The global economy seems to be on the verge of recovery. The advanced economies, hit particularly hard by financial crises and the collapse in world trade, are showing signs of stabilization, driven mainly by an unprecedented public policy response. The shape of the recoveries will vary, however, with economies that suffered financial crises likely to experience weaker recoveries than those that were affected mainly by the collapse in global demand. The rebound in emerging and other developing economies is being led by a resurgence in Asia, most notably in China and India, fuelled by policy stimulus and a turn in the global manufacturing cycle. Other emerging economies are benefiting from commodity price increases, as well as from policy frameworks that are stronger than during previous crises. However, recovery in the Commonwealth of Independent States (CIS) and emerging Europe is likely to be difficult, especially for economies most affected by sharply falling capital flows and domestic financial sector turmoil.

The U.S. economy is showing increasing signs of stabilization. Output declined substantially during the first half of 2009, and the unemployment rate rose to a level not seen since the early 1980s. Nevertheless, unprecedented monetary, financial, and fiscal policy interventions are helping stabilize consumer spending and housing and financial markets, which points to renewed moderate growth in the second half of 2009.

Regarding financial sector regulation, the crisis has revealed major weaknesses, particularly a failure to recognize the buildup of systemic risk.

Financial conditions have improved by considerably more than anticipated in the April 2009 World Economic Outlook (WEO) forecast. Interbank spreads have returned close to precrisis levels, and equity markets have rallied, although they remain way below previous peaks. High-grade corporate issues have rebounded, and corporate bond and mortgage spreads have tightened considerably, the latter in part reflecting massive purchases of mortgage-backed securities by the U.S. Federal Reserve. On the negative side, although the Term Asset Loan Facility has helped restart some securitization in markets for consumer and small business credit, overall securitization activity remains low. Credit also remains difficult to obtain for many households and businesses, with bank loan standards continuing to tighten, albeit at a slower pace.

For banks, the results of the Supervisory Capital Assessment Program (SCAP) reported in May have bolstered investor confidence, with many banks subsequently raising common equity on public markets and issuing nonguaranteed debt. Results for the second quarter of 2009 outperformed expectations, although in part because of a temporary surge in underwriting revenues, even while provisions for losses on most asset classes continued to rise in view of the likely continued deterioration of loan performance.

Output data confirm that the economy is stabilizing, with the preliminary estimate for 2009 second-quarter real GDP showing a decline of only 1 percent (seasonally adjusted annual rate), a significant improvement from the 6.4 percent fall during the first quarter. Nonetheless, the saving rate continues to climb and business investment to sink. Given the collapse of demand in the rest of the world, exports have made a negative contribution in recent quarters, which has been more than offset by the reduction in imports. Positive contributions were made by state and federal spending in the second quarter, reflecting the impact of fiscal stimulus.

The U.S. economy is projected to contract by 2³/₄ percent in 2009, mainly because of the sharp contraction during the first half of the year. Growth is expected to turn positive in the second half of 2009, reflecting the continuing fiscal boost and turns in both the inventory and the housing cycles. However, although financial conditions have improved significantly in recent months, markets remain stressed, and this will weigh on investment and consumption. Combined with the impact of ris­ing unemployment, the temporary nature of the fiscal stimulus, and subdued growth in trading partner economics, growth will remain slug­gish, reaching 1¹/₂ percent for 2010 as a whole. Unemployment is expected to peak at above 10 percent in the second half of 2010, while ris­ing economic slack should keep core inflation below 1 percent through most of next year.

Given the magnitude of shocks and the cloudy outlook for the rest of the world, there remains substantial uncertainty around the near-term outlook. On the upside, the strong policy response and a rapid recovery in emerg­ing markets could lead to a virtuous circle of rising confidence, improving financial condi­tions, and strong aggregate demand growth. But receding downside risks remain a concern. In particular, continued household deleveraging and rising unemployment may weigh more on consumption than forecast, and accelerating corporate and commercial property defaults could slow the improvement in financial conditions.

Turning to the medium-term outlook, poten­tial growth is likely to fall below 2 percent for a considerable time. Analysis of previous finan­cial crises suggests that many are followed by large, permanent output losses relative to precrisis trends, because impaired financial systems take time to heal and to again intermediate effectively, slowing investment and innovation. High cyclical unemployment could also raise structural unemployment, although the flexible nature of U.S. labor and product markets may make the needed reallocation of employment and capital across sectors more rapid and less painful than in some other regions with greater rigidity. On the demand side, although the personal saving rate has already climbed to about 5 percent, it may have to rise further given the need to rebuild house­hold balance sheets.

Monetary and fiscal support should be kept in place until the recovery is well established. If downside tail risks materialize and the recovery falters, there will likely be a need for further measures to support demand on the fiscal side given that the federal funds rate is close to the zero bound, although the Federal Reserve could set up additional targeted credit facilities and purchase more assets. Moreover, efforts must continue toward returning financial institutions to full health through recapitalization and the repair of balance sheets─this is the indispens­able condition for sustained growth. The results of the SCAP undoubted1v boosted investor confi­dence in major financial institutions. This could be undermined, however, if the recovery falters, leading to depressed earnings, an increase in nonperforming assets, and further capital losses.

Helping financial institutions clear their bal­ance sheets of troubled assets will also contrib­ute to their renewed ability to resume lending. The Public-Private Investment Program (PPIP) was set up to achieve this, by leveraging both public and private capital within public-private partnerships to purchase distressed assets, allow­ing banks and other financial institutions to free up capital and stimulate new credit. The PPIP comprises two related parts. The Legacy Loan Program seeks to draw private capital into loan markets by providing debt guarantees from the Federal Deposit Insurance Corpora­tion and equity co-investment from the U.S. Treasury; the Federal Deposit Insurance Corpo­ration is currently proceeding with a pilot. The Legacy Securities Program seeks to target legacy securities by providing debt financing from the Federal Reserve and by matching private capital raised for purchasing such securities. Fund man­agers have been appointed, although no assets have yet been purchased. It remains to be seen how successful these programs ultimately will be, particularly if banks prefer to hold assets to maturity rather than selling them and recogniz­ing losses up front.

Once a recovery gains traction and wide out­put gaps start to close, the process of unwind­ing the monetary stimulus will need to start. Although this point remains well in the future, early communication of a clear exit strategy is key to maintaining market confidence. A prema­ture withdrawal of support before the financial system has healed would impede the recovery. Calibrating the timing will be especially challenging given the uncertainty regarding how much the financial crisis has reduced potential output. Moreover, the massive increase in bank reserves (one consequence of the balloon­ing Federal Reserve balance sheet) must not be allowed to transform into excessive credit growth and lead to inflation.

Even though many of the short-term liquidity facilities are already unwinding as market condi­tions improve, the large quantity of longer-term assets on the Federal Reserve’s balance sheet will be harder to reduce, and this exposes the Federal Reserve to significant interest rate risk. This is especially true for assets that, unlike gov­ernment securities and agency mortgage-backed securities, lack a liquid market. Timing the sale of such longer-term assets will be delicate, especially given the potential market impact, but the Federal Reserve can use other tools─reverse repos and interest paid on deposits─to start tightening conditions as needed, even while its balance sheet remains large.

Regarding financial sector regulation, the crisis has revealed major weaknesses, particularly a failure to recognize the buildup of systemic risk. The Obama Administration’s proposals for regulatory reform are sensible, including an enhanced focus on systemic risk through cre­ation of a Financial Services Oversight Council and new mechanisms for prompt, corrective action for all large, interconnected institutions (including conservatorship and receivership powers). The key will be to implement the mea­sures as a comprehensive package, rather than in piecemeal fashion, and to tackle the problem of having firms that are "too big or connected to fail." One solution to the latter is penalizing size and complexity via higher capital requirements. This would also help to partly address increasing concentration in the U.S. financial system, which if not resolved could inarked1v reduce competi­tion and innovation.

The fiscal legacy of the crisis is a high and ris­ing debt trajectory that could become unsustain­able without significant medium-term measures. Deficits are forecast to be 10 percent of GDP for 2009/10 and 2010/11. Although deficits will fall below the 10 percent level thereafter, the level of gross general government debt will continue to rise rapidly, reaching nearly 110 percent of GDP by 2014, a worrisome deterioration given looming health care and pension pressures related to population aging. The current budget proposal increases transparency about such pressures by including medium-term forecasts, but these are based on growth assumptions that seem optimistic. More adjustment will likely be needed to ensure long-term fiscal sustainability, particularly on the revenue side, given that non­defense discretionary spending is near historical lows. The shape of health care reform will also be critical. Whereas richer nations such as the United States can be expected to spend rela­tively more on health care, there are significant inefficiencies in the U.S. health care system, as evidenced by the fact that similar health care outcomes are achieved at different costs across the U.S. states. With this is mind, coverage should only be expanded in a budget-neutral manner, and measures are needed to bring down the rate of cost growth to help maintain debt sustainability.

Although Asia’s export-oriented economies were battered by the abrupt global downturn, the economic outlook for the region improved markedly during the first half of 2009. Recent developments point to a strengthening of domestic demand and exports, but questions remain about whether the rebound can become a self-sustaining recovery ahead of a stronger growth pickup in the rest of the world.

Extensive fiscal and monetary support helped ease tensions in financial markets and helped soften the decline in domestic demand, even bolstering demand in China and India.

The recent, swift turnaround of economic fortunes is remarkable. At the onset of the crisis, Asian exporters were hit hard by the collapse of external demand. The deterioration of activ­ity was especially rapid for the more export­-oriented economies. In Japan, GDP shrunk by well above 10 percent on an annualized basis in the two quarters following the Lehman Brothers bankruptcy in September 2008. Slumping demand for durable goods, especially cars, and a decline in investment activity in the emerging economics in the region hurt manufacturing exports. Domestic demand faltered amid rapidly falling confidence, rising uncertainty, weakening labor markets, tightening financial conditions, and rising spare capacity. In other parts of Asia, the manufacturing-oriented economics (Korea, Singapore, Taiwan Province of China) also slumped and, by the end of 2008, had recorded peak declines in industrial production of about 25 percent compared with levels one year earlier. Only China, Indonesia, and India escaped a severe recession, the result of a large policy stimulus and, in the case of India, less dependence on exports.

The downward slide moderated during the first half of 2009. Recent indicators point to a strengthening recovery led by a rapid rebound in China, where growth accelerated to an annual rate of 7.1 percent in the first half of the year, driven entirely by domestic demand. In Japan, the turnaround was more gradual. Industrial production began to grow again in March, and retail sales followed in April, leading to a return to growth in the second quarter (2.3 percent). Other emerging and developing Asian econo­mies showed similar signs of stabilization, with rising industrial production in Hong Kong SAR, India, Korea, Philippines, Taiwan Province of China, and Thailand, which lifted growth dur­ing the second quarter into positive territory in several of these economics. The rebound was led by the electronics sector, which had experi­enced a sharp drop in production right at the onset of the crisis. The overall health of banking sectors in the region also limited the impact of the financial crisis.

The intensifying rebound in Asia can be linked to three factors: (1) expansionary fis­cal and monetary policy, which has been very aggressive in some countries; (2) a rebound in financial markets and capital inflows, which eased financing constraints for smaller export enterprises and improved consumer and busi­ness confidence; and (3) the growth impulse for industry following large inventory adjustments.

The pace of decline in activity appears to be moderating, but the recovery will likely be modest during the coming quarters.

Extensive fiscal and monetary support helped ease tensions in financial markets and helped soften the decline in domestic demand, even bolstering demand in China and India. Central banks provided ample liquidity (Japan) and lowered policy rates (India, Indonesia, Korea, Malaysia, Philippines, Taiwan Province of China, Thailand). In China, a relaxation of credit ceil­ings and low interest rates buoyed credit growth (private credit grew by 24 percent during the first six months of 2009). Given its comparably robust fiscal position at the onset of the crisis, discretionary support in Asia has been stron­ger than in other regions. Fiscal packages in China and Japan will reach close to 5 percent of GDP for 200910. Most programs are aimed at bolstering consumption, especially for durables (Japan, Korea) and at upgrading infrastructure and retooling factories (China).

The rebound in equity markets and the resumption of capital inflows in the context of a generalized decline in risk aversion is provid­ing a further impetus for the Asian economics. Stock markets rose during the first eight months of the year by 28 percent in Japan, 65 percent in the ASEAN4 economies, and 52 percent in the newly industrialized Asian economics (NIEs). This upward shift was accompanied by renewed capital inflows. Sovereigns tapped international capital markets, and net equity inflows turned positive in the second quarter. In addition, creditor banks in advanced economics stopped reducing their exposure in emerging Asia. In tandem, most currencies strengthened, although they remained below precrisis levels. These developments were accompanied by a decline in the spread for Asian corporate debt of more than 250 basis points since January 2009, which helped ease financing constraints on corpo­rations and households. Nonetheless, credit growth has stabilized in several Asian economics, including India and the NIEs, as private domestic demand picked up and banks benefit from ample liquidity and sound capital positions.

A third factor contributing to the rebound in activity has been inventory rebuilding. In much of Asia, firms responded to the sharp decline in demand in the fourth quarter of 2008 by reducing production and inventories. By mid-­2009, this destocking process was far advanced in Japan, Korea, and Taiwan Province of China, implying that the current rebound in external demand, together with progress in inventory adjustment, will provide impulses for increased production in the export sector.

Despite these positive signs, a sustained turn­around is not assured. Weakening labor markets will likely put a drag on consumption, and sig­nificant excess capacity in industry will dampen investment demand. Furthermore, the main driver of past recoveries a durable rebound in external demand from outside the region may be lacking this time around. Overall, exports from Asia are still far below 2008 peaks (about 30 percent lower), including in key sectors such as electronics. That said, the sharp increase in domestic demand has boosted Chinese imports from the region, especially from Indonesia and Korea, and this has helped arrest the sharp con­traction in the region’s export sector.

In the baseline projections, growth momen­tum will build during the second half of 2009, forming the basis for a generally moderate recovery in 2010, as external demand from advanced economies strengthens. China and India will lead the expansion this year and will grow at rates of 8.5 and 5.4 per­cent, respectively, boosted by large policy stimu­lus that is increasing demand from domestic sources. In Japan, after a sharp first-quarter fall, activity is expected to contract by 5.4 percent in 2009 as a whole, although a sizable fiscal stimulus and a modest increase in exports will sup­port growth in the second half of 2009 and will lead to a recovery of 1.7 percent in 2010. Given the significant slack in the economy, inflation will remain negative until 2012. The outlook for growth and inflation is similar in the export­-oriented NIEs. Output will contract during 2009 by 2.4 percent but will accelerate in the second half of the year, paying the way for a moderate expansion in 2010 (3.6 percent). For the ASEAN economies, the outlook is more mixed. In the more export-oriented economies (Malaysia, Thailand), activity will increase gradually during the second half of 2009, with stronger growth in 2010.

The risks to the growth outlook are gradu­ally becoming more balanced. The pickup in activity is so far being supported by many factors that could turn out to be temporary: rebounding capital markets, inventory adjust­ment, and expansionary fiscal and monetary policy. These forces may not be able to bring about a self-sustaining recovery if activity does not strengthen in other regions. On the upside, however, the policy stimulus in China could sup­port recoveries in other parts of Asia.

With the recovery gaining strength, the policy challenge is to determine when and how to withdraw policy support while ensur­ing a successful transition to more balanced medium-term growth. Asia’s dependence on export demand has contributed to rising global imbalances and has made the region vulnerable to global demand developments. A return to past growth and demand patterns is unlikely given drawn-out adjustments in the United States and Europe and many Asian economies therefore need to shift their compo­sition of growth to be more focused on domestic demand.

From this perspective, some caution is war­ranted about the sustainability of the rapid level of credit growth in a few countries, especially China. Maintaining credit growth at this level carries the risk of creating incentives for over­investment, unsustainable asset price inflation, and a worsening of credit quality in the bank­ing system. Recent monetary expansion should therefore be unwound as soon as there are clear signs that economic recovery is established. To promote growth that is based more on strength­ened domestic demand and less on investment and exports, fiscal support should encourage private consumption as Japan, Korea, and Taiwan Province of China, for example. In some economies, concerns about fiscal sustain­ability must be addressed, including through development of credible medium-term consoli­dation plans (India, Japan, Malaysia). Particular attention also must be given to devising exit strategies from credit guarantee programs for corporations, which were adopted in many parts of Asia during the crisis. Experiences in Japan and Korea during the past decade show that such programs can encourage excessive risk taking and that scaling them back can be challenging.

Shifting toward a more balanced growth path will require a combination of demand and supply-side measures.

By developing or improving social safety nets and health care systems, many emerging and developing economies can help reduce pre­cautionary saving by households. This would free up resources for consumption and create a larger market for domestic suppliers.

Development of the financial sector should help ensure efficient allocation of credit. As financial markets become deeper and more robust, they can offer stable saving and invest­ment vehicles, which would reduce reliance on foreign financing and make household savings a more important funding base for the financial sector. Easier access to market-based domestic financing for smaller enterprises may also help lower high corporate saving rates, help develop domestic services sectors, and support consump­tion. Of course, the development of the finan­cial sector should take place in the context of proper supervisory and regulatory frameworks.

More flexible exchange rate regimes would help rebalance growth. Appreciating exchange rates in economies where there is productivity growth would imply an increase in real household incomes as import prices decline, thereby strengthening domestic demand, and would also send a signal to businesses to shift supply toward the domestic sector. More flexible exchange rates would also allow Asian economies to develop monetary policy into an independent tool for macroeconomic management, which would help buffer the economic impact of exter­nal and domestic shocks.

Recent data from Europe suggest that the pace of decline is moderating. In the second quarter of 2009, euro area GDP contracted less than previously expected, with France and Ger­many posting positive growth and the United Kingdom registering a more moderate decline. Although contraction continues in much of emerging Europe, Poland recorded positive growth in both the first and second quarters. Even so, the rebound in Europe is likely to be slow. Financial market conditions in the region have improved, but the largely bank-based financial system will take time to fully resume its intermediating role. Tight credit conditions will limit private investment, and rising unemploy­ment will weigh on consumption, even as public support will need to be gradually withdrawn. Emerging Europe will need to adapt to much tighter external financing constraints.

Public policies should be geared to supporting domestic demand while recoveries remain fragile, provided countries have enough policy room.

The output decline across the region was driven by a combination of falling domestic demand─especially investment─and shrink­ing trade within the tightly integrated region, with individual economies suffering to varying extents depending largely on their precrisis imbalances. Abrupt reversals of asset price booms, especially in real estate, caused sharp falls in activity in Ireland, Spain, the United Kingdom, and a number of other economies, including some in emerging Europe. Iceland was hit especially hard and is receiving IMF support following the collapse of its finan­cial sector. Economies with moderate current account deficits or surpluses have generally seen smaller downturns. However, given its export-ori­ented economy, Germany was severely affected by the fall in external demand, although activ­ity is now benefiting more than elsewhere in the region from the recovery in global trade. In comparison, the downturn in France was somewhat less pronounced, in part because of lower trade openness and a larger public sector.

Emerging Europe has been hit particularly hard by the drop in capital inflows. This led to major contractions in the Baltic economies, Bulgaria, and Romania, although exchange rates acted as a shock absorber in economies with flexible regimes. Bosnia, Hungary, Latvia, Romania, and Serbia are currently receiving IMF balance of payments support, whereas Poland has access to the IMF Flexible Credit Line in order to safeguard market confidence. In recent months, the pace of contraction has slowed dramatically in much of the region, with risk appetite return­ing, exports accelerating, and the inventory drawdown moderating, although private credit remains sluggish and unemployment is on the rise.

The strength of the initial macroeconomic policy response has been largely determined by policy room, which varied considerably across the region. With inflation rates low and credit markets severely disrupted, central banks in the advanced economies reduced interest rates aggressively and introduced some unconven­tional measures, including direct acquisition of assets by the Bank of England and purchases of covered bonds by the European Central Bank. Many advanced economies committed consider­able budgetary resources to support the finan­cial sector, mainly through guarantees. Capital injections and asset purchases have generally been more limited so far, with the exception of Austria, Belgium, Ireland, the Netherlands, Norway, and the United Kingdom. A number of countries, including Germany, Spain, and the United Kingdom, introduced large discretionary stimulus packages to support the economy more broadly, in addition to the considerable support provided by automatic stabilizers.

At the same time, countries with more limited policy room at the onset of the recession, such as Greece, Italy, and most of the emerging economies, were not in a position to introduce major stimulus. More­over, most countries of emerging Europe have also been constrained by the outflow of foreign capital (or the risk thereof), with some forced to tighten their monetary stance and consolidate fiscal accounts, particularly those economies with fixed exchange rates. More recently, subsid­ing risk aversion has allowed some emerging economies to cut interest rates.

The pace of decline in activity appears to be moderating, but the recovery will likely be mod­est during the coming quarters. The turnaround during the second half of 2009 is expected to be driven mainly by rising exports and a turn in the inventory cycle, with continued support from policy stimulus. The euro area is projected to emerge from the recession in the second half of 2009, with recovery strengthening over the course of 2010, while inflation should remain low. The turnaround is most apparent on a fourth-quarter-over-fourth-quarter basis, from a decline of 2.5 percent in 2009 to an increase of 0.9 percent in 2010. The modest pace of recovery is consistent with continued housing market pressures in some economies, enduring strains in the largely bank-based financial sector, and a drag from the labor mar­kets. Even though initial job cuts were moder­ate, unemployment is projected to approach 10 percent during 2009 and to reach almost 12 percent by 2011, with job creation likely subdued as widespread reductions in hours worked are reversed.

In the United Kingdom, real GDP growth is expected to turn positive in the second half of 2009, as the real estate and financial markets stabilize and the weakened sterling supports net exports. In emerging Europe, following a contraction in real GDP of 5¹/₄ percent in 2009, a return to positive growth is expected in 2010. The recovery is expected to be slower than in other emerging regions because many economies will continue to face serious adjustment problems, given that cross-border capital flows will likely remain lower for some time. And the recovery will be uneven: some emerging European economies─notably the Baltics─will continue to contract in 2010, but sizable output gains are expected elsewhere, notably in Poland and Turkey.

Downside risks to the outlook for Europe are receding, and some upside risk has surfaced in several economies. The recovery may be more sluggish than expected if conditions in the financial and corporate sectors get worse and if unemployment rises faster than currently anticipated. Financial institutions are vulner­able to a further deterioration in asset quality, because losses in the corporate sector may rise while capitalization remains fairly low. Emerg­ing Europe is especially vulnerable to further contractions in cross-border funding, and large cross-border exposures by Austria, Belgium, and a number of other advanced economies remain a risk to banks in these countries. The recourse to shortened work hours in an effort to preserve jobs may have slowed the fall in employment so far, but as labor market pres­sures continue in the months ahead and as employment-support programs reach their limits, job shedding could intensify more than currently projected. The downside risks could become more pronounced if policy support in the advanced economies is withdrawn too early, if political pressures delay financial sector repairs, or if policy coordination falters. The upside risks lie mainly in a faster-than-antici­pated recovery of global trade and confidence.

Over the medium term, GDP growth is likely to return to precrisis rates only gradually, as supply remains sluggish and balance sheet adjustment continues to weigh on demand. Unemployment is forecast to remain high for some time, and it is likely that some of the increase will become structural, as displaced labor finds reentry difficult, especially in the euro area and some emerging economies. As credit conditions remain tight and public sup­port is gradually withdrawn, investment will likely remain low, and some of the existing capital stock will need to be scrapped as corpo­rations in a number of countries restructure. Indeed, past experience indicates that employment, capital accumulation, and productivity remain sluggish for a long time following finan­cial crises. At the same time, private demand is likely to remain particularly subdued in the many European countries that have undergone an abrupt unwinding of precrisis asset price and credit booms. Linked to this, current account deficits are expected to narrow in a number of countries, in particular, Greece, Ireland, Spain, and much of emerging Europe.

The outlook for the Middle East has improved recently, with the global economy stabilizing and oil prices rebounding. These economies have been hit hard by the global recession and, as a result, growth has decelerated sharply. In particular, the collapse in oil prices and sharp contraction in worker remittances and foreign direct investment have weighed on the econo­mies in the region. The recent improvement in global financial conditions and rise in commod­ity prices, however, are helping restore the pace of economic activity. Nonetheless, the aftermath of the regional asset price collapse continues to weigh down the outlook.

Bank credit to the private sector in the region dried up following the financial sector problems in Bahrain and Dubai, the region’s main financial centers, and this is sapping the strength of the recovery.

Real GDP growth for the region is projected at 2 percent in 2009 and almost 4¹/₄ percent in 2010. Real GDP growth of oil importers is projected at about 4¹/₂ percent in 2009, more than three times the growth rate of the oil exporters. The sharp slowdown in activity of oil exporters reflects cutbacks in oil production, a result of efforts by the Orga­nization of Petroleum Exporting Countries to stabilize oil prices, although most oil exporters have maintained strong public spending growth to help their nonoil sector. Part of this spending has spilled over to the nonoil producers in the region, providing important support to these economies. Within these regional aggregates, there are important cross-country differences. For instance, among oil exporters, the United Arab Emirates (UAE) nonoil sector has been most affected by its linkages to global trade and financial markets and by the fall in real estate prices. In contrast, Lebanon continues to demonstrate strong resilience to the global crisis because improved security conditions have buoyed economic activity, particularly in tourism and financial services.

Inflation in the Middle East has subsided as economies have slowed. For the region as a whole, inflation is projected to decline from 15 percent in 2008 to 8.3 percent in 2009. At the country level, Jordan and Lebanon are pro­jected to experience the sharpest drop in inflation (from double digits in 2008 to low single digits in 2009), as a result of the decline in the prices of imported food and fuel experienced by these import-dependent economies. Infla­tion in Egypt and the Islamic Republic of Iran is projected to remain in double digits, however. The current account surplus of the region is projected to narrow by 15³/₄ percent of GDP in 2009, primarily from a sharp reduction in oil exports (Kuwait, Qatar, Saudi Arabia).

The key risk to the outlook is the possibility that the global recovery may not be sustained and that oil prices may fall sharply, which could have important implications for oil exporters and their regional trading partners. In an attempt to bol­ster fiscal positions, oil exporters may need to cut public spending. This expenditure compression could have important regional spillover effects on the oil-importing countries by significantly reduc­ing worker remittances. Another risk is that the banking systems of several oil-exporting countries could come under severe stress if global financial conditions tighten again.

Public policies should be geared to support­ing domestic demand while recoveries remain fragile, provided countries have enough policy room. Monetary policy should balance the need to continue supporting domestic demand while avoiding the risk of allowing inflation pressures to build (Egypt). Some economies have been reducing interest rates (Kuwait, Saudi Arabia, UAE) as inflation has fallen. Although there is now limited room for further interest rate cuts, some central banks could modestly reduce inter­est rates if their economies slow.

Fiscal policies have been supportive of domes­tic demand in many Middle Eastern economies. In particular, oil exporters have maintained high levels of public spending despite a sharp drop in revenues. Countries with fiscal room should continue with these policies (which serve a similar function as automatic stabilizers) to help the recovery gain momentum. Saudi Arabia, which had sizable government surpluses during the oil boom, is implementing the largest fiscal stimulus program (as a percent of GDP) among the Group of 20 countries. However, countries with weaker fiscal positions will need to cut back unproductive spending to avoid an unsustain­able debt path. As part of such efforts, subsidy policies should be reined in.