Preparing for continued global

Justin Yifu Lin When weather forecasters predict the uncertain path of hurricanes, they often tell local residents to "hope for the best, but prepare for the worst." This motto is appropriate for the current global economic climate and prospects for the developing world. Fiscal and financial stresses in Europe, along with fiscal risks in the United States, have dramatically raised uncertainty among investors and consumers globally. This unease increases the probability of less favorable growth scenarios for the year ahead and makes it imperative that developing countries absorb lessons from the 2008 crisis so they can be buffered amidst the storms that lie ahead. Call them tips for 2012 and beyond. Contagion has been spreading to financial markets in the developing world and no market is entirely immune. While developing countries, for the most part, recovered rapidly from the 2008-2009 crisis, their scope for counter-cyclical policies is more limited now than it was a few years ago. World Bank simulations show that, with increased unease, growth among developing countries may slow from about 6 percent in 2011 to around 5.5 percent in 2012, and high income country growth may fall below 2 percent in 2011 and 2012. Should the situation in high-income countries deteriorate sharply, much worse outcomes could be envisaged. The precise transmission mechanism from rich country financial problems to slower growth and diminished poverty reduction in the developing world varies from country to country. Transmission channels include trade links, financial system vulnerabilities, as well as the risks of curtailed trade and infrastructure finance. Following are five actions that developing country policy makers can consider when "preparing for the worst": (1) Review fiscal space and reduce inefficiency in public spending. Fiscal space is smaller in many developing countries today than it was leading into the crisis that began in 2008. Forty-two percent of developing countries had a fiscal deficit of 4 percent of GDP or more in 2010. Governments need to identify areas for savings and new sources of revenue to create fiscal space for countercyclical interventions in the event of another conflagration. Problems are likely to be particularly acute for the 50-odd developing countries with external financing needs that exceed 5 percent of GDP. To the extent possible, countries burdened by significant maturing short and long term debt and current account deficits should seek to pre-finance these needs immediately to avoid an abrupt cut in government and private-sector spending later. Fiscal pressures could be particularly intense for oil and metals exporting countries. Falling commodity prices would cut into government revenues, causing government balances in oil exporting countries to deteriorate significantly. (2) Identify new drivers of growth. If the global economy enters a period of protracted slow growth, for countercyclical interventions to work, a focus is needed on projects that create jobs in the short term and enhance productivity and growth in the future. Governments should identify and prepare a list of those types of "investment ready" projects to promote medium-term growth rather than just "shovel ready" projects for short-term demand stimulus. Infrastructure bottlenecks, green investments, and vocational training are likely candidates. If governments can help launch such projects and programs, they can shift from a reactive crisis mode to a stance that fosters opportunities for long-term, sustainable growth. (3) Monitor the banking system to avoid banking crises. Governments need to monitor the soundness of their own financial systems and build resilience to shocks. The last crisis revealed that exposure to foreign banking systems can create vulnerabilities. Such exposure places a premium on having adequate regulatory, supervisory and resolution regimes. Such safeguards help mitigate incipient problems originating in particularly vulnerable or weak financial institutions. Since 2008, many developing countries have engaged in expansionary monetary and credit policies as well as state-owned bank lending to support the recovery. Some economies may be overheating, leading to the risk of asset price bubbles (for example in real estate or equity markets). Another risk relates to faster deleveraging in the financial sector. Several countries in Europe and Central Asia that rely on high-income European banks for day-to-day operations could be subject to a sharp reduction in wholesale funding and domestic banking activity. If such banks are forced to sell-off foreign subsidiaries, valuations of foreign and domestically owned banks in countries with large foreign presences could decline abruptly - possibly reducing banks' capital adequacy ratios. More generally, a downturn in growth and continued downward adjustment in asset prices could rapidly increase the number of non-performing loans throughout the developing world. To prevent such conditions from provoking domestic banking crises, particularly in countries where credit has increased significantly in recent years, countries should stress test their domestic banking sectors. (4) Strengthen social safety nets. Governments need to prepare to protect the vulnerable. The limitations on fiscal space imply the need for improved targeting of social programs. A number of developing countries enhanced safety net programs during 2008-2009. One can use the data and country case studies from that period to improve and expand programs. World Bank social policy experts have been working on synthesizing lessons from such nationwide programs as Bolsa Familia in Brazil and Oportunidades in Mexico. It is imperative to strengthen programs before a crisis hits. (5) Push for reforms that may not be easy in normal times. The 2008-2009 crisis and today's current volatility originated outside the developing world. This can be a moment when domestic political economy constraints might be overcome in the name of responding to economic risks created by external factors. Cutting waste and improving the quality of public spending can have permanent and positive impacts on public sector efficiency over the long-term (including "green" investment). A good example is wasteful subsidies for energy use - in particular, oil-which distort incentives towards environmentally damaging activities and which also tend to be regressive. In brief, this is an opportunity to prepare some necessary reforms that improve the long-term prospects for development and that can be implemented quickly in the event of a full blown crisis. In an interconnected world, developing countries cannot be immune to contagion originating in advanced countries. If developing countries are well prepared, they can weather through a squall or full blown hurricane and contribute to the global recovery. There are win-win linkages between developing countries and global prosperity. Developing countries have been an engine driving the global economy, contributing about two-thirds of global growth in the past five years. Sustaining momentum in these economies is important not only for their continued development, but also for global stability. (The writer is the Senior Vice President for Development Economics and Chief Economist of the World Bank Group)