Swedbank's Global Economic Outlook, 2011 March

Global Economic Outlook by Cecilia Hermansson 29 March 2011

Economic sekretariatet, Swedbank AB (publ), 105 34 Stockholm, tfn 08-5859 7740 E-post: [email protected] Internet: www.swedbank.se Ansvarig ugivare: Cecilia Hermansson, 08-5859 7720

Magnus Alvesson, 08-5859 1031,Jörgen Kennemar, 08-5859 7730, ISSN 1103-4897

The global recovery has gained a footing – but the risk of a backlash remains The global recovery economy strengthened last year. We have revised our GDP

forecast upward by a total of 0.3 percentage points to 4% per year in 2011 and 2012. This still represents a slowdown compared with last year’s strong 4.7%. Tighter economic policies, higher commodity prices and rising inflation at the consumer price level will lead to slower activity during the period. Emerging markets will remain growth engines.

Our risk outlook can be compared with the last lap of a 3000 m hurdle race. The hurdles that have to be jumped include Japan's disaster, political turbulence in the Middle East, rising commodity prices and their impact on inflation and interest rates, the debt crisis in advanced economies (water jump) and, lastly, the need for changes in the world order to avoid imbalances and new financial crises.

We give our main, positive scenario – which assumes that the recovery will continue and policymakers manage the debt crisis in Europe and the increasingly difficult policy mix to simultaneously tighten financial and monetary policy reasonably well – a combined likelihood of 50%. Two stronger scenarios (one sustainable and one less so) have a likelihood of 20%, and two weaker scenarios, with stagflation and a worsening debt crisis, have a likelihood of 30%.

The challenges to economic policy are growing. We urge that budget consolidation in Europe continue and begin as soon as possible in the US, and that monetary policy is allowed to remain expansive a little longer while tighter fiscal policies slow growth. Quantitative easing, on the other hand, should be phased out to speed up debt consolidation and increase the focus on much-needed structural reforms. It is also important to break the vicious cycle between public debt crisis and banking crisis, which – in addition to budget consolidation – requires more ambitious stress tests and capitalisation of banks in Europe.

Cecilia Hermansson Contents:

1. Favourable conditions in the global economy 2 2. In our main scenario the recovery continues 4 3. Many hurdles must be jumped 6 4. Our assumptions about commodity and financial markets 11 5. The optimal economic policy 17 6. Regions/countries: Most are downshifting 19 7. Conclusions for our home markets 35

2 Swedbank’s Global Economic Outlook • 29 March 2010

1. Favourable conditions in the global economy In 2010 the global economy grew more strongly than we had forecast. The difference can be explained by higher activity in emerging countries, particularly the BRIC countries, which accounted for two thirds of global GDP growth.1 The positive trend was also due to a surprisingly strong recovery in developed countries such as Japan, Germany and Sweden. On the other hand, GDP growth in the US and other euro zone members largely met our expectations at the beginning of last year.

Contribution to global GDP growth by various countries/regions, 2010

Seen through the rear view mirror, global economic development was generally positive, and current conditions are characterised by cautious optimism driven by strong global trade, relatively high profits and increased access to credit in the corporate sector, which as a whole should lead to investments and new jobs.

Conditions in many crisis-ridden economies are still weaker than normal with respect to the housing, labour and credit markets. Despite improvements, there are remaining problems of a more long-term, structural nature, which take time to resolve.

The economic stimulus is still a having positive impact on the economy. In emerging countries, stimulus programs have gone too far, raising the possibility of an overheating. Here, policy has to be tightened more than has been the case so far in order to slow growth to more sustainable levels going forward. In developed countries, monetary policies have remained expansive while financial policies are being tightened, which will eventually impact growth prospects more negatively.

The major differences in how developed countries and emerging economies have handled the crisis are clearly evident in the diagram below, which compares industrial production in various countries/regions. The US and Europe are now back to producing slightly more than their 2000 levels, while Japan is on

1 The BRIC countries refer to Brazil, Russia, India and China. Refers to GDP growth weighted with purchasing power parity (PPP). In dollar terms, the BRIC countries accounted for nearly half of global growth.

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Swedbank’s Global Economic Outlook • 29 March 2010 3

its way to the same level. On the other hand, less is produced today than levels before the financial crisis. After a brief dip, production in emerging countries has continued to grow strongly, more than doubling the level of 2000, at the same time that the production increase compared with before the crisis is more than 20%.

Industrial production in various countries/regions, Index 100 = 2000

There has been a lot of talk of a “two-speed world economy”. It is quite natural that emerging economies grow faster than developed countries, since they are beginning from a lower level often with higher growth in productivity and the labour supply. What is different from previous periods is that the rate of growth in emerging countries has risen, while it has fallen in developed countries.

The latter have a number of Achilles heels, which are slowing development, including problems in the financial sector, which are curtailing lending and investments; higher public debt, which requires tighter fiscal policies; and higher private debt, which must be cleaned up and is keeping consumption in check. That’s in addition to the structural problems in many labour and housing markets.

In summary, global economic conditions are better than expected. Growth is being driven mainly by countries in Asia, Latin America, the Middle East and Africa, while many developed countries are struggling with structural problems. The economic stimulus could cause overheating in emerging countries and must be phased out, at the same time that developed countries are entering a period of austerity. This will make it difficult to exceed the 2010 global growth rate.

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2. In our main scenario the recovery continues

Our previous view that the global economy is “muddling through” still remains a likely main scenario. The recovery won’t stall, but growth is slowing after last year’s rebound. Global GDP growth will fall from 4.7% last year to 4% this year and next.

Global GDP forecast

Source: National statistics and Swedbank’s forecasts. Note: These countries represent 75% of the global economy. To arrive at total GDP growth, approx. 0.3 percentage points should be added. The World Bank’s weights from 2009 have been used.

This represents a slight upward revision from our January forecast. In the US, the recovery has gained a firmer footing at the same time that the country has been reluctant to face up to its need for tighter fiscal policy and appears to be more focused on next year's presidential election. The euro zone and the UK are being adversely affected by higher inflation and their upcoming decision to tighten monetary policy earlier.

Japan’s GDP growth will decline this year due to the catastrophe, but will increase next year when reconstruction begins. Russia is benefitting from the rise in oil prices, but at the same time is struggling with higher domestic inflation. China, India and Brazil continue to grow strongly, but have slowed compared with last year now that their policies are no longer stimulating the economy to the same extent. On page 19 we go into more detail on developments in individual countries.

The main factor that is driving global growth is continued strong global trade, not least due to high demand in Asia. Despite fears of increased protectionism, trade has not declined and the key supply chains in our globalised world remain intact. Corporate profits have risen at the same time credit has become easier to come by and interest in new investments to expand existing

Spring Forecast January ForecastGDP growth (%) 2010 2011 2012 2010 2011 2011US 2,9 3,0 3,0 2,8 2,6 2,7

Euro zone: 1,7 1,5 1,5 1,8 1,6 1,5of which: Germany 3,6 2,4 1,9 3,6 2,5 2,0

France 1,5 1.5 1,6 1,6 1,6 1,5Italy 1,1 0.9 1,0 1,1 1,0 1,1Spain -0,1 0.3 1,0 -0,4 0,3 1,0

UK 1,4 1,5 2,0 1,7 1,8 2,0

Japan 4,0 0,6 3,0 3,2 1,5 1,3China 10,3 8,8 8,4 10,1 8,5 8,1India 9,1 8,0 7,5 8,8 8,2 7,5

Brazil 7,5 4,3 4,0 7,5 4,8 4,5Russia 4,0 4,6 4,5 4,0 4,3 4,5

Global GDP in PPP 4,7 4,0 4,0 4,6 3,9 3,8Global GDP in US dollars 3,8 3,1 3,3 3,7 3,1 3,0

We have revised our January forecast upward by a total of 0.3 percentage points for 2011 and 2012


capacity is growing. New hirings are on the rise, which means that labour markets in developed countries are gradually, though still slowly, improving. With more people employed and wage growth slightly higher, private consumption is rising from low levels.

In our main scenario, we assume that the economy and politicians will be able to handle the challenges of the Japanese disaster, the wave of democratisation in the Middle East and the debt crisis reasonably well. The question in this case is why the global economy won’t manage to maintain last year's GDP growth?

First, the inventory build-up, which had contributed strongly to growth, will have a less positive, neutral or maybe even negative effect.

Secondly, the impact of previous economic stimulus programs in the form of interest rate cuts, quantitative easing and the boost to demand from lower taxes and higher public spending is fading. What had been positive contributors will instead become negative contributors when fiscal policies are tightened in many developed countries, especially in Europe.

Thirdly, commodity prices have increased more than previously expected, which will raise inflation at least temporarily in our main scenario (but if commodity prices continue to rise, inflation will stick around longer). This means that higher energy and food prices – as well as higher mortgage rates as central banks raise interest rates earlier than expected – will leave households with less in than their wallets for other consumption.

Fourthly, the growing public debt in many developed countries is creating uncertainty. In the euro zone, it is looking very much like Portugal may soon need a rescue package, while Spain faces continued uncertainty whether it will be able to obtain financing through ordinary financial markets. In the US, the inability to address medium-term budget problems is creating uncertainty.

Solid corporate earnings have benefitted stock markets around the world, in turn helping the recovery in the financial sector and reducing the risk of bankruptcies among banks. Uncertainty whether Greece and Ireland will have to renegotiate their debts despite rescue packages is also putting stress on European banks, where stress tests so far haven’t been ambitious enough.

In summary, the recovery is continuing, but growth will slow to 4% this year and next. Despite various challenges in terms of natural disasters, the Middle East, commodity markets, public debt and their impact on economic policy, crisis management, banks and demand, the global economy continues to muddle through.

There are several reasons why the global economy is slowing compared with 2010

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but then rise when the need for raw materials and capital once again increases. The strength of the Japanese yen continues to frustrate, but can't be rectified by interventions.

The nuclear disaster affects the need for other energy sources as well as public opinion about nuclear power and investments in new plants. It is also affected the political debate in Germany after losses by the CDU and FDP in the regional election in Baden-Württemberg, owing in large part to the nuclear power issue. Several countries now want to delay any expansion to further evaluate safety concerns. In the long-term uncertainty about nuclear power could lead to higher energy prices and new, innovative technologies.

Second hurdle: Political turbulence in the Middle East

The wave of democratisation in the Middle East could continue for several years, affecting the region’s economy, geopolitical security and global oil supplies. The upheaval that began in Tunisia and Egypt and has spread to Libya, Bahrain, Yemen and Syria will hurt growth prospects short-term, but could create higher growth potential over time, which would also benefit investors in other parts of the world.

The focus at them moment, however, is whether unrest will spread to major oil-producing countries, especially Saudi Arabia, but also Qatar, Kuwait and the United Arab Emirates. The Middle East accounts for about a third of oil production, but has around 60% of oil reserves. These oil producers have the financial resources to offer concessions that will alleviate some of the concerns of their citizens. Energy and food subsidies are already high in the region, and to buy more time those in power are raising public sector salaries. This could contribute to even higher inflation pressures, which will not be kept in control by higher interest rates, since many currencies are pegged to the dollar. As a result, there is a risk of greater political instability in the wake of rising consumer prices.

The effects on the global economy are mainly tied to the price of oil. The West would like to see democratisation, but is most concerned about the predictability of oil production. There are political risks as well, such as NATO's involvement in the civil war in Libya as well as relations with China and Russia. Furthermore, Israel’s position in the region is affected by the new power structure in Egypt. The rivalry between Saudi Arabia and Iran could also rise to the surface and create tensions in the oil market. Political instability in the Middle East makes investors in other emerging countries cognizant of the political risks they face. “Stable” China in particular could be affected by increased risk aversion.

Third hurdle: Rising commodity prices and inflation, central bank actions, including overheating in emerging countries

Even before the democratisation process in the Middle East began, commodities had risen significantly in price. This was due

Public opinion about nuclear power could change entirely

The rise of democracies in the Middle East will eventually create new business opportunities

At this point the focus is on the region's role as an oil producer


to the stronger economy, which has increased demand for raw materials, as well as supply problems in connection with droughts and fires, which have reduced food production, the quantitative easing, which has increased liquidity and investor interest in commodity markets, and concerns about higher inflation and the decline in the dollar, which are driving up the prices of metals such as gold. The weaker dollar is also contributing to higher commodity prices, since sellers are demanding compensation for the currency effect. Oil supplies have not yet been affected by concerns in the Middle East, but prices have risen because of expectations of future shortages. Psychology is obviously an important factor as well.

If oil prices rise above current levels and reach USD 120-150 a barrel, there is a greater risk that other commodities, inflation expectations and inflation at the consumer price level will all rise as well, in addition to earlier-than-expected increases in policy interest rates and slower growth. Higher cost pressures on companies reduce their ability to invest and recruit. Households will see their wallets shrink, which will hold back consumption.

In the developed world, the policy mix for crisis-ridden countries that have to clean up their finances has become more complicated. There were expectations that monetary policy would remain expansive a little longer, so that the budget consolidation wouldn’t threaten growth. Policymakers in key central banks in the US and Europe may feel that they have to avoid the second-hand effects of higher import prices, however, which could mean that a period of interest rate hikes is nearing closer.

In emerging markets, higher commodity prices have contributed to signs overheating for some time. Central banks have been slow to tighten monetary conditions, however. Large capital flows in the wake of the quantitative easing have strengthened currencies, which has worried policymakers, since it could mean weaker export prospects. There is now a greater risk of a hard landing for countries that won’t or can’t slow inflation.

Higher commodity prices, inflation and benchmark interest rates are certainly among the biggest negative forecast risks for the global economy. The situation affects many people and threatens growth, jobs and inflation. There is also the risk of stagflation in certain countries.

Water jump: Debt crisis in the advanced economies

The effects of higher commodity prices could threaten the global recovery. At the same time we regard the debt crisis in the advanced economies as a more difficult hurdle to overcome. The impact could be felt in both the short and longer term. Risks can be tied to politics, to the economy and to financial markets. This could give rise to new recessions and deflation, and once you have fallen into the water jump it can be hard to get up.

Debt restructuring in the private sector, among households, businesses and banks, is far from over. When economic stimulus

The more oil prices rise above the current level, the greater the risk to global growth

A public debt crisis connected to the banking sector could create a new financial crisis and recession


programs are phased out and a period of austerity takes over, new risks could arise for the private sector and pose further risks to the banking system. The IMF estimates that banks in Europe, Asia and the US need around USD 500 billion in new capital.

Debt restructuring in the public sector has just begun in Europe, mainly in the UK and crisis-ridden euro members. They have to get their debt down to 60% of GDP from nearly 85%, which could take many years, especially since demographics and increased healthcare expenditures are making it more difficult.

In the US, the national debt is nearing 100% of GDP, yet the country seems to have put off any comprehensive measures, probably until after the presidential election in 2012. The budget deficit exceeds 10% this year. The longer the US waits to agree to a more ambitious medium-term plan across party lines, the greater the risk for the dollar, for long-term interest rates and for confidence in the US economy.

Expectations are that Portugal will be the next country to need a rescue package. Our main scenario includes this assumption. If Spain finds itself in a similar situation, there will not be enough capital in the European Financial Stability Facility (EFSF).

In addition, Greece and Ireland’s lenders are expected to have to take responsibility for their less-than-accurate risk assessments, i.e., to write off or renegotiate a portion of the debt they hold. This could put pressure on the euro if the results of the stress tests of the banking system that are announced in June show that there is not enough capital and that national governments will have to take over more banks, e.g., in Germany, Spain and France.

Too high of a public debt ratio – around 100% of GDP or more – could affect growth. The possibility of crowding out the private sector is contributing to this. Competition for capital is increasing.

Debt restructuring is already slowing GDP growth by about half of a percentage point for every per cent of GDP that is being sliced from government budgets. In Europe, the day is coming, but in the US it could take a little while before people feel the effects of austerity. If politicians do not handle the debt crisis correctly, there will be an increased risk of turbulence in financial markets and a greater impact on growth and employment.

Fifth hurdle: The global order – the global political and financial system

Reforming the current global order is another long-term challenge. If it doesn’t happen, new financial crises could arise more quickly and with a greater impact than otherwise would be the case. There is still a lack of efficient institutions to detect, manage and coordinate measures in the event of a crisis. Countries are acting out of national interests, and rarely are regulations created that work equitably across national borders. The G7 countries, G20 countries, International Monetary Fund (IMF), World Bank, World Trade Organization (WTO) and

The longer the US waits to seriously tackle its debt, the greater the risks

New financial crises are a greater possibility if the world order isn't working


Financial Stability Board (FSB) could all serve as crisis monitors and coordinators. The lack of strong institutions to manage currency tensions, large capital flows, protectionism and financial crises is exceeded only by the even weaker institutions available to tackle climate change and environmental issues.

Emerging countries led by China and India are demanding new international alliances. China would prefer not to see the dollar as a reserve currency any longer, but hasn’t yet taken responsibility as a growing economy for developing a viable currency that can be used outside its borders. With continued currency tensions and many emerging currencies rigidly pegged to the dollar, there is a risk that savings imbalances could again create financial crises. This hurdle, the last on the track, will take time to overcome. If it isn’t, the global economy won't reach the finish line!

Alternative scenarios:

Below we summarise the alternatives to our main alternative for 2011-2112. The probabilities we use are anything but scientific and merely provide an approximate risk level.

• Main scenario (see page 4)

• Stagflation (weaker scenario)

Higher commodity prices, inflation and interest rates could slow growth primarily in developed countries. Our stagflation scenario contains high inflation and unemployment, and little or no growth.

• Worsening debt crisis (weaker scenario)

If policymakers cannot manage the debt crisis and it worsens, there is a risk of slower growth and financial instability. A rescue package for Spain is included here.

• Faster balancing of growth (stronger scenario)

If China can transition to a consumption-driven economy at the same time that the US gets its growth from investments and exports, savings balances will decrease and growth, though not significantly higher, will at least be more sustainable.

• Further stimulus despite the risk of overheating (stronger scenario)

GDP growth could be stronger than we have predicted if emerging economies fail to slow down at the same time that the US supports another round of quantitative easing (QE3) and other stimulus measures. This higher growth rate is not sustainable, however.

The global order has to adapt to new global players like China and India

50% probability

15% probability

15% probability

5% probability

15% probability


4. Our assumptions about the commodity and financial markets Price trends in financial and commodity markets are difficult to predict. It is more a question of making reasonable assumptions that support the forecast for the real economy.

Commodity markets Commodity prices have risen markedly in the last half year. One reason is the stronger economy, which is raising demand for raw materials. Another is supply problems. Droughts and fires have reduced food production. A third reason is quantitative easing, which has increased liquidity and investor interest in commodities. A fourth reason is that inflation concerns have driven up the price of gold and other metals. The relatively weak dollar is also contributing to higher commodity prices, since producers are demanding compensation for the weaker dollar. Lastly, the democratisation process in the Middle East has created uncertainty about future oil production, which has raised oil prices despite that supplies haven’t yet decreased.

In our January forecast we assumed that oil would reach USD 85 this year and USD 90 next year. We expect the current price of USD 115 a barrel to drop when uncertainty about the Middle East eases, the pace of the global recovery slows slightly and the temporary effects of the cold weather subside. Our forecast is that the price of oil will reach an average of USD 105 this year and fall to USD 98 next year. The risk in these assumptions is on the upside, since concerns about oil production in the Middle East could be deeper and more long-lasting than we have assumed. Replacing nuclear energy with gas, oil and coal could prove necessary after the catastrophe in Japan, and could lead to a continuation of the upward trend in oil prices.

Commodity prices, total, food prices and commodity prices excluding oil (index)

The long-term price trend should point upward, since many low and middle income countries are growing quickly and expanding their infrastructure. The question, however, is whether we will see

Source: Reuters EcoWin

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Inde

x

25

50

75

100

125

150

175

Food prices

Total commodity price, excl oil

Total commodity price

There were several reasons for the rise in commodity prices

We assume an oil price of USD 105 this year and USD 98 next year


any pioneering energy innovations to replace oil. The nuclear crisis in Japan is creating new incentives for innovations in environmentally friendly energy sources.

We expect metal prices to continue to rise in 2011 and 2012, but not as quickly as in 2010. A slightly lower global growth rate suggests this, when the impact of the rebound is no longer as dominant.

Food production has been affected by weather conditions, which could occur again in future years, although we see signs that new agricultural acreage is now being added to boost supply, which reduces the risk that food prices will increase as quickly. As with metal prices, we expect food prices to continue to rise but at a slower rate. The risks are how much of food production can replace energy production and – like always – weather impacts.

Inflation and interest rates The upward commodity price trend raises inflation expectations at the consumer price level (CPI), but could also affect growth prospects by raising costs for businesses and reducing their ability to invest and hire new workers, and by weakening real disposable household income, leaving them less for other consumption after paying for more expensive energy and food.

It is also critical whether commodity prices continue to rise at the same rate, or if they rise faster or slower. A one-off effect on inflation would lead to fewer interest rate hikes than if prices rise for a longer period and accelerate.

Inflation (CPI) in a number of countries, 2008-2011

Inflation problems are and have been most evident in emerging countries. Energy and food account for a larger share of household spending there as well.

In India, weak monsoon rains caused food shortages and substantially higher prices at the same time that import prices rose. Economic policy has been expansive as well. Inflation is


08 09 10

Perc

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-2,50,02,55,07,5

10,012,515,017,5

India

Brazil

China

US

JapanGermany

UK

Metal and food prices continue to rise, but not as quickly as last year


now headed lower, but the levels will remain relatively high throughout the forecast period.

China has had problems with drought as well, in addition to higher import prices on the heels of rising global commodity prices. The inflow of capital as well as negative real interest rates and rapid credit growth have also driven inflation, which for many is considerably higher than official figures show. The administration is now trying to mitigate the price increase, but has been tardy in its attempts to tighten monetary policy. A stronger currency appreciation would help to slow the rise in import prices, but should be in real rather than nominal terms by increasing wages and prices faster than in the rest of the world. This raises the risk of higher inflation through the labour market. Inflation will exceed China’s comfort level of 3% throughout the forecast period.

In Brazil, large capital inflows and higher import prices have contributed to inflation problems, which are now being managed with the help of higher interest rates and tighter fiscal policies. A slowdown in inflation was noted in March, but concerns about high inflation still remain.

In February consumer prices rose rapidly in developed countries, exceeding inflation targets of at or below 2%. On an annual basis the increases were as much as 6.2% in the US, 4.4% in the UK and 2.4% in the euro zone.

To date the UK has been concerned about higher inflation, despite weak domestic demand. Rising import prices, a weaker pound and VAT hikes are driving the price increases. Inflation will subside, but it could take time and require interest rate hikes earlier than desirable from the standpoint of the economy’s recovery.

The euro zone’s inflation will slightly exceed the target in 2011. The ECB is expected to begin raising its benchmark rate as early as this spring, which could put the recovery at risk in a region where structural debt and financial sector problems weigh heavily.

The US is also seeing rising energy and food prices, but core inflation remains low. This will give the Federal Reserve a respite for its monetary policy, which the administration in particular is hoping for, when the quantitative easing (QE2) runs its course this summer.

China’s high inflation rate is due to both domestic and external factors

The policy mix is becoming especially difficult in the UK


Inflation projections measured according to the annual increase in CPI (%)

Source: National statistics and Swedbank’s forecasts.

To date only a limited number of central banks in developed countries have begun raising their benchmark rates, including Australia, Canada, New Zealand, Norway, Poland and Sweden. The Federal Reserve (Fed) in the US, European Central Bank (ECB), Bank of England (BOE) and Bank of Japan (BOJ), on the other hand, have taken a wait-and-see approach. Among emerging countries, all the BRIC countries have raised theirs, but to a lesser extent than what would have been needed to quickly mitigate inflation.

Benchmark interest rates 2000-2010

The ECB has signalled that its first rate hike will come in April. Its main concern is that higher inflation expectations and the second-hand effects of higher import prices could create problems further down the road. To a lesser extent it is worried that the recovery will lose steam in debt-laden countries. By raising rates, the ECB is also placing greater pressure on countries to implement structural reforms.

The next central bank to ease off the gas should be the BOE, which will raise rates after the summer to tame uncomfortably

2010 2011 2012US 1,6 2,3 1,8

Euro zone 1,6 2,2 2,0UK 3,3 4,1 2,6

Japan -0,7 0,2 0,7China 3,3 5,0 4,2India 9,2 8,5 6,8

Brazil 5,9 6,2 4,9Russia 6,9 9,9 9,3Global CPI 2,8 3,7 3,1


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

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cent

0

1

2

3

4

5

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8

US

UK

Japan

Euroarea

Sweden

AustraliaNorway

Major central banks haven’t raised rates yet …

… but the ECB is expected to begin raising as soon as April


high inflation despite relatively weak domestic demand. If the recovery fizzles before then, the BOE may wait a little longer.

We expect the Federal Reserve to put off any rate hikes until next year, probably the spring. Its focus is on how the phase-out of the quantitative easing (which we expect in June) will affect various markets. The key is to ensure that economic recovery is firmly entrenched. Late last fall its rhetoric changed to prepare the market for the first rate hike a few months later.

The BOJ will have to continue (and intensify) its expansive phase. Excluding the effects of higher import prices, the price trend in Japan is still deflationary. Depreciating the yen is likely to be a great priority in the short term.

Long-term interest rates have trended higher since Fed Chairman Ben Bernanke announced a second round of quantitative easing (QE2) last fall. The intended aim was to reduce interest rates, but that hasn't been fully achieved. Instead the focus has shifted to inflation and the declining dollar. A continued recovery and generally higher inflation in the global economy as laid out in our main scenario, as well as the continued need to finance relatively large budget deficits in several countries for a while longer, would suggest that long-term interest rates will continue to track higher.

The Basel III rules, which raise banks’ capital adequacy requirements, along with high government debts and a growing need for investment to expand business capacity, could increase competition for capital in the years ahead, pushing interest rates higher.

Long-term interest rates (10-year government bonds)

Policy Interest rates 28-mar-11 30-jun-11 31-dec-11 30-jun-12 31-dec-12Federal Reserve 0,25 0,25 0,25 1,00 1,50ECB 1,00 1,25 1,75 2,25 2,50Bank of England 0,50 0,50 1,00 1,50 2,00Bank of Japan 0,10 0,10 0,10 0,10 0,10


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Long-term interest rates have trended higher since last fall – despite the Fed's Treasury purchases


Currency trends Compared with a year ago most currencies have appreciated against the dollar. Among the exceptions are Hong Kong, Pakistan and Egypt. Some currencies have risen more than others, particularly the Japanese yen.

Nominal exchange rates in relation to the US dollar, index 9 August 2007 = 100

We expect that slightly stronger growth momentum in the US than in Europe and Japan will strengthen the dollar in 2011-2012. While the ECB will begin to raise its rates earlier, investors are likely to be less optimistic about the euro zone when fiscal and monetary tightening reduces growth.

With quantitative easing ending, concerns about inflation and a further decline in the dollar will diminish, strengthening the dollar’s position. We believe, however, that there is a risk of a bigger decline in the dollar in the medium term, and the longer the US avoids dealing with its financial issues, the greater the risk of a hard landing for the dollar.

China continues to appreciate the renminbi against the dollar by 4-5% per year in nominal terms, but in real terms the appreciation is even stronger. Efforts to internationalise the renminbi continue, including through a pilot project in Hong Kong, but the pace remains relatively slow.

The Japanese yen is weakening in the wake of a shrinking trade surplus and growing interest rate differential against Europe and the US. We expect that current pressure on the yen will decline when expectations of a massive capital repatriation fade. Our assumption that the US will end QE2 without replacing it with QE3 should also contribute to a weaker yen.


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FX 28-mar-11 30-jun-11 31-dec-11 30-jun-12 31-dec-12EUR/USD 1,41 1,45 1,30 1,25 1,25RMB/USD 6,56 6,40 6,25 6,10 5,95USD/JPY 82,4 81 90 95 95

During the forecast period the dollar could appreciate, but the risk that it could decline is greater in the slightly longer term

The yen should weaken, even without interventions


5. The optimal economic policy In an uncertain world it is difficult to determine an optimal economic policy. What is clear, however, is that global financial stability isn’t assured and that there are a large number of policy challenges left to tackle.

A significant risk is the interplay between public and private debt on the one hand, and weak banks on the other. A more severe debt crisis in the euro zone, the US or Japan could create turbulence in financial markets through a fragile financial system, which would affect the real economy negatively. This potentially vicious cycle has to be broken.

So what would be reasonable to do when the recovery isn't robust yet and too much austerity could lead to a new recession?

In Europe, the financial markets have helped to create a greater push for budget consolidation through higher CDS spreads and financing costs. There are few choices for Portugal, Ireland, Greece and Spain (PIGS) other than to implement austerity to balance their budgets and reduce government debt. The UK doesn't face the same pressure right now, but without austerity the sentiment could have quickly turned negative in the financial market. The ECB is now expected to begin raising interest rates as early as this spring, which would make monetary policy less expansive.

In the US and Japan (before the catastrophe), more fiscal stimulus has been introduced in 2011 despite that little impact on growth is expected. In addition to procyclical fiscal policies, they are maintaining highly expansive monetary policies: quantitative easing and low interest rates that are not expected to be raised until next year.

A number of conclusions can be drawn from this policy:

• It is not unreasonable that European countries improve their fiscal position. This would ease pressure on the banking sector and stop the increase in government debt, which would potentially slow growth for years to come.

• The focus has probably shifted too much to cutting spending and raising tax revenue. There is a risk that those worse off will have to bear a disproportionate share of the burden. Politically influential interest groups that oppose structural changes, e.g., Greek pharmacies that are resisting competition, are often protected. Instead, deregulated markets could contribute to lower consumer prices. Structural reforms must complement the budget consolidation in order to raise long-term growth potential.

• The euro zone – through Germany – is advocating a package of measures to bolster Europe’s competitiveness, although the contents don’t seem to focus on competitive strength; instead it seems more like

The euro zone’s crisis-ridden countries have no alternative to tighter fiscal policies

The US and Japan, on the other hand, have been able to continue to stimulate their economies – but with significant risks

Structural reform should go hand in hand with budget consolidation


a negotiating ploy to even out competitive advantages between countries. It would be preferable if the focus were on structural reforms that make labour, goods, services and financial markets more efficient while also strengthening productivity, entrepreneurship, education systems and pensions.

• In addition to reducing the risk from public finances, the banking system has to be strengthened through more ambitious stress tests that actually lead to measures that bolster European banks.

• The ECB probably needn’t be in such a rush to raise interest rates. Inflation is only marginally above the target, and weaker domestic demand shouldn't lead to much underlying inflationary pressure.

• Constantly being a step behind the financial markets in managing the crisis in the euro zone is far from an optimal economic policy. It would be preferable if national interests were set aside and that the measures taken matched the supposedly political commitment to the euro. The temporary crisis fund and permanent fund should both be designed to reduce concerns about insufficient liquidity. At the same time the responsibilities of lenders must be clearly spelled out, so that they can reasonably assess their risks when lending to countries that potentially face a crisis.

• Irresponsible financial policies in the US create a risk that the dollar will fall and market interest rates will rise in the longer term, which would also adversely affect the rest of the world.

• US finances are in worse shape than the euro zone’s, with a higher budget deficit and national debt. The effects of demographics and higher healthcare spending will eventually exacerbate the situation. The US is creating a heavy burden for future generations to bear.

• Debt restructuring in the private sector has been slow, which can also be explained by access to liquidity through low benchmark interest rates and quantitative easing. Cranking up the printing presses has also played a part in manipulating pricing in various markets and cannot continue. Quantitative easing cannot serve as a replacement for structural reforms, as in the case of mortgage reform in the US.

• In summary, budget consolidation, stress tests, structural reforms, the phase-out of quantitative easing and the postponement of interest rate hikes in regions with weak domestic demand are a more optimal economic policy than further fiscal stimulus, higher debt ratios, cranked-up printing presses and a lack of reform.

Staying a step behind the financial market is far from optimal

Quantitative easing and low benchmark interest rates have delayed debt restructuring in the private sector


6. Regions/countries: Most are downshifting Despite the relatively high growth rate in the global economy, there has been a slowdown in both emerging and developed countries. Still, the prospects of increased global trade, production and living standards in the world as a whole are relatively good.

GDP on an annual basis (%) in several major countries/regions

The challenges in the form of overheating risks in emerging countries as well as the debt crisis and stagflation in developed countries continue to create uncertainty, however. This is in addition to the remaining structural problems in many crisis-ridden countries. The US housing market remains in recession. Unemployment has fallen slightly and is significantly higher than in Germany, which is benefitting from previous reforms and the economic recovery.

Labour market in several OECD countries (%)

Given that corporate earnings continue to rise, though not as quickly as last year, there is room for more investment and new hiring. The private sector must be able to assume the role of growth engine as the public sector shrinks due to the debt crisis and phase-out of stimulus programs.


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It is unusual that US unemployment is higher than Germany’s


US – Stronger growth but budget concerns

• Employment is rising, but the weak labour and housing markets, and higher energy prices, are affecting the economic outlook negatively.

• Slight upward revision of GDP growth to 3% in 2011 and 2012. No austerity until after the presidential election.

• Forecast risks include public finances, which in the long term put currencies and interest rates at risk, even globally.

The US economy strengthened more than expected at the end of last year. Domestic demand grew with the help of monetary and fiscal stimulus as well as an improved job market. As a result, we are adjusting GDP growth upward in our spring forecast.

We project that GDP will grow by 3% this year and next. This is actually less than what would be expected after a recession, when there are latent consumption and investment needs. However, the US is wrestling with major structural problems in its housing, labour and credit markets, which is hampering the recovery. Moreover, higher energy and food prices are keeping a lid on consumer confidence and spending.

The labour market has improved, but slowly. The decline in unemployment from 9.8% in November of last year to 8.9% in February is due to job growth and a lower labour supply. The weak job market is creating difficulties for debt-laden, low-income households. Demand is affected for small businesses, which are vital to job growth. This is a vicious cycle that is difficult to break.

Labour market trends, 1980-2011

After trending downward for five years, the housing market is not yet showing signs of having reached bottom. The zigzagging trend in new and existing home sales has been driven by stimulus measures. In April, when tax credits for home buyers expired, sales fell markedly. A recovery began after that, but sputtered when households became worried about rising gas


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prices, higher mortgage rates and weak job growth. A stabilisation is on the way, but it will take time before home sales, home construction and home prices rise robustly.

Housing market trends, 1990-2011

Domestic demand is now continuing to grow. Business investment is on the rise, especially in technology. A relatively weak dollar continues to help exports, but at the same time stronger consumption and investments are leading to higher imports, so net exports are contributing little to growth.

The administration's fiscal stimulus, which was approved in December, is designed to increase investment and job growth. At the same time the effects of previous stimulus programs are now fading, which especially affects households that haven't yet finished eliminating their debt and may want to increase their savings. A policy transition from stimulus to austerity has begun. The Republicans, with a majority in the House of Representatives, are pushing for spending cuts, which are opposed by the Democrats, who have their sights set on growth and next year's presidential election. On March 17 Congress passed a three-week budget extension, but there is still a risk that the federal government won’t have a budget beyond that. Congress has to pass a budget for the rest of the fiscal year, which ends in September, and for 2011-2012. The US also has to reduce its medium-term debt. President Obama’s proposal aims to slash the budget deficit by USD 1.1 trillion over a 10-year period, which is less ambitious than his own bipartisan commission, which would cut close to USD 4 trillion. This means that debt will remain a major risk in the long term, which could hurt the dollar and interest rates.

Inflation as measured by the CPI is now rising, but core inflation, excluding energy and food, is a modest 1-1.5%. This gives the Fed a respite, and we don't expect its first rate hike until next year. The latest quantitative easing (QE2) is scheduled to wind down this summer, and we don't expect a third program given that the markets should remain stable when liquidity declines.


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It is vital that a budget agreement is reached for both short and long term to avert another government shutdown!


Japan – Reconstruction is beginning, but will take time

• Japan’s economy is weakening in the short term, but growth will benefit from the reconstruction, which we expect will take time.

• GDP growth will slow to just over 0.5% this year, but could rise to 3% next year driven by investment.

• Risks include the overall impact of the disaster, the stronger yen and political indecisiveness.

Before the earthquake and tsunami broke out on March 11, Japan had already seen a slowdown in economic activity due to the strong yen, among other reasons. The disaster, which is complicated by the nuclear crisis, will now cause a double dip recession in Japan.

We project that GDP will shrink during the first and second quarters. The factors that are limiting activity are electricity shortages, production disruptions, the loss of exports, increased energy imports and slower consumption due to immediate concerns and damaged confidence. The scope of the disaster is hard to fathom, with over 27 000 dead or missing and 260 000 people left homeless. For those who lost everything, the shortage of water, fuel and food remains the biggest challenge.

Still, the reconstruction will eventually begin. We expect it to take many years, possibly an entire decade. Growth could turn positive during the second half of this year, driven by public and private investment. GDP will grow by just over 0.5% this year before reaching 3% in 2012. Reconstruction costs are estimated at 25 trillion yen, or USD 300 billion, about 5% of GDP, which should be spread out over a period of 5-10 years. The large part will probably come in 2012 and 2013, however. Major nuclear problems are not included in this calculation.

Stock prices and exchange rates


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Lower growth this year but higher next year –other factors are far more important


The Japanese yen has risen in the wake of the catastrophe owing to expectations that capital invested abroad will return to Japan and be used in the reconstruction, and because less capital will be exported going forward. In light of Japan’s current account surplus, these expectations seem slightly overblown, since Japan has enough capital to use.

An intervention by the G7 countries has weakened the yen slightly, but not enough to make much difference. Because of the central bank’s expanded financial asset purchases, quantitative easing and liquidity to facilitate the financial system, monetary policy has become more expansive than before. This is reasonable since Japan is struggling with deflation problems and a debt ratio that was already rising significantly (estimated at 250% by 2015 before the catastrophe).

We expect the Japanese central bank to delay any rate hikes during the forecast period. This, in combination with a shrinking current account surplus, is weakening the yen slightly.

The government and opposition must reach an agreement to increase the budget deficit and issue more government bonds to jumpstart the reconstruction of the devastated northeast region. Even before the catastrophe, credit rating agencies had begun to downgrade Japan's debt, but the question is how far they will go now that debt will increase even more.

There are significant risks in analysing Japan. For one thing, it has not been possible to assess the full effects of the disaster on the economy. For another, we still don't know what the consequences of the nuclear crisis in Fukushima will be in terms of the rescue efforts, whether people will be able to return to the region, export prospects for seafood and agricultural products, energy supplies throughout Japan and their impact on prices, etc.

If economic policies were to become highly expansive, which we don't expect, the reconstruction would go faster, the yen would weaken and deflation would be replaced by inflation.

Another uncertainty concerns the political leadership during crisis and how well the government and opposition are able to work together. Confidence in Prime Minister Naoto Kan was low before the crisis and probably hasn't grown much, although it hasn't fallen either. The opposition isn't unlikely to gain any ground either for defending decisions that lead to a faster reconstruction.

The crisis isn’t over yet – the nuclear crisis complicates the picture

The political risk is far from negligible – and a government crisis before the end of the year is likely


China – Lower credit growth will lead to a soft landing

• The Chinese economy is decelerating, but the growth rate still exceeds the targets set in the five-year plan.

• Tighter economic policy will reduce the risk of overheating and accompanying political instability.

• Forecast risks include high inflation, real estate prices and difficulties achieving more sustainable growth.

At the end of 2010 China’s economy was surprisingly strong, and GDP growth for the full-year reached 10.3%. We now expect China to grow more slowly in 2011 and 2012, mainly due to lower credit growth, higher inflation and less of a net contribution from exports as imports grow due to higher oil prices. Our forecast calls for growth of 8.8% in 2011 and 8.4% in 2012.

China recently concluded its National Party Congress, where the GDP growth target was set at 7% in 2011-2015. During the previous five-year period, 2006-2010, the goal of 7.5% was surpassed by a wide margin at 11.3%. A contributing reason for the large margin of error was the global financial crisis and recession, which forced the Chinese administration to stimulate the economy, resulting in strong growth in exports and investment.

In the new five-year plan growth is concentrated more on household consumption. The goal is also to reduce income gaps, protect the environment, improve quality in manufacturing and reduce inflation in consumer and real estate prices.

Trends in the credit market, 1998-2011

The question, however, is whether the country's efforts to reduce GDP growth are sufficient. There are few economic tools available centrally that will have much of an impact, including interest rates, since lending is often local, and many state-owned companies and other important interest groups have access to


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Chinas party congress is over and ambitious new goals have been set – but can the Chinese achieve them?


low-interest loans. Local and regional politicians are pushing to raise growth, including by buying up and expropriating land and constructing new commercial and private property.

The high rate of credit growth in recent years has led to overheating in the real estate market, which has been difficult to slow despite various administrative measures such as mortgage caps and increased bank reserve requirements. Credit growth has now been brought down to lower levels, however, and reserve requirements are historically high. On the other hand, real interest rates are still negative.

The goal to strengthen households means that wages will increase more than before, which by itself could add to existing inflation problems. On the other hand, the yuan will appreciate more quickly in real terms, which will speed up the process of raising domestic demand and reducing global savings imbalances. China's current account surplus is expected to decline as imports become more expensive and global demand cools slightly. In nominal terms we expect the yuan to appreciate by about 5% against the dollar per year.

Households are being hurt by the high rate of inflation, which has fluctuated around 5% on an annual basis in recent months, but in reality is considerably higher for many people, since food and energy prices have risen substantially. High inflation could lead to political instability, and the administration has no choice but to fight inflation.

Inflation has risen partly because of supply problems stemming from droughts and higher international commodity prices, but just as importantly because several years of economic stimulus through the banking sector have created overheating. The latter can be influenced, and the lower credit growth which has been achieved and has been permitted to reach 14% this year is a step in the right direction.

China’s transition to slightly weaker growth was evident this quarter not only in credit growth but also retail and auto sales and among leading indicators. It is too early to say, however, how sustainable the slowdown will be. Not until the effects of the new year’s celebrations and the cold weather ebb can it be determined, for example, whether the trade deficit was temporary or indicated the beginning of a structural shift.

Despite a goal to increase domestic consumption, high inflation could mean that investments will remain the biggest contributor to growth in years ahead.

Higher inflation is hurting the economy, but could also create political instability

Is the slowdown temporary or will it last?


India – Slowdown due to supply problems

• Demand is growing quickly, but supply can't keep pace and the government’s reform fatigue is affecting investment.

• A slight downward revision in our GDP growth estimate to 8% this year and 7.5% next year presumes that the high rate of inflation will be checked.

• The forecast risks are access to foreign capital, the rupee and fiscal and monetary policy, including the pace of reform.

India’s economy grew quickly last year. After a high rate of investment compensated for the slowdown in consumption in the first half of 2010, investment declined late in the year. We are revising our GDP growth forecast downward to 8%, then see it declining further to 7.5% in 2012.

The reasons why activity in the Indian economy will grow somewhat slower going forward are lower capital inflows, inflation – which remains high but is declining slightly – and economic austerity.

Many companies in the manufacturing and service sectors will face higher costs due to oil prices. Increases in other commodity prices are also affecting growth, at the same time that interest rates and salaries are rising, the exchange rate is appreciating in real terms, and access to international capital is declining. In the business sector, a tailwind is being replaced by a headwind.

Growth in the economy and in various price indexes

In rural areas, the government continues to provide subsidies to offset rising cost pressures, which is stimulating demand.

In urban areas, previous salary increases have contributed to strong growth in auto and other durable goods purchases. Higher inflation, mainly through higher gas prices, could slow this trend slightly. The middle class is still growing, however, and we expect it to continue to contribute strongly to growth, though slightly less


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so than in 2010. When consumption grows faster than investment, the risk of shortages and higher inflation increases.

A faster pace of reform in the Indian economy would help to drive investment. This is especially true with respect to taxes and competition in the agricultural and retail sectors.

Policies remain focused on subsidising demand in rural areas to reduce the stress of higher producer and consumer prices. India is far too dependent on oil, and the subsidies are leading to higher budget and current account deficits.

Interest and currency rate trends

Smaller capital flows and larger current account and budget deficits are reducing appreciation pressure on the rupee. Since monetary policy is likely to remain the principal economic tool, we expect that the Reserve Bank of India (RBI) will have to further tighten this year. If oil prices increase beyond our assumptions, there is a risk that monetary policy will be even tighter, which will impact growth.

Major political developments include corruption scandals (MP bribery, Commonwealth Games, telecom licenses) and a number of state elections next month. Even if Prime Minister Singh retains his position (no successor is evident) and the Congress Party stays in power, uncertainty about scandals and the reluctance to institute reforms could affect interest among foreign investors. If capital inflows dry up, it could speed up deregulation of the retail sector for foreign investors.


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A faster pace of reform would contribute to higher investment and reduce cost pressures

Political scandals and corruption could affect interest among foreign investors


Brazil – aiming at more sustainable growth

• Higher inflation and tighter economic policies are slowing growth to a more sustainable 4-4.5% this year and next.

• Tighter fiscal policy is expected after last year's elections at the same time that the central bank is again being forced to raise its benchmark interest rate.

• Risks are focused on global developments, including commodity prices, and measures to prevent overheating.

Last year the Brazilian economy grew strongly by 7.5% after falling by 0.6% in 2009. The growth rate slowed during the second half of last year as a result of tighter economic policies, a stronger currency and higher inflation. This trend has continued this year and suggests a more modest growth rate during the forecast period. We have revised our GDP growth forecast downward to 4.3% this year and 4% in 2012, i.e., to a more sustainable rate.

Demand-based GDP growth, annual rate (%)

Of course, there is no shortage of challenges facing Brazil’s new president, Dilma Rouseff, who succeeded Lula da Silva on January 1 after defeating José Serra on October 31 of last year. Aside from the political and social challenges, there are economic issues to deal with as well.

Large capital flows have strengthened the currency, the real, which has worried policymakers in the government and central bank. Last year Financial Minister Guido Mantega coined the term currency war and criticised China and the US. Inflation is significantly higher than the central bank's target of 4.5%, and higher benchmark interest rates could increase capital flows and reduce the growth rate.

Against the US dollar, the real is back at levels from before the crisis, but in real effective terms the currency is considerably stronger, partly as a result of higher costs in Brazil versus


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Plenty of challenges face Brazil’s new president


abroad. The measures that have been taken, including taxes and tariffs on capital inflows, have not had enough impact.

The strong currency is helping to increase domestic consumption, since imports become less expensive. As a result, consumer prices are accelerating and in combination with higher international commodity prices are raising inflation. While a stronger currency is easing import prices, it is not enough to compensate for strong domestic demand. The rate of wage increases now significantly exceeds inflation expectations, which is putting further pressure on prices.

The benchmark interest rate has been raised by three percentage points since April of last year to 11.75%, and we expect further rate hikes during the year totalling at least 1 percentage point. At the same time the government wants to tighten fiscal policy – by about 1% of GDP down to a deficit of 2.5% of GDP – to reduce pressure monetary policy and restore public finances after the election year’s excesses.

Interest rate, currency and inflation trends

High commodity prices have also benefitted Brazil’s economy as a major commodity producer and exporter. As in many other large emerging countries, the service sector is developing into a more important growth engine. Value-added in production generally has to be improved, however, since the trade surplus is now based solely on price effects, not volume effects.

Global developments pose the greatest risk to the Brazilian economy on both the up- and downside. Strong demand, high, stable commodity prices and modest capital inflows are benefitting the country. A trade war and protectionism would adversely affect the outlook, however. It would be positive if Brazil’s economic policy could successfully reduce inflation and interest rates. If not, there is a risk of a hard landing later on, with an overheated domestic market and an inflated currency. How well exit strategies in other major economies are managed will also be critical for Brazil. If changes are made too quickly, it could endanger stability in Brazil.


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Benchmark interest rates are high – but further rate hikes are expected during the year

Weaker global growth, trade and commodity prices are Brazil’s biggest risks


Euro zone – Inflation concerns are hurting growth

• The recovery continues within the euro zone, but higher inflation and interest rates are slowing GDP growth slightly.

• The debt crisis and weak institutions could still affect growth and financial stability.

• The euro zone has to consolidate budgets, but that it also needs to strengthen competitiveness through reforms.

After rebounding during the first half of 2010, GDP growth tailed off during the second half of the year. The reasons were the cold weather, the stimulus phase-out and a slight global slowdown. The outlook for 2011 and 2012 is slightly less positive than in our January forecast, despite a stronger global recovery, including higher demand from the US. Commodity price increases have led to higher inflation at the consumer level, due to which the European Central Bank (ECB) signalled that a period of higher benchmark interest rates would begin as early as this spring (April). Owing to tighter monetary conditions, together with tighter fiscal policy in a number of countries, we are shaving a tenth of a per cent from our previous GDP forecast. GDP growth is now estimated at 1.5% this year and next. The financial crisis and recession have affected countries differently. Germany, with its competitive advantages, has regained its status as a strong growth engine, while countries in Southern Europe and Ireland are in need of major structural adjustments, which is inhibiting growth.

GDP growth (%), inflation (%) and government debt (% of GDP)

Although the euro has been relatively strong, exports remained an important growth engine. Investments are gradually taking over, but higher cost pressures could delay more balanced growth. If anything, our forecast of a weaker euro could strengthen net exports.


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Higher inflation and interest rates have contributed to a slight downward revision of growth


The big challenge for the euro zone is to combine debt restructuring in the private and public sectors with tighter monetary conditions without threatening growth in domestic demand. Private debt restructuring means capitalising banks and trimming their balance sheets, along with cutting household debt ratios. Public debt restructuring is a question of balancing budgets and reducing the public debt-to-GDP ratio, which is headed toward 100%.

The financial markets used to treat the euro zone’s members collectively with nearly the same risk premium on lending until differences arose in connection with the financial crisis in 2008. Premiums rose substantially in 2010 in connection with the crisis first in Greece and then Ireland. These countries have sought and received help from the EU, ECB and IMF. Next in line is politically unstable Portugal, which is expected to seek help, especially if attempts to finance its debt in April and June prove too costly. The financial markets still expect that Greek and Irish loans will have to renegotiated. The impact on European banks is unclear, but will be better understood when the results of the stress tests are reported in June (assuming that the tests are ambitious enough this time). There are also expectations that Spain may need a rescue package, although that seems to have died down lately as Spain has reduced its dependence on financing from the ECB. The question is how the euro zone’s institutions can manage these expectations. Will the decisions made most recently on March 24-25 suffice?

Differences between German and other European countries’ 10-year government bonds, percentage points

There is still not enough financing available through the European Financial Stability Facility (EFSF), since its lending capacity, now at 250 billion euros, would be insufficient if Spain, for example, should need help. There is an agreement to increase the fund to 440 billion euros, but no details on how this will be done.

The permanent fund to replace EFSF in 2013, the European Stability Mechanism (ESM), has a lending capacity of 500 billion euros. There is uncertainty how it will be financed, since it will include five instalments in 2013-17, part of which are guarantees (by the most creditworthy countries) and part are cash payments


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First risk premiums were too small – and now they’re too big?

Important details about the euro zone’s crisis funds are still lacking


that will impact national budgets (and which debt-ridden members may find difficult to afford). The reason that the payments are spread out over five instalments is that Germany couldn’t convince its voters to finance it in one lump sum.

Last year Germany’s GDP grew by 3.6%, which was its highest level in many years and at the same time was a result of the big decline in the previous year, as well as stimulus measures. Domestic demand, including inventory build-up, was the biggest contributor to growth, which also benefitted other countries in the euro zone. We expect GDP growth to slow to 2.4% this year and 1.9% next year. Less of a contribution from inventory will slow the growth rate at the same time that the improving job market could give a further boost to domestic demand. A higher inflation rate could worry price-sensitive consumers, however, and in combination with slightly weaker income growth produce only modest consumption. Nevertheless, Germany's economic development has been positive: its budget deficit is expected to be below 3% as early as this year (rather than next year, as predicted), it remains a competitive force and growth is considerably higher than its potential of around 1-1.5%.

France’s GDP fell by 2.5% in 2009, which was followed by weak growth of 1.5% in 2010 – the same rate we expect during the forecast period. After net exports had been the driving force behind growth, private consumption took over. We anticipate that investments and consumption will be the most important drivers, although exports could benefit from Germany's strong development. Unemployment remains relatively high at just over 9%. As a result, consumption growth and domestic inflation remain in check. Rising import prices are contributing to higher inflation, however. To date France has had a less ambitious budget consolidation goal, with a deficit estimated at 6% this year and not reaching 3% until 2013. The risk is that weak growth and a lack of strong action will delay the budget consolidation.

Italy’s GDP growth was just over 1% last year, and unlikely it will surpass that in 2011, when exports are slowed by weak demand in the euro zone – Italy’s most important export market – at the same time that competition from emerging countries may lead to the loss of market share. A weak labour market, low confidence and political instability, and economic austerity, are expected to stifle private consumption. Italy’s reforms have been slowed by political concerns, and a new election can't be ruled out this year.

Spain has managed to calm the financial markets somewhat by reducing its dependence on support from the ECB, although there are still concerns that a rescue package will be needed, not least due to the country's many weak banks (cajas). Since it has yet to resolve its crisis management needs in the short term, Spain has to continue to address its budget issues and introduce structural reforms, mainly to strengthen the labour market and pension system. We predict marginal growth this year, followed by a slight improvement to 1% next year, driven mainly by the export sector.

Good momentum in the German economy

No ambitious French recovery, but no budget consolidation either

Political uncertainty could affect the pace of reform and growth rate

Expectations of a Spanish rescue package have dropped


UK – Austerity is slowing growth

• The recovery in the British economy could get sidetracked when interest rates are raised at the same time that fiscal policy is sharply tightened.

• We still expect the economy to grow by 1.5% in 2011 and 1.8% in 2012, but the risks are on the downside.

• We anticipate that the BOE will not raise its benchmark rate until after this summer. Inflation could rise further before it starts to fall.

The British economy is in tough shape in terms of both business conditions and economic policy. GDP grew by 1.4% in 2010, but shrunk at the end of the year on a quarterly basis partly due to the cold weather, which adversely affected the construction sector.

The driving forces during the recovery have been the public sector, inventory build-up and higher industrial production and exports on the heels of a weaker pound and competitive improvements. At the same time households have been hurt by weaker labour, housing and credit markets. They are still trying to restructure their debt at the same time that the public sector is making cuts to reduce budget deficits and the national debt.

This, in combination with rising inflation, poses a difficult challenge for policymakers, who have to begin tightening monetary policy at the same time that the budget consolidation intensifies. As a result, the risk of the double dip recession has increased. We still expect GDP to grow, but by a modest 1.5% in 2011 and 1.8% in 2012.

Labour trends, 1992-2010

Employment was still lower at the end of last year than before the crisis in 2008. The expansion in the public sector continued until last year, with a million more public workers than at the beginning of year. The austerity package that has now been proposed calls


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for the elimination of up to a half-million public sector jobs. Many British are worried about cuts to healthcare, education and welfare, and demonstrators have taken to the streets in protest.

The goal is to balance the budget in 2014-15, compared with the current deficit of around 9% of GDP. The cuts will intensify this month, reaching about 2% of GDP this budget year, followed by austerity cuts of 1.4% in 2012-2013 and just over 1% in each of the budget years 2013-2014 and 2014-2015. Some critics have claimed that too many cuts will come at the beginning, before the recovery is robust enough. On the other hand, the government has wanted to avoid a crisis similar to what the PIGS countries are experiencing. Although outstanding government bonds have a relatively long maturity of 14 years, the debt is owned largely by foreign investors, which makes the UK more vulnerable than Japan, for instance.

Inflation and interest rates, 2005-2011

BOE chief Mervyn King has written several letters to Chancellor George Osborne explaining why the inflation rate of 4.4% is more than double the target of 2%. VAT rate increases in January 2010 and 2011 were mentioned, as was the previously weak pound and substantially higher commodity prices. However, all CPI measures are above the inflation target, including underlying measures.

If monetary austerity begins as the negative effects of the fiscal policy become evident, there is a greater risk that the recovery could fizzle. This would make it difficult to defend the latest “budget for growth” which was recently presented and could live up to its name by gradually reducing the corporate tax rate to 23% by 2015 as announced. The government has probably expected to receive the support of the central bank through a continuation of its expansive monetary policy. We expect the central bank to sit tight during the spring and not begin a period of cautious rate hikes until the fall. Inflation will slow, but it could take time.


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The pace of consolidation seems reasonable – but structural reforms are needed

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7. Conclusions for our home markets A continued recovery, with higher but manageable inflation, is benefitting businesses and households in our home markets, Sweden and the Baltic countries.

Nevertheless it makes sense to prepare for the alternative scenarios such as stagflation or renewed financial turbulence, which would affect demand in the real economy. The stagflation scenario would require companies to deal with higher costs, including by raising productivity and efficiencies through cheaper purchasing solutions and smarter logistics. They wouldn't be wrong to re-evaluate their business models in times of uncertainty about costs and growth prospects. Many will have to prepare for higher costs when competition for capital increases. Households have to think through their debt-to-equity ratios. Further reducing debt would give them better flexibility later on when interest rates are higher.

Uncertainty also increases the importance of market analysis. Continuously analysing external risks allows companies to sharpen their strategic thinking.

Countries that are now in crisis are implementing structural reforms, which will eventually make them more competitive. Even if this takes several years, countries that are now out front could quickly find themselves left behind after years of failing to institute reforms. A structural transformation is under way, especially now that smaller emerging countries that have been in crisis can strengthen their positions, which increases competition at home in segments where it hasn’t been as strong to date, i.e., higher up the value chain.

An optimal economic policy means creating sound competitive conditions by combining efforts to strengthen or consolidate government finances with structural reforms that make markets more efficient. In Sweden, the focus is mainly on public finances, while reforms have lost steam. The labour market in particular has major structural problems that must be addressed, including youth and long-term unemployment.

Another conclusion is that it is important to strengthen competitiveness throughout Europe – and not in accordance with the divisive competitive pact now being discussed. What is needed instead are measures to strengthen integration in the region’s various product markets and capitalise on its advantages in labour division and specialisation, especially in the service sector, which is undeveloped from a regional perspective. Countries that rank high in terms of competitiveness, like Sweden and Estonia, have a lot to offer to speed up the pace of reform in Europe.

Cecilia Hermansson

The worst growth scenarios require measures to raise productivity

While others are implementing structural reforms, it is easy to get passed by – despite better conditions

We benefit ourselves if all of Europe becomes more competitive

Swedbank Economic Research Department SE-105 34 Stockholm, Sweden Telephone +46858597740 [email protected] www.swedbank.se Legally responsible publisher Cecilia Hermansson, +46858597720 Magnus Alvesson, +46 858593341 Jörgen Kennemar, +46858597730 ISSN 1103-4897

Swedbank’s Global Economic Outlook is published as a service to our customers. We believe that we have used reliable sources and methods in the preparation of the analyses reported in this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or its use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in Swedbank’s Global Economic Outlook.

Swedbank's Global Economic Outlook, 2011 March

Education

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