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Global Economic Prospects June 2011: Subject Annex

Global industrial production has rebounded inthe fourth quarter of 2010 following the pause in

global growth in the third quarter, only tomoderate again by the end of the first quarter of2011. The growth slowdown in the third quarter

appears to have mainly reflected an inventorycycle, as underlying demand growth (proxied by

GDP) continued to expand at a more-than 1.5 percent annualized rate (figure IP.1). Indeveloping countries output accelerated

beginning in the fourth quarter of 2010, and bythe end of the first quarter of 2011, industrialactivity in developing countries was expandingat a 13.4 percent annualized pace. In high-

income countries industrial production growthdecelerated sharply to 6.4 percent in the threemonth to March, from 15.3 percent in the threemonths to February, on account of a sharp 15.5

percent month-on-month decline in Japanese

industrial production in March. Excluding Japan,growth in high-income countries was 7.9 percentin the three months to March, up from 6.7

percent in the fourth quarter of 2010.

The acceleration in the seasonally adjusted

annualized rate of growth in developing

countries was broadly-based, with the strongestpace recorded among countries in the East Asia

and Pacific (18.7 percent in March before easingto 15 percent in April), and Latin America and

the Caribbean (10.3 percent). Growth inindustrial production in Europe and Central Asiaregions was 9.8 percent in the three months to

March before decelerating to 3.8 percent byApril, while production rose to 8.7 percent in

South Asia in the three months to March, and to6.8 percent in the three months to February inthe 4 Sub-Saharan African countries reporting

data.

The good performance in industrial production

has been underpinned by buoyant domestic

demand in developing countries and a moderaterecovery in high-income consumer spending.Slowly improving labor markets in several high-income countries have contributed to a return to

solid retail sales volume growth. At the sametime, the expiration of various incentive

programs in both high-income and developingcountries has contributed to volatility. Forexample, Chinese retail sales volumes growth

slowed to 11.4 percent by March 2011 from 17.8 percent a year earlier, in part because of the

expiry of new-car sales tax incentives.

Nonetheless, global retail sales has posted positive annual growth for the last two years,

with gains in developing countries (in a range of7 to 15 percent annualized) while growth in high

-income countries remained subdued (figure

Industrial Production Annex

Figure IP.1 Recent rebound in Industrial pro-

duction following mid-year pause reflects inven-

tory cycle

Source: Thomson/Reuters Datastream; World Bank.

-40

-30

-20

-10

0

10

20

-10

-8

-6

-4

-2

0

2

4

6

Q1-08 Q3-08 Q1-09 Q3-09 Q1-10 Q3-10 Q1-2011

World real GDP growth, quarterly ch% q/q saar.Sample of 50 high-income and developing countries

GDP left

IP right

Quarterly GDP growth, % (saar) Monthly industrial production growth,

% (3m/3m saar)

Figure IP.2 Retail sales support growth

Source: Thomson Datastream and World Bank.

-10

-5

0

5

10

15

20

25

Jan-06 Nov-06 Sep-07 Jul-08 May-09 Mar-10 Jan-11

High-income

China

Developing countries,excl China

percent, y/y

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IP.2).

Many economies are now close to their pre-crisis peaks in industrial production, with emergingeconomies faring better than high-income

countries (first panel, figure IP.3a). Industrial

production in China is now more than 40 percentabove its pre-crisis peak, and 36 percent higherfor the East Asia region considered as a whole.Production in South Asia continues to grow

strongly, and stands 21.4 percent higher than before the crisis peak, while Latin America and

the Caribbean, Europe and Central Asia, and theMiddle East and North Africa have yet to exceed

earlier peaks levels.

Manufacturing capacity is now close to or abovetrend levels in East Asia & Pacific, Latin

America and South Asia. In these regions therecovery has entered a new more mature phasewhere additional investment in productive

capacity will be necessary to sustain growthahead. Ample spare capacity remains in Europe& Central Asia and the Middle East & NorthAfrica, with gaps estimated to be 14 percent and

around 12 percent respectively. Spare capacityfor the four countries in Sub-Saharan Africa forwhich data is available is also large at 9.2

percent (second panel, figure IP.3b).

To date only limited data (through February) areavailable for industrial production in the Middle-East and North Africa region. In Tunisia

industrial production reportedly dropped 9.2

percent in the first quarter of 2011 over the same period of 2010, and on a seasonally adjustedannualized basis, output contracted 38 percent.

In Egypt industrial production was down 8.3 percent year-on-year in the first two months of

2011, and 51.5 percent on a seasonally adjustedannualized rate relative to the previous twomonths. Industrial production is likely to begin

to recover only modestly in following months.

Accounting for the impact of the Japanese

Earthquake, Tsunami and nuclear crisis

The earthquake and Tsunami in Japan have alsodisrupted global industrial production. Current

estimates suggest that damage from the Tohokuearthquake and Tsunami is significantly larger

than that sustained following the Kobeearthquake in 1995. The impact of the Kobeearthquake on Japanese and global economic

activity was relatively modest (a one-monthdecline of 1.6 percent in Japanese industrial

production and of 8.4 percent in exportsfollowed by a 14 percent increaseand no

discernible effect on quarterly GDP). Ifanything, the boost to private and publicinvestment associated with the reconstruction

effort was a net positive for GDP growth (table

IP.1).

The current crisis is different because of themuch larger disruption to Japans electrical

Figure IP.3a Most countries are yet to reach their

pre-crisis industrial production peak

Source: Thomson Datastream and World Bank.

60

70

80

90

100

110

120

130

140

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11

USA

China

Other developingcountries

Japan

Other high-incomecountries

pre-crisis peak = 100

Figure IP.3b Industrial capacity utilization in Asia

and Latin America approaches trend rates

3.2 2.9 1.4-9.2 -11.9 -14.4

-60

-40

-20

0

20

40

60

South Asia East Asia &

Pacific

Latin Am. &

Caribbean

Sub-Saharan

Africa

Middle East

& N. Africa

Europe &

Central Asia

median percentage difference from long-term trend andwithin-region country sample-variation

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generating and distribution capacity, which hasforced Japanese utilities to institute rolling

blackouts that have contributed to plant

shutdowns. About of the disruption toelectrical generating capacity concernsgeothermic generating capacity and is expectedto be fully restored in May, while lost nuclearcapacity may be permanent. Currently,

generating capacity in the Tokyo area, whichrepresents about 40 percent of Japanese GDP,exceeds demand levels by almost 30 percent

partly because of voluntary conservation efforts.At the peak of the crisis capacity was reduced by

40 percent. TEPCO now expects to have 52mKW hours of capacity in place by the end of

July, approximately 84 percent of peak summerdemand. For Japan as a whole, the projectedshortfall represents 3.8 percent of generating

capacity.

March data suggest that the economic impact ofthe earthquake and tsunami was larger than

initially expected. Industrial production declineda sharp 15.5 percent in March, retail sales

contracted an annual 8.5 percent, and machineryand business equipment sales plunged 17

percent, while overall GDP declined 3.7 percent

(saar) in Q1.

After having declined 6.5 points in March to46.5 the all-industry PMI plunged further inApril to 35 suggesting a sharp decline in output.

This reflects port closures, supply-chaindisruptions and suspended production at major

plants due to uncertain electricity supply

affecting exports of automobiles, electronics, and

other industrial products. The disaster andrepeated large aftershocks appear to have cutinto the demand side as well. Partly out of

solidarity for those most immediately affected bythe crisis, many Japanese have cut back on

consumer demand (including electrical demand).Japanese auto sales declined 30 percentimmediately following the quake, and output

was down 49.2 percent month-on-month inMarch. Disruptions in the auto industry are

expected to last until the end of the second

quarter, and could result in a halving of output.

The disruption to industrial production has beendeep, but is likely to be relatively short-lived.GDP is expected to decline in the second quarter

due to damaged infrastructure, closure of major

industrial plants, disruptions in energy supply,shortages, and consumer restraint, before

bouncing back strongly in the third and fourthquarters, as reconstruction efforts start (see main

text). The all-industry PMI has increased to 46in May, suggesting a rebound in industrial outputfrom a very low base. Japanese output isexpected to pick up in H2 2011 (the Tankansurvey showed improved business sentiment for

May after a plunge in April). Nevertheless,activity for the year will be flat, according to the

latest Consensus forecast.

International impacts are limited so far butsectoral impacts are being felt. In the U.S.,

difficulties in securing parts caused total motorvehicle production to decline 12.2 percent month

-on-month in April. A sharp decline in activitywould be expected to have an important impacton Japans main trading partners, both as Japan-

sourced supplies become scarce and as demandfrom Japan declines. Emerging Asia will be the

region most affected by the loss in economicactivity in Japan, as these countries trade heavily

with Japan and depend heavily onmanufacturing. The most affected economieswill be the ASEAN countries, followed by Koreaand Taiwan, China. China and India will also beaffected but less intensely (indeed, following the

quake, Chinas purchasing manager indexactually improved reflecting domestic

conditions).

Table IP.1 Impacts of the 1995 Kobe and 2011

Tohoku earthquakes

Source: World Bank; Various press reports and offi-

cial estimates.

Kobe Tohoku

17-Jan-95 11-Mar-11

Dimension of tragedy

- size of tremor (Richter scale) 7.3 9.0

- Lives lost 6434 14,435- Missing 11,601

- people left homeless 300000 450000

- Estimated Property Damage (% of GDP) 2.5 4-5

- In it ial di srup ti on to powe r sy ste m ( % of ge ne rati ng cap aci ty ) 7.3

- Medium-term disruption to power system (% gen. cap.) 3.8

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Outlook

Both manufacturing and services purchasing

manager indexes1 (PMIs) have been risingstrongly at the beginning of 2011, but haveweakened starting in March reflecting, we

believe, temporary and one-off factors, includingthe developments in Japan and weaker than

expected growth in the United States. The lowerPMI readings suggest that industrial productiongrowth will ease markedly in the current quarter

before reaccelerating in the second half of 2011,on account of reconstruction efforts in Japan and

a lift from lower oil prices. More importantly,outside Japan industrial production is expectedto grow at an above-trend pace, albeit

decelerating.

The sharp retreat in global PMI in March andApril to its lowest level since July 2009 comesafter very strong readings in January andFebruary. Global PMI outside Japan has alsodeclined, down 4 points to 54.1 by May, areading still consistent with near-trend growth.

The global new orders component excludingJapan fell an even sharper 4.7 points in April,

but inched up 0.5 points in May. Mostcomponents of the global manufacturing indexdeclined, and the employment index is now

higher than both the new orders and output

components. The services PMI indexes have alsodeclined sharply to 51 in April, after havingsurged to 59.2 by February but has picked up

again in May to 52.5 (figure IP.4).

Industrial production in the euro area is expected

to perform well, supported by strengtheningconsumer spending, robust business confidenceand accommodative monetary policy.

Nevertheless growth is expected to ease thisquarter, as indicated by recent PMI readings,

reflecting a slowdown in global trade expansion,the effects of a stronger euro, and fiscal austeritymeasures, and debt concerns among somemembers. Industrial output is expected to expandat a rate close to 5 percent in the second half of

2011, before easing to a more trend-like pace in

the outer years of the forecast horizon.

Among developing countries the latest PMI

readings suggest robust growth in manufacturingoutput in India and South Africa, with more

moderate growth in Russia, Turkey, China, and

Brazil.

Although industrial production growth is

projected to surge in Japan during the secondhalf of the year due to reconstruction efforts,

elsewhere food and fuel inflation is cutting intoreal incomes and is expected to contribute to an

easing in consumer demand growth and aslowing of the industrial expansion. Theseinfluences are already observable in recent data.

The annualized pace of real retail sales growth inthe United States slowed to 5.2 percent in the

first quarter of 2011 from 9.6 percent in thefourth quarter of 2010.

Risks to the outlook

The overall outlook is subject to significant

risks, notably the possibility that the situation inthe Middle East and North Africa deteriorates,causing oil prices to remain high or rise evenfurther. In this scenario rising input costs andweaker consumer spending would likely lead to

weaker growth in industrial output in most

developing and high-income economies.

Growing capacity utilization ratios in manydeveloping countries may also restrict growth,especially if inflationary pressures become more

marked forcing an even more pronouncedtightening of monetary and fiscal policies

moving into 2012.

Figure IP.4 Global manufacturing PMI points

to deceleration in the broad global recovery

Source: JPMorgan.

30

35

40

45

50

55

60

65

Mar-09 Aug-09 Jan-10 Jun-10 Nov-10 Apr-11

Manufacturing output

New orders

Employment

points

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Finally, though the disruptive capital inflows to

several middle-income developing countrieshave eased, they could return in force

potentially resulting in further appreciation ofcurrencies and additional reductions tocompetitiveness (and therefore growth) of

industry in these countries.

Notes

1. J.P.Morgan, Global All-industry PMI, May

2011 survey.

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The outlook for global trade

International trade has been volatile during thecurrent recovery, reflecting the wider inventorycycle in global industrial production (see Maintext and Industrial Production annex). Therecovery in trade has been dominated by strongimport demand from developing countries,which has accounted for more than half of theincrease in global imports. As the recoverymatures, support for trade is shifting fromtemporary factors (government stimulus and re-stocking of inventories) to more sustainabledrivers, notably a rebound in private sectorspending on capital goods and consumerdurables. Looking forward, world trade isexpected to continue expanding at close to 8percent annual pace, above average in historical

context.

Trade volumes are surging again. After a blistering pace of growth in the first half of2010, global trade growth ground to a halt in thethird quarter, only to pick-up again strongly in

the fourth quarter. By March 2011 (latest data),global merchandise trade volumes wereexpanding at a 30 percent annualized rate(3m/3m, saar), the fastest pace in over a decade

(figure Trade.1).

The rapid pace of trade growth partly reflects thedepth of the decline observed during therecession. Despite faster growth rates, tradevolumes regained pre-crisis peak levels 32months after the crisis, something achieved inonly 16 months following the previous majorslump in world trade in 2001 (figure Trade.2).As of March 2011, global trade was 8.9 percentabove its pre-crisis peak, compared with 10.6percent higher at the same stage in the previousrecovery. And in spite of recovery, global trade

volumes remain below trend levels (the level oftrade would have been if the crisis did not occurand trade grew at its pre-boom average), thoughdeveloping countries have regained their trend

levels.

Developing country demand is at the heart ofthe recovery in global trade. Import demandfrom developing countries was responsible formore than half of the growth of global tradeduring the first half of 2010, and again duringthe fourth quarter of 2010 and the first quarter of

2011. Like other regions (with the exception ofthe United States) developing countries supportpetered out in Q3-2010, but then rose strongly inthe fourth quarter (while U.S. imports declined).

Figure Trade.1 After decelerating in Q3, the

trade recovery has gathered pace again

Source: World Bank.

-50

-40

-30

-20

-10

010

20

30

40

50

2008M01 2008M07 2009M01 2009M07 2010M01 2010M07 2011M01

High Income

Developing

Developing ex. China

World

volumes, percent growth

3m/3m saar

Figure Trade.2 Recovery in current crisis lags

behind previous crisis

Source: World Bank.

0.6

0.7

0.8

0.9

1.0

1.1

1.2

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35

From peak of April 2008

From peak of January 2001

Months

Peak volume= 1

Trade Annex

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For the first quarter of 2011, developingcountries accounted for nearly 50 percent (ofwhich Chinas contribution alone was 25 percentage points) of the increase in global

import demand (figure Trade.3).

Developing country export performance has

shown considerable heterogeneity. Tradevolume growth in Asia has been extremely rapid.Buoyed by strong growth in Pakistan and India,the annualized pace of export growth in SouthAsia reached a record 81.7 percent (3m/3m, saar)in February 2011 and moderated to 74.9 percentin March 2011 (figure Trade.4). Spurred bystrong performance in China, export volumes inEast Asia and the Pacific expanded at a 64.0 percent annualized pace in the 3 months to

January 2011 and moderating to 45 percent inMarch 2011. Strong exports in Russia drovevolume growth in Europe and Central Asia to aneight month peak of 15.5 percent (3m/3m saar) by March 2011. And reflecting exchange rateappreciation, export growth in the Latin Americaand Caribbean region lags other developingregions, having expanded at a 12.2 percentannualized rate in the three months ending

March 2011.

The recovery in the dollar value of exports is

less advanced than that of volumes. Notwithstanding the sharp rise in the price of

commodities in recent months, the dollar valueof exports has not recovered as far as volumes, because many prices remain below their pre-crisis peaks of 2008. As of January 2011, globalexports were 6.3 percent above their pre-crisispeak in volume terms, but remained 5.7 percentbelow earlier highs in dollar terms. Nevertheless, price developments have favored commodityexporters, in particular oil. metals and mineralexporters. For example, the terms of tradeimprovement for oil exporters in Europe andCentral Asia amounted to about 1.8 percent ofGDP, compared with a deterioration of 1.1 percent for oil importers in the same region

(figure Trade.5).

World trade growth is on more solid footing.

Capital goods exports have continued tostrengthen as the recovery matures, a sign of theincreasingly self-sustaining nature of therecovery (figure Trade.6). During the recession,capital goods imports fell by more than importsof consumer durables and agricultural products(although less than oil imports), as fallingdemand and increasing uncertainty led businesses to cut investment and run downstocks. During the initial phases of the recovery,growth in capital goods imports was driven bymassive government stimulus programs (most of

which had a heavy infrastructure component) aswell as a need for businesses to replenish their

Figure Trade.3 Contributions to global import

demand from selected regions and countries

Source: World Bank.

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-5

0

5

10

15

20

25

30

2010M01 2010M08 2011M03

Rest of Developing countriesChinaGermanyUSARest of High income countriesGlobal

volume, percent growth 3m/3m saar

Figure Trade.4 South Asia leads in second phase

rebound in global trade

Source: World Bank.

-20

0

20

40

60

80

100

Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11

Europe and Central Asia

East Asia and Pacific

Latin America and Carribbean

South Asia

Middle East and North Africa

Percentgrowth, 3m/3m, saar

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stocks. Since that time, these temporary factorshave waned, and imports of capital goods bybusinesses surged in the fourth quarter of 2010.In the United States, for example, businessspending on equipment and software rose at a7.7 percent annualized pace in the fourth quarter

although it eased to just 1.8 percent growth in

the first quarter of 2011.

Recently, slowly improving labor marketconditions in high income countries have boosted consumer goods imports, with trade inthese goods exceeding that of capital goods.Consumer goods imports are now 4.6 percent

higher than their pre-crisis peak levels, whilecapital goods imports remain 11.5 percent belowpre-crisis peak levels, partly reflecting the muchdeeper trough they experienced (capital good

demand declined 35 percent during the crisis).

The global recovery also is becoming more

broadly based. High-income country exportsare now growing rapidly, though, consistent withlower potential growth rates, not as quickly asamong developing countries. By March 2011export volumes for high-income countries wereincreasing at a 28.1 percent (3m/3m, saar) rate,up from the 2.7 percent (3m/3m, saar) in July2010. In contrast, developing countries exportvolumes advanced at 33.4 percent (3m/3m, saar)in March 2011, compared to a decline of 4.6

percent (3m/3m, saar) in September 2010.

Outlook and Risks

Global trade is expected to continue to grow

as the recovery matures. Though a moderationof growth from the high first quarter figures is inorder, the expansion in global trade is projectedto remain above pre-crisis averages over theforecast period. Overall, global merchandisetrade is anticipated to grow at about an averageof 7.6 percent over the forecast horizon (2011-

2013). Developing countries, which were at theforefront of the global trade revival, willcontinue to be important sources of demand.However, with improvements in high-incomecountry labor markets, ongoing lax monetary policy, and a rise in business and consumerconfidence, demand from high income countriesis expected to provide increasing support to

global trade growth.

Recent business surveys support the view thatglobal trade will continue to expand, at least for

the near term. Though the Global PurchasingManagers Index, as reported by JP Morgan andMarkit, has fallen from its peak level in March,it still remained in expansion territory in May,including the sub-index for new export orders.Moreover, the latest OECD Composite leadingindicators survey, designed to anticipate turning points in economic activity relative to trend,continues to point to expansion in most OECD

Figure Trade.5 The Recovery in Prices has Fa-

vored Oil Exporters

Source: World Bank.

-2 0 2 4 6 8 10

Sub Saharan Africa Oil Exporters

Europe and Central Asia Oil Importers

Middle East and North Africa

Latin America and the Carribean

Sub Saharan Africa Oil Importers

East Asia Pacific

Europe and Central Asia Oil exporters

South Asia

Terms of Trade Changes as a Share of GDP, percent

(%)

Figure Trade.6 Strong recovery in capital goods

imports but still below pre-crisis levels

Source: World Bank.

0.5

0.6

0.7

0.8

0.9

1.0

1.1

2008Q1 2008Q3 2009Q1 2009Q3 2010Q1 2010Q3

Agriculture

Capital and Industrial goods

Consumer goods

Oil

Values, 3mm imports

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countries even if at a lower pace- this shouldinevitably provide support to further trade

growth.

The risk of a faltering in global economic

recovery. Nonetheless, significant risks to the

continued expansion in global trade remain. Themost significant risk is a faltering of the globaleconomic recovery. As outlined in the main text,a key risk to the global recovery is the possibilityof higher oil prices either due to continueduncertainty in the Middle East, or because of amajor disruption to supplies. Though thisremains a tail- probability event, should itoccur, it could derail the recovery, since higheroil prices would reduce incomes in oil-importingcountries, cutting into consumer and businessdemand. A further $50/bbl increase in oil prices

could shave global GDP by 0.3 percent in 2011and 1.2 percent in 2012. These could in turnreduce global trade by 0.5-1.5 percent in 2011and by between 1.9-6.0 percent in 2012. Otherrisks to the global recovery include a possibleslowdown in growth from a tightening ofmonetary policy in some of the large fastgrowing developing economies and a resurgencein the euro area sovereign debt crisis (see main

text).

Ramifications of the Japan earthquake on

global trade. The recent disaster in Japan isanother source of concern. Japans share ofglobal trade is less than 5 percent, so even arecession there is unlikely to derail global tradegrowth. However, individual countries could besignificantly affected. Non-oil exportingcountries whose exports to Japan account for asizeable share of their total exports and GDP, forexample Malaysia, Papua New Guinea, Vietnam,Singapore, Thailand and the Philippines, will bemost affected. In addition, disruptions in theglobal supply chain due to the situation in Japan

could affect trade in many products, which couldhave major implications for industry (especiallywhere switching to other suppliers requiressignificant re-tooling). Against this backdrop,industries whose global supply chains are verymuch dependent on critical supply of parts fromthe North East part of Japan (Miyagi prefecture)are likely to be the hardest hit. These could

include parts supplies in the semiconductor,auto, camera recorders and office equipmentindustries (figure Trade.7). Already in the U.S,recent industrial production figures releasedshow that the total motor vehicles assembleddropped from an annual rate of 9.0 million units

in March to 7.9 million units in April mainly onaccount of disruptions to part supplies resulting

from the Japan earthquake.

While in the short-run Japanese industrial production and exports are likely to fall, in themedium term reconstruction will require a rampup in demand for capital goods and for theindustrial metals necessary to repair capital stockand build new infrastructure. This new demandfrom Japan could significantly boost exportsfrom the high-income countries that dominate

global exports of capital goods, as well as fromdeveloping country metals exporters.

Global Imbalances. The onset of the globalcrisis accelerated the narrowing of globalimbalances that had already begun in 2006.Global imbalances (measured as the absolutevalue of national current account balancesdivided by global GDP) peaked at 5.6 percent ofglobal GDP in 2005 and fell to 3.9 percent in2009 and to an estimated 3.3 percent in 2010.The question is whether this is a short-run

change or a structural change brought about bythe crisis.

Figure Trade.7 Share of Japans exports in

World exports

Source: Comtrade

0% 5% 10% 15% 20% 25% 30% 35% 40% 45%

Parts for spark-ignition type engines nes

(HS840991)

Automobiles piston engine > 1500 cc to 3000 cc

(HS870323)

Parts of printers, copiers and facsimile (HS

844399)

Automobiles piston engine > 3000 cc

(HS870324))

Television, digital, and video camera recorders(HS852580)

Tansmissions for motor vehicles (HS870840)

Excavators with a 360 revolving superstructure

(HS842952))

Machines for making semiconductor devices

(HS848620)

Tankers (HS890120)

Cargo vessels nes&oth vessels (HS8901090)

(average 2008-09)

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The future evolution of global imbalancesdepends on a constellation of real and financialforces, including exchange rate movements, theextent to which developing country domesticdemand remains a major source of growth, andthe extent to which high-income countries rein ingovernment deficits and low interest rates astheir economies recover. To the extent thatsurplus countries do not experience real effectiveappreciations of their exchange rates, and thatrecovering high-income countries maintaincurrent levels of government dis-saving and low-interest rates, which encourage low private-sector savings rates, the global imbalances thatcharacterized the early 2000s through 2007

could return.

Increased Protectionism. High unemployment

rates, global imbalances, and perceptions ofexchange rate undervaluation among tradingpartners puts pressure on governments to take amore protectionist stance on international trade,with the potential to slow the expansion of trade.These pressures have only heightened in theaftermath of the global recession. The WTOreports that between November 2009 andOctober 2010, new trade restrictive measurescovering some 1.2 percent of global importswere introduced.1 New trade restrictionsintroduced since the commencement of the crisis

in 2008 have affected some 1.9 percent of totaltrade. Though some of the measures were meantto be temporary, so far only 15 percent of themeasures introduced have been removed. Mostof the measures that have been introduced affecttrade in base metals and products, machinery andmechanical appliances, and transport equipment,all of which are important in helping to rebuildproductive capacity to help sustain the recovery.Further, Bown and others (2010), find thatincreasingly such measures are being appliedwithin the context of South-South trade.2 They

observe that protectionism has been imposeddisproportionately by developing worldimporters on developing world exporters,notably China. Though the current application ofsuch protectionist measures remains limited, thegreater threat lies in the continued accumulationof new restrictions, without repealing earlier

temporary ones, thereby leading to an increasing

share of trade affected by restrictive measures.

Notes1. WTO, 2010. Overview of Developments in

the International Trading Environment. WT/TPR/OV/13, World Trade Organisation,

Geneva.

2. Chad P.Bown and Hiau Looi Kee (2010)

Developing Countries, New Trade Barriers,and the Global Economic Crisis in MonaHaddad and Ben Shepherd (eds), ManagingOpenness, The World Bank, Washington,

D.C.

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Recent trends in capital flows

International capital flows to developing

countries have slowed since October

Gross capital flows (international bond issuance,cross-border syndicated bank loans and equityplacements) to developing countries totaled $175 billion in the first four months of 2011, 24 percent less than the last four months of 2010(figure FIN.1). Most of the decline was in equity placement (foreign investment in IPOs andfollow-on offerings), which plummeted by 35 percent. There have been no major IPOs fromdeveloping countries this year, after the record breaking equity issuance of 2010. Internationalsyndicated bank-loans remained subduedcompared with pre-crisis levelsalthough therewas a modest rebound in lending to Europe andCentral Asia (notably, Russia and Turkey) and

Sub-Saharan Africa (Nigeria and South Africa).

In contrast to equity placement and bank-lending, international bond issuance bydeveloping countries was strong in the firstquarter, attaining the highest monthly level on

record in January. A combination of relativelyfavorable pricing conditions and investorscontinued search for yield led to a near recordpace of borrowing activity. Corporate borrowers

continued to dominate bonds with about 80percent of year-to-date volume, with most issuescoming from companies in China, EmergingEurope and Latin America. Chinese companiesissued a record volume of international bonds inthe first quarter of 2011, partly reacting to theincreased cost and rationing of domestic financefollowing the governments policies to curbcredit growth. The pace of issuance has slowedconsiderably since January, partly reflecting theimpact of increased uncertainty in global

markets.

as have the hot money flows, easing some of

the pressures for currency appreciation.

Portfolio investmentequity placement, foreigninvestment in existing stocks and foreigninvestors purchase of local debt securities, also

referred to as hot moneyhas eased sinceearly 2011 (figure FIN.2). Most of the declinewas in equity placements and foreign investmentin stock markets, as there were considerablestock-market sell-offs during January andFebruary, aside from the sharp fall in equity

placement.

Growing concerns about sovereign debt in high-income countries, inflation, political turmoil inthe Middle-East and North Africa, and high

Figure FIN.1 Gross capital flows have eased since

November

Source: Dealogic.

0

5

10

1520

25

30

35

Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 Feb-11

3-month moving average ($ billion)Bond issuance

Equity placement*

Syndicated bank loans

*Foreign investment in IPOs and follow-on offerings

Figure FIN.2 Hot money flows slowed down since

October

Source: Central Banks and World Bank.

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

2007 Q1 2008Q1 2009Q1 2010Q1 2011Q1e

For eign portfolio investment flows*% of GDP Brazil

Turkey

South Africa

India

*Equity placement, foreign investment in existing stocks a nd foreign investors

purchase of local debt securities

Financial Markets Annex

41


12/39


commodity prices have combined to slow the pace of portfolio equity inflows to developingcountries. In addition, investors may also haveconsidered that market equity valuations hadreached maximum levels and started to take profits. During the first quarter of 2011, therewas a net outflow of nearly $25 billion fromemerging market (EM) equity funds, comparedwith a net inflow of $85 billion in 2010.

Similarly, foreign investors interest in emergingmarket bonds (both in local and other currencies)has also diminished considerably since October2010 (figure FIN.3). And the EM fixed incomefunds registered a net outflow in February with alittle improvement in March. Most of the declinewas in flows to EM local currency funds, whichhave become quite popular in recent years, andexperienced record inflows in 2010 (see box

FIN.1: Domestic debt market developments inemerging markets). The outflows from both EMequity and fixed income funds do not necessarilyimply a net outflow in terms of balance ofpayments financing, but highlights the easing in

these types of flows to developing countries.

Country specific factors also played an importantrole in the slowing of capital inflows. SouthAfrica (in November) and Turkey (in Decemberand January) cut their policy interest ratesreducing the attractiveness of the carry-trade

with these countries. The impact of the rate cutsturned out to be temporary in Turkey, however.After a slow down, foreign purchases of Turkish

local debt securities rose to a record $4.8 billionin March. While Brazil increased the tax onforeign investments twice in October, the fall-offlargely reflected at drop in IPO activityfollowing the record sale of Petrobras inSeptember 2010 that attracted large foreign

participation.

Several middle income countries experiencedsharp appreciation of their currencies in 2010following the surge in capital inflows. With theeasing of these flows during the first quarter of2011, the upward trend in real effectiveexchange rates also moderated (Thailand) oreven reversed (South Africa and Turkey) (figureFIN.4). Brazil (due to large FDI inflows) andMexico (flows into local debt securities) did notexperience large depreciations. Consistent with

the initial slowing of capital inflows, the pace ofreserve accumulation among developingcountries also slowed from 8 percent in 2010Q3

to 5 percent both in 2010Q4 and 2011Q1.

The fundamental conditions that underpincapital flows to developing countries remain

strong

Emerging markets entered 2011 with animproved risk profile, as well as higher growth prospects vis--vis the high income countries,

and policy interest rates that were rising. Despitesome recent increases (the ECB raised its

Figure FIN.3 Inflows to EM fixed income funds

have slowed down since October

Source: EPFR Global.

-2

-1

0

1

23

4

5

6

Jan-10 Apr-10 Jul-10 Oct-10 Jan-11

$ billion

"Blended" funds

Local currency funds

Hard currency funds

Figure FIN.4 Real effective exchange rate ap-

preciation in selected economies

Source: International Monetary Fund.

95

100

105

110

115

120

125

2010M01 2010M06 2010M11 2011M04

Brazil India

South Africa Turkey

Mexico

Index , January 2010 =100

42


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official rate by 25 basis points (bps) to 2 percentin April 2011), policy interest rates in high-income countries remain low, while those indeveloping countries are rising. The rates inemerging economies are expected to go upfurther as these countries tighten monetary policy in the face of heightening inflationarypressures. This will likely increase interest ratedifferentials in favor of developing countryassetsalthough this effect will be reduced ifand when high-income countries beginwithdrawing quantitative easing measures and

tighten more traditional monetary policy.

Policy interest rates for a number of developingcountries have been raised since mid-2009 asstrong economic activity has signaled a rapidclosing of output gaps and inflation has been

moving up. As the inflationary effects of higheroil prices are more evident, policy makers willundoubtedly look toward tightening monetarypolicy. This is especially likely in Asia and LatinAmerica, where central banks are alreadygrappling with higher inflation amid strongergrowth and record food prices. Market-estimatedchanges in policy rates point to further hikes inofficial rates for most of emerging marketcountries this year (figure FIN.5). Risinginflation rates have been pushing real yieldsdown in countries with increasing inflation. Real

yields turned negative in several emerging

markets, including Russia and Thailand, makinglocal bond less attractivethough yields remain positive in real terms if adjusted for the

expectation of currency appreciation.

and developing countries continue to struggle

with mitigating the impact of high capital flows.

In an attempt to limit the high levels of capitalinflows and currency appreciation, Turkeyreduced its policy interest rate twice inDecember 2010 (by 50 bps) and later in January2011 (by 25 bps) bringing the rate to an all timelow. While this move surprised the markets andled to portfolio equity outflows in December andJanuary, cross-border flows to local debt markets

remained strong. Nevertheless, Turkeys realeffective exchange rate eased by 7 percent

between December and April 2011. Similarly,South Africa lowered its policy rate by 50 bps onNovember 13th, with some impact on portfolioinvestment and the real exchange rate. Bothcountries will find it difficult to maintain lowrates however, as they are facing increasing

inflationary pressures.

Other policy responses to mitigate the short-termimpacts of hot money flows have included theintroduction of capital controls, higher foreigncurrency reserve requirements for banks,

minimum holding periods, or withholding taxeson foreign investment in order to discourageinflows; and improvements in the enforcementof existing restrictions on cross-border inflows.For example, Brazil raised its financialoperations (IOF) tax on foreign investment infixed income securities twice in 2010. Theimpact of these hikes was limited and short-lived, and they were followed by a furtherincrease in April. Brazil also announced that itwill extend the high tax rate on the renewal offoreign loans with maturities of up to a year,

while a reintroduction of a 15 percentwithholding tax on federal securities is under

consideration.

Indonesia imposed a 1-month minimum holdingperiod on central bank money market certificatesin July 2010, and introduced new regulations onthe net foreign exchange positions of

Figure FIN.5 Accelerating inflation could lead to

a further monetary tightening

Source: Bloomberg and World Bank staff calcula-tions.

0

50

100

150

200

250

300

350Change since 2009 low

Market estimated changebetween now and end of 2011

Change in off icial interest rates (basis points)

43


14/39


commercial banks. And Thailand implemented a15 percent tax on interest income and capitalgains earned by foreign investors. And ratherthan new measures, China announced that it willintensify enforcement of the existing measures

on capital inflows.

The IMF published a report in April 2011providing a framework for managing the impactof high capital flows (IMF, 2011a). The reportsuggests that, if possible, countries should firstrespond to higher capital inflows by letting theirexchange rates appreciate, easing monetarypolicy and tightening fiscal policy. If that is notpossible, countries are urged to first use controlsthat do not discriminate between foreign anddomestic investors, for example limits on foreign

currency borrowing by local banks or minimumholding periods. According to the framework,measures that discriminate against foreigninvestment, such as taxes on foreign capitalinflows imposed by Brazil, should be a last lineof defense. At the same time, the reportrecommends that the use of controls should be proportional to the economic risk, that they

should be withdrawn when they are no longerneeded; and importantly, that countries should

bear in mind the costs of using them.

FDI inflows have gained momentum since the

last quarter of 2010...

Foreign Direct Investment (FDI) inflows gainedmomentum in the last quarter of 2010 (figureFIN.6). FDI flows in early part of 2010 werelikely restrained by uncertainty concerning theglobal recovery. This uncertainty has sinceeasedespecially concerning growth indeveloping countriesand cross-border mergersand acquisitions (M&A) transactions (whichreact more quickly to changing economicconditions than greenfield investment) in

developing countries accelerated in the secondhalf of the year.

FDI inflows to developing countries increasedby 24 percent in 2010, a relatively modest gain(less than the rise in other capital flows todeveloping countries) considering its 36.5 percent decline in 2009. The rebound in FDI

Box FIN.1. Domestic debt market developments in emerging countriesDomestic debt markets in developing countries have grown markedly over the past decade as many countriesshifted from external to local currency financing to lower the volatility of their debt service given their more flexi-ble exchange rate regimes. This shift is particularly true for government bond issuers as domestic public debt nowaccounts for more than 80 percent of the total publicdebt for developing countries (box figure FIN.1). In

recent years, local-currency bond markets have ex-panded considerably in several countriesamong themBrazil, Colombia, China, India, Malaysia, Mexico,South Africa, and Turkey (World Bank 2009). Growinginterest from local investorsparticularly from pensionfundshas played a key role in the development of do-mestic debt markets in developing countries.

With extraordinarily easy monetary policy in the high-income countries, international investors are also in-creasingly drawn to emerging market local currencybonds, with higher yields and prospects of capital gainsarising from currency appreciation. As a result inflows

to fixed-income funds focusing on developing countriesreached a record $65 billion in 2010, with the overallallocation biased toward local currency funds (figureFIN.3 in the text). Despite the recent fall-off, foreignpurchases have continued in Latin America, with Mex-ico posting record $12 billion inflows through March

this year.

Box figure FIN.1 External and domestic public

debt in developing-countries

Source: JP Morgan.

0

10

20

30

40

2000 2002 2004 2006 2008 2010e

Do mestic Extern al

% of GDP

44


15/39


inflows in 2010 was much stronger than the

World Banks January estimate of 15 percentgrowth (Global Economic Prospects 2011a),mainly because of large revisions by China to itshistoric and 2010 FDI numbers (box FIN.2). Fordeveloping countries excluding China, the

rebound in 2010 was slightly above 10 percent.

Most of the increase in FDI inflows in 2010came from higher reinvested earnings. Incomegenerated by FDI projects in developingcountries increased 26 percent in 2010,compared to its level in 2009. Multinationalsinvested 30 percent of this income back intodeveloping country operations in 2010,accounting for 35 percent of FDI inflows. FDIwas also supported by increased South-Southflows particularly from Asia. With the sharp

decline of FDI outflows from high-incomecountries since the crisis, investment from otherdeveloping countries rose to 34 percent of total

inflows in 2010, up from 25 percent in 2007.

Cost of borrowing is on the rise

Long-term yields in developing countries are facing pressures from rising long-term rates in

high-income countries

The implicit yield on emerging market sovereignbonds (EM spread + U.S. 10 year treasury yield)has risen 50 bps since September 2010, mainlydue to upward movements in high-incomecountry long-term sovereign yields (figureFIN.7). Long-term interest yields forgovernment bonds rose since early September2010 in the United States (60 bps), Japan (25bps) and the European Union (74 bps), reflectingrising government debt, higher inflationaryexpectations and perhaps reduced demand as the

impact and extent of quantitative easing slows.

Figure FIN.6 FDI inflows for selected economies

Source: The World Bank.

0

20

40

60

80

100

120

2009Q1 2009Q3 2010Q1 2010Q3 2011Q1p

$ billion

Box FIN.2 China revised up capital account numbers for 2005-2010.

Chinas State Administration of Foreign Exchange (SAFE) revised the capital account in their balance of pay-

ments report following implementation of a new accounting method. Much of the adjustment is in FDI inflownumbers, which are revised up between 20-75 percent for the period 2005-2010 (see Box figure). SAFE cited better accounting for reinvested earnings by multina-tionals as the main reason for the upward revision. This portion of FDI does not cross the border, and hence

may not be fully recorded in government reports.

According to the new estimates, FDI inflows to Chinarebounded strongly by 62 percent in 2010, reaching$185 billion. The largest increase was in the financial

sector (300 percent) followed by the real estate sector(78 percent), reaching $12 billion and $21 billion, re-spectively. Nonetheless, the manufacturing sector re-mains the main recipient of FDI inflows to China.Manufacturing received $70 billion in 2010, 50 percentmore than in 2009. With the revisions, China now ac-counts for 30 percent of total FDI inflows to develop-ing countries, compared to an estimated one-fourth in

previous statistics.

Box figure FIN.2 FDI inflows to China

Source: Chinas State Administration of Foreign Ex-

change.

0

50

100

150

200

2005 2006 2007 2008 2009 2010

Old Revised

$ billion

45


16/39


Developing country spreads have remained in atight range despite ongoing geopolitical unrestand economic uncertainties. The events in theMiddle East and North Africa region led to awidening in spreads only within the region andamong the most affected countries. Credit risk(as reflected in 5-year CDs spreads) for Egypt,Bahrain and Saudi Arabia widened between 50-150 bps immediately after the turmoil in lateJanuary and February, but most stabilized inMarch. Meanwhile, concerns related to theEuropean debt crisis reemerged in early March,when International Credit Rating Agenciesdowngraded ratings of Greece, Spain andPortugal, citing worries about their ability toreach their fiscal adjustment targets, in somecases linked to political stability concerns. CDsspreads for these economies rose following the

downgrades.

While Japanese stocks plummeted following theMarch 11 earthquake, the impact of the crisis onworld financial markets has been limited.Developing countries were little affected byincreases in risk aversion owing to thedifficulties in Europe and Japansovereign bond spreads for the emerging markets as agroup remained within a tight range through the

end of April 2011 (figure FIN.8).

...and are expected to go up further.

Going forward, emerging market yields areexpected to increase amid rising long-term yields

in high-income countries. Spreads fordeveloping countries might also widen, as thetrend decline in risk premiums partly reflects thevery low policy rates and quantitative easing inhigh-income countries (Hartelius et al 2008).These easy monetary conditions have suppressedthe price of risk in both high-income anddeveloping countries, and prompted a search foryield similar to that observed in the pre-crisisperiod. Developing country spreads are sensitiveto U.S. Treasury yields. A jump in Treasuryyields, for example because of a sudden phase-out of quantitative easing, could spark a sharpwidening of spreads on emerging market debt. Amore gradual policy tightening is likely to resultin a more modest and short-lived widening of

spreads.

Tighter financial regulation may also contributeto higher long-term interest rates, and will likely

increase the cost of capital, potentially hindering

trade finance in the medium term.

Changes in the financial regulatory landscapethat have been implemented, and that are beingdiscussed both at the national and global level,would tend to raise the cost of bank lending andshould be reflected in higher long-term interestrates. In the United States, the June 2010 Dodd-Frank bill forbids future government bailouts of

banks; places limits on risk-taking by financialinstitutions, and introduces new clearing and

Figure FIN.7 The implicit yield on EM sovereign

bonds is up

Source: JP Morgan.

0

2

4

6

8

10

12

Jan-03 Jan-05 Jan-07 Jan-09 Jan-11

Yield on 10-year US treasury note

Implicit yield on EM sovereign bonds

PercentPercent

Bond spread(EMBIG compo site index)

Percent

Figure FIN.8 EMs spreads have remained in a

tight range despite the rising geopolitical risk

Source: JP Morgan.

220

240

260

280300

320

340

360

380

Apr-10 Jul-10 Oct-10 Jan-11 Apr-11

EMBIG Spread (basis points)

46


17/39


trading requirements for CDS markets. A revisedinternational agreement (Basel III) seeks tostrengthen banks resilience to systemic stresses, by raising capital requirements and imposingstricter definitions of what constitutes bankcapital. While the proposals incorporate agenerous phase-in period, with capital ratios to be raised gradually, and linear phasing out ofineligible securities between 2013 and 2019,there remains uncertainty related to theimplementation of these requirements acrosscountries. The impact of Basel III on tradefinance is expected to be significant (box FIN.3Impact of Basel III: Trade finance may become a

casualty).

Higher borrowing costs could reduce both the

level and the growth of GDP.

Higher capital costs due to increased long-terminterest rates and less abundant capital are likelyto cause firms to invest less, which will reducethe amount of capital employed in the economyand lower GDP levels from what they wouldhave been had capital costs remained low.During the transition period from a high capitalusage regime to a lower capital usage regime, the

rate of growth of potential output in the economy

will slow.

Simulations suggest that higher capital costscould lower developing country GDP growth by between 0.2 and 0.7 percentage points over a

period of between 3 and 5 years. GlobalEconomic Prospects 2010 estimated that thesubstitution away from capital intensivetechniques would reduce potential output indeveloping countries over the medium term by between 3 and 5 percent and potentially by asmuch as 8 percentdepending on how much

long-term interest rates rise.

Developing countries can mitigate the costs ofthe tightening of global financial conditionsthrough strengthening regional and domestic

institutions.

Inefficiency of domestic financial sectorsresulting from corruption, weak regulatoryinstitutions, poor protection of property rights,and excessive limits on competition can make borrowing costs in developing countries 1,000 bps higher than in high-income countries.Improvements in the policies and institutions

Box FIN.3. Impact of Basel III: Trade finance may become a casualty

The Basel Committee on Banking Supervision, which sets rules that national banking regulators implement, an-

nounced a comprehensive reform package in September 2010 that raises capital requirements and, for the firsttime, sets global standards for overall borrowing, known as leverage, and liquidity. The Basel III rules are de-

signed to make banks more resilient and prevent a repeat of the financial crisis, but several provisions combine tomake trade finance, already a low-margin business, much less profitable. Basel IIIs implementation could haveunintended consequences for trade financing through the proposed leverage ratio, which would require banks toset aside 100 percent of capital for any off-balance-sheet trade finance instruments, such as letters of credit. This isfive times more than the 20 percent credit conversion ratio used for trade finance in Basel II. New capital regula-tions would also require banks to set aside capital for one year for any instrument, even though that security maycarry a maturity of under a year. Most trade finance instruments have maturities of about 90 days: this would triple

the capital cost of such instruments.

Such higher capital requirements are likely to depress trade finance. According to Standard Chartered Bank, thenew regulations would lead to trade finance becoming 15 to 37 percent more expensive, with volumes falling by 6percentwhich implies a $270 billion a year reduction in global trade and a 0.5 percent fall in global gross do-

mestic product. Developing countries would be particularly affected by a fall in trade finance. Trade finance is animportant source of working capital, particularly for small and medium-sized enterprises. And developing coun-tries rely heavily on international banks for trade finance. In 2010, the largest rebound in capital flows was in short

-term debt, which reached $122 billion, and was for the most part trade finance (World Bank 2011).

There is some question as to whether this rise in capital requirements is necessary for trade finance, which is usu-ally collateralized and has low default risk. The International Chamber of Commerce has published a study thatexamined the trade finance activity of nine global banks from 2005 to 2009, which together arranged 5.2 milliontransactions accounting for $2.5 trillion. It found that only 1,140 of those transactions defaulted. Of the 2.8 milliontransactions arranged during the crisis in 2008 and 2009, only 445 defaulted (0.02 percent).

47


18/39


governing the financial sector can thus have asignificant impact on domestic borrowing andcapital costs in developing countries. Suchchanges have the potential to outweigh anynegative effect of higher costs for internationallysourced capital. Simulations suggest that ifdeveloping countries continue to improve policies and other fundamentals, so that theirinterest spreads fall by an average of 25 bps ayear, they would more than offset the long-termeffects of the financial crisispotentiallyyielding a 13 percent increase in long-termpotential output and increases in potential outputgrowth of about 0.3 percent per year by 2020.Developing countries may also further increasedomestic savings by following closely theircomparative advantages in their industrial

upgrading and diversification (Lin 2007).

Prospects

Despite their recent moderation, internationalcapital flows to developing countries are

projected to rise further over the forecast period.

Cross-border flows to developing countries are projected to increase further in nominal termsover the medium-term, but at a slightly slower pace than GDP growth, reaching $1.1 trillion(3.8 percent of GDP) by 2013 (figure FIN.9).

Much of the increase is expected to be in FDIinflows. FDI inflows to resource rich economiesand to developing countries with rapidlyexpanding domestic markets are expected torecover more firmly in 2011. Bank flows mightalso rise as the deleveraging cycle has largely

come to an end. However, bank lending isexpected to remain lower than pre-crisis levels

due to approaching regulatory changes.

Other capital inflows that led the initial reboundin 2010 have started to stabilize (or even decline)

as the expected monetary tightening in high-income countries and inflationary pressures inemerging markets dampens demand foremerging market assets. Short-term debt and portfolio investment flows in particular, mayface considerable weakening or sudden reversals(table FIN.1). When quantitative easing inadvanced countries is phased out and globalliquidity conditions begin to tighten (or riskaversion rises), developing country local bondmarkets could be adversely affected, as carry-trade related flows to developing countries slow.

Similarly, there may be a contraction in short-term debt flows by 2013 with speculative flowsfalling, and with trade-related portion hindered

by regulatory changes.

Downside risks for the outlook are stillconsiderable, however. First and most immediateis the European debt crisis. While its impact ondeveloping countries has been limited andtemporary so far, an unexpected or disorderlyresolution of the debt problem might prompt broad-based risk-aversion in global financial

markets driving capital flows toward safe-havenassets. This could lead to a sharp reversal incapital flows to developing countries, with apotentially disproportionate impact on countriesin developing Europe and Central Asia, whoseeconomies are more closely tied to those in high-income Europe. Second, international capitalflows are sensitive to the policy stance in high-income and developing countries. If high-incomecountries shift toward tighter policy morequickly, or if markets become increasinglyconcerned by the buildup of debt and central

bank liabilities, longer-term interest rates maybegin to rise quicklyraising the cost of capitalfor developing countries and likely weakeningflows faster than expected. In fact, a recent IMFstudy shows that an unanticipated 5 bps rise inU.S. real interest rates might cause a 1/2 percentage point (pp) reduction in net flows(inflows minus outflows) in the first quarter and

Figure FIN.9 Further increase in capital flows

Source: The World Bank.

48


19/39


1.25 pps cumulative reduction in two years (IMF2011b). The impact is projected to be larger incountries with higher financial linkages with

United States.

With higher oil prices and increased debt-

financing requirements, several oil importingeconomies will remain vulnerable to sudden

changes in global markets

Although the impact on credit risk was limited,the events in the Middle East and North Africaresulted in a sharp increase in oil prices. Andmany oil importing countries now face higher

import bills and current account deficits. Inaddition, developing countries issuedinternational bonds valued at $180 billion in2010, and entered 2011 with $855 billion inshort-term debt. As a result, external financingneeds (current account projections andamortization of external debt) for developingcountries increased from $0.8 trillion (3.5percent of GDP) to $0.9 trillion (3.9 percent of

GDP).

While international debt market conditions have been robust so far in 2011, high externalfinancing needs make countries vulnerable to

Table FIN.1 Net capital flows to developing countries

$ billions

Source: The World BankNote:e = estimate, f = forecast/a Combination of errors and omissions and transfers to and capital outflows from developing countries.

2004 2005 2006 2007 2008 2009 2010e 2011f 2012f 2013f

Current account balance 195.2 318.8 450.3 469.1 440.6 284.4 264.5 219.6 159.9 163.1as % of GDP 2.4 3.3 4.0 3.4 2.6 1.7 1.4 1.0 0.6 0.6

Financial flows:

Net private and official inflows 342.2 502.9 656.3 1132.1 771.1 633.8 930.2

Net private inflows (equity+debt) 366.3 567.0 725.9 1132.1 743.3 557.4 857.8 892.7 963.5 1065.3

Net equity inflows 243.6 379.2 497.0 664.9 561.2 498.1 633.2 674.1 733.9 839.8

..Net FDI inflows 206.7 311.7 389.3 529.8 614.4 390.0 485.4 555.0 603.6 696.2

..Net portfolio equity inflows 36.9 67.5 107.7 135.1 -53.2 108.2 147.8 119.1 130.3 143.6

Net debt flows 98.6 123.8 159.3 467.2 209.9 135.6 297.0 218.6 229.6 225.5

..Official creditors -24.1 -64.0 -69.6 0.0 27.8 76.4 72.4

....World Bank 2.4 2.7 -0.2 5.2 7.3 17.7 19.3

....IMF -14.7 -40.2 -26.7 -5.1 10.0 26.5 16.3

....Other official -11.8 -26.6 -42.6 0.0 10.6 32.2 36.8

..Private creditors 122.7 187.8 228.9 467.2 182.1 59.2 224.6 218.6 229.6 225.5

....Net M-L term debt flows 69.8 113.3 145.0 283.0 196.1 52.8 104.1......Bonds 34.3 48.3 31.7 88.2 24.1 51.1 66.5

......Banks 39.7 70.3 117.9 198.5 176.8 3.2 37.6

......Other private -4.1 -5.3 -4.7 -3.7 -4.8 -1.6 0.0

....Net short-term debt flows 52.9 74.5 83.9 184.2 -14.0 6.4 120.5

Balancing item /a -137.5 -406.9 -458.6 -509.5 -733.5 -271.1 -524.4

Change in reserves (- = increase) -399.9 -414.8 -647.9 -1091.7 -478.2 -647.0 -670.3

Memorandum items

Net FDI outflows 46.1 61.6 130.5 148.7 207.5 153.9 210.0

Workers' remittances 159.3 191.8 226.3 278.2 325.0 307.6 324.7 348.6 374.5

As a percent of GDP

2004 2005 2006 2007 2008 2009 2010p 2011f 2012f 2013f

Net private and official inflows 4.3 5.3 5.8 8.1 4.6 3.9 4.8

Net private inflows (equity+debt) 4.6 5.9 6.4 8.1 4.4 3.4 4.4 3.9 3.8 3.8

Net equity inflows 3.0 4.0 4.4 4.8 3.3 3.1 3.3 3.0 2.9 3.0

..Net FDI inflows 2.6 3.3 3.4 3.8 3.7 2.4 2.5 2.4 2.4 2.5

..Net portfolio equity inflows 0.5 0.7 1.0 1.0 -0.3 0.7 0.8 0.5 0.5 0.5

..Private creditors 1.5 2.0 2.0 3.3 1.1 0.4 1.2 1.0 0.9 0.8

49


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sudden reversals in capital markets and to a possible increase in borrowing costs. Countriessuch as Russia, Brazil, Indonesia and Turkey aresusceptible to these types of risks (the first threebecause of high debts, the last because of its highdebt and large current account deficit). Theserisks are further accentuated when a large shareof external financing comes in the form ofrelatively volatile portfolio equity and debt flows

(Brazil, Indonesia, and Turkey) (figure FIN.10).

References:

Hartelius, K., K. Kashiwase, and L.E. Kodres

(2008), Emerging market Spread Compression:Is it Real or is it Liquidity?. IMF working paper

08/10, January, Washington DC.

International Monetary Fund (2011a), RecentExperiences in Managing Capital InflowsCross-Cutting Themes and Possible Policy

Framework, Washington DC.

International Monetary Fund (2011b), WorldEconomic Outlook: Tensions from the Two-Speed Recovery: Unemployment, Commodities,

and Capital Flows April 2011, Washington DC.

Lin, Justin Yifu (2007) Economic

Development and Transition: Thought, Strategyand Viability, Marshall Lectures (Cambridge

University), October 31-November 1, 2007.

World Bank (2009), Global DevelopmentFinance 2009: Charting a Global Recovery,

Washington DC.

World Bank (2011), Global EconomicProspects: Navigating Strong Currents January

2011, Washington DC.

Figure FIN.10 External vulnerability

Source: International Monetary Fund and WorldBank.

-10

-8

-6

-4

-2

0

2

4

6

-50 0 50 100

External financing needs to FX reserve

ratio (%)

rtfli

a

a

ki

(

)

TR

PL

CL

BG

IN

ZA

ID

MY RU PE

PH

CN TH

BR

50


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Overview

Commodity prices have surged since their lowsduring the depth of the financial crisis (figureComm.1). Since end-2008, energy prices havemore- than doubled, but still remain well belowtheir former peaks. Metals prices are up almost170 percent while agriculture and food prices are

77 and 60 percent higher, respectively.

The 2010/11 spike in commodity markets has been driven by a recovery in demand andnumerous supply constraints. Adverse weather(droughts and heavy rains) in many regions hasaffected several agriculture markets, as well ascoal and metals production. Political unrest,mainly in North Africa and the Middle East, hasresulted in a loss of oil supplyand fears offurther disruptions have pushed oil prices evenhigher. And in so far as these commodityindexes reflect dollar prices, the depreciation ofthe dollar has also contributed to their rise.Between July 2010 and April 2011, the dollarhas depreciated 12.9 percent against the euro and7.7 percent against a broader group of trading

partners.

Crude oil prices, which were stable during thefirst three quarters of 2010 (averaging $77/bbl),began to rise as demand growth accelerated andstocks fell late in the year. In 2011, prices rosesharply and exceeded $116/bbl in April

following the loss of 1.3mb/d of Libyan oilexports (and smaller losses elsewhere). Fears offurther disruptions in major oil producingcountries have also underpinned prices. The lossof Libyan light/sweet crude tightened distillatemarkets, which were further aggravated by theloss of distillate exports from Japan followingthe earthquake that damaged refineries. OPECsspare capacity is mainly medium-sour crude,thus the challenge will be to replace light/sweetcrude to manufacture sufficient distillate to meetincreasingly stringent low-sulfur regulations.Crude oil prices are expected to remain elevatedin the near term until product markets are in better balance to meet summer demand, and

fears of further crude oil disruptions subside.

Metals and minerals prices recovered sharply in2009 due to strong demand and restocking inChina. While Chinese demand growth slowed in2010 it was offset by stronger growth elsewhere,mainly in the OECD. By February, prices ofmetals exceeded their May 2008 peak by 4 percent, with tin and copper reaching all-timehighs due to supply constraints. Other metalsmarkets have been less supply constrained, in

particular aluminum, where China is a netexporter. Prices are expected to strengthenfurther in 2011 as demand recovers, notably

from China.

Agricultural prices began to rise sharply in mid-2010 due to adverse weather conditions (notablydrought conditions in Central Europe which sawRussias wheat crop decline by 25 percent), andin the case of raw materials, strong demand.High energy prices have also played a role, both by diverting agricultural land to biofuel

production, but also as higher fuel and fertilizerprices pushed up production costs.

Overall, agricultural prices increased 45 percentbetween June 2010 and February 2011 and as ofMay 2011, they were 6.4 percent above theirJune 2008 peak. By May, raw materials priceswere 33 percent above their 2008 peak due to

Global Commodity Markets Annex

Figure Comm.1 Key price indices

Source: World Bank.

0

100

200

300

400

500

Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Energy Metals Food

$US nominal,2000=100

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record high prices for cotton and rubber onstrong demand and supply shortfalls. Beverage prices were almost 30 percent above peaksowing to weather-related shortages of Arabicacoffee supplies and political disruption of cocoasupplies in Cte dIvoire. High sugar prices have

pushed the other food category to 12 percentabove its earlier peak. Grains and edible oils prices remain below their former peaks onimproving supply conditions for many of thesecommodities, although stocks remain relatively

low.

Most commodity prices are set to remain high in2011 and to weaken only modestly through to2013, reflecting continued robust demand, lowstocks and ongoing supply constraints in somecases. Crude oil prices are expected to average

$107/bbl in 2011 and weaken slightly over 2012-13, assuming that political unrest in North Africaand the Middle East is contained. Metals pricesare expected to rise by 20 percent in 2011 on persistently strong demand, led by China, andweak supply response for some metals, notablycopper and tin. Food prices in 2011 are expectedto average 20 percent above 2010 levels as well,on the assumption of a normal crop year and no

further rises in oil prices (table Comm.1).

The risks to this price forecast are mostly to the

upside. The spread of political unrest in theMiddle East and North Africa could push crudeoil prices much higher in the shorter term,especially if there is disruption to a major oil producer. Stronger demand from China could boost metals prices by more than currentlyexpected, and continued supply constraints could

further aggravate markets. Given low stocklevels, agricultural (and especially food) priceswill remain sensitive to adverse weatherconditions and energy prices. Moreover, atcurrent or higher oil prices, biofuels production becomes an increasingly attractive use of landand produce, likely increasing the sensitivity offood to oil prices. Downside risks mainly entailslower demand growth and more favorable

supplies.

Energy: overview and outlook

Crude oil prices were fairly stable through thefirst three quarters of 2010, averaging $77/bbl,reflecting ample stocks and OPEC productionrestraint amid strong demand growth (3.3percent or 2.8mb/d for 2010) versus an average

1.3mb/d over the past decade. In the fourthquarter of 2010, prices began to rise due to anacceleration in demand growth to 3.8 percentand declining stocks; prices averaged $90/bbl in

December.

Oil demand in high-income OECD countrieswhich had been declining since the fourthquarter of 2005, advanced by 1.2 percent or0.6mb/d; while demand in non-OECD countriesincreased 5.7 percent or 2.3mb/dwith Chinesedemand representing about 1mb/d. In the first

quarter of 2011, global oil demand was 2.3percent higher than a year earlier, with year-over-year growth rates expected to ease to near 1.5percent (1.3mb/d) consistent with the long-term

trend of the past decade (figure Comm.2).

Figure Comm.2 World Oil demand

Source: IEA and World Bank

-4

-3

-2

-1

0

1

2

3

4

1Q03 1Q05 1Q07 1Q09 1Q11

Other

Other Asia

China

OECD

mb/dTable Comm.1 Key nominal price indices(Actual and forecasts, 2000=100)

Source: World Bank

20 05 2 00 6 20 07 2 008 2 00 9 20 10 2011 2012

Energy 188 221 245 342 214 271 362 345

Non-Energy 149 190 233 275 209 267 321 284

Agriculture 133 150 180 229 198 231 277 230

Food 134 147 185 247 205 224 265 222

Beverages 137 145 170 210 220 254 286 238

Raw Materials 131 160 175 196 169 237 304 247

Metals & Minerals 179 275 339 336 222 337 406 395

Fertilizers 163 169 240 567 293 280 349 283

MUV 110 112 117 125 118 121 127 123

Actual Forecast

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Most of the increase in oil demand was met fromincreased production by non-OPEC producersand through reductions in inventories. OPECoutput growth in recent months has been limitedas the cartel has sought to support prices at

below their recent amplified levels.

Non-OPEC output increased 2.0mb/d since2008, reflecting both the exploitation of newfields and more intensive production fromexisting ones made more profitable by higher prices. The biggest increases came from theUnited States, Russia, China, Brazil, Colombia,Kazakhstan, Azerbaijan, Canada, and Oman, aswell as from a sizeable increase in biofuels.Partially offsetting these gains were large

production losses in the North Sea and Mexico.

OPEC production increased 1.9mb/d since April2009 (prior to the loss in Libya), but still remainsbelow its peak levels of 31.9mb/d in mid-2008.1Most of the increase has taken place in SaudiArabia, Iraq, the UAE, and Nigeria (figure

Comm.3).

Despite a drawdown of inventories, globalstocks remain highthough outside of theUnited States, inventory levels at the end ofwinter were at the lower end of their 5-year

range (figure Comm.4).

Political turmoil adds to price volatility

The spikes observed in 2011 mainly reflect political developments in North Africa and theMiddle East, which resulted in the loss of 1.6mb/d in Libyan oil production and 1.3mb/d in

exports. Some damage to facilities and oil fieldsoccurred, and it is widely expected that exportswill be curtailed for some time. In addition morethan 0.1mb/d of crude oil production was shutdown in March from unrest and strikes inYemen, as well as smaller volumes in Oman,

Gabon and Cte dIvoireall non-OPECcountries. Just as importantly, oil prices were bidup by fears of larger supply disruptions in major

OPEC oil producers.

The supply response from other OPEC countrieshas been limitedmainly because of weakdemand for the medium-sour crude that OPEChas in spare capacity (the lost Libyan productionis light, sweet and distillate-rich crude oil), and because the supply disruption occurred duringthe seasonal downturn in demand due to refinery

maintenance.

Nevertheless, the pickup in global demand hasdrawn-down OPECs spare capacity (excludingLibya, Iraq, Venezuela and Nigeria) to 4mb/d,down from more than 5mb/d at the end of 2010.Because of the loss of Libyan distillate-richsweet crudes, distillate markets worldwide hastightened. As refinery demand picks up in thesecond quarter to meet summer demand, further

upward pressure on high-quality crudes is likely.

Outlook

Oil prices are expected to remain elevated aslong as physical supplies are disrupted and fearspersist of larger disruptions from political unrestin oil producing countries. The loss of Libyanlight sweet, crude will continue to affect product

Figure Comm.3 World oil production

Source: IEA

25

30

35

40

45

50

55

J an-00 J an-02 J an-04 J an-06 J an-08 J an-10 J an-12

mb/d

Non-OPEC

OPEC

Figure Comm.4 OECD oil inventories and oil price

Source: IEA, World Bank

10

30

50

70

90

110

130

45

50

55

60

65

1Q00 4Q02 3Q05 2Q08 1Q11

days forward consumption

Brent (right axis)

$/bbl

Inventories

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markets, especially as increasingly stringentregulatory rules on refined products further

intensify demand for light, sweet crude.

In the baseline projection, oil production isassumed to normalize toward the end of 2011,

and oil prices are anticipated to decline graduallytoward $80/bbl in real terms by 2020. Thisimplies a nearer-term price profile of $107.2/bblin 2011, easing only modestly to $98.7/bbl by

2013. Yet, individual prices may move within awide range from each other, as has been the case

during the past six months (box Comm.1).

At these prices, there are no resource constraintsfar into the future. At $80/bbl in real terms,

production of Canadian tar sands are profitableand reserves from this source are second only tothose of Saudi Arabia in crude oil. Such elevatedprices should also serve to both foster production

Box Comm.1 Different prices for different fuels

The recent run up in crude oil prices has been associated with an unusual divergence between the price of WestTexas Intermediate oil (WTI) and Brent and Dubai crude oil prices. Historically, WTI has traded at a premium ofabout $1.30/bbl to Brent, but toward the end of 2010 the WTI price began falling below the Brent price because ofa build-up in crude-oil inventories in Cushing Oklahoma, the delivery point for WTI oil in NYMEX futures con-

tracts. Currently WTI oil is trading at about 90 percent of the Brent price (box figure Comm.1a).

The increase in inventories was mainly due to the inflow of Canadian crude through the new Keystone pipeline,and has little outlet except through refinery processing in Cushing. Bottlenecks are likely to continue until new

pipeline capacity to the Gulf coast is available (2013), and from Alberta to the Pacific coast (2015).

The other major price divergence, which has been more durable, has been between oil prices and natural gasprices. Whereas the former have increased nearly fourfold since 2000, natural gas prices linked to oil (in Europeand Japan) have increased only 160percent, while those in the fully competitive U.S. market are essentially un-changed. Relatively lower natural gas prices reflect increases in supply from both new liquefied natural gas (LNG)capacity and unconventional shale gas. LNG capacity, which allows gas to be transported by sea, is projected toincrease more than 50 percent between 2009 and 2013. In the United States, natural gas from shale-gas reserveshas been growing rapidly due to new extraction techniques, which have not only pushed down U.S. natural gasprices, but also reduced prospective global demand for LNG.

Growing supplies of unconventional gas are expected to keep U.S. natural gas prices well below oil prices. Al-ready, U.S. natural gas now costs less than coal. Contract prices in Europe and Japan, which are tied to oil prices,

are expected to come under downward pressure as end-users increasingly push to tie these prices more closely tospot prices for natural gas (box figure Comm.1b).

Over time, these large gaps between oil and natural gas prices can be expected to induce shifts in consumptionfrom oil to natural gas, reducing demand for oil, and as a result reducing price pressures.

Box figure Comm.1a Brent/WTI price differential

Source: World Bank

-$5

$0

$5

$10

$15

$20

Apr-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Dec-10 Mar-11

US$/bbl

Box figure Comm.1b Energy prices

Source: World Bank

0

5

10

15

20

25

J an-00 J an-02 J an-04 J an-06 J an-08 J an-10 J an-12

Crude oil

LNG Japan

Europe Gas

US Gas

Coal Australia

$/mmbtu

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of alternative renewable energies and inducedemand-side substitution toward other less

expensive forms of energy.

The main impediments to supply growth areabove-ground policies and conditions, i.e.,

taxation, access, environmental constraints, andgeopolitical risk.

Risks to the oil outlook

On balance, short term risks are on the upsidelikely to emanate from further supplydisruptions. Large supply-shocks can havesignificant impacts on oil prices and economicactivity, as in the past. Environmental issuesmay curb non-OPEC production growth in bio-sensitive or resource-intensive areas, e.g.,

offshore, oil sands, and shale-rock fracturing(these sources account for more than one-third of

global oil supplies).

OPEC production policies can also affect pricelevels. In the past, the group has takenaggressive action to rein-in production when prices fall, but has taken only limited actionwhen prices rise, choosing instead to accept the

windfall gains.

An additional risk to energy prices is the longer

term impact of the Fukushima nuclear accident.Nuclear energy has played a key role in globalenergy consumption. Its contribution increasedfrom of 1.6 percent during the 1970s to 6.3percent during 2000-08 (table Comm.2). Duringthis period crude oils share declined from 44.7to 35.0 percent. In effect, the decline in crude oilwas compensated almost equally by increases in

natural gas and nuclear power. A combination ofreduction in the share of nuclear and the likelyenvironmental pressures in crude oil and coalmay indeed exert additional pressure in energy

prices over the longer term.

Metals: overview and outlook

Metals and minerals prices have recoveredstrongly in the last two years due to robustdemand, with the aggregate price index in May2011 up 155 percent since its recession-inducedlows of December 2008. Strong price increaseswere observed in markets that experiencedsupply constraints. For example, copper and tinreached all-time nominal highs in 2011 (up 220and 200 percent, respectively from their 2008/09lows) (figure Comm.5). Most metals prices have

at least doubled, but price increases were moremoderate for those where supplies were ample as

in the case of aluminum.2

Table Comm.2 Shares of global energy consumption(percent of total)

Source: IEA and World Bank

1971-80 1981-90 1991-2000 2001-08

Crude Oil (total) 44.7% 38.3% 36.6% 35.0%

Natural Gas 16.3% 18.2% 19.9% 20.8%

Coal and Coal Products 24.5% 25.5% 23.7% 24.9%

Nuclear 1.6% 4.8% 6.5% 6.3%

Combustible Renewables and Waste 10.6% 10.7% 10.5% 10.0%

Hydro/Other 2.3% 2.5% 2.8% 2.9%

Figure Comm.6 World metals consumption

Source: World Metal Statistics

0

10,000

20,000

30,000

40,000

2000 2002 2004 2006 2008 2010

OECD China Rest of world

'000 tons

Figure Comm.5 Copper and aluminum prices

Source: .World Bank.

0

2,000

4,000

6,000

8,000

10,000

Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

Copper

Aluminum

$/ton

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The recovery in metals during 2009 was led by

large restocking in China, worlds largest metalconsumer (figure Comm.6). As can be seen foraluminum (which accounts for nearly half ofworld consumption of the six base metals),Chinas demand growt

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Global Commodity Market - World Bank