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Rebalancing, retrenchment and reforms will prove much harder to deliver than stimulus

Developing countries responded to the 2007–08 global financial crisis by deploying fiscal and monetary stimulus. However, with fiscal and current account deficits some 3 percent or more of GDP higher in most countries than before the crisis, the scope for such reactions has declined greatly.

More to the point, for most developing countries improved growth will have to come from supply-side reforms that increase underlying growth potential.

Given the risks that developing countries are facing, policy makers need to give thought now to how they would respond to a sharp deterioration in external conditions. Appropriate policy responses will vary from country to country but may include a tightening of monetary policy to reduce vulnerabilities and attract capital, controlled depreciations (particularly for economies with flexible exchange regimes and overvalued exchange rates), and the prudent use of capital controls and macro-prudential regulations. These measures may need to be supplemented by policy reforms—for example, as being done in Mexico and China. By improving the longer-term growth outlook, credible reform agendas can go a long way toward boosting investor and market confidence and potentially set in motion a virtuous cycle of stronger investment, including foreign investment, and output growth over the medium term.

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