Four years after the onset of the global financial crisis, the world economy continues to struggle. Developing economies are still the main driver of global growth, but their output has slowed. To regain pre-crisis growth rates, developing countries must once again emphasize internal productivity-enhancing policies. While headwinds from restructuring and fiscal consolidation will persist in high-income countries, these should become less intense allowing for a slow acceleration in growth over the next several years.

Fragile rebound after mid-year turmoil ...

Following a resurgence of turmoil in high-income financial markets in May-June 2012, financial markets have improved markedly, as a result of national and EU-wide measures to improve fiscal sustainability, and the augmentation of measures that the European Central Bank (ECB) would take in defense of the euro. And, unlike past episodes of reduced tensions, when market conditions improved only partially, many market risk indicators have fallen back to levels last seen in early 2010 - before concerns about Euro Area fiscal sustainability took the fore.

The decline in financial market tensions has also been felt in the developing world.
International capital flows to developing countries, which fell by between 30 and 40 percent in May-June, have reached new highs.
Developing country bond spreads (EMBIG) have declined by 127 basis points (bps) since June, and are now below their long-term average levels (around 282 bps).
Developing country stock markets have increased by 12.6 percent since June (10.7 percent for high-income markets).

... but the real-side recovery is weak and business-sector confidence is low

While signals from financial markets are encouraging, those from the real-side of the global economy are more mixed. Growth in developing countries accelerated in Q3 of 2012, including in major middle-income countries such as Brazil and China, where mid-year weakness contributed to the global slowdown. Early indications for Q4 point to a continued acceleration in East Asia and the Pacific, Europe and Central Asia, and South Asia, but slowing in Latin America and the Caribbean.

Among high-income countries, investment and industrial activity in the United States was unusually weak during Q3 despite strength in housing and consumer demand - seemingly due to uncertainty over the stance of fiscal policy in the run up to November's elections and the end-of-2012 fiscal cliff. While the January 1, 2013 agreement on tax measures resolved most of the immediate concerns about the fiscal cliff, the legislation offers only a temporary reprieve. If no credible medium-term plan for fiscal consolidation is found by end of February and debt-ceiling legislation is unchanged or only short-term extensions provided for, the economy could be subjected to a series of mini-crises, which could have potentially strong negative consequences for confidence, and even the credit rating of the US.

In Japan, the economy appears to be contracting -in part because of political tension with China over the sovereignty of islands in the region and the expiration of automobile purchase incentives. Activity in Europe ceased to contract at alarming rates in Q3, but the economy appears to have weakened again in Q4 - perhaps reflecting weak demand for capital goods from the United States and Japan.
Prospects for a modest acceleration in the medium term ...
Overall, the global economic environment remains fragile and prone to further disappointment, although the balance of risks is now less skewed to the downside than it has been in recent years. Global growth is expected to come in at a relatively weak 2.3 percent and 2.4 percent in 2012 and 2013, respectively, and gradually strengthen to 3.1 percent and 3.3 percent in 2014 and 2015.

At an estimated 5.1 percent, GDP growth in developing countries during 2012 was among the slowest in 10 years. Improved financial conditions, a relaxation of monetary policy and somewhat stronger high-income country growth is projected to gradually raise developing-country growth to 5.5 percent in 2013, 5.7 percent in 2014 and 5.8 percent in 2015 - roughly in line with these countries' underlying potential. For high-income countries, fiscal consolidation, high unemployment and very weak consumer and business confidence will continue to weigh on activity in 2013, when GDP is projected once again to expand a mediocre 1.3 percent. Growth should, however, begin firming during the course of 2013, and expand by 2 percent in 2014 and 2.3 percent in 2015. In the Euro Area, growth is now projected to only return to positive territory in 2014, with GDP expected to contract by 0.1 percent in 2013, before edging up to 0.9 percent in 2014 and 1.4 percent in 2015.

This modest growth outlook is subject to risks.
Although the likelihood of a serious crisis of confidence in the Euro Area that would lead to a bloc-wide freezing up of financial markets has declined significantly, continued progress is needed to improve country-level finances, and enact plans to reinforce pan-European schemes for a banking union and sovereign rescue funds. If policy fails to maintain its reform momentum, some of the more vulnerable countries in the Euro Area could find themselves frozen out of capital markets, provoking a global slowdown that could potentially subtract 1.1 percent or more from developing country GDP.
In the United States, solid progress toward outlining a credible medium-term fiscal consolidation plan that avoids periodic episodes of brinksmanship surrounding the debt ceiling, is needed. Policy uncertainty has already dampened growth. Should policymakers fail to agree such measures, a loss of confidence in the currency and an overall increase in market tensions could reduce US and global growth by 2.3 percent and 1.4 percent, respectively.
While a progressive decline in China's unusually high investment rate is not expected to perturb global growth over the medium-to-long term, there would be significant domestic and global consequences if this position were to unwind abruptly. Impacts for developing commodity exporters would be especially harsh if commodity prices fell sharply.
An interruption to global oil supply and a resurgence in the price of internationally-traded food commodities remain risks, especially given the low maize stocks. Should local food prices rise markedly, nutrition and health outcomes for the very poor could be hit.
On the upside, a rapid resolution to policy uncertainty in the United States, a decrease in tensions in Asia, or an improvement in European confidence could speed up the return of high-income countries to stronger growth - with positive effects for developing-country exports and GDP.

Assuring growth through increased productivity

Addressing high unemployment and slack capacity remain priorities for countries in developing Europe and in the Middle East and North Africa. However, the majority of developing countries are operating at or close to full capacity. For them, additional demand stimulus could be counter-productive - raising indebtedness and inflation without significant payoff in terms of additional growth.

In what is likely to remain a difficult external environment, characterized by slow and potentially volatile high-income country growth over the next several years, strong growth in developing countries is not guaranteed. To grow rapidly, developing countries will need to maintain the reform momentum that underpinned the acceleration of growth during the 1990s and 2000s. In the absence of additional efforts to raise productivity through structural reforms, investment in human capital, and improved governance and investment conditions, developing country growth may well slow.
The longer-term structural reform agenda should also include efforts to improve food security, especially in the more vulnerable of developing economies. This would involve increasing local productivity, improving local storage and transportation infrastructure, to reduce spoilage and enable improved access to foreign markets, both in good times and bad times.
Given the still uncertain global environment, many developing countries would be well advised to gradually restore depleted fiscal and monetary buffers, so as to ensure that their economies can respond as resiliently as they did during the 2008/09 crisis, should a further significant external shock arise.
Developing countries also need to continue to be active players in the G-20 process, both in order to assist high-income countries recover from the crisis of 2008/9 but also to ensure that reform efforts, be they in financial or real markets, take into full consideration the potential impacts on developing markets.