Global Economic Outlook - August 2012

Global Economic Outlook
by Cecilia Hermansson 21 August 2012

The crisis in the euro zone is slowing the global
economy and leaving it more vulnerable
 The global economy received a temporary boost in the first quarter after the
major central banks expanded their quantitative easing, but during the second
quarter growth slowed once again. The euro zone is on the brink of recession,
the US recovery is sluggish and emerging markets are feeling the impact of
weaker demand from developed countries as well as the effects of their own
economic austerity in order to mitigate signs of overheating.
 The crisis in the euro zone and uncertainty about US fiscal policy will slow the
global economy going forward. We have revised GDP growth downward to
3.0% and 3.1% for 2012 and 2013, from 3.1% and 3.4%, at the same time that
the expected rise to 3.4% in 2014 assumes that the crisis is handled well and
produces stronger institutions and closer integration in the euro zone. We give
this muddling-through scenario a probability of 60%. Uncertainty about the euro
zone crisis also affects the accuracy of our forecasts. We have assigned the
scenario with slower development a probability of 35%, but only a 5%
probability that the economy will outperform expectations.
 Economic policy here at home has to address the crisis in our most important
export market, which affects exports and investment. Moreover, strategies have
to be developed to best deal with the prospect of a closer integration in the
euro zone, when countries on the outside will risk falling behind. We expect that
any anything-but-straight path to a banking union, fiscal policy union, economic
policy union and political union will eventually be chosen, since the alternative
is a crumbling currency union that will produce huge economic, social and
(geo)political costs. It is in our interest that the euro survives and that Europe’s
inner market continues to develop.
Cecilia Hermansson
Contents: Page:
1. Imbalances are reducing global growth 2
2. Downside risks outweigh upside risks 6
3. Crisis in the euro zone 8
4. Our assumptions about the commodity and financial markets 14
5. Emerging economies are driving growth 23
- USA 24
- China 26
- Japan 28
- India 29
- Brazil 31
- Euro zone 33
- UK 36
- Nordic countries 38
6. Conclusions for our home markets 39

Ekonomiska sekretariatet, Swedbank AB (publ), 105 34 Stockholm, tfn 08-5859 7740
E-post: ek.sekr@swedbank.se Internet: www.swedbank.se Ansvarig ugivare: Cecilia Hermansson, 08-5859 7720
Magnus Alvesson, 08-5859 1031,Jörgen Kennemar, 08-5859 7730, ISSN 1103-4897

1. Imbalances are reducing global growth
At the beginning of 2012 the global economy strengthened more Growth in early 2012
than expected, especially in Germany and Japan. Liquidity was stronger than
injections from central banks probably helped to hide actual expected …
conditions and delay the slowdown that arrived in the second
quarter. Now there are clear signs of recession in parts of the
euro zone and the UK, at the same time that the economies in
the US, Germany, Japan, China, India and Brazil have cooled off.

We have revised our global GDP growth estimates downward for
2012 and 2013 to 3.0% and 3.1%, respectively, from 3.1% and
3.4% in the April forecast. Not until 2014 – and with considerable
uncertainty – do we expect GDP growth to reach 3.4%, which is
still weaker than in 2011.

Global GDP forecast
August Forecast April Forecast
GDP growth (%) 2011 2012 2013 2014 2011 2012 2013
US 1,8 2,1 1,7 2,3 1,7 2,1 2,3

Euro zone: 1,5 -0,4 0,1 0,8 1,4 -0,5 0,4
of which: Germany 3,1 1,1 1,1 1,6 3,1 0,5 1,3
France 1,7 0,3 0,5 1,1 1,7 0,3 0,6
Italy 0,4 -2,2 -1,0 0,2 0,4 -1,8 -0,3
Spain 0,7 -2,0 -1,2 0,3 0,7 -2,0 -0,8
Finland 2,8 0,7 1,4 1,8 2,9 0,8 1,7

UK 0,7 0,2 1,0 1,7 0,7 0,5 1,0
Denmark 0,8 0,8 1,2 1,3 1,0 0,5 1,0
Norway 1,5 3,3 1,6 2,2 1,7 2,0 2,5

Japan -0,7 2,2 1,3 1,2 -0,7 1,5 1,2
China 9,2 7,9 7,8 7,6 9,2 8,1 8,0
India 7,2 6,2 6,5 6,8 7,2 6,7 7,3

Brazil 2,7 2,0 3,9 4,1 2,7 3,1 3,5
Russia 4,3 3,8 3,9 4,3 4,3 4,1 3,9
Global GDP in PPP 3,5 3,0 3,1 3,4 3,5 3,1 3,4
Global GDP in US dollars 2,6 2,2 2,3 2,7 2,5 2,2 2,6

Source: National statistics and Swedbank’s forecasts.
Note: The countries represent around 70% of the global economy. To gauge
total GDP growth, add around 0.3-0.4 percentage points.

Due to the strong results early in 2012, current-year growth … because of which
estimates for certain countries have been revised upward. This GDP growth estimates
mainly applies to Japan and Germany. As a result, weaker for some countries have
development in the euro zone’s crisis countries ended up being been revised upward
more than compensated by stronger gains in Germany. In the
US, the positive effect of lower gas prices on private consumption
was offset by increased concerns about growth-inhibiting
austerity measures set to take effect at the end of the year. While
the US forecast for 2012 is unchanged, the euro zone’s has been
revised upward slightly. At the same time growth has slowed

2 Swedbank’s Global Economic Outlook • 21 August 2012

more than expected in the BRIC countries (China, India, Brazil
and Russia), which necessitated a downward revision.

Our outlook for 2013 has been revised downward even more. On the other hand, the
Although US quarterly growth will rise in our forecast, the annual US and Europe will
rate in 2013 will fall due to the weak start to 2012. The slow continue to weaken in
improvement in the labour market, troubled small businesses 2013…
and, no less importantly, the negative effects of budget austerity,
which will have to happen in some form, will choke off the
recovery. In the euro zone, the recession in two crisis countries,
Italy and Spain, is worsening, while the core countries are also
seeing a slowdown due to the region’s weaker demand and
growing instability in the financial market.

While we expect stimulus measures and economic reforms to … and emerging
strengthen growth in India and Brazil in the years ahead, China’s markets will also grow
growth is headed in the opposite direction, though this is more slowly
desirable in some respects. The shift in focus from investments
and exports to private consumption will mean a slightly lower
growth rate. This process entails big risks, and experience shows
that a “fine-tuning” is hard to accomplish, even for politicians that
are used to steering the economy centrally – and should be hard
in an economy as large as China’s.

Actual growth in a number of countries
15,0
China
12,5
10,0
7,5
India

5,0
Percent

Brazil
2,5
0,0
-2,5
US Eurozone
-5,0
-7,5
Japan
-10,0
05 06 07 08 09 10 11
Source: Reuters EcoW in

Whether global GDP growth of 3.4% in 2014 will be reached A muddling-through
largely depends on crisis management in the euro zone and the scenario is important to
speed of the debt restructuring of the public sector in the majority growth in 2014
of developed countries. We expect the euro zone to continue to
muddle through. Even if the institutional framework is
strengthened, many problems will still exist, especially with debt
levels being high, the crisis countries struggling competitively and
reform needs so great. Growth will be weak or practically
nonexistent during the forecast period.

Swedbank’s Global Economic Outlook • 21 August 2012 3

Another important question is how strong potential growth really How high is potential
is in developed and emerging markets given the economic global growth at this
climate since the financial crisis. By potential production and point?
growth we mean the production and growth that are possible
without creating serious imbalances in the economy: the
production level at which supply meets demand and actual and
projected inflation are in line with the central bank’s explicit or
implicit targets.

Debt restructuring in the developed countries is likely to choke
investment in every part of the world, which will impact
productivity growth. In addition, potential growth could be held in
check by increased structural unemployment, which is another
reason why the skills that companies need are not available. This
could be the case in both the US and Europe.

For emerging markets, the crisis in the euro zone and slow US
recovery mean weaker export demand, but also a lower appetite
for investment. As a result, there is a risk that investment and
capital flows will dry up, adversely affecting productivity growth.

We have previously estimated potential global GDP growth at Without scientific
4.2%, but this assumes that the US rises by 3.3%, the euro zone precision, we estimate
by 2.3% and Japan, China, India by 1.5%, 8% and 7%, that potential growth has
respectively. Now it seems more likely that potential GDP growth shrunk from 4.2% to
will be less than 4%, and probably closer to 3.8%. Regardless of 3.8%
the debate on potential growth, there is reason to fear that a
number of deficiencies and imbalances will suppress global
growth in the years ahead:
1. The institutional crisis in the euro zone is affecting the
willingness to invest. High debt levels in the public and
private sectors in a number of countries are also impeding
growth. Other factors affecting growth prospects include a
democratic deficit, which is hurting future confidence, weak
competitiveness in certain countries, a flawed inner market
and generally inferior labour and product markets.

2. The fiscal crisis in the US and Japan, including the high
public debt levels, is affecting the willingness to invest, hire
and spend.

3. Economic policy is no longer as effective at stabilising
economic swings: interest rates can’t be cut any lower in
major developed economies, the marginal benefit of
quantitative easing is low and shrinking, and automatic
stabilisers aren’t totally effective when the need for budget
consolidation increases. This raises the risk of
protectionism and a currency war.

4. Weak balance sheets in banks in developed countries have
led to credit austerity and continued financial instability.
This is squeezing investment and growth.

5. Insufficient investment in education is creating problems in
the labour market and reducing productivity growth. A lack
of resources to invest in environmental and climate-smart
technologies and infrastructure due to weak government
finances will also affect long-term growth.


6. Growing income and wealth gaps mean that many people
will never reach their potential due to educational, health
and employment limitations. There is also a risk that
several countries will have to deal with a “lost generation”,
criminality and extremism.

7. Problems with capital allocation between and within
countries. Undeveloped financial sectors in emerging
markets are causing capital to flee and seek out more
developed markets, where returns are lower. Low interest
rates in developed countries could also distort capital
allocation there.

In a climate of credit and budget austerity, with a weak risk
appetite and reluctance to invest, politicians face growing The courage and
challenges to maintain sound economic policies that increase willingness of politicians
efficiencies while also reducing income gaps, and which improve to implement reforms
growth prospects in both the short and long term. Politicians who will be critical
are willing and courageous enough to push through structural
reforms that significantly improve the functioning of various
markets and incentivise innovation and creativity will be more
successful than those who focus solely on budget consolidation.
Furthermore, the West has to adapt its welfare systems to
available financing and acknowledge that huge annual budget
deficits can no longer be accepted.

We have revised our growth outlook downward for 2012 and
2013 compared with our April forecast. More importantly, growth
will remain below its potential for several years to come. A
number of imbalances in the global economy are stifling growth
in the form of high debt levels, skewed capital allocation,
institutional and political crises, confidence and democratic
deficits, insufficient investment and growing income gaps.


2. Downside risks outweigh upside risks
Uncertainty about global growth is very high, as has been the Forecast errors
case in recent years, and forecast errors increase the further in increase the further in
the future we try to predict. Several risks should be emphasised, the forecast horizon
including political and psychological risks as well as economic. we go
Assumptions about commodity prices entail risks associated with
the weather and geopolitical tensions. We have given our
“muddling-through” scenario a probability of 60%. In this scenario
growth is weak. Even though the problems formulating economic
policy and building institutions are numerous and monumental,
the work is progressing slowly and gradually, just enough that a
total collapse is avoided. Many issues are being addressed at the
last moment, which feeds doomsday headlines that a collapse is
nigh. Consequently, financial instability is high in this scenario as
well.

However, there are also several more or less optimistic
scenarios. We consider the downside forecast risks more
probable than the upside risks. This applies to how likely it is that
they will be realised and to the effects on the global economy if
they are.

The probabilities are tied to whether any of the risks are realised, If all the downside
but keep in mind that the scale is fluid: How much will the crisis risks are fully realised,
worsen and how far will commodity prices rise? The effects on the impact will be
the economy vary as a result. If all the downside risks are fully substantial
realised, the impact would of course be huge, compared with if
one of the risks is partly realised and has a modest impact. This
shows that the probabilities are of limited value, though they do
provide an indication of whether we feel it is more or less likely
that conditions will worsen relative to the main scenario.

1. Downside risks (35%)

 A growing crisis in the euro zone, where Spain and Italy need
support, but where the rescue funds prove insufficient and the
European Central Bank (ECB) lacks the mandate to stabilise
conditions. One or more euro countries are forced to exit the
currency union, with negative consequences for financial
stability and growth. The result: depression, deflation and mass
unemployment in combination with a wounded financial sector
(see chapter 3 on the euro zone crisis).

 The US stumbles off a “fiscal cliff” after Congress fails to agree
on a budget. As a result, taxes are raised at the same time
spending is cut after the turn of the year. If fiscal austerity is
fully implemented, GDP growth would be slashed by 4
percentage points and the US would fall into recession.

 The failure of the US and Japan to consolidate their public
finances in the medium and long term could affect confidence
and create concerns. Their status as safe havens, and the
reputations of the dollar and yen as safe haven currencies,
could change. If nothing else, a reversal from historically low
bond yields to very high yields in the wake of a collapse in
confidence would make it that much more expensive to finance
the government’s debt and could cause a recession.


 Attempts by Chinese officials to stave off inflation and a housing
bubble may have been taken too far with the help of austerity
and regulations. Sharp declines in land and housing prices
would impact many sectors of the economy, including
municipalities. A hard landing is possible in China if growth
slows significantly, e.g., if exports are affected by the global
crisis at the same time that overcapacity limits investment. If the
monetary and fiscal stimulus is insufficient, there is also a risk
that unemployment will rise and households will become more
cautious. Very low GDP growth could also create political
instability.

 Higher commodity prices could be caused by new supply
problems in food production, e.g., droughts and floods.
Geopolitical tension in the Middle East could push oil prices
higher than expected. Higher inflation reduces private
consumption.

 Emerging markets such as India and Brazil have tightened their
economic policies to prevent runaway inflation and credit
growth. Inflation has eased, allowing more room for stimulus. If
commodity prices rise again, inflation will too, limiting
opportunities for expansive economic policies. Capital outflows,
currency depreciation and falling stock prices could also create
financial instability in emerging markets.

 Political risks create uncertainty on both the up- and downside.
Increased political concerns in connection with the elections in
Italy and Germany next year could reduce confidence in the
euro zone. Power struggles in the US and China this year could
affect political resolve.

2. Upside risks (5%)

 Resolute action to address the euro zone crisis could
strengthen confidence and shorten the recession in the region.

 If supply problems are resolved at the same time that weaker
demand keeps prices in check, it could help commodity-
importing countries and companies. Lower inflation facilitates
expansive economic policies.

 A consumption boom in Germany could occur in the wake of
lower unemployment and declining inflation. Higher real wages
strengthen domestic demand and higher imports reduce the
current account surplus. Slightly more expansive German
economic policy would benefit the export-oriented euro zone
countries now in crisis.

 If emerging markets stimulate their economies more than
expected, growth may rise in the short term, but with a greater
risk of bubbles that burst in the medium term.


3. Crisis in the euro zone
Below we discuss the euro zone’s immediate and more long-term
problems as well as the solutions required and what is currently
preventing decision-makers from choosing them. We also make
an attempt to develop various scenarios for the euro zone’s
future development.

Euro zone’s problems

The euro zone is wrestling with several types of problems, some
more immediate than others. They are related in terms of how
they arose and how they should be resolved.

The most pressing problem is increased financial fragmentation Financial
and the high bond yields that have resulted in Spain and Italy, fragmentation and the
which are putting both countries at risk and jeopardising the euro crisis in Greece, Spain
zone’s stability. These countries are in a recession, which could and Italy are the most
become a depression. Despite its debt reconstruction, Greece pressing concerns
appears to be insolvent. There is a lack of confidence that the
crisis can be addressed with the current support mechanisms
that exist. This is creating fears that one or more countries will
default on their debt payments and have to exit the currency
union, which would then face the prospect of having to dissolve
or undergo a major transformation. Such a process would mean
huge costs within and outside the euro zone. If nothing else, the
crisis has drawn attention to the institutional weaknesses that
have plagued the currency union since its inception.

Another, more long-term problem is that several euro countries, The public debt crisis
including core countries, have high public debts – and in some and banking crisis are
cases private debt – as evidenced by the shaky condition of the closely related
banking sector. Restructuring public finances and cleaning up the
banking system will take time and entails tremendous risks.
Credit austerity, weak growth, high financing costs and volatility
are affecting investment and consumption. With continued high
bond yields, even countries that today are mainly looking at
liquidity problems may prove to be insolvent. The institutional
framework – the Stability and Growth Pact – was poorly
designed, far too weak and did little to stop an escalating and
unsustainable build-up of public debt.

The public sector’s gross debt as a percentage of GDP, 2013 forecast

300
250
200
150
100
50
0
Ge Sp EA UK Be US Po Ir It Gr Jp
Source: IMF


A third, more long-term problem is the divergence between the Big differences in
fairly well-functioning countries to the north and their competitiveness
competitively weaker neighbours with much bigger imbalances to between north and
the south. An undue focus on nominal convergence allowed the south
latter to join the currency union, and for several countries
exceptions were made so they would meet the criteria. Low real
interest rates and large capital inflows created a real estate and
financial crisis in several countries, in some cases contributing to
a bloated public sector. Rapid wage growth, coupled with low
productivity growth, weakened the competitiveness of these
countries and generated huge current account deficits. The need
for structural reforms was widely ignored.

Current account balance as % of GDP
10

5

0
Percent

-5

-1 0

-1 5

-2 0
96 98 00 02 04 06 08 10 12

G e rm a n y Ir e la n d S p a in
G re e c e P o rtu g a l
S o u r c e : R e u te r s E c o W in

The mere existence of the currency union didn’t create the The currency union
problems and imbalances described above, but it has made the has made the crisis
situation worse and limits how the countries can resolve their worse and makes it
problems. The crisis countries are at the mercy of the euro zone harder to resolve it
to collaboratively find a solution.

Other countries such as the UK, US and Japan are also
struggling with debt, but the biggest concern is how the euro
zone’s existing framework will handle the high levels of debt. In
the US, some states are more competitive than others, but the
transfers between them are larger, so when a local municipality
occasionally files for bankruptcy the dollar isn’t in jeopardy. The
credit risk to lend to these municipalities is increasing, however,
and their financing costs will remain high for years to come.

Other countries that have faced financial and real estate crises in Other countries have
recent years include the US, UK, Iceland, Baltic countries and developed similar
Denmark. The difference is that countries with their own central bubbles and debt
banks that aren’t members of the currency union have more tools crises, but have other
at their disposal, e.g., currency depreciation, printing presses and tools at their disposal
increased lending. The confidence crisis in the euro zone stems
from with the fact that its members have arrogated monetary
policy decisions, even though the euro zone hasn’t developed the
necessary crisis management resources and institutional
framework.


Which institutions are needed and how well are they working
today?

A monetary union won’t work long-term without a fiscal and A currency union isn’t
financial union, as well as a central bank that serves as a lender enough – financial and
of last resort, in the opinion of many economists (see, e.g., Jean fiscal unions are
Pisani-Ferry, 2012). The optimal currency area theory also cites needed as well
the need for increased financial and fiscal integration.

However, the EU Treaty contains a “no bail-out” clause, which The EU Treaty has
prohibits countries from paying each other’s debts. The idea was prohibited the
to force them to manage their own finances and not turn to others necessary
for help. This refers to what is called moral hazard, i.e., that the crisis solutions ...no
crisis countries aren’t fully suffering the negative effects of their bail-out clause...
actions. The Stability and Growth Pact was counted on to reduce
the risk that countries which join the currency union would break
their pledge to maintain budget discipline. Unfortunately the
reliance on group pressure proved misguided.

The ECB is prohibited from monetary financing, which means … no monetary
that the central bank can’t buy bonds from its member countries financing in the ECB
and monetise the debt. Aside from the moral hazard, there is a …
risk of accelerating inflation, currency depreciation and financial
instability.

A financial union or banking union was never part of the plan, … and the banks were
since member countries wanted to retain responsibility for “their regulated and
banks”. But with a common monetary policy and interest rate supervised nationally
convergence it will be hard to put national borders on banking.
This has increased the need for a supranational banking
authority, which should also be linked to a fiscal cooperation,
considering that the balance sheets of the banks and
governments are closely intertwined.

Note that although the treaty prohibits countries from assuming The crisis has forced
each other’s debts, the crisis has forced the euro zone to do just politicians to
that through the European Financial Stability Facility (EFSF). The circumvent the EU
ECB also appears to be dabbling with monetary financing by Treaty
buying government bonds on the second-hand market. One
reason why the EU Treaty has been contravened is that the risk
of an economic meltdown is seen as greater than the moral
hazard and the risk of inflation.

Are there any permanent solutions and what are their
limitations?

What are the more permanent solutions to the euro zone’s
problems? The financial market has put its faith in the ECB to
manage the crisis, since the central bank has the ability to print
money in emergencies. Politicians who have a responsibility to
their taxpayers back home, e.g., in Germany, prefer to focus on
long-term problems by demanding reforms and budget
consolidation and in that way increase confidence in the financial
market and keep pressure on crisis countries to take
responsibility for their own economies. These politicians are
demanding that stronger institutions be put in place before more


support is offered the crisis countries. The fact that the ECB can
no longer buy government bonds before the crisis country in
question has negotiated a program with the EFSF is one way for
Germany to tighten rules and encourage reforms, at the same
time that the ECB in this way – as long as Spain doesn’t ask for a
bailout through the EFSF – gives up an instrument that could
reduce the immediate crisis (at least temporarily).

There is a tug-of-war between the need for short-term solutions Crisis management
to support the financial market and crisis countries and those is a tug-of-war and
who’d rather ensure that the institutions are strong enough for the balancing act
long term. The tug-of-war is also evident by the need to promote
growth, which isn’t always consistent with the need for reform
and budget consolidation. While the financial market doesn’t
sufficiently understand the political process and importance of
taking a long-term view of the currency union, politicians lack a
thorough understanding of how the financial market works.

There are short-term problems and there are long-term problems, Short- and long-term
but both have to be addressed now. It takes time to increase problems both have to
competitiveness and reduce government spending, so reforms be addressed now!
will have to be implemented immediately. This could mean
deregulation, labour market and pension reform, tax reform and
privatisations. Growth would also be positively impacted in the
short term, not least from the increased confidence, which would
fairly quickly give the economy a jolt. It is also possible that the
institutions will first have to be strengthened before the crisis
countries receive help. Anything else would be unsustainable.
The euro countries wouldn’t be able to withstand another Greek
crisis, which means that the framework first has to be changed
before Spain can expect to reduce its high bond yields.

The euro countries are slowly working toward an optimal solution This fall's working
for the euro’s survival, where the monetary union incorporates groups will
fiscal policy and a financial union that allows the central bank to demonstrate whether
serve as a lender of last resort and lays the foundation for a the euro zone has
common bond market, a so-called Eurobond market. taken a step closer to
the optimal solution
There are several long-term advantages to a eurobond market,
and it could be designed so that every country “wins” by being a
part at the same time the moral hazard is reduced. A eurobond
market would increase the effectiveness of the European bond A eurobond market
market thanks to the increased volume, but it wouldn’t alleviate would be positive in
the immediate crisis. Redistributing the public debt burden from the long term, but
countries with large debts to those with smaller debts is hardly doesn’t resolve the
going to improve the euro's image and isn't reasonable if there immediate problems
are enough private assets in the crisis country to possibly
redistribute the burden to.

To achieve the optimal solution as outlined above requires a The euro zone’s
strong commitment to keep the currency union intact and to democratic deficit is a
democratic principles, which may take more time, but in the long huge risk
run will be more sustainable. By kicking the can down the road,
the euro zone’s politicians are not only putting off important
decisions in the hopes others will make them, but are also
neglecting to find a balance between support and reform


pressure and to design institutions that work better than those
created when the currency union was formed. The 17 euro
countries, with their varying national interests, also face the
challenge of agreeing on major changes that, despite their
reluctance, now appear to be imminent. The fact that politicians
have been slow to address the crisis and have focused on
solutions unrelated to the central problems (credit ratings
agencies, Tobin tax, etc.) has probably only made it worse.

The process to strengthen these institutions is under way based For the vision to have
on Herman Van Rompuy’s draft, where the vision incorporates lasting value will
four building blocks: 1) an integrated financial framework, 2) an require a more
integrated budgetary framework, 3) an integrated economic democratic process
policy framework, and one that is especially difficult, 4) ensuring
the necessary democratic legitimacy and accountability of the
decision-making process. Working groups will formulate the
details of this plan at the same time that the ECB has appointed
working groups to stipulate the forms of bond purchases,
provided that the crisis countries follow the programs prescribed
by the EFSF/ESM rescue funds.

Some immediate questions:
1. Will Greece need another bailout since its primary surplus will still
have to be very high, and will official lenders accept this? Is it
enough that Greece demonstrates a greater commitment to reform
for the euro countries? Would other euro countries accept that
Greece’s debt ratio would be lower than 120%? The alternative is to
give Greece more time to implement the consolidation program,
although such a solution also has to be financed.

2. Are other euro countries insolvent and how is this being handled?
Though Greece’s debt reconstruction may be unique, the actions
have probably contributed to Spain and Italy's high bond yields,
since the financial market sees a higher risk. It is reasonable for
banks to take losses, but the problem is that the crisis would then
spread to other countries. Next in line could be France and Belgium.

3. There is a risk that the ECB will no longer have the instruments to
address the crisis if the situation worsens in Spain and Italy. It would
take time to find support through the EFSF before the ECB could
begin buying bonds? It is important to consider the ECB’s
independence; the relatively young central bank is more vulnerable
to political pressure. The ECB has said that a program through the
EFSF is necessary but not sufficient for it to buy bonds. It claims
that it can make its own independent decisions (at least on paper).
An alternative would have been if the EFSF, or eventually the ESM
if and when it becomes a reality, had been given a banking license
to enlarge the fund. Now the ECB is expected to follow bailout
programs and boost the bailout funds by buying bonds.

4. Germany has to accept higher inflation to allow the crisis countries
in southern Europe to adjust their debt levels and become more
competitive. Otherwise they face a risk of deflation. Higher prices
and wages will reduce Germany's current account surplus, which
would also make it easier for the crisis countries to reduce their
deficits. The question is how far Germany is prepared to go,
probably not further than maintaining price stability for the euro zone
as a whole.


There is great uncertainty whether the working groups will There is a long way to
succeed in creating institutions given the needs that exist, go before any
whether politicians in the euro zone will be able to agree on the decisions are made
proposals and whether the national parliaments will approve the and implemented
changes. Even then it would take some time before the proposals
are implemented.

Unless the currency union is more closely integrated, and if The integration has to
instead the next the best solution is chosen, i.e., to develop the go further – the
ESM and combine it with the ECB’s various tools, there is a risk question is how far
that the financial market will continue to doubt the euro’s survival. member countries are
While it is difficult to see any alternative to the optimal solution, prepared to go
the integration could vary in terms of degree, i.e., how far the
budget framework is integrated. And what would a banking union
look like in terms of supervision, intervention for troubled banks
and a deposit guarantee?

What will happen? There are at least four possible future
scenarios looking forward:
1. Our main scenario has a probability of slightly over 50%. The
muddling-through scenario is a slow, nonlinear process that leads to
a further integration of fiscal policy, the financial sector and
economic policy. Thanks to stronger institutions, reforms in crisis
countries and budget consolidation, confidence improves. The crisis
eases, but the efforts to improve growth prospects, reduce the debt
burden and improve competitiveness take a long time.

2. Greece exits the euro zone after difficulty agreeing on reforms and
budget consolidation, and after the euro countries decide not to
provide more money to help reduce Greece’s debt burden. The
initial impact on Greece is significant. It is unclear how the euro
zone is affected, but the risks are on the downside. The probability
of this scenario is just under 50%.

3. Additional countries beside Greece have to exit the euro zone after
the debt crisis and political and social conditions worsen, with higher
unemployment as a result. The currency union is maintained but
with fewer member countries. The costs to restore the national
currencies in some countries are high and the spillover effects on
the other countries are likely to be great. The probability of this
scenario, i.e., that Greece and all the other crisis countries exit the
currency union, is lower at around 15% in our opinion.

4. The currency union is totally dissolved. It seems unlikely that all the
countries will decide to reintroduce their national currencies, but
political decisions can have surprising outcomes sometimes, so we
give this scenario a probability of 5%. The political, geopolitical,
social and economic effects would be huge: Europe's inner market
would dissolve and large parts of the EU cooperation would have to
begin anew.

The challenges for the euro zone are gigantic. A great deal is at
stake. There is still a political commitment to rescue the euro.
The alternative to greater integration is continued weak
confidence in the EU's crisis management capabilities with the
risk that the financial fragmentation will be long-lasting and that
the costs for the crisis countries to adapt will be extremely high.


4. Our assumptions about the commodity
and financial markets
Since our April forecast, commodity prices have fallen at the
same time that stock prices, after gains and losses, are
unchanged on a global basis and long-term interest rates for the
major economies have been further reduced. (The opposite is
true of crisis countries such as Spain and Italy). The euro has
weakened against the dollar. In the following, we describe our
assumptions about the financial and commodity markets, which
serve as the basis for our forecast for 2012-2014.

Commodity markets
After rising significantly during the first quarter, oil prices (Brent) Big swings in oil prices
retreated during the second quarter in the face of a weaker …
economy, lower risk appetite and less geopolitical volatility (Iran,
Strait of Hormuz). Then, in July and August, the trend again
turned higher. A shortage of North Sea oil, a ruptured pipeline in
Turkey, and the war and turbulence in Syria and Sudan pushed
prices higher, at least short-term. Demand has also risen due to
the slowdown in ethanol production from rising corn prices. In the
US, WTI oil has fallen in price after inventories rose and
production steadily increased. As a result, the difference between
Brent and WTI oil again is high at around $20 a barrel.

We expect prices to decline in line with the weaker global … but we now assume
economy, which is impacting demand. China's economy is of that prices will be
great importance to oil prices, and even though activity is now lower this year than
growing more slowly demand will continue to rise – though not as last year
quickly. Next year Japan will restart its nuclear power plants,
which should reduce global demand slightly.

Total commodity prices, food prices and commodity prices excluding oil (index)
170
T o ta l c o m m o d ity p r ic e
160
150
140
130 F o o d p r ic e s
120
Index

110
100
90
80
70 T o ta l c o m m o d ity p ric e , e x c l o il
60
50
05 06 07 08 09 10 11 12
S o u r c e : R e u te rs E c o W in

In April we assumed that oil would average $119 a barrel this
year and $113 next year. With our revised assumptions, we are
now forecasting a price of $110 this year, falling to $104 next


year. In 2014 oil prices are expected to average $111 a barrel,
but uncertainty is obviously very high.

Metal prices have fallen and are expected to continue to trend Metal prices continue
lower through the end of next year, after which we should see a to trend lower in the
recovery as the economy and industrial production gain strength wake of weaker
once emerging markets have seen the results of their expansive investment
policies. This is also a reflection of production cutbacks by the
mining industry, which will eventually push prices higher. Fairly
sluggish metal prices have to be seen in light of continued weak
global investment growth.

The biggest drama this summer was reserved for food prices. Dramatic rise in food
Corn, barley and soy bean prices have all skyrocketed due to prices
droughts (the US, Russia) and floods (Russia). Even if prices
gradually ease, they will probably be higher at the end of the
forecast period than they are right now. There is growing
competition between food production and biofuels, which will lead
to shrinking grain inventories and higher food prices in coming
quarters. Moreover, export embargos and other trade restrictions
could exacerbate imbalances in the global food markets.

Outcome and forecast for commodity prices 2010-2014
(Brent crude, food and metals in US dollar converted to index 2010 = 100)

160

150

140

130

120 Oil
Metals
110
Food
100

90

80
2010:1
2010:2
2010:3
2010:4
2011:1
2011:2
2011:3
2011:4
2012:1
2012:2
2012:3
2012:4
2013:1
2013:2
2013:3
2013:4
2014:1
2014:2
2014:3
2014:4

In April we warned that weather could disrupt food production, Many risks associated
which it did. The risk of higher (and lower) commodity prices still with commodity
remains. This also applies to oil prices, since supplies will remain forecasts
uncertain for geopolitical reasons. Keep in mind that higher
commodity prices usually have a bigger impact on growth when
supplies decrease rather than when higher demand drives up
prices.

Inflation and interest rates
Despite the recent rise in oil and food prices, commodity prices Lower commodity
are expected to be lower in 2012 than in 2011, because of which prices are keeping
inflation could fall. The recession in parts of Europe, mainly the inflation in check
euro zone and the UK, is also easing price pressure from
domestic demand and the labour market. In some countries,


such as Spain, tax hikes are keeping inflation relatively high
despite weak demand.

Rate of inflation (CPI) in a number of countries 2006-2012
1 7 ,5
I n d ia
1 5 ,0

1 2 ,5

1 0 ,0 C h in a
Percent

7 ,5
B r a z il
5 ,0
UK
2 ,5 US
G e rm a n y
0 ,0
Japan
-2 ,5
06 07 08 09 10 11 12
S o u r c e : R e u t e r s E c o W in

In India and Brazil, inflation has begun to rise again, which is a Emerging markets
problem given the limited opportunities for more expansive continue to struggle
economic policy. The rise in inflation is a sign of insufficient with inflation problems,
capacity and requires investments, including in education, to while developed
alleviate resource shortages and infrastructure bottlenecks. In the countries have to
US, Europe and especially Japan, there is a greater risk of avoid deflation
deflation if the negative forecast risks are realised. This also
applies to China. In our main scenario, inflation falls, stabilising at
around 2% in the US and Europe, while Chinese inflation stays
within the comfort zone. Japan would instead see slight deflation
as oil imports gradually decrease and economic conditions
normalise.

Inflation outlook measured by the annual increase in CPI (%)
Outcome August Forecast
CPI 2011 2012 2013 2014
US 3,1 2,1 2,0 2,2

Euro zone 2,7 2,0 1,8 2,0
o/w Germany 2,3 1,9 1,7 2,0
France 2,1 2,0 1,8 2,0
Italy 2,8 2,7 2,0 2,2
Spain 3,2 1,9 1,6 2,2
Finland 3,4 2,2 2,0 2,0

United Kingdom 4,5 2,5 1,9 2,0
Denmark 2,8 2,4 1,7 2,0
Norway 1,3 1,5 1,8 2,0

Japan -0,3 0,1 -0,1 0,0
China 5,5 3,0 3,5 4,0
India 8,5 7,2 6,6 6,0

Brazil 6,6 5,0 5,2 5,0
Russia 8,4 4,6 6,6 6,9

Source: National data and Swedbank’s forecasts.


Lower inflation means higher real interest rates. Since
Interest rates will
benchmark rates can’t be cut much more in most developed
continue to decline in
countries, low inflation essentially serves as economic austerity.
emerging markets
Among emerging markets, Brazil, India and China still have room
for rate cuts, but not much (0.25–0.50% in the next two-three
quarters), since overheating risks still exist. These countries
could complement monetary easing with fiscal easing, however
– a measure most politicians in the developed countries can only
dream of.

Policy interest rates 2008-2012
1 5 ,0
B r a z il
1 2 ,5

1 0 ,0
Procent

In d ia
7 ,5 C h in a

UK
5 ,0 A u s tr a lia

US E u ro z o n e
2 ,5 N o rw a y
Sweden
Japan
0 ,0
08 09 10 11 12

The European Central Bank (ECB) cut its benchmark rate from
The ECB can and
1.00% to 0.75% on July 11 and in all likelihood it will cut rates
should cut rates
again in the third (or possibly fourth) quarter, especially since
slightly more
inflation is slowing and expectations that the ECB will address
the crisis have increased since the July 26 statement by Central
Bank President Mario Draghi: “Within our mandate, the ECB is
ready to do whatever it takes to preserve the euro, and believe
me, it will be enough”.

Benchmark interest rates 2012-2014
Policy Interest Rates 17-aug-12 31-dec-12 30-jun-13 31-dec-13 30-jun-14 31-dec-14
Federal Reserve 0,25 0,25 0,25 0,25 0,25 0,50
ECB 0,75 0,50 0,50 0,50 0,50 0,50
Bank of England 0,50 0,50 0,50 0,50 0,75 1,00
Bank of Japan 0,10 0,10 0,10 0,10 0,10 0,10

The impact of another rate cut shouldn’t be overestimated,
however. When it comes to Spanish and Italian bond yields,
which have reached record levels and are threatening the
stability of the euro zone, other tools are needed. The ECB,
which on August 2 decided to announce the following, is trying to
calm the markets:

 The ECB can again buy government bonds on the second-hand
market, but only if the country needing such support has sought
help from the rescue funds, EFSF or ESM, which can buy them
directly when issued, i.e., in the primary market. Remember that
it is necessary but not sufficient that the country has a bailout
program, since the ECB wants to maintain its independence.


 The ECB is now focused on government bonds with shorter
maturities. As a result, 2-year bonds have fallen by about 2.5
bp, while 10-year bonds remain high. There is a risk, however,
that the financial market will remain nervous, since the loans
will often have to be refinanced. At the same time there is
pressure on countries that need help to implement reforms and
consolidate their budgets.

 Working groups will formulate the details of the bond
purchases, which includes the question of seniority, so that the
ECB doesn't make it harder for other creditors to get paid back
in the event of a debt reconstruction. Another question is
whether or not the loans will be sterilised. If they won’t be any
longer, quantitative easing becomes a more important
consideration. Working out the details will take time. Even
getting countries to seek support can take time. There is no
assurance either that the euro zone’s governments will approve
the ESM. The fact that the Bundesbank doesn't support the
ECB’s plan could mean that purchases by the central bank
won't be quite as large as the financial market expects.

The ECB already has about 212 billion euros in crisis country Buying bonds isn't a
bonds on its balance sheet, but its bond-buying plan to date sustainable tool
has been tapped very little and with great reluctance. Mario
Draghi recommended other solutions when he took over as
Central Bank President, and greater focus has been placed
on unlimited lending to commercial banks at a 1% fixed rate
for three years (about 1 trillion euro) in order to 1) reduce
credit austerity and improve lending opportunities, 2)
indirectly help the crisis countries by having banks buy their
bonds, and 3) indirectly help to strengthen the balance sheets
of these banks through the profits they can make by investing
in these bonds.

Long-term interest rates (2-year government bonds)
8
Ita ly
7

6

5
S p a in
4
Percent

3

2

1
G e rm a n y
0 UK

-1
07 08 09 10 11 12
S o u rc e : R e u te rs E c o W in

The ECB will actually now be less of a lender of last resort The new strategy is
than before August 2, since the bond purchases now require more sustainable – but
programs whose terms could take time to draft/meet. The still risky
strategy keeps the pressure on reform and ensures that the
ECB’s purchases won't fill a “black hole”. As a result,
countries that can't print their own money are still at risk of not


being able to finance their debt if interest rates rise too much
(the limit is usually said to be 7%). Since the financial market
recognises this dilemma, interest rates on the long end
continue to rise at the same time that shorter rates have
fallen after expectations of the purchases by the central bank.

The UK, US and Japan, through their central banks – the A new round of
Band of England (BoE), the Federal Reserve (Fed) and the quantitative easing is
Bank of Japan (BoJ) – have resorted to quantitative easing by expected this fall from
buying government bonds or other assets on the second- the BoE, Fed and BoJ
hand market. We expect an additional easing during the …
second half-year in all three countries. The US is likely to
focus on buying mortgage and government bonds. The UK is
continuing to buy bonds, but there are those who suggest
buying other assets (e.g., Adam Posen, who is now stepping
down from the Monetary Policy Committee, which sets
monetary policy in the Bank of England). Japan has been
buying equities and other assets for some time, but hasn't
found these measures effective. The financial markets are
happy right now, but their joy will be short-lived and they will
soon be demanding another easing.

In other words, quantitative easing and fixed-rate loans have … but will probably
been shown to have a diminishing marginal impact. Long- have a diminishing
term interest rates are already relatively low in the US, the marginal impact
UK and Japan, as well as in Germany, and in the euro
zone’s crisis countries the problem is quite different. There is
a limit on how much of their bonds can be held on the
balance sheets of commercial banks and central banks.

Long-term interest rates (10-year government bonds)
8
I t a ly
7
S p a in

6

5
Percent

4
UK

3
US

2
G e rm a n y

1 Japan

0
07 08 09 10 11 12

Since our April forecast, 10-year bond yields in the US, UK, Negative returns on
Germany and even Sweden have continued to decline, touching government bonds – is
historic lows. Bonds from these countries with shorter maturities it more important to get
have negative returns. Investors seem to think it is more your money back than
important to get their money back than to get a positive return. to get a return?
Among the reasons for the low bond yields are:


1. Benchmark rates are low, and central banks have announced
that they will stay that way. Since long-term rates reflect
expectations for future short-term rates, long-term rates are
also falling.

2. Quantitative easing has put further pressure on long-term bond
yields.

3. There are expectations of low inflation and slow growth, as well
as the risk of deflation and liquidity traps.

4. Investors are focused on short-term risks (Spain and Italy),
while medium-term risks (US, Germany) have been toned
down. As a result, investors are seeking what seem like safe
investments, but which are only in a relative sense. There is
also some question whether investors have become more
focused on catastrophic risks since the financial crisis, which is
creating a greater need for safety than return.

We expect long-term bond yields to remain low, but that the last
point above could create a new set of expectations if the crisis in
the euro zone eases somewhat. That could shift the focus to the
medium-term problems in the US, which should raise interest
rates, since there is little expectation that the country is headed
toward a period of Japanese-like deflation. Consequently,
interest rates will probably remain low, though rise slightly, and if
the emphasis changes from the euro crisis to the US budget
crisis they might rise even more. German interest rates are
affected by both the flight-to-safety argument, which is keeping
rates down at this point, and its future payment responsibility for
the entire euro zone, which is pushing rates higher in the slightly
longer term.

Exchange rates
Since our April forecast, the flight-to-safety argument has The flight to safe
increasingly applied to the currency market as well. With the currencies is
growing concerns in the euro zone, capital has fled the region overshadowing the
and the euro has fallen against the dollar. We expect it to currency market
continue lower against the dollar for much of the forecast period
due to weak growth prospects and continued financial instability.
The Swiss central bank has intervened to stop the franc from
rising too much in value and had success. The franc is back at
the same level as the beginning of 2011. To avoid having too
many euros in its portfolio, the central bank is selling off some,
which is weakening the euro, and at the same time buying
Swedish and Norwegian kronor as well as the Canadian and
Australian dollars, which is strengthening these currencies. The
rising trend in these currencies isn’t over, since the crisis in the
euro zone is continuing and the Swiss central bank (and other
central banks and individual investors) isn’t done with its
diversification process yet.


Nominal currency trends in relation to the US dollar, index 2008-08-15 = 100
160

150 S w e d is h K ro n a

140
K o re a n W o n
B ra z ile a n R e a l
130 E u ro

120

110

100
Yuan

90 S w is s F ra n c

80

70
Yen
60
07 08 09 10 11 12
S o u rc e : R e u te r s E c o W in

China is not letting the renminbi appreciate quite as quickly and China is not allowing
has even let it weaken against the US dollar, though it has its currency to
appreciated against the euro. We now expect the appreciation appreciate as quickly,
against the dollar to continue, but at a slower pace than in 2011. a trend that will
The Brazilian real has also weakened against the dollar, which probably continue for a
can be seen as a result of weaker growth, higher inflation and while
lower benchmark rates as well as the government’s attempts to
weaken the currency with the help of taxes on capital inflows.
Weaker currencies in emerging markets reduce the risk of more
talk about a currency war, but increase the risk of rising inflation
in these countries.

Exchange rates 2012-2014
FX 17-aug-12 31-dec-12 30-jun-13 31-dec-13 30-jun-14 31-dec-14
EUR/USD 1,23 1,16 1,18 1,20 1,22 1,25
EUR/GBP 0,79 0,77 0,76 0,75 0,75 0,75
RMB/USD 6,36 6,30 6,20 6,08 5,98 5,85
USD/JPY 79 80 83 88 90 90

Equities
The global stock markets (according to MSCI Global) have Major swings in
slightly passed the level they were at when the April forecast was equities and
published. After declining, equities bounced back once confidence indicators
expectations of another quantitative easing rose. Unlike in 2011, reflect expectations of
US stock markets have been the top performers, while the trend more quantitative
is negative in emerging markets, the euro zone and Japan – easing
especially in comparison with the first half of 2011, before
concerns rose during the summer months. Although we are
hesitant to forecast stock prices, it can generally be said that
macroeconomic conditions have weakened, making it harder for
companies to increase their profits, and it’s uncertain that this
has been fully discounted. If we don't see another quantitative
easing in the US, UK and Japan at the same time that the ECB
doesn't live up to the expectations it has created (Bazooka), there
is a risk that pessimism will gain the upper hand.


Stock markets in the emerging world ( MSCI EM), US (S&P 500), euro zone (FTSE
EZ 300) and Japan (Nikkei 225) 2007-2012, Index January 2007 = 100

150
MSCI EM
140

130

120

110 MSCI
G lobal
100
Index

90

80
USA S&P 500
70
FTSE EZ 300
60

50
Nikkei 225
40
07 08 09 10 11 12
Source: Reuters EcoW in

In summary, we anticipate lower commodity prices in 2012
than in 2011, but for oil and metals we see an increase in
2013 and 2014. Food prices will continue to rise in 2012
before turning lower. Interest rates will be cut slightly in
emerging markets and the euro zone, at the same time they
remain low in Japan, UK and US. Another round of
quantitative easing is expected during the second half-year,
which will keep long-term interest rates low and stimulate
equities. Low interest rates, weak growth and inflation, and a
growing need for “safe harbours” for investors’ money will
help to keep long-term interest rates low in the US and
Germany.

Note that an extrapolation of recent events could prove risky,
but on the other hand it is hard to find much of an argument
for rapidly rising interest rates and a stronger euro in these
precarious circumstances. Further in the future – in 2014 –
conditions may change and interest rates could rise faster
than we have assumed.


5. Regions/countries: Few tools available
During the second half-year growth will slow in the global Unemployment is
economy, and not until next year do we expect a gradual already high, but is
recovery. Unemployment is increasing mainly in the euro zone, at expected to rise further
the same time that it is becoming harder to reduce it in the US. in the euro zone
Fiscal austerity is expected mainly in Europe and the US. On the
other hand China and Brazil will tap expansive fiscal policies, at
the same time that monetary policy is also being loosened by
cutting interest rates.

Unemployment (%) in several countries/regions
2 5 ,0

2 2 ,5 S p a in

2 0 ,0

G re e c e
1 7 ,5

P o rtu g a l
1 5 ,0
Percent

1 2 ,5
E u ro z o n e
1 0 ,0
F ra n c e

7 ,5 G e rm a n y

US
5 ,0
Japan

2 ,5
05 06 07 08 09 10 11 12


In the current recession developed countries have had to tighten When the tools run
their belts and have mainly resorted to monetary policy in the out, hope rests on
form of quantitative easing, the effectiveness of which is probably exchange rates
low, while emerging markets have to take a more cautious
approach to fiscal and monetary expansion to avoid inflation and
other imbalances. Capacity shortages in India and Brazil, for
example, mean that these economies are quickly hitting a ceiling
and that inflation is rising. Many countries want to keep real
effective exchange rates from appreciating, as has been the case
for Japan and China since 2008, while the opposite has
happened in the euro zone. With or without interventions, the
goal is that the currencies will depreciate.

Real effective exchange rates in a number of countries/regions, index
170
C h in a
160 E u ro z o n e
Japan
150 US
B r a z il
Index 2000-01-01 = 100

140

130

120

110

100

90

80

70

60
00 01 02 03 04 05 06 07 08 09 10 11 12


USA – living a dangerous fiscal life
 The slow recovery is continuing and GDP will grow slightly
below and above 2% per year during the forecast period.

 Unemployment has risen, which should force the Federal
Reserve to act with a new program to ease monetary
conditions.

 If taxes are raised and automatic spending cuts take effect
after the turn of the year, the US will fall off a “fiscal cliff”
and see another recession. We expect Congress to reach
some kind of resolution and avoid most of the austerity.

The US economy is continuing its modest recovery. After a
strong quarter at the end of last year, GDP growth slowed to
0.5% and 0.4% during the first two quarters of 2012. A slowdown
in the wake of the unstable political climate and weaker global
economy are further darkening the outlook for the second half of
the year, because to which GDP growth is estimated at 2.1% for
2012. Despite a slight rise in quarterly growth from 0.3% to 0.6%
next year, annual growth is expected to slow to 1.7% before
eventually rising to 2.3% in 2014.

Among the factors hurting the recovery, besides the global Debt reconstruction,
economy, are debt consolidation in the household and banking the global economy
sectors and continued high unemployment, which is slowing and political (and
domestic demand. Uncertainty about fiscal policy and the fiscal) uncertainty are
confrontational political climate are also affecting confidence slowing the recovery
among households and businesses.

US small business owners and their future confidence and hiring plans
35 1 0 7 ,5
O p t im is m in d e x
30 1 9 8 6 = 1 0 0 ---> 1 0 5 ,0

25 1 0 2 ,5

20 1 0 0 ,0

15 9 7 ,5
Percent

Index

10 9 5 ,0

5 9 2 ,5

0 9 0 ,0
< --- S h a re o f
-5 c o m p a n ie s p la n n in g t o 8 7 ,5
r e c r u it
-1 0 8 5 ,0

-1 5 8 2 ,5
86 88 90 92 94 96 98 00 02 04 06 08 10 12

However, optimism has strengthened among small business
owners compared with recent years, but from a historical
perspective small businesses are still struggling and remain
cautious in their hiring plans. In the wake of a cooler global
economy, the purchasing managers index has fallen below the


50 mark in the last two months, which suggests that growth has
had a hard time gaining traction recently.

After the number of working Americans increased by a monthly
average of 226 000 in the first quarter of this year, hiring slowed
and the increase for the second quarter was only 73 000. It is too
early to say whether the July figure, 163 000, is the start of a
more positive trend. Employment growth is relatively good, but
the labour supply is increasing as well. Unemployment has risen
in recent months to 8.3%, from 8.1% in April. The forecast calls
for a slow decline in 2013 and 2014 to 7%, since GDP growth will
remain below its potential throughout the period.

The housing market has improved slightly, but from extremely The housing market is
low levels. Housing prices (Case-Shiller) have now returned to showing glimpses of
the lows of May 2009. Sales of existing homes have risen by improvement, but the
nearly 30% since bottoming out in July 2010, but represent only gains are from low
60% of the number sold in 2005. Housing construction has noted levels
a slightly upward trend since last year, but to only about a third of
the number of homes built before the crisis. Though it isn't
reasonable to expect the numbers to return their previous levels,
thus far the recovery has been shaky and underwhelming and a
large inventory of unsold homes still remains.

US household consumption has risen, but cautiously. Retail sales
had trended lower since the beginning of the year, but rose in
July. Weak incomes and a lack of confidence are keeping
consumers from spending, as evidenced by the savings ratio,
which has now risen to 4%. Lower inflation and higher
unemployment suggest that the Federal Reserve will have to
further ease monetary policy. We anticipate some form of
quantitative easing during the second half-year, while interest
rates remain at their current low levels for much of the forecast
period.

A more expansive fiscal policy designed to improve the labour If a consensus is
market would probably be more effective considering that long- reached, fiscal
term unemployment remains high. Instead, fiscal policy will be austerity will slice 4
tightened. By how much depends on the decisions made after percentage points off
the presidential election, but if nothing is resolved GDP growth of GDP growth
will drop by 4 percentage points and the US will find itself in
another recession after falling off the fiscal cliff. We expect
Congress to delay the tax hikes and reduce the spending cuts.
Not everything will be put on the back burner, however, and fiscal
policy will probably shave 1 percent off GDP growth next year.

The presidential election on November 6 between Obama/Biden
and Romney/Ryan is expected to be very close. The current
administration is feeling heat from the rising unemployment and a
lack of fiscal clarity, but the opposition will have a hard time
garnering support for tax cuts for the wealthy and spending cuts
for the poor while facing continued uncertainty about the
medium-term budget, given the threat of a fiscal collapse in a few
years.


China – slowdown and new stimulus
 China’s economy is cooling. Exactly how much is hard to
say, but we expect GDP growth to fall to 7.9% this year and
that the goal to rebalance the economy will be at least
partly met, with growth slowing in 2013 and 2014 as well.

 If the risk of a hard landing increases, Chinese politicians
will choose the easy way out, i.e., increasing investment,
though this could create new imbalances and an even
harder landing further in the future.

China’s slowdown has accelerated. The second quarter saw
GDP growth of 7.6%, which means relatively slow quarterly
growth of less than 2%. Other signs of the slowdown include
electricity production, which has levelled off; significantly slower
growth in industrial production, which is more in keeping with a
weak purchasing managers index; lower inflows of foreign direct
investment; and decreased demand for commodities in the global
market.

During the global financial crisis China’s economy slowed due to External demand had
lower external demand, and stimulus programs accounted for previously slowed
13% of GDP over a two-year period. Now domestic demand is China’s growth – but
slowing, but the crisis in the euro zone is also contributing to now it's mainly internal
weaker growth in China. Investment, especially in the housing demand
sector, has cooled in the face of the growing risk of a housing
bubble.

This changes the ways that China can utilise economic policy to
stimulate the economy compared with the last slowdown. China’s
central bank has already loosened lending conditions (interest
rates, reserve requirements), and lending growth is rising again,
though this also increases the risk that housing and land prices
will also significantly rise again. The stimulus packages in 2008-
2009 created imbalances which had to be corrected. This won’t
be easy to repeat.

China’s industrial production, inflation and housing prices in Beijing, annual
growth rate
2 2 ,5
I n d u s t r ia l p r o d u c t io n H o u s e p r ic e s ,
2 0 ,0 B e ijin g

1 7 ,5

1 5 ,0

1 2 ,5
Percent

1 0 ,0

7 ,5

5 ,0

2 ,5

0 ,0
I n f la t io n
-2 ,5
05 06 07 08 09 10 11 12


In the aftermath of the stimulus packages, there is now a need
for bailouts of local governments, entrepreneurs and property
owners. In fact, the debt problem is probably greater than official
data indicate. Loose monetary conditions skewed capital
allocation, and the investment wave that has been driving
China’s growth was allowed to get out of hand.

The country has now taken a step forward by shifting the focus
from investment and exports to private consumption. The Infrastructure
problem is that when the risk of a hard landing increases, investment is
Chinese politicians tend to fall back on their habit of stimulating increasing again, but
through investments and exports. This explains the renewed not as much as in
interest in infrastructure investments, though they won't be as big 2008-2009
as before, at the same time that there will be less appetite in the
private sector considering the overcapacity that already exists. It
will take a long time to rebalance growth to private consumption.
Higher wages, transfers and improved conditions for households
will gradually increase private consumption to around 35% of
GDP, moving toward the global average, which in some countries
is that double that figure. Political leaders will therefore try to
stimulate growth the usual way, without totally succeeding, which
will contribute to a slower growth rate in the years ahead. One
sign – other than infrastructure investment – is the reluctance to
let the currency appreciate further against the US dollar (it is still
rising against the euro), in order to protect the export sector.
However, this could hurt the relationship with the incoming US
administration. President Obama has avoided calling China’s
exchange rate policy manipulative, while Romney has threatened
during the election campaign to take a different tack.

We expect China’s central bank to cut interest rates at some
point this year, especially since prices are beginning to fall at a
monthly rate. Reserve requirements are being further reduced
and the renminbi has been allowed to appreciate more slowly
against the dollar than in 2011. The depreciation against the
dollar recently may have accelerated capital outflows, which
recently exceeded inflows. This surprisingly caused China’s
currency reserves (of about $3 trillion) to shrink.

China has many major challenges to address besides There is going to be a
rebalancing its economy: the environment and climate change, power shift in the
demographics and the pension system, healthcare reform, Politburo this fall and a
financial deregulation and a growing income gap. The power shift new Chinese president
in the Politburo this fall will mean the replacement of several in March – but without
members. Xi Jinping and Li Keqiang are expected to succeed Hu any major differences
Jintao and Wen Jiabao as president and prime minister next
March. It is unlikely that the effects of this shift will be evident
initially; changes will be made slowly. Our forecast is for GDP
growth of 7.9% this year before it continues to slow to 7.8% in
2013 and 7.6% in 2014. The expectation is that China’s
politicians will resist the pressure to significantly stimulate the
economy, which would cause bubbles, and instead continue to
rebalance gradually. If not, growth could be higher this year and
next, at the same time that a hard landing inches closer as new
imbalances build up and have to be corrected.


Japan – strong yen and weak demand
 After stronger-than-expected growth at the beginning of the
year, we are revising GDP growth for 2012 upward to 2.2%,
but there are already signs of a slowdown and that growth
will fall to 1.3% and next year and 1.2% in 2014.

 Japan’s trade deficit is the result of high energy imports,
weaker global demand and a strong yen. We expect the
yen to weaken during the forecast period.

 Notwithstanding the Bank of Japan’s quantitative easing,
structural reforms are needed to strengthen confidence in
the budget and create greater economic dynamism.

After rising by 1.3% in the first quarter, growth has slowed to
0.3%. Public spending and investment, including in the form of
reconstruction after the tsunami, earthquake and nuclear
disaster, contributed positively to growth, while net exports
contributed negatively. Private investment increased more than
expected, and households have benefitted from subsidies for
green cars – a measure that has increased private consumption,
but where the impact will be felt in the opposite direction later in
the year.

Because of the stronger-than-expected gains at the beginning of We have revised our
the year, we have revised our GDP growth estimate upward for GDP growth estimate
2012 from 1.5% to 2.2%. Considering that the government's upward this year, but
contribution to growth is gradually being phased out and net the outlook beyond
exports will remain negative due to the relatively high costs of that is weaker
energy imports and weaker global demand, mainly from Europe
and China, the growth rate is projected to fall to 1.3% in 2013
and 1.2% in 2014, in line with estimated or potential growth.

One reason for the high energy bill is that nearly all 54 of Japan’s
nuclear power plants have been idled, which has resulted in
higher oil and gas imports, the costs of which have risen by an
estimated $100 million per day. During the first half-year Japan
reported a trade deficit for the first time in three decades, other
than during the financial crisis.

During the summer two nuclear power plants were restarted, Nuclear power and tax
which led to major protests, not to mention political policy are the source
consequences for Prime Minister Yoshihiko Noda, whose of political tension
popularity has weakened. Moreover, the veteran politician Ishiro
Ozawa resigned from the ruling Democratic Party of Japan (DPJ)
in July and formed a rival party together with MPs who were
unhappy with tax policy, including a highly debated VAT hike
from 5% to 10%, which now looks like it will be passed. Japan is
still struggling with a primary deficit (budget deficit excluding
interest payments on government debt) of about 8%, however,
which means that there still aren't any strong measures available
to reduce the public debt burden (gross debt is expected to reach
240% of GDP by 2013).


Another reason for the trade deficit is the relatively strong yen.
The nominal effective exchange rate is hovering significantly
above its long-term average, while the real effective exchange
rate is only slightly above the average. The combination of
weaker global demand and a strong exchange rate is putting
pressure on companies, which have surprisingly been more
willing to invest than expected.

Nominal and real effective exchange rates
150
140
130
120
110
100
Index

90
80
70
60
50 N o m in a l E ff e c tiv e E x c h a n g e R a te In d e x
R e a l E f fe c tiv e E x c h a n g e R a te In d e x
40
30
80 85 90 95 00 05 10
S o u rc e : R e u te r s E c o W in

We expect the Bank of Japan to continue to grow its balance
sheet by buying assets. A small supplementary budget is Quantitative easing is
expected before the end of the year to stimulate the economy, expected, but the most
especially since the global economy is slowing and the governing important thing is
party needs more support in the upcoming election next year. structural reform
Deflation is coming back after a period of slight inflation against
the backdrop of higher commodity prices. The most important
things Japan can do to make its economy more dynamic are to
put a stop to deflation expectations, consolidate its medium-term
budget in order to reduce the future debt burden, especially for
young people, and strengthen the role of women in the
workplace. Japanese direct investment abroad has increased
owing to the strong yen, but it is also important to welcome more
foreign direct investment in Japan.

India – drought and reform fatigue
 We have revised our GDP growth estimate downward from
6.7% to 6.2% for 2012, and from 7.3% to 6.5% for 2013. If
the reform-weary political climate persists, growth won’t
reach beyond 7% during the forecast period.

 There are indications that inflation is again rising, which
makes it harder for the central bank to loosen monetary
policy. One or two rate cuts are possible next year if
inflation drops again. India’s public finances are being


Global Economic Outlook - August 2012

Global Economic Outlook - August 2012

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