The economic recovery from the Great Recession is well underway. Global industrial production and world trade have returned to their pre-crisis levels and most economies are now growing at levels close to their long-term averages.
While the easy, bounce-back portion of the recovery is over, the slower, more difficult process of restructuring economies and labor markets continues. This process will dictate the pace of expansion, particularly in those economies most affected by the excesses of the boom period and its subsequent crash, notably the United States, high-income Europe, and many countries in developing Europe and Central Asia. At the global level, growing differences in the extent of spare capacity and in macroeconomic policy stances are causing tensions that could create destabilizing capital flows and threaten growth in developing countries, which have been the major drivers of the global recovery so far.
Industrial Production and Trade Back to Pre-Crisis Levels
As deep and traumatic as the Great Recession was, the world economy has recovered relatively quickly. Global industrial production, the sector of activity most affected by the crisis—which fell by 10 percent between August 2008 and January 2009—regained pre-crisis activity levels by March 2010. Trade, which had declined by 19 percent in volume terms as of January 2009, has also regained pre-crisis levels, although somewhat later than industrial production.
Large differences exist in the rate at which this spare capacity has been re-absorbed. Some countries, such as China, have already regained their pre-crisis growth paths. Others, notably many high-income and developing European countries, have returned to their pre-crisis growth rates, but have not recovered fully or are only slowly closing in on their pre-crisis growth paths.
Though these levels are important milestones, the extent to which different countries or different regions have recovered varies widely. Many developing countries have surpassed pre-crisis activity levels by 10 percent or more (for example, China, India and Poland), while many other countries have drawn even with their pre-crisis activity levels. However, industrial activity in other countries—including many high-income countries and developing economies in Europe and Central Asia—is down 5 percent or more relative to August 2008 levels. Of course, if technological change helped productive capacity continue to grow during the post-crisis period then there is significantly more spare capacity throughout the world.
This pattern of lost output in those countries most directly involved in the boom is consistent with the evidence from previous financial crises. Research conducted by the IMF shows that post-crisis declines in investment, the need to shrink sectors that ballooned to unsustainable sizes during the boom period, and associated labor-force adjustments mean that, on average, even seven years after a financial crisis, the GDP of those countries most directly affected by a crisis remains 7 percent lower than it would have been had the crisis not occurred and had it maintained its pre-crisis growth rate.1
Most Developing Countries Have Regained Pre-Crisis Activity Levels
Differences in Policy Stances and Capital Flows
The wide differences in the extent to which economies have recovered their pre-crisis activity levels is reflected in their macroeconomic policy stances. Policy is tightening toward a more neutral stance in developing countries but remains extremely loose in high-income countries, notwithstanding some initial steps toward fiscal tightening. Central bank interventions in high-income countries have pushed down both short-term and long-term interest rates, simultaneously reducing the cost of credit and stimulating investors to place their money into riskier activities.
With higher growth rates, tighter monetary policy stances (and therefore higher interest rates), and more sustainable fiscal positions, developing countries are natural destinations for some of this money. Commodities, real estate, and relatively liquid markets—which offer a place to invest borrowed money and can be rapidly exited—are also natural attractors. Reflecting these considerations, gross international bond and equity flows—particularly corporate bonds—to developing countries have hit record levels, actually exceeding levels observed over the same period in 2007. However, bank lending remains weak, so total flows to developing countries are still 30 percent below their 2007 peak.
The strong bond and equity flows are positive for developing countries; they help compensate for the decline in international bank lending that followed the financial crisis and help finance investment and other productive activities. However, these benefits have been concentrated among middle-income countries, which have attracted the bulk of these flows, rather than lower-income countries. Bond and equity flows to Latin America and East Asia, for example, were even stronger during the first nine months of 2010 than during the same period in 2007.
Nevertheless, strong equity and bond flows can, and may be, creating dangerous and destabilizing dynamics. Already, these flows are placing upward pressure on currencies and reducing the competitiveness of firms in recipient countries. In addition, many countries have difficulties sterilizing (a process used by central banks to ease the threat of inflation or currency appreciation) these inflows for several reasons: Domestic bond markets cannot support the level of open-market transactions needed to absorb the excess liquidity generated by the inflow; higher domestic interest rates needed to withdraw the additional liquidity are attracting further capital inflows; and the cost of the interventions is too high. As a result, these inflows are causing a rapid expansion in credit, including consumer credit to finance real estate, automobile, and tourism purchases—with the first of these expansions potentially generating dangerous domestic bubbles.
The situation may be growing even more unstable. Expectations of currency appreciation due to capital inflows may prompt even more inflows, as investors seek to benefit from further appreciation. So far this year, almost 60 percent of the flows into developing country bond funds have gone into local currency funds—which offer the prospect of additional profits from appreciation. Normally, only about 35 percent of bond inflows go into locally denominated bond funds. Historically, this kind of bubble-inducing dynamic can go on for a considerable period of time, but can also result in a rapid, sharp, and painful reversal if the tensions between the real-side economic consequences of continued appreciations and the self-fulfilling behavior of financial markets reach a tipping point.
Recognizing the dangers inherent in this dynamic, developing countries are legitimately resisting these pressures. Several countries have taken steps to restrict inward capital flows by imposing taxes or restrictions on foreign purchases of short-term bonds (Brazil, Indonesia), relaxing restrictions on capital outflows (Indonesia, China), or stepping up the pace at which international reserves are accumulated (Brazil, China, Thailand). The dollar value of international reserves increased 14 percent between August 2009 and August 2010, with several countries increasing their rate of accumulation of currency reserves much more sharply.
Moreover, the pace has quickened in recent months. For example, over the past three months, Thailand has been accumulating reserves 2.8 times faster than it did in 2007, and almost three times faster than during the previous nine months.
How long this can last is uncertain. Already, South Africa—which has been exposed to growing capital inflows for much of the year—has been forced to call off efforts to fight the appreciation of its currency. Other economies may be forced to follow, with potentially serious negative consequences for activity, as capital inflows increase domestic credit, widen current account imbalances, and potentially generate domestic asset bubbles.
Andrew Burns is a lead economist and manager of the World Bank's Global Macroeconomic team in the Development Prospects Group. His team is responsible for monitoring global economic and financial developments and producing the World Bank's global forecasts.