The outlook is subject to significant uncertainties
While the baseline forecast remains the most likely outcome, the outlook is subject to significant uncertainties. While the main tail-risks that have preoccupied the world economy over the past five years have subsided, the underlying challenges, though less acute, remain.
- In the Euro Area much has been achieved, and banks have gone a long way toward restructuring themselves, but there is still a long road ahead before all of the problems that the global financial crisis laid bare are fully resolved. In order to close the large output gaps that have opened, a strong acceleration in growth will be necessary, and the drivers of such growth remain unclear. Moreover with the banking sector still weak and details on a fully fledged banking union still being worked out, the currency bloc remains susceptible to shocks, including a tightening of policy in the United States.
Meanwhile significant amounts of spare capacity have opened up. On the one hand, pervasive youth and long-term unemployment are raising concerns about a permanent deterioration in job skills and employability of the jobless. At the same time, continued sharp credit contractions raise the specter of deflation, which could exacerbate debt overhang problems and result in a much more muted recovery than considered in the baseline.
- In the United States the general government deficit has also come down significantly, mainly through heavy spending cuts imposed by the sequester and rising tax revenues as the economy recovers. Nevertheless, little progress has been made to agree to a medium-term plan for bringing the debt-to-GDP ratio under control, and the risk of additional brinksmanship and an excessive and disruptive tightening of policy remains.
- In China concerns persist over the scale of investments being made, their medium-term profitability, and the viability of the loans taken out to finance them. Recognizing the challenge the authorities have made restructuring the economy toward greater reliance on consumer demand and services for growth. While now a core objective of Chinese policy, the challenge remains formidable. Even though it remains a tail risk, an abrupt unwinding of investment in China there remains a possibility, which if realized could sharply reduce GDP by 3 percent or more (see World Bank, Global Economic Prospects 2013a for more) with significant knock on effects in the region and other economies with close trading linkages (including commodity producer).
While disappointments along any of these fronts could slow growth, there are also potential upside risks. A forceful reinforcement of the structural component of Japanese policy, a multiyear agreement on fiscal policy in the United States and additional progress toward a banking union and recapitalization of European banks would all likely boost confidence and clear the way for a more forceful recovery in high-income countries.
On the upside, a stronger-than-expected recovery in high-income economies could provide considerable support to external demand in developing countries, helping offset downward adjustments in domestic demand triggered by rising global interest rates. Finally, lower food prices should also reduce inflation pressures and contain food import costs, although they are a negative for food exporters.