As the global economic crisis moves into the fifth year, an environment of financial and political weakness has increased concerns of a default risk in advanced economies. And with time running out for tackling the vulnerabilities that threaten the global financial system and the global recovery, policymakers are in a bind. A large pubic debt run up in recent years threatens governments? ability to mobilise new resources for boosting economic activity.
And with interest rates at very low levels, there is very limited room for monetary policy to provide a stimulus.
Markets were initially sceptical of the governments? ability to stabilise finance in many of the smaller advanced economies in the periphery of Europe. But with growth prospects further dipping, their worries have extended to include not only the larger economies in Europe but even beyond, to Japan and the US. And, consequently, the worries over sovereign debt of nations have transformed into worries about the stability of the banks holding the sovereign bonds of these nations.
This has partially affected financial flows and pulled down stock
prices, which will further dampen economic activity.
Thus, the World Economic Outlook published by the IMF has lowered the growth estimates for both 2011 and 2012 to just 4%, just one year after the initial recovery boosted growth to a buoyant 5%. Though the brunt of the slowdown is to be borne by the advanced countries, the shrinkage in the volumes of global trade in goods and services will have an impact on the growth of the developing economies. And high inflation will restrain the use of monetary policies for boosting growth at least till the next year, when a sharp fall in most commodity prices would provide some scope for the central banks to lower interest rates and boost growth. However, financial conditions in the developing economies remain largely supportive despite the higher volatility.
Bank credit flows remain strong in most economies. And strong capital inflows in search of yields are bloating domestic liquidity. However, as the downside risks of the global economy increase, the developing economies may have to face a reversal in capital flows and a rise in funding costs, which would impact the soundness of the banking system.