
associated with an investment boom and a significant increase in capital-to-output ratios indeveloping countries (figure 3.10). Many factors, including the tax regime, inflation, therate of depreciation of the asset in question,and other regulatory features that impinge on
profitability (Jorgenson 1963; Lau 2000) go
into determining the cost of capital in a given
country (or firm for that matter); however,most of these factors are relatively constantover time, and there is very limited information on their appropriate values at the country
level. As a result, the second panel of table 3.4
converts the historical interest rates and interest rate spreads of the first panel into estimates
for the cost of capital based on very strong
simplifying assumptions. Specifically, the cost

M E D I U M - T E R M

I M P A C T S

Figure 3.10 Falling capital costs werereflected in rising capital-output ratios
Change in capital-output ratio (2000–08), % of GDP
20

15

10

5

0

an (ex D
d ce ev
C p e
en t E lo
tra u pinl A rop gsi e
a)an Easd tA
Pa san
d La cif ia
th tin ic
e
C Am
ar e
ib ri
M
be ca
id
an
dl
N eE
or as
th t
Af an
ric d
a
So
ut
h
As
ia
Su
bSa
h
Af araric na–5

Source: World Bank.

of capital at the country level is defined as thereal dollar borrowing cost (deflated by core
inflation from the U.S. consumer price index)
plus depreciation, which is assumed to be
7 percent throughout the developing world.33
In addition to abstracting away from manyof the determinants of the cost of capital,
this definition also assumes that developingcountry borrowers (both domestic and external) pay the U.S. Treasury-bill rate plus the interest rate spread. In reality, formal domestic
interest rates tend to be higher, and informal
borrowing rates significantly higher still.
Table 3.5 calculates the change in the costof capital by region between the boom period
and three alternative futures. The first assumes
Table 3.5
costs

O F

T H E

C R I S I S

O NF I N A N C E

A N D

G R O W T H

that spreads remain at their current levels butthat real base rates in the United States returnto their pre-boom-period levels. In the second
scenario, the same assumption about baserates is applied but spreads are assumed to risein response to a return to the levels consistent
with the long-term price of global risk. And
the final scenario builds on the previous two
by assuming that U.S. base rates rise by a further 100 basis points above their pre-crisis average levels, reflecting the potential impact ofhigher high-income-country debt and tighter
regulations.
In the first scenario, the cost of capitalrises a great deal in some regions (notably by
as much as 240 basis points in Europe andCentral Asia), while in others it changes relatively little. In the second scenario, interest
rate spreads rise from current levels to levels
consistent with fundamentals. This implies afurther capital cost increase of 50–100 basis
points in every region other than East Asiaand the Pacific. In the final scenario, the cost
increases are augmented by a 100-basis-point
increase in the base interest rate—assumed
to be caused by concerns about debt servicing, long-term inflation, and the influence oftighter regulation raising the cost of capital in
high-income countries.

Implications of higher borrowing
costs for growth and potential GDP
in the medium term
Economic theory suggests that higher capitalcosts would cause the desired capital-output

Possible impact of tighter financial conditions on developing-country capital

Alternative scenarios

Real baserate

East Asia
andPacific

Europe andCentralAsia

Latin
America andCaribbean

Middle Eastand North
AfricaSouth
Asia

SubSaharanAfricaChange in cost of capital compared to the boom period (percentage points)

Spreads contant at today’s level
Spreads consistent with long-term average
price of risk
Higher base rates and spreads consistent
with long-term price of risk

0.3

1.1

2.4

0.0

0.9

0.3

0.3

0.3

1.2

3.5

1.2

1.7

1.7

2.1

1.3

2.2

4.5

2.2

2.7

2.7

3.1

Source: World Bank.

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2 0 1 0Box 3.7 Higher borrowing costs will constrain
domestic and external financeT

he expected rise in risk aversion and in the costof capital will likely slow, possibly even reduce,
the gains in domestic intermediation that the low interest rates of the boom period facilitated (see chapter 2). Already, the sudden increase in borrowing
costs and increased risk aversion that followed thecrisis have cut into lending (and borrowing) throughout the developing world (see also chapter 1). Since
September 2008 the pace of credit expansion in the
69 developing countries for which data are available fell by almost half, from a monthly increase ofaround 1.1 percent between January and September
2008 to a much more modest 0.6 monthly pace between September 2008 and October 2009 (box figure 3.7.1). The decline was particularly pronounced
in middle-income countries, perhaps because theirmore integrated financial systems were most directly
affected by the change in global financial conditions.
While sovereign bond flows have picked up recently,
corporate bond issues and especially bank lending
remain sharply lower than during the boom period.
As policy interest rates in high-income countries
rise, the differential between long-term yields on
developing-country debt and short-term dollardenominated borrowing costs will decline, and thefinancial incentive that is currently boosting capital
flows to developing countries will ease. As a result,borrowing costs are expected to be relatively highover the medium term, and therefore the growth ofdomestic financial intermediation is also likely tomoderate on a sustained basis. While these eventsare likely to have negative consequences for development in many countries, they may have some benefits
in those countries, including many in Europe andBox figure 3.7.1 The growth of bank credit
to the private sector dropped following thecollapse of Lehman Brothers
Average monthly percentage change in real terms
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0
All developing
countries

Jan. 2008–Sep. 2008

Lower-middle Upper-middle
incomeincomeSep. 2008–May 2009

Sources: International Financial Statistics, IMF.
Note: Refers to 69 countries with data through May 2009. Bank
credit to the private sector is deflated by the U.S. Consumer
Price Index.

Central Asia, that were unable to sustain the verystrong capital inflows of the first part of this decade.
As seen in the discussion of the boom in chapter 2,higher financing costs will affect international capital
flows as well. Higher interest rates will reduce thedemand for external finance, while banks are likely
to lower the supply of loans because marginally creditworthy developing countries will be able to reliably
service a smaller quantity of debt. Thus the expected
rise in borrowing costs will compound the reductions
in external finance owing to tighter regulation inindustrial countries (described above).

ratio in the economy to fall. As a result, if costs
do rise in the longer run, entrepreneurs will haveless capital to work with than if interest rates
had remained low (box 3.7).34 This implies
that the level of output that the economy will
be able to sustain is likely to decline and thatduring the transition period to the new lower
capital-output ratio, the reduced rate of growthof potential output will be temporarily lower.

100

Low
incomeTable 3.6 reports on three simulations
undertaken to provide some insight into thelikely quantitative impact of the higher cost ofcapital on growth. The interest rate scenariosthat drive the simulations are those outlined
in table 3.4.
In these simulations, higher borrowing
costs serve to lower long-term developingcountry potential output (measured as theM E D I U M - T E R M

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Table 3.6 Impact on potential output of a return to normal pricing of risk and higher base rates
Spreads remain at October
2009 level, but base rates
rise to pre-crisis levels

Spreads return to “normal”
levels, and base rates riseto pre-boom levels

Spreads return to “normal”
levels and base rates rise
100 basis points above
pre-boom period levels

Long-termlevel ofpotentialb

Short-term
impact on
potential
growthaLong-termlevel ofpotentialb

Short-term
impact on
potential
growthaLong-termlevel ofpotentialb

Short-term
impact on
potential
growthaDeveloping countries
Middle-income countries
Low-income countries

0.2
0.3
0.1

3.4
3.5
1.0

0.4
0.4
0.5

5.2
5.2
5.7

0.7
0.7
0.7

8.0
8.0
8.2

East Asia and Pacific
Europe and Central Asia
Latin America and Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa

0.3
0.5
0.0
0.2
0.1
0.1

3.9
6.5
0.0
3.0
1.0
0.5

0.4
0.8
0.3
0.4
0.4
0.4

4.3
9.2
3.6
5.4
5.1
3.4

0.6
1.0
0.6
0.7
0.6
0.5

7.5
11.4
6.3
8.2
7.8
4.9

(percent)

Source: World Bank.
a. Short-term impact on potential growth rate change is measured in percentage points during the transition to new lower level ofpotential output (about 5–7 years).
b. Percent change in long-term level of potential output.

difference between the simulated 2050 level ofpotential in the base case versus the scenario)35
by between 3.4 and 8.0 percent overall, with
regional declines as large as 11.4 percent. The
impact on trend growth during the period inwhich economies transition down to theselower long-term levels of potential (about
5–7 years in these simulations) is less marked,
averaging between a 0.2 and 0.7 percentage
point annual decline.
The first simulation can be understood asa relatively benign outcome. It assumes thatdeveloping-country spreads remain at today’s levels—somewhat lower than might be
expected when high-income monetary policy
tightens and interest rates rise—and that interest rates in high-income countries rise to theirpre-crisis average level between 2002 and2005. Even with this modest tightening of liquidity conditions, long-term potential output
in developing countries falls 3.4 percent compared with a scenario where the cost of capital remained at the very low levels observed
during the boom period. During the transition
to new lower capital ratios, the annual rate of
growth of potential output declines by about
0.2 percentage points for about seven years.

The second scenario assumes that developing-country spreads rise somewhat asmonetary conditions tighten, in line with thehistorical relationship between developingcountry spreads and high-income policy rates.
Overall, potential output falls 5.2 percent in
the long run, and transitional growth rates are
expected to be about 0.4 percentage points
lower than they would have been otherwise.
In this second scenario, low-income countries
are hit somewhat harder relative to the firstscenario because their interest rate premiums
are projected to rise by more than those of
middle-income countries.
In the third scenario, weaker fundamentals are assumed to raise borrowing costs inhigh-income countries an additional 100 basis
points. This causes borrowing costs to rise
globally, with developing-country long-run
potential output falling by around 8 percent
and annual potential growth rates falling by
0.7 percentage points for about seven years.
The impact of higher interest rates, investment, and the capital stock is illustrated infigure 3.11, which is drawn from the second
scenario. The declining capital stock causes thelevel of output that the economy can sustain101

G L O B A L

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2 0 1 0Figure 3.11 Impact of 110-basis-point shockon the capital-output ratio of a typicalcountry

Figure 3.12 Higher borrowing costs result ina permanent decline in developing-country
GDP

Capital-output ratio, postshock level divided by baseline level(Potential output)

1.05

Trillions of real 2005 U.S. dollars

1.00

6

0.95

Low capital costs growth path

0.90

5

0.85
0.80

4

Higher capital costs
growth path

0.75
3

0.70
0.65
0.60
2005

2
2013

2021

2029

2037

2045

Source: World Bank.
Note: Results from the second scenario in table 3.6.

in the long run to be lower than it would
have been had borrowing costs remained
unchanged. Overall, the capital-output ratio
falls by about 12 percent compared with thebaseline—a baseline that already includes thepost-crisis recession but assumes that the longterm cost of capital returns to its boom-period
level. Initially the capital-output ratio rises
in response to the shock because the decline
in investment it provokes causes GDP to fall
more quickly than the capital stock. Relatively
quickly the combination of depreciation of theexisting capital stock and slower investment
growth causes the capital stock to fall.36
As the new capital-output ratio is achieved,
the pre-crisis potential output growth rate isregained. Nevertheless, as presented in table
3.6, there is a permanent 5.2 percent loss in
GDP (figure 3.12).
Of course, this process may occur more
quickly in the real world owing to a more
rapid depreciation of the existing capital stock
stemming from the closing down of industries
that are no longer competitive. An important
implication of this logic is that a policy designed to assist existing firms that are placedin long-term difficulty by less liquid global
conditions will tend only to prolong the periodof slow growth through which an economy
must pass in these circumstances. In contrast,a policy that combined efforts to facilitate the

102

1
2005

2010

2015

2020

2025

2030

Source: World Bank.

movement of both people and capital from lessto more productive uses, especially if it succeeded at the same time in boosting aggregate
productivity, would help to speed the transition toward a new equilibrium.
The long-run declines in potential output visà-vis the baseline reported in the first and second scenarios of table 3.6 are broadly consistent
with results produced by McKibbin and Stoeckel(2009) in their analysis of the global financial
crisis—even though their focus is not on theimpact on potential output in developing countries and the shock is not framed in precisely thesame manner. In part, this similarity reflects thefact that their model includes many of the samemechanisms as the one presented here. These results are also very similar in size to the averagepost-financial-crisis decline in potential output
identified by the International Monetary Fundin its September 2009 World Economic Outlook (IMF 2009), although that work, which
was based on a decomposition analysis of theeconomic outturns following past crises, attributed a smaller share of the total decline to thedecline in the capital output ratio. The analysis
presented here differs by explicitly modeling in
a forward-looking manner the main mechanism
through which lower potential output is reachedand relating it to the primary driver of both theboom and the bust—the decline and subsequent
sharp rise in the global price of risk.37

M E D I U M - T E R M

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Table 3.7 Higher borrowing costs and slower population growth imply slower growth inpotential output over the longer term
Developing
countries

MiddleincomeLow
incomeEast Asia
and Pacific

Europe andCentral Asia

Latin
America andCaribbean

Middle EastandNorth Africa

South
Asia

SubSaharanAfrica

2.6
4.2
5.0
5.4
2.9

5.1
5.8
7.4
7.4
4.9

1.8
3.4
5.6
6.5
5.1

2.6
4.2
5.0
4.9
2.8

5.1
5.8
7.4
7.0
4.8

1.8
3.4
5.6
6.3
5.1

0.0
0.4
0.1

0.0
0.4
0.1

0.0
0.3
0.0

(Average rate of growth of potential output, percent)Baseline scenario: spreads and base interest rates constant at boom period levels
1980–95
2.6
2.6
2.6
8.3
0.6
2.4
1996–2002
4.6
4.6
3.9
7.8
3.1
3.0
2003–08
6.2
6.2
5.4
8.7
5.9
3.5
2009–15
6.3
6.3
5.8
8.1
5.7
3.8
2016–50
4.5
4.5
5.2
5.5
4.5
1.6
Pre-crisis base rates and return to normal spreadsa
1980–95
2.6
2.6
2.6
8.3
0.6
2.4
1996–2002
4.6
4.6
3.9
7.8
3.1
3.0
2003–08
6.2
6.2
5.4
8.7
5.9
3.5
2009–15
5.9
5.9
5.4
7.8
5.2
3.3
2016–50
4.5
4.4
5.2
5.4
4.4
1.5
(Percentage point difference in average potential output growth rates)
Difference compared with baseline
2003–08
2009–15
2016–50

0.0
0.4
0.1

0.0
0.4
0.1

0.0
0.4
0.1

0.0
0.3
0.1

0.0
0.5
0.1

0.0
0.5
0.1

Source: World Bank.
a. Results from the second scenario in table 3.6.

The top panel of table 3.7 illustrates theinfluence of slower population growth andan aging population on potential output inthe baseline scenario, where borrowing costs
are assumed to remain unchanged at their2008 level and where total factor productivity trends remains unchanged. In this scenario,
developing-country growth is set to slow by
1.7 percentage points between the boom period and the 2016–50 period, mainly becauseof slower growth of the working-age population reflecting both aging and slower population growth. Total factor productivity is
assumed to be constant.38 The second panel
shows average potential output growth rates
assuming the same increase in capital costs asin the second scenario of table 3.6. Although
the long-term growth rate of potential output after adjustment of the capital stock to
its new levels is broadly the same as in thebaseline case, potential output growth is 0.4
percentage points slower during the transition period and potential output in the end
period is some 5.2 percent lower than in thebaseline.

Slower future growth and lower income
levels imply potentially large long-term impacts on poverty and disease in developing
countries. Recent estimates suggest the recession will likely result in some 30,000–50,000
additional childhood deaths in 2009 and 2010
in Africa (Friedman and Schady 2009). And,assuming the 4.2 percent of GDP decline inpotential output reported in the second scenario of table 3.7, by 2015 the crisis and its
aftermath can be expected to have prevented
some 46 million poor people from emerging
from poverty (table 3.8).
The higher borrowing rates under the scenarios outlined above are unlikely to have amajor impact on debt sustainability, even forthe most highly indebted developing countries.
Assuming that borrowing costs rise by
2.7 percentage points (roughly equivalent
to the most pessimistic of the scenarios intable 3.6), private-source-debt-to-GNI ratios
among developing countries would rise by atmost 6 percentage points. In most of the 20
developing countries with the highest ratio ofprivate-source debt to GNI, the rise is about103

G L O B A L

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2 0 1 0Strategies for dealing with aweaker international financesystemTable 3.8 The crisis could increase poverty
by 46 million in the long term
Impact on poverty of a
5.2 percent decline inpotential output as of 2015
Change inhead count(millions)

Percent change
in head countEast Asia and Pacific
Europe and Central Asia
Latin America and Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa

6.3
0.9
3.4
0.8
16.3
18.2

19.3
27.7
14.3
46.8
31.2
11.7

Developing countries

46.0

17.0

RegionW

hile individual developing countries cando little to influence developments in
the global financial system, they can do a great
deal at the local level to influence intermediation costs and offset, possibly even reverse, theexpected increase in capital costs—perhaps not
immediately but over the longer term.
As discussed in chapter 2, the most important
influence on changes in borrowing costs in developing countries during the past 10 years has
been changes in the international cost of risk.
However, inefficiencies in domestic financial
systems are more important than international
financial conditions in explaining the levels ofborrowing costs in many developing countries.
Fundamentals still matter—in determining both
the risk premium attached to financial transactions with individual countries and the relative
cost effectiveness of a given investment project.
Even the financial systems of the most advanced
developing countries underperform the financial
systems in high-income countries. For example
11 of the 14 developing countries included inan aggregate index of financial system efficiency scored in the bottom half of the rankings(Dorrucci, Meyer-Cirkel, and Santabarbara 2009).

Source: World Bank.
Note: Estimates based on the GIDD model.

1 percentage point (figure 3.13). However,
the impact of higher interest rates for countries with external borrowing constraints
could be more disruptive if it occurs quickly.
If borrowing costs rise 270 basis points, acountry with a private-source-debt-to-GNI
ratio of about 40 percent (the median of the
20 most indebted countries) would have to reduce its foreign exchange expenditures by 1.1
percent of GNI. Assuming a 4 percent importelasticity, this would imply a 4.4 percent cut
in domestic demand.39

Figure 3.13 The effect of higher borrowing costs on the ratio of private-source debt to grossnational income
Percent of GDP
7
6
5
4
3
2
1

104

Tu
rk
ey
g
ni
en
a
tin
H
er
a
ze
go
vi
na

er
Fe
d

an

Ar

Bo
s

nd
la

ai

ai
Th
R

us

si

ac
M
Source: World Bank.

at
io
n

ca

le
hi
C

m
Ja

YR

nd
ed

on

ia

Po

,F

la

ia

e
R

om

an

in

ia
rb

kr
a
U

ol
M

Se

a

do
va

ia

an
i

ar

rit
au
M

he
yc

Se

Bu
lg

lle

s

ia

n
ta

tv
La

oa

hs
ak

Sa
m

Ka
z

Li

be
ria

0

M E D I U M - T E R M

I M P A C T S

O F

T H E

C R I S I S

O NF I N A N C E

A N D

G R O W T H

Table 3.9 Selected indicators of banking sector efficiency(Operational ratios of commercial banks, average 2006–08)
Net interest
margin (%)

Net interest revenue/
average assets(%)

Other operating
income/averageassets (%)

Noninterest
expenses/
average assets (%)

Profit margin(before tax and nonoperational items

East Asia and Pacific
Europe and Central Asia
Latin America and Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa

3.85
6.94
8.38
3.21
3.47
7.17

3.34
5.86
6.69
2.58
3.05
5.80

1.52
11.05
3.51
1.66
1.88
4.23

3.09
14.18
8.44
2.66
3.26
6.58

1.77
2.73
1.77
1.58
1.68
3.45

Developing countries
High income
Low income
Lower-middle income
Upper-middle income

6.62
3.57
6.16
5.57
7.00

5.50
3.25
5.02
4.37
5.91

7.12
1.94
3.46
2.42
9.05

10.22
4.06
5.47
5.21
12.39

2.40
1.13
3.01
1.58
2.57

RegionSource: World Bank calculations using data from Bankscope.

Table 3.9 reports information on net interest revenues (the difference between interest
income paid on deposits and earned on loans),other income, and noninterest expenditures(principally overhead), all expressed as a percent of the total value of banks’ assets. On average, the difference between interest paid on
deposits and charged on loans by developingcountry banks is 225 basis points higher thanin high-income countries. Overhead expenditures are more than twice as large as in highincome countries, and profit rates are twice as
high. In addition, in some developing countries
banks rely much more heavily on nonbanking
activities for revenues and profits. Indeed, ifdeveloping-country banks did not have theseother revenues, they would be making losses inall but one of the developing regions.
High overhead costs (as a share of total asset
ratios) reflect a variety of factors, and their relative weight varies across banks and countries. In
countries and regions that also show high profit
rates (Sub-Saharan Africa and to a lesser extent
Europe and Central Asia), these high overheads
may reflect a lack of competitive pressure aswell as a thin market. High levels of noninterest income such as in Europe and Central
Asia, Latin America, and Africa suggest thatshortcomings in the regulatory environment,
including in the protection of property rights,
may make nonbanking activities more profitable than traditional deposit and loan making,reducing the overall level of intermediation thatbanks might otherwise accomplish.
Although interest rate margins and overhead costs provide only rough indicators of
the economic costs imposed by inefficient financial systems, they do suggest considerable
potential for reducing borrowing costs by improving efficiency. For example, if the spread
between deposit and lending rates in SubSaharan Africa, Latin America, and Europe
and Central Asia were reduced to the levels
observed in East Asia or South Asia, borrowing costs in these regions would be lowered by
between 300 and 450 basis points, much morethan the estimated increase from tighter global
financial conditions in even the most pessimistic scenario discussed earlier. Based on theeconometric work reported in chapter 2, sucha reduction in borrowing costs could prompt
an increase in the level of domestic intermediation equivalent to 2.5 percent of GDP.
Moreover, the differences in banks’ netinterest margins between developing andhigh-income countries are considerable understatements of differences in the costs of borrowing. Particularly in low-income countries,
small formal banking systems tend to drive
borrowers to informal lenders. Because theinterest rates charged by informal lenders areoften several multiples of interest rates in highincome countries, improvements in efficiency
that expanded developing countries’ banking

105

G L O B A L

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P R O S P E C T S

2 0 1 0systems could result in very large reductionsin interest rates facing less-creditworthy borrowers. In addition, many potential borrowers are denied finance altogether, so efficiency
improvements that expanded the volume ofcredit would have large welfare effects.
The impact of improvements in the regulatory environment would likely be even morepositive, because weak protection of property
rights and excessive levels of corruption reduce
the profitability of investment projects in ways
Table 3.10

other than through higher borrowing costs.
Thus, according to the regression analysis inchapter 2, in addition to a lower cost of capital, a one-standard-deviation improvement in
the business environment would increase theprofitability of investments by enough to increase investment-to-GDP ratios by another 4
percentage points.
Table 3.10 gives a sense of the potential
growth implications if developing countries
were successful in reducing borrowing costs

Potential impact of improved fundamentals on long-term growth prospects
MiddleEast andNorth
AfricaSouth
Asia

SubSaharanAfrica(Average rate of growth of potential output, percent)Baseline scenario: spreads and base interest rates constant at their 2008 level
1980–95
2.6
2.6
2.6
8.3
0.6
2.4
1996–2002
4.6
4.6
3.9
7.8
3.1
3.0
2003–08
6.2
6.2
5.4
8.7
5.9
3.5
2009–15
6.3
6.3
5.8
8.1
5.7
3.8
2016–50
4.5
4.5
5.2
5.5
4.5
1.6

2.6
4.2
5.0
5.4
2.9

5.1
5.8
7.4
7.4
4.9

1.8
3.4
5.6
6.5
5.1

Higher base rates and return to “normal” spreads
1980–95
2.6
2.6
2.6
1996–2002
4.6
4.6
3.9
2003–08
6.2
6.2
5.4
2009–15
5.9
5.9
5.4
2016–50
4.5
4.4
5.2

2.4
3.0
3.5
3.3
1.5

2.6
4.2
5.0
4.9
2.8

5.1
5.8
7.4
7.0
4.8

1.8
3.4
5.6
6.3
5.1

Higher base rates, initially “normal” spreads that fall subsequently due to improved policies
1980–95
2.6
2.6
2.6
8.3
0.6
2.4
1996–2002
4.6
4.6
3.9
7.8
3.1
3.0
2003–08
6.2
6.2
5.4
8.7
5.9
3.5
2009–15
6.0
6.0
5.5
8.1
5.3
3.4
2016–50
4.9
4.8
6.0
5.6
5.1
1.9

2.6
4.2
5.0
5.1
3.3

5.1
5.8
7.4
7.1
5.5

1.8
3.4
5.6
6.3
5.5

0.0
0.5
0.1

0.0
0.4
0.1

0.0
0.4
0.1

0.0
0.3
0.0

Higher base rates, initially “normal” spreads that fall subsequently due to improved policies
2003–08
0.0
0.0
0.0
0.0
0.0
0.0
2009–15
0.3
0.3
0.3
0.0
0.4
0.4
2016–50
0.3
0.3
0.7
0.1
0.5
0.3

0.0
0.3
0.4

0.0
0.3
0.6

0.0
0.2
0.3

Developing
countries

MiddleincomeLow
incomeEast Asia
and Pacific

8.3
7.8
8.7
7.8
5.4

Europe andCentral Asia

Latin America
and Caribbean

0.6
3.1
5.9
5.2
4.4

(Percentage point difference in average potential output growth rates)

Difference compared with baseline
Higher base rates and return to normal spreads
2003–08
0.0
0.0
0.0
2009–15
0.4
0.4
0.4
2016–50
0.1
0.1
0.1

0.0
0.3
0.1

0.0
0.5
0.1

(Cumulative change in potential output)

Change in final potential output compared with baseline
Higher rates scenario
4.8

4.9

4.3

6.0

6.3

5.7

5.4

2.8

Higher rates plus improved policy scenario
7.4
7.0
20.4

1.5

14.8

7.9

8.8

17.2

8.1

Source: World Bank.

106

4.8

M E D I U M - T E R M

I M P A C T S

through a mixture of regulatory reform andimproved macroeconomic management. It
compares the outcomes from the third scenario
in table 3.6 (the scenario with higher base rates
and a return to “normal” interest rate spreads)
and a scenario that builds upon the same increase in base rates and interest rate spreads
but assumes that developing countries continue to make strides in reducing borrowing
costs (by 25 basis points a year until spreads
reach 150 basis points). In this simulation, developing countries still experience a period ofsignificantly slower growth in the five to sevenyears following the crisis, but the assumed cumulative improvements in fundamentals resultin a gradual increase in growth rates relative
to both the higher base rates and baseline scenarios. Overall, these improvements mean that
potential output is actually some 7.4 percent
higher than in the original baseline scenario
and 12.2 percent higher than in the higher
rates scenario, with the largest gains accruingto those countries and regions currently facing
the highest spreads.

Implications for the global
balance between savings andinvestmentThe preceding analysis focused on the impact of increasing costs of capital on potential output. However, GDP growth may fallshort of historical levels for reasons other thana decline in the capital-output ratio during thetransition period. The adjustment process, during which investment rates are suppressed, mayalso have an impact on effective demand, andthus on utilization rates, although that impact
is more speculative than the analysis of potential growth.
Especially in middle-income countries, investment rates are likely to remain substantially lower during the next five years thanduring the boom period as the capital stock
adjusts to higher borrowing costs and slowing
population growth. The impact of lower investment rates on the global balance between

O F

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G R O W T H

savings and investments could be substantial
because middle-income countries have become
the source of more than half of global investment growth. Moreover, lower investment
rates will likely have an impact on regional
imbalances. In Europe and Central Asia lower
rates will contribute to a reduction in current
account deficits, in a way similar to what happened in East Asia after the 1998 financial crisis. In East Asia, where annual growth rates
during the next five years are expected to bealmost 1 percentage point lower than during
the boom, lower investment rates will increase
current account surpluses—unless savings
rates decline.
In low-income countries, capital needs remain substantial. The impact of higher borrowing costs could be counteracted by totalfactor productivity gains that are already inthe pipeline and by sustained population
growth.
The increase in borrowing costs describedin the preceding pages reflects both an increase in the cost of intermediation (stemmingfrom stricter regulation of financial markets
and consolidation in the banking sector) andan increase in the price of a given quantityof risk (caused by the disappearance of somerisk-management instruments and a generalized increase in risk aversion). The risk-freeinterest rate that is relevant for savers is notaffected directly by these factors. It is affectedindirectly, however, because higher intermediation costs and risk premiums will increase
the wedge between borrowers’ costs and therisk-free interest rate that motivates savers. If
savings are interest-rate elastic, this will provoke a rightward movement along both thedemand and supply of savings curves, reducing the risk-free rate of interest (from rs1 to
rs2 in figure 3.14). This decline will reducesavings and increase domestic demand—atleast partially compensating for the decline
in investment and working to eliminate current account surpluses. The overall impact on
global imbalances will depend on the balanceof these affects across current account surplus
and deficit countries.

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2 0 1 0Figure 3.14 Higher intermediation costs will
reduce the risk-free interest rate relevant tosavings decisions
Increased intermediation costs raise borrower’s interest
rates and lower those of savers
Percent
10
rb(2)
rb(1)

rs(1)
rs(2)
0
0

100
Volumes

Source: World Bank.

Apart from increasing consumption sharesin some of the emerging economies, measures
to counteract the potential decline in investments may be needed too. The possibilityof ineffective demand provides another reason to accelerate productivity growth, either
by eliminating bottlenecks or by opening up
new areas of growth. Only with such growth
impulses can investment rates in developing
countries return to the levels seen during theboom. In that sense the most successful strategy to create sufficient effective demand in themedium run is consistent with policies that
aim to maximize potential growth.

ConclusionDeveloping countries are likely to face amuch more constrained financial environment over the next decade or so than they
did during the pre-crisis boom. The discrediting of many of the financial innovations that
led investors to believe that the ultimate costof holding a risky asset had declined sharply,
a tighter regulatory environment, more risk
aversion on the part of investors, and the necessity of both the high-income banking andhousehold sectors to consolidate and rebuild
their balance sheets is expected to result in amore stable and ultimately more robust global

108

financial environment, but also one characterized by less liquid and more expensive financing
conditions.
The combination of a more constrained
and more expensive financing environment islikely to have important real-side implications
for developing countries. For low-income
countries with relatively weak domestic financial sectors and binding capital constraints,
weaker bank finance and FDI flows will be
particularly problematic. In some of thesecountries FDI inflows represent more than 40
percent of total investment, so the projected
30 percent cut in flows from pre-crisis levels
could have particularly strong repercussions.
For middle-income countries with access tointernational financial markets and better developed domestic markets, the main impact islikely to be through the increased cost of borrowing. Here, estimates suggest that the adjustment to higher capital costs could reduce
potential growth rates in developing countries
by between 0.2 and 0.7 percentage points overthe next five to seven years, and that, longer
term, potential output in these countries could
be lower by between 3.4 and 8.0 percent.
The extent to which domestic finance will
be able to step in to supplement a weaker international financial system is very uncertain.
Countries with strong policies and institutions have the most to lose from a weakeningof the international financial system because
they benefit most from it. However, in general they also have the strongest domestic
intermediation systems and are well placed
to compensate for a weaker international
system by expanding this sector. Increased
domestic intermediation could ultimately
generate larger benefits than the cost that
reduced access to international capital might
impose. For many low-income countries thedomestic financial sector may be too weak
to respond effectively. Moreover, while theimmediate costs from reduced internationalflows may be smaller—because these countries have little access and therefore little tolose—the longer-terms costs could be significant. In particular, if international financeM E D I U M - T E R M

I M P A C T S

and the expertise and spillover effects that
can accompany it are not available or areavailable to a lesser degree, in the future
this could hamper the ability of low-income,weakly intermediated countries to make thetransition to middle-income countries withmore robust financial systems.
Developing countries themselves can be expected to react to the crisis in ways that are
not necessarily beneficial. The crisis has madeclear once again the lesson that financial flows
can be very volatile and that this volatility
can generate extremely costly real-side adjustments. With GDP growth off by as much as 4
percent, it is a small consolation to a country
that has pursued prudent macroeconomic andstructural policies that the growth recessionthat it has experienced was much smaller thanthat of countries that went into the crisis withlarge current account and budget deficits.
Throughout the world public pressure andprudent policy making will force a rethinking of the costs and benefits of both financial
and trade openness. The evidence supports acautious approach to capital account liberalization, while supporting the view that relatively flexible exchange rate regimes are lesssusceptible to the kind of crises that have been
observed in the past. Countries with weak domestic institutions and limited intermediation
can find a too rapid capital account liberalization to be destabilizing, while those with moremature domestic systems can benefit fromthe additional competition and in some cases
funding that a more liberalized external account can provide. Similarly, while a buildup
of reserves gives a country additional room formaneuver, in the event of a crisis these reserves
can be very expensive to maintain and, ofcourse, cannot prevent exchange rate revaluations in the presence of overwhelming fundamental forces.
Although individual developing countries
may be powerless to influence global developments, much can done at the domestic levelto mitigate these costs. The sensitivity ofdeveloping-country GDP and growth prospects to borrowing costs and the high cost

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of intermediation suggests that policies thatsucceed in increasing the efficiency of the domestic banking sector—through improved
enforcement of property rights, enhanced
competition, or better regulation—could havesignificant impacts on domestic intermediation, investment levels, and growth potential.
Borrowing costs in many regions could be reduced by more than 300 basis points, a reduction that could be associated with a long-term
increase in potential output of 8 percent or
more. Of course, implementing the reforms totake advantage of this potential will be a slow
and difficult process—especially if they run
afoul of domestic interests.

Notes
1. It was possible to retain the risk of off-balance-sheet
assets but avoid capital requirements by abusing exceptions to the “true sale” rule governing securitization; thatrule states that to avoid capital requirements the seller ofloans must not retain any responsibility for subsequentloan performance or collateral. U.S. regulators were
aware of this practice but found it difficult to control(Calomiris and Mason 2004).
2. Calomiris and Mason (2004) argued that theuse of securitization with implicit recourse to evade
capital requirements was socially beneficial, essentially because regulatory capital requirements were
too high.
3. Efforts by regulators to close insolvent banks andimpose capital requirements that are commonly based on
the risk of an individual bank can fail to mitigate systemic risk (Acharya 2009).
4. For a broad view of potential changes in financial
sector regulation, see the G-20 statement on “Strengthening the Financial System,” issued at the London
Summit on April 2, 2009; “A New Foundation: Rebuilding Financial Supervision and Regulation” (issued
by the Obama administration in June 2009); and “The
Turner Review: A Regulatory Response to the Global
Banking Crisis” (issued by the United Kingdom’s Financial Services Authority in March 2009). One example of legislative progress is passage by the US Houseof Representatives of a bill to strengthen consumer protection, extend regulation to some over the counter derivatives, and create a process for addressing troubled
firms that may pose systemic risks. The bill may yet
undergo significant modification before a compatible
version is passed by the U.S. senate and it becomes law.
5. See cross-country studies in Claessens, DemirgüçKunt, and Huizinga (1998); Barth, Caprio, and Levine109

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2 0 1 0(2001); and Claessens and Laeven (2003). Bayraktar
and Wang (2004) find that domestic banks’ efficiency
gains from foreign entry are greatest in countries thatliberalized their stock markets before domestic financial markets.
6. The data on local claims on foreign-owned banks
include only banks reporting to the BIS and thus exclude claims by some foreign-owned banks (particularly from many developing countries). Also, these dataon the stock of claims are not adjusted for changes inexchange rates. Thus the appreciation of the dollar during the second half of 2008 contributed to reducing thelevel of claims. It is unclear, however, whether the currency denomination of claims differed greatly between
foreign and locally owned banks.
7. Up to 20 percent of the $15.8 trillion of world
merchandise trade in 2008 involved secured documentary transactions (such as letters of credit), and otherforms of trade finance play an important role (either infinancing inventories or accounts receivables) in helping bridge the gap between the time when costs are incurred in producing a product and the time when final
payment is made upon receipt.
8. World Bank calculations using data from
Dealogic.
9. Mutual funds based in developed countries began
investing in the 1980s in the form of closed-end funds(whose shares cannot be redeemed), to limit turnoverin the relatively illiquid markets in many developing
countries (Kaminsky, Lyons, and Schmuckler 2001).
As liquidity increased, open-end funds became morecommon. Other major foreign investors in emerging
stock markets (many of whom invest through mutual
funds) include pension funds, insurance companies,
hedge funds, and individual investors.
10. This includes evidence that stock market liberalizations reduce the cost of capital (Henry 2000, Bekaert
and Harvey 2000). Kose, Prasad, and Terrones (2008)
find a positive relationship between portfolio equity liabilities and total factor productivity growth in a sample
of industrial and developing countries.
11. For example, Gupta and Yuan (2005) find that
following equity market liberalizations, industries that
depend on external finance grow faster than industries
dependent on finance internal to the firm. Similarly,
Vanassche (2004) finds that financial openness has apositive effect on growth of industrial sectors generally,
and that this impact is greatest in industries that rely
more on external finance. Eichengreen, Gullapalli, andPanizza (2009) find that capital account openness has apositive impact on the growth of financially dependent
industries only in high-income countries and that thiseffect disappears during periods of crisis.
12. There remains some theoretical argument overthis effect, however, because the opportunity to exit

110

at low cost may also reduce incentives for monitoring
managers, leading to weaker corporate governance andless productive investments (Levine and Zervos 1998).
13. Levine and Zervos (1998) find that stock market
liquidity (along with banking sector development) is positively associated with growth, capital accumulation, andproductivity improvements in a cross-country regression.
Demirgüç-Kunt and Maksimovic (1996) find that active
stock markets are associated with higher-than-predicted
rates of firm growth. Kassimkatis and Spyrous (2001)
find that equity markets boost growth only in relatively
liberalized economies. In addition, some authors havefound that the lifting of restrictions on stock market development is positively associated with growth, either
temporarily or over the long term (Fuchs-Schundeln andFunke 2003).
14. Foreign investors may spur investment in infrastructure services such as clearing and settlement
systems, as countries compete for the limited poolof foreign investors willing to devote resources todeveloping-country markets, and provide information
on practices in more developed markets. In a crosscountry regression, Chinn and Ito (2006) find that
openness to external financial flows contributes to thedevelopment of equity markets.
15. While the database does not distinguish whether
the acquisition is cross-border or domestic, we assume
that multinational firms borrow internationally mostly
for cross-border acquisitions.
16. Outward FDI from developing countries actually increased in 2008 to $164 billion (from $138 billion
in 2007), in contrast to the 25 percent fall in outflows
from developed countries, and is expected to slow only
slightly in 2009. Chinese companies have spent morethan $20 billion on oil assets overseas since December
2008, including in Kazakhstan, Nigeria, and the Syrian
Arab Republic.
17. The superior technology (and marketing andmanagement practices) often used by foreign firms istransmitted to domestic firms either through observation or because domestic firms hire workers trained byforeign firms (Fosfuri, Motta, and Ronde 2001). Foreign
firm entry also can increase the intensity of competitionin an industry, potentially forcing domestic firms to improve their efficiency (Blomström, Kokko, and Zejan
2000; Javorcik, Keller, and Tybout 2006). The extent
of efficiency gains from FDI depends on the quality ofdomestic policies and institutions, including policies toward FDI (Beamish 1998); policies promoting the diffusion of technology (Lall 2003); the level of human capital(Borensztein, DeGregorio, and Lee 1998); the level oftechnology in the recipient country and how close it is
to technology used by foreign firms (Saggi 2002); trade
policy (Moran 2002); and financial development (Alfaro
and others 2002).

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18. See World Bank (2004) for a discussion of infrastructure financing in developing countries, andDailami and Hauswald (2007) for an example of how
complex financing arrangements helped ensure thesuccess and lower the costs of a major project financetransaction in Qatar.
19. For example, the share in dollar terms ofdeveloping-country institutions in project finance transactions increased from about 0.5 percent in 1997 to 9
percent in 2008 (Project Finance International, http://
www.pfie.com). Moreover, participation by firms in
high-income countries that recently were viewed as
developing—for example the Republic of Korea; Taiwan,
China; and Singapore—also increased markedly.
20. The high levels of volatility in consumption
in developing countries imply large welfare benefits
to consumption smoothing (Pallage and Robe 2003).
Consumption smoothing may also facilitate specialization and hence development by reducing the impact onwelfare of higher volatility that may be associated withspecialization.
21. The correlation between ratios of short-term
debt to reserves and the change in GDP growth is 0.2.
And using our forecasts of GDP growth in 2009, thecorrelation between reserves-to-import ratios in 2007
and the fall in GDP growth in 2008–09 is zero.
22. This last term reflects the difference between
the interest on domestic-currency securities issued in
the course of past efforts to sterilize capital inflows
and the domestic-currency return on the international
reserves.
23. Hauner’s country groups do not correspond to
the World Bank’s distinction between developing andhigh-income countries.
24. This figure, which refers to reserves holdings
where the currency composition is known, is taken fromthe International Monetary Fund’s COFER database.
25. World Bank calculations based on table 7A of
the Locational Banking Statistics from the Bank forInternational Settlements.
26. The Chinn-Ito index aggregates information
on restrictions on financial transactions reported in
the IMF’s Annual Report on Exchange Arrangements
to produce a single indicator of financial openness formost of the world’s countries. The data can be found atwww. http://web.pdx.edu/~ito/.
27. Information asymmetries may be smaller at regional levels than at the global level (Ocampo 2006).
28. As reported in the People’s Daily Online,
May 4, 2008 (http://english.people.com.cn/90001/
90780/91421/6650574.html). ASEAN  3 refers to the
ASEAN countries plus China, Japan, and the Republicof Korea.
29. The observed increase in the synthetic price ofrisk in the fourth quarter of 2008 was equivalent to

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what might have been expected if high-income policy
rates increased by some 600 basis points. In fact during
the period, the effective Federal Reserve rate actually
fell by close to 180 basis points, although corporatebond defaults (another important fundamental) did risesignificantly.
30. Prediction errors are largest for Brazil,
Hungary, and to a lesser extent Bulgaria and Malaysia;
for more see Kennedy and Palerm 2009.
31. The interest rate spread rose by more than 30
percent more than expected by the model in Argentina
and Brazil and by 30 percent less than expected in thecase of Poland.
32. The basic OECD model has the form
SynRiskIndex  1.24  0.41*BaseRate  Other
variables. In Kennedy and Palerm (2009), developing-country spreads (EMBI spreads) are a functionof the SynRiskIndex (and indirectly, the BaseRate).
Two specifications were retained: one for countries with good credit histories, and one for thosewith less good histories: EMBI(poor risk)  140*
SynRiskIndex  Other variables; and EMBI(betterrisk)  27* SynRiskIndex  Other variables.
Combining the two equations results in a reduced
form equation for EMBI spreads as a function of the
BaseRate: ΔEMBI(poor risk)  140* 0.41*ΔBaseRate 
57.4*ΔBaseRate and ΔEMBI(better risk)  27*
0.41*ΔBaseRate  11.1*ΔBaseRate. Dailami, Masson,
and Padou (2008) modeled the relationship between
fluctuations in high-income policy interest rates anddeveloping-country risk premiums directly, in contrast
with the less direct approach here, which first estimatesthe impact of policy rates on the global price of risk
and then the impact of the price of risk on specificdeveloping-country risk premiums.
33. Empirically, depreciation rates range from 3
to 13 percent in the manufacturing sector (Nadiri andPrucha 1993) for manufacturing in the United Statesto as high as 18 to 36 percent in the high-tech researchand development sector. Economy-wide depreciation
rates represent a weighted average of very long depreciation rates on physical capital such as roads and building and other much shorter ones on high technology.
The aggregate depreciation rate varies from country tocountry with these values and the weight of different
activities in overall output. While the 7 percent assumption used here is a rough approximation, it corresponds
to the assumption used in IMF (2005) in a slightly different modeling exercise and is broadly consistent with
implicit values used in the OECD interlink model.
34. In the model of potential output described inchapter 2, a 100 basis point fall in the cost of capital fora country with a cost of capital of 1,000 basis points
should result in a 4 percent increase in its capital-output
ratio over the long term (assuming capital’s share in

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2 0 1 0value added of 40 percent, a real interest rate of 3 percent, and an average depreciation rate of 7 percent).
35. The simulations are run out to 2050 to allow
medium-term dynamics to resolve themselves.
36. The dynamic interaction between investment
rates and the desired capital stock actually causes theratio to overshoot its final level about by 3 percent of
the baseline capital output ratio.
37. The IMF analysis is based on an ex post analysis of the factors that explain past post-crisis declines
in potential output, among which is the same fall incapital-output ratios described here.
38. See World Bank (2007) for a more in-depth
discussion of likely long-term scenarios and their longterm implications for poverty.
39. Based on an assumed import elasticity of 4.

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1
Appendix
Regional Economic Prospects

East Asia and the Pacific
Recent developmentsAs chapter 1 outlined, economies in the
East Asia and Pacific region were particularly hard hit by the collapse of global business
investment in the fall of 2008. The crisis curtailed financing flows to private firms worldwide, and together with depressed growth
expectations, investment plans were marked
down sharply. Household wealth, incomes,
and demand for consumer durables were affected just as adversely. Outside of China,
investment in the East Asia region was hit
exceptionally hard. Local equity markets fellby almost 60 percent from January to October 2008; currencies tumbled between 5 and25 percent against the dollar through the firstquarter of 2009. And bond spreads increased
by 515 basis points from January 2007 toreach 645 points by November 2008.1
As one of the key producing regions fordurable and capital goods—highly integrated
into global production networks—East Asian
economies experienced dramatic declines intrade and production between September
2008 and March 2009. Dollar-based exports
dropped 25 percent, while production (excluding China) plummeted 15–30 percent overthe period. High-income economies within theregion—including Japan; Republic of Korea;
Singapore; Taiwan, China; and Hong Kong,
China—were equally or more severely hit bythese developments (figure A1).2

East Asia’s rebound from the global downturn over the course of 2009 was quicker andmore robust than in other parts of the world.
China led the global recovery in industrial production, with contributions to growth from thehigh-income OECD countries emerging only
later in the year. The recovery in East Asia wasunderpinned by domestic stimulus programs
put in place by a number of economies, mostnotably by China; a shift from large inventory
reduction to restocking by firms; and a return
to positive growth in exports and production
by the second quarter of 2009.3 Against thisbackground, GDP losses for East Asia werelimited in 2009, with current growth estimatesplaced at 6.8 percent, down from 8 percent
in 2008. China grew by an estimated 8.4 percent during the year, while performance inIndonesia (4.5 percent) and Vietnam (5.5 percent) was strong. Output contractions werelimited to Cambodia (⫺2.2 percent), Malaysia(⫺2.3 percent), Thailand (⫺2.7 percent), andseveral Pacific islands. However, when China
is excluded from the 2009 growth estimates,
GDP numbers for the remainder of the region
offer a better reflection of the crisis, with anadvance of just 1.3 percent following 4.8 percent growth in 2008 (table A1).
As the global downturn took hold across
East Asia in late 2008, many developing countries, together with major developed economies, began to implement large-scale fiscal andmonetary stimulus measures to support domestic demand and to counter the drag from the117

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 1 0Figure A1 East Asian exports and production hard hit by downturn in capital goods demand
Exports in U.S. dollars

Industrial production
percent change (saar)

60

percent change (saar)

60
NIEs

40

40

Indonesia

China
20

20

0

0

–20

–20

–40

–40

Malaysia–60

Other East Asianand Pacific countries

Thailand

Korea, Rep. of

–60

–80

–80

Jan.
2008

May
2008

Sep.
2008

Jan.
2009

May
2009

Sep.
2009

Jan.
2008

Sep.
2008

May
2008

Jan.
2009

May
2009

Sep.
2009

Sources: Haver Analytics and World Bank.

Table A1 East Asia and Pacific forecast summary(annual percent change unless indicated otherwise)

GDP at market prices (2005 US$)b
GDP per capita (units in US$)PPP GDPc
Private consumption
Public consumption
Fixed investment
Exports, GNFSd
Imports, GNFSd
Net exports, contribution to growth
Current account balance/GDP (%)
GDP deflator (median, LCU)
Fiscal balance/GDP (%)
Memo items: GDP
East Asia excluding China
China
Indonesia
Thailand

1995–2005a

2006

2007

2008

2009e

2010f

2011f

7.4
6.3
7.3
5.7
8.1
8.1
12.5
9.7
0.7
2.2
5.9
⫺1.8

10.1
9.2
10.1
8.1
8.2
12.4
18.8
12.7
3.4
8.4
4.4
⫺0.7

11.4
10.5
11.3
8.7
9.8
8.7
15.4
11.0
3.0
9.9
3.5
0.0

8.0
7.2
8.0
6.7
7.8
5.3
7.4
4.9
1.7
8.8
4.3
⫺0.6

6.8
6.0
6.8
5.9
11.1
14.3
⫺13.5
⫺12.1
⫺2.0
7.1
3.2
⫺3.3

8.1
7.2
8.0
7.3
8.4
9.3
6.6
6.2
0.7
6.5
3.3
⫺3.7

8.2
7.3
8.2
7.5
7.3
9.3
8.8
8.5
0.8
6.4
3.4
⫺3.1

3.5
9.1
2.7
2.7

5.7
11.6
5.5
5.3

6.2
13.0
6.3
4.9

4.8
9.0
6.1
2.6

1.3
8.4
4.5
⫺2.7

4.7
9.0
5.6
3.5

5.1
9.0
5.8
4.0

Source: World Bank.
a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.
b. GDP measured in constant 2005 U.S. dollars.
c. GDP measured at PPP exchange rates.
d. Exports and imports of goods and non-factor services (GNFS).
e. Estimate.
f. Forecast.

collapse of export markets. The Chinese stimulus package is of special note; it entails some$575 billion to be spread proportionately overtime from late 2008 through 2010, financed

118

in part by a surge in credit expansion, withtotal new lending equivalent to 30 percent of
GDP in 2009. Elsewhere in the region, government deficits (as a share of GDP) increased

R E G I O N A L

Figure A2 Malaysia: A profile of recovery
Percentage change (saar) in real GDP and components

E C O N O M I C

P R O S P E C T S

Figure A3 China’s stimulus programsupports exports from regional partners
Export values, US$, seasonally adjusted annual
percentage change

40
30

80
20
10

60

0

40

Developing East
Asian exports
Chinese imports

⫺10

20

⫺20
⫺30

0

⫺40

⫺20

⫺50

⫺40

⫺60
GDP

Government Consumer Investment Exports
spending spending

East Asian
NIE exports

⫺60

09

09

20
p.
Se

ay
M

n.

20

20

09

08
Ja

p.

20

20
ay
M

n.
Ja

Sources: Haver Analytics and World Bank.

Se

2009Q308

2009Q220

2009Q108⫺80
2008Q4

Sources: Haver Analytics and World Bank.

significantly, reflecting both automatic stabilizers and countercyclical measures.
Over the course of 2009, East Asia’s stimulus measures began to bear fruit, supporting
incomes and helping to boost household spending, underpinning infrastructure development
though public investment outlays, and providing support for the financial sector (figure A2
shows the recovery for Malaysia). China’s
stimulus had regionwide impacts, by boosting
demand for East Asian exports. China’s infrastructure outlays also underpinned demand
for regional commodities and raw materials
used in construction, from countries such as
Indonesia, Papua New Guinea, and Lao People’s Democratic Republic (as well as Australia). As replenishment of inventories got underway, firms in China began to restock parts andcomponents from regional suppliers, notably
electronic goods from countries such as Malaysia and Thailand (as well as NIEs). Also,
rising Chinese consumer expenditure stimulated demand for a variety of consumer durable goods across the region (figure A3).
In Malaysia, fixed investment declined by
35 percent during the fourth quarter of 2008
(saar) as an indirect result of the surge ininternational capital costs, combined (moreimportantly) with existing excess capacity, andexpectations among Malaysian business thatconditions in the main developed markets forelectronics and other equipment would be in
decline for an extended period (see figure A2).
Exports fell abruptly, by 45 percent (saar), as
the synchronous global shutdown of demandfor capital and related goods took hold. GDP
declined by a sharp 9.1 percent during thequarter. However, fiscal stimulus measures
were implemented that helped to shore up
confidence and provide direct support to theconstruction sector. The overall impact on theeconomy during the first two quarters of 2009
was limited, as decision and implementation
lags affected the speed and rate of disbursement. While the steep decline in exports deeply
affected the manufacturing sector, the impact
on the economy as a whole was mitigated by
the compression in processing imports.
Still, GDP declined by 18.3 percent (saar)in the first quarter of 2009, as exports continued in sharp decline, even though thefalloff in investment was mitigated by asecond fiscal measure (RM15 billion, or
2.3 percent of GDP). By the second and third
quarters, Malaysia had emerged to recovery,119

E C O N O M I C

P R O S P E C T S

2 0 1 0after additional government spending andeffects of earlier stimulus helped to turnaround investment and consumer spending, while exports rebounded sharply (inpart because of Chinese demand). The
annualized pace of GDP growth rebounded strongly to 14.0 and 12.2 percent,respectively, in the second and third quarters.
Capital flows are returning to East Asia,with a notable pickup during the fall of2009. East Asian bond and initial public
offerings (IPO) increased as conditions ininternational markets became more hospitable, with spreads much reduced from crisis levels and underlying demand conditions
firming. Some $12.8 billion in bonds were
issued in the year to October, representing adoubling of issuance from the like period of
2008. IPO issuance increased to $38 billion,
largely from China, but also from Malaysia
and Indonesia, up 65 percent from the same
period in 2008. But cross-border bank lending disappointed, largely reflecting risk aversion on the part of international commercial
banks, where deleveraging continues to be
the order of the day. Syndicated loans toEast Asian entities amounted to $12.8 billion
during the year through October, down substantially from the $37 billion raised in thesame period of 2008. Total gross flows todeveloping East Asia amounted to $63 billion over the year through October—a
4.5 percent decline from the $66 billion accrued in the same period of 2008.
Local financial market developments haveprovided further impetus to the recovery. A
return of capital from the United States, where
funds had earlier fled to safe-haven securities
has underpinned a rapid rebound in regional
equity markets following steep declines in2008 and early 2009 (figure A4). Bourses inIndonesia and Thailand are close to regaining
levels that prevailed in January 2008, while
Indonesia’s market has more than doubled
from October 2008 troughs, as have equity
markets in Thailand and Singapore. The rebound in equity markets and falling interest
rate spreads have helped reduce the cost of120

Figure A4 Equity markets have nearlyrecovered from earlier declines
Local currency–based equity prices
Index, Jan. 1, 2008 = 100
110
100

Thailand90
80

Indonesia

70
60

China

50
40

Singapore30
Jan. 1, Apr. 1, Jul. 1, Oct. 1, Jan. 1, Apr. 1, Jul. 1, Jul. 1, Jan. 1,
2008 2008 2008 2008 2009 2009 2009 2009 2010
Sources: Morgan-Stanley through Thomson/Datastream.

capital for firms, restore a significant portion of earlier wealth losses, and lift overall
confidence. The return of foreign capital also
helped to reverse some of the earlier sharp declines in local currencies (figure A5). Under

Figure A5 East Asian currencies continue
to recoup against U.S. dollar
Local currency unit, percentage change
45
40
35

Stronger local currency

30
25
20
15
10
5
0

Ko
re
In wo an
do n
n
ru es
C pia ia
hi h
na
do
lla
M
r
al
ay
rin sia
n
g
Si g
ng it
ap
d o
Ph olla reilip rpi
pe nesTh soa
H i
C on bahhi gna K t, d onol g,lC arre hin
nm es
in e
bi

G L O B A L

Percentage change (US$ per local currency unit)
Cumulative depreciation, Sep. 2008–March 2009
Cumulative appreciation, March 2009–Dec. 2009
Source: Thomson/Datastream.

R E G I O N A L

these circumstances the potential formation ofa “new” financial market bubble in the region
is an increasing cause for concern.
Inflation has eased broadly in East Asia,
given the slowing in activity and lower foodand fuel prices, although conditions vary
widely across countries. Increases in the consumer price index for 2009 range between
highs of 20 and 12 percent in Cambodia andVietnam, to 3 and zero percent (or slightly
negative) in China, the Philippines, andThailand.
In step with the cyclical downturn (a sharp
drop in government revenues) and with large
discretionary stimulus packages, fiscal deficits have widened across both middle- andlow-income countries in the region—thiseven as fiscal space for the latter countries
such as Cambodia and Lao PDR appears limited. The World Bank’s East Asia and Pacific
Department in a recent “East Asia Update”(November 2009) estimates that fiscal stimulus in the regions’ middle-income countries
amounted to 2.1 percent of GDP in 2009,up from an earlier estimate of 1.7 percent.
China’s fiscal shortfall is projected to havereached a record 3.3 percent of GDP during
2009, but a number of countries exceeded
this deficit when the deficit is expressed asa proportion of GDP (figure A6). Examples

Figure A6 Stimulus measures yield widening
fiscal shortfalls across the region
Overall government fiscal balance, percent of GDP
2
0
⫺2
⫺4
⫺6
⫺8
⫺10

Vietnam Malaysia Thailand
2007

2008

China

Indonesia

2009

Sources: National authorities and Bank staff projections.

E C O N O M I C

P R O S P E C T S

include Vietnam at 9.4 percent of GDP,
Malaysia at 7.8 percent, Thailand (4.2 percent) and the Philippines (3.8 percent). The
unwinding of these fiscal support measures
will play an important role in shaping the
economic recovery over the forecast period.
Although trade conditions have improved
over the course of 2009 as Chinese imports
recovered, regional export volumes (goods
and services) dropped 13.5 percent during
the year, while imports fell 12.1 percent,leading to a narrowing of the aggregate
current account position from a surplus of
8.8 percent of GDP in 2008 to 7.1 percent
for 2009. This was aided in particular by a
sharp decline in China’s current account surplus, which fell from 9.8 percent of GDP in2008 to 6.4 percent of GDP during the firstsix months of 2009.

Medium-term outlook
Momentum underlying economic activity inthe region should be sustained, as a gradualdecline in the effects of domestic stimulus
measures is countered over the course of2010 by the return to growth (albeit moderate) in East Asia’s main OECD export markets. But contrasted with earlier episodes ofglobal downturns (for example the 2001–03“dot-com” bust), the rebound and recovery path of GDP in East Asia is expected
to be more muted, reflecting weaker global
demand and less buoyant financial conditions. Continued strong advances in China’s
domestic demand, and associated imports,should play an important role in underpinning a second export-led revival phase forthe remainder of the region. At the sametime, world trade growth is anticipated torevive from the estimated 14.4 percent decline in 2009 to a gain of 6.2 percent by 2011.
Against this background, East Asian export
volumes are forecast to advance by 6.6 percent in 2010 and 8.8 percent in 2011, picking
up additional market share. The regional current account surplus position is anticipated tomoderate from 7.1 percent of GDP in 2009 to121

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E C O N O M I C

P R O S P E C T S

2 0 1 06.4 percent by 2011 (see table A1), reflecting
an increased contribution to overall growthfrom domestic demand.
The recovery in business investment is expected to be gradual (by historic standards),
as excess capacity will first have to beworked down. Growth of public sector outlays should ease from 2009 peaks of 11.1 percent to 7.3 percent by 2011. Recognizingthat prospects for an export-led recovery
are less favorable than in the past, policy
is likely to shift further toward fostering
growth in household demand, helping, inturn, to offset the profile of weaker government spending.
On balance, regional GDP growth is expected to increase to 8.2 percent by 2011
from the 6.8 percent registered in 2009.
This is a modest recovery by historic standards, but, at the end of the first year of
financial crisis, the regional downturn has
been equally moderate, compared, for example, with the East Asian crisis of the late
1990s. Domestic demand will be the key
growth driver, with more modest net tradecontributions. China will lead the regional
advance with GDP growth of 9 percent by
2010 (figure A7; table A2). Growth excluding China is anticipated to pick up to
5.1 percent by 2011, from an estimated
1.3 percent in 2009. In particular, shifts
from negative to positive growth in Malaysia and Thailand and a solid accelerationin activity in Indonesia and Vietnam should
underpin the turnaround.

Risks
Downside risks facing the region have diminished owing to improvements in the
global financial environment and positive
growth developments within East Asia andthe Pacific. The possibility of a “doubledip” global recession remains, particularly
as mature economies will be unwinding bothmonetary and fiscal stimulus. Also within
the region, the Chinese stimulus program,

122

Figure A7 East Asia will enjoy a moderate
rebound in 2010–11
Growth of real GDP, percent
10
8
6
4
2
0
⫺2
⫺4
Developing
East Asia

2008

China

2009

East Asia
excluding
China
2010

NIEs

2011

Source: World Bank.

and in particular the surge in liquidity overthe course of 2009, raises uncertainties
regarding the future growth path. Prospects
for low-income countries (Cambodia, Lao
PDR, and Vietnam) will depend heavily on
improvements in the international environment for bank lending. Recent developments
in Dubai and credit rating downgrades for
Greece are indicative of continued uncertainties, which, should they become widespread,
may have serious implications for bank lending and growth around the globe, particularly in developing countries. Consequently,
banking flows may remain sluggish for an
extended period of time as commercial banks
remain cautious and rebuild balance sheets.
Furthermore, for middle-income countries
currently benefiting from the return of largescale inflows, driven by international investors’ search for yields above those available
in mature markets, there is a risk of yet
another round of “asset bubbles,” this timein emerging markets, the bursting of which
could carry adverse effects over the short tomedium term.

R E G I O N A L

E C O N O M I C

P R O S P E C T S

Table A2 East Asia and Pacific country forecasts(annual percent change unless indicated otherwise)
1995–2005a

2006

2007

2008

2009c

2010d

2011d

Cambodia
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

8.3
⫺4.4

10.8
⫺3.6

10.2
⫺6.3

6.7
⫺10.2

⫺2.2
⫺3.5

4.2
⫺4.0

6.0
⫺4.0

China
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

9.1
2.6

11.6
9.7

13.0
11.0

9.0
9.8

8.4
5.6

9.0
4.1

9.0
4.0

Fiji
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

2.3
⫺4.8

3.6
⫺22.5

⫺6.6
⫺14.4

0.2
⫺19.6

⫺0.3
⫺25.4

1.8
⫺24.8

2.2
⫺27.7

Indonesia
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

2.7
1.5

5.5
3.0

6.3
2.4

6.1
0.1

4.5
1.4

5.6
0.5

5.8
0.3

Lao PDR
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

6.2
⫺9.8

8.4
1.4

7.6
2.5

7.3
⫺12.5

6.4
⫺8.1

7.5
⫺6.0

7.3
⫺7.0

Malaysia
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.8
6.5

5.8
16.3

6.2
15.5

4.6
17.5

⫺2.3
15.3

4.1
15.5

4.8
15.0

Papua New Guinea
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

0.7
3.0

2.6
2.2

6.5
1.8

6.6
2.8

3.9
⫺6.7

3.7
⫺4.7

3.3
⫺4.3

Philippines
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.2
⫺1.4

5.3
4.5

7.1
4.9

3.8
2.5

1.0
3.4

3.5
2.8

3.8
2.3

Thailand
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

2.7
1.9

5.3
1.1

4.9
5.7

2.6
⫺0.1

⫺2.7
5.5

3.5
3.5

4.0
3.0

Vanuatu
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

1.5
⫺9.8

7.4
⫺4.1

6.8
⫺5.3

6.6
⫺5.9

4.2
⫺4.7

4.5
⫺4.4

5.5
⫺3.4

Vietnam
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

7.2
⫺2.5

8.2
⫺0.3

8.5
⫺9.8

6.2
⫺11.9

5.5
⫺5.1

6.5
⫺4.5

7.0
⫺4.4

Source: World Bank.
Note: World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently,
projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not significantly differ at any given moment in time.
American Samoa; Micronesia, Fed. Sts.; Kiribati; Marshall Islands; Myanmar; Mongolia; N. Mariana Islands; Palau; Korea, Dem.
Rep.; Solomon Islands; Timor-Leste; and Tonga are not forecast owing to data limitations.
a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.
b. GDP measured in constant 2005 U.S. dollars.
c. Estimate.
d. Forecast.

Europe and Central Asia
Recent developments

A

mong developing regions, the Europe andCentral Asia region4 has been the mostnegatively affected by the global financial
crisis, albeit with large variations across theregion in the degree of impact. Aggregate GDP
is estimated to have contracted 6.2 percent in2009, nearly twice as much as the 3.3 percent
estimated decline in high-income countries, andsharply more negative than the (2.2 percent)contraction for the remaining developing countries excluding China and India (table A3).

123

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 1 0

Table A3 Europe and Central Asia forecast summary(annual percent change unless indicated otherwise)

GDP at market prices (2005 US$)b
GDP per capita (units in US$)PPP GDPc
Private consumption
Public consumption
Fixed investment
Exports, GNFSd
Imports, GNFSd
Net exports, contribution to growth
Current account balance/GDP (%)
GDP deflator (median, LCU)
Fiscal balance/GDP (%)
Memo items: GDP
Transition countries
Central and Eastern Europe
Commonwealth of Independent States
Russian Federation
TurkeyPoland1995–2005a

2006

2007

2008

2009e

2010f

2011f

4.1
4.0
4.0
4.8
2.0
4.7
7.9
8.7
0.1
0.9
18.8
⫺5.5

7.6
7.5
7.7
7.5
6.0
16.5
8.1
13.9
⫺1.5
1.1
9.3
3.0

7.1
7.1
7.4
9.2
5.2
14.2
7.1
17.9
⫺3.4
⫺0.6
7.7
2.4

4.2
4.2
4.5
6.4
4.1
8.7
3.9
9.0
⫺1.9
⫺0.3
9.5
0.7

⫺6.2
⫺6.2
⫺6.5
⫺4.6
2.3
⫺16.5
⫺13.2
⫺12.9
0.3
0.5
3.5
⫺6.2

2.7
2.6
2.7
2.2
2.1
4.1
4.3
3.7
0.1
0.4
6.7
⫺4.5

3.6
3.5
3.6
3.3
2.6
4.7
6.6
6.0
0.0
⫺0.2
4.0
⫺3.4

4.0
3.8
4.1
3.9
4.3
4.3

6.9
6.8
8.3
7.7
6.9
6.2

5.7
6.8
8.4
8.1
4.7
6.7

3.0
5.0
5.4
5.6
0.9
4.9

⫺4.1
⫺2.5
⫺8.1
⫺8.7
⫺5.8
1.6

2.2
1.3
3.1
3.2
3.3
2.2

3.8
3.5
3.3
3.0
4.2
3.4

Source: World Bank.
a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.
b. GDP measured in constant 2005 U.S. dollars.
c. GDP measured at PPP exchange rates.
d. Exports and imports of goods and nonfactor services.
e. Estimate.
f. Forecast.

The severity of the impact of the crisisin the region reflects significant preexisting
vulnerabilities in many countries. Many economies were heavily reliant on foreign finance(a result of excessive credit expansion that had
been enabled by foreign banks, large current
account deficits, elevated external debt levels,and considerable currency mismatches in both
corporate and household debt). As a result,
this region was particularly vulnerable to thereversal in capital flows that accompanied theinitial phases of the financial crisis.
Sharply reduced external demand for exports, a halving of foreign direct investment
inflows, and falling remittances exacerbatedthe collapse in investor confidence and credit
tightening, forcing a sharp contraction of
4.6 percent in regional private consumption, and a decline in gross fixed investmentof 16.5 percent in 2009—down from expansions of 6.4 percent and 8.7 percent, respectively, in 2008. The impact of the crisis wasmost negative in countries where households

124

and corporations held large foreign currency obligations (Armenia, Bulgaria, Croatia, Latvia, Lithuania, Romania, Turkey,
and Ukraine), and where pre-crisis growth
relied heavily on foreign capital inflows(Bulgaria, Georgia, Latvia, Lithuania, theformer Yugoslav Republic of Macedonia,
Moldova, Montenegro, and Romania areamong the largest, with current account deficits equivalent to 10 percent or more of GDP
in 2008). At the same time, petroleum exporters (Kazakhstan, the Russian Federation) werealso hit hard by the plunge in internationalcommodity prices.
Sharp declines in international financing have forced large adjustments in domestic
demand. Gross capital inflows to the region fell
54 percent during 2009, versus the 19 percent
increase posted by other developing countries(figure A8). This decline in inflows primarilyreflects the drying up of syndicated bank lending, which represented 60 percent of total flows
to the region in 2007, before the crisis. Partly

R E G I O N A L

Figure A8 Gross capital flows to Europe andCentral Asia picked up in mid-2009
US$ (billions)
70
60
50
40
30
20
10

Q
4

Q
3

09
20

09

Q
2

Bond

Bank

20

Q
1

09
20

Q
4
20

09

Q
3

08
20

Q
2
20

08

Q
1

08
20

08
20

20

07

Q
4

0

EquitySources: Dealogic: Bondware, Loanware and World Bank.

Figure A9 Many European and Central Asian
economies post sharp current accountadjustments
Change in current account balances (2008 to 2009)
Percent of GDP

Tu
rk
ey

ia
at

ro

nd
Po

la

ia
rg
eo

G

C

ia

ne

U

kr

ai

an

om

do
ol

M

R

ia

va

ia

ar
lg

tv
La

Bu

Li

th

ua

ni

a

18
16
14
12
10
8
6
4
2
0

Source: World Bank.

reflecting substantial support from international
financial institutions, bond and equity flows tocountries in the region began recovering in thethird quarter of 2009, although bank lending
remains very weak.
Reflecting the cut in capital inflows (andthe associated cuts in domestic demand), regional current account deficits have narrowed,
with Bulgaria, Latvia, and Lithuania posting double-digit improvements in current account positions measured as a share of GDP(figure A9). As a result of the cuts in spending,

E C O N O M I C

P R O S P E C T S

the region’s ex post financing needs declined,
while at the same time external assistanceand moral suasion helped prevent access toexternal finance from declining as sharply as
had been initially expected.
Reflecting these developments, financing
conditions have improved. Spreads on sovereign debt, which rose sharply in the third
quarter of 2008 and into the first quarterof 2009, have since narrowed. In the caseof Ukraine, for example, spreads over U.S.
Treasuries jumped by as much as 3,100–3,660
basis points in March 2009 but have since reversed to a spread of 768 points, as of early
January. These improved market conditions
have also been supported by an easing of inflationary pressures, which has enabled monetary
policies to focus on cushioning the downturn.
Many governments also implemented countercyclical fiscal policies to support domestic
demand. Reflecting these measures, as well as
the depth of the recession and much weaker
commodity prices, government deficits haveincreased by about 7 percent of GDP, moving from a surplus of 0.7 percent in 2008 to a
6.2 percent of GDP deficit in 2009.
Although economic activity in Europe andCentral Asia remains depressed, the pace ofcontraction is moderating. Thus, althoughindustrial production in the region began
expanding at a 4.8 percent annualized pace inthe second quarter of 2009, output in October
2009 remained 6.0 percent below its pre-crisis
level in October 2008 (figure A10).
In Russia, the 2009 recession is estimatedto have been much sharper than was the one
following the 1998 crisis. During the 2009
recession, GDP is estimated to have fallen
8.7 percent, compared with 5.3 percent in
the 1998 crisis, and represents the largest decline in growth since the breakup of the Soviet
Union.5 The contraction reflects both external
factors (import demand among Russia’s main
trading partners decreased by an estimated
15 percent in 2009) and domestic factors (an18 percent decline in investment and a 4.7 percent contraction in private consumption). Reflecting widespread economic slack, inflation

125

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 1 0Figure A10 Pace of contraction in industrial
production moderates in Europe and Central
Asia
Annual percentage change
20
15
10
5
0
⫺5
⫺10
⫺15

Latin America and Caribbean
Middle East and North Africa
Sub-Saharan Africa
High-income countries

9
.2

20

ct
O

l.
Ju

r.
Ap

00

09

09
20

09

8
Ja

n.

20

00

08
O

ct

.2

20

Ju

l.

20
r.
Ap

Ja

n.

20

08

08

⫺20

South Asia
East Asia and Pacific
Europe and Central Asia

Sources: IMF and World Bank.

has fallen below the 10 percent level, and theRussian central bank has repeatedly lowered its
refinancing rate, so that it is nearly zero in realterms. The government has also put in place alarge fiscal stimulus program, and as a result the
fiscal budget is projected to move from a surplusof 4.3 percent of GDP in 2008 to a deficit equivalent to 7 percent of GDP in 2009.
Turkey’s economy is projected to have contracted by 5.8 percent in 2009, nearly on parwith the 5.7 percent decline posted during the2001 economic crisis and its largest contraction
on record since 1969. The economy has been
hit by an investor pullback and sharp decline
in demand from export markets, notably fromwestern and eastern Europe, where economies
have posted some of the sharpest slowdowns
globally. The pace of contraction in growth
hit the trough in the first quarter of 2009, at
14.7 percent compared with the previous year,
but has eased significantly to a 3.3 percent rateof contraction in the third quarter—a relatively
rapid turnaround. Unemployment has surged,
contributing to the marked decline in private
consumption and fixed investment. With import
volumes contracting even faster than export volumes, the current account deficit improved to126

1.9 percent of GDP in 2009 from an estimated
5.8 percent of GDP in 2008. To support domestic demand, the Central Bank of Turkey
has more than halved its key policy interest
rate, cutting it by a cumulative 1,025 basis
points from 16.75 percent in October 2008 to
6.5 percent as of January 2010.
Economic conditions remained difficult overthe first three quarters of 2009 for the five newmembers of the European Union that are developing countries, although the pace of contraction in real output moderated from 12.6 percent
year-over-year in the first quarter to 4.4 in thethird quarter. Partly in response to strengthening
demand in high-income Europe, industrial production grew at a 6.5 percent annualized rate in
the three months ending in October.
Among the five European Union accession
members that are developing countries,6 Poland
has best weathered the economic storm and is
one of a handful of the 24 developing countries
in Europe and Central Asia not to witness a contraction in output. Poland’s good performancereflects comparatively resilient service and agricultural sectors, compared with industrial output, which fell by 9 percent in the first half of2009 over the first half of 2008. Exports werealso relatively resilient, and as a result, net exports contributed positively to growth.
Outside of Poland, the other four developing European Union accession economies posted
marked contractions in output during 2009,
given the bursting of the credit boom and contraction in demand from Western Europe. The
economies of Latvia and Lithuania were undersignificant stress before the onset of the acutephase of the crisis—a situation that was exacerbated by heightened international risk aversion(and concerns about the sustainability of theirpegs to the euro given huge accumulated imbalances). GDP in both countries is estimated tohave declined by well over 10 percent in 2009.
All four countries entered the crisis with verylarge current account deficits. While the collapse
in domestic demand has improved their external
positions, substantial external debt obligations
remain, further undermining the business andinvestment environment.

R E G I O N A L

Among the Commonwealth of Independent
States, Ukraine is projected to post the deepest
contraction in GDP of 15 percent in 2009—indeed one of the sharpest contractions in theworld. The plunge in metal prices in 2008
took a toll on the economy, where nonprecious metals represent over 40 percent of goods
exports. Further, political strains in the leadup to the January 2010 presidential elections
have delayed the government from meeting thefull set of IMF policy measures (such as raising household gas prices) under its $11 billion
November 2008 stand-by facility. Thus, while
the government has made some progress inmeeting its commitments to the IMF, it appears
that the release of the latest $3.7 billion tranche
will be postponed until after the elections. This
uncertainty—along with ongoing politicalinstability—has undermined confidence andcontributed to the depreciation and heightened
volatility in the hryvnya, which depreciated by
50 percent against the U.S. dollar in 2009.
Economic growth in the five Central Asian
countries has been relatively more robust than in
the rest of the region.7 However, this aggregate
picture masks wide differences in economic performances at the country level. Turkmenistan andUzbekistan—among the least open economies in
the Commonwealth of Independent States andexporters of natural gas—were only modestly
affected by the global crisis. In addition, these
economies benefited from the implementationof fiscal stimulus measures and are estimatedto have posted the strongest GDP growth outcomes in the Europe and Central Asia region,
with 8 percent and 5.5 percent, respectively,
in 2009. Growth in Tajikistan and Kyrgyz
Republic was buoyed by an upswing in agricultural output stemming from good harvests.
In contrast, GDP in Kazakhstan is estimatedto have contracted, led by the negative fiscal
effects from the collapse in oil prices.
Among the three Caucasus countries,8 theglobal crisis has had a particularly pronounced
impact on Armenia and to a lesser extent
Georgia—with economic conditions in the latter also negatively affected by the conflict with
Russia in 2008. In most of the other Central

E C O N O M I C

P R O S P E C T S

Asian and Caucasus countries, weaker economic conditions—notably a sharp reduction
in trade demand from Russia, lower oil andcommodity prices, and significant reductionsin investment and remittance flows—have been
partially offset by sustained economic assistance from Russia.
Overall, the number of poor or vulnerable
people in the Europe and Central Asia regionis estimated to have increased by some 10 million in 2009—compared with what might
have been had the crisis not arisen (based on a
$5-a-day poverty line). The contraction in economic activity has led to a 2.5 percentage point
jump in the median unemployment rate of the
10 countries reporting data (compared with
August 2008). Unemployment is expected toremain high for some time, curtailing household expenditures and contributing to higher
poverty rates. Partly as a result of higher unemployment in destination countries (notably
the European Union and Russia) for migrants,
remittances are projected to decline by 15 percent in 2009—placing additional pressure on
poor households. The macroeconomic impact
from the decline in remittances will be largest in countries such as Albania, Armenia,
Moldova, and Tajikistan, where remittances
represent between 9 percent of GDP (Armenia) and as much as 50 percent of GDP(Tajikistan). In Tajikistan an estimated 30 percent contraction in remittances may cause anadditional 5 percent of the population to moveinto poverty.9

Medium-term outlook
The recovery in economic growth in the region
is expected to be slow and marked by a risein poverty. GDP is projected to rise a modest
2.7 percent and 3.6 percent in 2010 and 2011,
respectively. This growth path contrasts sharply
with the average growth rate for the region of 7
percent from 2003 through 2007, and with theaggregate growth of 5.6 percent and 6.1 percent projected for other developing countries
in 2010 and 2011, respectively. While resurgent demand in parts of Europe and Asia—
combined with stable and/or modestly rising127

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 1 0commodity prices—should support a turnaround in the region’s exports, the projected
weak recovery for developed Europe will result
in relatively muted overall export growth. Similarly, foreign direct investment—which correlates strongly with trade activity—and credit
inflows are expected to remain significantly
lower than the levels observed before the crisis.
Given the region’s overleveraged private sector, weakness in the banking sector, and household indebtedness, the recovery in domestic
demand is expected to be muted. Higher tax
rates, cuts in public spending, higher unemployment, and lower wages will curb private
consumption, which is projected to firm to
2.2 percent in 2010 and 3.3 percent in 2011—
half the unsustainable 8.4 percent pace recorded
in 2006–07. Excess capacity and crowding-out
from increased government borrowing will
constrain investment, which is projected to
grow by 4.1 percent in 2010 and by 4.7 percent
in 2011—well below the double-digit growth
rates recorded in the pre-crisis years.
Because of weak domestic demand andrelatively tight financial conditions, the regional current account balance is forecast to
remain close to zero over the forecast horizon.
Across the region, however, there is greater
variety (table A4). For instance, hydrocarbon exporting economies are expected to record rising surpluses or reductions in deficits
resulting from somewhat higher petroleum
prices and increased production (Azerbaijan,
Kazakhstan, Russia, Turkmenistan, andUzbekistan). This improvement is projected to
be offset by an expansion in the current accountdeficits—given a more rapid recovery in domestic demand leading to import volumes
that exceed exports—in Moldova, Poland,
Romania, Ukraine, and Turkey. For developing
European countries with important automotive
industries, sales are expected to decelerate as
cash-for-clunkers programs in high-income
European countries unwind.
Most countries have little room for further
fiscal expansion. Indeed, government spending
is projected to moderate as a result of planned
structural fiscal consolidation. Combined with128

a projected firming of growth, which should
support stronger revenues, fiscal consolidation is projected to progressively reduce theregional fiscal deficit from 6.2 percent of GDP
in 2009 to 4.5 percent in 2010 and to 3.4 percent in 2011. However, the adjustment in anenvironment characterized by large negative
output gaps and low growth will be difficult,particularly as the recovery in tax revenues
may initially underperform, and that recovery
will be exacerbated by additional pressure in
the medium term emanating from extensivesocial assistance and pension regimes to support the aging population.
Monetary policy is expected to remain accommodative in most regional economies overmuch of the forecast horizon. Inflationarypressures should remain subdued, given large
excess capacity, weak domestic demand, anda relatively open economy. In countries facing continued adjustment in demand to reduce
external and internal imbalances, monetary
policy is expected to remain relatively restrictive to help dampen activity. Monetary policy
in countries with IMF programs will be guided
by the framework defined by the ongoingStand-by Arrangements. For those economies
that are moving toward adoption of the euro,
or whose currencies are pegged to the euro
(Bosnia and Herzegovina, Bulgaria, Latvia,
and Lithuania), monetary policy will be influenced by the European Central Bank’s policy
stance—which is expected to remain supportive of growth over the forecast horizon, but
incrementally withdraw stimulus measures(including reversal of policy interest rate cuts)as demand conditions permit. A moderate uptick in median regional headline inflation is
projected for 2010, as the downward pressure
from the fall in oil prices in the second half of2008 ceases and the recent uptick in commodity prices starts to work through the system.
These pressures should be partly neutralized
by the strong appreciation in currencies since
March 2009 (particularly the Russian ruble
and the Turkish lira), which will help to reduce import costs. However, core inflation
will continue to be subject to disinflationary

R E G I O N A L

E C O N O M I C

P R O S P E C T S

Table A4 Europe and Central Asia country forecasts(annual percent change unless indicated otherwise)

Albania
GDP at market prices (2005 US$)b
Current account balance/GDP (%)
Armenia
GDP at market prices (2005 US$)b
Current account balance/GDP (%)
Azerbaijan
GDP at market prices (2005 US$)b
Current account balance/GDP (%)
BelarusGDP at market prices (2005 US$)b
Current account balance/GDP (%)
Bulgaria
GDP at market prices (2005 US$)b
Current account balance/GDP (%)
Georgia
GDP at market prices (2005 US$)b
Current account balance/GDP (%)
Kazakhstan
GDP at market prices (2005 US$)b
Current account balance/GDP (%)
Kyrgyz Republic
GDP at market prices (2005 US$)b
Current account balance/GDP (%)
LatviaGDP at market prices (2005 US$)b
Current account balance/GDP (%)
Lithuania
GDP at market prices (2005 US$)b
Current account balance/GDP (%)
Macedonia, FYR
GDP at market prices (2005 US$)b
Current account balance/GDP (%)
Moldova
GDP at market prices (2005 US$)b
Current account balance/GDP (%)
PolandGDP at market prices (2005 US$)b
Current account balance/GDP (%)
Romania
GDP at market prices (2005 US$)b
Current account balance/GDP (%)
Russian Federation
GDP at market prices (2005 US$)b
Current account balance/GDP (%)
Tajikistan
GDP at market prices (2005 US$)b
Current account balance/GDP (%)
TurkeyGDP at market prices (2005 US$)b
Current account balance/GDP (%)
UkraineGDP at market prices (2005 US$)b
Current account balance/GDP (%)
Uzbekistan
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

1995–2005a

2006

2007

2008

2009c

2010d

2011d

5.4
⫺5.5

5.0
⫺5.9

6.0
⫺8.6

6.5
⫺13.4

2.2
⫺12.8

3.0
⫺7.6

4.5
⫺6.7

8.6
⫺11.7

13.2
⫺1.8

13.8
⫺2.6

6.8
⫺4.9

⫺13.0
⫺2.8

1.5
⫺0.6

3.5
3.7

10.2
⫺16.6

34.5
17.7

25.0
28.5

10.8
37.6

3.1
19.5

5.2
27.2

8.5
26.2

6.9
⫺3.2

10.0
⫺4.0

8.6
⫺6.8

10.0
⫺8.4

⫺1.0
⫺9.2

2.0
⫺6.3

4.0
⫺5.1

2.2
⫺3.6

6.7
⫺18.4

6.2
⫺25.2

6.0
⫺25.4

⫺6.5
⫺9.8

⫺2.0
⫺5.2

3.6
⫺4.9

6.6
⫺10.0

9.4
⫺16.2

12.3
⫺16.9

2.2
⫺22.8

⫺4.0
⫺18.2

2.0
⫺15.8

3.5
⫺16.7

6.4
⫺2.3

10.7
⫺2.5

8.2
⫺7.0

3.0
9.5

⫺1.9
⫺1.3

1.8
2.2

3.5
1.4

4.7
⫺10.2

3.1
⫺10.6

8.5
0.6

7.6
4.6

0.6
5.2

2.4
2.4

2.8
4.9

6.9
⫺7.5

12.2
⫺22.7

10.3
⫺21.5

⫺4.6
⫺11.3

⫺17.5
5.3

⫺3.9
6.0

2.4
7.0

6.0
⫺7.9

7.8
⫺10.7

8.9
⫺14.6

3.0
⫺16.1

⫺17.5
0.5

⫺3.5
0.3

2.2
⫺0.5

2.2
⫺5.9

4.0
⫺0.5

5.9
⫺4.4

5.0
⫺12.5

⫺1.3
⫺9.4

1.9
⫺8.3

3.8
⫺7.3

2.3
⫺7.9

4.8
⫺11.3

3.0
⫺16.5

7.2
⫺17.4

⫺9.0
⫺9.0

1.4
⫺10.2

2.8
⫺11.1

4.3
⫺3.3

6.2
⫺2.7

6.7
⫺4.7

4.9
⫺5.5

1.6
⫺0.9

2.2
⫺2.6

3.4
⫺2.5

2.2
⫺5.8

7.9
⫺10.4

6.2
⫺13.5

7.1
⫺12.4

⫺7.8
⫺4.2

0.5
⫺4.9

4.2
⫺5.5

3.9
7.6

7.7
9.6

8.1
5.9

5.6
6.2

⫺8.7
3.1

3.2
2.5

3.0
1.7

4.6
⫺4.5

7.0
⫺2.8

7.8
⫺8.6

7.9
⫺7.9

2.0
⫺10.9

5.0
⫺11.1

5.0
⫺10.2

4.3
⫺1.5

6.9
⫺6.0

4.7
⫺6.1

0.9
⫺5.8

⫺5.8
⫺1.9

3.3
⫺2.5

4.2
⫺2.8

2.7
2.7

7.3
⫺1.5

7.9
⫺3.7

2.1
⫺7.2

⫺15.0
⫺0.6

2.2
0.1

3.0
⫺2.1

4.6
3.3

7.3
14.4

9.5
19.5

9.0
26.3

5.5
16.9

6.5
20.4

6.5
19.2

Source: World Bank.
Note: World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently,
projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not significantly differ at any given moment in time.
Bosnia and Herzegovina, Turkmenistan, and Yugoslavia, FR (Serbia/Montenegro) are not forecast owing to data limitations.
a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.
b. GDP measured in constant 2005 U.S. dollars.
c. Estimate.
d. Forecast.

129

G L O B A L

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P R O S P E C T S

2 0 1 0tendencies and headline inflation is expectedto ease into 2011.

Figure A11 Nonperforming loans rise acrossmuch of developing Europe and Central Asia
% share of total

Risks
Despite the weak baseline forecasts for the region, risks remain tilted toward the downside,a result of financing constraints, the limited
scope for supportive fiscal policy, large andrising banking sector vulnerabilities, and a lackof economic diversification. If the domestic
recovery is slow and subdued with continued
high interest rates stifling investment growth,potential output could suffer—leading to arise in structural unemployment. A more protracted and deeper-than-projected recession
could place further pressure on banking systems and on currencies in those countries withrelatively inflexible exchange rate regimes.
Balance-sheet consolidation by parent banks
of foreign subsidiaries may manifest as further cuts in financial flows to the region in themonths ahead. Rising domestic nonperforming loans and inadequate provisioning thereof
pose significant risks to regional growth byrestricting capital availability or, in a worst
case scenario, leading to a freezing of banking
systems (figure A11). This already somber scenario may be further darkened if it coincides
with a global double-dip scenario, particularly
if the region’s major export markets (such as
Germany) are severely affected.
A related and enduring risk for the region derives from the high level of household
and corporate foreign-currency-denominateddebt. Exposure to foreign exchange loans exceeds 50 percent of total lending in Hungary,
Kazakhstan, Latvia, Lithuania, Romania, andUkraine for both corporate and household borrowers. For households in particular, high levelsof foreign exchange debt post significant risks,because unlike corporations, households areunlikely to have hedged against exchange rate
movement.10 For countries with relatively inflexible exchange rate regimes, outturns could
find these regimes under assault, which in turnwould limit the ability of regional central banks
to conduct accommodative monetary policy.

130

Belarus
2007

Bulgaria
Bosnia andHerzegovina
Turkey2009

PolandMacedonia,
FYR
RussianFederation
Moldova
Montenegro
SerbiaLatviaLithuania
Ukraine
0

5

10

15

20

25

30

Percent share of total
Sources: IMF Global Stability Report, October 2009; World Bank.
Note: Ranked by 2009 median for all reporting countries. Medianwas 2.7 percent for 2007; 4.4 percent for 2009.

Reinvigorating the reform programs thathave stalled with the global crisis could help deliver stronger growth outturns than projected.11
Regional governments have space to introduce
institutional reforms to improve the regulatory
framework and reduce red tape, tighten legal
standards and further adopt international contract and property rights norms, and clamp
down on corruption to improve competitionand efficiency, among other reforms. Failure toreform the pension systems poses a long-term
threat to growth, given high social security financing burdens. Successful implementation ofthese reforms may lower precautionary savings,
with positive spin-offs for private consumption
and growth. Higher private consumption in theregion is indeed identified as a possible upside risk
and incorporated in the global “more buoyant
private-sector reaction” scenario (see chapter 1).
Finally, given the degree of dislocation engendered by the crisis, black market activity is
expected to rise, posing challenges for policy
makers and undermining greater fiscal consolidation. In the Commonwealth of Independent States, a lack of economic diversification

R E G I O N A L

outside of mineral-export-led activities is acommon structural weakness and remains a
key vulnerability.

Latin America and the Caribbean
Recent developments

T

hanks
to
sound
macroeconomic
fundamentals in place before theonset of the crisis, the Latin America andCaribbean region has been able to weather
the global financial crisis much better thanprevious external shocks. Nevertheless,economic activity in the region decelerated sharply in the aftermath of the crisis.
For the 2009 calendar year, GDP is estimated to have fallen 2.6 percent, following
an expansion of 3.9 percent in 2008 (table A5).
This aggregate result masks a high degree ofheterogeneity among countries in the region
with respect to the timing and magnitude of

E C O N O M I C

P R O S P E C T S

the contraction in domestic output. Central
American economies (including Mexico)
were the worst affected, with output contracting a sharp 6.4 percent, while growth in the
Caribbean economies stagnated.
In the immediate aftermath of the crisis,
the region was hit by a sharp slowdown inprivate capital inflows, while increased uncertainty and credit tightening led to a marked
contraction in private consumption and private investment. The capital outflows induceda sharp depreciation of currencies in the region, a decline in equity markets, and muchhigher borrowing costs. Nevertheless, the region managed to avoid falling into a balanceof payments and/or financial crisis.
Private consumption contracted by nearly
2 percent, while fixed investment declined
sharply by 13.6 percent, after growing at
double-digit rates in the previous years. The
region was also affected by the collapse in external demand for commodity exports, falling

Table A5 Latin America and the Caribbean forecast summary(annual percent change unless indicated otherwise)
1995–2005a

2006

2007

2008

2009e

2010f

2011f

GDP at market prices (2005 US$)b
GDP per capita (units in US$)PPP GDPc
Private consumption
Public consumption
Fixed investment
Exports, GNFSd
Imports, GNFSd
Net exports, contribution to growth
Current account balance/GDP (%)
GDP deflator (median, LCU)
Fiscal balance/GDP (%)

2.9
1.4
2.9
3.4
2.2
3.3
6.0
6.2
0.2
⫺1.6
7.1
⫺3.5

5.4
4.0
5.5
6.1
2.8
13.4
6.7
14.0
⫺1.5
1.4
7.2
⫺1.1

5.5
4.1
5.7
3.5
2.9
20.7
4.9
11.9
⫺1.7
0.4
5.4
⫺1.1

3.9
2.6
4.2
4.2
4.1
11.7
1.6
9.2
⫺2.0
⫺0.6
8.4
⫺0.9

⫺2.6
⫺3.8
⫺2.3
⫺1.9
2.9
⫺13.6
⫺11.2
⫺15.8
1.6
⫺0.9
7.2
⫺3.3

3.1
1.8
3.0
3.2
2.8
6.1
7.8
10.3
⫺0.7
⫺1.0
3.0
⫺2.8

3.6
2.3
3.5
3.4
2.6
5.8
5.0
5.6
⫺0.3
⫺1.0
4.0
⫺2.5

Memo items: GDP
Latin America excluding Argentina
Central America
CaribbeanBrazilMexicoArgentina

3.0
3.6
4.2
2.4
3.6
2.3

5.2
5.0
9.0
4.0
4.8
8.5

5.2
3.7
6.1
5.7
3.3
8.7

3.7
1.7
3.6
5.1
1.4
6.8

⫺2.6
⫺6.4
⫺0.1
0.1
⫺7.1
⫺2.2

3.2
3.3
2.3
3.6
3.5
2.3

3.7
3.6
3.3
3.9
3.6
2.4

Source: World Bank.
a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.
b. GDP measured in constant 2005 U.S. dollars.
c. GDP measured at PPP exchange rates.
d. Exports and imports of goods and nonfactor services.
e. Estimate.
f. Forecast.

131

G L O B A L

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P R O S P E C T S

2 0 1 0Figure A12 Industrial production and tradevolumes are gaining momentum in Latin
America and the Caribbean
Industrial production growth (3 month saar)
50
40
30
20
10
0
⫺10
⫺20
⫺30
⫺40
⫺50
Jan.
2000

Industrial
production

Export volume

Jul.
2001

Jan.
2003

Jul.
2004

Jan.
2006

Jul.
2007

Jan.
2009

Source: World Bank.

commodity prices, lower remittance inflows,
and declining tourism activity. The decline
in domestic demand translated into a sharp
15.8 percent contraction in import volumes.
As a result, and despite an 11.2 percent contraction in export volumes, net trade contributed 1.6 percent to growth. Reflecting thesedevelopments industrial activity fell rapidly,
plunging at a 20 percent saar rate in the lastquarter of 2008 and at 16 percent in the firstquarter of 2009 (figure A12).
Countries that rely heavily on trade with
the United States were especially hard hit by
the crisis. Mexico’s economy suffered thesteepest contraction in the region (7.1 percent)and its worst economic performance in sevenand a half decades, both because of its close
economic ties with the United States in the sectors most affected by the crisis (construction,
automotive, and electrical appliances) and because of the AH1N1 flu outbreak in the second quarter of 2009. The flu outbreak hit the
tourism sector especially hard and is estimatedto have reduced overall GDP by 0.5 percent.
Furthermore Mexican firms suffered foreign
derivatives losses in December 2008 after the
global crisis drove the peso to record lows.

132

Exports collapsed in the first half of the year,
dragging output down 7 percentage points,
while the collapse in import volumes boosted
growth by close to 9 percentage points. In
2009 private consumption is estimated tohave contracted by 6.9 percent, as the labormarket was severely affected by the economic
slowdown, with formal unemployment almost
doubling to 6.4 percent by September, and asremittances fell 13.4 percent in the first ninemonths of the year.
In Argentina, the global recession in conjunction with policy-related uncertainty took
a toll on investment and trade. Collapsing
imports and declining fiscal revenues point to
weak domestic demand and relatively poor
output performance in the first half of 2009,
while a severe drought added to the economy’s
weak performance.
In República Bolivariana de Venezuela,
GDP is estimated to have declined 2.4 percent as a result of the collapse in external
demand, weak private consumption, andlower investment spending. Manufacturing andretail sales plunged owing to weak domestic
demand, and output fell at a 4.5 percent annualized pace in the third quarter of 2009. The
oil sector is becoming increasingly dominant
in the economy. Supply bottlenecks, a difficult
business environment, and a lack of private
investor confidence are undermining new investment, impairing much-needed economic
diversification.
Strong retrenchment in private investment
spending and a steep drawdown in stocks(close to 1 percent of GDP) caused Chile’s output to decline 4.7 percent year-on-year in thesecond quarter of 2009. Marked weakness indomestic demand resulted in a sharp contraction in imports that exceeded the plunge inexports.
Peru’s economic growth decelerated froma double-digit pace in the first half of 2008
to a standstill in the first half of 2009, withthe sharp contraction in investment spending
leading to a 5.4 percent contraction in domestic demand. Weak external demand resulted

R E G I O N A L

in a 6.3 percent decline in exports, although
imports contracted more sharply on accountof weak domestic demand.
Countries in Central America and the
Caribbean were afflicted by the recession in the
United States and major economic partners in
the European Union, particularly Spain, which
has resulted in a contraction in trade, tourism,
FDI, and remittances. The Caribbean economies contracted only 0.1 percent in 2009,
down from the 3.6 percent growth recorded
in 2008. Jamaica recorded one of the sharpest
declines in GDP in the subregion, attributable
to its heavy dependence on the U.S. economy(remittances declined 17 percent in the firsthalf of 2009), and to sharp cuts in mining
production. In the Dominican Republic, economic performance deteriorated sharply, with
output down by 0.1 percent after 5 percent
growth in 2008, reflecting developments in the
U.S. economy that affected remittances, FDI,
and tourism. The improvement in the termsof trade, as the oil price declined, has had apositive impact on economic performance, however. Caribbean economies benefited somewhat
from the AH1N1 outbreak in Mexico as visitors
shifted holiday destinations from Mexico to the
Caribbean islands, and consequently in the earlystages of the crisis, tourism and offshore financial services proved somewhat resilient.
The Central American economies, excluding Mexico, contracted by 1.0 percent in 2009.
External demand for their exports was hit by
the global economic crisis, while remittances
and tourism revenues also declined. Costa
Rica’s economy was afflicted by a 10.3 percent decline in U.S. tourist arrivals in thefirst nine months of 2009, but investment in
the services sector continued and back-officeservices were resilient. The decline in tourist
arrivals has prompted large price cuts for tourism packages as countries competed for a declining number of tourists. Remittances havealso suffered because of weak labor markets
in high-income countries. Compared with ayear earlier, remittances to Guatemala andEl Salvador were down by 9.5 and 10.3 percent,

E C O N O M I C

P R O S P E C T S

respectively, during the first half of 2009. In
the first quarter of 2009, FDI inflows to Costa
Rica fell by 19 percent (year-on-year), and by
41 percent to the Dominican Republic.
In response to the crisis, many governments in
the region implemented countercyclical macroeconomic policies in an effort to support domestic demand, with government spending being theonly demand component that registered growthduring 2009. The aggressiveness of the fiscal
policies implemented depended on the fiscal
space available in each country and the extent
to which they had access to financial markets.
That said, the region entered the crisis muchbetter prepared with respect to both the fiscal
and external accounts. In Mexico, the declining
oil revenues constrained the countercyclical response. In Chile, fiscal stimulus has helped limit
the output contraction, and the government also
provided credit support to SMEs through the development bank Banco Estado. The implementation of the fiscal stimulus in Peru was to someextent hindered as budget appropriation anddistribution rules limited the increase in government spending, even as procurement rules havebecome more lax. Furthermore the government
provided credit support to SMEs through the development bank Banco de la Nacion to help ease
the impact of the credit crunch.
To support domestic demand at the timethat external demand was collapsing, countries more integrated in the global economy
lowered interest rates aggressively and allowed
real exchange rates to depreciate (figure A13,
figure A14). During the monetary-easing cycle,
the central bank of Colombia cut rates by acumulative 6.5 percentage points. Chile cut
rates by 7.75 percentage points since the beginning of 2009, while Peru also eased monetary
policy substantially. Brazil cut the SELIC12rate by an unprecedented 500 basis points to8.75 percent.
As elsewhere, many economies in the region showed signs that the recession bottomed
out in the second half of 2009, with external
demand rebounding faster and more strongly
than initially anticipated (figure A15).

133

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P R O S P E C T S

2 0 1 0Figure A13 Central banks across Latin
America eased monetary policy aggressively

Figure A15 Quarterly GDP points to output
stabilization in Latin America

Percent

Percent change
6

15

4
2
10

0
⫺2
⫺4

5

⫺6

Feb.
2009

May.
2009

Aug.
2009

Aug.
2009

MexicoBrazilColombia

Peru

Chile

Sources: Central banks; Datastream; Thomson Financial.

Figure A14 Real effective exchange rates
depreciated in more integrated economies
Jan 2006 ⫽ 100
150
140
130
120
110
100
90
80
70
Jan.
2006

Jul.
2006

Jan.
2007

Jul.
2007

Jan.
2008

BrazilChile

Mexico

Peru

Jul.
2008

Jan.
2009

Jul.
2009

Colombia

Source: JPMorgan.

In Brazil, a swift rebound in domestic demand was boosted by expansionary monetary
policy and countercyclical fiscal policy. These
steps pulled the economy out of recession in
the second quarter of 2009. Brazil’s economy
is also benefiting from the shift in the inventory cycle. This in conjunction with the stimulus for the automotive sector has set the stage

134

Pe
ru

hi
le
C

om
bi
a
ol

a
in
nt

M
ex
ic
o

C

Nov.
2008

Ar
ge

0
Aug.
2008

Br
az
il

⫺8

2008Q1

2008Q2

2008Q3

2009Q1

2009Q2

2009Q3

2008Q4

Source: Haver Analytics.
Note: Data represent the seasonally adjusted change quarter overquarter except for Mexico, which are seasonally adjusted annual
rates.

for a sharp recovery in industrial production,
which increased by an annualized 17.6 percent
in the second quarter and by 20.5 percent in
the third quarter. However, because of baseeffects and a rather moderate recovery inexternal demand, as Chinese restocking tailed
off, output is estimated to have remained relatively flat in 2009, implying the worst economic performance since the early 1990s.
In Mexico, the rate of contraction moderated in the second and third quarters, supported
by less dramatic output declines in the manufacturing and service industries. In Argentina,
an improved external environment has igniteda modest recovery and led to improvements inexternal balances, as commodity prices firmed
and demand for exports increased, in particular from its main trading partner Brazil. In
Chile significant fiscal and monetary stimulus contributed to the moderation in output
contraction to 1.7 percent year-on-year in thethird quarter, bringing the decline in GDP overthe first three quarters of the year to 2.7 percent. In Colombia the improved external environment and the lagged effect of aggressive
monetary easing helped the economy recoverin early 2009. Output growth in the first two

R E G I O N A L

Medium-term outlook
Fiscal stimulus, lagged impacts of accommodative monetary policy, the shift in theinventory cycle, improvements in the termsof trade, rising consumer and business confidence, stronger demand from high-income
countries, and an easing of external financing
conditions are all expected to support growthin the region over the next few quarters. GDP
growth in the region is projected to accelerate to
3.1 percent in 2010, following an estimated
2.6 percent contraction in 2009, but growth
will not regain the growth rates recorded
during the boom years, in part because of

P R O S P E C T S

Figure A16 Capital flows return to Latin
America
US$ (billions)
70
60
50
40
30
20
10

20
09
Q
4

20
09

09

Equity

Q
3

20

09
Q

Q

2

20

08

Bank

1

20

08
4
Q

Q

3

20

20
08
Q
2

20
08

0

Q
1

quarters of 2009 was also boosted by strong
growth in public investment spending, eventhough private consumption and investment
remained weak. In Peru a significant rebuilding of inadequate stocks is projected to contribute to growth in the second half of 2009.
Uruguay’s economy expanded by 0.5 percent
in the second quarter of 2009 relative to theprevious quarter, bolstered by growth in construction and transportation, reflecting theimpact of several megaprojects, which offset
output declines elsewhere, particularly in energy, agriculture, and manufacturing.
Corporate and sovereign spreads have retreated to pre-crisis levels in countries more
integrated into the global financial system—
demonstrative of a return of investors’ confidence, while access to the international debt
market has also improved. Lower-rated countries in the region continue to be perceived
as risky by investors and this is reflected in
spreads remaining above pre-crisis levels.
Overall, capital inflows to the region havereturned, especially in economies that proved
resilient to the crisis, such as Brazil, with total
capital inflows rising to $57.4 billion in the
fourth quarter of 2009, up from $15.7 billion
in the second quarter. Bond issuance increased
almost sixfold, nearing $30 billion, while equity inflows more than tripled to $14.8 billion.
Bank lending recovered modestly, totaling$13.2 billion, down 33 percent compared withthe second quarter of 2008 (figure A16).

E C O N O M I C

Bond

Sources: Haver Analytics; World Bank.

weaker investment growth. The shape of therecovery will, to a large extent, be determinedby the growth path of the United States andother major economic partners of the region.
Growth is expected to remain strong for the
next couple of quarters but to weaken in thesecond half of 2010, as the impact of stimulus measures and the rebuilding of depleted
inventories cease to bolster growth. A double
dip or a more buoyant growth scenario is also
possible as a result of close linkages with highincome countries.
Economies more integrated through tradeand financial linkages with the global economy, which have been the worst affected by
the global downturn are expected to benefit
most from the global economic recovery. The
region’s exports are projected to reboundstrongly, expanding by 7.8 percent in 2010 asdemand from major trading partners recovers. Higher commodity prices will also benefit commodity exporters in the region, easingpressures on external balances and in somecases fiscal balances. A weakening of growth
momentum or even a double dip in highincome countries (see chapter 1) could lead toa deceleration in export growth in the second
half of 2010 and into 2011.

135

G L O B A L

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P R O S P E C T S

2 0 1 0Private consumption in the region is projected to bounce back strongly, rising 3.2 percent in 2010, partly because of a low baseeffect (it contracted by an estimated 1.9 percent in 2009) but also owing to improvements
in labor markets throughout the region andin migrant-destination countries. Domestic
demand growth may be supported by a pronounced bounce back in fixed investment asconfidence returns and financing constraints
ease (see chapter 1 regarding a more buoyant
private sector reaction scenario). Less restrictive financing conditions compared with thecrisis period and a return of investor confidence together with resumptions in delayedinvestment, are projected to boost fixed investment by 6.1 percent in 2010. However,investment growth will remain below the
double-digit pace recorded in the boom years,
as excess capacity lingers. Large output gaps,
weak international financing conditions, andweak public sector investment will all weighon prospects. The lagged impact of the substantial monetary easing in some countries,
along with stronger fiscal stimulus, and a oneoff benefit from inventories accumulation willbolster growth into 2010. In other countries,
such as Chile, there will be fiscal consolidationin 2010, which will moderate the contributionof government spending to growth.
The tourism sectors in many countries
in the region are expected to stage a recovery after a sharp decline in tourist arrivals in
2009, although a recovery in Mexico’s tourism sector may weaken the recovery in someof the Caribbean countries that had seen alower-than-expected decline in tourist arrivals
in 2009, as they managed to attract tourists byoffering discounted packages.
Remittances are expected to recover only
modestly in the 2010–11 period, underminedby weak labor market conditions in the
United States and other high-income countries, although the bottoming out of the housing sector in the United States bodes well forcountries receiving remittances from the construction sector. The weak recovery in remittances will limit the strength of the recovery in136

private consumption in many countries in the
Caribbean and Central America.
The recovery in the United States will help
Mexico exit the deep recession it entered following the collapse in U.S. demand. Mexico’s
economy is forecast to expand by 3.5 percent
in 2010 and growth will accelerate marginallyto 3.6 percent in 2011 (table A6). Government spending is not expected to grow as it
implements fiscal adjustments to compensate
for lower oil revenues associated with declining oil production. Both exports and imports
are projected to rebound strongly in 2010, as
external and domestic demand strengthen, but
net trade will be a drag to growth, as the acceleration in imports due to stronger domestic
demand will outpace export growth. A strong
rebound in the service sector is projected, after
a subdued performance in 2009 on accountof the negative impact of the AH1N1 flu.
Mexico’s growth outlook is clouded, however,by concerns about the long-term sustainabilityof fiscal accounts. The fiscal shortfall over the
2009–10 period is estimated at a cumulative
6.6 percent of GDP, with almost half of thedeterioration related to lower oil prices andproduction. The expected fiscal reform should
reduce government discretionary spending,which may have a negative impact on growthover the short(er) term.
Domestic demand in Brazil should benefit
from strong fiscal and monetary stimuli, while
exports are projected to rise in response tostrong external demand from China. Overall,the economy is projected to stage a comebackin 2010, with growth accelerating to 3.6 percent. Economic growth will be largely driven by
the recovery in private consumption and investment, as well as stronger external demand.
Recovery in external demand will help
Argentina’s economic recovery strengthen into
2010 as job creation in export-oriented industries will underpin a mild recovery in private
consumption. The expected recovery in the agriculture sector will boost economic activity,
as will less restrictive external financing conditions. The recovery will be fragile, however,with investment remaining a drag on growth

R E G I O N A L

E C O N O M I C

P R O S P E C T S

Table A6 Latin America and the Caribbean country forecasts(annual percent change unless indicated otherwise)
1995–2005a

2006

2007

2008

2009c

2010d

2011d

Argentina
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

2.3
⫺0.2

8.5
3.6

8.7
2.8

6.8
2.2

⫺2.2
2.3

2.3
2.2

2.4
2.2

BelizeGDP at market prices (2005 US$)b
Current account balance/GDP (%)

5.6
⫺12.1

4.7
⫺2.1

1.2
⫺4.0

3.8
⫺10.8

⫺0.1
⫺7.7

1.7
⫺7.7

2.3
⫺7.6

Bolivia
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

3.8
⫺3.0

4.6
11.5

4.6
12.5

6.1
12.0

2.6
2.6

3.2
1.8

3.8
2.9

Brazil
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

2.4
⫺2.0

4.0
1.3

5.7
0.1

5.1
⫺1.7

0.1
⫺1.1

3.6
⫺1.6

3.9
⫺1.8

Chile
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.2
⫺1.5

4.6
4.9

4.7
4.4

3.2
⫺2.0

⫺1.8
1.5

4.7
1.1

4.5
1.4

Colombia
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

2.4
⫺2.2

6.9
⫺1.8

7.5
⫺2.9

2.5
⫺2.7

⫺0.1
⫺2.9

2.6
⫺2.6

3.9
⫺2.3

Costa Rica
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.5
⫺4.0

8.8
⫺4.5

7.8
⫺6.3

2.6
⫺9.2

⫺1.8
⫺4.2

2.1
⫺5.1

2.9
⫺6.3

Dominica
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

1.4
⫺19.8

3.2
⫺17.3

0.9
⫺28.5

3.1
⫺36.5

⫺1.7
⫺24.2

1.4
⫺24.1

3.0
⫺23.8

Dominican Republic
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

5.2
⫺0.8

10.7
⫺3.6

8.5
⫺5.1

5.0
⫺10.1

⫺0.1
⫺6.8

2.4
⫺7.2

2.6
⫺6.7

EcuadorGDP at market prices (2005 US$)b
Current account balance/GDP (%)

3.2
⫺1.4

3.9
3.9

2.5
3.6

6.5
2.2

⫺2.2
⫺3.0

1.7
⫺3.3

3.0
⫺3.4

El Salvador
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

2.7
⫺2.5

4.2
⫺3.6

4.7
⫺5.4

2.5
⫺7.2

⫺2.1
⫺2.6

0.8
⫺3.5

2.3
⫺4.7

GuatemalaGDP at market prices (2005 US$)b
Current account balance/GDP (%)

3.5
⫺4.9

5.4
⫺5.2

6.3
⫺5.4

3.8
⫺4.8

⫺0.4
⫺2.8

1.6
⫺4.1

3.0
⫺4.4

GuyanaGDP at market prices (2005 US$)b
Current account balance/GDP (%)

1.7
⫺9.4

⫺2.4
⫺19.8

5.4
⫺17.8

3.2
⫺20.2

1.1
⫺12.6

2.5
⫺18.1

3.0
⫺18.2

Haiti
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

0.9
⫺4.0

2.3
⫺9.0

3.2
⫺5.7

1.4
⫺8.2

⫺0.3
⫺7.9

1.9
⫺9.1

2.1
⫺10.6

Honduras
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

3.8
⫺6.7

6.3
⫺4.7

6.3
⫺9.8

4.0
⫺14.3

⫺2.5
⫺8.7

1.8
⫺10.9

2.8
⫺9.3

Jamaica
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

0.8
⫺5.5

2.7
⫺9.9

1.5
⫺15.3

⫺1.0
⫺19.8

⫺3.7
⫺14.3

0.3
⫺12.6

2.2
⫺9.9

Mexico
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

3.6
⫺1.9

4.8
⫺0.5

3.3
⫺0.8

1.4
⫺1.5

⫺7.1
⫺1.4

3.5
⫺1.7

3.6
⫺1.9

(continued)137

G L O B A L

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P R O S P E C T S

2 0 1 0

Table A6 (continued)(annual percent change unless indicated otherwise)
1995–2005a

2006

2007

2008

2009c

2010d

2011d

Nicaragua
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.1
⫺20.2

3.7
⫺13.4

3.2
⫺17.6

3.2
⫺23.8

⫺2.5
⫺15.2

1.7
⫺19.8

1.7
⫺21.7

PanamaGDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.5
⫺5.3

8.5
⫺3.1

11.5
⫺7.3

9.2
⫺12.3

1.2
⫺7.4

2.7
⫺10.1

3.8
⫺10.0

Paraguay
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

1.2
⫺1.5

4.3
1.4

6.8
0.8

5.8
⫺2.1

⫺3.8
⫺0.3

2.6
⫺1.5

3.7
⫺1.9

Peru
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

3.3
⫺3.3

7.7
3.0

9.0
1.6

9.8
⫺3.4

1.2
⫺2.4

3.9
⫺2.5

5.2
⫺2.3

St. Lucia
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

2.9
⫺13.8

2.2
⫺33.1

1.7
⫺32.6

0.7
⫺33.6

⫺1.4
⫺26.5

1.5
⫺27.9

2.7
⫺29.0

St. Vincent and the Grenadines
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.2
⫺18.3

10.8
⫺24.1

6.7
⫺26.3

2.3
⫺27.8

⫺1.0
⫺20.1

1.2
⫺21.4

1.8
⫺21.8

Uruguay
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

1.5
⫺0.9

4.6
⫺2.0

7.6
⫺0.9

8.9
⫺3.8

1.3
⫺1.4

3.2
⫺2.4

3.4
⫺2.5

Venezuela, R. B. de
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

1.6
7.5

10.3
14.3

8.4
8.7

4.8
12.4

⫺2.4
2.2

⫺0.2
3.5

1.4
2.5

Source: World Bank.
Note: World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently,
projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’
prospects do not significantly differ at any given moment in time.
Barbados, Cuba, Grenada, and Suriname are not forecast owing to data limitations.
a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.
b. GDP measured in constant 2000 U.S. dollars.
c. Estimate.
d. Forecast.

owing to policy uncertainty. Furthermore,
the unsustainable fiscal stimulus implemented
ahead of the presidential elections will likely
fade in the second half of the year, weakening
one of the growth engines.
República Bolivariana de Venezuela is expected to buck the regional trend of economic
recovery and is likely to continue to contract fora second consecutive year in 2010, as private
consumption, investment, and exports continue
to shrink. Macroeconomic imbalances—theresult of inadequate macroeconomic policies
and high inflation (notwithstanding economic
contraction)—will undermine investment. Also,
the strong growth of government spending,138

funded by an increasing public debt issuance aswell as price and exchange controls, is undermining growth. Inflationary pressures are likely
to continue to be fueled by currency mismanagement as well as rising import costs, partly stemming from the government’s decision to importthrough Argentina instead of Colombia. Furthermore, inadequate investments will exacerbate domestic shortages, thereby exerting further
upward pressure on prices.
Small open economies like Chile are likely tobenefit most from the global economic recovery
as their business cycles are highly correlated withthe global economy. Chile’s recovery will also be
supported by domestic factors because aggressive

R E G I O N A L

and front-loaded countercyclical policies areboosting domestic demand. Improved terms oftrade as well as rising consumer and business confidence should also bolster the recovery, bringing
growth closer to potential.
Peru’s recovery will benefit from stronger
demand for commodity exports, particularly
from Asia. Furthermore, the Free Trade Agreement with China, which comes into operationin January 2010, will further boost exports,
in particular those of fishmeal and minerals.
Government consumption and investment
should be firm in 2010 as the government
maintains efforts to support economic growththrough new spending on public works andsocial programs, and it should remain a highpriority ahead of the April 2011 presidential
and congressional elections.
Growth in Central America is expected tobounce back in 2010 in line with developmentsin the United States and other major economic
partners. Recovery in the region is highly dependent on workers’ remittances from the UnitedStates and Europe (El Salvador, Guatemala,Honduras, and Nicaragua), and is projected to be
more gradual, as the expected jobless recovery inhigh-income countries will put pressure on remittances, thereby delaying the recovery in private
consumption in these countries. Similarly, tourism in the region (of particular importance for
the Caribbean) is expected to recover only moderately as labor markets in client countries recover
only gradually. FDI, which was a major sourceof growth over the 2003–08 period, is unlikely
to return to pre-crisis levels while excess capacity
lingers. The recovery in most countries in Central
America will thus be anemic at best. In Jamaica,
low alumina and bauxite production and export
prices will constrain the recovery. Growth in theseregions will continue to be undermined further bycrime, corruption, weak democratic institutions,and a lack of competitiveness.

Risks
In countries where domestic demand is strengthening rapidly, delays in withdrawing policy
stimulus represent an upside risk to growth andinflation. In such cases, output gaps could close

E C O N O M I C

P R O S P E C T S

faster than anticipated, leading to an inflationary
environment. In particular, the risks for Brazil
have shifted to the upside as domestic demand isrebounding strongly, while the effects of alreadyenacted monetary loosening and countercyclicalfiscal policy easing have not yet run their course.
Another upside risk emanates from commodity
prices, should the world economy (particularly
in resource-intensive economies such as China)
stage a stronger-than-expected rebound.
The recent run-up in equity markets andstronger capital inflows in general, stemming inpart from still large interest rate differentials,
have put upward pressure on real effective exchange rates in some countries. The surge incapital inflows to the region, which reached$87.2 billion in the second half of 2009 (ofwhich $34.3 billion came in December), compared with $36.8 billion in the first half of theyear, has prompted the Brazilian government toimpose a 2 percent financial transaction tax on
foreign portfolio inflows. However, this measure has been ineffective in preventing capital
inflows and real currency appreciation. Shouldsuch flows persist, this may lead to renewed
asset price bubbles. Also, some economies may
lose external competitiveness because of realcurrency appreciation at a time when external
demand recovery remains fragile.

Middle East and North Africa
Recent developmentsT

he impact of the global financial crisis forthe developing economies of the Middle
East and North Africa region varied across oil
exporters and importers of the region.13 Initially,
the decline in regional equity markets was
sharper than the average for emerging markets(figure A17). Since then, recovery in these markets has been hesitant owing to the unfolding of
the Dubai World debt problems in the United
Arab Emirates as well as concerns regarding
growth prospects for the broader region.
Conditions at the outset of the financial
crisis were less than propitious for the Middle
East and North Africa. The “food-fuel” crisis

139

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2 0 1 0Figure A17 Equity markets in the Middle East
dropped quickly, and GCC recovery has been
muted
U.S.$-based equity prices (Jan. 1, 2008 = 100)
120
100
80
60
40
20
Jan. 1, Apr. 1, Jul. 1, Oct. 1, Jan. 1, Apr. 1, Jul. 1, Oct. 1, Jan. 1,
2008 2008 2008 2008 2009 2009 2009 2009 2010
MSCI-All

GCC

Egypt, Arab. Rep.

UAE

Source: Morgan-Stanley through Thomson/Datastream.
Note: MSCI-AII is all emerging markets; GCC is Gulf Cooperation
Council; UAE is United Arab Emirates.

of 2007–08 was a challenge for the region,
the largest net exporter of oil and the largest net importer of food. Oil exporters wereless adversely affected, but food import billsrose sharply. Hardest hit were countries in
the Maghreb, as well as Jordan and Lebanon,
which are large importers of both food andfuel; and the Arab Republic of Egypt (highfood-import dependence). The policy environment had to shift quickly from mitigating theeffects of higher commodity prices to shoring
up banking systems and applying fiscal stimulus to bolster domestic demand.
Over the course of 2009, net terms-of-trade
movements for the developing oil exporters (Algeria, Islamic Republic of Iran, Syrian
Arab Republic, and Republic of Yemen) and
the Gulf Cooperation Council (GCC) were favorable, as oil prices increased and food prices
declined. But high oil prices have been maintained at the expense of much reduced output.
Because of falling oil production, key GCC
oil exporters suffered modest GDP declines
during the year, only partially offset by fiscal
stimulus programs and more buoyant non-oil
sectors. Developing oil exporters in contrast
saw a marked downturn in oil sectors of their140

economies, but stimulus measures and stronger
non-oil developments helped to maintain positive overall growth. For the more diversified
economies (Egypt, Jordan, Lebanon, Morocco,
and Tunisia) steep declines in external demand(notably from the dominant Euro Area) had anegative effect on merchandise exports, compounded by falling tourism volumes, lower
worker remittances, and declining FDI inflows,
notably those from the GCC economies. The
decline in FDI was at first linked to falling oilrevenues among the GCC and softer conditions
in host markets. This came to be further cloudedby the question of sovereign debt sustainabilityon the part of Dubai, owing to past overinvestment in real estate and tourism ventures within
the United Arab Emirates.
Against this background, GDP growthin 2009 for the developing countries of theregion is estimated to have eased to 2.9 percent, from 4.3 percent in 2008. For developing oil exporters, growth almost halved, to
1.6 percent from 2.9 percent in 2008. GDP
gains for the oil importers (diversified economies) faltered by almost 2 percentage points
in the year, from a strong 6.6 percent outturnin 2008 (powered by growth of more than
7 percent in Egypt) to 4.7 percent in 2009.
And for the high-income GCC economies covered in this report, GDP is estimated to havecontracted by 0.6 percent in 2009 following afirm 4.6 percent growth in the preceding year,
as the sharp slide in oil production and revenues dampened output (table A7).
Developments among regional oil exporters. The
global economic crisis ended the oil boom that
saw oil prices peak at more than $150 a barrel
on an intra-day basis in mid-2008 (figure A18),
and prices have settled into a range of $65–$80
a barrel, supported by OPEC (Organizationof Petroleum-Exporting Countries) production
cuts. As part of this effort, regional oil exporters scaled back production by nearly 10 percent(11 percent among high-income producers and7.3 percent among the developing exporters of
the region). The combination of much lower
prices and reduced output caused oil and gas

R E G I O N A L

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Table A7 Middle East and North Africa forecast summary(annual percent change unless indicated otherwise)
1995–2005a

2006

2007

2008

2009g

2010h

2011h

4.4
2.7
4.5
4.2
3.3
6.5
4.9
5.7
⫺0.2
2.9
5.2
⫺2.2

5.2
3.5
5.4
4.8
5.7
5.9
5.9
7.0
⫺0.1
11.6
8.3
⫺0.9

5.9
4.1
6.2
6.3
2.2
18.7
6.5
12.4
⫺1.6
10.1
6.1
0.4

4.3
2.6
4.3
1.2
11.3
19.4
0.2
9.0
⫺3.0
10.5
16.0
1.9

2.9
1.2
2.7
4.6
10.6
8.0
⫺8.8
1.1
⫺3.5
⫺0.1
6.7
⫺6.1

3.7
2.0
3.6
4.5
7.5
4.0
2.3
5.2
⫺1.1
1.5
6.2
⫺4.1

4.4
2.8
4.4
5.1
6.4
4.6
5.2
6.7
⫺0.8
1.0
3.9
⫺3.7

4.0

4.6

4.9

4.4

1.4

3.5

4.3

3.6
4.4
4.8
4.0

3.8
6.8
5.9
2.0

3.6
7.1
7.8
3.0

4.6
7.2
2.5
3.0

⫺0.6
4.7
1.0
2.1

3.2
5.2
2.2
3.9

4.1
6.0
3.2
4.0

GDP at market prices (2005 US$)b
GDP per capita (units in US$)PPP GDPc
Private consumption
Public consumption
Fixed investment
Exports, GNFSd
Imports, GNFSd
Net exports, contribution to growth
Current account balance/GDP (%)
GDP deflator (median, LCU)
Fiscal balance/GDP (%)
Memo items: GDP
Middle East and North Africa geographic
regioneSelected GCC Countriesf
Egypt, Arab Rep.
Iran, Islamic Rep. of
Algeria
Source: World Bank.

a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.
b. GDP measured in constant 2005 U.S. dollars.
c. GDP measured at PPP exchange rates.
d. Exports and imports of goods and non-factor services.
e. Geographic region includes high-income countries: Bahrain, Kuwait, Oman, and Saudi Arabia.
f. Selected GCC countries: Bahrain, Kuwait, Oman and Saudi Arabia.
g. Estimate.
h. Forecast.

Figure A18 Oil prices, 2004–09
US$ per barrel
Jul. 2008: $133/bbl

140

Figure A19 Lower oil prices and lower Middle
Eastern output yield sharp decline in oilrevenues in 2009
Revenues, Middle East oil exporters, US$ (billions)

120

800

100

Dec. 2009:$75/bbl

80

600

Other
Middle East

400

Other GCC

60
Jan. 2007: $53/bbl

40
20
Jan.
2004

Jan. 2009: $43/bbl
200
Jan.
2005

Jan.
2006

Jan.
2007

Jan.
2008

Jan.
2009

Jan.
2010

Sources: IEA and DECPG Commodities Group.

Saudi Arabia
0
2004

2005

2006

2007

2008

2009

Sources: World Bank and International Energy Agency.

revenues for all exporters to drop from $755
billion in 2008 to $485 billion in 2009—a decline equivalent to 30 percent of the group’s
GDP (figure A19). For the developing exporters, the decline in revenues was less severe, butnonetheless a substantial 12.5 percent of GDP.
Current account surplus positions fell sharply
across the region for all oil exporters, from141

G L O B A L

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2 0 1 0Figure A20 Reduced oil revenues cut
current account surplus positions in 2009
Current account balance for Middle East oil exporters
Percent of GDP
45
40
35
30
25
20
15
10
5

revenues plummeted 40 percent. This placed
substantial pressures on budget revenues,
which normally support domestic demand. Inflation continues at rates near 20 percent, andthe current account surplus fell from 22 percent of GDP in 2008 to 7.5 percent in 2009.
Iraq is facing a major short-term financing gap
in the year ahead owing to the global slowdown,with a fiscal deficit of 26 percent of GDP accrued in 2009 and a current account that moved
from substantial surplus in 2008 (13.3 percent ofGDP) to major deficit in 2009 (31 percent).

Ku
w
ai
t
D
oi ev
le e
xp lopo in
Ira rter g
n, s
Is
R lam
ep i
.o c
f
Al
ge
ria

Al
lM
ex Ea idd
po st lerte oil
rs
G
C
C
Sa
ud
iA
ra
bi
a

0

2008

2009

Sources: Word Bank data and estimates.

25 percent to 7.3 percent of GDP between
2008 and 2009, and from 19.7 percent to
3.3 percent for developing oil exporters (figure A20). With public expenditure growing
at a rapid pace, fiscal deficits for developing
exporters increased sharply during 2009, to
11 percent of GDP in Algeria (though well covered by reserves of some $150 billion), 5.5 percent in Syria, 3.8 percent in the Islamic Republicof Iran, and 2 percent in the Republic of Yemen.
GDP growth in Algeria slowed to 2.1 percent
in 2009 from 3 percent in 2008. A 2 percent decline in the oil sector was partly offset by nonoil activity, which increased by 5.7 percent,supported by construction and services tied
to a long-running infrastructure development
plan (PIP). The program has continued to be
implemented in part as a stimulus measure,and in early 2009 the government announced
it would put about $60 billion from its oillinked fiscal surplus toward the investment
program. Even though partial national accounts data for 2009 are not available for theIslamic Republic of Iran, growth is estimatedto have slowed to 1 percent in 2009, from 2.5
percent during 2008, as crude oil production
contracted 7.3 percent and oil and gas export

142

The diversified economies. The Euro Area is thedestination for more than 70 percent of export
goods from the diversified economies of the
Middle East and North Africa region. Moreover,the Euro Area is also the host for overseas workers from the Maghreb and Mashreq and an important source of remittance flows and tourism
arrivals to the developing region. As investment
and trade plummeted in key Euro Area economies, GDP for the zone declined to 0.5 percent
growth in 2008, and it is anticipated to contractby a sharp 3.9 percent in 2009, the deepest recession since WWII.
The effects of the European downturn onexports from the region have been dramatic,with Egypt’s merchandise exports declining
from growth of 33 percent in 2008 to minus
15 percent by July 2009 (year-on-year). Similar patterns of export decline were registeredin Jordan, Morocco, and Tunisia (figure A21).
Together with only modest declines in imports(supported by stimulus measures), the current
account position for the group deteriorated
from a deficit of 2.1 percent of GDP in 2007
to 5.2 percent by 2009. Deficits during 2009varied between 2.5 percent of GDP in Egypt
and Tunisia, 5.8 percent in Morocco, and
7.0 percent in Jordan.
Slackening economic activity and worsening labor conditions in Europe, as well as
across the GCC economies over the course of2009 caused worker remittances flows into thedeveloping region to decline by 6.3 percent
for the year—in contrast to the strong gainsof 23.0 and 11.3 percent in 2007 and 2008,

R E G I O N A L

E C O N O M I C

Figure A21 Middle Eastern exports declined
sharply as European demand fell

Figure A23 Tourism receipts fall from record
2008 performance, but modest recovery likely

Import, export values (US$), percentage change, three-monthaverage, year over year

Tourism receipts, US$ (billions)125

P R O S P E C T S

30
25

Egypt exports

100

20
15

75

10
50

Morocco exports

5
0

25

2004

Euro area imports

2005

2006

2007

2008

2009

0
Egypt, Arab Rep. of
Tunisia

Tunisia exports

⫺25
⫺50

09
p.

M

Se

ay

n.
Ja

20

09
20

09
20

08
20
p.
Se

ay
M

Ja

n.

20

20

08

08

Sources: World Bank, IMF, World Tourism Organization.

Sources: Haver Analytics; World Bank.

respectively (figure A22). Among the larger recipient countries, Egypt appears to have been
most adversely affected, with flows declining
9 percent, while Morocco experienced an
8 percent drop in receipts. Jordan, Lebanon,
and Tunisia experienced lesser declines, varying between 1 and 3 percent.

Figure A22 Worker remittances fell by amoderate 6.3 percent in 2009
Workers’ remittance receipts, US$ (billions)
35
30
25
20
15
10
5
0
2004

MoroccoJordan

2005

2006

2007

2008

2009

MoroccoEgypt, Arab Rep. of

JordonTunisia

LebanonAlgeria

Yemen, Rep. of

Syrian Arab Rep.

Source: World Bank; IMF; national agencies.

Tourism receipts are a key source of foreign
currency (equivalent to 14 percent of GDP
for the diversified economies of the region).
With Europe suffering increasing unemployment rates, faltering wage growth, and efforts
by households to repair balance sheets badly
damaged by the financial market meltdown of2008, tourism receipts are estimated to havedeclined by 5 percent during 2009, following
strong gains in the 20 percent range since 2006
(figure A23). Tunisia appears to have bucked
the downtrend with a gain of 4 percent. But
declines elsewhere range from 8 percent in
Morocco to 3 percent in Egypt.
Foreign direct investment (FDI) inflows to thediversified group, which is increasingly sourced
from the GCC economies, fell to 4.3 percent of
GDP in FY09 from 8.1 percent a year earlier.
Morocco and Tunisia registered a 35 percent decline in inflows during calendar year 2009, while
FDI in Jordan dropped by 80 percent during thefirst quarter of 2009. These declines reflect thesubstantial deterioration of financial conditionsin the wake of the Dubai World debt-payment
standstill, inducing GCC economies to scaleback on current investment projects and putting
earlier planned FDI endeavors on hold.
In addition to pressures on FDI, the Dubai
financial crisis may have adverse consequences
for the countries of the Mashreq (Jordan, Lebanon, and Syria), which hold particularly close143

G L O B A L

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P R O S P E C T S

2 0 1 0ties to the GCC. Lower investment within the
GCC portends fewer job opportunities forworkers from these countries, lower remittances, and consumption in home markets.
Growth in Egypt slowed to 4.7 percent in
FY09, from 7 percent during the three previous
years. The slowdown was driven by lower external demand with exports of goods and services
declining by 25 percent; growth was negativein economic sectors with a strong exposure
to external markets such as the Suez Canal(down by 7.2 percent, compared with 18 percent growth in FY08) and hotels, restaurants,
and related activities linked to tourism (downby 1.3 percent in real terms compared with
30 percent growth). Declining fixed investment(down 10 percent compared with 14.8 percent growth a year ago) has moved in tandemwith increases in unemployment, which rose
to 9.4 percent from 8.4 percent a year earlier.
In response, the government implemented acrisis stimulus plan featuring fiscal, monetary,and direct support measures in the form of
LE 15 billion in additional spending, including higher subsidies and social benefits. On themonetary side, the Central Bank of Egypt cut
policy rates six times between February and
September 2009, reducing overnight deposit
and lending policy rates by 325 and 275 basis
points, respectively.

Medium-term outlook
Following the tortuous conditions of 2009,
prospects for both the developing and highincome economies of the Middle East andNorth Africa should improve through 2011.
Growth is projected to increase to 4.4 percent
by that year, the same pace registered on average between 1995 and 2005. Though domestic absorption will be a continuing source ofstrength, the forecast for regional recovery ispremised on a revival in global oil demand
and a rebound in key export markets. Despite
the gradual withdrawal of fiscal stimulus measures, moderate advances in consumer andcapital spending are expected to underpin thestrengthening of growth (see table A7). But

144

Figure A24 Oil price and export revival hold
key to recovery in the Middle East andNorth Africa
Growth of real GDP, percent
8
6
4
2
0
⫺2
Developing
Middle East

Oil exporters

2008

2009

Diversified
economies
2010

GCC

2011

Source: World Bank.

the regional profile masks both the diversity of
performance across countries and the driving
forces for growth.
Oil prices are expected to remain broadly
stable over the forecast period, at around$75 a barrel. Stronger global activity should
allow for crude oil and gas production to return to positive growth, implying moderate
revenue gains. As a result, current accountpositions for developing oil exporters areprojected to stabilize near 5 percent of GDP
by 2011. GDP growth for developing oil exporters should reach 3.1 and 3.7 percent, respectively, in 2010 and 2011 (figure A24).
By 2011 growth will vary from 3 percent in
the Islamic Republic of Iran to 5.5 percent in
Syria, grounded in developments in non-oil
sectors and in investment in hydrocarbons
capacity (table A8).
GDP for the high-income GCC economies
is anticipated to increase by 3.2 percent in2010 and 4.1 percent in 2011, as oil production firms and a higher average oil price help
to restore revenues, albeit in more moderateincrements. Current account surplus positions for the group are expected to reboundfrom 11 percent of GDP in 2009 to 14.5 percent by 2011, providing a means to support

R E G I O N A L

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Table A8 Middle East and North Africa country forecasts(annual percent change unless indicated otherwise)
1995–2005a

2006

2007

2008

2009c

2010d

2011d

Algeria
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.0
8.2

2.0
25.0

3.0
22.4

3.0
20.8

2.1
⫺3.4

3.9
2.7

4.0
5.6

Egypt, Arab Rep. of
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.4
0.4

6.8
2.4

7.1
0.3

7.2
⫺0.9

4.7
⫺3.2

5.2
⫺3.5

6.0
⫺3.2

Iran, Islamic Rep. of
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.8
7.3

5.9
9.2

7.8
12.0

2.5
22.2

1.0
7.5

2.2
3.6

3.2
3.2

JordanGDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.7
0.0

8.0
⫺10.8

8.9
⫺16.7

7.9
⫺11.4

3.2
⫺10.1

3.9
⫺9.7

4.5
⫺9.2

LebanonGDP at market prices (2005 US$)b
Current account balance/GDP (%)

3.2
⫺20.0

0.6
⫺11.3

7.5
⫺11.1

8.5
⫺20.5

7.0
⫺14.5

7.0
⫺15.2

7.0
⫺14.2

Morocco
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.4
0.7

7.8
2.0

2.7
⫺0.3

5.6
⫺5.4

5.0
⫺5.9

3.0
⫺5.7

4.4
⫺5.2

Syrian Arab Republic
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

3.2
2.9

5.1
⫺2.8

4.2
⫺3.3

5.2
⫺4.0

3.0
⫺3.2

4.0
⫺4.3

5.5
⫺4.0

Tunisia
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

5.0
⫺3.0

5.7
⫺2.0

6.3
⫺2.6

4.5
⫺4.2

3.3
⫺3.5

3.8
⫺2.6

5.0
⫺2.0

Yemen, Rep. of
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.9
3.1

3.2
1.1

3.3
⫺7.0

3.6
⫺5.6

4.2
⫺5.2

7.3
⫺2.3

4.5
⫺2.5

Source: World Bank.
Note: World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently,
projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not significantly differ at any given moment in time.
Djibouti, Iraq, Libya, and West Bank and Gaza are not forecast owing to data limitations.
a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.
b. GDP measured in constant 2005 U.S. dollars.
c. Estimate.
d. Forecast.

domestic growth while once more accumulating international reserves. A rekindlingof interest in regional FDI may emerge asfinancial and economic conditions begin tonormalize.
Economic recovery in Europe and among
the GCC countries will be supportive of a revival for the diversified economies, suggestinga resumption of export growth, a rebound inremittances and various services receipts, andimprovement in business expectations, leading to a revival in capital spending. GDP gains
in Jordan, Morocco, and Tunisia are likely tobe driven by domestic demand, with the helpof fiscal and monetary stimulus measures, as
external contributions fade. The anticipatednormalization of agriculture in Morocco (following the post-drought boom of 2009) will
be a drag on growth in 2010, and gains for thediversified group are projected to pick up to
4.5 percent in 2010 and 5.4 percent in 2011,
respectively.

Risks
The broadly favorable outlook for the Middle East and North Africa over 2010–11

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2 0 1 0remains subject to substantial downside
risks, which would pose additional challenges to policy makers already grapplingwith the current crisis. A deeper and more
protracted global recession (the deeper
growth recession discussed in chapter 1)
cannot be ruled out. Within the region, political tensions remain a constant, tending
to restrain international capital flows thatmight otherwise contribute to a deepening of
capital markets and private investment. Further, needed reform efforts, some initiatedduring the crisis period, could receive lessattention and commitment once economic
conditions start to normalize.
The recent difficulties of Dubai World holding company—an entity of the Governmentof Dubai, United Arab Emirates—in asking
its creditors for a six-month standstill on allscheduled debt payments, indicates that financial institutions in the region were not entirely
unaffected by the global financial crisis. Given
the very high investment levels of the past several years, as well as asset inflation (property
prices increased particularly sharply in Egypt
and Morocco), there may be additional largescale financial losses that have yet to be realized. Though a systemic crisis in Dubai will
likely be averted thanks to the diversified
holdings of the Dubai government and emergency support from the emirate of Abu Dhabi(both bilaterally and through the federal authorities), it may have an adverse impact on
the balance sheets of local and regional banks
holding Dubai World debt. The financial
problems facing Dubai, along with previous
defaults by two large Saudi private companies,
will continue to raise concern amidst the needfor comprehensive corporate governance anddebt restructuring reforms in the region.

South Asia
Recent developmentsThe global financial crisis contributed to amarked deceleration in real GDP growthin South Asia, from 8.7 percent in 2007 to

146

6.0 percent in 2009, which was largely driven
by a pronounced decline in investment growthand, to a lesser extent, private consumption.
While exports contracted sharply with external demand, the decline in imports was steeper,and net trade actually supported growth on
the regional level. As the crisis took hold, equity markets and exchange rates plunged inmost countries in the region. Sovereign bondspreads spiked with the contraction in capital
flows, as both domestic and international investors sought safe-haven assets outside the region.
Although the global financial crisis had asharp negative impact on South Asia, the slowdown in regional GDP growth was the least
pronounced among all developing regions.
This partly reflects the relatively closed nature of the region’s economies. Private capital inflows—a key transmission channel ofthe crisis—are less significant as a share ofSouth Asia’s GDP (particularly foreign direct
investment), compared with most other regions. Economic activity in South Asia is alsoless specialized in manufacturing and natural
resources—sectors that have been particularly
negatively affected by the crisis. Correspondingly, the region’s greater reliance on services
trade—roughly double the 7.7 percent average share of GDP for developing countries in
2008—also provided a buffer to the crisis, asservices tend to be more resilient during downturns (although smaller countries with important tourism sectors, such as the Maldives,
were hit hard). Domestic demand in the region
was relatively resilient, having been cushioned
by countercyclical macroeconomic policies.
Interest rates were rapidly cut across mosteconomies. Although fiscal space in most economies was limited, substantial fiscal stimulus
measures were introduced in India (including
pre-election spending), Bangladesh and Sri
Lanka (in the form of incentives and safety
net expenditures). Relatively robust, albeit
moderating, regional remittance inflows havebeen supportive, particularly in Bangladesh,
Nepal, and Sri Lanka, where they continue torepresent over 5 percent of GDP. Real incomes
were also boosted by the collapse in global

R E G I O N A L

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Figure A25 Gross capital inflows to South
Asia are recovering but remain below
pre-crisis levels
US$ (billions) per quarter

US$ (billions) per quarter

140

16

120

14
12

100

10

80

8
60

6

40

4

4
Q

3
20

09

Q

2
Q
20

09

1
Q

09
20

4
20

09

Q

Q

08
20

Q

08
20

08

Q
20

08

3

0

2

2

0

1

20

20

commodity prices—particularly for food andfuel, which represent a large share of regional
household outlays.
The extent of the downturn in the individual economies has been mixed and reflects
initial conditions. Growth has been weakest
in countries that entered the crisis with large
internal and external imbalances and thatwere forced to severely constrain domestic demand, such as the Maldives, Pakistan, and Sri
Lanka. Countries that entered the crisis withstronger fundamentals, such as Bangladesh
Bhutan, and India, weathered the crisis better.
A number of regional economies also faced
ongoing internal conflicts that continued to disrupt economic activity, notably Afghanistan,
Pakistan, Sri Lanka (which ended a decadesold civil war in mid-2009), and to a lesser extent Nepal (where warring factions reached apeace accord in late 2006, but are still vying
for political control).
The stabilization and progressive thawing of global financial markets in early 2009
and the rebound of world trade and output
growth beginning in the second half of 2009
have contributed to improving conditions inSouth Asia. Since the second quarter of 2009,
local equity markets and capital inflows to theregion began to recover—largely in line withE C O N O M I C

Total gross flows to emerging markets excludingSouth Asia (left axis)
Total gross flows to South Asia (right axis)
Sources: Dealogic and World Bank.

trends across developing countries (figures A25
and A26). This process has been supported
by improved investor sentiment on comparatively strong growth outturns (India and
Bangladesh), ongoing or new International
Monetary Fund (IMF) stabilization programs(Pakistan, Sri Lanka, and most recently the
Maldives), steep reductions in interest rates,

Figure A26 Local equity markets have generally returned to pre-crisis levels
MSCI indexes (US$), Jan. 1, 2009 = 100
500
450
400
350
300
250
200
150
100
50
0
Jul.
2007

Sep.
2007

Nov.
2007

Jan.
2008

India

Mar.
2008

May
2008

Jul.
2008

Emerging markets

Sep.
2008

Nov.
2008

Jan.
2009

Sri Lanka

Mar.
2009

May
2009

Jul.
2009

Bangladesh

Sep.
2009

Nov.
2009

Jan.
2010

Pakistan

Sources: Bloomberg and World Bank.
Note: MSCI = Morgan Stanley Capital International.

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2 0 1 0and improved political stability. While theregion experienced a sharp decline in grosscapital inflows during the first half of 2009,
portfolio inflows surged in the fourth quarterand bond issuance and syndicated bank lending jumped in the fourth quarter, such that
total gross inflows firmed in 2009 to an estimated $31 billion. As inflows to other regions
shrank (particularly in Europe and CentralAsia), South Asia’s share of total capital inflows to developing countries rose to 8.9 percent in 2009 from 6.7 percent in 2008. Whilemost local stock exchanges have recovered topre-crisis levels, the majority remain well below
peak levels posted in late 2007 and early 2008
(in both local currency and U.S. dollar terms).
In Bangladesh, where capitalization of listedcompanies (relative to GDP) is lower than in
its neighbors and where foreign participation
is limited, the equity market remained stable
during the crisis and posted strong growth inrecent months. Sri Lanka’s equity market isalso an exception, with a recovery to pre-crisis
highs of 2007 supported by the improvement
in sentiment following the end of the civil war
and the formal standby arrangement reachedwith the IMF in mid-2009.
Regional industrial activity, which did notcontract as much as in most other developing regions, has shifted into positive growth,
led by India, Bangladesh, and more recently
Pakistan. Fiscal stimulus measures have supported the rebound in output by helping torevive consumer demand. Further, continued
robust remittance inflows boosted construction activity, especially in Bangladesh and
Nepal. The recovery in regional output isahead of most other developing regions—with
the exception of East Asia and the Pacific—
and of high-income countries (figure A27).
Regional agricultural output was buoyed bya good monsoon in 2008 that contributed
to a good harvest in 2009 across much of theregion. One exception is Afghanistan, where agricultural output contracted sharply (16.5 percent
in FY2008/09). In Sri Lanka the agricultural
sector benefited from the end of fighting andfrom acreage brought back into production.

148

Figure A27 Recovery in industrial production has taken hold in South Asia ahead of
most other regions
Annual percent change
20
15
10
5
0
⫺5
⫺10
⫺15
⫺20
Jan.
2008

Apr.
2008

Jul.
2008

Oct.
2008

Jan.
2009

Apr.
2009

Jul.
2009

Oct.
2009

Latin America and Caribbean

South Asia

Middle East and North Africa

East Asia
and Pacific
Europe andCentral Asia

Sub-Saharan Africa
High-income countries

Sources: Thomson Datastream, IMF and World Bank.

However, a poor monsoon season in India in2009 suggests that agricultural growth will
be modest in the current 2009–10 crop year
(which began in late 2009). Regional services
activity decelerated with the decline in global
tourism, hitting the Maldives, Nepal, and Sri
Lanka, in particular, where tourism is a key
sector. In contrast, in India, services activity
was supported by resilient outsourcing.
Merchandise trade growth remains below
previous-year levels for the region, with imports down much more sharply than exports,
given the sharp compression of demand in
Maldives, Pakistan, and Sri Lanka in particular. Indeed, the 32 percent decline in South
Asia’s import volumes through July 2009
compared with the previous year is the second
steepest among developing regions after that ofEurope and Central Asia (39 percent). In contrast, the decline in the region’s merchandise
export volumes was less severe than in mostother developing regions, with the exceptionsof East Asia and the Pacific and Latin America
and the Caribbean. This partly reflects the low
manufacturing and commodity content (sectors particularly hard hit by the recession) of

R E G I O N A L

the region’s exports. Some sectors also demonstrated marked resilience during the crisis,such as ready-made garments in Bangladesh,
where competitive pricing has enabled producers to build market shares (i.e., the “Wal-Mart
effect”) and in Sri Lanka, where long-term
strategic partnerships with mid- to high-end
retailers in the United States and the European
Union, (such as Victoria’s Secret, Diesel, andNike) created a buffer, and in India, where
information technology software also proved
relatively resilient.
Overall, the combination of a sharp fall in thevalue of imports, a somewhat less steep decline inexports (both reflecting favorable terms-of-tradedevelopments), and resilient remittance inflows
meant that current account balances generally
improved in 2009 (figure A28). Regional external positions had come increasingly understrain from the multiyear boom in food and fuelprices before mid-2008. During 2009, the Maldives, Pakistan, and Sri Lanka posted the largest
adjustments in their current account deficits.
Domestic demand was sharply compressed in
the three economies, where large fiscal deficits
had contributed to the buildup of considerable external imbalances before the crisis. The
Maldives is an extreme case, where a massive

E C O N O M I C

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upswing in government outlays and a surge inimports for resort-related construction materials contributed to the sharp deterioration in
the current account balance.
While the adjustment was less stark, India
also posted a shrinking current account deficit in 2009, as imports fell faster than exports.
Bangladesh and Nepal recorded rising current
account surpluses, as the moderation of export
growth was less pronounced than the decline
in imports, supported by continued firm remittances inflows. In contrast, Bhutan’s current
account deficit is estimated to have grown from
10 percent of GDP in 2008 to 12.3 percent in2009, partly reflecting the start of interest payments for the Tala hydropower scheme (figure
A28). Afghanistan’s current account deficit,
including official transfers (equivalent to some
50 percent of official GDP) is estimated to haveshifted from a surplus of 0.9 percent of GDP in2008 to a deficit of 1.6 percent in 2009.
Remittance inflows—a key source of foreign exchange for the region—declined in 2009,
pushed down by the decline in economic activity and the rise in unemployment in migranthost countries. However, remittance inflows
remained relatively strong compared with othersources of foreign exchange, and indeed areabove their 2007 levels (figure A29). Remittanceinflows to South Asia contracted by a modest

Figure A28 Current account balances
improve across much of South Asia in 2009
Figure A29 International flows toSouth Asia

Percent of GDP
64
4

Percentage point change between 2007 and 2009 (as a shareof GDP)

0

1.0

⫺2

0.5

⫺4
⫺6

0

⫺8

⫺0.5

⫺10
⫺12

⫺1.0
al
ep

la
de
ng
Ba

Sr

⫺1.5

N

sh

a
di

an
iL

In

ka

n
ta
is
Pa
k

Bh

ut

an

⫺14

⫺2.0
Equities

2007
Source: World Bank.

2008

2009e

Bank
lending

Bonds

FDI

Remittances

Source: World Bank.

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2 0 1 01.8 percent in 2009, compared with a 7.5 percent decline for developing countries excludingSouth Asia (World Bank 2009). Growth in the
Arabian Gulf and East Asian economies, whichhost a significant share of South Asia’s migrant
workers, has not been as adversely affected as
growth in other key host economies, such as theUnited States, the European Union, and Russia. Among South Asia’s economies, India—thelargest recipient of remittances in the world in
dollar terms—posted a contraction in remittanceinflows in 2009, while Bangladesh, Nepal, Pakistan, and Sri Lanka, experienced a slower paceof growth of remittances inflows.
With the moderation in demand and collapse
in energy prices, inflationary pressures acrossthe region subsided following the onset of thecrisis, particularly in the first half of 2009.
This helped reverse the buildup of inflationarypressures that became increasingly evident in2007 and 2008, as fuel and food prices spiked—
despite efforts by authorities to contain theprice increases. Lower oil prices have eased
pressures on fiscal deficits stemming from fuelprice subsidies. The moderation in inflationarypressures and falling international commodity
prices also provided scope for regional central
banks to introduce expansionary measures tosupport domestic demand in response to thecrisis. Bangladesh, India, Pakistan, and Sri
Lanka cut policy interest rates. Activity in
Bhutan and Nepal, where the currencies aretied to the Indian rupee, was supported byIndia’s expansionary monetary policy stance.
Regional fiscal positions deteriorated in 2009
in response to a combination of reduced tax
receipts resulting from the decline in economic
activity and higher outlays. Corresponding to
the introduction of more accommodative monetary policies, expansionary fiscal policy measures were introduced in Bangladesh, India, andSri Lanka to support domestic demand throughvarious expenditure and incentive programs.
Pakistan also sought to stimulate its economy
through an increase in its public sector development program. While these stimulus measures
helped offset the negative effects of the global
crisis, they also led to higher fiscal deficits in

150

Figure A30 Budget deficits in most South
Asian countries outstrip developingcountry average
Maldives
India
High-income
countries
BhutanSri Lanka
Pakistan
Developing
countries
Bangladesh
Nepal
0

5

10

15

20

25

30

35

Percent share of GDP, ranked by 2009 estimates
2008

2009e

Source: World Bank.

nearly all of the regional economies. Even before the crisis, sizable fiscal deficits were alreadya problem for many South Asian economies,
where weak tax administration and structure
resulted in low domestic resource mobilization(figure A30).

Medium-term outlook
South Asia’s GDP growth is projected tofirm from an estimated 6 percent in 2009 to
7.0 percent in 2010 and 7.4 percent in 2011.
External demand for goods and services isanticipated to recover, while improving consumer and business confidence, combined withthe lagged effects of expansionary monetaryand fiscal policy measures and a positive turnin the inventory cycle, should contribute tostrengthening domestic demand. A projected
firming of capital inflows will also support
regional economic activity. The regional current account deficit is projected to rise modestly, from 1.2 percent in 2009 to 2.2 percent
in 2010 and 2.4 percent in 2011, a result of
firming domestic demand that is expected todrive import growth ahead of export growth.

R E G I O N A L

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Table A9 South Asia forecast summary(annual percent change unless indicated otherwise)

GDP at market prices (2005 US$)b,f
GDP in calendar year basisc
GDP per capita (units in US$)PPP GDPd
Private consumption
Public consumption
Fixed investment
Exports, GNFSe
Imports, GNFSe
Net exports, contribution to growth
Current account balance/GDP (%)
GDP deflator (median, LCU)
Fiscal balance/GDP (%)
Memo items: GDPf
South Asia excluding India
India
Pakistan
Bangladesh

1995–2005a

2006

2007

2008

2009g

2010h

2011h

6.0
6.1
4.1
6.0
4.7
5.0
8.0
11.3
10.6
⫺0.2
⫺0.6
5.9
⫺8.1

9.0
9.3
7.3
9.0
6.0
9.9
14.6
17.7
22.7
⫺1.7
⫺1.5
5.2
⫺5.1

8.5
8.7
6.8
8.5
7.0
5.6
13.6
3.5
6.8
⫺1.0
⫺1.3
7.4
⫺5.7

5.7
6.9
4.2
5.7
2.7
21.1
7.6
10.5
14.9
⫺1.7
⫺3.3
7.2
⫺8.9

5.7
6.0
4.3
5.7
4.2
7.1
4.1
⫺4.6
⫺6.9
0.9
⫺2.3
13.8
⫺9.5

6.9
7.0
5.5
6.9
6.0
7.3
9.7
10.3
10.6
⫺0.6
⫺3.2
6.9
⫺8.6

7.4
7.4
6.1
7.4
6.7
7.2
10.2
12.1
12.3
⫺0.7
⫺3.4
6.5
⫺7.8

4.5
6.4
4.1
5.3

6.4
9.7
6.2
6.6

6.0
9.1
5.7
6.4

3.9
6.1
2.0
6.2

4.4
6.0
3.7
5.9

4.1
7.5
3.0
5.5

4.8
8.0
4.0
5.8

Source: World Bank.
a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.
b. GDP measured in constant 2005 U.S. dollars.
c. GDP figures are presented in calendar years (CY) based on quarterly history for India. For Bangladesh, Nepal, and Pakistan, CY
data is calculated taking the average growth over the two fiscal year periods to provide an approximation of CY activity.
d. GDP measured at PPP exchange rates.
e. Exports and imports of goods and nonfactor services.
f. National income and product account data refer to fiscal years (FY) for the South Asian countries with the exception of Sri
Lanka, which reports in calendar year (CY). The fiscal year runs from July 1 through June 30 in Bangladesh and Pakistan, from
July 16 through July 15 in Nepal, and from April 1 through March 31 in India. Because of reporting practices, Bangladesh,
Nepal, and Pakistan report FY2007/08 data in CY2008, while India reports FY2007/08 in CY2007.
g. Estimate.
h. Forecast.

Although regional GDP growth is projectedto accelerate, a return to boom-period growth
rates is not anticipated over the forecast horizon, as investment growth is expected to continue to be constrained by supply bottlenecks
and higher capital costs in the wake of thecrisis. (table A9). External demand is expected
to firm, but it too will expand less quickly
than during the boom years. The regional fiscal deficit is projected to narrow on planned
structural fiscal consolidation and cyclical factors, as well as a reversal of stimulus measures
introduced to support demand during the crisis. Nevertheless, the aggregate regional fiscal
deficit is projected to continue to exceed its
pre-crisis 2007 deficit of 5.7 percent.
Expected progressive tightening of monetary conditions over the forecast horizon willcontribute to an easing of inflationary pressures by 2011 across the region. Further, given
strong aversion to food price inflation within
the region, monetary authorities are particularly responsive to signs of inflationary pressures building.
The recovery path for the individual economies will vary substantially (table A10). India,
Bangladesh, and Bhutan are expected to emerge
from the global crisis with stronger growth performances, backed by generally sound economic
policies and greater resilience of trade, investment, and remittances. Sri Lanka is also forecast
to post a relatively firm recovery, supported by
the recent surge in capital inflows and improvement in investor confidence following the cessation of fighting after nearly three decades of civil
war. Elsewhere in the region, conflict-affected151

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2 0 1 0

Table A10 South Asia country forecasts(annual percent change unless indicated otherwise)
1995–2005a

2006

2007

2008

2009c

2010d

2011d

Calendar year basis
Bangladesh
GDP at market prices (2005 USD)b
Current account balance/GDP (%)

5.0
⫺0.6

6.3
2.0

6.5
1.3

6.3
1.4

6.1
3.1

5.7
1.8

5.7
1.5

India
GDP at market prices (2005 USD)b
Current account balance/GDP (%)

6.7
⫺0.4

9.9
⫺1.1

9.3
⫺0.7

7.3
⫺2.6

6.4
⫺2.4

7.6
⫺3.5

8.0
⫺3.6

Nepal
GDP at market prices (2005 USD)b
Current account balance/GDP (%)

3.9
⫺3.1

3.4
⫺0.1

3.5
⫺1.5

4.3
3.7

5.0
4.4

4.3
1.0

4.3
1.4

Pakistan
GDP at market prices (2005 USD)b
Current account balance/GDP (%)

3.7
⫺1.0

6.9
⫺5.7

5.9
⫺6.3

3.8
⫺10.2

2.9
⫺5.2

3.3
⫺4.1

3.5
⫺4.6

Sri Lanka
GDP at market prices (2005 USD)b
Current account balance/GDP (%)

4.5
⫺3.2

7.7
⫺5.8

6.8
⫺4.7

6.0
⫺9.1

3.6
⫺1.7

5.0
⫺2.7

6.0
⫺2.9

Fiscal year basis
Bangladesh
Real GDP at market prices
Current account balance/GDP (%)

5.3
⫺0.8

6.6
1.3

6.4
1.4

6.2
0.9

5.9
2.8

5.5
2.2

5.8
1.5

India
Real GDP at market prices
Current account balance/GDP (%)

6.4
⫺0.2

9.7
⫺1.2

9.1
⫺1.0

6.1
⫺1.4

6.0
⫺2.6

7.5
⫺3.1

8.0
⫺3.3

Nepal
Real GDP at market prices
Current account balance/GDP (%)

4.1
0.2

3.7
2.3

3.3
⫺0.1

5.3
3.2

4.7
4.6

4.0
2.4

4.5
1.1

Pakistan
Real GDP at market prices
Current account balance/GDP (%)

4.1
⫺0.8

6.2
⫺4.0

5.7
⫺4.9

2.0
⫺8.6

3.7
⫺5.9

3.0
⫺4.5

4.0
⫺4.1

Source: World Bank.
Note: World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently,
projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not significantly differ at any given moment in time.
Afghanistan, Bhutan, and the Maldives are not forecast owing to data limitations. National income and product account data
refer to fiscal years (FY) for the South Asian countries with the exception of Sri Lanka, which reports in calendar year (CY). The
fiscal year runs from July 1 through June 30 in Bangladesh and Pakistan, from July 16 through July 15 in Nepal, and April 1
through March 31 in India. Because of reporting practices, Bangladesh, Nepal, and Pakistan report FY2007/08 data in CY2008,
while India reports FY2007/08 in CY2007. GDP figures are presented in calendar years (CY) based on quarterly history for India.
For Bangladesh, Nepal, and Pakistan, CY data is calculated taking the average growth over the two fiscal year periods to provide
an approximation of CY activity.
a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflators are averages.
b. GDP measured in constant 2000 U.S. dollars.
c. Estimate.
d. Forecast.

countries—Afghanistan, Pakistan, and to alesser extent, Nepal—are expected to face more
moderate growth outturns, as political uncertainty and fighting continue to disrupt economic
activity.
Regional economies are projected to benefit from stronger remittance inflows overthe forecast horizon, which in turn should152

boost private consumption and support
growth—particularly in Bangladesh, Nepal,
Pakistan, and Sri Lanka. However, the recovery in remittance growth is anticipated
not to take hold immediately as job growth
typically lags output growth in high-income
markets—a lag that could be more extended
than usual given the synchronicity of the global

R E G I O N A L

downturn. However, the slowdown in growthin the Arabian Gulf and East Asia—South
Asia’s key migrant destination countries—was
generally less pronounced than in other laborimporting countries, which is expected to allow
a relatively rapid recovery in remittances inflows
to South Asia.

Risks
As the global economic recovery begins to takehold in the second half of 2009, risks to the GDP
growth forecast for South Asia have lessened.
Nevertheless, downside risks remain and centeron the extent of the upswing and durability of
the global recovery.
Downside risks to the forecast are represented by the region’s large fiscal imbalances
and its relatively high reliance on trade taxes.
An extended period of weak external demand
would likely erode these revenues and increasepressures on government coffers. The region’slarge fiscal imbalances also represent a potential drag on long-term growth by crowding out
private investment through the public sector’s
large financing requirement and higher interest rates. Interest payments in South Asia represented 21.7 percent of central government
expenditures in 2007, more than double theshare represented in other developing regions(figure A31). By reducing the large fiscal deficits and payment obligations, regional governments could free up resources to devote todevelopment spending. The region has a very
low tax base compared with other developing
regions, so improving tax collection would
help alleviate fiscal pressures. Similarly, revamping the tax structure (including introduction of value-added taxes in some countries)
could help boost revenue mobilization.
Remittances inflows—which provided acushion for the region—could fail to recoverin the event of a prolonged global recession ora jobless economic recovery (potentially coupled with tighter immigration controls). The
debt payment problems of Dubai World in
the United Arab Emirates that erupted in lateNovember 2009 suggest that economic activity in the Arabian Gulf economies could

E C O N O M I C

P R O S P E C T S

Figure A31 Interest payments represent asignificant burden in South Asian economies
Percent share of fiscal expenses in 2007 a
30
25
20
15
10
5
0

a

sh

a

di

de

In

la

g
an

B

nk

i
Sr

La

d
d
d
an n
an a
an a
a ea
e si
st ricop al A Ea Af eric ibbrre hEu ntrdl rt Am Ca
e
id No tin
C
M
a
L

an

st

ki

Pa

Source: World Bank.
a. Pakistan data are from 2008.

surprise to the downside, pointing to downside risks for South Asian migrants working
in the Gulf and reduced remittances flows totheir home countries. Correspondingly, shoulda significant portion of the stock of expatriate
workers return home with accumulated savings due to the downturn in the Gulf, nearterm remittances inflows might rise.
Overheating is also a risk. Should the recent
surge in capital inflows to developing countries(see chapter 1) be sustained, they could leadto ballooning asset markets and appreciationof currencies (with the latter hindering export
prospects), creating challenges for monetary
authorities. Failure to mop up excess liquidity
in banking systems or to bring down the region’s large fiscal deficits could lead to higher
inflationary pressures. Separately, while global
rice markets appear well-supplied, and stockto-use ratios have returned to more normal
levels (along with maize and wheat stocks), a
serious weather event or policy action could
also cause prices to rise significantly, as only
seven percent of global rice production istraded.

153

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 1 0

Table A11 Sub-Saharan Africa forecast summary(annual percent change unless indicated otherwise)

GDP at market prices (2005 US$)b
GDP per capita (units in US$)PPP GDPc
Private consumption
Public consumption
Fixed investment
Exports, GNFSd
Imports, GNFSd
Net exports, contribution to growth
Current account balance/GDP (%)
GDP deflator (median, LCU)
Fiscal balance/GDP (%)
Memo items: GDP
Sub-Saharan Africa excluding South Africa
Oil exporters
CFA countries
South Africa
NigeriaKenya

1995–2005a

2006

2007

2008

2009e

2010f

2011f

4.0
1.4
4.0
2.0
5.2
6.5
4.9
6.1
⫺0.1
⫺1.7
7.3
⫺2.3

6.4
3.9
6.4
7.0
5.8
16.9
4.8
13.2
⫺2.7
0.7
7.3
4.3

6.5
4.0
6.5
8.1
5.8
19.5
3.8
11.8
⫺2.9
⫺0.1
7.6
0.4

5.1
3.1
5.2
3.5
5.6
12.2
4.6
6.7
⫺0.9
0.1
9.7
0.9

1.1
⫺0.8
1.6
0.4
5.6
0.3
⫺5.2
⫺5.2
0.2
⫺3.4
6.2
⫺4.2

3.8
1.9
4.1
3.2
5.2
6.3
6.6
7.5
⫺0.6
⫺2.5
6.1
⫺2.1

4.6
2.7
4.9
4.5
5.2
5.7
5.9
6.6
⫺0.5
⫺2.4
4.1
⫺1.7

4.5
4.6
4.4
3.3
4.6
2.9

6.9
7.5
2.7
5.6
6.2
6.4

7.1
7.9
4.5
5.5
6.3
7.1

5.9
6.3
4.0
3.7
5.3
1.7

2.8
2.8
1.6
⫺1.8
4.3
2.8

4.8
4.9
3.4
2.0
4.8
3.7

5.6
5.3
3.8
2.7
5.1
4.8

Source: World Bank.
a. Growth rates over intervals are compound average; growth contributions, ratios, and the GDP deflator are averages.
b. GDP measured in constant 2005 U.S. dollars.
c GDP measured at PPP exchange rates.
d. Exports and imports of goods and nonfactor services.
e. Estimate.
f. Forecast.

Recent developmentsThe global financial crisis has had a marked,
negative impact on economic performancein Sub-Saharan Africa, affecting trade, foreign
direct investment, tourism, remittances, andofficial assistance. GDP is estimated to havegrown only 1.1 percent for the region as awhole in 2009 (table A11). Notwithstanding
the severity of the shock, the improved macroeconomic fundamentals in place in many
countries of the region as they entered the crisis meant that the impact was less pronounced
than in other regions and relative to previous
external shocks. The growth slowdown hasvaried across countries in Sub-Saharan Africa,
with oil exporters and middle-income countries affected more severely, at least initially,
than low-income, fragile, and less globally
integrated countries (figure A32). Per capita
GDP has declined by an estimated 0.8 percent
in 2009, the first decline in a decade. This is154

Figure A32 Middle-income and oil-exporting
countries of Sub-Saharan Africa hit hardest
by global crisis
Percent growth
10
9
8
7
6
5
4
3
2
1
0
⫺1
⫺2
⫺3
⫺4
⫺5

Oil exporters
Low-income
countries

Middle-income
countries

0.27

Fragile countries

19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
20
06
20
08

Sub-Saharan Africa

Source: World Bank.

likely to have long-term consequences for SubSaharan African countries, as more people fall
into poverty in the region, according to Chen
and Ravallion (2009); 30,000 to 50,000 more

R E G I O N A L

infants are likely to die of malnutrition in
2009, with a larger impact among infant girls(Friedman and Schady 2009).
As Sub-Saharan Africa is a major commodity exporting region, lower commodity prices,
declining export volumes, as well as lower tourism revenues, and declining remittances have
all undermined income and private consumption, which decelerated to 0.4 percent growthin 2009, down from 3.5 percent the previous
year. Weak external demand for commodities,
excess capacity, scarce credit, and tight liquidity all led to delays and scaling back of investment spending. Although FDI declined by
19 percent in 2009 the decline was more muted
than in other regions except South Asia, mainly
because of sustained investment in the extractive sectors. Weak private consumption andinvestment resulted in lower imports, partially
offsetting the negative growth impact emanatingfrom the sharp contraction in export volumes(figure A33).
As expected, the contraction in both export and import volumes was more severein middle-income countries, which are more

Figure A33 Private consumption and tradecontracted markedly in South Africa
Percent
20
10
0
ⴚ10
ⴚ20
ⴚ30
ⴚ40
ⴚ50
ⴚ60

Im

po

rts

rts
po
Ex

co

ns

P
um riv
pt ate
io
n
G
ov
er
sp nm
en e
di nt
ng
G
in rosve sst fixe
m d
en
t

ⴚ70

2008Q3
2009Q2

2008Q4
2009Q3

Source: South African Reserve Bank.

2009Q1E C O N O M I C

P R O S P E C T S

Figure A34 Current account balances of
middle-income and oil-exporting countries
deteriorated the most, while low-income
countries remained aid-dependent
Percent of GDP
15
10
5
0
⫺5
⫺10
⫺15
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Low-income countries
Middle-income countries
Oil exporters
Source: World Bank.

integrated into the global economy. Becauseof the marked declines in oil prices, the deterioration in current account balances wasmost pronounced in oil-exporting countries,
where it fell from 9.7 to 1.4 percent of GDP(figure A34). Meanwhile lower tourism revenues, remittances, and private current net
transfers brought the current account balances in middle-income countries to a deficitof 1.2 percent of GDP—down from a surplusof 3.3 percent of GDP in 2008. Low-income
countries remain dependent on foreign assistance to finance deficits of nearly 10 percent
of GDP. For most of these countries the termsof-trade boost from lower oil prices was offset
by lower export prices or volumes (primarily
metals and minerals, agricultural products), or
both. Indeed, the marked decline in oil imports
merely offset the decline in current account inflows, with current account balances improving by less than 1 percent of GDP.
Sovereign spreads rose sharply in thewake of the financial crisis but have declined
significantly since the first quarter of 2009.
In many cases, however, these spreads remain above the pre-crisis level (figure A35).

155

2 0 1 0

156

Figure A36 Inflation in Sub-Saharan Africa
down to low single digits on lower foodpricesMedian inflation, percent
14
12
10
8
6
4
2

Source: World Bank.

09
20
l.
Ju

n.
Ja

l.

20

20

08

09

0

08

Most countries in the region have beenspared from the most abrupt financial turbulences experienced by other regions, but
in countries that enjoyed rapid credit expansion in the boom years (like Cape Verde, theDemocratic Republic of Congo, Ethiopia,
Nigeria, Rwanda, Tanzania, Uganda, andZambia), nonperforming loans will mountin the quarters ahead, putting strains on theshallow financial systems.
Expectations about an imminent recovery
in the global economy triggered a return ofinvestors to stock markets across the world,
boosting share prices. In South Africa shareprices rose by 56 percent in dollar terms since
January 2009. The capital inflows have also
supported the rand, which gained 28.1 percent against the U.S. dollar during the courseof 2009. Furthermore, a more positive investor attitude toward risk taking in emergingmarket economies boosted inflows of direct
and portfolio investment during the second
quarter.
On the policy front many countries in theregion had only limited space for countercyclical measures, notwithstanding more prudent
fiscal stances during the boom period. Automatic stabilizers worked in South Africa and the20

Source: JPMorgan.

JuSouth Africa

07

Gabon

n.

Ghana

20

Au

g
Se . 20
p 0
O . 20 8
ct 0
N . 20 8
ov 0
D . 20 8
ec 0
Ja . 20 8
n 0
Fe . 20 8
b 0
M . 20 9
ar 0
Ap . 20 9
r 0
M . 20 9
ay 0
Ju . 20 9
n. 09
Ju 200l
Au . 20 9
g 0
Se . 20 9
p 0
O . 20 9
ct 0
N . 20 9
ov 0
D . 20 9
ec 0
.2 9
00
9

0

Ja

200

07

400

l.

600

20

800

Ju

1,000

06

1,200

n.

1,400

20

1,600

Ja

1,800

06

2,000

l.

Basis points

Seychelles, which were among the small numberof countries that were able to implement significant countercyclical fiscal policies. A large part ofthe deterioration in fiscal balances in commodity
exporters is linked to both lower volumes andlower export prices for commodities. For the region as a whole, the fiscal balance deteriorated
from a surplus of 0.9 percent of GDP in 2008
to a deficit of 4.2 percent of GDP in 2009. Furthermore, monetary policy remains ineffective inbolstering domestic demand in many countries
owing to a lack of depth in the financial systems
and weak transmission mechanisms.
Lower food and oil prices since mid-2008
contributed to a sharp decline in headline inflation, which has eased to low single-digit levels
in many countries (figure A36). By September
2009 several countries in the region were reporting falling headline prices. However, in East
Africa, as a result of high food inflation related
to recurrent droughts, inflation has remained
stubbornly high. Subdued inflation in many
countries in the Sub-Saharan Africa region has
created room for lowering interest rates. Moreover, lower food and energy prices have relieved
some of the pressure on fiscal balances, althoughsharply lower trade volumes and lower export

20

Figure A35 EMBI-stripped spreads retreat as
investor confidence returns

Ju

P R O S P E C T Sn.

E C O N O M I CJa

G L O B A L

R E G I O N A L

Figure A37 Quarterly GDP readings point to
output stabilization in Sub-Saharan Africa
Percentage change (saar)
20
15
10
5
0
⫺5
⫺10
South Africa

Kenya

2008Q1

2008Q2

2008Q3

2009Q1

20092Q2

2009Q3

2008Q4

Source: Haver Analytics.

and import prices have slashed trade-related
government revenues, which has been particularly acute in the Southern Africa Customs
Union countries.
In South Africa output contracted forthree consecutive quarters, starting with thefinal quarter of 2008, then posted 0.9 percent
growth (saar) in the third quarter of 2009,
thereby ending the recession (Figure A37).
Domestic demand remains weak, underminedby declining disposable income, higher unemployment, and high levels of debt. Growth inboth government consumption and fixed investment deteriorated in the second quarter,
the latter partly attributable to more conservative lending practices. Weaker domestic demand, in particular postponements of capital
expenditure by the private sector, led to a
sharp contraction in imports during the firsthalf of 2009. This in conjunction with lessrapidly falling exports brought the second
quarter trade balance into surplus, and helped
bring the current account deficit down to
3.2 percent of GDP in the third quarter from
7 percent of GDP in the first quarter.
Nigeria’s economy, the second largest in
the region, seems to have weathered the crisis well. Notwithstanding lower oil prices andE C O N O M I C

P R O S P E C T S

disruptions in oil production, GDP expanded
4.5 percent and 7.2 percent in the first twoquarters of the year, and growth remained
strong in the third quarter, largely on account of the non-oil sectors. Agriculture andwholesale and retail trade made positive contributions, suggesting continued strength indomestic demand. However poor performancein the manufacturing, mining, and electricitygeneration sectors led to a decline in industrial
output. The central bank’s recent bailouts ofNigeria’s top five commercial banks underscore the weakness of Nigeria’s financial
system. Together these banks account for
40 percent of all loans, 30 percent of deposits,
and 31.5 percent of total assets. These banks
had a very large exposure to capital markets
and the gas and oil sectors, as well as a highlevel of nonperforming loans, thanks to poor
corporate governance practices, lax credit administration, and nonadherence to the banks’credit risk management practices. The stock
market has been severely battered since theonset of the global crisis, with share prices down
57.6 percent and market capitalization down
50.7 percent in the first nine months of 2009.
Kenya’s economic growth has been constrained by recurrent drought and ensuing electricity shortages while also suffering the effectsof the global economic crisis. When comparedwith a year earlier, growth decelerated from
4.3 percent in the first quarter, to 2.1 percent in
the second quarter, to – 0.1 percent in the third
quarter, in contrast with growth rates of above
6 percent in 2007, before the election-related
tensions. The drought-generated general crop
failure affected food security, leading to higher
imports of basic foods. Major export crops
fell, with tea output down 11.6 percent andhorticulture output down 7.4 percent in thefirst eight months of 2009. Power shortages,
higher power costs, and weak global demandcaused mining and quarrying, manufacturing,
construction, and wholesale and retail trade tocontract in the second quarter. On the brightside, transport and communications, as well as
the hotel and restaurant sector rebounded as
the effects of the postelection violence in early157

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 1 02008 dissipated. Tourist arrivals rose 42 percent in the first eight months of 2009.
In Ethiopia economic activity has been supported by growth in the agricultural sector,
underpinned by an expansion of roads andbetter market access that have enabled subsistence farmers to enter the commercial sector. The economy was faced with significant
external shocks, however. The global recession caused remittances to fall by 6 percent in
the first half of 2009 relative to a year earlier,while merchandise exports fell 11 percent. In
manufacturing, capacity utilization has been
affected by weak demand, shortages of waterand electricity, insufficient raw materials andother inputs, and a shortage of capital. Foreign direct investment has also been affected,
making it more difficult to finance the large
current account deficit. Economic growth isestimated to have decelerated to 7.2 percent in2009, as remittances, investment, and export
growth weaken. Two new hydroelectric dams,
one commissioned in November 2009 and theother to become operational in the next few
months, will help ease power shortages andremove some of the growth constraints.
Lower demand for minerals is estimatedto have weakened performance in southern
Africa, and the region was also negatively affected by the recession in South Africa, withwhich it has close trade, investment, and financial links. Angola’s economy also performed poorly: oil output declined to below
1.8 million barrels a day, while falling oil revenues forced the government to cut back on
investment spending, and private consumer
spending contracted. Lower demand for mining and hydrocarbon products pushed the
Democratic Republic of Congo into recession
in the last quarter of 2008, and this contraction
was extended into the first half of 2009, when
output dropped a cumulative 5.8 percent. Strong
growth in the agriculture sector helped Mozambique’s economic growth to stay at 5.9 percent
in the first quarter of 2009 notwithstanding a
deceleration in growth in the services sector.
Subsequently, growth accelerated to above
6 percent in the second and third quarters.

158

Growth performance has been stronger inWest and Eastern Africa: major economies
in the regions have recovered and reformoriented economies such as Burkina Faso,
Mali, Senegal, and Tanzania have turnedin relatively strong performances. In Côte
d’Ivoire, which has been enjoying a peace
dividend following the easing of politicaltensions, growth accelerated to above 3 percent in 2009, as agricultural, mining, andhydrocarbon output increased. In Central
Africa, growth remained plagued by weak
performances in the oil sectors of Cameroon
and Gabon.

Medium-term outlook
The recovery in growth is projected to be modest and fragile, with output in Sub-SaharanAfrica expected to accelerate to below-trend
growth rates of 3.8 percent in 2010 and
4.6 percent in 2011. The growth pace will bewell below the 6 percent growth rate recorded
during the boom years, as a result of lower realcommodity prices and slower global growth.
Excluding South Africa, the region is projected
to enjoy a modest acceleration in growth, from
2.8 percent in 2009 to 4.8 and 5.6 percent in2010 and 2011, respectively, as global growthrecovers; however, this is still below the average 6.6 percent experienced during the boom
years. The South African economy is expected to recover modestly in 2010, growing
by 2.0 percent, before accelerating further to
2.7 percent in 2011. In per capita terms, GDP
in Sub-Saharan Africa is projected to grow
1.9 percent in 2010 and 2.7 percent in 2011.
The rebound in economic activity will
primarily be fueled by a recovery in private
demand, exports, and investment, with thelargest contribution expected to come fromexports. However, the overall strength of therecovery will depend on the growth performance in key export markets and investment
partners, particularly the United States, theEuropean Union, and China. The projected rebound in growth in these economies, fueled by
the inventory cycle and impressive countercyclical policies, is expected to result in stronger

R E G I O N A L

external demand for Sub-Saharan African exports and should trigger a modest recovery ininvestment flows. However growth in external
demand is expected to wane in the second halfof 2010, as the growth impact of the inventory
restocking cycle and fiscal stimulus wanes.
Stronger domestic demand will cause import
growth to accelerate, with net exports contributing negatively (⫺0.6 percent) to overall
growth. Furthermore, given that recovery inglobal labor markets will lag, the recovery intourism revenues and remittances is expected
to be modest in 2010. Many countries in

E C O N O M I C

P R O S P E C T S

Sub-Saharan Africa have very limited social
safety nets, which means that recovery of private consumption will be weaker than in otherregions. Indeed private demand is projected to
grow by 3.2 percent, partly fueled by higher
incomes in export-oriented sectors that benefit
from stronger external demand.
Middle-income countries such as Botswana,
Seychelles, South Africa, and oil-exporting countries like Angola are likely to register the mostdramatic turnaround from low bases owing
to weak performance in 2009 (table A12; figure A38). Growth in middle-income countries

Table A12 Sub-Saharan Africa country forecasts(annual percent change unless indicated otherwise)
1995–2005a

2006

2007

2008

2009c

2010d

2011d

AngolaGDP at market prices (2005 US$)b
Current account balance/GDP (%)

8.3
⫺2.2

18.6
25.1

20.3
15.6

13.2
8.5

⫺0.9
⫺4.2

6.5
5.9

8.0
6.2

Benin
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.6
⫺7.2

3.8
⫺7.1

4.6
⫺12.1

5.0
⫺8.7

3.1
⫺8.5

3.3
⫺7.4

4.8
⫺7.3

Botswana
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

6.8
8.1

3.0
17.6

4.4
15.6

2.9
7.8

⫺8.3
⫺7.3

4.8
⫺7.2

5.6
⫺7.7

Burkina Faso
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

6.4
⫺10.1

5.5
⫺11.5

3.6
⫺8.7

4.9
⫺10.4

3.6
⫺9.8

4.6
⫺9.5

5.2
⫺10.2

BurundiGDP at market prices (2005 US$)b
Current account balance/GDP (%)

0.4
⫺13.7

5.1
⫺35.3

3.6
⫺26.7

4.4
⫺28.4

2.6
⫺23.2

3.7
⫺21.8

5.1
⫺21.8

Cameroon
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.2
⫺3.5

3.2
⫺0.8

3.3
⫺2.7

3.1
⫺1.0

1.4
⫺6.0

2.6
⫺5.0

3.2
⫺5.5

Cape Verde
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

5.2
⫺10.1

10.8
⫺6.9

7.8
⫺13.5

5.9
⫺18.3

3.3
⫺23.1

4.4
⫺22.3

5.4
⫺19.9

Central African Republic
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

0.7
⫺4.4

4.0
⫺7.6

3.7
⫺5.9

2.2
⫺8.5

2.4
⫺7.2

2.8
⫺7.3

2.7
⫺7.6

Chad
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

8.6
⫺24.2

0.2
⫺7.5

0.2
⫺10.7

0.2
⫺12.2

0.8
⫺20.7

2.7
⫺14.8

3.0
⫺14.3

Comoros
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

2.1
⫺6.3

1.2
⫺5.5

⫺1.0
⫺6.8

0.6
⫺11.8

0.5
⫺8.2

1.7
⫺8.2

2.3
⫺8.5

Congo, Dem. Rep. of
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

0.1
⫺1.7

5.6
⫺4.0

6.3
⫺2.7

7.1
⫺14.5

3.0
⫺13.6

5.2
⫺12.8

6.9
⫺12.0

(continued)

159

G L O B A L

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P R O S P E C T S

2 0 1 0

Table A12 (continued)(annual percent change unless indicated otherwise)
1995–2005a

2006

2007

2008

2009c

2010d

2011d

Congo, Rep. of
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

3.4
⫺2.2

6.2
1.6

⫺1.6
⫺9.3

5.8
⫺2.6

6.8
⫺9.3

11.0
3.2

2.9
0.9

Côte d’Ivoire
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

1.6
⫺0.2

0.7
2.8

1.6
⫺0.7

2.3
2.6

3.2
23.6

4.0
2.6

4.1
0.8

Eritrea
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

1.7
⫺15.3

⫺1.0
⫺20.8

1.3
⫺15.7

1.2
⫺16.3

1.5
⫺8.7

4.2
⫺9.3

4.3
⫺10.1

Ethiopia
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

5.5
⫺3.3

11.5
⫺9.2

11.5
⫺4.5

11.6
⫺5.6

7.2
⫺5.8

7.0
⫺8.1

7.5
⫺6.5

Gabon
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

1.0
10.6

1.2
15.7

5.6
13.6

2.3
17.1

⫺1.2
1.7

2.3
6.7

3.4
7.8

Gambia, The
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.4
⫺5.3

6.6
⫺13.9

6.3
⫺13.1

6.1
⫺15.6

4.6
⫺18.3

5.0
⫺16.8

5.1
⫺16.3

Ghana
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.7
⫺5.4

6.4
⫺8.2

5.7
⫺12.9

7.3
⫺18.2

4.1
⫺12.6

4.6
⫺15.5

17.5
⫺12.7

GuineaGDP at market prices (2005 US$)b
Current account balance/GDP (%)

3.7
⫺5.2

2.2
⫺11.4

1.8
⫺10.5

3.0
⫺15.6

2.0
⫺11.5

2.6
⫺11.1

4.1
⫺11.6

Guinea-Bissau
GDP at m arket prices (2005 US$)b
Current account balance/GDP (%)

⫺1.4
⫺13.5

3.5
⫺18.5

2.7
⫺9.7

2.9
⫺12.5

2.1
⫺16.4

3.4
⫺15.4

3.4
⫺15.3

Kenya
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

2.9
⫺7.5

6.4
⫺2.3

7.1
⫺3.5

1.7
⫺6.9

2.8
⫺8.3

3.7
⫺7.6

4.8
⫺6.9

Lesotho
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

2.8
⫺22.0

6.5
4.4

2.4
13.7

4.5
9.8

0.6
⫺3.1

2.3
⫺18.5

2.8
⫺19.6

Madagascar
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

3.1
⫺8.6

5.0
⫺9.5

6.2
⫺14.7

6.9
⫺21.6

0.9
⫺17.1

3.1
⫺15.8

3.6
⫺15.2

MalawiGDP at market prices (2005 US$)b
Current account balance/GDP (%)

2.4
⫺5.7

8.2
⫺4.2

8.6
⫺1.6

9.7
⫺6.3

6.5
⫺3.4

5.4
⫺4.8

4.6
⫺4.6

Mali
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

5.8
⫺8.7

5.3
⫺3.9

4.3
⫺7.4

5.1
⫺8.5

3.9
⫺6.8

4.7
⫺7.9

4.8
⫺8.5

Mauritania
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

3.3
⫺3.2

11.7
⫺3.4

1.9
⫺10.9

2.2
⫺16.4

2.5
⫺15.0

4.1
⫺16.3

5.0
⫺17.6

Mauritius
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.8
0.1

3.6
⫺9.4

5.5
⫺6.4

4.5
⫺9.0

1.9
⫺8.2

3.5
⫺8.1

4.4
⫺8.8

Mozambique
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

8.0
⫺15.1

8.7
⫺10.9

7.0
⫺12.9

6.8
⫺11.5

5.0
⫺10.6

5.5
⫺10.1

5.7
⫺9.1

(continued)

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1995–2005a

2006

2007

2008

2009c

2010d

2011d

Namibia
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.2
3.0

7.1
12.7

5.5
9.1

2.9
1.9

⫺1.9
⫺1.3

3.0
⫺2.0

3.3
⫺1.2

Niger
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

3.5
⫺7.1

5.8
⫺8.6

3.3
⫺7.8

9.4
⫺12.8

1.6
⫺17.9

4.9
⫺16.3

5.3
⫺17.7

Nigeria
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.6
5.4

6.2
15.7

6.3
17.7

5.3
19.1

4.3
8.0

4.8
10.6

5.1
10.3

RwandaGDP at market prices (2005 US$)b
Current account balance/GDP (%)

8.3
⫺4.6

7.3
⫺6.4

7.9
⫺3.8

11.2
⫺7.0

5.1
⫺6.9

5.5
⫺7.0

5.8
⫺7.1

SenegalGDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.4
⫺5.7

2.4
⫺9.2

4.7
⫺11.2

2.5
⫺12.4

2.1
⫺11.4

3.4
⫺10.5

4.2
⫺10.6

Seychelles
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

2.8
⫺13.4

8.3
⫺15.0

7.3
⫺29.9

0.1
⫺47.5

⫺10.1
⫺8.8

2.7
⫺16.0

3.7
⫺17.5

Sierra Leone
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

4.6
⫺12.4

7.3
⫺9.5

6.4
⫺14.3

5.3
⫺16.1

4.0
⫺17.0

4.7
⫺16.6

6.5
⫺16.6

South Africa
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

3.3
⫺1.3

5.6
⫺6.2

5.5
⫺7.3

3.7
⫺7.4

⫺1.8
⫺5.0

2.0
⫺5.7

2.7
⫺6.0

Sudan
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

6.2
⫺6.3

11.3
⫺15.2

10.2
⫺12.5

6.8
⫺9.1

3.8
⫺11.5

4.9
⫺9.6

5.1
⫺8.8

Swaziland
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

3.5
⫺0.8

2.9
⫺7.3

3.5
0.8

2.4
⫺4.3

0.2
⫺8.6

1.1
⫺10.5

2.4
⫺11.5

Tanzania
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

5.4
⫺6.3

6.7
⫺8.0

7.1
⫺9.4

7.5
⫺9.9

4.6
⫺7.9

5.5
⫺8.5

6.2
⫺8.4

Togo
GDP at market prices (2005 USS)b
Current account balance/GDP (%)

3.2
⫺9.6

3.9
⫺7.8

1.9
⫺7.7

1.0
⫺11.2

1.7
⫺7.0

2.0
⫺7.6

3.2
⫺7.6

UgandaGDP at market prices (2005 US$)b
Current account balance/GDP (%)

6.4
⫺7.1

10.8
⫺4.4

8.4
⫺3.7

9.0
⫺3.5

5.1
⫺4.8

5.6
⫺6.0

5.9
⫺6.4

ZambiaGDP at market prices (2005 US$)b
Current account balance/GDP (%)

3.8
⫺11.8

6.2
1.2

6.2
⫺6.1

5.7
⫺7.6

5.2
⫺4.2

5.4
⫺4.3

5.9
⫺4.4

Zimbabwe
GDP at market prices (2005 US$)b
Current account balance/GDP (%)

⫺2.4
⫺11.5

⫺6.3
⫺16.6

⫺6.9
⫺10.3

⫺14.1
⫺26.6

4.7
⫺20.8

7.1
⫺23.6

6.3
⫺21.3

P R O S P E C T S

Source: World Bank.
Note: World Bank forecasts are frequently updated based on new information and changing (global) circumstances. Consequently,
projections presented here may differ from those contained in other Bank documents, even if basic assessments of countries’ prospects do not significantly differ at any given moment in time.
Liberia, Somalia, and, São Tomé and Principe are not forecast owing to data limitations.
a. Growth rates over intervals are compound average; growth contributions, ratios and the GDP deflator are averages.
b. GDP measured in constant 2000 U.S. dollars.
c. Estimate.
d. Forecast.

161

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P R O S P E C T S

2 0 1 0Figure A38 Growth in middle-income andoil-exporting countries in Sub-SaharanAfrica will accelerate faster
Growth, percent
9
8
7
6
5
4
3
2
1
0
2007

2008

2009

2010

2011

Low-income countries
Middle-income countries
Oil exporters
Source: World Bank.

is projected to accelerate from 0.3 percent in 2009
to 3.5 percent in 2010 and to accelerate further to
4 percent in 2011, boosted by stronger external
demand and a moderate recovery in tourism andremittances. Meanwhile growth in oil-exporting
countries will almost double, reaching 4.9 percent in 2010, and accelerate marginally, to
5.3 percent in 2011, helped by stronger demandfor energy. For low-income countries, a more
moderate acceleration in growth of slightly lessthan 1 percentage point is forecast, as remittances, tourism, and private capital flows recover
more slowly. Indeed, remittances to Sub-SaharanAfrican are projected to rise only modestly, by
1.8 percent in 2010, after having declined by
2.9 percent in 2009, as weak labor markets indestination countries undermine migrants’ incomes. In contrast, remittances grew 40 percent
over the 2006–2008 period (World Bank Group
2009). Growth in fragile states will accelerate byslightly more than 1 percentage point to above
4.2 percent having weathered the global crisis
remarkably, benefiting in some cases from thepeace dividend.
Current account balances in middle-income
countries will improve only marginally in thenext couple of years, as recovery in domestic

162

demand, and in particular investment (withhigh import content), will boost import demand, causing imports to grow faster thanexports. Furthermore the recovery in tourism
revenues and remittances will also be moderate because of a weak (even jobless) recovery
in high-income labor markets during the forecast period. Current account balances in these
middle-income countries are projected to improve by less than 1.5 percent of GDP between
2009 and 2011. Current account balances inoil-exporting countries should improve by
2.7 percent of GDP, with stronger oil revenues
partially offset by stronger import demandand higher profit repatriations.
Higher commodity prices and increased
trade volumes, along with more robust levelsof domestic economic activity, should reduce
fiscal deficits in the region. After fiscal balances deteriorated to ⫺4.2 percent of GDP in
2009, fiscal balances are expected to ameliorate in 2010, narrowing to ⫺2.1 percent ofGDP, before improving further to ⫺1.7 percent of GDP by 2011 as accelerating output
growth raises tax revenues. However, most
low-income countries will continue to experience fiscal gaps in excess of 3 percent of
GDP. Fiscal balances in oil-exporting countries are expected to improve from a deficit of
5.2 percent of GDP to marginal surpluses overthe forecast horizon.

Risks
The major risk facing the Sub-Saharaneconomies is that the world economy could
experience a double dip or economic stagnation. This would undermine the recovery inexternal demand for the Sub-Saharan economies and would put pressure on commodity
prices, undermining government revenues
and possibly pushing debt to unsustainablelevels. This could in turn force governments
to implement procyclical fiscal cuts, increase
taxation, or both, with adverse implications
for poverty, health, education, and longterm growth prospects. Tourism, remittances, and private capital flows may also
decline further, thereby negatively affecting

R E G I O N A L

growth and incomes and ultimately causing
more people to fall into poverty. Furthermore, safety nets in many countries in theregion are very limited, which means thatthe impact on the poor cannot be cushioned.
A jobless recovery in high-income countries
would have similar negative consequences
for tourism and remittances to Sub-SaharanAfrican countries, some of which depend
heavily on these revenues.
The Sub-Saharan Africa region will facea large external financing burden in 2010,equivalent to close to 12 percent of GDP, andgrowth could fall short of the baseline forecast if unmet financing requirements lead tolower investment and growth prospects. For
countries with external financing needs, maturing foreign debt will amount to close to
6.5 percent of GDP in 2010, while the current account deficit including grants is forecast at 5.2 percent of GDP. There is thus arisk in many Sub-Saharan economies, and inparticular in low-income countries, that concessional lending will fall short of the needto finance a swift return to growth. In somecases, this shortfall may be exacerbated byinstitutional capacity constraints, which also
limit effectiveness. Given the role that foreign
investment flows play in the region, a reversal
in these flows not only would directly affectexternal financing needs, but also would havea severe impact on investment and growth.
Given the increased global growth uncertainties, investment flows to the region may be
adversely affected.
The fiscal position in some of the smaller
members of the Southern Africa Customs Union(particularly Lesotho and Swaziland) may comeunder severe pressure over the next two to three
years, because one of the major revenue sourcesof the union’s revenue pool is related to taxes
on South African imports, which have deteriorated rapidly in the aftermath of the global
financial crisis.
In countries that experienced rapid credit
growth during the boom years, there is amarked risk that nonperforming loans willrise sharply during the economic downturn

E C O N O M I C

P R O S P E C T S

affecting the financial sector, which in turnwould have an adverse impact on the real
sector. Countries like Cape Verde, the Democratic Republic of Congo, Ethiopia, Nigeria,
Rwanda, Tanzania, Uganda, and Zambia haveregistered rapid increases in nonfinancial private sector claims (as a share of broad money)
and therefore run larger risks. For countries
with low capital adequacy, the effect of deteriorating balance sheets on performance will
be even more severe.

Notes
1. Fixed investment plummeted across most developing and high-income countries of the East Asia region from the final quarter of 2008 through the second
quarter of 2009. For example, investment in Thailand
tumbled 40 percent in the first quarter of 2009 (saar),
Malaysia experienced sequential falloffs of 35 and
14 percent over the final quarter of 2008 and the firstof 2009, while several newly industrialized economies(NIEs) were much more severely affected, with Taiwan,
China, suffering four successive quarterly declines, twoof which were in excess of 40 percent.
2. The developing East Asia region as referenced
in this report comprises the larger countries of China,
Indonesia, Malaysia, the Philippines, and Thailand,
as well as Fiji, Cambodia, Lao People’s Democratic
Republic, Papua New Guinea, Vanuatu, and Vietnam.
Smaller Pacific island nations generally carry insufficient economic and financial data for inclusion in
the database and projections. The importance of highincome East Asian countries—those noted in the
text—as well as Australia, should be underscored in
the current context of crisis and recovery, because thestrong trade relationships among all countries in East
Asia tend to amplify the down-phase of recession, butshould come to support the rebound and recovery in asimilar fashion as recovery evolves over coming months
and years.
3. Dollar-based exports picked up to growth of
52 percent for China by November 2009 (saar) fromdeclines of 54 percent in March; to 41 percent for theremainder of the developing region by October, and to17 percent for the NIEs, also by October of the year.
At the same time industrial production for most economies rebounded sharply, for example, to 25 percent for
Thailand in September (saar) from trough declines of
48 percent in December 2008.
4. The countries covered in the Europe and Central
Asia section of the appendix are those that fall into theWorld Bank’s definition of low- and middle-income163

G L O B A L

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P R O S P E C T S

2 0 1 0classifications (with 2008 per capita Gross National
Income equal to or below $3,855). These 24 countries are Albania, Bosnia and Herzegovina, Bulgaria,
Kosovo, Latvia, Lithuania, Former Yugoslav Republicof Macedonia, Montenegro, Poland, Romania, andSerbia (in the Central European subregion); Armenia,
Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyz
Republic, Moldova, Russian Federation, Tajikistan,
Turkmenistan, Ukraine, and Uzbekistan (in the Commonwealth of Independent States subregion); andTurkey. Transition countries include all 24 countries,
with the exception of Turkey. Among these developing countries, Bulgaria, Latvia, Lithuania, Poland, andRomania are new European Union members. Owing todata limitations, forecasts are not available for Bosnia
and Herzegovina, Kosovo, Montenegro, Serbia, Tajikistan, and Turkmenistan.
5. See World Bank (2009b).
6. Bulgaria, Latvia, Lithuania, Poland, and Romania. See World Bank, 2009a.
7. Kazakhstan, Kyrgyz Republic, Tajikistan, Turkmenistan, and Uzbekistan.
8. Armenia, Azerbaijan, and Georgia.
9. World Bank Group (2009).
10. World Bank (2010a).
11. World Bank (2010b).
12. SELIC stands for Sistema Especial de Liquidação e Custodia, or Special System of Clearance andCustody, which is Banco Central do Brasil’s overnight
lending rate.
13. The low- and middle income countries of the
Middle East and North Africa region as presented
in this report include Algeria, the Arab Republic of
Egypt, the Islamic Republic of Iran, Jordan, Lebanon,
Morocco, the Syrian Arab Republic, Tunisia, and theRepublic of Yemen. Several developing economies are
not covered owing to data insufficiencies, including
Djibouti, Iraq, Libya, and the West Bank and Gaza.
High-income economies of the broader geographic
region, including Gulf Cooperation Council (GCC)
members Bahrain, Kuwait, Oman and Saudi Arabia

164

are covered in this report under the category of “otherhigh-income countries.” But as this group has become
increasingly more integrated with the developing
economies of the region, discussion of economic andfinancial developments for the group is a feature of thisappendix. Among the GCC, insufficient data exists forinclusion of Qatar and the United Arab Emirates.

References
Chen, S., and M. Ravallion. “The Impact of the Global
Financial Crisis on the World’s Poorest.” Vox:
Research-Based Policy Analysis and Commentary from Leading Economists, www.voxeu.org/
index.php?q=node/3520 [accessed Dec. 9, 2009].
Friedman, J., and N. Schady. 2009. “How Many More
Infants Are Likely to Die in Africa as a Result of
the Global Financial Crisis?” Research Paper 60(August). World Bank, Washington, DC.
World Bank. 2009a. “EU10 Regular Economic
Report: From Stabilization to Recovery.”
Washington, DC (October). http://go.worldbank.org/UNCGIKEPH0.
———. 2009b. “Russian Economic Report #20:
From Rebound to Recovery?” Washington,
DC (November10). http://go.worldbank.org/
FKGLSQ4NF0.
———. 2010a. “The Crisis Hits Home: Stress-Testing
Households in Europe and Central Asia.” Prepared by Erwin R. Tiongson, Naotaka Sugawara,
Victor Sulla, Ashley Taylor, Anna I. Gueorguieva,
Victoria Levin, and Kalanidhi Subbarao. http://
go.worldbank.org/H92ZH3CK20.
———. 2010b. “Turmoil at Twenty.” Washington,
DC. http://go.worldbank.org/ZQTRLRED70.
World Bank Group. 2009. “Migration and Remittance Trends 2009.” Migration and Development
Brief 11. Washington, DC (November 3). http://
siteresources.worldbank.org/INTPROSPECTS/
Resources/334934-1110315015165/
MigrationAndDevelopmentBrief11.pdf.

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“The crisis has deeply impacted
virtually every economy in theworld, and although growth
has returned, much progressin the fight against poverty
has been lost. More difficultinternational conditions in theyears to come will mean thatdeveloping countries will haveto place even more emphasis on
improving domestic economic
conditions to achieve the kindof growth that can durably
eradicate poverty.”—Justin Yifu Lin
Chief Economist andSenior Vice President
The World BankG

lobal Economic Prospects 2010: Crisis, Finance, and Growth
explores both the short- and medium-term impacts ofthe financial crisis on developing countries. Although
global growth has resumed, the recovery is fragile, and unlessbusiness and consumer demand strengthen, the world economy
could slow down again.
Even if, as appears likely, a double-dip recession is avoided, therecovery is expected to be slow. High unemployment and widespread
restructuring will continue to characterize the global economy for the
next several years. Already, the crisis has provoked large-scale humansuffering. Some 64 million more people around the world are expected
to be living on less than a $1.25 per day by the end of 2010, andbetween 30,000 and 50,000 more infants may have died of malnutritionin 2009 in Sub-Saharan Africa, than would have been the case if thecrisis had not occurred.
Over the medium term, economic growth is expected to recover. But
increased risk aversion, a necessary and desirable tightening of financial
regulations in high-income countries, and measures to reduce theexposure of developing economies to external shocks are likely to makefinance scarcer and more costly than it was during the boom period.
As a result, just as the ample liquidity of the early 2000s prompted
an investment boom and an acceleration in developing-country
potential output, higher costs will likely yield a slowing indeveloping-country potential growth rates of between 0.2 and 0.7
percentage points, and as much as an 8 percent decline in potential
output over the medium term.
In the longer term, however, developing countries can more than offset
the implications of more expensive international finance by reducing
the cost of capital channeled through their domestic financial markets.
For more information, please visit www.worldbank.org/gep2010.
To access Prospects for the Global Economy, an online companion
publication, please visit www.worldbank.org/globaloutlook.

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