Over the past two years, the world has seen turmoil in a relatively small segment of the U.S. credit markets morph into a severe global economic and financial crisis. Although aggressive monetary policy, fiscal stimulus, and guarantee programs to shore up the banking industry have begun to stabilize financial markets and slow the pace of economic contraction, policy makers face an extended battle to revive the global economy.

Going forward, national and international policy makers must support emerging signs of recovery with persistent, robust efforts to restore confidence in the financial system and transform the adverse feedback loop between the financial sector and the real economy into a positive one.

With analysis and data extending from short-term bank lending to long-term bond issuance in both local and foreign currency, Global Development Finance 2009: Charting a Global Recovery is unique in its breadth of coverage of the trends and issues of fundamental importance to the financing of the developing world, including coverage of capital originating from developing countries themselves.

The report is an indispensable resource for governments, economists, investors, financial consultants, academics, bankers, and the entire development community.

A new report from the World Bank warns that the globe is entering a new era of slower growth. The World Bank’s new Global Development Finance Report, for 2009, looks at the prospects for an end to the world-wide downturn…and the long-term effects it will leave behind.

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2009 The International Bank for Reconstruction and Development / The World Bank
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OVERVIEW
ALMOST TWO YEARS AFTER PROBLEMS in the U.S. mortgage market set in motion the biggest financial crisis since the Great Depression, global financial markets remain unsettled, and prospects for capital flows to the developing world are dim. The intensification of the financial crisis in September 2008 dramatically altered the world economic outlook. Global output is now expected to shrink by 2.9 percent in 2009, the first contraction since World War II.

International trade is likely to experience the sharpest drop since that time. Unemployment, already soaring in industrial countries, will follow a similar path in the export-dependent economies of East Asia, as high-income countries reel from an unprecedented asset-market bust, and global investors retreat from emerging markets.

The implications of these unfolding events for investment flows to developing countries have already been dramatic: total private capital flows in 2008 dropped to $707 billion (4.4 percent of total developing-country GDP), reversing the strong upward surge that began in 2003 and reached a pinnacle of $1.2 trillion in 2007 (8.6 percent of GDP).

For 2009 the most likely scenario is that as global equity markets regain momentum and credit markets heal, net private flows to developing countries will remain positive—barely. But they will drop to $363 billion, approximately the level of 2004 and a decline of 5 percentage points of GDP from 2007. The magnitude of the decline is troubling for its macroeconomic consequences and for vulnerability to further shocks, particularly in countries in which banks and firms have high levels of external debt. Much of the $1.2 trillion external debt raised by emerging market banks and firms between 2003 and 2007 is now maturing, putting pressure on the borrowers’ finances at the time when the average cost of external borrowing has increased to 11.7 percent, compared with 6.4 percent in the pre-crisis years when the debt was contracted.

Although extraordinary policy responses by governments around the world have helped save the global financial system from systemic collapse, they have not, thus far, closed the negative feedback loop between financial instability and economic recession. Fragile consumer confidence and a much-diminished appetite for risk among investors in developed countries have all contributed to a plunge in global aggregate demand.

Simultaneously, the deepening economic downturn has caused major global banks to scale back domestic and international lending, thereby exacerbating the credit crunch. Actual bank lending in the United States and Europe, as well as surveys of bank intentions and credit terms, point to a slowing in the supply of bank credit to the corporate and household sectors. In recent months, that slowdown has become a decline. Likewise, foreign claims on developing-country residents held by major international banks reporting to the Bank for International Settlements declined by $200 billion between December 2007 and December 2008 (from $4.3 to $4.1 trillion).

To break the cycle and revive lending and growth, bold policy measures, along with substantial international coordination, are needed. In this regard, the joint announcement by the Group of 20 (G-20) leaders at their London summit in April 2009 was encouraging. The leaders vowed to strengthen the capacity of multilateral financial institutions to lend to emerging economies facing traditional balance-of-payments shortfalls or elevated risks from debt rollover and refinancing.

Addressing the various regulatory failures, bank governance shortcomings, and macroeconomic imbalances that contributed to the crisis has been another focus of the international policy response. Bad lending and poor investment decisions stemmed from lax regulation as well as from overconfidence and euphoria associated with low real interest rates and ample liquidity. Therefore, new measures that embrace all systemically important financial institutions (including hedge funds), that strengthen international accounting standards to improve transparency and asset valuation, and that bolster the Financial Stability Board are desirable and timely, even if their immediate success cannot be guaranteed.

In charting the course ahead, policy makers in developed and developing countries should give priority to four tasks: following up on the G-20’s promise to restore domestic lending and the international flow of capital, addressing the external financing needs of emerging-market sovereign and corporate borrowers, reaffirming preexisting commitments to the aid agenda and the Millennium Development Goals (MDGs), and, eventually, unwinding governments’ high ownership stake in the banking system and reestablishing fiscal sustainability.

Rapid progress on these fronts will make it easier for low-income countries to cope with the crisis. Already under severe strain, low-income countries face increasingly grave economic prospects if the dramatic deterioration in their capital inflows from exports, remittances, and foreign direct investment (FDI) is not reversed in 2010. As it stands, the amount of development assistance available to low-income countries will not fully cover their external financing needs in 2009, while the outlook for donor countries to increase aid significantly is bleak, given the intense fiscal pressures they face because of the crisis.

FORWARD
THE CRISIS OF THE PAST TWO YEARS is having dramatic effects on capital flows to developing countries, and the world appears to be entering an era of lower growth. This edition of Global Development Finance revisits the genesis of the turmoil—which began in a relatively small segment of the U.S. credit markets and mutated into a major worldwide financial and economic crisis—and explores the broad approach needed to chart a global recovery.

This year, global output is projected to fall by 2.9 percent; global trade by 10 percent. Growth in the developing world is expected to slow to 1.2 percent. Excluding China and India, GDP in other developing countries will fall at a rate of 1.6 percent. Meanwhile, private investment flows to developing countries plummeted by more than 40 percent in 2008 as access to international debt markets dried up and portfolio equity inflows all but ceased. ...

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