The global economic recovery that is now underway will slow later this year as the impact of fiscal stimulus wanes. Financial markets remain troubled and private sector demand lags amid high unemployment, according to a new report from the World Bank.

Global Economic Prospects 2010, released today, warns that while the worst of the financial crisis may be over, the global recovery is fragile. It predicts that the fallout from the crisis will change the landscape for finance and growth over the next 10 years.

Global GDP, which declined by 2.2 percent in 2009, is expected to grow 2.7 percent this year and 3.2 percent in 2011 (or -1, 3.5 and 4 percent when aggregated using Purchasing Power Parity weights). Prospects for developing countries are for a relatively robust recovery, growing 5.2 percent this year and 5.8 percent in 2011 -- up from 1.2 percent in 2009. GDP in rich countries, which declined by 3.3 percent in 2009, is expected to increase much less quickly -- by 1.8 and 2.3 percent in 2010 and 2011. World trade volumes, which fell by a staggering 14.4 percent in 2009, are projected to expand by 4.3 and 6.2 percent this year and in 2011.

While this is the most likely scenario, considerable uncertainty continues to cloud the outlook. Depending on consumer and business confidence in the next few quarters and the timing of fiscal and monetary stimulus withdrawal, growth in 2011 could be as low as 2.5 percent and as high as 3.4 percent.

"Unfortunately, we cannot expect an overnight recovery from this deep and painful crisis, because it will take many years for economies and jobs to be rebuilt. The toll on the poor will be very real," said Justin Lin, World Bank Chief Economist and Senior Vice President, Development Economics. "The poorest countries, those that rely on grants or subsidized lending, may require an additional US$35-50 billion in funding just to sustain pre-crisis social programs."

In this still weak environment, oil prices are expected to remain broadly stable, averaging about US$76 a barrel; and other commodity prices should rise by only 3 percent per year on average during 2010 and 2011.

The report warns that, despite the return to positive growth, it will take several years before economies recoup the losses already endured. It estimates that about 64 million more people will be living in extreme poverty (on less than US$1.25 a day) in 2010 than would have been the case had the crisis not occurred.

Further, over the next 5 to 10 years, increased risk aversion, a more prudent regulatory stance, and the need to curb some of the riskier lending practices during the boom period that preceded the crisis can be expected to result in scarcer, more expensive capital for developing countries.

"As international financial conditions tighten, firms in developing countries will face higher borrowing costs, lower levels of credit, and reduced international capital flows. As a result, over the next 5 to 7 years, trend growth rates in developing countries may be 0.2 to 0.7 percent lower than they would have been had finance remained as abundant and inexpensive as in the boom period," said Andrew Burns, lead author of the report.

While all forms of finance are likely to be affected, foreign direct investment (FDI) should be less constrained than debt flows. However, parent firms will face higher capital costs, reducing their ability to finance individual products. As a result, FDI inflows are projected to decline from recent peaks of 3.9 percent of developing country GDP in 2007 to around 2.8-3.0 percent over the medium term. The consequences of such a decline could be serious, as FDI represents as much as 20 percent of total investment in Sub-Saharan Africa, Europe and Central Asia and Latin America.

"While developing countries cannot avoid tighter international financial conditions, they can and should reduce domestic borrowing costs and promote local capital markets by expanding regional financial centers and improving competition and regulation in local banking sectors," said Hans Timmer, Director of the World Bank Prospects Group. "Although likely to take time to bear fruit, such steps could expand access to capital and help put developing countries back on the higher growth track from which they were derailed by the crisis."

The report finds that very relaxed international financial conditions from 2003 through 2007 contributed to the boom in developing country finance and growth. Much lower borrowing costs caused both international capital flows and domestic bank lending to expand, which contributed to a 30 percent increase in investment rates in developing countries. The resulting rapid expansion of the capital stock explained more than half of the 1.5 percentage point increase in the rate of growth of potential output among developing countries.

While very strong developing country growth during the boom period may reflect underlying growth potential, the global financial conditions that fueled it were clearly unsustainable.

(China Development Gateway January 25, 2010)