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Recent Developments

Weak global activity in the first quarter reflected unusually severe weather in the US, conflict in the Ukraine and weak growth in several major middle-income economies. Global financial markets also suffered from a bout of turbulence in late January. Activity has since then shown signs of strengthening in developing countries, and rebounded in the US. Global financial conditions have also turned supportive. Stable or declining commodity prices have been a positive for commodity importers but a negative for exporters.

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More than five years into a painfully slow recovery, high income economies are stirring back into life. Idiosyncratic factors, including weather conditions, have weighed on growth in Q1. But in the three major high-income regions – the US, Euro Area and Japan – there are indications that private spending is beginning to heal, helped by improvements in job markets and progress with balance sheet adjustments which, in the case of the US, have drawn to a close. In the Euro Area and the United States a significant easing in the pace of fiscal consolidation is contributing to the pickup in demand, and business confidence in both remains high (figure 1).

Traditional monetary policy in all three economies remains very loose, though the United States is slowly reducing the scope of its quantitative easing program. In Japan, quantitative easing measures have intensified, while further steps were recently taken in the Euro Area to combat the risk of deflation.

FIGURE 1 Despite some Q1 weakening, business sentiment in Europe and the US signals further expansion
Source: World Bank, Markit Economics.

Bad weather temporarily slowed the US recovery

Incoming data in the US suggest that the economy is rebounding strongly after contracting for the first time in three years in Q1, when abnormally cold weather curtailed investment and exports, while firms cut back on inventories. Despite the weakness, more than half a million jobs were added in Q1, with current trends implying that some 2.6 million jobs will be added this year, the most since 1999. This, coupled with reduced fiscal drag, rising household incomes and wealth (stocks are up some 32 percent since the start of 2013) is boosting demand, business productivity, investment and hiring – and is expected to lead to even stronger growth. With deleveraging at an end, consumer lending is also growing at the same pace as in pre-crisis years. Surveys indicate a strong pick up in the second half of the year in business investment, which has so far lagged the recovery.

Nevertheless, although the short-term environment is much improved, medium-term challenges remain. Little progress has been made to bring fiscal policy back to a sustainable path, and, although unemployment is down, participation rates are at record lows raising concerns that workers may suffer from de-skilling and permanent labor market-scarring.

The recovery in the Euro Area remains hesitant


Growth has meanwhile remained tepid in the Euro Area following its exit from recession in 2013Q1, with the currency union growing at a 0.8 percent annualized pace in Q1 (figure 2). In part, the data reflect genuine economic fragility—Portugal’s and Italy’s economies contracted after pulling out of recession during 2013. But data has also been noisy, reflecting one-off factors that should fade over time, including unusually strong contraction in gas production in the Netherlands due to warm weather, that led to a contraction in GDP, and a VAT increase in France that undermined consumption.

Importantly, soft Q1 data mask signs of strength in Germany, the Euro Area’s largest economy and a key source of demand for the rest of Europe. Growth in Germany accelerated to a solid 3.3 percent annualized pace, the strongest in 3 years led by private domestic demand. Euro Area-wide manufacturing and service PMIs also show a broadly-based improvement in activity that is gathering momentum in Q2.

FIGURE 2 Economic activity is strengthening from very weak levels in the Europe
Source: World Bank, Haver Analytics. High-spread countries comprise Italy, Greece, Portugal, Ireland and Spain.

The Euro Area is still in the early phases of recovery. GDP and private consumption spending in some periphery economies remain nearly 10 percent below pre-crisis peaks and investment is 40-50 percent lower in Spain, Portugal and Ireland. To date the recovery in the periphery has been driven by exports, reflecting competitiveness gains earned painfully through weak or even negative wage growth that have brought down unit labor costs. Competitiveness gains continue to remain strong, supporting underlying activity. Encouragingly, there are signs that the labor market may be bottoming out, with unemployment rates throughout the Euro Area beginning to inch down, albeit from extremely high levels. Financial conditions have also eased considerably, reflected in the fall in periphery sovereign debt spreads to pre-crisis lows.

In addition to substantial progress in restoring fiscal balance within the Euro Area, the establishment of a pan-European banking supervision regime and bailout rules represent important achievements. However there is some way to go before full backstop measures are in place to cope with large-scale banking sector distress. Bank lending also continues to contract, although this weakness partly reflects a transition from a loan-based financing model to increased use of bond markets as an alternative source of financing for the corporate sector (ECB, 2013). Persistently low Euro Area-wide inflation also remains a concern (figure 3), complicating the task of dealing with high public debt burdens and still high levels of private sector indebtedness in some periphery economies. As a result, the ECB loosened monetary policy substantially in June, via cuts in its benchmark rate and a substantial injection of liquidity and credit easing measures including a Targeted Long Term Refinancing operation (TLTRO) in a bid to restore bank lending to households and firms (see box 1).

FIGURE 3 Inflation and unemployment trends are on divergent paths across the major economies
Source: World Bank, OECD, ECB, Consensus Economics. *2014 Q3 and 2015Q3 estimates are from Consensus Economics. ** NAIRU refers to non-inflationary rate of unemployment: 6.1% in US, 9.1% in Euro Area and 4.3% in Japan.

In Japan, spending in advance of the sales tax increase boosted Q1 growth but will eat into Q2 outturns even as structural reforms get underway

Japan’s economic cycle remains out of sync with other high income economies, reflecting domestic policy factors. The extremely strong acceleration in Q1 GDP (to 5.9 percent annualized) reflected a one-off front-loading of demand by consumers before the April sales tax hike, and extremely strong business spending which may also have been influenced by the tax increase. Business confidence indicators slid sharply in April but have since slightly recovered, suggesting activity is stabilizing.

The structural reform agenda—necessary for boosting productivity and potential growth—has begun to advance. Special economic zones, where business and labor regulations are to be eased, have been announced covering 38 percent of economic activity and corporate tax reforms are expected to be announced in June, which should help boost investment.

Nevertheless, the near term outlook remains challenging. Fiscal drag from the April tax increase will likely slow growth, although the effects of this will be partially offset by the fiscal and monetary stimulus which is currently being implemented. Finally, over the medium-term, the pace of growth will depend on how successful structural reforms are in increasing productivity growth and investment and in mobilizing labor supply.

Overall economic activity in developing countries slowed in early 2014 (see box 2 and the regional outlooks webpages for a detailed summary of recent developments). Developing country industrial production grew at a 3.7 percent annualized pace during the first quarter of 2014 well off the average of 7.6 percent between 2000 and 2013.

Much of the aggregate slowdown reflected weakness in China (figure 4). Chinese first quarter GDP expanded at only a 5.8 percent annualized rate with industrial production decelerating sharply. Among other factors, China’s slowing was due to financial re-regulation designed to rectify past misallocation of credit. As a result, the pace of total aggregate financing is estimated to have slowed by some 9 percentage points in 2013, with tighter financing conditions reflected in an increasing frequency of defaults in bond markets and the shadow banking sector; and rising onshore corporate bond yields.

FIGURE 4 Developing country activity is strengthening but at a modest pace
Source: World Bank, Markit Economics.

Weakness was evident elsewhere too. Barring India, Mexico and Philippines where GDP growth accelerated slightly in Q1, the pace of growth slowed in Indonesia, Mongolia, Malaysia and Brazil, turned negative in South Africa and Peru, while particularly sharp contractions (between 8-12 percent annualized) occurred in Ukraine, Thailand and Morocco which will affect annual growth outturns in these economies. The weakness reflects a combination of factors including knock-on effects from the severe winter in the US, political tensions (Thailand, Ukraine and Turkey), labor unrest (South Africa), capacity constraints, declining commodity prices (a negative for exporters), and monetary policy tightening following last summer’s turmoil all played a role.

Business sentiment data suggest strengthening activity in Q2 in East Asia and South Asia

Nonetheless in many developing countries, industrial output is beginning to accelerate, often in tandem with export growth. In China there are signs of a tentative turnaround: industrial output growth accelerated to 5.1 percent (3m/3m saar) in April, while May PMIs rose to a five-month high (figure 5), boding well for momentum in Q2. The improvement follows a strengthening in exports and the announcement of a 2.5 percent of GDP growth support package announced in March. Another (modest) package of targeted measures was announced in late May, which should support sentiment and activity further. That said, there remain concerns that China’s property boom, which has been a major driver of growth in recent years1, may be drawing to a close as rising stocks of unsold apartments, combined with credit tightening put pressure on prices and stall residential investment demand.

FIGURE 5 Manufacturing surveys are pointing to continued expansion in East Asia and South Asia
Source: World Bank, Haver.

Industrial production in the rest of the developing world grew at 2.3 percent in Q1 (after contracting slightly in Q4 2013). Activity has been the strongest in developing Europe and Central Asia despite the turmoil in Ukraine, with industrial output rising at a 13 percent pace in Q1, boosted by demand in the Euro Area. A deterioration in business sentiment—reflecting a sharp tightening of policy during Q1 in Turkey and the confidence effects from the crisis in Ukraine—suggest that an export-driven rebound in Q1 is fading with PMIs pointing to muted output growth going forward.

Industrial output in India expanded at a 3.5 percent annualized pace in Q1 after a 4.8 percent contraction in 2013Q4, with May PMI surveys indicating further improvements in business conditions albeit at a modest pace. In East Asia, business confidence in Indonesia has improved as price pressures have stabilized and currency pressures have eased, and sentiment continues to show solid expansion in Vietnam despite the recent unrest. The outlier is Thailand, where political tensions have caused a sharp slide in industrial output at a 16.5 percent annualized pace in the three months to April.

In contrast, confidence in Latin America and South Africa has fallen sharply due to domestic weakness. In Latin America, a challenging economic environment and weak domestic demand in Brazil have contributed to the downshift in PMIs. Activity is also subdued in Mexico, but improving order books suggest that the outlook there is improving.

1. Property investment in China accounts for about 16 percent of GDP by some estimates, and possibly even more. According to estimates by Moody’s Analytics, the building, sale and outfitting of apartments accounted for 23 percent of GDP in 2013.

A cyclical deceleration in growth in developing countries to more sustainable rates in recent years and modest monetary tightening over the past year have helped to narrow the large positive output gaps that characterized the immediate post-crisis period (see January 2014 edition of Global Economic Prospects and figure 6). This has helped unwind excess demand pressures (generated during the pre-crisis boom years and by counter-cyclical policies in the post-crisis period) that contributed to a build up in external imbalances and domestic vulnerabilities in several developing countries.

Nevertheless, activity continues to grow broadly in line with potential. As a result, output gaps remain positive and capacity constraints prominent, suggesting limited scope for a sharp acceleration, particularly in East Asia and Latin America. This is also the case for developing Europe and Central Asia where (negative) gaps have all but closed as the region has recovered from the crisis, and to a lesser extent in Sub-Saharan Africa due to robust domestic demand that has powered growth in recent years.

FIGURE 6 Output gaps remain small in most developing regions
Source: World Bank.

The main exception to this observation is the Middle East and North Africa where yawning negative gaps between actual and potential output have continued to expand amid persistent socio-economic and political tensions and following substantial disruptions to oil production last year.

After the turmoil that accompanied speculation about the end to quantitative easing in the United States, financial markets calmed in the fall of 2013. And the actual beginning of the taper was greeted with a muted reaction by financial markets, with US long term bond yields actually narrowing slightly.

That initial calm was interrupted toward the end of January 2014, when equity markets began a broadly-based sell-off provoked by a string of adverse news, including slowing growth and default risk in the shadow-banking sector in China, the devaluation of the Argentine peso and increased political tensions in several middle income economies. Capital flows to developing countries plummeted 65 percent in February driven mainly by an 80 percent decline in bond flows (figure 7) and the currencies of many developing countries depreciated vis-à-vis the USD, but by less than in the summer (see box 3).

FIGURE 7 Capital flows have recovered strongly after a steep fall in February
Source: World Bank.

The equity selloff that ensued hit both high-income and developing-country stock-markets about equally hard (6.2 percent in developing countries and -5.8 percent in high-income markets). The selloff provoked modest flight to safety flows, that pushed down US long term yields 45 basis points compared with their peak of 3 percent in late December and caused a 60 basis points spike in developing country bond spreads. Overall, developing country yields rose slightly less than 20 bps.

The market jitters were relatively short-lived and capital flows to developing countries bounced back to an average of $54 billion since March, more than fully recouping the February weakness. The strength of the rebound in bond financing flows meant that volumes for the first quarter exceeded those in 2013 Q4, with the bulk headed towards corporations in Latin America and the Caribbean region (mainly Brazil and Mexico).

Developing country stock markets have also recovered, in many cases surpassing levels at the start of the year and relative to a year ago (figure 8). In part, the recovery in flows reflects a resurgence in carry trade investments, with investors borrowing at low rates in high-income countries to earn higher returns in middle-income countries (notably Brazil, Turkey, India and Indonesia).

Developing country borrowing costs have fallen, led by declining spreads

Notwithstanding the brief episode of volatility in late January, and in contrast with previous expectations of a gradual normalization in long term interest rates and risk premia, global financial conditions for developing countries have eased significantly since the end of last year. Developing country sovereign borrowing costs fell to 5.2 percent in early June from 6.7 percent in early September last year, unwinding more than half of the 2.3 percentage points increase in financing costs that occurred during the spring and summer of 2013 (figure 9).

Part of the fall can be attributed to declining high income benchmark yields, amid growing expectations that central banks in the US, Japan and Europe will hold long-term interest rates low for longer than had been expected to support domestic recoveries and, in the case of the Euro Area, initiate new credit easing measures to ward off deflation threats.

FIGURE 8 Most developing country equity markets have fully recouped losses since mid-2013
Source: World Bank.* As of 20th May.
FIGURE 9 Borrowing costs have fallen since the start of the year for developing countries
Source: World Bank.

Two-thirds of the decline in developing country borrowing costs is due to a compression in spreads (the difference between the yield on a 10-year sovereign bond and that of the US 10-year treasury). The narrowing —amounting to about 110 basis points since late August 2013—has been underpinned by multiple factors including an easing in financial market tensions since the start of the year, a renewed search for yield (reflected in the strong rebound in bond financing flows to developing countries since February) and the policy and economic adjustments in major middle-income countries that have helped to reduce vulnerabilities in these economies.

As a result, overall financing costs for developing countries remain much lower than in the immediate pre-crisis years and are well below average costs at the start of the 2000s (figure 9). This in turn has allowed a growing number of sovereign borrowers to return to markets in recent months including low- or un-rated sovereign borrowers such as Pakistan and Ukraine.

Falling or even stable commodity prices (figure 10) have helped ease inflationary pressures (just as their earlier rise contributed to them), particularly in low-income countries. As such, recent commodity price developments have been positive for commodity importing countries. For exporters, however, the story is mixed. Stable and still high energy prices have been good for oil exporters, but falling metals and food prices have cut into incomes and government revenues in a number of developing-country exporters.

While impacts so far have been manageable for most producers, income effects over the past year have exceeded 1 percent of GDP in several producers (figure 11). Should energy prices fall or metal prices extend their losses they could slow growth in commodity exporting countries, and add to current account and fiscal difficulties in some countries. Already the declines in metal prices that have been observed in 2014Q1 are likely to weigh on growth and government finances of major copper, iron ore and coal producers (such as Mongolia and Zambia) where expanding budgetary outlays and lack of fiscal restraint in recent years have increased vulnerabilities.

FIGURE 10 Metal prices have extended their falls while food prices have turned up
Source: World Bank.
FIGURE 11 Commodity exporters have suffered significant terms of trade losses over the past year
Source: World Bank. * Terms of trade impact evaluated in terms of difference between 2014 forecast and average 2013 commodity prices.

Recent upticks in grain prices come despite good supply conditions, perhaps reflecting El Niño worries

Dry weather in South America (and to a lesser extent South East Asia) put pressure in internationally traded food prices during Q1 bringing an end to the steady decline of 18.4 percent since mid-2012 of the USD price of most food commodities including soybeans and sugar. Since then, most grain and oilseed prices began weakening following the release of the U.S. Department of Agriculture’s first assessment of the 2014/15 season. The outlook projects record maize and rice production at 979 and 481 million tons and stock-to-use (S/U) ratios of 18.8 and 22.9 percent for 2014/15, somewhat higher than long term averages. The outlook for wheat remains relatively tight, however, with production expected at 697 million tons, down 2.4 percent from the current season. Nevertheless wheat’s S/U ratio is expected to rise marginally due to lower feed use.

Price risks remain on the upside. The adverse weather conditions and the associated uptick in food prices at the start of the year have been linked to the El Niño phenomenon, which can inflict heavy damage on crops.2 The U.S. National Oceanic and Atmospheric Administration and Australia's Bureau of Meteorology gives a 65–70 percent likelihood that this could be an El Niño year. Global yields of rice, which grow at 1.7 percent per annum in normal years, grew only 0.7 percent during the five strong El Niño years (figure 12). Growth in wheat yields experienced similar declines (from 2.1 to 1.4 percent per annum).

FIGURE 12 If 2014 is an El Nino year, global grain yields could suffer, pushing up prices
Source: World Bank.

From a regional perspective, El Niño tends to inflict considerable damage to crops in South America (mainly rice and wheat), South East Asia (mostly rice), and Australia (wheat). Oilseeds (especially soybeans), edible oils (soybean and palm oil), and tropical beverages (coffee) could be affected as well. Rice and wheat production in South America, which grew at 2.6 and 4.7 percent, respectively, during 1960-2013, contracted by 3.9 percent (rice) or grew only 0.7 percent (wheat) during the five strong El Niño episodes. Likewise, rice production in South-East Asia, which grew at 2.6 percent during 1960-2013, experienced no growth during El Niño. Wheat production in Australia grew at 10.3 percent during the past 5 decades but experienced a 27 percent decline during the strong El Niño years.

Further upside price risks also stem from tensions in Ukraine. Between 2010-13, Russia and Ukraine accounted for 11 percent and 5 percent of global wheat exports, and Ukraine accounted for more than 14 percent of global maize exports. While the risks of disruption are low (only about 13 percent of Ukraine agricultural production grows in the conflict zones of the country), any shortfall in supplies that occurs in tandem with the El Niño phenomenon could lead to significantly higher prices, and pressures on current account and fiscal deficits among large importers in the Middle East and Sub-Saharan Africa.3

Robust supply and weakening Chinese demand weigh on metals prices

In contrast to food commodities, prices of internationally traded industrial metals have trended lower in Q1 after being mostly flat during the second half of last year. Copper and iron-ore prices have fallen sharply in the first five months of 2014 (by 5.5 and 21.5 percent respectively), extending cumulative declines since peaks in 2011 to 30 and 46 percent. The longer term decline in metal prices reflects moderate demand growth and a strong supply response, the latter a result of increased investment of the past few years.

Base metal prospects remain critically dependent on developments in China, which accounts for almost 45 percent of global metal demand — some of it stock-piled for use as collateral in the shadow banking sector. Industrial demand for metals could recover in the near term to the extent that the recent stimulus package supports a rebound in activity. Ongoing financial reforms and efforts to regulate the shadow banking sector have raised stockpiling and funding costs, putting downward pressure on copper and iron ore prices, and could prompt further de-stocking and weaker prices.

Energy prices have been surprisingly stable, but increased supply from the Middle-East could exert downward pressure

Energy prices have been range-bound since 2012 and volatility has decreased (World Bank 2014A). Rising supplies of unconventional oil and natural gas from the US; efficiency gains globally; and ongoing substitution away from hydrocarbons due to their still high prices has fully offset the impact of disruptions in Middle East supply.

With oil production scaling up rapidly in the Middle East, oil prices risk further falls, especially if Iran is able to negotiate an end to sanctions. Coal prices have declined more than 40 percent since 2011 reflecting slower demand in China but also rising global supplies from highly competitive producers in Australia, Russia and North America. Of course, the situation in Ukraine, represents upside risk. In the event of a physical disruption in supplies, prices could spike rapidly.

2. The El Niño phenomenon is a prolonged warming of the Equatorial Pacific that occurs every 3-4 years. It lasts 12-18 months and negatively affects crop conditions, especially in the Southern Hemisphere. According to NOAA’s Oceanic Niño Index, there have been five strong El Niño episodes since 1960 (the last and strongest on record occurred in 1997-98) and another seven moderate episodes (the last in 2009-10).

3. Sub-Saharan Africa and Middle East and North Africa are the two regions most dependent on imported wheat. For example, all wheat in Angola, Burkina Faso, Cameroon, Cote d'Ivoire and both Congos is imported. Egypt, Libya and all Gulf States are importing most of their wheat as well. In volume terms, Egypt is the world's largest importer (7 percent of global imports), followed by Algeria (4 percent), Nigeria, and Iran (3 percent each). For many of these countries Russia is a key supplier. More than one third of Russian wheat exports are destined for Egypt, followed by Turkey (15 percent), Yemen and Libya (4 percent each).

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  1. FIGURE 1Despite some Q1 weakening, business sentiment in Europe and the US signals further expansion
  2. FIGURE 2Economic activity is strengthening from very weak levels in the Europe
  3. FIGURE 3Inflation and unemployment trends are on divergent paths across the major economies
  4. BOX 1Credit easing in the Euro Area could have significant positive trade and financial spillovers, but may also expose currency mismatches in some countries
  1. FIGURE B1.1Net capital flows and net financial exposures
  2. BOX 2Recent regional economic developments
  3. FIGURE 4Developing country activity is strengthening but at a modest pace
  4. FIGURE 5Manufacturing surveys are pointing to continued expansion in East Asia and South Asia
  5. FIGURE 6Output gaps remain small in most developing regions
  6. FIGURE 7Capital flows have recovered strongly after a steep fall in February
  7. BOX 3Exchange rate pressure during the January/February turmoil episode has been less pronounced than earlier episodes
  1. FIGURE B3.1Currency depreciations were more modest during the winter turmoil among countries that reduced external imbalances
  2. FIGURE B3.2Distribution of changes in developing country bilateral exchange rates with the US$
  3. FIGURE 8Most developing country equity markets have fully recouped losses since mid-2013
  4. FIGURE 9Borrowing costs have fallen since the start of the year for developing countries
  5. FIGURE 10Metal prices have extended their falls while food prices have turned up
  6. FIGURE 11Commodity exporters have suffered significant terms of trade losses over the past year
  7. FIGURE 12If 2014 is an El Nino year, global grain yields could suffer, pushing up prices
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