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07 January 2014 Economics Research

http://www.credit-suisse.com/researchandanalytics

European Economics
Research Analysts Christel Aranda-Hassel +44 20 7888 1383 christel.aranda-hassel@credit-suisse.com Steven Bryce +44 20 7883 7360 steven.bryce@credit-suisse.com Mirco Bulega +44 20 7883 9315 mirco.bulega@credit-suisse.com Violante Di Canossa +44 20 7883 4192 violante.dicanossa@credit-suisse.com Neville Hill +44 20 7888 1334 neville.hill@credit-suisse.com Axel Lang +44 20 7883 3738 axel.lang@credit-suisse.com Giovanni Zanni +44 20 7888 6827 giovanni.zanni@credit-suisse.com

14 points for 2014
The euro area should continue its modest recovery this year. Abating financial and fiscal headwinds should support domestic demand and stronger global growth spur exports. It's possible corporate spending provides an upside surprise as firms resume investment after a five-year dearth. Perhaps the key theme of the euro area in 2013 was its resilience. Both the financial system and the economy absorbed several political and financial shocks remarkably well compared to previous years. We think that was a consequence of the move of most of the periphery into current account surplus. That theme should continue this year. But the European Parliament elections in May should continue the theme of political volatility as populist parties are likely to perform well. There's also a small, but real risk, of elections in Greece and Italy. And the ECB's Asset Quality Review and continued negotiations over banking union could provide further financial uncertainty. And those current account surpluses could provide their own risks. Given the inability of core Europe to generate stronger domestic demand, the euro area's surplus is now at a record high. That should keep upwards pressure on the currency and leave markets extremely concerned about deflation risks. Although we think it'll take another recession for the euro area to slip into deflation, there'll be a number of months this year when inflation could print low enough to spook markets. Aggressively easier monetary policy from the ECB would help address these risks, and there are several tools it could use. But in the absence of a new slowdown, we don't expect the ECB to use them. Monetary conservatism – with its associated risks – is likely to prevail. The countries that could garner interest are France, Germany and the UK. France's relative economic underperformance has become more apparent, but investors shorting its fixed income have been consistently disappointed. That may remain the case. At the same time, the new German government will bed down this year. The thrust of its policies appear to be in the opposite direction to those it has prescribed for other euro area economies. Over the next few years, that may be constructive for addressing some of the euro area's imbalances, especially if the introduction of a minimum wage boosts labour incomes and consumption. But, in the longer-run it may hinder economic performance. The vigour of the UK's recovery has taken many by surprise , not least Governor Carney. We think the strength of the upswing can be sustained, meaning there's likely to be tension between the desire of most of the MPC to signal that rates will be on hold for some time and markets watching a burgeoning recovery mature and spare capacity diminish.

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07 January 2014

2014: The year of doing better, but not well
This year should be one of positive growth in the euro area. The recovery that began early in 2013 looks set to continue at a modest pace. Surveys such as the PMIs – that track growth well – are consistent with the economy growing at an annualized rate of around 1%. The recovery is made in Europe, like the recession before it. The tight monetary, financial and fiscal conditions that pushed the economy into recession in 201112 have abated sufficiently for the economy to grow. For example, the fiscal tightening across the euro area this year should amount to no more than half a percentage point of GDP, compared to 2pp of GDP in 2011 and 2012. The main driver of the recession was the collapse in domestic demand (Exhibit 1). That has now stabilized and started to grow . And the external environment looks more promising: the improvement in global cyclical indicators that accompanied the end of the euro crisis should support an acceleration in export growth (Exhibit 2). In all, then, there's scope for the pace of euro area growth to pick up further from the limited pace it put in in the second half of last year. The upswing should be apparent across all the euro area. We expect GDP across the stressed periphery to register a rise this year, as domestic demand in these economies also stabilizes and their net trade moves further into surplus. So the euro area should do better than it has done in recent years – this should be the third year in six in which GDP has not shrunk – but it is unlikely to do well. A recovery predicated on conditions becoming less challenging, rather than a dose of stimulus, is unlikely to be vigorous. The contrast with the UK, which saw significant monetary and credit easing ahead of last year, is striking. We expect euro area growth of just 1.3% this year, compared to 2.8% in the UK. That's hardly impressive given the cumulative loss in output relative to potential in the last few years. The euro area economy needs more stimulus, but recovery has reduced the urgency of policymakers to respond. As we discuss below (page 10), we don't expect the ECB to ease further. The major problem with this outcome is that the growth we forecast should do little to meaningfully lower the high levels of unemployment in the periphery, especially amongst young people, that will continue to pose a risk to political stability (page 14).

Exhibit 1: Euro area domestic demand has troughed
Q1 2008=100

Exhibit 2: And export growth should pick up
Euro area exports and global PMI new orders

20 104 102 100 Euro area US Japan 15 10 5 0 -5

Real exports, y/y%, 3mma, lhs 60 55

50
45 40 35 Global PMI new orders, 6m lead, rhs 1999 2001 2003 2005 2007 2009 2011 2013

98 96
94 2008

-10

-15
-20

-25
2009 2010 2011 2012 2013

30

Source: Credit Suisse, Thompson Reuters Datastream

Source: Credit Suisse, ECB, Markit

European Economics

2

07 January 2014

The not so jobless recovery to come
Last year saw the start of a recovery in GDP in the euro area. This year should see the start of a recovery in the euro area labour market. That shouldn't be the case. By most estimates the pace of growth at which the euro area is currently running – around 1%pa – should still be consistent with rising, not falling, unemployment. But the labour market has recently performed better than GDP growth would suggest, as Exhibit 3 shows. Unemployment barely rose last year and employment looks to have stabilized in Q3. The employment component of the composite PMI survey is almost at 50. So the labour market looks to be turning. At the country level there's some dispersion in performance, but even in Spain it appears that unemployment is falling. Although that may reflect a slowdown in productivity, it does mean that the modest acceleration in growth we expect this year should bring about a further improvement in labour dynamics. That's important for a number of reasons. For a start, as Exhibit 4 shows, falling unemployment should support a further rise in consumer confidence . In turn, that should help the nascent recovery in domestic demand. But as well as providing fundamental support to the recovery, the turn in the labour market should also go some way to help address some of the "stock problems" – legacies of the crisis – that we discussed in the 2014 Global Outlook. One of our key concerns remains the sharp increase in support for radical political parties in many euro area economies (see page 14). We think some of that increase in support reflects the high level of unemployment, especially among young people. So to the extent to which unemployment rates start to fall, so should current and expected levels of political risk. The other stock problem is the high (and still rising) level of impaired and bad loans. As we discuss below (page 9), the ECB's Asset Quality Review should go some way to more clearly reveal and address the scale of the problem. But, to the extent to which bad loans are a lagging function of the cycle, falling unemployment should both correlate with and cause this stock problem to stabilize and possibly improve.

Exhibit 3: Growth and unemployment
Euro area GDP growth and changes in the unemployment rate

Exhibit 4: Unemployment and consumer confidence
-6 -4 -2 0 2 4
-0.6
-0.2 0.2 0.6
Consumer confidence, lhs

2.5 2.0 1.5 12m change in unemployment rate, pp, lhs

0 -5

-10
-15 -20

1.0
0.5 0.0 -0.5 -1.0 GDP, y/y%, 3qma, rhs, inv

-25
-30 -35 -40

1.0
6 months change in unemployment rate, rhs, inverted

1.4

-1.5
90 91 92 93 94 96 97 98 99 00 01 03 04 05 06 07 08 10 11 12 13
Source: Credit Suisse, Thompson Reuters Datastream

6

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Source: Credit Suisse, Thompson Reuters Datastream

European Economics

3

07 January 2014

Can corporate spending make a difference this year?
Investment has finally stabilized in the last couple of quarters, having fallen by 8% in the 2011-13 recession after a 16% drop in the 2008-09 recession. Given investment's capacity to contribute significantly to any volatility in output, it is important for this upswing to continue and strengthen. We don't think corporates lack the means to invest. Although bank deleveraging and the associated decline in lending to corporates should present a stiff headwind against a strong recovery in investment, we note that the "credit impulse", which matters most for growth, has turned (European Economics – Peripheral Data Monitor: Credit where Credit is Due). And corporates across the euro area are relatively cash-rich. Over the last few years the corporate sector has been running a much higher financial balance than usual, meaning there's capacity for firms to boost spending on investment from existing cashflows rather than needing to borrow. Corporates may have a growing need to invest, as well. Net investment has been especially weak in the euro area in the last few years, meaning that the capital stock is becoming increasingly obsolete. Investment has fallen back to the end of the 90s levels. Our view has been that the euro area financial crisis of 2010-12 was a powerful brake on corporate spending. Given the high levels of uncertainty – and the tail risk of a catastrophic financial collapse – it's unsurprising that corporate behavior was cautious. Uncertainty has abated, though. The European policy uncertainty index, which has fallen steadily over the past 12 months. It is also evident in the improvement in business confidence, especially the forward-looking components, from the lows. These three factors – corporates having the financial wherewithal and the need to invest and reduced uncertainty – should all make for stronger corporate spending. There is evidence for that from the latest European Commission surveys or our latest proprietary survey of European corporates (see here). Given that investment has been growing at an annualized pace of around 1% since the spring, this suggests that corporate spending should make a stronger contribution to euro area demand growth in the coming six to twelve months.

Exhibit 5: Uncertainty abates
European policy uncertainty index

Exhibit 6: Investment intentions for 2014
Survey taken in October-November of the prior year (%)

210
190 170 150

4

2
0 -2 -4 -6

130
110 90 70

50 1999

-8
2001 2003 2005 2007 2009 2011 2013
1999 2001 2003 2005 2007 2009 2011 2013
Source: European Commission, Credit Suisse

Source: Scott Baker, Nicholas Bloom and Steven J. Davis at www.PolicyUncertainty.com, Credit Suisse

European Economics

4

07 January 2014

Could global growth be more supportive than expected?
Net trade has been the only engine of euro area GDP growth in recent years, despite a lackluster performance of global trade growth. In 2014 and for the first time since 2010, domestic demand will contribute more than net trade to GDP growth, reflecting a more balanced composition of growth. Even so, the performance of the world’s first exporter could surprise on the upside thanks to a global investment revival, improved competitiveness and of course, the (slow) recovery of euro area domestic demand – intra euro area exports represent about half of total euro area exports. Companies’ higher investment intentions are the main reason for global trade to pick up (remember that the import content of investment is high). In the US, where the net investment-to-GDP ratio is historically low, firms are facing increased demand from consumers whose saving effort is likely to ease as the large fiscal drag experienced in 2013 fades away and the job market continues to gradually improve. In Japan, incentives to invest are high inasmuch as firms have delevered, face low financing costs and enjoy high profits thanks the Abe/BoJ policies. Higher investment in those two major countries would be positive for the euro area given its export specialisation (machine equipment) and the second round effect on EM growth. Indications that global trade is likely to support the euro area economy are already evident in the surveys. The global manufacturing PMI is currently at robust level and the new export components of the euro area PMI is also very well oriented. Exhibit 2 indicates that export growth could accelerate quickly in the first half of the year

Exhibit 7: Global trade growth
15

Exhibit 8: US net investment ratio (% of GDP)
8 7 6 5 4 3

10
5 0 -5 -10

Long term average

-15 1992

1996

2000

2004

2008

2012

2 1970 1975 1980 1985 1990 1995 2000 2005 2010
Source: Credit Suisse

Source: Credit Suisse, Ameco

Negative shocks to the global economy are possible, though. Indeed, communication challenges lie ahead for the Fed despite a smooth start to reducing the size of QE3. A bumpy road can certainly not be excluded and policy uncertainty would most likely derail investment plans. Japan’s planned VAT hike in April could depress final demand if wages don’t increase accordingly. China’s efforts to change the structure of its economy could be hindered by fragility in credit markets while markets could test the strength of other key and weaker EM countries such as Brazil, India, Indonesia, Turkey and South Africa in the midst of the Fed tapering.

European Economics

5

07 January 2014

Fiscal policy: Letting the cycle do some work
Pressure on euro area government bond markets has diminished during 2013, driven by the OMT in the backdrop and by improving activity and external balances indicators. Barring new political/policy turbulences in 2014, we expect euro area bond markets, and in particular the periphery, to stabilize further this year. Fiscal data available for 2013 suggests that most countries have broadly complied with their yearly targets – with some limited slippage still possible. Full-year data are still not available – general government figures, on a national account basis, will only be available in March. However, the monthly indicators of fiscal developments suggest a broad compliance with the official targets set in agreement with the European Commission – and generally slightly better than 2012 figures. 2014 budget balances should continue to improve. We anticipate a further fall in the euro area aggregate deficit/GDP ratio next year, to 2.4% from 2.9% in 2013 (Exhibit 10). Low interest rates and reduced indexation of government expenditures should help drive deficits down, despite the still modest 2014 GDP growth projections. Peripheral countries are still under some pressure to reduce their structural deficits – although less than in recent years, after an impressive overall structural consolidation achieved – while Germany is benefitting from favourable funding conditions and stronger domestic demand. Both circumstances will drive net funding requirements lower, we believe. The structural adjustment is largely completed for the euro area as a whole, especially when compared to other major economic area around the world. Estimates from the IMF put the 2013 structural deficit at around 1.4% of GDP, vs. estimates of a 4% structural deficit for the UK and for the US (and 9% for Japan). Looking ahead, this should allow the euro area cyclical recovery to proceed more smoothly, without major fiscal headwinds.

Exhibit 9: General government balance and debt
% GDP Austria Belgium Finland France Germany Greece Ireland Italy Netherlands Portugal Spain Euro area General government balance 2012 2013E 2014E -2.5 -2.5 -1.7 -4.0 -2.8 -2.6 -1.8 -2.0 -2.0 -4.8 -4.1 -3.6 0.1 0.0 0.1 -6.0 -4.0 -2.0 -7.6 -7.3 -4.5 -3.0 -3.2 -2.7 -4.1 -3.2 -3.3 -5.9 -5.5 -4.3 -6.8 -6.5 -5.7 -3.2 -2.9 -2.4 Debt 2013E 75 100 58 94 80 176 124 133 75 128 95 96

Exhibit 10: Change in euro area structural balances
5 4
3 2 1 0 -1 Ger Aust Fra Fin Bel Neth Ita
Source: Credit Suisse estimates

2011

2012

2013

2014

Ire Spa Por Gre

EA

Source: Credit Suisse estimates

European Economics

6

07 January 2014

The unbearable weight of a current account surplus
The euro area's large current account surplus will remain a perennial theme this year. As Exhibit 11 shows, it is now running at close to 2.5% of the region's GDP. In large part, this surplus is a consequence of the crisis and the severe external adjustment in the periphery (Exhibit 12). But it has also been a consequence of continued high savings rates in core Europe and the lack of any adjustment in their external surplus. In large part the rise in the current account surplus was due to a collapse in domestic demand in the periphery and stagnant domestic demand in core Europe leading to a sharp fall in imports. And at the same time, solid growth outside the euro area, along with significant improvements in competitiveness and market share in some peripheral economies, has supported exports. Given that the weakness in domestic demand is, in large part, a consequence of the relatively restrictive stance of both monetary and fiscal policy, it is not a surprise that the surplus was associated with a strong currency. There's little to suggest a change in these fundamentals this year. Given their improving competitiveness and domestic headwinds against demand, we expect surpluses in the periphery to continue to rise. Recent data do suggest a marked improvement in domestic demand in Germany. But given the unwillingness of fiscal or monetary policymakers to ease policy further, it seems unlikely that demand will grow sufficiently to bring about an equivalent decline in surpluses in core Europe. But such a large current account surplus is likely to put growing pressure on those policymakers to ease. Germany's persistent current account surplus came under criticism from both the US government and the European Commission last year. We should expect more of the same this year. And the strong euro will continue to add to disinflationary pressures in the euro area. Indeed, a strong appreciation from here would likely have a marked impact on inflation, potentially pushing headline inflation rates closer to deflation (see page 8), and so raising the prospect of a more aggressive policy response from the ECB.

Exhibit 11: An unsustainably high surplus
Euro area current account surplus, as % GDP

Exhibit 12: Asymmetric adjustment
Trade balances as % euro area GDP

2.5
2.0 1.5

3.0
2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5
1985 1990 1995 2000 2005 2010

"Core"

1.0
0.5 0.0 -0.5 -1.0 -1.5 -2.0 1980

"Periphery"

-2.0 1999

2001

2003

2005

2007

2009

2011

2013

Source: Credit Suisse, ECB

Source: Credit Suisse, Eurostat

European Economics

7

07 January 2014

Deflation scares
Inflation is unlikely to move steadily above 1% until the end of the year. And our projections show a new trough in March, when a combination of base effects and subdued energy inflation should push it back to 0.7%. Given the low starting point and the consequent concerns over deflation, downside risks to prices will be closely watched by markets. We see short-term risks coming from some weakness in services inflation, apparent in the December preliminary prints, a smaller than expected impact from French VAT on prices and a relapse of the euro area economy back into recession. Also, a strong currency would heighten deflation scares. December core inflation fell to an all-time low, partly because of one-off factors in Germany affecting services inflation. Core HICP should not print lower inflation rates, but risks remain on the downside. Furthermore, recent experiences showed that the pass through from higher indirect taxes has been far more muted than in the past. Given the tentative state of the household sector in France, we would expect this to be the case there too and we pencil in only a mild (but with downside risks) impact of the change in taxation on prices. On the growth side, the mild recovery we are expecting should put a floor to downside pressures on inflation. Different measures of capacity utilization are pointing to relatively stronger inflationary pressures, rather than to a protracted period of disinflation or even deflation. Against the argument of lower inflation ahead we also note that shortterm inflation expectation measures have turned the corner, while longer-term inflation expectations remain well anchored. Exhibit 14 shows our proxy for euro area standardized price expectations. These have troughed in April and have been grinding higher for the last nine months. To conclude, a broad range of factors impacting short- and long-term inflation expectations are pointing to low, but not lower inflation in the euro area. We will likely see a “prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on”. Other things being equal, inflation should not push the hand of the ECB further.

Exhibit 13: Inflation projections
HICP and HICP ex energy, food, alcohol and tobacco, y/y%

Exhibit 14: Euro area price expectations
Standardised

3.0
2.5 2.0 1.5 1.5 1.0 0.5 0.0 2012 0.9 1.1 1.4 1.4

2

1
0

-1
1.0 0.9 0.7

Headline inflation
Core inflation

0.8

-2

-3
2013 2014 2015

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: Credit Suisse, Thomson Reuters DataStream, Markit Economics

Source: Credit Suisse estimates, Thomson Reuters DataStream

European Economics

8

07 January 2014

Banking union and AQR: A risk and opportunity
The latest banking union deal has come in for considerable criticism, both for its complexity and lack of significant backstop. Against the backdrop of the ECB's Asset Quality Review this year, it's a common view that these polices will contribute to continued bank deleveraging and possibly risk a relapse back into recession. However, it's worth bearing in mind that the stress tests and asset reviews are taking place at a time of relative financial calm. Capital markets are open. And given that a key aim of the process is to ensure banks have properly valued the loans on their books and provisioned and capitalized sufficiently against them, there's evidence that the process is already under way. As Exhibit 15 shows, capital and reserves on banks' balance sheets in the euro area has already risen significantly over the past year or so. This is a process that should continue. So although deleveraging is likely to continue this year, it's not clear its pace will worsen. Indeed, as recovery becomes entrenched and banks become better capitalized, bank lending could start to stabilize. Given that it's the second derivative of credit growth that matters for GDP growth, there's scope for this headwind to ease. On the banking union deal itself, we also maintain a more constructive view, for now. While it still lacks important details – notably on the backstop during the fund's buildup phase (2015-25), as well as on the decision process to resolve a bank – we consider as positive the fact that the Single Resolution Fund will eventually become fully European and mutualized ten years from now. We also believe that the steady state amounts available in the fund (€55bn) would be sufficient to deal with most banking crisis – with the ESM or other backstops having to deal only with the most acute systemic crises. We would have liked more explicit commitments from European officials, but the banking union framework is there to be improved – possibly already in the coming months, thanks to the intervention of the European Parliament. In the absence of further clarifications, the risk is that confidence would not be sufficiently restored, maintaining an unnecessary, too high, level of fragmentation in European financial markets.

Exhibit 15: A recapitalizing banking sector
Euro area banks' capital and reserves as % liabilities

Exhibit 16: Credit growth still weak
Euro area private sector credit growth %

14 7.5 7.0 6.5 6.0 5.5 5.0 1999 12 10

8
6 4

2
0 -2 1999

2001

2003

2005

2007

2009

2011

2013

2001

2003

2005

2007

2009

2011

2013

Source: Credit Suisse, ECB

Source: Credit Suisse, ECB

European Economics

9

07 January 2014

Weapons but not the will? The ECB’s options for 2014
Our 2014 forecast has an unchanged ECB monetary policy stance. This assumes that economic activity will continue to recover at a modest pace accompanied by very subdued price pressures. But the ECB is not asymmetric when it comes to inflation and is likely to act if it falls further. In The ECB's arsenal we outlined an array of measures that we believe are still in the toolbox and could be used if required. The ECB’s bazooka, outright asset purchases, requires a serious risk of deflation, in our view. This is not our base scenario but the very subdued inflation backdrop provides little buffer in the event of another shock to economic activity. The tools for pure money creation in order to preserve the price stability objective have always been available to the ECB and it is interesting to note that ECB members have not ruled asset purchases out. Should the need arise asset purchases are likely to follow the Fed’s script: open ended and not limited to sovereign bonds but also including corporate paper. And since size and variety will be important it makes little sense to relate QE to the ECB’s capital key since it could amount to the entire outstanding debt of Greece and exceed it in the case of a smaller economy such as Estonia. Prior to using the bazooka and to start with we believe that the ECB would cut rates further in the event of inflation falling to 0.5% or lower. A further cut in the key policy rate would also entail a negative deposit rate, in our view. Other options in the ECB’s toolbox are unlikely to be related to inflation but will be more a response to liquidity issues of the euro area’s banking system. Another VLTRO, lower reserve requirements and ending or setting a rate cap to sterilizing the SMP are often mentioned in this category. At the December press conference President Draghi ruled out more unconditional unlimited funding through another VLTRO ahead of the AQR. But cutting reserve requirements further to help periphery banks that have problems fulfilling these and/or suspending the SMP drain against the backdrop of shrinking excess liquidity cannot be excluded.

Exhibit 17: Percentage of outstanding debt bought under € 1 trn QE using ECB capital key
%

Exhibit 18: The ECB has to provide increasingly higher fine tuning rates as excess liquidity shrinks
%

97 40 151 35 30 25 20 15 10 5 0 27 25 25

1.4 1.2 Average fine tuning rate ECB deposit rate

1.0
18 17
13 13 13 13 12 12 11 9

0.8

9

0.6

8

0.4 0.2

SPA

LUX

FIN

GER

BEL

POR

GRE

MAL

CYP

AUS

FRA

EST

SLK

SLJ

NET

ITA

IRE

0.0 May-10

Mar-11

Jan-12

Nov-12

Sep-13

Source: Credit Suisse

Source: ECB, Credit Suisse

European Economics

10

07 January 2014

The UK: Carney's challenge
This year is likely to bring volatility to UK markets, driven by a tension between a burgeoning recovery and a central bank keen to keep monetary policy expansionary. The UK economy begins the year on a strong note. Business surveys, such as the PMIs, are consistent with growth stronger than the 3% annualized rate that the economy saw in the middle quarters of 2013. This strength can be sustained. Business optimism is at its highest in years, suggesting a long-overdue rise in business spending. That could be supported by the recent fall in the size of corporate pension deficits, in turn a consequence of rising long-term real interest rates. And given there's a general election next year, the tone of fiscal policy is also likely to become (temporarily) more stimulative. These are pro-cyclical forces at work that can generate a vigorous recovery. This strength challenges the signal and intent of the Bank of England MPC's forward guidance. As Exhibit 20 shows, unemployment is likely to hit the 7% threshold, at which the MPC's current guidance to keep policy rates on hold becomes obsolete, at some point in the next few months. Given that the aim of forward guidance was to signal to UK economic agents that the MPC intended "to maintain the current exceptionally stimulative stance of monetary policy until we’ve seen a sustained period of strong growth", as Chief Economist Dale has put it, the MPC may have to rephrase its guidance language. We expect the MPC to sign up to a statement similar to that above, possibly at the February Inflation Report, or sooner. But it's also possible that while a majority of MPC members pursue such guidance, others – most notably Weale – could start voting for higher rates soon after the threshold is met (see UK Economics: Forward forward guidance). Although strong growth is likely to be welcomed by the Bank, the recent changes made to the FLS suggest that policymakers are likely to lean against any increase in household debt accumulation. "Macroprudential" policy tools, such as increasing capital charges for types of lending, are likely to be deployed by the Bank this year. We think they're intended as a substitute to monetary tightening. But markets may judge that the only way they're likely to be effective is if they're used as a complement to higher rates.

Exhibit 19: UK growth set to strengthen further
Market sector GDP growth and composite PMI

Exhibit 20: Unemployment rate set to fall sharply
Fitted measure using claimant count rate and vacancy rate

10
Market sector GDP, q/q% ann, lhs 5

65
60 55
8 Actual unemployment rate Average of fitted values

7

0

"7% threshold"

50 Composite PMI, rhs 45 40
6

-5

-10

5

35 30
4 2002

-15

1998

2000

2002

2004

2006

2008

2010

2012

2014

2004

2006

2008

2010

2012

2014

Source: Credit Suisse, Markit, ONS

Source: Credit Suisse, ONS

European Economics

11

07 January 2014

The French contrarian
After some improvement at the beginning of 2013, France’s PMIs weakened in 4Q 2013. National surveys paint a better picture of activity, but we still believe that French GDP growth is likely to underperform the euro area in 2014. We have been in the past more optimistic than the consensus on France – and the data have supported our view , in the sense that France has outperformed euro area GDP growth for the past three years. The reasons for our more optimistic view have been explained in previous works. We also stressed that, from a bond market perspective, France could hardly be associated with the "periphery". France is, indeed, at the true core of Europe, in terms of economic structure and politically, meaning that policies will in most cases suit the needs of the country. The French economy has also a number of strengths, its bond market is liquid, and seen as sufficiently stable by rating agencies. As a matter of fact, bond rates have remained relatively close to the German Benchmark in 2013. We believe that the French bond market should continue to be supported in 2014. But complacency would be misplaced. Losses of competitiveness might dampen the gains expected from a rebound in external demand. Although demand from France's key trade-partners has been recovering and should continue to accelerate this year, the new export orders component of France’s manufacturing PMI has been weakening in recent months suggesting that France has not (yet) benefitted meaningfully from the stronger external demand. A more significant overhaul of the economy is necessary to lift potential growth in France. Despite some timid reforms and some tentative signs of their impact on labour costs, more needs to be done, notably on labour market flexibility and competitiveness. We view as positive the fact that the first declarations of the government this year include the intention to cut further labour costs before the end of 2014. Meanwhile, non-price factors also remain a drag on competitiveness, in our view. Timing is of the essence, though. In our view, France should reform, but only progressively. Indeed, we have stressed on several occasions that risking killing one of the few remaining engines of growth in the euro area – French domestic demand – is not a good idea, especially if there is no other strong engine to take up the baton of growth. France needs to build a solid reform framework, applying those reforms in earnest only once domestic demand in Germany takes off more robustly. This is, en passant, the strategy deployed by Germany in the 2000s: reforms happened while the rest of the euro area was enjoying strong domestic demand growth. Fiscal consolidation appears to be on track so far, but additional steps will be needed by 2015. The European Commission (EC)’s forecasts published in November envisaged that France’s general government budget deficit will be 4.1% of GDP in 2013 and 3.8% of GDP in 2014, and the EC concluded that France is compliant with European rules so far. However, we concur with the EC’s view that additional measures will have to be taken to comply with the 3% of GDP deficit target for 2015. Overall, recent data are consistent with our view that French GDP growth will pick up this year relative to 2013 but also that it will likely underperform the euro area growth acceleration. The popularity of the government is currently very low. However, in the context of improving euro area growth numbers, the relative underperformance of the French economy should occur without causing too much additional collateral damage to the French government.

European Economics

12

07 January 2014

German structural reforms? Nein danke!
The European crisis has been a major catalyst of reform action, but not in Germany. From the start, the German economy was under less reform pressure thanks to weathering the financial crisis with more resilience. In part, however, this was also due to the economy harvesting labour market reforms implemented before the Merkel governments by her centre-left predecessor in the first half of last decade. But the Merkel years, which started in 2005, have not been characterized by any reform impulses at home. This could be blamed on the fact that her first term in office was at the helm of a grand coalition, but she led a centre-right coalition in her second term and as Exhibits 21 and 22 show, that time was not used to tweak and implement any furthering of the previous reform effort. If anything, temporary labour contracts became marginally less flexible again, although on that front Germany remains below the EU average. But it remains way above that average when it comes to protection of permanent workers. The rolling back of reforms is likely to be speeded up in coming years. Merkel has started her third term in office leading a grand coalition once more and the coalition agreement is a significant step-back from hard-won past economic reforms. This applies not only to the labour market, where the introduction of a statutory minimum wage will be accompanied by more regulation and restrictions on temporary work, but rent controls and a lowering of the pension age is likely to put a brake on economic progress. As the panel of independent economic experts who advise Merkel, the so-called five wise men, bluntly remarked in their annual report: “…economic policy measures [in the coalition agreement] taken together threaten to ruin the reform progress Germany has achieved” This flies in the face of periphery euro area members which have seen much pressure to reform coming from Germany. As the wise men put it: “The German federal government can only convince other European governments to assume national responsibility and conduct necessary reforms, if it adheres to this advice in its own national area of responsibility”. We could not agree more.

Exhibit 21: Protection of temporary workers against individual and collective dismissals
Scale from 0 (least restrictions) to 6 (most restrictions)

Exhibit 22: Regulation on temporary contracts
Scale from 0 (least restrictions) to 6 (most restrictions)

4.0
3.5 3.0 2.5 2.0 1.5

2013 2008 EU average 2013

4.0 3.5
3.0 2.5 2.0 EU average 2013 2013 2008

1.5 1.0
0.5

1.0
0.5 0.0

USA

UK

IRL

SPA

GRE

POR

ITA

FRA

GER

0.0

USA

UK

IRL

SPA

GRE POR

ITA

FRA

GER

Source: OECD, Credit Suisse

Source: OECD, Credit Suisse

European Economics

13

07 January 2014

Political risk 1: The (European) Parliament of Populists
One of the consequences of the euro area crisis has been an increase in social tensions and a rise in non-mainstream parties in several countries. There are still residual risks of destabilising early-elections in Greece or Italy, for example, this year, but the main political event should be the European parliamentary elections, on May 25. The risk is that a similar increase in "extremism" surfaces in the European elections. Our view is that this is more than a risk – it is almost a certainty. If we trust recent polls, the European parliament will have 25% – or even close to 30% in some scenarios – of Eurosceptic MEPs (from just under 20% currently). However, we also believe that eurosceptic MEPs will not be enough to block decisions – also because they are, differently from the large European Parliament's political parties, quite heterogeneous amongst themselves. A strong nationalist party like the Front National, in France, has been hovering around 20% of national vote for many months now, according to polls. The same is true for Italy's M5S. Both parties present themselves as fundamentally eurosceptic, and given the proportional electoral system in existence for the EP elections, those two parties will have a significant delegation in Brussels. However, these Eurosceptic parties are very heterogeneous. Similar considerations are valid for other – left or right – national Eurosceptic parties. The most likely outcome is that "Grand coalition" majorities will form on major decisions, as has been the case until now in the present Parliament. Although polls are suggesting a fall in support from the traditional center-right parties, and potentially a slight relative majority in favour of the center-left (thanks notably to a return to form of the Labour party in the UK), it is highly unlikely that the latter will be able to reach an absolute majority without support from centrists and/or centre-right parties. Overall, the risk of a blockage of the European institutions due to the surge in antieuro sentiment seems very small. However, it is a risk that needs to be monitored closely – first, because we are still five months away from the European elections; and second, because the risk would be amplified later this year and beyond if the European, and in particular euro zone economy, does not improve more forcefully.

Exhibit 23: Actual and predicted percentage of seats held by each parliamentary group
Estimates based on current polls

Abbr. EPP S&D ALDE Greens-EFA ECR GUE-NGL EFD Non-Inscrits Total

Group Name European People's Party Socialists & Democrats Alliance of Liberals and Democrats for Europe The Greens–European Free Alliance European Conservatives and Reformists European United Left–Nordic Green Left Europe of Freedom and Democracy Non-Inscrits

2009 36.0% 25.0% 11.4% 7.5% 7.3% 4.8% 4.3% 3.7% 100.0%

2014 (E) 27.8% 28.4% 8.3% 5.1% 8.1% 6.3% 4.3% 11.9% 100.0%

Predominantly Pro-European (PP) or Predominantly Eurosceptic (PE) PP PP PP PP PE PE PE PE

Source: www.notre-europe.eu, Credit Suisse

European Economics

14

07 January 2014

Political risk 2: Independence days
On September 18 Scotland will hold a referendum on the question “Should Scotland be an independent country?” Current polls suggest that a no vote is likely, with about 60% of those polled voting no (excluding undecided and don’t know votes). Nonetheless , there are still eight months to go before the vote, and a yes vote does appear to be a distinct risk. A yes vote would raise significant economic questions. The most significant probably concerns Scotland’s choice of currency. While the yes campaign has stated that its intention is for an independent Scotland to keep sterling as its legal currency, issues remain unresolved. For example, if the Bank of England were the lender of last resort for Scottish banks, what would its role be in bank supervision? Would there be a Scottish representative on the MPC? Is it sensible to enter into a monetary union in which fiscal transfers are being explicitly dissolved? The manner in which the national debt would be split is also of interest. It seems likely that the current stock of gilts would remain a liability of the remaining UK (rUK), while Scotland would take on a portion of the debt, incurring a liability to the rUK (probably weighted by population or GDP) and gradually issue its own sovereign bonds. The Fitch ratings agency has recently commented that Scottish independence would not have a material impact on the credit rating of the rUK, though presumably it could increase gross debt to GDP for the rUK by around 10% (with net debt unchanged in the scenario described above). The transition process could also be challenging. The yes campaign has said that if the referendum passes they expect Scotland to become a fully independent country by March 2016, leaving a year and a half of transition period between the referendum and actual independence. This creates a risk of cross-border capital flows out of Scotland, particularly if investors fear redenomination risk (as we saw in peripheral Europe). Outside of the UK, a yes vote for Scottish independence could also have an impact on other separatist groups, most notably in Catalonia. Spain’s government can and will block Catalonia’s referendum on independence. That is the big difference to Scotland. Catalonia’s president, Artur Mas, had to deliver on his election promise and plans to hold a referendum on 9 November. But the Spanish constitution requires approval from both the government and the lower house of parliament and both the majority conservative government and the main opposition socialist party oppose it. The referendum might thus be a mere consultation which is not legally binding. But this risks pushing the problem out into 2016. Mas has already warned that if Madrid opposes the referendum he will turn the regional election due that year into a vote on independence. Much will depend on Spain’s economic recovery. Fiscal austerity has been at the root of the more secessionist fervour as we wrote in Catalonia's choice. The region, Spain’s wealthiest but also most indebted one, has long sought to re-negotiate intra-regional transfers and to have more tax autonomy along the lines of Navarre and the Basque country. A reform of the financing of the regions via a more federal system could appease Catalonia, but although favoured by socialists, the conservative government continues to oppose this path. But this might change after the 2015 national election if calls for secession remain strong.

European Economics

15

GLOBAL FIXED INCOME AND ECONOMIC RESEARCH
Dr. Neal Soss Global Head of Economics and Demographics Research (212) 325 3335 neal.soss@credit-suisse.com Eric Miller Co-Head, Securities Research & Analytics (212) 538 6480 eric.miller.3@credit-suisse.com

ECONOMICS AND DEMOGRAPHICS RESEARCH
GLOBAL / US ECONOMICS
Dr. Neal Soss (212) 325 3335 neal.soss@credit-suisse.com Jay Feldman (212) 325 7634 jay.feldman@credit-suisse.com Dana Saporta (212) 538 3163 dana.saporta@credit-suisse.com Isaac Lebwohl (212) 538 1906 isaac.lebwohl@credit-suisse.com

LATIN AMERICA (LATAM) ECONOMICS
Alonso Cervera Head of Latam Economics 52 55 5283 3845 alonso.cervera@credit-suisse.com Mexico, Chile Casey Reckman (212) 325 5570 casey.reckman@credit-suisse.com Argentina, Venezuela Daniel Chodos (212) 325 7708 daniel.chodos@credit-suisse.com Latam Strategy Di Fu Juan Lorenzo Maldonado (212) 538 4125 (212) 325 4245 juanlorenzo.maldonado@credit-suisse.com di.fu@credit-suisse.com Colombia, Peru

BRAZIL ECONOMICS
Nilson Teixeira Head of Brazil Economics 55 11 3701 6288 nilson.teixeira@credit-suisse.com Daniel Lavarda 55 11 3701 6352 daniel.lavarda@credit-suisse.co Iana Ferrao 55 11 3701 6345 iana.ferrao@credit-suisse.com Leonardo Fonseca 55 11 3701 6348 leonardo.fonseca@credit-suisse.com Paulo Coutinho 55 11 3701-6353 paulo.coutinho@credit-suisse.com

EURO AREA / UK ECONOMICS
Neville Hill Head of European Economics 44 20 7888 1334 neville.hill@credit-suisse.com Axel Lang 44 20 7883 3738 axel.lang@credit-suisse.com Christel Aranda-Hassel 44 20 7888 1383 christel.aranda-hassel@credit-suisse.com Steven Bryce 44 20 7883 7360 steven.bryce@credit-suisse.com Giovanni Zanni 44 20 7888 6827 giovanni.zanni@credit-suisse.com Mirco Bulega 44 20 7883 9315 mirco.bulega@credit-suisse.com Violante di Canossa 44 20 7883 4192 violante.dicanossa@credit-suisse.com

EASTERN EUROPE, MIDDLE EAST AND AFRICA (EEMEA) ECONOMICS
Berna Bayazitoglu Head of EEMEA Economics 44 20 7883 3431 berna.bayazitoglu@credit-suisse.com Turkey Alexey Pogorelov 7 495 967 8772 alexey.pogorelov@credit-suisse.com Russia, Ukraine, Kazakhstan Sergei Voloboev 44 20 7888 3694 sergei.voloboev@credit-suisse.com Russia, Ukraine, Kazakhstan Natig Mustafayev 44 20 7888 1065 natig.mustafayev@credit-suisse.com EM and EEMEA cross-country analysis Carlos Teixeira 27 11 012 8054 carlos.teixeira@credit-suisse.com South Africa Nimrod Mevorach 44 20 7888 1257 nimrod.mevorach@credit-suisse.com EEMEA Strategy, Israel Gergely Hudecz 33 1 7039 0103 gergely.hudecz@credit-suisse.com Czech Republic, Hungary, Poland

JAPAN ECONOMICS
Hiromichi Shirakawa Head of Japan Economics 81 3 4550 7117 hiromichi.shrirakawa@credit-suisse.com Takashi Shiono 81 3 4550 7189 takashi.shiono@credit-suisse.com

NON-JAPAN (NJA) ECONOMICS
Dong Tao Head of NJA Economics 852 2101 7469 dong.tao@credit-suisse.com China Santitarn Sathirathai 65 6212 5675 santitarn.sathirathai@credit-suisse.com Regional, Malaysia, Thailand Robert Prior-Wandesforde 65 6212 3707 robert.priorwandesforde@credit-suisse.com Regional, India, Indonesia, Australia Michael Wan 65 6212 3418 michael.wan@credit-suisse.com Singapore, Philippines Christiaan Tuntono 852 2101 7409 christiaan.tuntono@credit-suisse.com Hong Kong, Korea, Taiwan Weishen Deng 852 2101 7162 weishen.deng@credit-suisse.com China

GLOBAL DEMOGRAPHICS & PENSIONS RESEARCH
Dr. Amlan Roy Head of Global Demographics 44 20 7888 1501 amlan.roy@credit-suisse.com Sonali Punhani 44 20 7883 4297 sonali.punhani@credit-suisse.com Angela Hsieh 44 20 7883 9639 angela.hsieh@credit-suisse.com

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