Global Development Finance 2009: Outlook summary

The financial crisis that erupted  in September 2008—following more than a year of financial turmoil—has become a global crisis for the real economy. Economic activity in high-income and developing countries alike fell abruptly in the final quarter of 2008 and in the first quarter of 2009.
Unemployment is on the rise, and poverty is set to increase in developing economies, bringing with it a substantial deterioration in conditions for the world’s poor and most vulnerable. The outbreak of the financial crisis provoked a broad liquidation of investments, substantial loss in wealth worldwide, a tightening of lending conditions, and a widespread increase in uncertainty. Higher borrowing costs and tighter credit conditions, coupled with the increase in uncertainty provoked a global flight to quality, caused firms to cut back on investment expenditures, and households to delay purchases of big-ticket items. This rapid increase in precautionary saving led to a sharp decline in global investment, production, trade, and gross domestic product (GDP) during the fourth quarter of 2008, a trend that continued in the first quarter of 2009.  The sharpest declines in economic activity were concentrated among countries specialized in the production of durable and investment goods and in countries with serious pre-existing macroeconomic vulnerabilities. This suddenly very weak international environment accelerated the fall in commodity prices that began in mid-2008. By end-May 2009, oil prices were down 60 percent from their peak and non-oil commodity prices, including internationally traded food commodities, were off 35 percent. Lower food and fuel prices have cushioned the poverty impact of reduced activity to a degree and helped to reduce the pressure on the current accounts of oil-importing developing countries, even as they reduced surpluses among developing oil-exporters by as much as 17 percent of GDP. Policy reactions to the crisis have been swift and, although not always well coordinated, have so far succeeded in preventing a broader failure among financial institutions, and thereby avoided a much more severe collapse in production. In the absence of public-sector assistance, the massive losses suffered by investment banks and other institutions would have forced commercial banks to sharply reduce lending—forcing firms to cut back on investment and production even more forcefully. Instead, bank lending continued to grow until very recently, although much less rapidly than in the past. These policy measures have not been costless. Fiscal balances in 2009 are expected to deteriorate by about 3 percent of GDP in high-income countries, and by about 4.4 percent of GDP in developing countries. Longer term, increased high-income country indebtedness may raise borrowing costs, potentially crowding out developing-country private and public-sector borrowers. The drop in economic activity, combined with much weaker capital flows to developing countries, is placing a large number of low- and middle-income countries under serious financial strain. Many countries are having difficulty generating sufficient foreign currency from exports or borrowing to cover import demand. Overall, borrowing needs for developing countries are expected to exceed net capital inflows by between $350 billion and $635 billion. Many countries are meeting this financing gap by drawing down on the international currency reserves they built up during good times. However, the sustainability of this strategy is uncertain.

Since September 2008, 16 countries have consumed 20 percent or more of their foreign reserves, and the current stock of reserves covers less than 4 months of imports in 18 countries. The challenges of widening current-account deficits and deteriorating fiscal positions are most acute in the Europe and Central Asia region, partly because the recession is expected to be deepest there, but also because many countries entered the crisis period with double-digit current-account deficits (as a share of GDP) and/or elevated government debt. If, as appears likely, financing is not fully forthcoming for these economies, heavy compression of domestic demand and exchange-rate depreciation will be required to restore internal and external balances. Despite the rapid decline in GDP in high-income countries during the first quarter of 2009, a number of indicators point to the beginnings of an economic recovery. Stabilizing and even recovering stock markets, modest improvements in exports in some countries, a recovery in consumer demand and the still-to-come demand-boosting effects of discretionary fiscal stimulus measures are among the factors pointing to the beginning of recovery.

High frequency indicators vary distinctly by country at the moment, however, with data for the United States and China more suggestive of economic revival than those for western Europe and other developing regions. Moreover, several factors point to continued weakness. Unemployment continues to rise throughout the world, housing prices in many countries are still falling (adding to negative wealth effects), bank balance sheets are fragile, and much more consolidation and recapitalization required. As a result, the timing and strength of the eventual recovery in the global economy remain highly uncertain. Indeed, many countries are facing growing pressure on their currencies and banking sectors. Already several high-and middle-income developing countries have entered into special borrowing agreements with the International Monetary Fund (IMF) to prevent deteriorating external and fiscal positions from getting out of hand.
The baseline scenario presented in this edition of Global Development Finance depicts a much more subdued recovery than during a normal recession, partly because this downturn follows a financial crisis—which tends to be deeper and longer-lasting than normal ones—and partly because today’s downturn has affected virtually the entire world, precluding the more typical scenario where recovery from a more geographically isolated downturn is at least partly achieved by exporting to healthier and more rapidly growing countries. In this scenario, global GDP, after falling by a record 2.9 percent in 2009, recovers by a modest 2.0 percent in 2010 and by 3.2 percent in 2011.

Banking sector consolidation, continuing negative wealth effects, elevated unemployment rates, and risk aversion are expected to weigh on demand throughout the forecast period. Among developing countries, growth rates are higher (given stronger underlying productivity and population growth) but remain similarly subdued at 1.2, 4.4, and 5.7 percent, respectively, over 2009 through 2011.  Given the output losses already absorbed—and because GDP only reaches its potential growth rate by 2011—the output gap (or the difference between actual GDP and its potential), unemployment, and disinflationary pressures are projected to build over 2009 to 2011. A more robust recovery is possible, fueled by the substantial fiscal, monetary, and sectoral initiatives that have been put into place. So too is a much weaker outcome. In the latter scenario, the drag of the financial sector on economic growth, which is a key feature of the baseline, is projected to be more intense, while even weaker confidence impedes recovery in discretionary investment and consumer spending—leading to still slower growth.  Moreover, pressure on current accounts, exacerbated by a weaker recovery, could force a number of countries (notably, several in Europe and Central Asia) into a much less orderly process of adjustment, characterized by substantial currency depreciation and painful cuts in domestic demand.

Source: World Bank

Immediate impacts of the crisis
What began in the summer of 2007 as an extended period of financial turmoil caused by the losses in the U.S. subprime mortgage market, erupted into a full-blown and global financial crisis in mid-September 2008, precipitated by the failure of the investment bank, Lehman Brothers. The realization that such a key player in the international financial system could fail shook the confidence of bankers, investors, and households alike and reverberated rapidly throughout the global economy. The initial loss of confidence in the financial system provoked a liquidity crunch in the interbank market. Banks became extremely reluctant to lend to one another, and liquidity dried up rapidly, causing spreads between the interest rates banks charge each other (LIBOR, or the London Interbank Offer Rate for overnight funds) and what they expect to pay central banks (the overnight index swap rate) to jump to unprecedented levels. Uncertainty about the future and fears that the crisis could provoke a deep recession or even depression skyrocketed, evidenced, for example, by some 4,500 stories about the financial crisis and its potential negative effects appearing in major English-language print media in September 2008.

The sudden drying up of liquidity and increased uncertainty also yielded a change in the pricing of risk throughout the global economy.  Interest rate spreads on riskier assets, including the bonds of firms in developing- and high-income countries, and, to a lesser extent sovereign states, increased substantially. Increased risk aversion, a reassessment of growth prospects, and the need for firms and investors in high-income countries to strengthen their balance sheets resulted in a large-scale repatriation of capital from developing countries.  As a consequence, stock markets the world over lost between 40 and 60 percent of their dollar values—the currencies of almost every country in the world depreciated against the U.S. dollar—implying a massive loss in global wealth.

Successive interventions by authorities in both high-income Europe and North America (including substantial efforts by the Federal Reserve in the United States to intermediate directly between banks) have helped restore short-term liquidity. As of end-May 2009, interbank spreads are down some 350 basis points since September 2008 in the case of the United States and by 200 basis points in the Euro Area. This, plus the fact that there have been no additional failures of major financial institutions or significant currency crises, has brought about a near-stabilization and even improvement in financial conditions over the period since March 2009. Spreads on developing-country bonds have narrowed, with the market now distinguishing better between the risks posed by different countries.  At the same time, stock market valuations are regaining ground in a number of countries.

Still, conditions continue to be tight and markets nervous.  Interbank spreads remain above historical levels, and the IMF estimates that only a third of all financial sector losses have been booked at this stage. Similarly, developing-country spreads remain high, and, even though the base rates against which these spreads are calculated have declined in response to the post-crisis relaxation of monetary policy in high-income countries, yields and borrowing costs for developing-country firms have increased substantially—doubling in some cases—with potentially important effects on debt sustainability and the profitability of future investment .

Source: World Bank

Second wave of crisis

The eruption of the financial crisis and the uncertainty that it provoked a crisis in the real economy. Individuals, suddenly uncertain about their job prospects and facing more expensive and difficult-to-obtain financing, delayed purchases that could be put off, typically consumer durables such as automobiles, refrigerators, and televisions. Similarly, firms delayed the implementation of investment projects, preferring to wait and see if such projects would remain profitable under future demand and financing conditions. This increase in precautionary saving (and the associated reduction in investment and consumer demand), together with increased borrowing costs and tighter lending standards, explains the unprecedentedly rapid fall in global demand for manufactured goods during the fourth quarter of 2008 and the first quarter of 2009.  Moreover, while consumer demand has and will recover, saving rates are unlikely to return to earlier low levels, because households will continue to save to restore a proportion of the financial wealth destroyed during the crisis. The cutback in fixed investment spending was widespread. It involved countries directly affected by the financial crisis, those with close links to affected commercial and investment banks, and those that suffered through the indirect channel of falling export demand.

For some economies, notably those with large current-account deficits, these transmission channels were further amplified by a reversal in private capital flows, which forced a much sharper decline in domestic demand. Investment activity fell by an average of 4.4 percent (at a 16.5 percent annualized rate) in 27 of 30 high-income countries in the fourth quarter of 2008.  The slowdown was not limited to the high-income countries where the financial crisis originated. In the 25 developing economies that report quarterly national accounts data, investment growth in the final quarter of 2008 fell by an average of 6.9 percent, or at an annualized pace of 25 percent. Investment demand continued to decline precipitously in the first quarter of 2009. Investment fell at a 37 percent annualized pace in the United States, and by close to a 30 percent annualized rate in Japan, Germany, and Russia. Consumer savings increased sharply as households cut back or delayed large expenditures. In the United States, the personal saving rate increased from 0.6 percent in 2007 to more than 5.7 percent in April 2009. Demand for consumer durables fell at a 22 percent annualized rate in the fourth quarter of 2008 in the United States, and by 20 percent in high-income Europe. Worldwide demand for autos plummeted by 30 percent in the quarter, sending firms in the United States, Europe, and Japan to national governments for emergency financial support. Data for the first quarter of 2009 suggest that consumer demand for durable goods may be stabilizing or even advancing—partly in response to government-sponsored incentives in several countries.

In the United States, consumer spending increased at a 1.6 percent annual pace in the first quarter, led by a 9.6 percent annualized gain in durable goods. The falloff in consumption growth was less pronounced in other countries, save Japan, in part because savings rates in most economies were not as depressed as they had become in the United States.  Nevertheless, increasing unemployment and the growing recession has pushed consumer confidence to all-time lows, which, in addition to the negative wealth effects from falling equity and housing prices, is weighing on—and will continue to weigh on— consumer demand for some time (the value of household assets in the United States declined by 14.7 percent, or $11.3 trillion, between the fourth quarter of 2007 and the fourth quarter of 2008). For developing-country commodity exporters, the decline in incomes resulting from lower commodity prices is exercising a similar effect, although lower food and energy prices will tend to boost the purchasing power of consumers in commodity-importing countries.

Source: World Bank