The Global Economy No. 7 - October 31, 2011: A step forward – but several fundamental problems remain

1. The Global Economy
Monthly letter from Swedbank’s Economic Research Department
by Cecilia Hermansson No. 7 • 31 October 2011
A step forward – but several fundamental problems remain
• The EU’s decision to write down Greece’s debt, recapitalise European banks and
leverage the European Financial Stability Fund (EFSF) is a step in the right
direction, but with so many outstanding details left to resolve it will take time before
the effectiveness of the rescue package can be judged.
• We revised our global GDP growth forecast downward in connection with the
Baltic Sea Region Report presented on October 19. For the years 2011-2013 we
see global GDP growth slipping by 0.6% to a rate of 3.6% per year.
• The focus for the euro zone has already shifted from Greece to Italy. With its 10-
year bonds now yielding over 6%, Italy’s government has to quickly build
confidence that it will take the necessary reforms to improve the country’s growth
potential at the same time that the budget consolidation continues. The euro
zone’s future is now increasingly dependent on the political process in Italy.
The economy is at a standstill – the debt growth of 3.8%, we are now forecasting 3.6% next
crisis could still worsen the situation year, mainly because the US is growing by just over
The global economy is struggling with two main 1.5%, instead of just over 2%, and GDP growth in
concerns. One is growing economic pessimism, the euro zone has been revised downward from
which has caused many forecasters, including us, 1.3% to 0.8%. As a whole for 2011-2013, the
to write down our growth forecasts for the next two downward revisions mean that global GDP is 0.6%
years. The other is the debt crisis in the West, lower in 2013 than our August forecast.
where the focus is currently on the euro zone but
GDP growth in a number of countries, annual rate
will increasingly embrace the US as well in the next
month. China
12,5
India
These two phenomena are closely related. If the 7,5 Brazil
debt crisis worsens, the economy could slow even
Percent
more and put all or parts of the West at risk for a 2,5
new recession. Weaker confidence among Eurozone
-2,5
businesses and households, as well as the financial UK
US
markets, is contributing to lower investment and a -7,5
lack of new hiring. If the economy worsens, it would Japan
make it even harder to implement the budget -12,5
consolidation, which would necessitate tighter 06 07 08 09 10 11
austerity with even more of a negative impact on Source: Reuters EcoWin
growth. This could naturally also lead to greater
political turbulence considering how difficult it is to Third-quarter GDP growth in the US was about as
find support for even more massive cutbacks. expected at an adjusted annual rate of 2.5% and an
annual rate of 1.6%. To date household
Hard and soft (confidence variables) economic data consumption has grown faster than the weak future
for the US, UK and euro zone have weakened, confidence would indicate. Housing prices are still
which was one reason why we revised our global falling, but home sales have provided some
forecasts in connection with the recently published glimmers of light. The labour market remains
Baltic Sea Region Report. Instead of global GDP considerably weaker than normal following a
Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46-8-5859 7740
E-mail: ek.sekr@swedbank.se Internet: www.swedbank.com Responsible publisher: Cecilia Hermansson, +46-8-
5859 7720, Magnus Alvesson, +46-8-5859 3341, Jörgen Kennemar, +46-8-5859 7730, ISSN 1103-4897

2. The Global Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 7 • 31 October 2011
recession, which is why this balance sheet equation that includes Greece, banks and the EFSF
recession doesn’t offer the same opportunities to still has a number of unknown variables. If any of
kick-start the economy with lower interest rates. them change, the whole equation changes.
Small and medium-sized companies have been
especially troubled by low domestic demand, while First and foremost it is reasonable that Greece’s
large US companies have managed fairly well. debt is reduced to a more manageable level, but
the 50% haircut applies only to the private portion.
China has also released its GDP data for the third The banks still have to “voluntarily” agree to the
quarter. Economic growth slowed compared with settlement. Obviously this is more than the 21%
the previous year, but on an annual basis is still agreed to on July 21, but the question is whether
relatively high at 9.1%. Due to tighter monetary 50% is enough or if we will see further write-downs
conditions and slightly lower commodity prices, at a later point. Greece’s national debt is expected
inflation peaked at 6.5% in July, and in September to decline to 120% of GDP (like Italy’s) in a couple
the official rate was 6.1%. The biggest concern of years, instead of the previously predicted 180%.
remains housing prices, which, if they fall Growth prospects will have to improve to reach that
substantially, could jeopardise municipal level.
finances/growth and lead to a substantial increase
The recapitalisation of European banks should be
in nonperforming loans in the financial sector.
seen from the perspective of both short- and long-
Consumer prices, annual percentage change term needs. The newer stress tests are more
9
ambitious than those done last summer, when the
8 China shortfall was 2.5 billion euro. Now we are talking
7 about 106 billion euro. However, these calculations
6 do not include a new recession. The amounts would
5 USA
rise if the economy worsens. The market valuation
4
Percent
3 as of September 30 favours France (which has
2 since seen values decline) and assumes that the
UK Germany
1 value of German and French bonds will rise, while
0 bonds from the PIIGS countries will be worth less.
-1
-2
Critics claim that overly aggressive recapitalisation
-3
06 07 08 09 10 11 requirements could compromise the recovery, since
it would further shrink the banks’ balance sheets. A
Source: Reuters EcoWin
In Japan and Europe, third-quarter GDP growth credit tightening is in the cards. At the same time
figures have not yet been published. Signals from there is good reason to recapitalise the banks,
German analysts (banks, central bank) suggest that which have already had time to foresee this. The
growth could be relatively strong at around 0.5% on hardest hit will be banks in southern Europe. In
a quarterly basis. There is considerable uncertainty, Italy’s case, its banks haven’t been responsible for
however, not least because confidence variables excessive credit growth in recent years; it is more a
are beginning to point to a slowdown, which is question of the large exposure against the country’s
probably more likely in the fourth quarter of this bonds.
year and first quarter next year. The alternative would have been to listen to France
and let the ECB buy more bonds, but there is also
With the economy at a standstill it is even more the risk of ruining its balance sheet. This would
important that political leaders take responsibility for mean a recapitalisation of the ECB, which would
building future confidence. The EU’s meeting last require the consent of the euro zone’s taxpayers.
week was a step toward better crisis management,
but many fundamental problems remain and are In the end Germany won its battle with France to
now coming to the fore as the crisis package is convince its voters to maintain support for the euro
analysed. Developments in Italy are an especially zone. Moral hazards are the focus of attention, and
big concern. the key is to avoid a new crisis due to a lack of
discipline. This approach is likely to reduce growth
The euro zone has taken a step forward – more than France’s, but the risk of a new crisis and
but has to do more escalating inflation are kept in check. Both
The EU countries have reached a possible approaches are risky, and even if the German’s is
resolution to the crisis in the euro zone, but a more stable, a new recession could sabotage these
number of details have to fall into place first. The efforts.
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3. The Global Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 7 • 31 October 2011
Another detail is how the stability fund could be reforms now being discussed include raising the
made more potent without a bigger contribution retirement age from 65 to 67 by 2026, creating a
from the euro countries. German taxpayers have more efficient labour market and selling off public
little interest in providing more money to Italy, for assets valued at 5 billion euro per year in the years
example. The leverage achieved by insuring Italian ahead.
and Spanish bonds is one possibility, but at the
same time would create two bond markets: one Italy has to stabilise its debt, which has now risen to
guaranteed by the stability fund (read Germany and just over 120% of GDP. While the Italians
France) and one that isn't. If the situation reaches themselves own 60% of the debt, the external share
the point where France – and eventually Germany – in relation to GDP is high at 54%. Only Greece,
has problems with its credit rating, the leverage Belgium, Portugal and Austria have higher
model will create new problems and more percentages within the OECD. Although Italy has
turbulence. Similarly, the Special Purpose Vehicles extended the maturity of its bonds to 7.1 years
(SPVs) funded by Norway and China, for example, (from slightly over 5 years in the early 2000’s), 300
could create uncertainty, since the first losses billion euros (of a total of 1.9 trillion euros) matures
would be taken in accordance with the stipulations next year and has to be replaced. In recent years
of collateralised debt obligations (CDOs), which Italy has accounted for 30% of the euro zone’s
played a prominent role leading up to the subprime bond market, despite that it generates less than
crisis and in 2008 triggered the largest and most 20% of the region’s GDP.
global financial crisis in history. How much leverage
Annual GDP growth in a number of euro countries (%)
the stability fund will have and how the details will
12,0
be worked out are critical to how effective or risky
the rescue package will be. 9,5
Spain Greece
7,0 Ireland
Weak growth is again the focus 4,5 Germany
Percent
Despite the settlement reached by the EU on 2,0
October 26, the financial market’s worries haven’t -0,5
subsided. Stocks rose initially, but the interest rate France
Eurozone
-3,0 Italy
Italy offered at its bond auction after the summit
-5,5
shows that confidence hasn’t improved much that
the crisis will be resolved. -8,0
00 01 02 03 04 05 06 07 08 09 10 11
The focus has shifted from Greece to Italy. Source: Reuters EcoWin
Confidence is lacking in Prime Minister Silvio An interest rate rising to 6-7% would be increasingly
Berlusconi and his coalition government. Even prior difficult to handle unless GDP grows much faster
to the summit, credit rating agencies lowered Italy's than the 0.5% per year forecast for the next two
rating and, in the case of Fitch, threatened to years. This would mean having to deregulate, raise
downgrade it further after the summit, when the efficiencies in the public sector and academia, and
growth outlook worsened. The euro zone’s increase the labour supply, which, except for men
politicians – led by Angela Merkel and Nicolas ages 30-50, is lower than the EU average.
Sarkozy, along with the ECB’s outgoing president
Jean-Claude Trichet and his successor, Mario Italy now has to show it is serious about
Draghi – have publicly demonstrated on repeated consolidating its budget and improving growth.
occasions that they lack confidence. Demands have Otherwise there is the chance that the euro zone’s
now been made to speed up the reform process. problems will persist, with risks not only to the
region but the entire global economy. Italy is not at
The question the financial markets are struggling all as weak economically as Greece, but could face
with is which politicians will carry out the reforms increasing difficulty in the absence of the political
Italy is now proposing to the euro zone’s resolve to improve its outlook and strengthen
representatives. A new election is drawing closer at confidence outside the country.
a time when the government and opposition are
both weak. Cecilia Hermansson
The fact that Italy's 10-year bond reached 6.06%
right after the summit, up from 5.86% a month
earlier and 4% a year earlier, shows the depth of
the challenges facing economic policymakers. The
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4. The Global Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 7 • 31 October 2011
Swedbank
Economic Research Department Swedbank’s monthly The Global Economy newsletter is published as a service to our
customers. We believe that we have used reliable sources and methods in the preparation
SE-105 34 Stockholm, Sweden
of the analyses reported in this publication. However, we cannot guarantee the accuracy or
Phone +46-8-5859 7740
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ek.sekr@swedbank.se
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on other material as well. Neither Swedbank nor its employees may be held responsible for
Legally responsible publisher losses or damages, direct or indirect, owing to any errors or omissions in Swedbank’s
Cecilia Hermansson, +46-88-5859 7720. monthly The Global Economy newsletter.
Magnus Alvesson, +46-8-5859 3341
Jörgen Kennemar, +46-8-5859 7730
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