As 2012 begins, the global economy continues to be buffeted by the aftermath of the 2008–09 crisis. The sovereign debt crisis in Europe, which took a turn for the worse in August, is generating significant headwinds, and the associated financial turmoil has spread to countries that had earlier been spared. In light of deteriorating conditions in Europe and the spread of financial contagion to both developing and high-income countries outside Europe’s periphery—developments that eerily resemble the kind of downside scenarios that economists described just six months ago—the World Bank has significantly downgraded its forecasts in its just-released January 2012 edition of Global Economic Prospects.

Since the publication of the World Bank’s last report in June, financial markets reflect greater risk and uncertainty. Between the end of July 2011 and early January 2012, yields on the sovereign debt of developing countries increased by an average of 117 basis points (bps), as did those of nearly all the euro-area countries, including France (86 bps) and Germany (36 bps), and those of non-euro-area countries such as the United Kingdom (18 bps) (see figure). In addition to higher spreads, capital flows to developing countries have weakened sharply as investors withdrew substantial sums from developing country markets in the second half of the year. Overall, gross capital flows to developing countries plunged to $170 billion in the second half of 2011, only 55 percent of the $309 billion received during the same period in 2010. Developing country stock markets have lost 8.5 percent of their value since the end of July. This decline, combined with the 4.2 percent drop in high-income stock market valuations, has translated into $6.5 trillion (9.5 percent of global GDP) in wealth losses.

In addition, global economic conditions are much weaker. Europe appears to have already entered recession, while growth in several major developing countries (Brazil, India, and, to a lesser extent, Russia, South Africa, and Turkey) has slowed, mainly reflecting policy tightening that was initiated in late 2010 and early 2011 to combat rising inflationary pressures (see figure). As a result, despite relatively strong activity in the United States and Japan, global industrial production and trade have slowed sharply. Global trade volumes declined at an annualized pace of 8 percent during the three months ending in October 2011, mainly reflecting a 17 percent annualized decline in European imports.

Reflecting this new world, the World Bank has significantly downgraded its forecasts in the latest edition of Global Economic Prospects:

• The global economy is now expected to expand 2.5 and 3.1 percent in 2012 and 2013 (3.4 and 4.0 percent when calculated using purchasing power parity weights), down from the 3.6 percent that was projected in June for both years.
• High-income-country growth is now expected to come in at 1.4 percent in 2012 (-0.3 percent for euro-area countries, and 2.1 percent for the rest) and 2.0 percent in 2013, as compared to the June forecast of 2.7 and 2.6 percent for 2012 and 2013 respectively.
• Developing country growth has been revised down to 5.5 and 6.0 percent, from 6.2 and 6.3 percent in June.
• Reflecting the growth slowdown, world trade, which expanded by an estimated 6.6 percent in 2011, is expected to grow by only 4.7 percent in 2012 before strengthening to 6.8 percent in 2013.

However, even achieving these much weaker outcomes is very uncertain. The downturn in Europe and slow growth in developing countries could reinforce one another to a greater extent than is anticipated in the new baseline forecasts, resulting in even more anemic figures. At the same time, weak growth in Europe is complicating efforts to restore market confidence in the sustainability of the region’s finances and could exacerbate tensions.

Meanwhile, the medium-term challenges represented by high deficits and debts in Japan and the United States and slow trend growth in other high-income countries have not been resolved and could trigger sudden adverse shocks. Additional risks to the outlook include the possibility that political tensions in the Middle East and North Africa will disrupt oil supplies, and the possibility of a hard landing in one or more important middle-income countries.

The crisis in high-income Europe is contained for the moment. But if it expands and markets deny financing to several more European economies, this could result in a decline in global GDP relative to the baseline amounting to 4 percent or more. Such a crisis, should it occur, would be centered in high-income countries, but developing countries would feel its effects deeply, and their GDP could decline by as much as 4.2 percent by 2013.

In the event of a major crisis, the downturn may well be deeper and longer than in 2008–09 because high-income countries do not have the fiscal or monetary resources needed to bail out the banking system or stimulate demand to the same extent as before. Developing countries have some maneuverability on the monetary side, but they could be forced to pro-cyclically cut spending—especially if financing for fiscal deficits dries up.

Whatever the actual outcomes for the world economy in 2012 and 2013, at least two trends are clear. First, growth in high-income countries is going to be weak as they struggle to repair damaged financial sectors and badly stretched fiscal balance sheets. Second, developing countries will have to increasingly search for growth within the developing world—a transition that has already begun but is likely to bring with it challenges of its own.

Developing countries are more vulnerable than in 2008

One of the most heartening aspects of the 2008–09 recession was the speed with which developing countries (other than those in Central and Eastern Europe) exited the crisis. By 2010, 53 percent of developing countries had regained levels of activity close to, or even above, estimates of their potential output. This time, developing countries will likely be more vulnerable if there is a sharp deterioration in global conditions.

Fiscal conditions are generally better in developing countries than in high-income countries. Still, since the 2008 financial crisis, government balances have deteriorated by at least 2 percent of GDP in almost 44 percent of developing countries, and some 27 developing countries had government deficits of at least 5 percent of GDP in 2011. As a result, developing countries have much less fiscal space available to respond to a new crisis.

Should conditions in high-income countries further deteriorate and a second global crisis materialize, developing countries will find themselves operating in a much weaker global economy—with much less abundant capital, fewer vibrant trade opportunities, and weaker financial support for both private and public activity. Under these conditions, prospects and growth rates that seemed relatively easy to achieve during the first decade of this millennium may become much more difficult to attain in the second, and vulnerabilities that remained hidden during the boom period may become visible and require policy action.

In this highly uncertain environment, developing countries should evaluate their vulnerabilities and prepare contingency plans to deal with a downturn.

• If global financial markets freeze up, governments and firms may be unable to finance growing deficits. Countries should engage in contingency planning, prioritizing social safety nets, and infrastructure spending to assure longer-term growth. Problems are likely to be particularly acute for developing countries with external financing needs that exceed 5 percent of GDP. Where possible, they should prefinance to avoid abrupt cuts in government and private-sector spending.
• A renewed financial crisis could accelerate the ongoing financial sector deleveraging process. Several countries in Eastern Europe and Central Asia, reliant on high-income European banks, are particularly vulnerable to a sharp reduction in wholesale funding and domestic bank activity. The deleveraging of banks in high-income countries could result in a forced sell-off of foreign subsidiaries and affect valuations of foreign and domestically owned banks in countries with large foreign presences. And slower growth and deteriorating asset prices could rapidly increase nonperforming loans throughout the developing world. To prevent domestic banking crises, countries should stress-test their domestic banking sectors.
• A severe crisis in high-income countries could put pressure on the balance of payments and government accounts of countries heavily reliant on commodity exports and remittance inflows. A severe crisis could cause remittances to developing countries to decline by 6 or more percent, with particularly acute impacts among the 22 countries where remittances represent at least 10 percent of GDP. Oil- and metal-exporting countries would also be affected in a major crisis. The fiscal balances of major oil and metal exporters could deteriorate by over 4 percent of GDP. Although lower food prices would reduce producer incomes—a drop that would be partially offset by lower oil and fertilizer prices—it would benefit consumers.

Overall, the global economy is at a very difficult juncture. The financial system of the largest economic bloc in the world is threatened by a fiscal and financial crisis that has so far eluded policymakers’ efforts to contain it; outside of Europe, high-income-country growth remains weak in historical perspective; and some of the largest and most dynamic developing countries have entered a slowing phase. As the risk of significant further deterioration of conditions remains real, developing countries should undertake contingency planning now to prepare for such an outcome by scrutinizing their own fiscal positions, identifying priority pro-growth and pro-poor spending programs, and stress-testing domestic financial systems.

Andrew Burns is a lead economist and manager of the World Bank's Global Macroeconomic Trends 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.