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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: What’s Next for the Eurozone? 1 2

Executive Summary
Since 2009, Moody’s “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 doesn’t 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.

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

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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

Financial conditions have eased across most of the world. 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. 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. but have become more hostile in the Eurozone than we expected. Over the longer term. of fiscal austerity versus growth-friendly policies. with large emerging market economies leading the way. Developments and trends over the past six months We have experienced a slight economic rebound. Currently.5% in 2010 and slightly lower in 2011. At the same time. The continuation of the disorderly risk repricing of the sovereign asset class. All along. we continue to see the risk of financial repression (with financial systems increasingly taking on the role of financiers of governments). with global growth likely be around 4. However. GLOBAL FINANCIAL RISK PERSPECTIVES 2 MOODY’S RESEARCH • JULY 2010 . after an almost unprecedented contraction of -0. our view has been that the macroeconomic outlook was dependent on the sovereign outlook. The necessary deleveraging process is dampening growth prospects. from a credit standpoint.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. the extent of which depends on investors’ and lenders' patience. 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. 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 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). the key macroeconomic question in Europe and the US is whether governments should retrench while banks and households also repair their balance sheets. aggravated by financial markets' divided stance concerning the respective merits.9% in 2009. 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. A further decoupling of monetary conditions in advanced and emerging economies. We also view deflation and inflation risk as being successive rather than mutually exclusive threats.

2 0.While some studies have shown that deleveraging has typically been negative for economic growth.5 --8. but that deleveraging forces do not entirely overwhelm new growth in less leveraged parts of the economy.0 3.0 Australia 6.5/2.0/6.0/8.0 3.8 1.0 1.0 1.9 1.5 1.6 0.0 USA 3.2 2.5/3.5 UK 2.5/3.5/1.5/6.5/1.0 positive -Mexico 4.0 2.5 8.5 neutral -China 0.6 1.5 1.0 4.0/7.5 4. [4] Green denotes improvement from last update.9 6.8 1.5/3. “Debt and deleveraging: The global credit bubble and its economic consequences” McKinsey Global Institute.5 neutral neutral neutral neutral positive neutral neutral positive neutral neutral neutral neutral neutral neutral neutral neutral positive neutral positive -4.5 -7.0/9.9 1. WB. Lastly.3 0. OECD.5/5.0 positive -India 5.0 6.0 --9.0 2.5 2.0/10.0 8.0 1.8 0.0 neutral 9.0 0. e.5 4.5 2.4 6.0/4. Our central assumptions are based on a sample of forecasts.7 0.5/7.5/2.5 neutral -South Korea 4.5/5. 1 other (admittedly isolated) cases suggest that fiscal consolidation can even be growth-positive.5 -----7.0 Canada 9.e.9 4.4 1.5/2.7 1.6 1. JPMorgan and Moody’s.4 0.0 2.4 1. including of course Moody’s own economic forecasts.5/10.5 positive -Argentina 2. orange denotes deterioration.5 8.0/5.5 7. We indicate whether the bias [1] is positive or negative.4 2.5/4.5/3.0 neutral 7.7 1.5/9.5/9.0/9.0 3.0/5.0 1.1 1. 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] 4.2/2. Eurostat.3 0.5 neutral -Indonesia 0. 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.5 0.0 4.7 1.5/8.0/3.0/4. we indicate the level of uncertainty surrounding the central forecast.5/8.5 neutral -Eurozone 1.0/2.0/4.4 2.5 positive 5.0 1.5 0.5 0.5/5.9 1.6 2.5 3.8 1.0 3.0/5.0 positive -Turkey 0.9 0.5/4.1 1.5/8.8 Notes: [1] Positive bias denotes higher risks to the upside. We present the range of forecasts that we survey and compare them to the historical standard deviation of the countries’ real growth.0 positive -Russia -South Africa 2. January 2010.g.9 2. Also.5/2.0/2. growth could be higher than the central range.5/5.0 4.5 Germany 8. 1 GLOBAL FINANCIAL RISK PERSPECTIVES 3 MOODY’S RESEARCH • JULY 2010 .0/5. i.5 neutral 9.5 neutral 7.0 Italy 1.e.9 0.0 0.5 neutral 5.0/8.5 Japan 4.0 1.5/10.7 1. i.5 neutral 8.0/2.5 positive 4.9 2.5 neutral -Brazil 3. our rating decisions across asset classes are influenced by meaningful economic shifts rather than decimal changes.5/1.0/5.8 4.0 2.8 1.8 0.0/4.5/8.2 neutral 7.0/9.4 1.0/6.6 1.3 1.2 2.3 1.3 2.5/10. [2] The difference between the highest and lowest forecasts of sources such as the IMF.3 5. [3] The standard deviation of real GDP growth over the past 15 years including 2009.0/5.0/9.5/5. whether we are more likely to be positively or negatively surprised. in such agitated times.5 France 1.

which is on track for a rather sharp recovery.5%. are increasingly being perceived as part of the problem for banks. Deflationary forces would also prevail. com- 2 Moody’s Global Macro-Financial Risk Scenarios 2010-2010. ±0. which in turn fuels counterparty risk worries. for 2010 and 2011. hence this report’s focus on the Eurozone’s challenges. and an outright double-dip recession would be a distinct possibility. be repaired in an orderly fashion. 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. they may not appear as credible. then either (i) creditors will have to incur losses. they must help investors differentiate between strong and weak banks (cf. Therefore. 3 The risk scenarios The macroeconomic backdrop in Europe has so far been consistent with a rather sluggish rebound – indeed. and more private sector debt restructuring would likely be necessary. We are therefore proposing two risk scenarios: a severe and a disruptive downside risk. with its weakest parts restructured.Risk Scenarios: What’s Next for the Eurozone? The downside risks. This is masking discrepancies between Germany. the Eurozone is currently the place where many of these risks have coalesced. respectively. and/or (iii) an unexpected decline in the dynamism of the Chinese economy. Overall. which used to be part of the solution. and those economies that have started to retrench fiscally – and more generally between a dynamic manufacturing sector and less upbeat services sector. governments would have to compensate the provision of budgetary support to banks with even tougher fiscal measures. GLOBAL FINANCIAL RISK PERSPECTIVES 4 MOODY’S RESEARCH • JULY 2010 . which in turn raises questions about the financing of the economy. at least for several more quarters. In this scenario. “On the “Hook” for Some Time Yet”. remain: (i) a disorderly exit from highly stimulating fiscal and monetary policies. 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. This is an unstable equilibrium. Risk Scenario 2: Persistently negative eco- nomic developments. the outlook for Europe will depend on whether the circularity discussed above is halted. over time. clusion – and there’s no need for an elaborate stresstest to conclude that banks would be devastated by widespread government bankruptcies. The circularity of the problem illustrates how governments. The economy will rebound modestly (about 1. this is true everywhere in the world.5% Eurozone growth in 2011) and public finances will. we expect the Eurozone’s real growth to be 1.0% and 1. the risk of a sharp slowdown in growth would be significant (0. thus complicating fiscal consolidation plans and increasing real debt burdens. (ii) the possibility that financial institutions may not have rebuilt capital buffers quickly enough to withstand the remaining economic and financial stress. they cannot but lead to a nihilist conHowever. In this scenario. particularly the US. Central scenario: The banking system will become more capitalised and stronger overall.5% growth in 2011). 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 Europe’s main trading partners. In a sense. This also explains the conundrum: if the stress-tests underplay the potential risk arising from sovereign troubles.5%. the stress tests). if they overplay them. January 2010. But if no public funds are to be disbursed. or (ii) banks will have to shrink their balance sheet. such as weak economic growth and stubbornly high unemployment. detailed in our January 2010 update 2. To allay concerns about sovereign debt. 3 Risk Scenario 1: Fiscal tightening fails to re- store confidence sufficiently to spur a robust expansion of private sector investment and consumption. weaker banks should receive government intervention that uses public funds in a cost-effective way. 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.

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. In most countries. even more unorthodox monetary policies. and a combination of deleveraging and austerity would be required. at least for a while.). extreme risk scenario is therefore bifurcated. a Euro debt agency. some sort of EU federal budget institution that controls and transfers funds between states.g. (iii) the ability of governments to avoid committing further public funds to the restructuring of private debts. central bank money can legitimately be used. major policy developments on this scale are likely to restore confidence over time and lead to a benign outcome (back to the central scenario). characterized more by an intense uncertainty rather than by a clear directional outcome. o Abrupt dislocation. etc. (ii) the ECB’s willingness to help governments limit the collateral damages for sound banks as a result of the restructuring of the weakest ones. 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. over-indebted households) and their own creditors (including other banks). their debtors (e. this severe. Under this scenario. GLOBAL FINANCIAL RISK PERSPECTIVES 5 MOODY’S RESEARCH • JULY 2010 . Therefore. Assuming a smooth execution. 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. spiral out of control to threaten the Eurozone. Whether the Eurozone’s risk scenarios will materialise will ultimately depend on three factors: (i) the credibility of governments’ fiscal consolidation plans and growth-focused economic strategies. Such developments would be in line with past instances when senior leaders have used crises to drive EU integration. bringing public finances on a sound footing would require public finances to be largely ring-fenced from a natural debt restructuring process involving banks. Conclusions Given that the circularity between sovereign and banking risks lies at the heart of the scenarios for Europe. The second.bined with an unconvincing policy response to the worsening public debt situation and banks’ vulnerabilities. the policy of socializing losses has reached its political and/or financial limits. such as government defaults or a break-up of the Eurozone.g.

000 40.e. The problem is that.000 35. 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.000 30. This is illustrated in the graph below: when the curve steepens. Spain. There are no easy answers to these issues .000 50.) has had diminishing economic returns and magnified financial costs. the first issue is about the direction (i. corporates. not whether debt is optimal or not.e. In a sense. etc. Both are at the heart of our “hook-shaped” scenario. 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.and this increases the uncertainty to the economic outlook. the UK. 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: Moody’s). beyond a certain threshold. and other problems can arise. GLOBAL FINANCIAL RISK PERSPECTIVES 6 MOODY’S RESEARCH • JULY 2010 . banks and governments alike.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. have we seen the end of the leverage-led growth model in advanced economies?) and the second is about the impact (i. additional debt no longer equates to proportionally more income. and (ii) examining whether deleveraging might not be recessionary after all. Therefore.000 45. Credit ratings measure how prudent borrowers' balance sheets are. is deleveraging deflationary?).000 25. 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. there can be “too much of a good thing” for households. Two critical issues at this juncture are (i) determining the “right” level of debt that economic agents should try to target. and the economic implications of the pace of deleveraging. and even more so when the country exits a period of financial repression. Ireland.000 GDP per capita (USD.000 20. 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. A longstanding economic precept has been that financial deepening is good for growth – so the impact of a bit more debt on a country’s prosperity should theoretically be positive.

Again. For instance. what should they do and what public policies are needed to ensure best results for the real economy?” Lecture. 5 GLOBAL FINANCIAL RISK PERSPECTIVES 7 MOODY’S RESEARCH • JULY 2010 . It is possible for a country to experience both austerity and default – with the government hoping that growth will eventually resolve the situation. For most advanced economies. the UK. at 6% of GDP in the UK. Moreover. this is what is happening in the countries that have been most hard hit by the housing crisis (such as the US. 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). if the "optimal" leverage level is unknown. public or private. this is a truly challenging ten-year project. mortgage finance supports the ability of individuals to smooth consumption over time. (2) massive defaults. if relatively more focused on productive investment. should not necessarily bring about economic decline. etc. a less leveraged banking system. Spain. A report by McKinsey 4 has analyzed different experiences of deleveraging. However. in which credit growth lags against GDP growth. and (4) growing out of debt. 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. Indeed. banks’ shareholders – much more rarely creditors – are in turn taking losses. It obviously cannot be defined as the level of debt that would make all borrowers. the banking sector has a clear reference point: the capital ratio prescribed by regulators. fixed capital formation in commercial real estate is higher than total investment in plant. However. ships and aircrafts. As stated above. 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). there is no end in sight. If there is too much leverage.): some households have defaulted on their mortgage debt. some leverage is actually necessary to foster an efficient level of consumption-smoothing and not set an artificially low speed limit for the economy. capital replenishment and lower lending. Ireland. Therefore. the economic function of mortgage finance is only to a very limited extent related to the financing of new investment. from the point of view of (high-debt) government deleveraging. on the basis of which it has identified four archetypical “ways out”: (1) a period of austerity. while also trying to reduce leverage through austerity. (3) high inflation. how can one pinpoint when there is too much debt. CASS Business School. 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. Indeed. January 2010. “Debt and deleveraging: The global credit bubble and its economic consequences”. 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. banks and households in turn. that deleveraging should start. stabilizing the debt trajectory is a higher priority than the need to reduce debt levels. 4 A. then – unless incomes or asset values grow unexpectedly – there must also be an increase in savings and demand will be weak. with younger generations buying houses from the older generation. March 2010. most are repairing their balance sheet through higher savings. worthy of a Aaa rating. McKinsey Global Institute. public debt levels will have to move back towards 50-60% of GDP. Therefore. 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.The exact location/timing of this inflection point is a bit of a mystery. 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. Likewise. However. Turner “What do banks do. in a mature economy with broadly stable demographics. there is no such thing as an optimal level. The trouble is that. 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. At which point will deleveraging have run its course? Let us consider governments. machinery. it takes time to stop an “oil tanker”. There is a strong inertia in government debt – after all. For most advanced governments. That being said. To the extent that the intention is to reduce leverage in the system. vehicles. and (ii) the need to maintain spare resources for contra-cyclical stabilisation as the economy approaches its full potential.

what is the logic of restraining consumption if one’s net worth is high and increasing?) This is the most probable explanation for the extremely low household saving levels in the US – and indirectly. the global imbalances. when combined with supply-side reforms to raise growth potential. A number of cases in the 1990s have been put forward: Canada. the need for a sustained increase in the savings rate would fade away. growth-neutral. fiscal consolidation can be growth. Therefore. real or artificial wealth effects have led many households to reduce their savings rate. however. Source: OECD Economic Outlook. If this approach prevails. the end to deleveraging is not in sight either. Net wealth is defined as non-financial and financial assets minus liabilities. if the relevant indicator is the debt-to-GDP ratio. However. or growth-friendly. economic agents are worried.. 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.friendly. it seems that the case for deleveraging is rather strong in crisis-hit advanced economies. certainly for most governments. the conventional (postKeynesian) economic wisdom asserts that fiscal retrenchment sets multipliers in reverse. Non-financial assets consist mainly of dwellings and land. 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. households want to bring their debt-toincome ratios back to historical averages. debt may decline by less than GDP. and somewhat partially. Therefore. How costly is deleveraging? The transition to a new growth regime that is less reliant on debt will take time. reduces private spending and may trigger a deflationary process. and the economy is very open). On the other hand. 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 . If. put the economies back on a much more solid economic and financial path. a non-Keynesian version contends that. and most likely also for households and banks. given that it is simultaneous and takes place in a lowinterest-rate environment. Finland and Sweden in particular. Therefore. Fiscal retrenchment – operating mainly through a reduction in exceptionally high and somewhat distorted public expenditures. the key question is whether. public spending is very elevated. It is a testimony to the “social science” nature of economics that such a question can have three so entirely different responses. and with the help of a rebound in asset prices. 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. The arguments can be condensed as follows: On the one hand. except for Italy. A middle-of-the-road approach would suggest that fiscal retrenchment is now unlikely to be expansionary. In some years. interest rates are high. generating some room for a (hopefully) sustainable rebound in consumption. countries will either attain more growth GLOBAL FINANCIAL RISK PERSPECTIVES 8 MOODY’S RESEARCH • JULY 2010 . in advanced economies. in some circumstances (especially when debt is very high.As for the household sector. 818 697 768 476 [1] Households include non-profit institutions serving households. net financial wealth is financial assets minus liabilities. and a decisive containment of future liabilities – could. given that their net worth position appeared to be prosperous. households will shift from a debt-to-asset perspective to a debt-to-income one. (After all. beyond an adjustment to the leverage ratio with temporarily more savings to repay some debt.

today and less tomorrow – or less growth today and more tomorrow (if. June 2010: “G20 Mutual Assessment Process – Alternative Policy Scenarios”. and only if. 6 GLOBAL FINANCIAL RISK PERSPECTIVES 9 MOODY’S RESEARCH • JULY 2010 . fiscal consolidation is combined with policies that are resolutely aimed at raising growth potential 6). IMF report for the G20 Toronto summit. Cf.

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