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July 2010

Global Macro-Risk Scenarios 2010-2011: Diminished Expectations

Table of Contents
Executive Summary Our Scenarios in Perspective Our Forecasts for 2010-2011: Still HookShaped Risk Scenarios: Whats Next for the Eurozone? 1 2

Executive Summary
Since 2009, Moodys hook-shaped central scenario has essentially envisaged that growth would be constrained in most high-income countries for several years because of ongoing deleveraging efforts, but also that the vitality of the rest of the world would limit the risk of recession. We continue to maintain this as our base-line scenario. Specifically, our most likely scenario anticipates a multi-speed rebound in high-income economies, with the US and Japan emerging more vigorously from the 2009 contraction than Europe. This scenario rests on the assumption that, sooner or later, both the private and the public sectors will have to repair their respective balance sheets and reduce their debt-to-income or debt-to-wealth ratios. The global macroeconomic and financial outlook is therefore closely intertwined with the sovereign outlook. Downside risks to our scenario emanate primarily from (i) the risk of a disorderly exit from highly stimulating fiscal and monetary policies; (ii) the possibility that financial institutions may not have rebuilt capital buffers quickly enough to withstand the remaining economic and financial stress; and/or (iii) a concern that there might be unexpected decline in the dynamism of the Chinese economy. These downside risk concerns have recently heightened and have resulted in growing financial anxiety, which has the potential to hinder the recovery and trigger disruptive dynamics. The place where these concerns have coalesced is Europe, where the feeling that public authorities are running out of alternative solutions (what if plan B doesnt work?) is more widespread. The discussion that follows therefore covers two broad topics: (1) the underpinnings and implications of our base-line scenario and (2) the downside risks to this base-line as they might be realized in Europe. In addition, in an appendix, we provide our perspective on the ongoing deleveraging process and its implications for the pace of the global economic recovery.

Appendix I: A focus on deleveraging :Why this matters so much and yet it is so little-known. 6

Contact Us
Email and Web page globalriskanalysis@moodys.com www.moodys.com/gra Richard Cantor Chief Risk Officer richard.cantor@moodys.com +1.212.553.3628

Bart Oosterveld +1.212.553.7914 Managing Director Sovereign Risk Group bart.oosterveld@moodys.com Albert Metz Managing Director Credit Policy Research albert.metz@moodys.com +1.212.553.4867

Elena Duggar +1.212.553.1911 Vice President Senior Analyst Credit Policy elena.duggar@moodys.com Aurelien Mali +44.20.7772.5567 Assistant Vice President Global Financial Risk Unit aurelien.mali@moodys.com Client Services +44.20.7772.5454 clientservices@moodys.com Media Relations: +44 20 7772 5456

Our Scenarios in Perspective

Our expectations so far in a nutshell
Our central macroeconomic and financial scenario assumed a sluggish rebound in advanced economies against the headwinds of deleveraging and the hypersensitivity of financial markets to real or perceived policy mistakes in contrast with a sharp and sustained rebound in the economies that have not suffered as a result of banking and credit dislocations. All along, our view has been that the macroeconomic outlook was dependent on the sovereign outlook.

Our expectations going forward

Our forecast remains focused on the following key themes: A continuation of the solid economic pace in the emerging world and sluggish average growth in the advanced world where policy priorities have shifted towards fiscal consolidation. The continuation of the disorderly risk repricing of the sovereign asset class, aggravated by financial markets' divided stance concerning the respective merits, from a credit standpoint, of fiscal austerity versus growth-friendly policies. A further decoupling of monetary conditions in advanced and emerging economies. Over the longer term, we continue to see the risk of financial repression (with financial systems increasingly taking on the role of financiers of governments). We also view deflation and inflation risk as being successive rather than mutually exclusive threats. Perhaps the most fundamental issue underlying the global economic and financial outlook centres around how much leverage advanced economies can sustain and the economic implications of the pace of deleveraging. Currently, the key macroeconomic question in Europe and the US is whether governments should retrench while banks and households also repair their balance sheets. At the same time, the issue of how much capital is required and how quickly it should be raised lies at the heart of the bank capital debate. There is no agreement on the economic impact of deleveraging (Appendix I presents more detail on this issue).

Developments and trends over the past six months

We have experienced a slight economic rebound, with global growth likely be around 4.5% in 2010 and slightly lower in 2011, after an almost unprecedented contraction of -0.9% in 2009. However, this recovery now appears to be running out of steam in some parts of the world: The intensity of the recovery varies from region to region, with large emerging market economies leading the way. The necessary deleveraging process is dampening growth prospects, the extent of which depends on investors and lenders' patience. Financial conditions have eased across most of the world, but have become more hostile in the Eurozone than we expected. The interdependence between Eurozone governments and banks has the potential of triggering a vicious circle and give succour to the troubling view that policy options could be exhausted.

The diagram below illustrates how we see the balance of risks evolving for 2010 and 2011 and how decoupled we expect regional prospects to be.

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While some studies have shown that deleveraging has typically been negative for economic growth, 1 other (admittedly isolated) cases suggest that fiscal consolidation can even be growth-positive. Our multi-year hook-shaped central scenario is based on the premise that growth will be subdued because of the need to repair balance sheets, but that deleveraging forces do not entirely overwhelm new growth in less leveraged parts of the economy.

in such agitated times. Also, our rating decisions across asset classes are influenced by meaningful economic shifts rather than decimal changes. Our central assumptions are based on a sample of forecasts, including of course Moodys own economic forecasts. We indicate whether the bias [1] is positive or negative, i.e. whether we are more likely to be positively or negatively surprised. Lastly, we indicate the level of uncertainty surrounding the central forecast. We present the range of forecasts that we survey and compare them to the historical standard deviation of the countries real growth.

Our Forecasts for 2010-2011: Still Hook-Shaped

We present our central scenario as follows: We provide a range (of 1%) to avoid spurious precision

Countries
Growth central range

2010
Bias [1] Unemploy ment central range Growth central range

2011
Bias [1]

Forecast uncertainty measures

Unemploy 2010 ment growth central forecast range range [2] 2011 GDP growth volatility forecast [3] range [2]

4.5/5.5 positive -Argentina 2.5/3.5 neutral 5.0/6.0 Australia 6.5/7.5 neutral -Brazil 3.0/4.0 neutral 7.0/8.0 Canada 9.5/10.5 neutral -China 0.5/1.5 neutral -Eurozone 1.0/2.0 neutral 9.5/10.5 France 1.2/2.2 neutral 7.5/8.5 Germany 8.0/9.0 positive -India 5.5/6.5 neutral -Indonesia 0.5/1.5 neutral 8.0/9.0 Italy 1.5/2.5 positive 4.5/5.5 Japan 4.0/5.0 positive -Mexico 4.0/5.0 positive -Russia -South Africa 2.5/3.5 neutral -South Korea 4.5/5.5 positive 5.0/6.0 positive -Turkey 0.5/1.5 neutral 7.5/8.5 UK 2.5/3.5 neutral 9.0/10.0 USA

3.0/4.0 3.0/4.0 4.0/5.0 3.0/4.0 8.5/9.5 1.0/2.0 1.5/2.5 1.5/2.5 8.0/9.0 6.0/7.0 1.0/2.0 1.5/2.5 3.5/4.5 4.0/5.0 3.5/4.5 4.0/5.0 4.0/5.0 2.0/3.0 2.5/3.5

neutral neutral neutral neutral positive neutral neutral positive neutral neutral neutral neutral neutral neutral neutral neutral positive neutral positive

-4.5/5.5 -7.0/8.0 --9.5/10.5 7.5/8.5 --8.0/9.0 4.5/5.5 -----7.5/8.5 8.5/9.5

2.5 0.4 2.0 0.6 1.3 0.9 0.7 1.5 0.7 0.9 0.6 2.3 1.4 1.6 0.7 1.5 2.3 0.8 0.7

1.4 0.8 1.0 0.6 1.4 1.9 1.2 2.2 0.7 1.0 1.8 0.8 1.2 2.3 1.0 1.0 2.3 2.0 1.4

6.5 0.9 2.1 1.9 1.6 1.8 1.4 1.9 1.8 4.9 2.0 2.0 3.9 6.8 1.9 4.3 5.4 2.1 1.8

Notes: [1] Positive bias denotes higher risks to the upside, i.e. growth could be higher than the central range. [2] The difference between the highest and lowest forecasts of sources such as the IMF, WB, OECD, Eurostat, JPMorgan and Moodys. [3] The standard deviation of real GDP growth over the past 15 years including 2009. [4] Green denotes improvement from last update, orange denotes deterioration.

e.g. Debt and deleveraging: The global credit bubble and its economic consequences McKinsey Global Institute, January 2010.

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Risk Scenarios: Whats Next for the Eurozone?

The downside risks, detailed in our January 2010 update 2, remain: (i) a disorderly exit from highly stimulating fiscal and monetary policies; (ii) the possibility that financial institutions may not have rebuilt capital buffers quickly enough to withstand the remaining economic and financial stress; and/or (iii) an unexpected decline in the dynamism of the Chinese economy. In a sense, the Eurozone is currently the place where many of these risks have coalesced, hence this reports focus on the Eurozones challenges. We are therefore proposing two risk scenarios: a severe and a disruptive downside risk. Note that these scenarios are selected not so much because of their likelihood they are respectively unlikely and very unlikely but because of their potential impact.

clusion and theres no need for an elaborate stresstest to conclude that banks would be devastated by widespread government bankruptcies. 3

The risk scenarios

The macroeconomic backdrop in Europe has so far been consistent with a rather sluggish rebound indeed, for 2010 and 2011, we expect the Eurozones real growth to be 1.0% and 1.5%, respectively, 0.5%. This is masking discrepancies between Germany, which is on track for a rather sharp recovery, and those economies that have started to retrench fiscally and more generally between a dynamic manufacturing sector and less upbeat services sector. Overall, the outlook for Europe will depend on whether the circularity discussed above is halted.

Central scenario: The banking system will become more capitalised and stronger overall, with its weakest parts restructured. The economy will rebound modestly (about 1.5% Eurozone growth in 2011) and public finances will, over time, be repaired in an orderly fashion.

The nature of the challenges

The Eurozone authorities have to address a few seemingly intractable challenges: In order to combat indiscriminate fears about some banking systems, they must help investors differentiate between strong and weak banks (cf. the stress tests). To allay concerns about sovereign debt, weaker banks should receive government intervention that uses public funds in a cost-effective way. But if no public funds are to be disbursed, then either (i) creditors will have to incur losses, which in turn fuels counterparty risk worries, or (ii) banks will have to shrink their balance sheet, which in turn raises questions about the financing of the economy. The circularity of the problem illustrates how governments, which used to be part of the solution, are increasingly being perceived as part of the problem for banks. This also explains the conundrum: if the stress-tests underplay the potential risk arising from sovereign troubles, they may not appear as credible; if they overplay them, they cannot but lead to a nihilist conHowever, this is true everywhere in the world. Therefore, the idea that stress-tests in Europe would not be plausible unless they assume the demise of a few governments would set the bar at a level where no banking system in the world would likely survive.
3

Risk Scenario 1:

Fiscal tightening fails to re-

store confidence sufficiently to spur a robust expansion of private sector investment and consumption. The negative impact of fiscal tightening could also be exacerbated by continued uncertainties about the health of the banking system (perhaps due to a less-than-convincing banking sector strategy) and weaker growth among Europes main trading partners, particularly the US. In this scenario, the risk of a sharp slowdown in growth would be significant (0.5% growth in 2011), and an outright double-dip recession would be a distinct possibility. In this scenario, governments would have to compensate the provision of budgetary support to banks with even tougher fiscal measures, and more private sector debt restructuring would likely be necessary. Deflationary forces would also prevail, at least for several more quarters, thus complicating fiscal consolidation plans and increasing real debt burdens. This is an unstable equilibrium.

Risk Scenario 2:

Persistently negative eco-

nomic developments, such as weak economic growth and stubbornly high unemployment, com-

Moodys Global Macro-Financial Risk Scenarios 2010-2010, On the Hook for Some Time Yet, January 2010.

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bined with an unconvincing policy response to the worsening public debt situation and banks vulnerabilities, spiral out of control to threaten the Eurozone. Under this scenario, this severe, quasiexistential crisis for the 50-year-old European project could lead to one of two radical and very different outcomes: o Further European integration (e.g. a Euro debt agency, some sort of EU federal budget institution that controls and transfers funds between states, even more unorthodox monetary policies, etc.). Such developments would be in line with past instances when senior leaders have used crises to drive EU integration. Assuming a smooth execution, major policy developments on this scale are likely to restore confidence over time and lead to a benign outcome (back to the central scenario). o Abrupt dislocation, such as government defaults or a break-up of the Eurozone. The second, extreme risk scenario is therefore bifurcated, characterized more by an intense uncertainty rather than by a clear directional outcome.

Conclusions
Given that the circularity between sovereign and banking risks lies at the heart of the scenarios for Europe, what is going to drive the outcome? If there is too much debt in the system and this appears to be the view in financial markets an imminent outburst of nominal growth would be very unlikely, and a combination of deleveraging and austerity would be required. In most countries, the policy of socializing losses has reached its political and/or financial limits. Therefore, bringing public finances on a sound footing would require public finances to be largely ring-fenced from a natural debt restructuring process involving banks, their debtors (e.g. over-indebted households) and their own creditors (including other banks). The role of governments is to make sure that their interventions are only focused on limiting the systemic damages to other banks and for this, central bank money can legitimately be used, at least for a while. Whether the Eurozones risk scenarios will materialise will ultimately depend on three factors: (i) the credibility of governments fiscal consolidation plans and growth-focused economic strategies; (ii) the ECBs willingness to help governments limit the collateral damages for sound banks as a result of the restructuring of the weakest ones; (iii) the ability of governments to avoid committing further public funds to the restructuring of private debts.

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Appendix I: A focus on deleveraging: why this matters so much and yet is so little-known
Perhaps the most fundamental issue underlying the global economic and financial outlook centres around how much leverage advanced economies can sustain, and the economic implications of the pace of deleveraging. There are no easy answers to these issues - and this increases the uncertainty to the economic outlook. Two critical issues at this juncture are (i) determining the right level of debt that economic agents should try to target, and (ii) examining whether deleveraging might not be recessionary after all. In a sense, the first issue is about the direction (i.e. have we seen the end of the leverage-led growth model in advanced economies?) and the second is about the impact (i.e. is deleveraging deflationary?). Both are at the heart of our hook-shaped scenario.

can serve as a clear yardstick. A simple observation is that the massive leverage that has accumulated in some economies over the past decade (the US, the UK, Spain, Ireland, etc.) has had diminishing economic returns and magnified financial costs. Credit ratings measure how prudent borrowers' balance sheets are, not whether debt is optimal or not. The graph below shows the extent to which income per capita has increased over recent decades compared with the incremental increase in total country debt. A longstanding economic precept has been that financial deepening is good for growth so the impact of a bit more debt on a countrys prosperity should theoretically be positive, and even more so when the country exits a period of financial repression. The problem is that, beyond a certain threshold, there can be too much of a good thing for households, corporates, banks and governments alike. This is illustrated in the graph below: when the curve steepens, additional debt no longer equates to proportionally more income, and other problems can arise. Therefore, many advanced economies have over the years seen that an increase in debt has in fact "bought" much less in terms of incremental output and revenues.

How much debt is too much debt?

There is no such thing as an optimal debt level that
500

2009 2009

450

400
USA

Total Debt as % of GDP

350

UK Spain

2009
Italy

300
Germany

2005

2005 2005

250

2000 2000
200

2009 1995

2000

1995 2009 2005

150

1995

1995 1995

2000

100 15,000

20,000

25,000

30,000

35,000

40,000

45,000

50,000

GDP per capita (USD, PPP)

Note on calculation: The total debt of the economy is the sum of the following components: -Household & Corporate (non-financial institutions) debt composed by the loans to household and corporates (source: IFS) and the bonds issued by the corporate (source: BIS Statistics on International debt securities by nationality of issuer [12C] & Domestic debt securities by sector and residence of issuer [16B]) -Financial Institutions debt (source: BIS statistics on International debt securities by nationality of issuer [12B] & Domestic debt securities by sector and residence of issuer [16B]) -General Government Debt (source: Moodys).
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The exact location/timing of this inflection point is a bit of a mystery. It obviously cannot be defined as the level of debt that would make all borrowers, public or private, worthy of a Aaa rating. Moreover, some leverage is actually necessary to foster an efficient level of consumption-smoothing and not set an artificially low speed limit for the economy. The trouble is that, if the "optimal" leverage level is unknown, how can one pinpoint when there is too much debt, that deleveraging should start, and that debt ratios should converge towards a certain level? This question is critical as it holds the key to the main engine of growth in advanced economies: consumer spending. If there is too much leverage, then unless incomes or asset values grow unexpectedly there must also be an increase in savings and demand will be weak. A report by McKinsey 4 has analyzed different experiences of deleveraging, on the basis of which it has identified four archetypical ways out: (1) a period of austerity, in which credit growth lags against GDP growth; (2) massive defaults; (3) high inflation; and (4) growing out of debt. It is possible for a country to experience both austerity and default with the government hoping that growth will eventually resolve the situation. Indeed, this is what is happening in the countries that have been most hard hit by the housing crisis (such as the US, Ireland, the UK, Spain, etc.): some households have defaulted on their mortgage debt; most are repairing their balance sheet through higher savings; banks shareholders much more rarely creditors are in turn taking losses, while also trying to reduce leverage through austerity, capital replenishment and lower lending. At which point will deleveraging have run its course? Let us consider governments, banks and households in turn. For most advanced governments, stabilizing the debt trajectory is a higher priority than the need to reduce debt levels. There is a strong inertia in government debt after all, it takes time to stop an oil tanker. Once the debt dynamic is under control which will not even be 2012 or 2013 for most crisis-hit advanced economies the next challenge will be to determine the policy objective in terms of public debt level. As

stated above, there is no such thing as an optimal level. However, public debt levels will have to move back towards 50-60% of GDP, assuming that governments want to keep public debt affordable while preparing for (i) the multiple contingent liabilities that can arise (including ageing and financial sector risk), and (ii) the need to maintain spare resources for contra-cyclical stabilisation as the economy approaches its full potential. For most advanced economies, this is a truly challenging ten-year project. Therefore, from the point of view of (high-debt) government deleveraging, there is no end in sight. But the main cause of the total debt increase in advanced economies over recent decades has been (housing-related) household borrowing and financial sector leverage. Again, there are no optimal levels to serve as clear benchmarks and to help determine when deleveraging will cease to be a drag on the economic outlook. However, the banking sector has a clear reference point: the capital ratio prescribed by regulators. To the extent that the intention is to reduce leverage in the system, and given that it will be very hard to raise enough capital to keep asset levels stable if only because it may take time to convince equity investors that the future risk-adjusted return on equity for banks offers a better value proposition than before one can expect that banks deleveraging will restrain credit availability in the system. That being said, a fundamental question is whether all bank lending has a compelling economic value and whether the shrinking of banks books may not necessarily have to be economically devastating. For instance, Turner 5 points out that mortgages account for almost two thirds of UK bank lending (and 79% of GDP compared with 14% almost half a century ago). However, in a mature economy with broadly stable demographics, the economic function of mortgage finance is only to a very limited extent related to the financing of new investment. Indeed, mortgage finance supports the ability of individuals to smooth consumption over time, with younger generations buying houses from the older generation. Likewise, at 6% of GDP in the UK, fixed capital formation in commercial real estate is higher than total investment in plant, machinery, vehicles, ships and aircrafts. Therefore, a less leveraged banking system, if relatively more focused on productive investment, should not necessarily bring about economic decline.

Debt and deleveraging: The global credit bubble and its economic consequences, McKinsey Global Institute, January 2010.

A. Turner What do banks do, what should they do and what public policies are needed to ensure best results for the real economy? Lecture, CASS Business School, March 2010.

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As for the household sector, the key question is whether, in advanced economies, households will shift from a debt-to-asset perspective to a debt-to-income one. In some years, real or artificial wealth effects have led many households to reduce their savings rate, given that their net worth position appeared to be prosperous. (After all, what is the logic of restraining consumption if ones net worth is high and increasing?) This is the most probable explanation for the extremely low household saving levels in the US and indirectly, and somewhat partially, the global imbalances. If this approach prevails, beyond an adjustment to the leverage ratio with temporarily more savings to repay

some debt, and with the help of a rebound in asset prices, the need for a sustained increase in the savings rate would fade away, generating some room for a (hopefully) sustainable rebound in consumption. If, however, households want to bring their debt-toincome ratios back to historical averages, the end to deleveraging is not in sight either. Therefore, it seems that the case for deleveraging is rather strong in crisis-hit advanced economies, certainly for most governments, and most likely also for households and banks.

Household Net Wealth (as % of disposable income) [1] 1995 Canada France Germany Italy Japan United Kingdom United States 477 461 541 703 735 568 509 2000 502 552 537 758 744 768 583 2005 534 748 581 823 739 827 642 2006 546 792 606 846 745 875 650 2007 550 803 629 857 735 912 620 2008 544 752 .. 818 697 768 476

[1] Households include non-profit institutions serving households, except for Italy. Net wealth is defined as non-financial and financial assets minus liabilities; net financial wealth is financial assets minus liabilities. Non-financial assets consist mainly of dwellings and land. Source: OECD Economic Outlook.

How costly is deleveraging?

The transition to a new growth regime that is less reliant on debt will take time. Will it be very costly in terms of growth and unemployment? A crucial debate these days is whether government austerity measures are likely to be recessionary, growth-neutral, or growth-friendly. It is a testimony to the social science nature of economics that such a question can have three so entirely different responses. The arguments can be condensed as follows: On the one hand, the conventional (postKeynesian) economic wisdom asserts that fiscal retrenchment sets multipliers in reverse, reduces private spending and may trigger a deflationary process. Therefore, if the relevant indicator is the debt-to-GDP ratio, debt may decline by less than GDP. On the other hand, a non-Keynesian version contends that, in some circumstances (especially when debt is very high, public spending is very elevated, economic agents are worried, interest

rates are high, and the economy is very open), fiscal consolidation can be growth- friendly. A number of cases in the 1990s have been put forward: Canada, Finland and Sweden in particular. A middle-of-the-road approach would suggest that fiscal retrenchment is now unlikely to be expansionary, given that it is simultaneous and takes place in a lowinterest-rate environment. However, while the short-term effects will likely be negative only mitigated by extremely accommodative monetary conditions medium-term conditions may turn out to be even more favourable than they were before the crisis. Fiscal retrenchment operating mainly through a reduction in exceptionally high and somewhat distorted public expenditures, and a decisive containment of future liabilities could, when combined with supply-side reforms to raise growth potential, put the economies back on a much more solid economic and financial path. Therefore, the real difference is the slope of the growth trend: given that there is limited debate about the need to decisively bring public debt under control at some point, countries will either attain more growth

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today and less tomorrow or less growth today and more tomorrow (if, and only if, fiscal consolidation is combined with policies that are resolutely aimed at raising growth potential 6).

Cf. IMF report for the G20 Toronto summit, June 2010: G20 Mutual Assessment Process Alternative Policy Scenarios.

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All our publications can be found at www.moodys.com/gra. Alternatively, you can also click on the links below.

Global Imbalances: A Positive-Sum Game from a Global Credit Perspective, April 2007. French Presidential Elections: A Slow Entry into the 21st Century, April 2007. The European Union at 50: Are its Best Years Behind it?, March 2007. Current Account Deficits In Emerging Europe More Inflammability But No Repeat Of Asian Crisis, March 2007. Why Is Credit Risk Priced so Low? A Perspective on Global Liquidity, February 2007.

Global Financial Risk Perspectives -- Report On the Hook for some time yet, January 2010 On the hook, May 2009 From Global integration to Global disintegration, December 2008. Navigating the Fog, July 2008 Mapping
the Near Future: Macro Stress Scenarios for 2008-2009, January 2008

The Archaeology of the Crisis, January 2008. Stress-Testing the Modern Financial System: Feds rate
cut, key pressure points, risk scenarios, September 2007.

Stress-Testing the Modern Financial System, September 2007. From Illiquidity to Liquidity: The Path Towards Credit Market Normalization, September 2007. The Asian Crisis Ten Years Later: What We Know, What We Think We Know and What We Do Not Know, May 2007.

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