Global Economic Research July 16, 2010

Tuuli McCully
1 (416) 863-2859
tuuli_mccully@scotiacapital.com

Pablo Bréard
1 (416) 862-3876
pablo_breard@scotiacapital.com

• European currency and debt markets regain a strengthening tone

• Germany leads the way in euro zone economic recovery and fiscal improvement
• Portugal’s sovereign credit rating downgrade − bonds still in high demand
• Interest rates on hold in Turkey; economy in robust growth mode

European currency and debt markets regain a strengthening tone

The euro (EUR) continues in recovery mode, approaching the US$1.30 mark by the end of the
trading week. Intensifying concerns about the strength of the US economic recovery, prolonged
monetary easing prospects and technical overvaluation dynamics have weighed on the US dollar
(USD), which has weakened against major global currencies over the past two months (indeed,
the Japanese yen strengthened to 86.50 per USD early in the day). Moreover, market sentiment
towards European debt assets has somewhat improved as global investors continue to differenti-
ate (on the back of recent industrial production data) between “core” (Germany, France) and
“peripheral” (Greece, Spain, Portugal) members of the euro zone. Interest rate differentials favour
the British currency and debt assets at present. Indeed, the British pound (GBP) has emerged as
a strengthening currency within the “majors” group; in fact, Sterling edged the 1.55 mark today,
prolonging a steady appreciating trend in place since late May.

Finally, a successful Spanish government bond sale reduced investor anxiety about European debt
sustainability: Spain issued €3 billion in 15-year debt securities with an average yield of 5.12% with a
bid/cover ratio of 2.6 times. Spain’s offering crowned a week of relatively well received bond issuance
activity by Greece, Portugal and Italy. The cost of insurance of Spain’s debt assets implied in credit de-
fault swaps (CDS) has declined over the past week: Spain’s five-year CDS closed the week at 220 ba-
sis points (bps). Improved market sentiment in Europe helped sustain a strengthening trend in other
emerging-market currencies such as the Russian ruble (RUB) and the Turkish lira (TRY) which closed
the week at 30.4 and 1.53 per USD, respectively.

Germany leads the way in euro zone economic recovery and fiscal improvement

Industrial activity across the euro zone continues to be on the mend. For the region as a whole, produc-
tion rose 0.9% m/m (and 9.4% y/y) in May, a third consecutive monthly gain; nevertheless, at the na-
tional level, there were significant differences in performance between the core countries and the euro
zone periphery. The European Central Bank (ECB) assesses that euro zone economic growth picked
up in the second quarter of 2010 from the 0.2% q/q rate recorded in the January-March period. We ex-
pect euro zone output to expand by around 1% through 2011, with Germany − the largest economy in
the region − being the growth engine helped by the significantly cheaper euro that continues to boost
the nation’s exports. Nevertheless, the ZEW indicator of economic sentiment points to business activity
in the country slowing towards the end of the year. Meanwhile, Germany’s government finances appear
to be in a relatively healthy condition compared with many other developed countries; this week, Ger-
many cut its 2010 fiscal deficit target from 5.5% to 4.5% of GDP on the back of a solid economic recov-
ery that has allowed an improvement in unemployment and government tax revenues. The fiscal short-
fall is expected to reach the Maastricht limit of 3% of GDP in 2012. With euro zone inflationary pres-
sures muted − consumer price inflation was 1.4% y/y in June − the ECB is in no rush to tighten mone-
tary policy conditions. We expect the ECB to keep the benchmark interest rate unchanged at 1.0% until
the final quarter of 2011 due to ongoing uncertain growth prospects in the region.

Europe Weekly Outlook is available on www.scotiabank.com, Bloomberg at SCOE

Global Economic Research
Portugal’s sovereign credit rating downgraded;
bonds still in high demand
The global rating agencies’ perception of Portugal’s
creditworthiness is deteriorating. Moody’s Investors
Service downgraded Portugal’s sovereign credit rat-
ing this week by two notches to “A1” and assigned it
a “stable” outlook. Nevertheless, the rating remains
comfortably in the investment grade category, and six
notches above that of Greece. Moody’s justified its
decision by Portugal’s weak fiscal situation. It as-
sesses that the government’s financial strength will
continue to weaken for another two or three years,
with the stock of government debt eventually reach-
ing 90% of GDP; at end-2009, the debt burden was
equivalent to 76.8% of GDP. In the mean time, the
rating agency remains somewhat concerned about
the country’s medium-term growth potential despite
the fact that the administration has recently intro-
duced structural reforms to boost productivity. Mean-
while, Standard and Poor’s maintains a “negative”
outlook on Portugal’s “A-” rating. The Bank of Portu-
gal expects the economy to expand by 0.9% this year
with fiscal consolidation slowing the growth rate to
0.2% in 2011.
The Portuguese government is decisively embarked
on achieving fiscal sustainability, and is planning to
reduce the general government deficit from 9.4% of
GDP in 2009 to 4.6% in 2011. Fiscal consolidation
measures include upward adjustments to income,
corporate, capital and value-added tax rates, a freeze
on new hires, a reduction in public sector spending, a
reduction in public servants’ wages and privatization
of state assets. On Wednesday, a day after the sov-
ereign credit rating downgrade, Portugal successfully
issued two- and ten-year bonds that were significantly
oversubscribed. While high demand for the debt se-
curities improved investor sentiment, Portugal is pay-
ing a markedly higher price for its borrowing. The
country’s 2-year and 10-year sovereign bonds are
yielding 3.02% and 5.48%, respectively, while the
yield spread between Portuguese and German 10-
year securities has increased by around 200 bps over
the past six months to 282 bps.
July 16, 2010
Interest rates on hold in Turkey; economy in ro-
bust growth mode
Monetary conditions remain on hold in Turkey. Fol-
lowing the Monetary Policy Committee meeting on
July 15th, Turkish policymakers maintained the new
policy rate, the one-week repo rate, at 7.0% (please
see official monetary policy statement at http://
www.tcmb.gov.tr). Monetary authorities noted that
while domestic demand is growing in a stable man-
ner, there are signs of a slowdown in the external
sector. As risks regarding the global outlook remain in
place while the inflation outlook is becoming more
favourable, the policymakers assess that the bench-
mark interest rate may remain at the current level “for
some time”. We expect the central bank to start tight-
ening monetary conditions in the final months of
2010. The Turkish economy is on a robust growth
path. Industrial production increased by 3.7% m/m
and 15.6% y/y in May, nearing pre-recession levels;
output in May was less than 5% below the level two
years ago. Real GDP jumped by 11.7% y/y in the first
quarter of 2010, though a low base of comparison
was a key contributor to the strong result; we antici-
pate the country’s output to expand by 5½% this
year. Growth will likely slow to around 4% in 2011 as
many European economies switch to fiscal consolida-
tion mode, dampening demand for Turkish exports,
and as domestic demand slows due to monetary
tightening. Inflationary pressures continued to ease in
June; the consumer price index increased by 8.4% y/
y compared with 9.1% the month before. We expect
inflation to hover around 7½% at the end of 2010.
Prospects for normalization in the monetary policy
stance amid robust economic recovery are providing
support to the TRY; the currency has gained more
than 5% vis-à-vis the USD since early-June low. We
expect the TRY to close the year at 1.60 per USD.
2
 Global Economic Research July 16, 2010

INTERNATIONAL RESEARCH GROUP

Pablo F.G. Bréard, Head

1 (416) 862-3876
pablo_breard@scotiacapital.com

Tuuli McCully
1 (416) 863-2859
tuuli_mccully@scotiacapital.com

Estela Ramírez
1 (416) 862-3199
estela_ramirez@scotiacapital.com

Oscar Sánchez
1 (416) 862-3174
oscar_sanchez@scotiacapital.com

Scotia Economics
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Toronto, Ontario Canada M5H 1H1
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Email: scotia_economics@scotiacapital.com
This Report is prepared by Scotia Economics as a resource for the
clients of Scotiabank and Scotia Capital. While the information is from
sources believed reliable, neither the information nor the forecast shall
be taken as a representation for which The Bank of Nova Scotia or
Scotia Capital Inc. or any of their employees incur any responsibility.