the international economy and prospects for …...values, financial uncertainty prevents the spread...

Developments in early 2002 showed acyclical rebound—Macroeconomic stimulus, a rebound from arecord trough in the high-tech sectors anda bottoming-out of inventory cycles, broughtlarge parts of the global economy onto a re-covery path at the end of 2001. Lower interestrates helped keep consumers’ demand fordurable goods strong. Together with fiscal eas-ing, that demand provided support for therebound in the United States and, to a lesserextent, in some East Asian and Europeancountries. High-tech markets—in which tech-nologies quickly become obsolete—returnedto strong growth by creating replacements forold products. Inventory selloffs ceased, therebycontributing to an acceleration of gross do-mestic product (GDP) growth in early 2002.

The driving forces behind the initial phaseof the recovery were strong, but short-lived, asbusiness confidence remained weak. Inventoryand high-tech cycles typically are short, andboth appear to have peaked toward the middleof 2002. The effects of fiscal stimulus andmonetary easing can also, under current cir-cumstances, dissipate quickly.

—but uncertainty in financial markets hassapped momentum In the second phase of a typical recovery, theupturn spreads to other sectors and otherregions, and the driving force shifts from in-ventory dynamics to accumulation of fixedinvestment. In the current upswing, however,

the second phase is in jeopardy because of ten-sions in financial markets, which reflect accu-mulated financial imbalances and significantuncertainties. These pressures have made therecovery in 2002 less uniform, and they arelikely to moderate growth in 2003.

In Japan, deflation and high and rapidlygrowing government debt have placed severelimits on both monetary and fiscal stimuli.Combined with the fragility of the bankingsector, which is burdened by bad loans anddiminishing capital caused by lower equityvalues, financial uncertainty prevents thespread of recovery from export sectors tothose that produce for the domestic market.The accounting scandals in the United Stateshave undermined the trust in reporting sys-tems. Investors, who have come to rely oncontinuously rising equity prices, now find itdifficult to assess the profitability of firms.That difficulty sharply pushed up risk premi-ums in equity markets. European financial in-stitutions were forced to adjust their balancesheets in the wake of large-scale defaults,notably by Argentina and several majorU.S. firms, which probably played a role insuppressing a nascent recovery in Europeaneconomies. In Europe and elsewhere, telecom-munication sectors still suffer from overin-vestment and high debt burdens, making aspeedy recovery of capital spending in thosesectors unlikely.

Uncertainty is keeping investors cautious,if not skittish, throughout the world. While

1

1The International Economy andProspects for Developing Countries

1

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investors in high-income countries take theirlosses and replenish their reserves, they limittheir exposure to developing countries andconcentrate their assets in investment-gradeborrowing countries.1 Capital flows into largeparts of Latin America dropped sharply, re-flecting the aftermath of Argentina’s defaultand the vicious combination of global uncer-tainty, domestic problems in some large coun-tries, and intra-regional contagion. The reversalof capital flows—with the accompanying risein spreads and depreciation of currencies—when combined with vulnerable balance-sheet characteristics triggered a dangerousworsening of debt dynamics in some LatinAmerican countries. In such an environment,average per capita income in Latin Americahas fallen in 2002 for the second year insuccession.

The rebound in 2002 was less uniformthan anticipated—Rapid recovery in the beginning of 2002,driven in part by sharp increases in the U.S.government’s expenditure in the aftermath ofterrorist attacks, has resulted in upward revi-sions of 2002 growth for the United States,East Asia, and Japan, relative to forecastsprepared in February (table 1.1). At the otherextreme, growth in Latin America has beenlowered by 1.6 percentage points for theyear. This decrease reflects not only the crisisin Argentina, but also the major contrac-tions of GDP in Uruguay and the RepúblicaBolivariana de Venezuela, plus slow growthin Brazil, Chile, and Mexico. Those eventsmade the 2001–02 period the worst for theregion since the debt crisis of the early 1980s.Consistent with higher-than-anticipatedglobal growth, non-oil commodity prices in2002 have risen more than anticipated.Nonetheless, the present rebound in com-modity prices is modest from an historicalperspective, thus highlighting the continuingdownward pressures on prices tied to struc-tural factors. Higher commodity prices havesupported modestly improved performance inSub-Saharan Africa.

—and the outlook for 2003 is for tepid growth Reflecting financial uncertainty and the dis-appointing recovery of business confidence,projected growth for 2003 has been markeddown for almost all developing regions, be-cause a robust rebound in industrial coun-try growth—driven by strong advances ininvestment—has become less likely. In linewith these revisions, inflation, interest rates,and non-oil commodity prices are also likelyto be lower. The sole exception to this patternis the Middle East and North Africa region,where oil exporters have benefited from highoil prices during 2002. Several of these coun-tries are seeing increased government expendi-ture, financed by rapidly mounting surplusesof oil revenues.

Investment cycles in developing countriesare more volatile than in rich countriesWith the sharp fall in global investment in2001 and the uncertainty surrounding a re-bound in capital expenditure, investmentbehavior has become a key element of theoutlook. A closer look at investment cycles indeveloping countries suggests the followingconclusions:

• Investment behavior in low- and middle-income countries is a determinant ofoverall volatility that is even moreimportant than it is in high-incomecountries.

• Those developing countries with astronger policy environment exhibitlower volatility in investment.

• Although in rich countries domesticfixed investment tends to drive foreigncapital inflows, in middle-income coun-tries the opposite tends to occur (that is,capital inflows typically drive domesticinvestment).

These conclusions imply that the middle-income countries are especially vulnerable tothe current jitters in financial markets. Suchcountries are exposed to sudden reversals in

G L O B A L E C O N O M I C P R O S P E C T S 2 0 0 3

2

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T H E I N T E R N A T I O N A L E C O N O M Y A N D P R O S P E C T S F O R D E V E L O P I N G C O U N T R I E S

3

Table 1.1 Global conditions affecting growth in developing countries and world GDP growth(percentage change from previous year, except interest rates and oil price)

Global DevelopmentCurrent estimate Current forecasts Finance 2002 forecasts

2000 2001 2002 2003 2004 2002 2003

Global conditionsWorld trade (volume) 13.1 �0.5 2.9 7.0 8.0 1.8 8.3

Inflation (consumer prices)G-7 OECD countriesa,b 1.9 1.7 0.9 1.2 1.5 0.9 1.6United States 3.4 2.8 1.5 2.1 2.3 1.5 2.4

Commodity prices (nominal $)Commodity prices, except oil ($) �1.3 �9.1 5.0 5.8 4.4 1.3 7.3Oil price ($, weighted average), $/bbl 28.2 24.4 25.0 23.0 20.0 20.0 21.0Oil price (% change) 56.2 �13.7 2.7 �8.0 �13.0 �17.9 5.0Manufactures export unit value ($)c �2.1 �1.4 0.5 3.0 2.2 �0.5 3.6

Interest ratesLIBOR, 6 months (US$, percent) 6.6 3.6 1.8 1.5 3.1 2.3 4.0EURIBOR, 6 months (euro, percent) 4.5 4.2 3.4 3.2 3.8 3.0 4.0

GDP (growth)d

World 3.8 1.1 1.7 2.5 3.1 1.3 3.6Memo item: World GDP (ppp)e 4.5 2.1 2.8 3.4 4.0 2.4 4.3

High-income countries 3.5 0.7 1.5 2.1 2.7 0.9 3.3OECD countriesf 3.4 0.8 1.4 2.1 2.6 0.8 3.1

United States 3.8 0.3 2.3 2.6 3.1 1.3 3.7Japan 2.1 �0.3 0.0 0.8 1.3 �1.5 1.7Euro Area 3.7 1.5 0.8 1.8 2.6 1.2 3.3

Non-OECD countries 6.8 �0.7 2.3 3.7 5.3 2.7 5.3

Developing countries 5.2 2.9 2.8 3.9 4.7 3.1 4.9East Asia and Pacificf 7.0 5.5 6.3 6.1 6.4 5.6 7.1Europe and Central Asia 6.6 2.3 3.6 3.4 3.6 3.2 4.3

Transition countries 6.4 4.6 3.5 3.3 3.5 3.4 4.0Latin America and the Caribbean 3.7 0.4 �1.1 1.8 3.7 0.5 3.8

Excluding Argentina 4.5 1.2 0.7 1.9 3.6 2.1 4.3Middle East and North Africa 4.2 3.2 2.5 3.5 3.7 2.7 3.3

Oil exporters 3.6 2.4 2.4 3.7 3.6 2.2 2.8Diversified economies 3.7 4.3 2.2 2.7 3.6 3.1 4.4

South Asia 4.8 4.4 4.6 5.4 5.8 4.9 5.3Sub-Saharan Africa 3.2 2.9 2.5 3.2 3.8 2.6 3.6

Memorandum items

Developing countriesExcluding the transition countries 5.0 2.6 2.7 4.0 4.9 3.1 5.1Excluding China and India 4.6 1.7 1.5 2.8 3.8 2.0 4.1

Note: OECD � Organization for Economic Co-operation and Development, bbl � barrel, EURIBOR � European interbank offered rate, LIBOR � Londoninterbank offered rate, ppp � purchasing power parity.a. Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States.b. In local currency, aggregated using 1995 GDP weights.c. Unit value index of manufactures exports from the G-5 countries to developing countries, expressed in U.S. dollars.d. GDP in 1995 constant dollars: 1995 prices and market exchange rates.e. GDP measured at 1995 purchasing power parity (international dollar) weights.f. Republic of Korea income classification changed from middle to high income (July 2002). Both forecasts were adjusted for this revision.Source: World Bank, November 2002 and Global Development Finance 2002 projections of February 2002.

gep_ch01.qxd 12/5/02 4:15 PM

capital flows, which can dampen investmentsharply and can undermine growth momen-tum. Countries with strong policy environ-ments are more likely to avoid or smoothlyabsorb potential external financial shocks.

In the long term, faster growth can be achieved in most developing regionsMarket reforms and trade liberalization dur-ing the 1990s have opened opportunities foraccelerating technological advances through-out the developing world for the next 15 years.An exception is emerging East Asia, wheresome moderation of technological progressis anticipated, reflecting in part the extra-ordinarily rapid catching-up that occurred dur-ing the 1980s and 1990s. The acceleration ofgrowth in many of the other regions is likelyto coincide with increasing savings and invest-ment rates. Demographic transitions are anti-cipated to boost saving rates in developingcountries, while reducing them in high-incomecountries.

On balance, the declining availability ofsavings in the aging populations of high-incomecountries and the increased savings in thedeveloping world—set against investmentpatterns needed to accommodate potentialgrowth—imply that more and more develop-ing countries will move toward surplus on thecurrent account and that the recent shift fromdebt accumulation to debt reduction is likelyto continue. As long as domestic credit mar-kets continue to mature and public savingsdo not deteriorate, domestic savings can beexpected to rise, and the required reduction indebt levels will not conflict with the requiredinvestment.

A recovery constrained by major risks

During the summer of 2002, investor riskperceptions increased and market senti-

ment deteriorated across large parts of theworld’s economy, thereby jeopardizing theglobal recovery that had started in the fourth

quarter of 2001. Accumulated financial im-balances that had built up during the 1990semerged as a critical factor that clouded theeconomic outlook. In the United States, thebursting of the equity bubble and cumulatedprivate sector debt kept investors cautious andresulted in a continuous flight to quality,which moved the yield on government bondsto a 40-year low while hampering the recoveryin private investment. In Japan, banking prob-lems and the lack of scope for monetary eas-ing and fiscal stimulus limited the spilloverfrom an export-driven recovery to a reboundin domestic investment. In Europe, weaknesswas concentrated in the highly indebtedtelecommunications sector and in financialsectors that had to absorb sharp devaluationsof their assets.

Bankruptcies and reductions in investmentduring the global downturn of 2001 and thesubsequent first phase of recovery in early2002 had not reduced corporate debt nor re-stored profitability sufficiently. In a number ofcases, the downturn has generated new imbal-ances. Throughout the world, fiscal balancesdeteriorated and balance sheets of financialinstitutions weakened. Continued tension infinancial markets made the recovery less uni-form in 2002—as well as probably less robustin 2003—than would have been the caseunder more normal circumstances. Vulnerabil-ity to adverse shocks has increased, and eventhe potential for a “double-dip” recession sce-nario in the industrial countries cannot—atthis juncture—be entirely ruled out.

Three distinct phases characterize recentdevelopments. The first phase portrays thedriving forces behind the initial phase of therecovery that started in late 2001, a recoverythat was more robust in the United States andEast Asia. These forces range from the end ofinventory adjustment, monetary easing, andfiscal stimulus to a technical rebound in thehigh-tech industrial sectors. This picture nor-mally would be characterized as a favorableenvironment for developing countries. Thatenvironment includes low inflation and inter-est rates, plus a significant recovery in global


4

gep_ch01.qxd 12/5/02 4:15 PM

trade and commodity prices, albeit a recoveryfrom low levels. During the second phase, arecovery typically broadens to other regionsand other sectors. Therefore, a recovery ofprofits and strong growth in fixed investmentbecomes the driving force that sustains or evenaccelerates growth. In the absence of suchbroadening and deepening, driving forces thatunderpin the initial phase would suddenlyappear to become short lived, which is thesituation today. Finally in the third phase—typically the shift from “recovery” to eco-nomic expansion—implications of the set ofopposing forces (cyclical rebound and finan-cial turbulence) for the medium-term globaloutlook (2003–04) are analyzed. The lack ofuniformity in growth performance during2002, following an almost synchronized slow-ing of growth across regions in 2001, is par-ticularly notable. The growth projections for2003 are more uniform across regions, butare distinctly weaker than would have beenanticipated in a strong, synchronized globalrecovery.

The first phase of the global recovery was driven by policy stimulus—In the wake of the terrorist attacks in Septem-ber 2001, forceful monetary easing in theUnited States—and to a lesser extent inEurope—helped prevent a deepening of theglobal downturn. U.S. consumers benefitedfrom historically low interest rates to boosttheir purchases of durable goods. Combinedwith double-digit growth in governmentspending—mainly driven by security, defense,and reconstruction efforts—the stimulus wassufficient to turn U.S. GDP growth positive, to2.7 percent (annualized), in the fourth quarterof 2001. One quarter later, Japan, which suf-fered steep output declines for three quartersin succession, and Europe, having experiencedonly a modest fall in GDP, broke away fromnegative growth rates as well.

The importance of U.S. domestic demandin this recovery is striking. During the firsthalf of 2002, GDP advanced at a 3 percent

annual rate, despite a drag of nearly 1.5 per-centage points stemming from a deteriorationof net exports. In contrast, output in Japan in-creased by 2.5 percent, of which foreign tradecontributed 1.8 percentage points, while in theEuro Area, GDP growth of 1.6 percent wassupported by almost 1 percentage point frompositive net exports contributions.

—inventory dynamics—Inventory dynamics played a pivotal role inthe recovery, thus complementing macro-economic stimulus efforts. The same reductionin the inventory stock that led to a negativecontribution of stock building to GDP growthin 2001 implied a positive contribution ofstock building to GDP growth in 2002. Oncethe lower level of desired inventories wasachieved, stock building shifted from sharplynegative to close to zero. The slowing of inven-tory liquidation significantly shifted the con-tribution to GDP growth from the second halfof 2001 to the first half of 2002: that shiftadded 1.2 percentage points to the accelera-tion of GDP growth in both Japan and theEuro Area, and a full 2.2 percentage points inthe United States (figure 1.1).

—a high-tech rebound—Recovery in global high-tech markets was anequally powerful stimulant. After demand forsemiconductors and related equipment plum-meted during 2001, markets were anticipatedto rebound sharply, but the scope of recoveryexceeded expectations. There are severalnatural limits to declines at rates of up to50 percent. The nature of the product—thetechnology of which becomes obsoletequickly—warrants a periodic return to highgrowth, as old products are replaced by newones and as the introduction of advancedtechnologies generates new and growing mar-kets. Defense- and security-related spending inthe United States also played a role in bolster-ing demand (U.S. manufacturing orders forcomputers and communications equipmentratcheted to annual rates of 40 and 90 per-cent, respectively, in early 2002). As the


5

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6

�3

�4

�5

�6

�2

�1

0

1

2

3

4

5

Q22002

Q32001

Q42001

Q12002

Q22002

Q32001

Q42001

Q12002

Q22002

Q12002

Q42001

Q32001

United States

Japan

Euro Area

Source: U.S. Department of Commerce; Japan Economic Statistics and Research Institute (ESRI) and Eurostat.

Figure 1.1 The recovery was initiated in a typical fashion(growth in percent)

GDP growth

Stock contribution

�20

�15

�10

�5

0

5

10

15

20

Jan.2000

May2000

Sep.2000

Jan.2001

May2001

Sep.2001

Jan.2002

Sep.2002

May2002

Note: 3m/3m saar refers to 3-month/3-month seasonallyadjusted annualized rate.Source: Datastream.

Figure 1.2 A brief rebound in industrialcountries was underway

Manufacturing production

(percent change, 3m/3m saar)

EU-15

Japan

United States�50

�25

0

25

50

75

100

125

�20

�10

0

10

20

30

40

50

Jan.2000

Jul.2000

Jan.2001

Jul.2001

Jan.2002

Jul.2002

Figure 1.3 Rebound in industrialcountries boosted production in EastAsia

Semiconductor dollar sales and industrialproduction*

(percent change, 3m/3m saar)

Note: Through July 2002. *Republic of Korea, Malaysia,Singapore, and Taiwan, China.Source: Semiconductor Industry Association (SIA) andnational sources through Datastream, World Bank staffestimates.

Semiconductor sales(left axis)

Industrial production(right axis)

rebound intensified, a strong boost was givento manufacturing output in industrial coun-tries, and especially to production and exportsfrom East Asia (figures 1.2 and 1.3).

Macroeconomic stimuli, inventory dynam-ics, and a powerful turnaround in high-techmarkets in the industrial countries set the stage

for a broader global recovery through thetraditional channels of international transmis-sion. With world trade increasing, commodityprices firming, and interest rates—fostered bylow inflation—standing at historically low

gep_ch01.qxd 12/5/02 4:15 PM

levels, developing countries faced a broadlyfavorable environment during the early part of2002.

—and a recovery of global tradeWorld trade began to grow at near double-digit annual rates, recovering from a fall tonegative territory during 2001. The WorldBank’s non-oil commodities price indexgained 19.2 percent between October 2001and October 2002 (figure 1.4), while the rele-vant index for Sub-Saharan African (SSA)countries rose further—by 30 percent. How-ever, commodity prices are still one-thirdbelow their peak levels, which occurred duringthe summer of 1997, and several exporters,notably those in Caribbean countries thatspecialize in coffee and sugar, did not benefitfrom the rebound in average prices during thefirst half of 2002. Historically low inflationcharacterized not only the high-incomeeconomies, but also those in the majority ofdeveloping countries. The median inflationrate in developing countries is presently one-third of that during the 1990s, despite rela-tively high oil prices and more widespreadadoption of flexible exchange rates. Indeed,double-digit inflation rates have become anexception, and countries experiencing recent

crisis, such as Argentina and Turkey, haveposted inflation peaks of just 20 to 40 percent.

The second phase of the recovery is on uncertain footingNotwithstanding the positive environmenttaking shape in early 2002, it became appar-ent before the middle of the year that financialstrains were clouding the outlook. In thewake of large corporate bankruptcies andthe accounting scandals in the United States,stock markets still seemed overvalued anddebt levels seemed underestimated. Fallingequity prices further eroded the capital baseof Japanese commercial banks and otherfinancial institutions. The growth outlookfor Latin America deteriorated noticeably.Following Argentina’s default, Uruguay andParaguay were also hit hard through financialand trade linkages. Political uncertainty in theRepública Bolivariana de Venezuela triggeredcapital flight, and in several other countriesdebt dynamics worsened as a result of a com-bination of domestic problems and increasedrisk aversion in international capital markets(box 1.1). In Europe, financial institutionswere hit hard by defaults in the United Statesand in Argentina, as well as by falling equityprices and a weakening of the dollar. And the


7

Source: World Bank staff.

Jan.2002

Jul.2001

Jan.2001

Oct.2002

Jul.2000

Jan.2000

Jul.2002

Jul.1999

Jan.1999

Jul.1998

Jan.1998

Jul.1997

Jan.1997

100

110

120

130

140

150

160

170

180

190

Figure 1.4 Non-oil commodities are recovering but stand well below previous peaks(index, Sept./Oct. 2001 � 100)

Sub-Saharan Africancommodities

Metals/minerals

Agriculture

gep_ch01.qxd 12/5/02 4:15 PM


8

Economic activity in Latin America and theCaribbean (LAC) has fallen behind production

trends in other developing countries (box figure).The region’s per capita gross domestic product(GDP) is estimated to have dropped by 2.6 percentin 2002, the only developing region where per capitaoutput contracted during the year. This decline wasthe second consecutive year of contraction in percapita incomes—the worst performance since thebeginning of the debt crisis in the early 1980s. Whyis LAC going against the tide of rising global incomegrowth?

The crisis in Argentina and the spillovereffects on Southern Cone Common Market(MERCOSUR) countries (particularly Uruguayand Paraguay) clearly contributed the most to thedecline in regional output during 2002. In Brazil,the combination of rising public debt, of decliningexport revenues tied to the collapse of demand in

Box 1.1 Is Latin America going against therising tide?

Argentina, and of expanding political uncertaintiesin the run-up to the October elections all con-tributed to a weakening in financial market senti-ment toward the country. The combination also re-sulted in a sharp reduction in private financingflows, which, in turn, led to a deterioration of publicdebt dynamics.

With financial markets increasingly averse totaking risks through financial flows to the majorLAC countries over the course of the year, othercountries in the region were unable to obtain signif-icant new financing from international capitalmarkets at reasonable terms. This lack of financinglimited growth in high-debt countries with significantfinancing requirements. Political instability inRepública Bolivariana de Venezuela—an abortedcoup in March that came on top of poor economicmanagement in previous years—led to a largecontraction in GDP of some 6 percent.

The crisis in Argentina and its fallout is a classicexample of a vicious circle of instability in interna-tional financial markets and domestic vulnerabilities:high levels of debt; large financing requirements;and, in some countries, fixed exchange rates, politi-cal uncertainties, and weak banking systems. Oncea crisis erupts, the vicious circle turns into a brutaldownward spiral in which a depreciation of thecurrency, debt burdens, a deterioration of dollarreturns, a rise in spreads, and a reversal of capitalflows reinforce each other. Argentina’s peso lostmore than two-thirds of its value in the year toSeptember. In a comparative perspective, stockprices increased over the same period by 20–30 per-cent in several countries in East Asia and CentralEurope, currencies were stable and spreads did notincrease substantially.


Feb.1997

Feb.1998

Feb.1999

Feb.2000

Feb.2001

Feb.2002

Source: National statistics; World Bank staff.

100

105

110

115

120

125

130

135

Latin America

All developingcountries

Latin America falls behind(industrial production, index, 1995 � 100, 3-monthmoving average)

plight of European telecommunications sec-tors continued to deepen under the weight ofoverinvestment and mounting debt loads.

Bankruptcies and sharp reductions in in-vestment expenditure, driven by the erosion ofequity values and a tightening of credit stan-

dards, have reduced some of the corporatedebt, but they have also led to a deteriorationof the balance sheets of financial institutions.To improve their reserves and to decrease theirrisk exposure, these financial institutions, inturn, sold part of their equity assets. In doing

gep_ch01.qxd 12/5/02 4:15 PM


9

so, they further fueled the fall in stock pricesand amplified new imbalances. Similarly,the drop in capital flows has increased debtproblems in several vulnerable middle-incomecountries.

Another example of new or deterioratingimbalances is the public sector deficit acrossthe industrial countries. The U.S. general gov-ernment deficit deteriorated from a surplusposition of 2.3 percent of GDP in calendaryear 2000 to a deficit of 2.5 percent in 2002,with 2.5 percentage points of that shift attrib-uted to structural deterioration. In turn, theUnited States has not taken advantage of therecession to narrow its deficit on current ac-count. Despite increases in the household sav-ings rate and declines in the private investmentrate, the current account deficit widened toa watershed mark of 5 percent of GDP as ofthe second quarter of 2002.

In the Euro Area as well, fiscal deficits havedeteriorated from a 0.9 percent surplus to a likelevel of deficit, though this deterioration re-flects mainly the work of automatic stabilizers.Unlike the U.S. fiscal deficit, it is not a struc-tural deterioration. France, Germany, Italy,and Portugal are now approaching the currentlimits of a 3 percent of GDP deficit, limitsthat were imposed by the European MonetaryUnion Growth and Stability Pact. The originalplan to eliminate deficits by 2004 has beenabandoned and replaced by an agreement toreduce structural deficits by at least 0.5 per-centage points per annum over the comingyears. Japanese fiscal deficits remain extra-ordinarily high, at levels above 7 percent ofGDP. And East Asian emerging economies, onaverage, continue to run relatively high deficitlevels—above 4 percent of GDP—contrastedwith a deficit of 1 percent before the 1997 crisis.In other parts of the developing world, primarysurpluses are increasing, but improvement ofthe overall deficit remains difficult to achieve,given the burden of debt service.

Deteriorated government deficits, com-bined with low nominal interest rates, haveleft little room for further fiscal stimulus ormonetary easing, although some lowering of

interest rates seems still likely, especially inthe Euro Area. The limited scope for macro-economic policy makes the risks surroundingthe recovery even more severe. Policy solutionsin the industrial world may best be focusedon eliminating bad debts and restoring in-vestor’s sentiment by strengthening institu-tional oversight.

Capital flows to emerging markets are decliningAlso important for middle-income coun-tries was a continued decline in internationalmarket-based capital flows, despite low inter-national interest rates and the initial phase ofrecovery in the industrial world. New grosscapital market flows fell from $228 billion in2000 to $175 billion in 2001, falling furtherto near $140 billion during 2002 (figure 1.5),with bank lending showing the steepest falloff.The latter point highlights the cautious posi-tion that international banks have adoptedfollowing financial crises in Turkey andArgentina and following defaults by severallarge U.S. corporations. These capital flow fig-ures suggest that total external debt in thedeveloping world continues to contract.

Net foreign direct investment (FDI) inflowsto developing countries also trended down-

Source: Euromoney and World Bank staff estimates.

AJJMAMFJ

2001 2002

DNOSAJJMAMFJ

25

20

15

10

5

0

2001 monthly average � $14.3

2002 monthly average � $12.1

Figure 1.5 Private sector creditors havecut debt exposures so far in 2002(gross market-based monthly flows in billions of dollars)

gep_ch01.qxd 12/5/02 4:15 PM

ward, from about $170 billion in both 2000and 2001, to an estimated $145 billion during2002 (figure 1.6). The decline can be almostwholly attributed to reduced flows into LatinAmerica, as FDI into Central Europe and EastAsia retained a resilient tone. That resilienceunderscored the importance of the course ofintegration into global and neighboring mar-kets that China [recently gaining membershipin the World Trade Organization (WTO)] andCentral European countries [anticipatingEuropean Union (EU) accession] are followingat present.

Financial strains may inhibit corporate investment—During the fall months of 2002, investmentwas still declining in both high-income anddeveloping countries, although the declineswere bottoming out, which indicated the be-ginning of a turnaround (figure 1.7). In a typ-ical recovery, once investment growth returnsto positive territory, the recovery gets newimpetus, because a virtuous circle of adjust-ments in the capital stock and in expectedmarket growth may easily generate double-digit advances in capital spending. However,

financial strains currently battering corporatesectors are likely to have a restraining effecton investment. Falling equity prices, concernsabout corporate debt, uncertainty about prof-itability, and cautious commercial bank lend-ing in high-income countries tend to curtailfinancing for investment. Moreover, currentbusiness uncertainty regarding future demandgrowth serves as an additional restrainingforce on capital spending. Reduced capitalflows to emerging markets place a damperon investments in the developing world. Ifone looks further ahead, large and increas-ing public sector deficits carry the potentialto “crowd out” private investment in high-income and developing countries alike, al-though low interest rates on governmentbonds show that such crowding out is not yeta problem.

—and driving forces for the initial phasecould be short-lived—Without a solid upswing in investment anda concomitant broadening of recovery, theforces driving the first phase of the rebound


10

Q11997

Q11998

Q11999

Q12000

Q12001

Q12002

Note: q/q refers to quarter over quarter. *Argentina, Brazil, Chile, Mexico, Czech Republic,Poland, Turkey, Indonesia, Rep. of Korea, Malaysia,Philippines, Thailand, and South Africa (45% ofdeveloping country total).Source: Datastream and World Bank staff estimates.

0

5

10

15

�10

�5

Figure 1.7 Investment recovery is stilluncertain(4-quarter moving average, percentage changeq/q, saar)

Developing countries*

Industrialcountries

Source: World Bank staff estimates.

0

10

5

20

15

30

25

35

45

40

50

1sthalf

2ndhalf

1999

1sthalf

2ndhalf

1sthalf

2ndhalf

1sthalf

2000 2001 2002

Figure 1.6 FDI flows to emerging Asiaare proving to be quite resilient

Net inflows of FDI by region

(billions of dollars, half yearly rate)

Emerging Europe

Latin America

Emerging Asia

gep_ch01.qxd 12/5/02 4:15 PM

could well become short-lived. Widening pub-lic sector shortfalls limit the range of optionsfor fiscal policy. As France, Germany, andItaly approach Maastricht limits; as the U.S.deficit widens; and as Japan remains encum-bered by continuing massive fiscal imbalance,opportunities for further fiscal stimulus in theindustrial world have indeed become quitescarce. Moreover, it appears that several otherdriving forces for the initial recovery couldquickly run out of momentum while theirstimulative properties dissipate. Official inter-est rates now standing at historically lowlevels (particularly in Japan and the UnitedStates) leave little prominent role for furthermonetary easing. And the inventory andhigh-tech cycles—typically of short duration—probably reached peak levels by mid-2002.

Japanese output growth is now largelygrounded in export growth, although con-sumers have begun to spend at more rapidrates—despite softening labor market condi-tions. Japan’s strong export performancestands at risk and could fade quickly shouldforeign demand conditions worsen, should theyen resume its appreciation against the dollar,or both. In the United States, considerable un-certainty is attached to the outlook for con-sumer spending. Following robust purchasesof durable goods during the third quarter—particularly automotive sales that were in-duced by zero interest incentives—questionsarise concerning the tenor of growth into thefinal quarter of the year. Incentives cannot con-tinue indefinitely, and massive equity-basedwealth losses of the past two years could playa larger role in households’ consumption deci-sions. Though low interest rates have spurredmortgage refinancings and “cash outs,” whichare anticipated to place some $100 billion to$200 billion of additional liquidity into thehands of consumers during 2002, this trendcould prove limited if the recovery falters seri-ously. U.S. business remains cautious in invest-ing or rehiring, in part because of the cloudedoutlook for growth in final demand. And inthe Euro Area, especially in Germany, domes-tic demand is lackluster, and near-term growth

appears to be dependent on (and exposed to)global demand and financial conditions.Growth was disappointing in the first half of2002, and expectations for only a sluggishadvance in output during the second half of theyear have now become more widespread.

—implying a much less supportiveexternal environment for developingcountriesAgainst this background—particularly thelack of a rebound in fixed investment acrossindustrial countries and the intensification offinancial uncertainties—the environment fordeveloping countries is much less favorable.International interest rates may remain low,but borrowing costs have risen in step with in-creases in interest rate spreads. Trade volumesand commodity prices may be on the rise, butthey are still at low levels, and momentum isweakening. Metal prices started to declineagain in the middle of 2002, adding to thedoubts about the strength of the global recov-ery. The further rise in agricultural prices wasmainly due to specific supply disruptions—ascivil strife in Côte d’Ivoire jeopardized cocoaproduction and as droughts in Australia,Canada, and the United States boosted wheatprices—and was not a sign of rising demand.Inflation remains low, but the danger ofoutright deflation has emerged in parts ofdeveloping and industrial East Asia—China,Hong Kong (China), Singapore, Taiwan(China), and Japan. Stable and low inflation isa prerequisite for solid growth and creates afavorable environment for effective monetarypolicy. However, in several cases, a sharp dropin inflation has increased real interest ratesand has worsened debt problems. Althoughdeflation limits the options for monetary pol-icy, it tends to depress investment and demandfor durable goods.

With market emphasis on financial strainsand risk perceptions, it is important not tolose sight of several brighter spots in thedeveloping world. Market reforms, includinga diminution of trade barriers and an open-ing up to foreign competition achieved in


11

gep_ch01.qxd 12/5/02 4:15 PM

many countries during the 1990s, are note-worthy. These changes have contributed tofaster growth in trade and in welfare gains, andthe process continues across many countries.

China and several Central European countriesare examples of successful reforming econo-mies that are preparing for even further inte-gration into foreign markets. This integration


12

The recent global downturn has depressed exportgrowth across the developing world, leading to

a contraction in aggregate volume from the thirdquarter of 2001 through the first quarter of 2002.However, several countries—notably China, theCzech Republic, Hungary, and Poland—have beenable to record impressive export volume growth(box figure). They have done so by increasing theirmarket share, which has allowed them to partiallyoffset the dampening effect of the global downturn.This increase in market share, in turn, reflects acontinuing pattern of their intensifying integrationinto the global economy and of attendant inflowsof FDI.

Greater integration with world markets hasbeen achieved by China, for example, through itsrecently gained membership (December 2001) inthe WTO, after years of negotiations and efforts tocomply with WTO rules and standards. The threeCentral European countries have raised their trade

Box 1.2 Integration pays off where policies are supportive

integration with global markets largely through theEU accession process, association agreements, andlower trade barriers, which will culminate with fullmembership in the EU, which appears now on trackfor 2004.

Reduction of trade barriers is but one factorthat has made these countries successful and ableto take advantage of trade opportunities. Macrostability, rapid institutional reforms toward liberal-ization of domestic markets, good or adequatelevels of education, and competitive wages (relativeto productivity growth) all contribute to thesuccess.

These four countries have benefited fromstrong and sustained inflows of FDI from Westerninvestors that have been building productioncapacity and transferring management skills andtechnical know-how, in addition to financing, suchthat these countries can gain additional marketshare as integration deepens. FDI inflows help ex-pand production capacity and raise productivity(that is, they help to improve the recipient country’scompetitiveness). All four countries have postedhigh FDI inflows according to various measures.For example, using the ratio of the economy’s shareof world FDI inflows to the economy’s share ofworld GDP, China, the Czech Republic, Hungary,and Poland all posted ratios of above 1 (or the worldaverage) for 1998–2000—of 1.3, 2.7, 1.2, and 1.5,respectively. As a share of gross fixed capital forma-tion, FDI inflows to these countries have also beenhigh, particularly in China, where FDI inflows aver-aged 13 percent of gross fixed capital formation dur-ing 1990–99. In the Czech Republic, Hungary, andPoland, FDI inflows averaged 25, 19, and 16 per-cent, respectively, as a share of gross fixed capitalformation during 1997–99.


40

�10

0

Jan.2000

Jul.2000

Jan.2001

Jul.2001

Jan.2002

Jul.2002

30

20

10

Note: y/y refers to year over year.Source: Datastream and World Bank staff estimates.

Several developing countriesshow solid export performance(volumes, 3-month moving average, percent y/y)

Other developing countries World

China

Eastern Europe

gep_ch01.qxd 12/5/02 4:15 PM


13

not only pays off in the long run, but also hasassisted these countries in absorbing or evenavoiding short-term shocks and fluctuations,by promoting business confidence and by facil-itating export-oriented FDI. Perhaps moreimportant, through relatively large inflows ofFDI, these countries have become less vulner-able to turmoil in international financial mar-kets (box 1.2).

The medium-term outlook calls for modest growth in the global economy—third phaseThe baseline forecast reflects the interactionof strong opposing forces: the stimulativepolicies and the intrinsic recovery in stockbuilding and high-tech production that workto accelerate global growth on the one hand,and the financial strains—high and rising debtlevels, falling equity prices, and uncertaintyabout profitability—on the other hand. Thesedriving and restraining forces affect the out-look in three ways:

• Global growth in 2002, the initial yearof the forecast, shows little resemblanceto the uniform recovery that one wouldnormally expect after an almost synchro-nous downturn in 2001. Instead, it dis-plays quite diverse patterns of activityacross industrial as well as developingcountries.

• Growth in 2003–04 is anticipated to bemoderate. World GDP reflects a combi-nation of a more gradual recovery inLatin America, an emergence of modestgrowth in Japan, and a generally sub-dued rebound in other parts of the globaleconomy. The average outturn does notfollow the typically strong patterns ofrecovery and expansion that is concurrentacross regions and reinforced by accom-modating macro policies.

• Downside risks to the baseline forecastare substantial. The global recoveryappears vulnerable to additional shocks.(These points are discussed after wereview the external environment andoutlook for developing countries.)

The external environment is mixedThe driving forces may be found in expecta-tions for growth of global trade volumes:2.9 percent in 2002 and an average of 7.5 per-cent in the following two years (figure 1.8 andtable 1.2). The restraining forces make a sub-stantial rise in capital flows unlikely over themedium term. The modestly firming trends innon-oil commodities prices—5 percent in 2002and averaging 5.1 percent in the followingyears—reflect the subdued recovery. The 5 per-cent gains in commodity prices remain farbelow historical patterns during booms. In-creases in real commodity prices are expected

�21998 1999 2000 2001 2002 2003 2004

2

0

4

6

8

10

12

14

Source: IMF, OECD, World Bank, and World Bank projections.

Figure 1.8 World trade rebounds along with GDP, 1998–2004(percentage change)

World trade

Forecast

World GDP

gep_ch01.qxd 12/5/02 4:15 PM

to be even more moderate, about 2.5 percentper year. Most of the increase in commodityprices in 2002 was due to a surge in agricul-tural prices, which bounced off cyclical lows:the agricultural index had dropped 40 percentbelow its peak, which was reached in 1997.The recent surge is to a large extent inducedby supply factors: for example, droughts inAustralia and the United States have boostedgrain prices, and supply disruptions in Côted’Ivoire and Ghana did the same for cocoaprices. Conversely, the rally in metal prices thatstarted in October 2001, which is normallystrongly correlated with the business cycle,stalled in the second quarter of 2002. The fore-cast for metal prices is one of decline in 2002,and of a return to 5–6 percent gains thereafter.This trend is another indication that the tenorof global recovery is anticipated to be modest.

The base forecast assumes that the currentrisk premium in the oil market gradually dis-

sipates and that increased supply, both fromOrganization of Petroleum Exporting Coun-tries (OPEC) and non-OPEC sources, can eas-ily meet moderate increases in demand. Thisforecast would imply oil prices of around$20 per barrel by 2004. The lack of strengthin the recovery is also reflected in the interestrate projections. The London interbank of-fered rate (LIBOR) and European interbankoffered rate (EURIBOR) are anticipated todrop modestly further during 2003, but to in-crease in step with firming economic activityby 2004, at rates below 4 percent.

The recovery in global markets is shapedprimarily by developments in industrial coun-tries. At 1.4 percent in 2002 and an average of2.3 percent in the following years, growth re-mains at or below potential, which is a rarephenomenon during a recovery (figure 1.9). Inthis forecast, inflation will accelerate little, re-maining below 2000 or 2001 levels.


14

Table 1.2 External environment for developing countries, 1991–2004 (percentage change from previous year, except interest rates and oil price)

Currentestimate Current forecasts

Growth rates/ratios 1991–2000 1999 2000 2001 2002 2003 2004 2002–04

Industrial country GDP growth 2.4 2.9 3.4 0.8 1.4 2.1 2.6 2.0World trade growtha 7.2 5.6 13.1 �0.5 2.9 6.7 7.7 5.7

Industrial country import demand 6.9 8.5 11.6 �1.0 1.3 5.3 6.8 4.4United States 9.4 12.4 13.7 �3.6 4.4 8.1 8.0 6.8Japan 5.6 6.6 10.7 �2.8 �2.0 7.7 8.6 4.7Euro Area 6.6 6.4 11.2 0.8 �0.5 4.0 6.6 3.3

Developing-country import demand 8.2 �1.3 16.9 4.5 5.6 10.1 10.0 8.0Market growth for developing countriesb 10.7 5.3 13.1 0.2 2.6 7.0 8.4 6.0Non-oil commodity prices (nominal) �1.4 �11.2 �1.3 �9.1 5.0 5.8 4.4 5.1

Agriculture �1.3 �13.9 �5.5 �9.1 8.4 8.5 4.8 7.0Metals and minerals �1.8 –2.3 12.6 �9.6 �3.5 5.6 5.7 2.5Real non-oil commodity pricesc �1.1 �11.0 0.8 �7.8 4.5 2.8 2.2 3.2

Oil price ($, weighted average), $/bbl 19.1 18.1 28.2 24.4 25.0 23.0 20.0 22.7Manufactures unit value indexd �0.3 �0.2 �2.1 �1.4 0.5 3.0 2.2 1.9Developing-country terms of trade 0.1 3.3 2.8 0.3 �3.2 �1.4 �1.3 �2.0

Terms of trade/GDP (%)e 0.1 0.7 0.6 0.1 �0.8 �0.4 �0.4 �0.5LIBOR (US$, 6 months) 5.6 5.5 6.6 3.6 1.8 1.5 3.1 2.2EURIBOR (euro, 6 months) 5.4 3.1 4.5 4.2 3.4 3.2 3.8 3.5

Note: bbl � barrel, LIBOR � London interbank offered rate, EURIBOR � European interbank offered rate. a. Goods and nonfactor services.b. Weighted average growth of import demand in export markets.c. Deflated by manufactures unit value index.d. Dollar-based export prices of manufactures in the G-5 countries.e. Change in terms of trade, measured as a proportion to GDP (percent).Source: World Bank, November 2002.

gep_ch01.qxd 12/5/02 4:15 PM

An outlook for moderate growth acrossdeveloping regions—What does this environment imply for outputgrowth in the developing countries? In 2002,a strong recovery in East Asia coincides with adisappointing performance in Latin America,where GDP declined by 1.1 percent (excludingArgentina, where GDP plummeted by nearly

12 percent, and growth in the region slowedfrom 1.2 percent in 2001 to 0.7 percent in2002). The region’s per capita income fell2.6 percent after a drop of 1.2 percent in 2001,which was the worst performance across twoyears since the debt crisis in the early 1980s(figure 1.10). Oil exporters, particularly inthe Middle East and North Africa (MENA),


15

0

1

2

3

4

5

6

1998 1999 2000 2001 2002 2003 2004

Source: World Bank data and projections.

Figure 1.9 2002 marks the start of a moderate recovery(GDP growth rate in percent)

Forecast

World GDP

Industrial countries

Developing countries

East Asiaand Pacific

South Asia LatinAmerica and

the Caribbean

EasternEurope andCentral Asia

Middle Eastand North

Africa

Sub-SaharanAfrica

7

�2

�1

0

1

2

3

4

5

6

Source: World Bank projections.

Figure 1.10 LAC and MENA are not experiencing the recovery(developing countries GDP growth, percent change)

2004

2003

2001

2002

gep_ch01.qxd 12/5/02 4:15 PM

follow an independent growth pattern, which,to some extent, is the same for developingcountries that are rapidly integrating into for-eign markets (for example, Central Europeancountries, China, and Mexico), where exportswere recently able to outperform world tradegrowth as a whole (see box 1.2).

Average growth in 2002 for developingcountries is anticipated to be 2.8 percent,0.3 percentage points lower than was expectedin the February 2002 forecast and 0.8 per-centage points lower than was projected in theDecember 2001 forecast. Even with the bene-

fit of hindsight, it is quite difficult to disentan-gle the set of recent shocks and their effects ondeveloping countries. Yet the downward revi-sions do not contradict the assessment madein the fall of 2001 that adverse effects stem-ming from the terrorist attacks of September2001 would not be limited to the UnitedStates, but would spread to developing coun-tries as well (box 1.3).

Sharply different growth patterns are likelyto characterize economic activity across coun-tries and regions in the short run, as jitteryfinancial markets affect the vulnerable and


16

Shortly after the terrorist attacks of September 11,2001, the World Bank concluded that the eco-

nomic effects would be most severe in the UnitedStates but would be significant in developing coun-tries. The main transmission mechanisms werethought to be:

• Tourism revenues would decline, especially in SouthAsia, the Middle East, and the Caribbean.

• Increased risk perceptions in international marketswould make oil prices more volatile, foreign capitalless readily available, and transportation more costly.

• There would be delayed recovery in the United States,where immediately after the attacks air traffic wasconstrained, equity prices had declined sharply, andconsumer confidence had plummeted. That delaywould also hamper the recovery in world trade, com-modity prices, and financial flows.

Of the developing world, Latin America wasthought to be the hardest hit because of its proximityto the United States, its dependence on tourism rev-enues and commodity prices, and its vulnerabilityto financial shocks. Countries in Sub-Saharan Africawere also vulnerable because they have limitedoptions to absorb adverse shocks.

Even with the hindsight of a year, it still remainsquite difficult to assess the independent effect of 9/11on the global economic environment. Not only arethe counterfactuals unknown but new shocks, suchas the financial crisis in Argentina or the emergence

Box 1.3 The terrorist attacks of September 11, 2001had an economic effect

of accounting scandals in the United States, compli-cate the picture.

The fiscal stimulus and rapid monetary easingin the United States probably prevented a seriousdelay in the U.S. recovery and in world trade growth.Non-oil commodity price increases have slightly out-performed forecasts made in the fall of 2001. How-ever, the steep decline in tourism revenues and theincrease in risk perceptions did materialize, and theoutlook for developing countries has further deterio-rated, especially for Latin America. This observationsuggests that 9/11 did exert strong influence in shap-ing ensuing economic trends in developing countries,albeit reinforced by other factors.

Following continuous and robust growth overthe past decade, global tourism arrivals declinedby 0.6 percent in 2001, tied in large measure to theeffect of the terrorist attacks. The most-affecteddeveloping regions were South Asia (down 6 per-cent), Latin America (down 4 percent), and the Mid-dle East (down 3 percent).

Business and consumer confidence across theindustrial centers fell abruptly in the aftermath ofthe attacks. Although the losses evaporated within2 months as the recovery took shape, the tenor ofbusiness and financial market confidence has contin-ued to be exceptionally fragile (box figure). This fac-tor was one underlying the decline of capital marketflows to emerging market recipients in 2002, as wellas the rise in bond markets.

gep_ch01.qxd 12/5/02 4:15 PM

highly indebted developing countries moreseverely than countries with lower debt ratios.Though the forecasts for 2003—and espe-cially for 2004—display acceleration ofgrowth that tends toward more uniformityacross regions, that acceleration is weakerthan one would expect in a strong, synchro-nized global recovery.2

The forecast for Latin America and theCaribbean (LAC) assumes some rebound inArgentina, where output has fallen some20 percent below 1998 levels, but the reboundis insufficient to return to earlier prevailinglevels within the time horizon of this forecast.Modest growth rates are anticipated for Braziland most other countries of the region. Thatgrowth is grounded in a recovery in globaltrade and an end to the freefall in Argentina,

together with the pursuit of policies geared to-ward reducing financial strains. Mexico andsome Central American and Caribbean coun-tries are in position to benefit most from theexpected upswing in the United States, andMexico’s growth in particular is anticipated toexceed that of most Latin American countries.

—has the strongest growth evident in East Asia—Prospects for developing East Asia and Pacific(EAP) appear more buoyant than those forother regions, as growth is expected to reach6.4 percent by 2004. Continued solid expan-sion in China and recovery in most othercountries—albeit with growth rates that re-main below the robust performance of 2000—underpin this view. Favorable prospects do


17

Developing countries’ GDP growth in 2002 hasbeen limited to 2.8 percent—about 0.8 percentagepoint below that expected one year ago (notably,figures that included an assessment of the 9/11 ef-fects). Although not all barriers to stronger growthare linked directly to the terrorist attacks, most of

Box 1.3 (continued)

these developments took form under the influence ofa global environment that was highly unsettled bythe destruction of the New York World TradeCenter.


40

45

50

55

60 120

110

100

90

80

70Jan.2001

Jul.2002

Jul.2001

Oct.2002

Apr.2001

Apr.2002

Oct.2001

Jan.2002

Source: Institute for Supply Management and Conference Board, through Datastream.

U.S. confidence plummets(ISM and Conference Board business and consumer sentiment indices)

Consumer confidence

(right axis)ISM index(left axis)

gep_ch01.qxd 12/5/02 4:15 PM

not imply that risks are negligible, however.East Asia remains vulnerable to oil pricespikes, to uncertain demand conditions in theUnited States, and to the fragile state of theJapanese commercial banking system andgrowth prospects there. Moreover, the dy-namics in high-tech markets remain volatile.Options for domestic stimulus are more lim-ited than in previous years because in mostcountries fiscal deficits have widened and in-terest rates stand at low levels.

In Europe and Central Asia (ECA), growthis expected to remain strong, but it will begrounded in a highly differentiated outlookbetween the Central and Eastern European(CEE) group of countries and the hydrocarbonexporters that dominate growth trends in theCommonwealth of Independent States (CIS—Russian Federation, Kazakhstan, and severalsmaller states). For the former group, outputgrowth is projected to accelerate from 2.3 per-cent in 2002 to 3.1 percent and 4.3 percentin 2003 and 2004, respectively. Activity isexpected to be driven by increased importdemand from the EU and by intensificationof the EU’s accession process. For Turkey(included in this group), assuming that thereis relative political stability and that the newgovernment continues to pursue the current re-form path, recovery is expected to strengthenin 2003. In contrast, growth is anticipated toease in the CIS subregion in the years through2004 (through fiscal and trade linkages to thehydrocarbon exporters in particular), assum-ing a significant medium-term decline in theoil price. CIS GDP is anticipated to deceleratefrom 4.4 percent in 2002 to 3.5 percent and3 percent in 2003 and 2004. These divergenttrends combine to shape the path of growthfor the broader region, from 3.6 percent in2002 to an average of 3.5 percent in the yearsfollowing.

Growth in the Middle East and North Africa(MENA) region is expected to revive in2003–04 to average 3.6 percent, as hydrocar-bon output increases in line with global energydemand, and as accumulated oil-surplus fundsare progressively committed and expended on

infrastructure and other development activities,especially in Algeria, the Islamic Republic ofIran, and Saudi Arabia. Growth among the di-versified exporters should increase to an aver-age of 3.2 percent, as drought conditions easein Morocco and Tunisia and as fiscal deficitsare brought under tighter control and businessconfidence returns in Egypt—as the govern-ment there sets an appropriate interest rate andpushes ahead with policies, such as privatiza-tion, that will increase international investorconfidence. Risks to this outlook are substan-tial, however, with political tensions mountingduring apparent preparations for militaryaction in Iraq. At this juncture, the baselinedoes not explore these potential developments,but rather focuses on the country-specific andregion-specific economic fundamentals, as wellas global factors that contribute to shape theoutlook.

—and South AsiaA forecast of consistent growth in the SouthAsia region (SAR) of well above 5 percentover 2003–04 comes after a significant cycli-cal downturn in 2001, when manufacturingoutput in India and Pakistan stopped growingand when GDP growth mainly reflected con-tinued expansion in the service sectors. Themain challenge for the subcontinent remainsfiscal reforms to curb over-large governmentdeficits and to promote further trade liberal-ization. With almost-balanced current ac-counts and with substantial capital flows intoPakistan, external financial tensions remainlimited at present. But, it is expected that theeffects of accumulated fiscal debt will, at somefuture point become an obstacle to achievingthe acceleration in growth required for sub-stantial alleviation of poverty levels.

Growth in Sub-Saharan Africa (SSA) re-mains restrained by unfavorable domestic con-ditions, ranging from civil strife, to droughts,to macroeconomic imbalances, and to the AIDSepidemic. Elements of the external environ-ment should, however, provide some supportfor a modest acceleration of growth over thenext years. Despite a relatively sluggish pickup


18

gep_ch01.qxd 12/5/02 4:15 PM

in world GDP growth in 2003–04, a robustrecovery is anticipated for African trade vol-umes, ratcheting from growth of 3 percent in2001 toward 6 percent by 2004. That recov-ery should be accompanied by generallyfirmer non-oil commodity prices (exceptionsare cocoa and gold, where prices have surgedto unsustainable levels). The resulting terms oftrade gains should support relatively buoyantexternal performances by African non-oil ex-porters. For oil exporters of the region, theprice of crude is expected to weaken in themedium term. Even so, oil sectors will remainprofitable, and production and export vol-umes are anticipated to rise—from Nigeriaand other producers in the Gulf of Guinea, aswell as from Angola’s offshore sector.

In the domestic sphere, agricultural pro-duction will benefit from a return to morenormal weather patterns in southern Africa,thus contributing to a recovery of domesticoutput and expenditure. On balance, GDPgrowth for the region is expected to rise from2.5 percent in 2002 to 3.2 percent in 2003 and3.8 by 2004. The overall acceleration reflectsgains by non-oil exporters, which will morethan offset modest retrenchment by oil pro-ducers. The current projection for the regionrepresents a slight deterioration of prospectscompared with the spring 2002 forecast,which is consistent with the overall down-grading of expectations for world output andtrade growth. Nevertheless, though perfor-mance will continue to lag behind other devel-oping regions, per capita incomes are set toresume positive growth following several yearsof stagnation.

Risks to the base case are substantial The world recovery is clouded by substantialuncertainties in the immediate to near term.These uncertainties carry with them implica-tions for medium-term developments in globalgrowth and financial flows. Among criticalfactors in the outlook are (a) continued finan-cial turbulence in high-income countries thatcould jeopardize a rebound in investment;(b) a reversal in capital flows to emerging

markets, thereby heightening tensions in sev-eral vulnerable middle-income countries; and(c) the risk of higher oil prices, which are as-sociated with prospective developments in theMiddle East.

The base case presents a moderate butsteady recovery in investment; it effectivelyrules out financial crises in middle-incomecountries and foresees a gradual decline in oilprices. If downside risks materialize, adverseoutturns in these domains could easily occurat the same time or could, in sequence, rein-force cumulative effects on the economy. Togauge the sensitivity of economic recovery tothese risks, we have traced the possible effectson the economic outlook of these elements.The results underscore the set of tensions em-bedded in the base-case forecast and can illu-minate the magnitude of potential downsiderisk to the projections—with particular focuson the implications for developing countries.3

Global recovery could be delayed until 2004Table 1.3 outlines the global effects of a low-case scenario in which the risks highlightedabove occur essentially at the same time, buteach of the adverse shocks is fairly short lived.The scenario reflects the joint effects of atemporary relapse to negative growth in theindustrial country’s investment cycle, of short-lived financial disruptions in several middle-income countries, and of a momentary spiketo $45 per barrel (bbl) in world oil prices. Thescenario suggests that, rather than an acceler-ation of global growth in 2003 to 2.5 percentas in the base case, a continuation of sluggishoutput advance in a range of 1.9 percent couldcharacterize the year. Contrasted with base-case forecasts, cumulative differences over2003–04 in world trade growth, OECD infla-tion, and interest rates are fairly substantial.The latter element reflects a strong monetarypolicy response to the financial and real dis-turbances of the scenario. OECD outputgrowth is dampened by 1 percentage point,and for developing countries, it is dampenedby 0.8 point over the period (figure 1.11).


19

gep_ch01.qxd 12/5/02 4:15 PM

Among industrial countries, growth pro-files in the United States and Japan are moreadversely affected. This is linked to the relapseof fixed investment spending during 2003,with less room for monetary easing than existsin the Euro Area. Among developing regions,Latin America will feel the initial brunt ofdiminished capital inflow during 2003 (growth

falling substantially below baseline), but itwill rebound with some vigor as conditionsequilibrate in 2004. East Asia—with stronglinks to export markets in all three industrialcenters—will also suffer a sharp falloff ingrowth, but less so than Latin America.

Initially, inflation increases slightly in reac-tion to the rise in oil price. However, when oilprices start falling again and the effect oflower growth becomes noticeable, inflationwill drop in high-income countries, therebytriggering substantial monetary easing com-pared with the baseline. In developing coun-tries, inflation will remain on average aboveits base-case level, as higher oil prices are com-plemented by devaluation of several curren-cies in reaction to financial tensions.

Table 1.4 breaks out for 2003 the contri-butions of the individual risk scenarios (out-lined below) to the overall low-case simula-tion. A relapse of investment in the industrialcountries carries the largest downside poten-tial to the global outlook, which affects outputgrowth, world trade, and interest rates mostacutely. Developing-country growth is moreaffected under the restraint of capital flowscenario, but is equally diminished by devel-opments under the G-7 investment scenarioand by higher oil prices. The latter scenario


20

Table 1.3 Global effects in a low-case scenario, 2003–04

2003 2004 2003–04

Scenario Diff. (base) Scenario Diff. (base) Cum. diff.

GDP growth (%)World 1.9 �0.6 2.7 �0.4 �1.0

Industrial countries (OECD) 1.5 �0.6 2.2 �0.4 �1.0Developing countries 3.0 �0.9 4.8 0.1 �0.8

Consumer price index inflation (%)Industrial countries 2.2 0.1 1.2 �0.6 �0.5Developing countries (median) 5.0 0.6 4.4 0.0 0.6

Short-term interest rates (%)Industrial countries 2.9 �0.3 3.3 �0.8 �1.1

Trade volumes (%)OECD imports 5.5 �1.3 7.5 �0.4 �1.7Developing-country exports 9.3 �1.0 9.2 �0.3 �1.3

Source: World Bank, November 2002.

�2.0

�1.5

�1.0

�0.5

0.0

Source: World Bank.

�1.7

�1.1

�0.5

�1.0

�0.8

Figure 1.11 Low case: world trade andother indicators will be much lower thanthe baseline(cumulative differences, 2003–04; low-case scenarioversus base-case scenario, percent)

Developing-countrygrowth

OECDgrowth

OECDinflation

Interestrates

Worldtrade

gep_ch01.qxd 12/5/02 4:15 PM

prospectively could hamper a fuller easing ofmonetary policy across the industrial centers,with growth suffering commensurately.

Financial market turbulence in high-income countries could trigger a relapse in the investment cycle—Though investment growth momentum is nowbuilding in selected sectors and countries, thepotential for relapse looms large as imbal-ances and uncertainties remain acute through-out the industrial world. The low-case sce-nario assumes that the growth of real businessinvestment in industrial countries drops tonegative territory (�0.7 percent) during 2003,which would be 3.5 percentage points ofgrowth below the baseline path. Spilloversinto 2004 carry cumulative growth differencesin capital spending to 6.5 percentage points(figure 1.12).

If one examines the scenario environmentamong the industrial countries, cumulativeinflation over 2003–04 is reduced by 0.5 per-cent. At the same time, the profile of short-term interest rates reflects reductions that aremore than the improvement in inflation per-formance, which represents a substantialeasing of monetary policy in the wake of de-velopments. The rate of unemployment risesby 0.4 percentage points in OECD countries.Among prominent growth effects, industrialcountry output gains are dampened by

0.4 percent in 2003 and by a further 0.3 per-cent during 2004, as multiplier effects placepressure on household consumption. Withthe compression of imports, adverse growtheffects in the major industrial countries aretransmitted to smaller advanced economies,while weakened demand for commoditiesplaces downward pressure on nonenergyprices, thus affecting developing countries’terms of trade adversely. On balance, GDPgrowth in developing countries will declineby 0.3 percentage points relative to the basefigures during 2003–04.


21

Table 1.4 Low case: contributions to global effects in 2003

Total Diff. (base) Investment Capital flows Oil prices

GDP growthWorld 1.9 –0.6 –0.3 –0.1 –0.2

Industrial countries (OECD) 1.5 –0.6 –0.3 –0.1 –0.2Developing countries 3.0 –0.9 –0.2 –0.5 –0.2

Consumer price index inflation (%)Industrial countries 2.2 0.1 –0.1 0.0 0.2Developing countries (median) 5.0 0.6 –0.1 0.1 0.6

Short-term interest rates 2.9 –0.3 –0.3 –0.1 0.1

World trade 5.8 –1.3 –0.9 –0.1 –0.3OECD imports 5.5 –1.3 –1.0 0.0 –0.3Developing exports 9.3 –1.0 –0.6 –0.2 –0.2

Source: World Bank, November 2002.

Q4 2000

Q22001

Q42001

Q22002

Q42002

Q22003

Q42003

Q22004

Q42004

Source: National statistics; World Bank projections.

�10

0

�5

5

Figure 1.12 G-7 investment falls sharply(base-case scenario and low-case scenarios, volumegrowth, percent saar)

Base-casescenario

Low-casescenario

gep_ch01.qxd 12/5/02 4:16 PM

—while financial tensions pose difficultiesfor emerging markets—Under a scenario of substantially lower in-flows of private capital into countries withweak or declining credit ratings and with largefinancing requirements, interest rates rise, ex-change rates depreciate, or both, which raisesthe cost of servicing debt and results in diffi-culties in meeting debt payments for both thepublic and private sectors. To understand thepossible implications of such development, weperformed a simulation in which capital flowsto selected emerging market countries wereassumed to drop by 15 percent below thebaseline forecast in 2003, while spreads on in-ternational debt would increase substantially.

With these assumptions, the Latin Americaregion will suffer an average falloff in outputgrowth of 1.9 percentage points comparedwith the baseline in 2003. Rebound in re-sponse to eventual equilibration in exchangeand interest rates, as well as to falling riskspreads, should be grounded in stronger ex-ports, and output growth rises some 0.9 per-centage point above the base in 2004. Thecumulative fall in regional growth amountsto 1.1 percentage points during 2003–04. Thisfall is a reflection of the strong dependenceof Latin America on capital inflows, whereasreversals in capital flows tend to have far-reaching consequences for domestic economiesin that region (figure 1.13). Central Europe isanother region that is affected by the reversalin international capital flows, although thegreater diversity within the region makes theoverall effect smaller than for Latin America.

—and higher oil prices could temporarily(yet moderately) dampen recoveryCrude oil prices have risen to more than$29/bbl because of expectations of a supplydisruption in Iraq and of increasingly tightermarket fundamental conditions. Crude oilstocks fell sharply in the third quarter of 2002,particularly in the United States. The drop wasdue to high runs of refined products, a declinein Iraqi crude exports, and continued restraintby OPEC to limit exports in support of higher

prices. A so-called war premium on prices hasbeen estimated at up to $8–$9/bbl. The basecase assumes that the oil market normalizeswith further increases in non-OPEC supply,with a modest rise in OPEC quota, and witha dissipating of the war premium. These as-sumptions might turn out to be too optimistic.

With continued tensions in the Middle Eastand with the possibility that, for example,some 2 million barrels per day (mb/d) of Iraqioil exports would be temporarily lost to themarket, oil prices might rise well above$30/bbl—partly because of low stocks andtight market conditions—and might peak at$45/bbl during the height of the disruption.However, it is likely that any loss in supplywill eventually be replaced by other OPECproducers. They currently have about 5 mil-lion barrels per day (mb/d) of spare capacity—of which Saudi Arabia alone has some 3mb/d.Or supply will otherwise be replenished. Pricescould fall relatively quickly below $20/bbl by2004 before OPEC begins to restrain output asworld demand increases, as the organizationattempts to bring prices back into its targetprice band of $22–$28/bbl (figure 1.14).


22

Q11994

Q11995

Q11996

Q11997

Q11998

Q11999

Q12000

Q12001

Q12002

*Net capital flows defined as CAD—addition toreserves-IMF funds.Source: Datastream and World Bank staff estimates.

0

1

2

3

4

5

6

7

�20

�15

�10

�5

5

0

10

15

20

25

Figure 1.13 Investment growth and netcapital flows* into Latin America arestrongly correlated(4-quarter movingaverage, percent GDP)

Investment

Net capital flows*as percent of GDP

(4-quarter movingaverage, percent saar)

gep_ch01.qxd 12/5/02 4:16 PM

On a cumulative basis, a $2.50/bbl increasein oil price above baseline levels (but with dy-namics as outlined above) will yield a moder-ate fall in global growth of 0.1 percent during2003–04. Effects during 2003 will be some-what more pronounced, however: a drop inworld output of 0.2 percentage points. Infla-tion and interest rates in the industrial coun-tries will be boosted modestly, by some0.2 and 0.1 percentage points, respectively.

Investment cycles in developingcountries

For developing countries, the risk of anuntimely interruption to the recovery in

global investment comes after a period of sharpswings in investment in the past five years.During the East Asian crisis, investment fell atan annual rate of 30 percent, three times thefall in output (figure 1.15). Crises in Argentinaand Turkey dominated recent developments inLatin America and Central Europe, respec-tively, with regional investment declining atannual rates of 15–20 percent (figures 1.16 and1.17). The dynamics of investment are muchmore forceful than that of output.4

This section looks at three importantpatterns:

• The volatility of investment, relative tothe volatility of output, and compar-

isons of developing with high-incomecountries.

• The effects of improvements in the in-vestment climate on the volatility ofinvestment and output.

• The role of capital flows that influence theinvestment cycle in developing countries.


23

18.0

22.5

27.0

31.5

36.0

Q42000

Q22001

Q42001

Q22002

Q42002

Q22003

Q42003

Q22004

Q42004

Source: World Bank data; World Bank projections.

Figure 1.14 Oil prices spike(base-case and low-case scenarios; oil price $/bbl)

Base-casescenario

Low-casescenario

Q11997

Q11998

Q11999

Q12000

Q12001

Q12002

Note: Indonesia, Rep. of Korea, Malaysia, Philippines,and Thailand.Source: Datastream and World Bank staff estimates.

(4-month moving average, percentage change q/q, saar)

Figure 1.15 Investment is more volatilethan GDP in East Asia

�30

�40

�10

�20

0

10

20

30Investment

GDP

Q11997

Q11998

Q11999

Q12000

Q12001

Q12002

Note: Argentina, Brazil, Chile, and Mexico.Source: Datastream and World Bank staff estimates.

Figure 1.16 Investment is more volatilethan GDP in Latin America(4-month moving average, percentage change q/q, saar)

GDP

Investment

�10

�15

0

�5

5

10

15

20

gep_ch01.qxd 12/5/02 4:16 PM

Investment cycles are more pronounced in lower-income countries than in higher-income countriesThe volatility of investment growth relative tothe volatility of output growth is twice as largein low-income countries as in high-incomeeconomies—and volatility has increased overtime (table 1.5). An understanding of the in-vestment cycle is pivotal to the explanationof overall cyclical behavior in developingcountries.

A similar picture emerges if one examines adifferent measure of the cyclical component ofinvestment, namely the percentage deviationfrom trend.5 Figure 1.18 displays the meanand standard deviation of that measure

for some 160 countries over the 1990–2000period.6 The volatility of the cyclical compo-nents of investment declines steeply withhigher income per capita.

Explanations for the high volatility of in-vestment in low- and middle-income countrieswill vary from large external shocks relative tothe size of the country to a poor investmentclimate. Properly functioning domestic finan-cial institutions may smooth cycles by allow-ing additional savings to be channeled toinvestors during downturns.

Poor countries, on average, tend to be rela-tively small economies. Thus, the GDP of anaverage low-income country during the 1990swas $25.6 billion, barely 2.5 percent of theaverage high-income country. Baxter andCrucini (1993) and Crucini (1997) argue that,as a result, external shocks are relatively largein proportion to GDP, which explains reason-ably well the patterns observed in figure 1.18.For example, international capital flows caneasily be much larger from the standpoint ofa small country, and reversals in capital flowscan have a relatively large effect. The decisionby a French multinational to invest $100 mil-lion in Senegal instead of at home would re-duce France’s investment spending in 2000 by


24

Q11997

Q11998

Q11999

Q12000

Q12001

Q12002

Note: Czech Republic, Poland, and Turkey.Source: Datastream and World Bank staff estimates.

�30

�15

0

15

30

45

Figure 1.17 Central Europe and Turkeyexperience greater volatility ininvestment than in GDP(4-month moving average, percentage change q/q, saar)

GDP

Investment

Table 1.5 Relative volatility of investmentis high in developing countries

1971–80 1981–90 1991–2000

Low income 4.6 5.2 7.6Middle income 4.9 3.6 4.5High-income OECD 2.9 3.2 3.5

Note: This table presents unweighted averages of country-specific standard deviations of investment growth as a ratioto the unweighted average of standard deviations of GDPgrowth.Source: World Bank.

0

0.05

0.10

0.15

0.20

High incomeOECD

High incomenon-OECD

Middleincome

Lowincome

Note: Investment volatility is defined as the standarddeviation of the deviation from (HP filtered) trend.Source: World Bank staff estimates.

Figure 1.18 Investment volatility declineswith income(mean and standard deviation of volatility of investment)

MeanStandard deviation

gep_ch01.qxd 12/5/02 4:16 PM

just 0.04 percent, but it would raise Senegal’sinvestment by 11.5 percent. The effects onthe two economies of such a decision wouldbe disproportionate. Similarly, idiosyncraticshocks—economic, weather-related, or thereflection of civil strife—have a relatively largeeffect on smaller countries. Low levels of de-velopment and small size will tend to implyless diversification in the output and exportmix but stronger dependence on commodityprices, so that poor countries’ terms of tradewill tend to be more volatile than those ofOECD countries.

Improvements in the investment climatecan reduce volatilityThe quality of the investment climate, exten-sively discussed in the following chapters ofthis report, appears to be highly correlated withinvestment volatility. If one examines theinvestment climate, several candidates areavailable to proxy for this environment, all ofwhich correlate highly with one another. Fig-ure 1.19 is based on the quality of governanceindicators compiled by Kaufmann, Kraay,and Zoido-Lobatón (2002), which have theadvantage of comprehensiveness. Six sub-indexes attempt to capture various dimensionsof policy and institutional quality. An un-weighted average of all six is identified inthe figure as “All.” Meanwhile, two of thesubcomponents seem especially pertinent tomeasuring the investment climate: “regulatoryburden,” which reflects the incidence of marketfriendly policies, and “rule of law,” which mea-sures respect for society’s rules. “Regulation”consists of the first of these, while “Regulationand Law” is an average of the two. All threeindexes show a similar pattern of decliningvolatility as the policy environment improves,suggesting the finding is robust.

One concern about the evidence presentedin figure 1.19 is that all three indexes correlatevery highly with income.7 However, in regres-sions that explain volatility with both incomeand governance as explanatory variables, thecoefficient for governance tends to be moresignificant than is the coefficient for income.

The independent effect of governance onvolatility can be shown in a different way.Figure 1.20 repeats the analysis, but it correctsfor the possible influence of income by first re-gressing the governance index on income andthen examining the relationship between thevolatility of investment cycles and the residuals


25

Source: World Bank staff estimates using governanceindicators developed by Kaufmann, Kraay, andZoido-Lobatón (2000).

Figure 1.19 A better investment climatereduces volatility of investment cycles(standard deviation of cyclical component of investment)

0.0

0.1

0.2

0.3

0.4

4th quartile3rd quartile2nd quartile1st quartile

Bad GoodGovernance

Regulation

All Regulation and law

Source: World Bank staff estimates using governanceindicators developed by Kaufmann, Kraay, andZoido-Lobatón (2000).

4thquartile

3rdquartile

2ndquartile

1stquartile

0.00

0.05

0.10

0.15

0.20

0.25

Figure 1.20 Impact of policy climate oninvestment volatility after correcting forincome remains strong(standard deviation of cyclical component of investment)

Bad GoodGovernance

gep_ch01.qxd 12/5/02 4:16 PM

from this regression (that is, in relation to thatpart of the governance indicator that is notcorrelated with income). Investment volatil-ity continues to fall with a better investmentclimate.

International net capital inflows are pro-cyclical, both in developing and high-income countries—Because investment cycles are more pro-nounced than output cycles, investment as ashare of GDP tends to rise during a boom andto decline during a downturn. For countries atall income levels, financing of the increase inthe investment ratio during a boom comesfrom both domestic and foreign sources. Dur-ing an upturn, domestic savings rates normallybuild, while current accounts deteriorate(table 1.6). In other words, foreign investorsturn away during downturns, while domesticconsumers reduce their savings and increasetheir consumption as a share of income.Clearly, procyclical capital flows do not pre-vent consumers from absorbing shocks bysmoothing consumption over time (box 1.4).

—but capital flows tend to triggerdomestic cycles in middle-incomecountriesBoth “push” and “pull” factors are respon-sible for the procyclical nature of capitalinflows. In a downturn, demand for invest-ment financing is reduced as firms postponeinvestment plans and reduce capital stocks(the pull factor). At the same time, financialinvestors look for less risky or risk-free invest-ments and show little appetite to invest incountries and sectors that suffer from declin-ing growth and profit rates (the push factor).For developing countries, the push factorshave often been emphasized as a major chal-lenge. Sharp increases in external finance fre-quently preceded severe crises (such as inMexico, East Asia, and Turkey), which weretriggered by sudden reversals of these flows.The dynamics of net capital inflows and thechanges of official reserves over the cycle doindeed indicate that the push factor is moreimportant for middle-income countries, whilethe pull factor dominates in high-incomecountries. Net foreign capital inflows actuallylead the domestic investment cycle in middle-income countries, while they lag the cycle inhigh-income countries. For example, one-year-lagged capital inflows are correlated with in-vestment by 0.27 in middle-income countries,compared with a correlation of only 0.08 forhigh-income countries. In middle-incomecountries, one-year-lagged capital inflows areas strongly correlated with the domestic in-vestment cycle as they are with contempora-neous capital inflows (table 1.7). In high-income countries, a one-year lead in capitalinflows is, by contrast, as strongly correlated


26

Table 1.6 Upturns can be financed abroadand domestically

Correlation of cyclical High investment components Low Middle incomewith changes in … income income OECD

Current account (as % of GDP) �0.21 �0.39 �0.43

Domestic savings (as % of GDP) 0.16 0.16 0.45

Note: The table shows unweighted averages of correlationcoefficients of variables in individual countries.Source: World Bank.

Table 1.7 Capital inflows lead investment in middle-income countries: correlation betweeninvestment ratios and (past or future) capital flows

2-year lag 1-year lag No lag or lead 1-year lead 2-year lead

Net capital inflowsLow income �0.09 0.09 0.21 0.07 �0.01Middle income 0.13 0.27 0.35 0.10 �0.11High income (OECD) �0.20 0.08 0.32 0.35 0.25


gep_ch01.qxd 12/5/02 4:16 PM

with the domestic investment cycle as withcontemporaneous capital inflows.

The picture of capital inflows being a pushfactor for middle-income countries is strength-ened when one considers the behavior of

official reserves. Some of the foreign capitalinflow that precedes a domestic investmentboom in middle-income countries is temporar-ily accumulated as foreign reserves, while cap-ital outflows that precede a domestic bust are


27

In all country groupings, the savings rate is posi-tively (or the consumption rate is negatively) corre-

lated with GDP growth in the short run (see boxfigure). The correlation is relatively weak fordeveloping countries, but that weakness is mainlybecause GDP is an inaccurate measure of income inthe presence of terms-of-trade shocks. Real growthof gross national income (GNI), which includesterms-of-trade gains and losses, is much morevolatile than growth of real GDP in developingcountries. In industrial, high-income countries, theterms of trade have a much smaller effect (see boxtable). The correlation between the savings rate andreal growth of GNI is decisively more similar acrosscountries.

The strong evidence of consumption smoothingin low- and middle-income countries is remarkable,because the conditions in such countries for absorb-

Box 1.4 Consumption in low- and middle-incomecountries is smoothed over the business cycle

ing fluctuations in income are less favorable than inhigh-income countries. First, domestic credit marketstend to function less smoothly, and access to interna-tional capital markets is more difficult than in high-income countries. Second, as far as fluctuations inincome are caused by terms-of-trade shocks, thesmoothing of consumption over time is less attractivethan in the case of volume shocks, which prevail inhigh-income countries. If, for example, import pricesfall, the decline in price amounts to a rise in income,which could trigger an increase in the savings rate.However, a temporary price fall implies a futureprice rise, making future spending of current savingsless attractive. In the case of a temporary rise in thevolume of income, it is more appealing to save nowand spend later, when income is back at a lowerlevel.

Despite these impediments, developing countries’consumption is being smoothed over the businesscycle, providing relief for consumers and supportingdomestic financing of procyclical investment ratios.


Relative and increasing vulnerability of low-, middle-, and high-income countries toterms-of-trade shocks


�0.6

�0.5

�0.4

�0.3

�0.2

�0.1

0

GDP growth

High incomeOECD

High incomenon-OECD

Middleincome

Lowincome

Consumption smoothing is strongest inhigh-income countries(correlation of change in average propensity to consumeand GDP growth)

Income growth

1971–80 1981–90 1991–2000

Low income 2.1 2.2 2.8Middle income 1.9 1.8 2.2High income (non-OECD) 2.8 1.5 1.5

High income (OECD) 1.4 1.3 1.3

Note: Standard deviation of national income growth/standarddeviation of GDP growth.Source: World Bank data.

gep_ch01.qxd 12/5/02 4:16 PM

temporarily absorbed by reductions in officialforeign exchange reserves.

In low-income countries, capital inflowsare also procyclical, but the correlation withthe domestic cycle is less significant. Theweaker correlation reflects the specific charac-ter of these flows—official aid and FDI are lesscyclical—and also the dependence of thosecountries on commodity prices. Part of the fi-nancing for investment booms comes not fromforeign borrowing, but from increased exportrevenues as a result of terms-of-trade gains.Similarly, investment busts are not necessarilydriven by a reversal of capital flows, but theycan originate from terms-of-trade losses.

On the basis of these relationships, it ap-pears that cycles are still a prominent featureof macroeconomic developments, which iseven more important in developing countriesthan in industrial countries, and cycles weremore pronounced during the 1990s than dur-ing earlier decades. Investment swings arefinanced both domestically and abroad, whichmakes current account deficits and capitalinflows strongly procyclical. A major differ-ence between developing countries and high-income countries is that middle-incomecountries are more exposed to independentreversals in capital flows, while capital flowsare more accommodating in high-incomecountries, and the cyclical dynamics in low-income countries are to a significant extentinfluenced by terms-of-trade shocks andidiosyncratic disturbances.

Growth and poverty to 2015:coming changes in savings andinvestment patterns

After an impressive wave of market re-forms and increased openness in develop-

ing countries during the 1990s—both ofwhich prompted acceleration of technologicalprogress and brought about a more stablemacroeconomic environment—long-term eco-nomic growth prospects for developing coun-tries are relatively optimistic. If the projectionscome to pass, growth patterns could lead to a

significant reduction of poverty. Thus, the mil-lennium development goal of halving povertyby 2015 could be reached on a global level,although growth will be insufficient to achievepoverty targets in all regions. At the sametime, financial imbalances and volatility ininternational capital flows continue to jeopar-dize uninterrupted growth. Vulnerable coun-tries will benefit from further debt reductionin their pursuit of sustained high growth.

The acceleration of growth in developingcountries is expected to coincide with in-creases in investment ratios. Saving rates arealso expected to increase, driven particularlyby a declining proportion of youths and bythe need for adults to save for retirement. Op-posite movements are expected in industrialcountries, where aging is bound to reducesavings rates and where a sharp decline inpopulation growth will suppress investmentratios.

The long-term forecast suggests that, on bal-ance, net inward capital flows toward develop-ing countries could well decline, though grossflows will continue to play an important role inenhancing growth potential. These changes inglobal savings and investment behavior raisequestions about the critical role of financialintegration and the need for improvements ininternational financial intermediation.

Long-run per capita growth is expected to accelerate—Developing-country growth, on a per capitabasis, is projected to more than double duringthe 10-year period from 2005 to 2015 whencompared with the performance of the 1990s(table 1.8). This projection reflects substan-tially improved growth prospects for Europeand Central Asia—leaving behind sharp con-tractions that characterized the transition tomarket economies during the 1990s—and forSub-Saharan Africa. For Africa, the scenario ispredicated as a continuation of broad trendstoward better governance and economic poli-cies, of progress toward resolving conflicts anddiversification away from agriculture, and ofexport dependence on primary commodities.


28

gep_ch01.qxd 12/5/02 4:16 PM

At the same time, a lack of human capital,poor infrastructure, and the AIDS epidemicremain pressing problems.

Per capita growth in Latin America isexpected to accelerate by 1 percentage pointunder this scenario, but as a result of slowingpopulation growth, the acceleration of realGDP growth is small. Latin American coun-tries are expected to have benefited fromreform efforts during recent years and fromsustained improvements in macroeconomicstability. The East Asia and Pacific Regionshould witness a declining per capita growthrate from 6.4 percent in the 1990s to 5.4 per-cent in the longer term, as economies matureand as options for rapid catching up becomeless abundant. Per capita growth in the rest ofthe world, including South Asia, the MiddleEast and North Africa, and high-income coun-tries, is projected to accelerate moderately.

—leading toward significant povertyreductionAs projected in previous Global EconomicProspects (GEP), achieving the millennium

development goal of halving extreme povertyby 2015 from the 1990 poverty level should beachieved on a global level, though with wideregional disparities. The revised poverty projec-tions indicate a poverty rate of some 13.3 per-cent in 2015 compared with 29.6 percent in1990. The actual number of poor woulddecline to around 809 million from 1.3 billionin 1990 and 1.1 billion in 1999. Asia shouldreadily achieve the target, but the MENAand SSA regions will make little progress inimproving poverty incidence (table 1.9).

Though the central message remains thesame, the long-term outlook reflects rathersignificant changes from last year’s forecasts.These changes are a combination of threefactors:

• The economic projections reflect recenttrends and a downgrading of the medium-term forecast, as detailed earlier in thechapter, page 5. The long-term forecasthas remained relatively unchanged, butlower growth—actual and forecast—between 2000 and 2005 has slightly


29

Table 1.8 Long-term prospects are projected to be stronger for most regions (real GDP per capita, annual average percentage change)

Forecast scenario

Medium term Long term

1980s 1990s 2001–05 2006–15

World total 1.3 1.2 1.1 2.1

High-income countries 2.5 1.8 1.5 2.4OECD 2.5 1.8 1.5 2.4

United States 2.2 2.2 1.6 2.4Japan 3.5 1.2 0.4 2.0European Union 2.1 1.7 1.9 2.4

Non-OECD countries 3.3 3.6 1.7 3.3

Developing countries 0.7 1.6 2.4 3.5East Asia and the Pacific 5.6 6.4 5.1 5.4Europe and Central Asia 0.7 –1.9 3.3 3.4Latin America and the Caribbean –0.9 1.6 0.3 2.6Middle East and North Africa –0.6 1.0 1.3 1.3South Asia 3.4 3.3 3.5 4.0Sub-Saharan Africa –1.2 –0.4 0.8 1.6

Note: Aggregations are moving averages, reweighted annually after calculations of growth in constant prices.Source: World Bank.

gep_ch01.qxd 12/5/02 4:16 PM

worsened the poverty forecast, all elsebeing equal.

• New surveys and methodology have sig-nificantly altered the 1999 estimate ofpoverty incidence. For developing coun-tries, this change has led to a 1.6 percentrise in the estimate of the number ofpoor living on less than $1 per day.However, the revisions are not uniformacross regions. There is a significant risein East Asia and in Europe and CentralAsia, while the estimated number ofpoor has dropped in Latin America.8

• The third factor is the change in therelation between economic growth andpoverty reduction. This relation has beenre-estimated using the new survey data.Overall, the relationship has weakened

(that is, for the same growth rate, therate of poverty reduction has declined).

The reader should bear in mind that thesenumbers are sensitive to the poverty line cho-sen and underlying assumptions and data (seebox 1.5).

The relation between growth and povertymay not have changed in a fundamental way,but the change may be a consequence of pasttrends at a more disaggregated level. Recentstudies9 of poverty trends in India indicatethat poverty has been successfully reduced ina number of states in which growth rates arehigh and in which the responsiveness ofpoverty reduction to growth is likewise higher.Moreover, the evidence suggests that these re-gions had significantly better initial conditions


30

Table 1.9 Large poverty reductions in EAP and SAR partially offset by poverty increases in SSA

Number of people living on less than $1 per day (millions)

GEP 2002 GEP 2003

Region 1990 1999 2015 1990 1999 2015

East Asia and Pacific 452 260 59 486 279 80Excluding China 92 46 6 110 57 7

Europe and Central Asia 7 17 4 6 24 7Latin America and the Caribbean 74 77 60 48 57 47Middle East and North Africa 6 7 6 5 6 8South Asia 495 490 279 506 488 264Sub-Saharan Africa 242 300 345 241 315 404

Total 1,276 1,151 753 1,292 1,169 809Excluding China 916 937 700 917 945 735

$1 per day headcount index (percent)

GEP 2002 GEP 2003

Region 1990 1999 2015 1990 1999 2015

East Asia and Pacific 27.6 14.2 2.8 30.5 15.6 3.9Excluding China 18.5 7.9 0.9 24.2 10.6 1.1

Europe and Central Asia 1.6 3.6 0.8 1.4 5.1 1.4Latin America and the Caribbean 16.8 15.1 9.7 11.0 11.1 7.5Middle East and North Africa 2.4 2.3 1.5 2.1 2.2 2.1South Asia 44.0 36.9 16.7 45.0 36.6 15.7Sub-Saharan Africa 47.7 46.7 39.3 47.4 49.0 46.0

Total 29.0 22.7 12.3 29.6 23.2 13.3Excluding China 28.1 24.5 14.8 28.5 25.0 15.7

(continued on page 31)

gep_ch01.qxd 12/5/02 4:16 PM


31

Arecent study (Bhalla 2002) concludes that theWorld Bank has overestimated the number of

poor in developing countries, and that the millen-nium development goal of halving extreme povertyby 2015 (from its 1990 level) was already achievedin 2000. The study estimates that the percentageof poor in developing countries in 2000 was only13.1 percent and that the World Bank’s estimate is10 percentage points higher (see table 1.9). Threedifferences between the Bhalla estimates and theWorld Bank’s explain Bhalla’s different conclusion.These differences include the choice of the poverty

Box 1.5 Is the World Bank overestimating global poverty?

line, his use of secondary data sources rather thanprimary surveys, and consumption adjustments.These differences highlight the complexity in count-ing the number of poor and are described here. Amore complete critique of the Bhalla study can befound in a separate paper (Ravallion 2002).

The World Bank has chosen to use $1 per dayand $2 per day poverty lines for global estimations,roughly spanning the range of national poverty linesin developing countries. Bhalla uses $1.50 per day.Because the cost of purchasing 2,200 calories differsfrom country to country, each country estimates its

Table 1.9 (continued)

Number of people living on less than $2 per day (millions)

GEP 2002 GEP 2003

Region 1990 1999 2015 1990 1999 2015

East Asia and Pacific 1,084 849 284 1,114 897 339Excluding China 285 236 93 295 269 120

Europe and Central Asia 44 91 42 31 97 45Latin America and the Caribbean 167 168 146 121 132 117Middle East and North Africa 59 87 65 50 68 62South Asia 976 1,098 1,098 1,010 1,128 1,139Sub-Saharan Africa 388 484 597 386 480 618

Total 2,718 2,777 2,232 2,712 2,802 2,320Excluding China 1,919 2,164 2,041 1,892 2,173 2,101

$2 per day headcount index (percent)

GEP 2002 GEP 2003

Region 1990 1999 2015 1990 1999 2015

East Asia and Pacific 66.1 46.2 13.5 69.7 50.1 16.6Excluding China 57.3 40.4 13.3 64.9 50.2 18.4

Europe and Central Asia 9.6 19.3 8.7 6.8 20.3 9.3Latin America and the Caribbean 38.1 33.1 23.4 27.6 26.0 18.9Middle East and North Africa 24.8 29.9 16.7 21.0 23.3 16.0South Asia 86.8 82.6 65.5 89.8 84.8 68.0Sub-Saharan Africa 76.4 75.3 68.0 76.0 74.7 70.4

Total 61.7 54.7 36.3 62.1 55.6 38.1Excluding China 58.8 56.5 41.0 58.7 57.5 44.7

Note: The GEP 2002 figures include the Republic of Korea, which has been reclassified into the high-income group. Source: World Bank staff estimates.

gep_ch01.qxd 12/5/02 4:16 PM

than did states with lower growth rates. Thisevidence implies that progress in the futurewill be harder to achieve with the same na-tional growth rate. Poverty-reducing policieswill, therefore, have to focus on raising the

initial conditions in the laggard states andshould not rely exclusively on raising the na-tional growth rate.

The number of poor in last year’s reportwas projected to be 753 million in 2015,


32

own national poverty line. This approach also re-flects the fact that the nature of poverty varies signif-icantly across and within countries. Moreover,poverty has many dimensions: inadequate consump-tion of essential commodities, as well as low life ex-pectancy, high child mortality, and low school enroll-ment rates, among other attributes related to thequality of life. Poverty is also a relative and subjec-tive concept. What is deemed a necessity in somecountries (for example, indoor plumbing in richcountries) may be a luxury in others. In Latin Amer-ica, the regional estimate for the percentage of peo-ple living in extreme poverty is 17.8 percent in 1998(Wodon and others 2002), compared with 11.1 per-cent in 1999 using the $1 per day poverty line. Theformer is based on national poverty lines and is froma regional perspective. This higher number—ar-guably a more accurate reflection of the incidence ofpoverty from a social point of view—is more rele-vant in determining policies for reducing poverty.However, for purposes of global comparisons, theWorld Bank has tried to select a level of real con-sumption that best measures the same level of con-sumption across countries so it can make aggregatejudgments independent of where the poor live.

Unlike the Bhalla study—which relies on aggre-gate secondary data sources—the World Bank’spoverty estimates rely exclusively on primary datafrom comprehensive household surveys. Since the1980s, the World Bank and developing-country gov-ernments have been actively involved in undertakingnational household surveys to get an accurate pictureof the distribution of consumption across individu-als. To date, more than 300 comprehensive surveyshave been collated and used to estimate the numberof poor. Currently, the surveys cover more than90 countries, with surveys available for various yearsfor most counties. The surveys used all have nationalcoverage. They include consumption from own-production—a key feature in many developing

Box 1.5 (continued)

countries—and the calculations are properlyweighted to reflect survey design and differences inhousehold size. Consumption is deemed to be thepreferred measure to income, but income is usedwhen consumption is not available.

Finally, Bhalla’s study makes consumptionadjustments, which may not be warranted and couldlead to a biased poverty estimate. The headcountindex (that is, the percentage of the population livingat or below the poverty line) is calculated using anestimate of the per capita consumption level relativeto the poverty line. There can be significant discrep-ancies between the survey-based mean consumptionand the mean consumption as measured by the na-tional accounts. Part of this discrepancy is explainedby the way consumption is estimated in the nationalaccounts (which typically includes consumption ofnon-household private agents such as nonprofitorganizations). Other discrepancies can arise frommeasurement error (for example, misreporting ofconsumption in surveys). Adjustments for these dis-crepancies can lead to different estimates of poverty.If, for example, the misreporting is biased towardhigh incomes—that is, if only rich households under-report consumption in the surveys—and if an up-ward adjustment is applied to all households (includ-ing the poorest), then the number of poor will clearlybe underestimated (see Ravallion 2002). The WorldBank’s poverty estimates rely on the survey-basedconsumption levels.

Transparency in the methodology and data usedto assess the level of poverty is critical in this debateregarding how to count the number of poor. Theability of different researchers to easily assess andcompare results will lead to improved estimates andto a better understanding of the nature of povertyand policies that accelerate poverty reduction.


gep_ch01.qxd 12/5/02 4:16 PM


33

or a headcount rate of 12.3 percent. The cur-rent forecast shows the number of poor willdecline to only 809 million by 2015, or aheadcount rate of 13.3 percent. This changerepresents a 7.4 percent increase when com-pared with last year’s figure. The percentageincrease can be decomposed into two factors.The higher initial level of the number of poorin 1999 would lead to an increase of 2.3 per-cent in the 2015 forecast, all else being equal.The remaining 5.1 percent of the increase inthe forecast is attributed to a weakening of therelation between growth and poverty.

Population, savings, and investment are factors underlying the long-termforecastSome developing regions will need to see areversal in performance of underlying growthfactors—particularly in productivity and insavings and investment—from the last decade.That reversal should show either changes topolicies or persistence with ongoing reforms.Assessing the factors underlying the long-term forecast—population and labor supply,technological progress, and savings andinvestment—will elucidate some of the under-lying dynamics in the long-term growth fore-cast and its policy implications.

Population growth will ease in all regions—In virtually all countries, growth of theworking-age population is slated to declineover the next 15-year period, thereby affect-ing labor supply and thus contributing less toGDP growth in the long run (figure 1.21).High-income countries and those in Europeand Central Asia are likely to see an absolutedrop in the working-age population by 2015.Developing regions will see a slower pace ofdecline, although East Asia is expected to seeits growth rate halved to 0.7 percent per yearby the end of the period.10 A slower growthrate in the labor force means that achievingthe same rate of per capita growth will requirean acceleration of investment, a higher level ofproductivity, or a combination of both.

—but technological progress shouldaccelerateThe role of total factor productivity (TFP)growth in determining growth rates has beenthe subject of significant research over the pastdecade (see box 1.6), but there is a growingconsensus that technological advances andefficiency improvements are pivotal determi-nants of growth patterns. If one looks for-ward, many countries are expected to reap the

Note: HIY refers to high-income countries; SSA refers to Sub-Saharan Africa; EAP refers to East Asia and Pacific; SAS refers toSouth Asia; ECA refers to Eastern Europe and Central Asia; MNA refers to Middle East and North Africa; LAC refers to LatinAmerica and the Caribbean.Source: World Bank staff demographic projections.

Figure 1.21 Growth of working-age population decelerates(annual growth of population for ages 15 to 65)

�1.01998 2000 2002 2004 2006 2008 2010 2012 2014

�0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0 MNA

SSA SASLAC

EAP

ECA

HIY

gep_ch01.qxd 12/5/02 4:16 PM


34

Agrowing consensus in the economic literature isthat TFP accounts for the bulk of cross-country

differences in the level of income and the rate ofGDP growth (Easterly and Levine 2001).11 WhetherTFP or capital and labor accounted for the bulk ofincome differences among countries has been anissue of dispute since seminal articles by Denison(1972) and Jorgenson and Griliches (1967, 1972).The debate sharpened in the 1990s when a numberof comparative growth studies found that the successof the East Asian Tigers was driven mostly by in-creases in capital and labor rather than by increasesin TFP (Young 1992, 1995; Collins and Bosworth1996). Because capital is subject to diminishing re-turns, such studies implied that the high rates ofgrowth achieved in East Asia were not sustainable(Krugman 1994).

More recently, the weight of evidence appearsto be moving toward the conclusion that TFP is themain driver of growth. The East Asian studies havebeen criticized for not accounting for the role thattechnological progress plays in encouraging greatercapital accumulation (Hulten 2000; Barro and Sala-i-Martin 1992).12 Nelson and Pack (1999) emphasizethat learning, technology absorption, and forceful en-trepreneurship were critical to the success of large in-vestments in physical and human capital. Klenow andRodríquez-Clare (1997) estimate that TFP made animportant contribution to growth in all of the EastAsian “miracle” economies, except Singapore. East-erly and Levine (2001) summarize studies that showTFP accounts for more than 40 percent of outputgrowth in most of the industrial countries, 30 percentor more in most Latin American countries, and awide range (from �5 percent to 30 percent) in EastAsia (box figure). Some writers attempt to refine esti-mates of the contribution of TFP to growth by incor-porating some measurement of the quality of in-puts—for example, adjusting data on labor input forthe degree of education or training (see Easterly andLevine 2001 and Parente and Prescott 2000 for recentcontributions). In general, efforts have not been suc-cessful in greatly reducing the amount of growth orincome differences that are accounted for by TFP.

The evidence that growth in TFP is the maindriver of economic growth is essentially an optimistic

Box 1.6 Technological progress is an importantdeterminant of growth

sign for developing countries, because constraints ondomestic resources and access to external financingseverely limit a country’s ability to raise growth ratesby increasing the volume or improving the qualityof physical and human capital. To the extent thatdifferences in TFP growth will reflect differences intechnology, then developing countries (which arewell below the technological frontier) can potentiallyachieve high “catch-up” rates of growth by import-ing technology. Parente and Prescott (1994) see themain source of cross-country productivity differencesas stemming from policy-induced barriers to adopt-ing advanced technology. TFP growth also reflectsother aspects of economic efficiency that areamenable to change through improving policies. Forexample, policies that increase competition may raiseTFP by improving the allocation of labor and capitaland by increasing the ability of the economy to re-spond to changes in the economic environment(Easterly and Levine 2001; Solow 2001; Hulten2000).

Critiques of using this accounting approachinclude the fact that it typically relies on variousrestrictive assumptions (for example, constantreturns to scale and competitive markets) that maynot hold in reality (although models that incorporate

Source: Easterly and Levine (2001).

TFP is a major contributor to growth(percent)

�10

0

10

20

30

40

50

60

Taiw

an (C

hina

)

Kore

a, R

ep. o

f

Sing

apor

e

Hon

g Ko

ng (C

hina

)

Vene

zuel

a, R

.B. d

e

Mex

ico

Chi

le

Braz

il

Arge

ntin

a

Uni

ted

Stat

es

Uni

ted

King

dom

Japa

n

Italy

Ger

man

y

Fran

ce

gep_ch01.qxd 12/5/02 4:16 PM


35

benefit of reforms undertaken during the past10 years. These benefits will likely show up asan acceleration of technological progress (fig-ures 1.22 and 1.23). Among industrial coun-tries, those countries in Europe will see accel-erating benefits from the single currency plusgreater capital and labor mobility. Japan,though still burdened with significant prob-lems in its financial sector, is witnessing

changes in its service sectors, which will havelong-term payoffs. Both Europe and Japan,although lagging somewhat behind the UnitedStates, have the opportunity to reap gains fromimproved use of information technologies.

The East Asia region has been the leaderamong developing regions in terms of acceler-ating productivity over the past two decades.It has built on compositional shifts (fromagriculture to manufacturing and services),

market imperfections also confront difficult econo-metric problems; see Brock and Durlauf 2001).Often, key parameters, such as the share of capital inoutput, are assumed to be based on limited empiricalwork (Senhadji 2000). Solow (2001) notes that thegrowth-accounting framework assumes that theeconomy is moving along the potential output fron-tier. In developing countries, the volatility of thebusiness cycle means that actual output may be con-siderably different from potential at any point intime. Thus, growth-accounting estimates using timeseries data may be biased by differences betweenpotential and actual output levels at the beginningand end points, even if a considerable time period is

Box 1.6 (continued)

covered. Finally, growth accounting generally doesnot reflect either improvements in the quality ofgoods or the introduction of new products, whichare also important for welfare (Hulten 2000). Thosecriticisms underscore the substantial methodologicaland measurement difficulties involved in quantify-ing the contribution of inputs and productivity togrowth rates. Nevertheless, as Hulten (2000) stresses,this approach has provided a simple and internallyconsistent intellectual framework that has been usedto gain vital insights into the process of economicgrowth.


SSASASMNALACECAEAPHIY

HIY � high-income countries.Source: World Bank staff estimates.

Figure 1.22 Productivity has not beenthe dominant source of growth inregions(average percent per annum 1990–2000)

0

�4

�2

8

6

4

2

Labor

Capital

Productivity

SSASASMNALACECAEAPHIY

HIY � high-income countries.Source: World Bank staff estimates.

Figure 1.23 Productivity is expected tobe more significant in the longer term(average percent per annum 2005–15)

0

�4

�2

8

6

4

2

Labor

Capital

Productivity

gep_ch01.qxd 12/5/02 4:16 PM

educational improvements, and productivity-enhancing policies (for example, increasingopenness). The region will continue to benefitfrom good policies and compositional shifts.After all, the largest country in the region,China, still has more than 60 percent of itswork force in agriculture. However, as the gapwith technologically more advanced countriescloses, the opportunities for extreme advancesin productivity diminish.

Europe and Central Asia is benefiting fromthe substantial reforms of the 1990s, accom-panied by large FDI flows. Moreover, many ofthe accession countries will accelerate the re-form process in preparation for joining the EUearly in the forecast period.

In Latin America, progress has been visibleregionwide. As has been positively demon-strated by Chile and Mexico, openness andstability are key elements in providing sustain-able growth. A recent study of Latin Americangrowth over the past three decades concludesthat structural reforms and stabilization poli-cies accounted for a large contribution to theoverall acceleration in the rate of growth inthe 1990s compared with the “lost decade” ofthe 1980s.13 These trends are expected to con-tinue in the next decade, with increasing in-vestments in infrastructure and education andwith greater openness to trade underpinningsolid productivity growth. The key downsiderisk includes the vulnerability of the region toexternal shocks, particularly given its sizableexternal debt burden, and the effects that thisdebt could have on the stability of the domes-tic financial sector.

Sub-Saharan Africa has benefited from sim-ilar policy reforms and stabilization. FDI hasbeen increasing, and the resolution of somelong-term civil conflicts should provide amore enabling environment for sustainedgrowth. South Asia and the Middle East andNorth Africa regions have maintained some ofthe highest trade barriers in the world. Thesebarriers will slowly be removed under the im-petus of multilateral and regional trade agree-ments, with ensuing efficiency gains.

Figures 1.22 and 1.23 summarize the de-composition of the various sources of GDPgrowth into three broad components: thelabor supply, capital accumulation and pro-ductivity for the historical period 1990–2000,and the long-term projection for 2005–15.The decomposition profiles projected for theperiod 2005–15 are rather similar to the1990–2000 period, with the significant excep-tion of the contribution from technologicalprogress. As argued on page 38, we have pro-jected that most regions will see an accelera-tion of technological progress, which willdrive the improvements in GDP growth. Thatprogress will trigger further capital accumula-tion to accommodate and to further enhancegrowth prospects—hence the need for pro-viding an enabling investment environment.Capital accumulation implies an investmentprofile—discussed in more detail below—linked, of course, to behavioral assumptionsregarding savings during the coming decade.

Convergence of investment ratios is likelyto continueAfter a distinct divergence of investment ratiosacross regions during the past decades, someconvergence is expected during comingdecades, though disparities will remain signifi-cant. Investment rates in the developing EastAsia and the Pacific region gradually increasedfrom 15 percent of GDP during the 1960s toalmost 30 percent during the 1980s (fig-ure 1.24a). This increase coincided with rapidgrowth of the economies in the region, majorsectoral shifts as a result of diversification,and regional and global integration, which allrequired expansion or replacement of capitalstocks. During the first half of the 1990s, theaverage investment rate jumped further to35 percent, of which a substantial part wasused for real estate development when foreigncapital streamed in. In 1997, investors realizedthat their collective behavior was based onoverly optimistic expectations. The resultingfinancial crisis sharply lowered investmentrates back to levels near 25 percent.


36

gep_ch01.qxd 12/5/02 4:16 PM


37

The investment rate in South Asia was ex-tremely low until the mid-1970s, but then itstarted to rise. To a large extent, that rise is areflection of the green revolution and industri-alization programs in India. Although not asstrong by far as in East Asia, the average ratecontinued to increase during the 1980s and1990s, and the current level is now close toOECD levels of around 22–23 percent. Thatlevel is well above rates in Latin America andSub-Saharan Africa.

Structural developments in the latter tworegions (LAC and SSA) were quite differentfrom the Asian experience. A gradual rise ininvestment rates during the 1970s, which waspartly financed abroad, suddenly turned intoa sharp decline when the debt crisis hit in theearly 1980s. Investment rates dropped around5 percentage points. Macroeconomic imbal-ances and hyperinflation in Latin America, aswell as sharp terms-of-trade losses in Africa,led to extremely low growth during the 1980s.In this environment, investment rates contin-ued to fluctuate around historical lows. Dur-ing the 1990s, investment rates showed onlya slight recovery, although the compositionshifted significantly away from public to pri-vate investment, following major structural

changes and privatization programs. One rea-son for the lack of a strong rebound in invest-ment was the continued low domestic savingsrate in both regions (figure 1.24b). Even withlow investment rates, the current accountshowed large deficits during the 1990s.

Future investment trends will be influencedby expected GDP growth, by real domesticinterest rates, and by expected domestic ratesof return to capital compared with the averageglobal rate of return. If one assumes a stablerisk environment, the last effect should tendto benefit developing countries, where ratesof return are higher than in rich counties.Table 1.10 summarizes the changes in invest-ment behavior between the average of the1997–2001 period and the final year (2015)of the baseline scenario. On average, the high-income countries will see a drop in the invest-ment rate of about 2.9 percentage points (rel-ative to GDP). This figure is derived largelyfrom lower projected GDP growth rates andthus changes in the optimal capital to outputratio. The average investment rate in develop-ing countries increases slightly by 0.2 percent-age points, with higher investment rates inmany regions offset by lower investment inEast Asia. The latter region is still suffering


Figure 1.24 Major structural shifts in investment and savings behavior have occurred

a. Investment-to-GDP ratio

(current dollar-weighted average)

0

5

10

15

20

25

30

35


Sub-SaharanAfrica

LatinAmerica and

the Caribbean

SouthAsia

b. Savings-to-GDP ratio

(current dollar-weighted average)

0

5

10

15

20

25

30

35

Sub-SaharanAfrica

SouthAsia

LatinAmerica and

the Caribbean


1970s 1970s1990s

1990s

1980s

1980s

1960s 1960s

gep_ch01.qxd 12/5/02 4:16 PM

from past overinvestment, particularly insome sectors, and will adjust its investmentneeds to a slight deceleration in growth. Mostof the other developing regions will see accel-eration in investment in anticipation of highergrowth. Investment in those regions will alsoprovide relatively higher returns than in themore mature economies.

Future changes in investment rates do notnecessarily lead to corresponding changes incurrent accounts. Despite capital mobility,investment rates tend not to correlate withcurrent account deficits in the long run, theso-called Feldstein-Horioka puzzle (1980).Also in the coming 15-year period, the savingsrate is expected to increase in those countriesthat are anticipated to enjoy an acceleration ofgrowth, partly because of rapidly changingdemographics.

Changing demographics will raise savings in developing countries and will lower savings in industrialcountriesGlobal population dynamics are evolvingfairly rapidly at the beginning of the new mil-

lennium. Rich countries are seeing an exten-sion of life spans and a rapid decline inbirthrates, leading to a sharply aging popula-tion. Developing countries are witnessing arelatively sharp drop in the percentage ofyouths as well as modest increases in thenumber of elderly. Recent economic evidencesuggests that these trends could have signifi-cant implications on national saving rates—lowering them in rich countries because ofaging, but raising them in developing coun-tries as workers save for future retirement.Lower birthrates also lead to a reduction inresource demand for the young.

The demographic transition with respect tothe proportion of youths is largely over in thehigh-income countries (figure 1.25). The over-all average was 27.4 youths per 100 workers14

in 2000 and is expected to drop to 24.4 by2015. Developing regions are likely to witnessmuch greater changes. First of all, the propor-tion of youths is starting from a significantlyhigher base, with the dependency ratio aver-aging 51.0, which is nearly double the high-income average. The ratio is expected to dropto 40.7 by 2015, twice the percentage of the


38

Table 1.10 Savings fall in high-income countries, but increase in most other regions(as a percentage of GDP)

1997–2001 2015

Capital CapitalSavings Investment inflows Savings Investment inflows

(S) (I) (KA) (S) (I) (KA)

Total 22.4 22.5 0.1 20.5 20.5 0.0High income 22.0 21.9 �0.1 18.6 19.0 0.4Low and middle income 24.2 24.7 0.5 26.0 24.9 �1.1European Union 20.8 20.4 �0.4 17.5 17.4 �0.1Japan 29.8 27.5 �2.2 26.0 25.4 �0.6United States 17.5 19.5 2.0 14.5 16.3 1.9Rest of high income 30.8 26.1 �4.7 24.9 23.2 �1.7East Asia and Pacific 36.9 33.9 �3.0 35.0 29.3 �5.8South Asia 21.3 22.2 0.9 23.7 23.5 �0.2Middle East and North Africa 26.2 21.4 �4.8 23.1 22.2 �0.9Sub-Saharan Africa 13.9 17.6 3.7 19.0 20.1 1.1Europe and Central Asia 21.9 22.6 0.7 22.0 27.1 5.1Latin America and the Caribbean 17.9 21.7 3.7 20.5 20.6 0.0

Note: The columns (S), (I), and (KA) represent, respectively, the national saving rate, the national investment rate, and the capitalaccount, all as a share of GDP. The values for 2015 are simulated values from the global general equilibrium model (maintainedby the Development Economics Prospects Group). The values for the 1997–2001 period represent the average observed valuesfrom the World Bank’s statistical databases. For the high-income countries, these values are the 1997–99 or 1997–2000 averages,depending on data availability. For the totals, the averages cover only the years 1997–99.Source: World Bank model simulations.

gep_ch01.qxd 12/5/02 4:16 PM


39

fall expected in industrial countries. This anti-cipated decline is the consequence of two fac-tors: a boom in births over the past twodecades, leading to a rapid rise in the working-age population, and, more recently, decliningbirthrates, which are caused by a combinationof economic growth and family-planningprograms.

The elderly dependency ratio, defined asnumber of members of the population whoare older than 65 per 100 workers, is rising inalmost every region (figure 1.26). The transi-tion is occurring rapidly in industrial countriesas the Baby Boom generation ages and aslife expectancy improves, but there will onlybe modest changes in developing countriesthrough 2015 because relatively more recentimprovements in health and life expectancywill affect elderly demographics only furtherin the future.15 The elderly dependency ratioaverage in 2000 for industrial countries was21.2 per 100 workers. It is expected to rise to26.9 by 2015, surpassing the youth depen-dency ratio. Japan will witness the most dra-matic increase, from 25.1 to 39.8. This change

alone could have major macroeconomic impli-cations for Japan and have consequences forthe rest of the world, because Japan has longhad large excess savings that have been recy-cled abroad. Outside the industrial countries,the average elderly dependency ratio is notexpected to change significantly. The averagewas 8.9 in 2000, increasing to only 9.6 in2015.

Several recent studies of private savingsbehavior have linked the private savings rateto a number of different factors: demograph-ics, income levels and growth, interest and in-flation rates, and degree of financial interme-diation.16 The results discussed next focus ononly three channels affecting savings: the rateof per capita GDP growth, the youth depen-dency ratio, and the elderly dependency ratio.Other channels may prove to be equally im-portant, however, such as improved financialintermediation and a stable macroeconomicenvironment. Combining these three effectssuggests that global savings may decline byaround 1 percentage point over the longerterm, a figure that takes into account a

Figure 1.25 Youth dependency ratio willfall everywhere except Japan (number of youths, age 15 and under, per 100working-age population)

0

10

20

30

40

50

60

70

80

90

LMY

HIY

TOT

LAC

ECA

SSA

MN

A

SAR

EAP

RH

Y

USAJPN

E_U

RHY � rest of high income; TOT � global average;HIY � high-income average; LMY � low- and middle-income average.Note: Working-age population is defined as those peoplebetween the ages of 15 to 65.Source: World Bank staff.

2015

2000

2015

2000

0

10

20

30

40

50

(number of elderly, age over 60, per 100 working-agepopulation)

LMY

HIY

TOT

LAC

ECA

SSA

MN

A

SAR

EAP

RH

Y

USAJPN

E_U

RHY � rest of high income; TOT � global average;HIY � high-income average; LMY � low- and middle-income average.Note: Working-age population is defined as those peoplebetween the ages of 15 to 65.Source: World Bank staff.

2015

2000

Figure 1.26 Elderly dependency ratioswill rise in some regions

2015

2000

gep_ch01.qxd 12/5/02 4:16 PM

2.7 percentage point decline in high-incomecountries and a 3.7 percentage point rise indeveloping countries.

With relatively large swings in domesticsavings rates, the scenario suggests a rathersignificant change in net capital flows. In1997, the base year of model simulations,industrial countries were exporting around$67 billion in net investment to low- andmiddle-income countries, some 1.1 percent oflow- and middle-income countries’ GDP. EastAsia was the only developing region that wasa net exporter of capital in the base year.17 By2015, under these savings and investment as-sumptions, low- and middle-income countrieswould be significant net exporters (some1.1 percent of their GDP), while industrialcountries would be net importers. Among in-dustrial countries, Europe would be in ap-proximate investment-to-savings balance, butthe United States could continue to be a sig-nificant net importer of capital. The UnitedStates would actually see little change in itscapital account surplus from the base year (asa share of GDP), though it would experiencea reversal from its present high level. Japan’scapital account deficit would diminish sharplywith a rapidly increasing elderly populationleading to a decrease in savings.18

The actual magnitude of these changesin savings and investment rates remainsspeculative—even though they are grounded inempirically validated economic theory withina consistent accounting framework—becausesome of the underlying behavioral relationscould change the savings rates, the investmentrates, or both to some extent and could havea noticeable effect on the balance (that is, thecapital account). Nevertheless, there is littledoubt regarding the broad changes in thepattern in these projections. A clear trendemerges of further reduction in developingcountries’ foreign debt. East Asia could con-tinue to show significant surpluses on the cur-rent account, while Latin America could con-verge toward a balanced current account. Thelatter would be the result of, and represent arise in, the savings rate and a relatively stable

investment ratio. Those figures would reflectno change in overall growth compared withthe 1990s because declining populationgrowth will counteract the acceleration in percapita growth.19 These trends in savings andinvestment rates will require adjustments torelieve the strains on budget and other vari-ables. Open capital and goods markets wouldfacilitate the potential strains from demo-graphic transition.

Major policy challenges are likely to emergeWhile there is evidence in support of the eco-nomic growth projection in this long-run sce-nario, the degree of uncertainty regarding theprojections is high. There is recognition thatthese trends will require good policies, be-cause many developing countries are still sub-ject to major shocks.

These scenarios raise important long-termpolicy issues. First, the changing savings andinvestment patterns will have consequencesfor net capital flows. Several developing coun-tries that in past decades have relied on netcapital inflows will find it harder to do so inthe coming 15 years. Indeed, the recent shiftfrom debt accumulation to debt reduction inmany of these countries is likely to heralda new long-term trend of further declinesin debt. If the expected increase in privatedomestic savings is accompanied by furthermaturing of domestic credit markets and isnot thwarted by deterioration of public sav-ings, then debt reduction will not conflict withthe investment patterns needed to underpingrowth.

Underlying large swings in net capital flowsare even larger movements of gross capitalflows, because FDI expands into growingmarkets in developing countries and becausefinancial agents in developing countries seekto diversify their portfolios in rich countries.These capital movements will require furtherinternational financial integration. Becausethe history of financial integration has notbeen entirely felicitous—and at times has beendamaging to growth and poverty reduction—


40

gep_ch01.qxd 12/5/02 4:16 PM


41

the international community and developingcountries have had to search for mechanismsto provide for greater stability in integration.

Developing countries can further facilitatepotential growth by improving their invest-ment climates. A sound policy environmentwill trigger investment flows and, more im-portant, will ensure that these flows go intointernationally competitive activities. A soundinvestment climate in developing countriescan also attract FDI, which is a form of less-volatile capital inflow.

Notes1. Examples of investment-grade borrowing coun-

tries are Chile, China, the Republic of Korea,Malaysia, Mexico, Thailand, and several CentralEuropean countries.

2. See Appendix 1, “Regional Economic Prospects,”for detail on recent developments, policy, and prospectsfor developing regions.

3. Simulation used the world model by OxfordEconomic Forecasting Inc.

4. Investment is the most cyclical component ofGDP and is the key driving force underlying the emer-gence of turning points in the economy. The flow ofinvestment expenditures is volatile because investment,unlike consumption, represents the desired change ofa stock. As the capital stock tends to move with incomeand consumption, the change in the stock showssharper fluctuations than the change in income. Fur-thermore, a downturn in investment is inherently tem-porary and bears the seeds of subsequent recovery.Once the lower desired capital stock has been achieved,the flow of investment stops falling and starts increas-ing again to keep the capital stock stable at the newlevel.

5. The trends are computed with Hendrick-Prescottfilters.

6. To reduce the potential risk of bad data contam-inating the results, we have excluded outliers (invest-ment volatility more than three standard deviationsabove the mean).

7. The correlation coefficient exceeds 0.75.8. The large drop in the poverty incidence in Latin

America comes from new surveys and from revisions toconsumption levels. The surveys predate the recent tur-moil in the region, particularly in Argentina, where theincidence of poverty has increased substantially afterthree years of recession. The large recent rise in povertyin Argentina reflects the national poverty line. The riseusing the World Bank’s $1 per day or $2 per day may

have a lower magnitude because average per capita in-come in Argentina ($12,100 in purchasing power par-ity terms in 2001, and $7,750 in 1995 terms) is muchhigher than the $2 per day level.

9. See, for example Datt and Ravallion (2002). 10. The growth rates are weighted by labor value

added, which may bias the regional estimates down-ward if high-wage countries have slower growth rates.Among other things, this method would affect a worldtotal because industrial countries have significantlyhigher wages than developing countries.

11. TFP is not the same as technical progress, butinstead includes all contributions to growth that arenot captured by data on capital and labor. However,the integration of more efficient technologies into pro-duction can raise the level of TFP.

12. Technically, only the fraction of capital accu-mulation that arises from the underlying propensity toinvest at a constant rate of TFP growth should beviewed as capital’s independent contribution to outputgrowth. Hulten (2000) found that correcting for theinduced capital accumulation caused by higher TFPalmost doubled estimates of the contribution of TFPto growth for the United States.

13. See Loayza, Fajnzylber, and Calderón (2002).14. We will use the term “workers” as shorthand

for the working population between ages 15 and 65.15. With the significant exception of SSA, where

AIDS has dramatically reversed life expectancy, and toa lesser extent ECA, where health systems deterioratedduring the transition toward market economies.

16. See, for example, Loayza, Fajnzylber, andCalderón (2002) and Masson, Bayoumi, and Samiei(1998).

17. Model simulations start in the base year 1997,and net capital flows for that year are derived from theGlobal Trade Analysis Project (GTAP), release 5.0,database. Note that the GTAP data, though based onofficial statistics, are adjusted to ensure global ac-counting consistency (that is, the sum of the capitalaccount across all regions is identically equal to zero).The world capital account has had a significant andincreasing residual over the past few years. The valuesin the first three columns of table 1.10 (that is, theaverage savings to investment ratios for the period1997–2001) are largely consistent with the initial 1997base levels from the GTAP dataset. The only regionwhere the sign of the capital account balance differs be-tween 1997 and the 1997–2001 average is the MENA,which is subject to considerable volatility because ofthe price of oil, the region’s main export.

For all other regions, the sign of the observed earlyperiod capital account balance is consistent with the1997 base year, though the magnitude may differ. Thedifference in magnitude is easily magnified because the

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capital account balance is a residual item. Thus, evenif there is little volatility in the savings and investmentcomponents individually, there could be significantlymore variation in the capital account balance.

Finally, as already highlighted in the table note, thecapital account imbalance at the global level has beenlarge of late—and is increasing. In the model simu-lations, the base data are adjusted to remove theglobal imbalance, and the model itself ensures globalaccounting consistency in each year of any simulation.(The model could track perfectly the observed savingand investment ratios for each country except one. Orthere would have to be a residual country in the modelthat would absorb any adjustments to ensure globalaccounting consistency.) Even if the global capitalaccount imbalance is small as a share of global GDP,squeezing out the $100 billion to 200 billion residualerror is bound to have significant effects on the capitalaccount of individual countries, even a large one suchas the United States. If the U.S. imbalance is $400 bil-lion and the entire adjustment is forced on it, the U.S.capital account imbalance could change by as much as50 percent.

18. Note that this concept is flow based. All indus-trial countries have significant assets in other industrialcountries as well as in developing countries. Onewould anticipate, as in the case of Japan, that as thepopulation ages, the retired elderly will draw downtheir accumulated savings, including those funds in-vested abroad.

19. Table 1.10 compares the observed investmentratios over the 1997–2001 period with the end-of-period investment ratio generated by the model. Thestarting point of the model, 1997, has an investmentratio of 20.5 for Latin America. Thus, the scenario isforecasting virtually no change in the ratio.

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