In an update to Global Economic Prospects 2010, the World Bank says any default or major restructuring among the five heavily-indebted euro-zone countries could threaten the solvency of several banks in Europe with “potentially far-reaching consequences for global financial system”. A fall-out from the debt crisis in Europe has so far been “contained“.

After nearly two years, the world economy had begun a subdued recovery in the latter half of 2009 after overcoming the most severe global downturn in over sixty years. This resulted from a period of “rapid and ultimately unsustainable credit expansion, accompanied by excessive risk taking by financial institutions“. Even as the world is engaged in repairing the financial system, Europe's debt crisis has created new hurdles to sustainable medium term growth across countries and regions.

The World Bank projects global GDP to expand between 2.9 and 3.3 percent in
2010 and 2011 while developing economies are expected to grow between 5.7 and 6.2 percent each year from 2010-2012. High-income countries, however, are projected to grow by between 2.1 and 2.3 percent in 2010—not enough to undo the 3.3 percent contraction in 2009—followed by between 1.9 and 2.4 percent growth in 2011.

Growth in China and India is projected at 8.7 and 8.2 in 2010 respectively. Growth in developing countries in today's world of multi-polar growth is reassuring,” said Justin Yifu Lin, the World Bank's Chief Economist but for the global rebound to endure, high-income countries need to “seize opportunities offered by stronger growth in developing countries.”

The recovery faces several important headwinds over the medium term, including reduced international capital flows, high unemployment, and spare capacity exceeding 10 percent in many countries. According to the report, prolonged sovereign debt crisis in Europe could make credit more expensive and curtail investment and growth in developing countries.

The World Bank's projections assume that efforts by the IMF and European institutions will stave off a default or major European sovereign debt restructuring. But even so, developing countries and regions with close trade and financial connections to highly-indebted high-income countries may feel “serious ripple effects“. It may impact on both short- and medium-term growth prospects of developing countries. The crisis and the regulatory reaction to the financial excesses of the preceding several years may have lasting impacts on financial markets, raising borrowing costs and lowering levels of credit and international capital flows, the Bank said.

As economies adjust to tighter financial conditions, it noted, the level of potential output in developing countries could be reduced by between 3.4 and 8 percent over the long run, compared with its pre-crisis path. The report further said that the very liquid conditions of the first half of the decade contributed to the expansion in credit available in developing countries and that this expansion was responsible for about 40 percent of the approximately 1.5 percentage point acceleration of the pace at which many developing-country economies could grow without generating significant inflation.

While developing countries probably cannot reverse the expected tightening in international financial conditions, there is considerable scope for reducing domestic borrowing costs, or increasing productivity and thereby regaining the higher growth path that the crisis has derailed.

The developing countries had through the global crisis demonstrated that, when exposed lower capital costs, developing countries were capable of sustaining significantly higher growth rates without generating higher inflation. Over the medium term, international capital costs are going to be higher than they were during the boom period. As a result, developing-country growth potential will remain well below recent highs, which is likely to be a source of frustration for many countries.

While some prudent reforms to reduce the sensitivity of domestic economies to some of the more volatile forms of international capital may be advisable, the Bank asked policy makers to remain mindful of the benefits that financial openness and improved intermediation can bring.

Looking forward, the report said, it is not desirable to recreate the unstable and unsustainable international conditions of the boom period. However, the domestic savings in developing countries represent an enormous growth potential that is waiting to be released through reforms aimed at reinforcing and growing domestic intermediation. Although such reforms will take time to bear fruit over the longer term they may once again place developing countries on the higher growth path that the crisis has derailed.

In another report on South Asia, the World Bank says as the region's recovery gathers momentum, an immediate challenge is to create fiscal space and contain rising inflationary pressures, while ensuring that the exit from fiscal and monetary stimulus is in tune with the recovery of private demand. 'Greater fiscal space is needed to deal with unexpected future shocks and permit governments to finance crucial public investments.' Food prices have been rising especially sharply in recent months, because of poor weather in India compounded by delayed adjustment to higher global prices the report said. While prices should moderate in the near-term, a renewed focus on agriculture is also vital, especially given the persistently high rural populations and poverty.

The strategy for South Asia is to intensify their Look East policies and integrate faster with East Asia. This could expand trade between the two regions from the present 126 billion dollars to 450 billion dollars a year. Also, countries in South Asia must integrate more closely with each other to generate upto 50 billion dollars per year. At the same time, they needed to preserve links to high-income markets in Europe and North America as these will continue to be important for labor-intensive exports, services, and as sources of capital and know-how.(IPA Service)