Market nervousness concerning the fiscal positions of several European high-income countries poses a new challenge for the world economy. This arises as the recovery is transitioning toward a more mature phase during which the influence of rebound factors (such as fiscal stimulus) fades, and GDP gains will increasingly depend on private investment and consumption.
· So far evolving financial developments in Europe have had limited effects on financial conditions in developing countries. Although global equity markets dropped between 8 and 17 percent, there has been little fallout on most developing-country risk premia. And despite a sharp deceleration in bond flows in May, year-to-date capital flows to developing countries during the first 5 months of 2010 are up 90 percent from the same period in 2009.
· Little real-side data is available to evaluate the impact of the European fiscal/debt crisis on economic activity. Existing data suggests that through the end of March, the recovery remained robust in most developing and developed countries, with the exception of high-income Europe where it has stagnated.
· Assuming that measures in place prevent today’s market nervousness from slowing the normalization of bank-lending, and that a default or restructuring of European sovereign debt is avoided, global GDP is projected to increase by 3.3 percent in 2010 and 2011, and by 3.5 percent in 2012. Private capital flows to developing countries are projected to increase from 2.7 percent of their GDP in 2009 to 3.2 percent in 2012 (Table 1). Reflecting stronger productivity growth, and less-pronounced headwinds than in high-income countries, GDP in developing countries is expected to grow by 6.2, 6.0, and 6.0 percent in 2010, 2011 and 2012. This is more than twice as quickly as in high-income countries, where growth is projected to strengthen from 2.3 percent this year to 2.7 percent in 2012.
· However, should current uncertainty regarding developments in Europe persist, outturns could be weaker. A high probability alternative baseline, characterized by an accelerated tightening of fiscal policy across high-income countries, would see a more muted recovery, with global GDP expanding by 3.1 percent in 2010 and by 2.9 and 3.2 in 2011 and 2012. The easing of momentum would be concentrated in high-income countries, where GDP might rise 2.1, 1.9, and 2.2 percent during each of the three years. Under these conditions growth in developing countries could average 5.9 percent during the projection period.
· Deeper and more widespread effects might arise if the situation causes investors to become significantly more risk averse; or in a less likely scenario, if there is a major crisis of confidence, prompted by (or causing) a default or major restructuring of high-income sovereign European debt.
o Simulations suggest that an increase in risk aversion that caused long-term yields on U.S. government bonds to rise by 100 basis points could slow global growth by 0.5 percentage points.
o A serious loss of confidence in the debt of five EU countries combining high fiscal deficits and high government debts that led to a freezing-up of credit in those countries could cause GDP growth to slow by as much as 2.4 percent in 2011—pushing high-income countries into recession.
o A default or major restructuring among the EU-5 (Greece, Ireland, Italy, Portugal and Spain) could threaten the solvency of several banks outside the EU-5, with potentially far-reaching consequences for the global financial system.
o Because of significant presence of EU-5 banks, international capital flows to Europe and Central Asia and to a lesser extent to Latin America and the Caribbean might be seriously affected in the event of a default or restructuring of high-income sovereign debt.
· To ensure longer-term sustainability, fiscal policy in many high-income countries needs to be tightened sharply over the next several years. Although politically difficult, a policy that favors a more aggressive reining-in of deficits will, by reducing high-income country borrowing costs, favor medium-term growth in both developing and high-income countries.
· Limited fiscal space in low-income countries means that if official development assistance were to decline, policymakers in low-income countries could be forced to cut growth enhancing infrastructure and human capital investments. As a result, the number of people living on $2 or less per day in 2020 could be higher by as much as 79 million.Concerns about the sustainability of Greece’s fiscal position spilled over into global financial markets in early May 2010. Although there was a sharp increase in risk premia and a steep decline in stock markets worldwide, there are only limited indications of contagion – at least so far.1
Following the announcement of a €750 billion, or nearly $1 trillion aid package by the European Union, the International Monetary Fund, and the European Central Bank, the initial sharp uptick in the price of credit default swaps (CDSs) on the sovereign debt of select European countries receded before rebounding partially in the following weeks. LIBOR-OIS spreads have increased to 32 basis points, suggesting that commercial banks are concerned that the ability of counterparties to repay even short loans might be affected by a default or restructuring of high-income sovereign debt. Moreover, anecdotal evidence suggests that some European banks are having trouble getting funding. Nevertheless, LIBOR-OIS spreads remain well below the values observed during the initial phases of the sub-prime crisis, and suggest that for the moment, markets are not overly concerned.
The credit ratings of most developing country sovereigns have not been affected by the crisis. Since the end of April, though May 24, the credit ratings of 5 countries (Azerbaijan, Bolivia, Nicaragua, Panama and Ukraine) have been upgraded, and none have been downgraded. For the year to date, there have been 22 upgrades and only 4 downgrades. EMBI spreads for major developing countries, after rising much less than in September 2008, have declined again and are only a little higher than in January 2010 (less than 10 basis points in the case of Brazil and Russia, and 27 and 40 basis points in the case of South Africa and Turkey). Indeed, a recently developed index of the deterioration in financial conditions2 for a sample of 60 countries (31 high-income, 27 middle-income, and 2 low-income countries), shows that as of early June 2010, only 8 of the 23 countries displaying relative deterioration in market conditions since March 31st were developing counties. Four of the 8 countries where the deterioration in the aggregate index exceeded 0.5 were developing countries. However, in two cases, the deterioration reflected rising interest rates following a tightening of monetary policy in response to improving economic conditions, rather than a reaction to the situation in Greece.
While market conditions have improved―the size of the EU/IMF rescue package (close to $1 trillion); the magnitude of the initial market reaction to the possibility of a Greek default and eventual contagion; and continued volatility, are indications of the fragility of the financial situation. As discussed in the risks section below, a further episode of market uncertainty could entail serious consequences for growth in both high-income and developing countries.
Stock markets worldwide lost between 8 and 17 percent in May, with losses generally larger in high-income Europe and developing Europe than in markets further removed from Greece. Moreover, data for May indicate a significant decline in capital inflows toward developing countries, although year-to-date flows are 90 percent higher than in 2009. Most of the decline was concentrated in bond issuance by developing countries, with more modest declines in bank-lending and equity flows. Although it is difficult to determine with precision to what extent this reflects a normal seasonal decline in flows, or a temporary reduction in issuance prompted by elevated spreads at the beginning of the month,3 these developments could signal a further tightening of capital markets.
