The World Bank has concluded that global economic growth has peaked in reaching 3.8% in 2004 — the fastest rate in four years. It predicts growth will slip to 3.1% for 2005 and 2006, rising to 3.2% in 2007.

Developing countries outgrew high-income countries, and the gains were widespread — all developing regions grew faster in 2004 than their average over the last decade, it adds. But global growth momentum has peaked, and developing country gains are vulnerable to risks associated with adjustments to ballooning global imbalances — especially the US$666 billion U.S. current account deficit.

The strong global performance was underpinned by solid U.S. growth and rapid expansion in China, India, and Russia. Record expansion of 6.6% in developing countries was encouraged by favorable global conditions and supported by years of domestic policy improvements, it adds. As a result, financial flows to developing countries during 2004 reached levels not seen since the onset of the financial crises of the late 1990s.

Net private capital flows, including debt and equity to developing countries, increased by US$51 billion to US$301.3 billion in 2004. Of this, net foreign direct investment (FDI) totalled $165.5 billion, up by US$13.7 billion in 2004, the bank reports. Developing countries themselves continued to increase their exports of capital in tandem with their strengthening current account balances, which reached an aggregate surplus of US$124 billion in 2004. FDI outflows from developing countries rose to an estimated $40 billion in 2004, up from US$16 billion in 2002; these outflows are coming, for the most part, from the same countries receiving the bulk of private capital inflows, namely Brazil, China, Mexico and Russia.

“This recovery of financial flows is a welcome sign of renewed market interest in developing countries and a tribute to the substantial strengthening in economic fundamentals achieved in many countries,” said François Bourguignon, the World Bank’s senior vice president for Development Economics and chief economist. “But we should also keep in mind that current global financial imbalances pose risks — of disorderly exchange rate movements, or of interest rate increases — that could threaten these gains. Developing countries need to prepare themselves for adjustments, some of which could be sudden.”

The bank’s report points to a baseline scenario in which tightening of U.S. fiscal policy and higher interest rates — along with strong growth among developing countries — starts to redress global imbalances and reduce the U.S current account deficit. It forecasts that global growth will slow down to 3.1% in 2005, as a result of increases in U.S. interest rates, fiscal tightening, and the effects of the 25% real effective appreciation of the Euro. A reduction in demand for developing-country exports is expected to slow growth among them to 5.7% in 2005, which still remains above recent growth trends.

But it also highlights the risks to this outlook, and argues that developing countries need to reduce their vulnerability to shifts in market sentiment prompted by higher-than-expected interest rate hikes, or a greater-than-expected depreciation of the U.S. dollar.

“History has shown, time and again, that financial crises often take markets and policymakers by surprise,” said Uri Dadush, Director of the Bank’s Development Prospects Group. “There is a tendency for financial markets and policymakers to miss the warning signs and overshoot, making the necessary adjustment larger when it does occur. For developing countries, the key question is whether the pickup in flows witnessed over the last two years can survive under less favorable and less stable global conditions.”

Tightening global conditions also highlight the vulnerability posed by increased debt burdens, which have been at the heart of the financial crises over the last decade, the bank adds. “Many developing countries have improved their capacity to manage debt, and acted aggressively to address the weaknesses that contributed to previous crises,” it notes. “But external debt burdens have risen in more than half of emerging market economies, and, in many, domestic borrowing has risen dramatically as well. Although the shift from external to domestic borrowing can reduce vulnerability to external shocks, it also carries risks from possible over-borrowing or inadequate supervision.”

“While these risks should not be overstated, policymakers in developing countries need to keep them in mind,” said Jeffrey Lewis, manager of the Bank’s Finance Team. “As long as conditions remain favorable, efforts to strengthen fiscal positions and take advantage of low interest rates to restructure debt should continue. And the lessons from past financial crises remain clear – excessive borrowing, whether external or domestic, is risky, and problems in one arena can quickly spill over into the other.”