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29 July 2011
2009 2010 2011f 2012f Real GDP (% yoy) CPI (% yoy) CPI core rate (% yoy) Unemployment rate (%) Employment growth* (% yoy) Current account balance** Ø EUR/USD -2.6 -0.4 1.7 9.3 -4.4 -2.7 1.39 2.9 1.6 1.0 9.5 -0.7 -3.2 1.33 2.7 3.1 1.3 8.7 1.0 -3.0 1.46 2.7 2.2 2.0 8.2 1.1 -2.7 1.30
Overshadowed by the sovereign debt crisis in the Eurozone, the USA is also heading for a worst-case scenario with its own public debt situation: partial non-performance of government obligations. In other words, the United States may soon be in a position where it is unable to pay its bills. The main reason for this is the inability of the Republicans and Democrats to reach an agreement on raising the debt ceiling. In reality, however, there is much more at stake: the decision to take wide-ranging measures to tackle the urgently needed consolidation of the US budget.
* non-farm ** % of GDP Source: Thomson Reuters, Raiffeisen RESEARCH
History of the debt ceiling
The US debt ceiling is an institution which dates back to the 19th century. Prior to the First World War, the US Congress generally only allowed the Treasury to take out loans for specific purposes, for example for the construction of the Panama Canal. Within this framework, the guidelines on the type of financial instrument to be used, the duration and the applicable interest rate were very strict. Congress only granted the Treasury wider ranging powers during times of war, allowing it to issue bonds and Treasury bills to raise the necessary financial resources.1 With the Second Liberty Bond Act of 1917, Congress relaxed the strict conditions imposed on borrowing. With this change, the US Treasury was then allowed to make its own decisions on the duration, coupon and type of securities to be issued, working within the framework of a pre-defined debt volume.
Building up debt is nothing new
16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 Jan-39 Jan-44 Jan-49 Jan-54 Jan-59 Jan-64 Jan-69 Jan-74 Jan-79 Jan-84 Jan-89 Jan-94 Jan-99 Jan-04 Jan-09
Debt ceiling in USD bln.
Source: The White House. Raiffeisen RESEARCH
Analysts Jörg Angelé, CIIA
Valentin Hofstätter, CFA
1 With the War Revenue Act passed in 1898 to finance the Spanish-American War between April and August 1898, the US Congress authorised the Treasury to issue debt obligations with a maturity of less than one year in a volume of USD 100 mn and to issue bonds with longer maturity in a volume of USD 400 mn.
After the end of the First World War, separate ceilings were once again instituted for borrowing funds depending on the specific type of security which was issued. This meant, for example, that there were individual limits on Treasury notes, Treasury bills, certificates of indebtedness, etc. This practice was only abandoned in 1939, when a debt ceiling for all types of government debt was introduced. In 1939, this debt ceiling was USD 45 bn, the equivalent of USD 724 bn today.
According to the Congressional Budget Office, an independent agency of the Congress, based on the budget planned proposed by President Obama the budget deficit of 9.5% of nominal gross domestic product for this year will only sink to 4.4% in 2016. Along with this, the ratio of debt would increase from 93.2% of GDP in 2010 to 109.1%.4 With this, US debt is approaching levels above which sustainability becomes questionable. Indeed, by 2021, the level of debt is projected to rise to 116.0%. One of the most problematic aspects of these projections is that they are based on the assumption of average real economic growth of 3.4% yoy. According to the estimation of the US Federal Reserve (central bank), the potential growth rate of the US economy is around 2.7% yoy. For the period 1990-2010, the average real increase in gross domestic product only amounted to roughly 2.5% yoy. Furthermore, one can almost certainly assume that the US economy will slip into a recession again sometime before the year 2020. Since 1950, the period of time between the beginnings of two recessions has been just six years on average. The longest period without any recession at all was 1991-2001. Despite this, another period of recession is not included in the projection on the public budget through to the year 2021 and thus this represents a significant risk factor, insofar as the public deficit and debt paths may turn out to be considerably worse than expected.
The current dispute
Upon inception, the debt ceiling was never really intended to be a way of limiting government spending or public debt. As noted above, its original purpose was to make it easier for the government to take on debt. Consequently, when the ceiling was reached, there was never any question as to whether the it should be raised. This has happened on 73 occasions since 1939, whereas there were only 4 instances in which the debt ceiling was lowered.2 Regardless of whether a Democrat or a Republican was sitting in the Oval Office, the debt ceiling and along with it, US public debt, was always adjusted to meet the needs. Viewed in this light, the current dispute is a novel development. At its heart, the question is how the US intends to gain control over its currently enormously high budget deficit. In 2009 and 2010 alone 3 US public debt increased by USD 2,707 bn, which is equivalent to slightly more than the nominal gross domestic product of France. The plans to reduce the budget deficit presented by President Barack Obama so far are seen as being relatively unambitious.
Economic cycle is very reliable
14,000 13,000 12,000 11,000 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000
Burst of New Economy bubble Restrictive monetary policy and/ or restrictive fiscal policy 1st oil price shock 2nd Gulf war/Saving and Loans crises 2nd oil price shock and restrictive monetary policy Subprime crises
No plans for consolidation
6.0 4.0 2.0 0.0 -2.0 -4.0 -6.0 -8.0 -10.0 -12.0 1980 1985 1990 1995 2000 2005 2010 2015 2020 Federal government deficit (% of nominal GDP) Gross federal debt (% of nominal GDP, r.h.s.)
Source: Congressional Budget Office. Office of Management and Budget
120.0 110.0 Forecast 100.0 90.0 80.0 70.0 60.0 50.0 40.0 30.0
Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 50 54 59 63 68 72 77 81 86 90 95 99 04 08 Recession due to BCDC GDP (real, in USD bn)
Source: The Business Cycle Dating Committee. Thomson Reuters. Raiffeisen RESEARCH
By way of example, following five recessions since 1974,5 public debt as a percentage of nomnial GDP in the third year after the recession was higher by
4 If one filters out intra-governmental bond holdings (held by the public), the debt level increases from 62.1% to 79.9%. 5 In relation to the double-dip recession in the early 1980s, only the first phase of the recession in 1980 was taken into consideration and the second recessionary phase in 1981/82 was not counted again.
2 This count only includes changes which resulted in an effective change in the debt ceiling. If one also includes amendments which did not result in a numeric adjustment, there were more than 100 changes. 3 Fiscal years.
11.2 percentage points than it was in the year prior to the recession. Hence, it is highly likely that, if the current budget planning is followed, US public debt in 2020 will be higher by 20 to 30 percentage points compared to the current projections, and will thus amount to 135% to 145% of US nominal gross domestic product, on the one hand because of weaker-than-projected economic growth and on the other hand due to a renewed period of recession. A level of 135-145% of GDP would come close to the current debt level of Greece.
Overly optimistic budget planning
35 30 25 20 15 10 5 0 -5 0 1974 1980 1 1990 2 2001 2008 3 Average Increase of gross federal debt compared to nominal GDP in percentage points
creased in two steps by a total of USD 2,600 bn to approximately USD 16,900 bn. The first step of USD 1,000 bn will come after approval of the savings measures in discretionary spending, with the second step occurring after agreement on further savings amounting to USD 1,800 bn. Numerous Democrats have already signalled that they will reject this offer, as the savings are primarily centred on social expenditures, whereas higher income earners remain completely unaffected. President Obama has already announced his veto, as he is unhappy with the twostep approach to increasing the debt ceiling: he is worried that the same situation will occur next year, if the parties are unable to reach an agreement on the savings of USD 1,800 bn. In light of the Republican’s fundamental opposition to any form of tax increases, the Democratic Speaker of the Senate, Harry Reid, recently saw no alternative but to make a compromise proposal himself, which has a volume of USD 2,700 bn and does not contain an increases in taxes. In particular, this plan calls for cuts of USD 1,200 in discretionary military spending and other discretionary items over the next 10 years. Furthermore, another USD 1,000 bn in spending is to be avoided by reducing the US presence in Iraq and Afghanistan. Another USD 400 bn is to come from the desired decline in interest payments if the savings plans are implemented. In return, the debt ceiling is to be increased in one step by USD 2,400 bn to USD 16,700 bn. Even though Mr. Reid’s proposal accommodates the Republicans insofar as it does not contain any provisions for tax increases, the initial reactions were negative. Without the broad support of Republicans in the House of Representatives, however, the plan has no chance of being passed, as there is also some stiff resistance to it amongst the Democrats themselves. In particular, many Democratic representatives find it highly unjust in social terms that the savings package does not call for any participation of higher-income groups at all. In the meantime, the Congressional Budget Office (CBO), an independent Congressional agency, has analysed both plans and reached the conclusion that the anticipated volume of savings is significantly lower than stated by Boehner and Reid. According to the CBO, the possible savings if all of Boehner’s plans were implemented would only amount to USD 850 bn and not USD 1,200 bn over the next 10 years. No conclusions could be reached about the targeted savings volume of USD 1,800 above and beyond that, as no specific measures were stated for achieving these savings. By contrast, the CBO projected savings of USD 2,200 bn over 10 years with the Reid plan, as opposed to Reid’s estimate of USD 2,700 bn.
0 = first full year of recession or year with the strongest impacts of a recession Source: Congressional Budget Office, Raiffeisen RESEARCH
As both the Republicans and the Democrats have realised that this kind of debt level is no longer sustainable, both sides wish to implement a long-term plan to consolidate the budget. The problem is that both sides have completely different ideas about how this should be done. While the Republicans are essentially arguing for spending cuts, the Democrats would rather increase revenues via tax increases. This dilemma has been reflected in all of the compromise proposals that have been set forth so far. For example, the latest proposal by the Republican Speaker of the House, John Boehner, envisages spending cuts on discretionary spending items (i.e. items which are not stipulated by law) with a volume of USD 1,200 bn over the next 10 years. At the same time, limitations on future spending are to be enacted, which are intended to minimise the increase in public spending. Additionally, the plan calls for the creation of a committee which is to pinpoint another USD 1,800 bn in potential savings on non-discretionary spending between 2012 and 2020, in particular in the field of social expenditures. The proposal does not contain any plans for tax increases. In return for approval by the Democrat-controlled Senate and President Obama, the debt ceiling is to be in-
Moving towards a solution
Considering the almost fanatical position of certain Republican representatives on tax increases and the demands for draconian cuts in social spending, reaching a compromise hardly seems feasible. The rude rejection of Reid’s proposal, simply because it did not include deep cuts in the healthcare programmes Medicaid and Medicare as well as other social benefits, but does manage to avoid tax increases and achieve roughly the same volume of savings as the Boehner plan, raises the suspicion that those involved are actually not interested in reaching a compromise and would rather attempt to reap as much political profit as possible from their obstructionist policy. In this regard, the Republican members of the so-called Tea Party movement are playing a particularly negative role, as they called upon all Republican representatives to refuse any compromise solution, including that of their fellow party-member John Boehner. At the same time, the proposals which have been made so far could easily be used to find a viable compromise: tangible cuts in military spending as proposed by Senator Reid; cuts in the field of healthcare – the USA spends by far the most money of all OECD countries on its healthcare system6 – as well as further cuts in discretionary spending and spending caps, as demanded by Boehner; quick implementation of the savings measures starting in 2011 already, but by 2012 at the latest as envisaged by the Republicans; increasing the debt ceiling in one step to around USD 17,000 bn as desired by President Obama. With a compromise like this, it would most certainly be possible to avoid the looming partial default by the USA; the negative economic consequences would be minimal and the government budget deficit could at least be stabilised in the next few years. This notwithstanding, real consolidation of the US budget is still miles away. In order for such consolidation to proceed, tax increases will be unavoidable over the medium term. The calls by some Republican representatives to immediately reduce spending so much that the budget is balanced and then to maintain this balanced budget in the coming years are completely unrealistic. The fiscal shock that this would trigger would be certain to plunge the US economy into another recession. And as the effect of automatic stabilisers would essentially be negated in de facto terms, there would be a risk of a vicious downward spiral with devastating consequences. Germany was
6 According to the OECD, the USA spent around 17.4% of its nominal gross domestic product on its healthcare system, more than any other OECD country. Although a large part of the spending is privately financed, the USA also ranks among the highest in terms of public spending on healthcare as well.
one of the countries that had this experience during the global economic crisis in the 1930s, when the German state reacted to the steep decline in revenues with massive spending cuts, which actually exacerbated the crisis itself. Whilst tax increases are generally to be used with caution and should always be the last instrument deployed, in the case of the USA a modest increase in the tax burden would clearly outweigh the possible ramifications of sharp cuts in spending. According to calculations by the EU Commission, measured in terms of 2009 gross domestic product, the tax burden in the USA was just 24.2% and was thus lower than that of any other industrialised country. Tax burdens are higher even in so-called ‘tax havens’ such as Ireland (28.2%), Switzerland (29.5%) and Slovakia (28.8%). Viewed in a historical light, a tax ratio of less than 25% is also extremely low by American standards.
USA with low tax burdens
60.0 50.0 40.0 30.0 20.0 10.0 0.0
Tax burden in % of nominal GDP
Source: EU Commission
There are two very simple tools which can be used to tangibly increase the government’s revenues, without excessively dampening economic activity: one of these would be the introduction of a nationwide value added tax, which has never existed in the USA, in contrast to all of the members of the EU. With the nominal volume of private consumption at more than USD 10,000 bn, levying a value added tax of just one percent would immediately generate additional revenues of around USD 100 bn. Over a 10-year period, this would result in additional revenues of almost USD 1,300 bn, working on the assumption of an estimated increase of 3.75% yoy in nominal consumption expenditures (the average rate for the period 2000-2010). This would be equivalent to one-third of the savings volume of USD 4,000 bn which is desired by President Obama and is viewed by the rating agencies as necessary to achieve a sustainable debt path. Above and beyond this, there
is leeway for increases in personal income tax. For example, the top tax rate is currently at 35% and is thus very low compared to the historical average. Following the Great Depression, the top tax rate was increased to 63% in 1932. To finance the massive rise in public debt during the Second World War, it was even raised to over 90% at times. Only from the mid-1960s was the top tax rate reduced below this high level, but it still was over 70% until the early 1980s. While income tax rates this high are not desirable, one glance at the tax rates of the past confirms that there is ample leeway to increase rates.
shutdown, meaning that numerous government services will be suspended. Amongst other things, such a shutdown would include the closure of government offices and agencies, national parks and schools. If this situation only lasted a short time, the economic impacts would most likely be manageable.
Interest payments covered (theoretically)
400.0 350.0 300.0 250.0 200.0 150.0
Top tax rate low in historical comparison
150 135 120 105 90 75 60 45 30 15 0 1913 1925 1937 1949 1961 1973 1985 1997 2009 Gross federal debt (% of nom. GDP) Top bracket income tax Lowest bracket income tax
Source: Internal Revenue Service, Congressional Budget Office
100 90 80 70 60 50 40 30 20 10 0
100.0 50.0 0.0 02Aug 09Aug 16Aug 23Aug 30Aug
Interest payments Social security benefits Deposits
Forecast based on daily revenues and spending in August 2010 Source: Treasury, Raiffeisen RESEARCH
What will happen if worst comes to worst
If the parties to the conflict are unable to reach an agreement on raising the debt ceiling by early August, starting from August 3 the US Treasury will only be able to spend as much as it receives from current revenues. The budget is thus automatically balanced. Nevertheless, a default in the traditional sense of the word, i.e. failure to service interest payments on outstanding government bonds, is highly unlikely. The current revenues of the Treasury are easily sufficient to pay the interest due and to cover various social benefits. But there is no automatic prioritisation of payments. This means that it is up to the Treasury to decide which obligations it wishes to settle. Redemption of maturing bonds is not affected by the spending limits. Old debts can be rolled over at any time, as they do not result in an increase in the level of debt. Accordingly, as long as the USA can find enough investors (and one can assume that it will), default on payment is impossible. In any case, it is very likely that there will be a so-called government
A longer-lasting shutdown, however, would have serious consequences for the economy. For example, if no agreement on raising the debt ceiling is reached by August 31, the outstanding payments would amount to around USD 145 bn. This would represent a massive fiscal shock and have the potential in its own right to trigger a recession in the economy. At the same time, the negative impacts of the shutdown on other economic processes are at least as serious: licenses would not be renewed, applications would not be processed, no social security cards and passports would be issued and permits would not be granted. In 1995/96, the last time there was a government shutdown, in just three weeks some 25,000 visa applications went unprocessed, which resulted in millions in losses for the airlines. Thus, failure to raise the debt ceiling in a timely manner is like playing with fire and in the worst case, it could cause the US economy to slip into recession again. Even if a compromise is reached by August 2, we believe that it is unlikely that the related consolidation measures which are planned will be sufficiently large, in light of the current destructive atmosphere. It is more likely that an emergency solution will be found. The rating agencies have announced that they will lower the USA’s current AAA rating in that case as well as in the case of raising the debt ceiling too late. In mid-July, both Moody’s and S&P assigned a negative outlook to the AAA rating and warned of a possible downgrade to AA within the next three months, unless a credible plan is presented on how 5
the USA intends to avert further growth in the debt in the years ahead. According to S&P, such a consolidation package would have to have a volume of at least USD 4,000 bn over the next ten years, in order for the AAA rating to still be justified. In light of the current political environment in the USA and looking at the results of negotiations so far, a result on this order of magnitude appears highly unlikely. Consequently, US politics will probably fail to convince the rating agencies, even after an agreement is reached on raising the debt limit. Hence, a downgrade to AA is likely to come from at least one of the three major rating agencies in the weeks/months ahead. Many market participants now take the same view: a Reuters survey this week showed that 30 of 53 economists polled were expecting a downgrade of the USA’s credit rating.
What consequences would loss of the AAA rating have?
Naturally, failure to raise the debt ceiling in time and in particular the loss of the AAA rating by the world’s largest economy would come as a painful blow to the credibility and reputation of the USA. In theory, a lower risk rating should result in higher risk premiums and thus higher financing costs for the US government. In the worst case, this would mean that US debt servicing was much more expensive; moreover, the higher interest burden could significantly dampen US economic activity. Accordingly, it is very probable that there would be some shortterm turbulence on the financial markets. While the impact on US government bonds is relatively neutral (their prices should actually fall, but this could be compensated by the concomitant rise in risk aversion and the ensuing declines on the equity markets, etc.), German government bonds should profit over the short term as an alternative investment, with the US dollar thus depreciating versus most other currencies. There will not, however, be a massive sell-off of US government bonds. Even with an AA rating, US governments would still be the most “risk-free” securities in the USA. If the US sovereign rating is lowered to AA, most of the other AAA-rated issuers in the USA (e.g. the state-affiliated mortgage banks Fannie Mae and Freddie Mac, and other issuers with close ties to the government) would also be downgraded to AA at best. Accordingly, investors’ alternative options to reallocate capital into “better” USD securities with adequate liquidity and market depth are seriously limited, and this would strongly reduce the impact on bond yields. Of course, there are certain portfolios which are only allowed to invest in AAA-rated securities. But as long as all three of the major rating agencies do not lower the US credit rating and at least 6
one of the agencies leaves the AAA rating in place, it will be possible for most of this capital to remain invested in US government bonds. On the other hand, if all three agencies lower the rating, then this capital would have to seek alternative investment opportunities and turbulence on the financial markets would be unavoidable. The experiences with the downgrade of Japan’s credit rating from AAA to AA, however, suggest that this turbulence would also be limited. In that case, there was neither any unnatural turmoil on the market nor have yields on Japanese government bonds risen since then. In our opinion, the argument that – in contrast to Japan – the USA is a net importer of capital is not strong enough: because many nonresident buyers of US government bonds also have limited alternatives to US government bonds, such as US banks or insurers. First and foremost, this group of investors includes foreign central banks, some of which purchase massive amounts of US bonds and US dollars, to keep their own currencies weak. These buyers thus have no other option than to continue investing in US government bonds. Consequently, unless these countries, including China, dramatically change their exchange rate policy, their investment in US government bonds will hardly be affected by a downgrade to AA. We confirm our EUR/USD exchange rate forecast of 1.50 for September, as we expect further escalation of the debt dispute over the short term and a downgrade of the US credit rating despite an eventual agreement on raising the debt limit. Although a brief downward correction in EUR/USD can be anticipated following an agreement on raising the debt ceiling, interest rate developments will continue to diverge in favour of the Eurozone and this will support the euro. We leave unchanged our Sell recommendation on US government bonds; it is not so much the current debt and rating debate that is a factor here, but rather our expectation of an improvement in the US labour market in the second half of 2011.
Raiffeisen RESEARCH GmbH A-1030 Vienna. Am Stadtpark 9 Tel: +43 1 717 07-1521 Head: Peter Brezinschek (1517) Research Sales: Werner Weingraber (5975)
This report was completed on 29 July 2011
Economics. Fixed Income. FX: Valentin Hofstätter (Head. 1685). Jörg Angelé (1687). Wolfgang Ernst (1500). Gunter Deuber (5707). Julia Neudorfer (5842). Matthias Reith (6741). Andreas Schwabe (1389). Gintaras Shlizhyus (1343). Gottfried Steindl (1523). Martin Stelzeneder (1614) Credit/Corporate Bonds: Christoph Klaper (Head. 1652). Christoph Ibser (5913). Igor Kovacic (6732). Martin Kutny (2013). Peter Onofrej (2049). Gleb Shpilevoy (1461). Alexander Sklemin (1212). Jürgen Walter (5932) Stocks: Helge Rechberger (Head. 1533). Aaron Alber (1513). Christian Hinterwallner (1633). Jörn Lange (5934). Hannes Loacker (1885). Richard Malzer (5935). Johannes Mattner (1463). Christine Nowak (1625). Leopold Salcher (2176). Andreas Schiller (1358). Connie Schümann (2178). Magdalena Wasowicz (2169) Quant Research/Emerging Markets: Veronika Lammer (Head. 3741). Mario Annau (1355). Lydia Kranner (1609). Nina Kukic (1635). Albert Moik (1593). Manuel Schuster (1529) Technical analysis: Stefan Memmer (1421). Robert Schittler (1537)
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