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2010 Global Economic Outlook

NOMURA GLOBAL ECONOMICS

A Tale of Two Recoveries
The aftermath of the crisis should constrain the developed world recovery, but, led by a booming China, emerging markets look set for strong growth.

Please see analyst certifications and important disclosures on the last page of this report.

2010 Global Economic Outlook

Contents
GLOBAL
Forecast summary Our view on 2010 in a nutshell Outlook 2010: A tale of two recoveries Fiscal forces GEMaRI: Vulnerability remains QE: Back to basics Key political issues for 2010 3 4 5 6 8 10 11

UNITED STATES
Outlook 2010: The slow road from recession Financial stress Constrained by debt The Fed’s balance sheet Economic outlook: Strong finish to 2009, but cooler growth ahead 12 14 16 17 18

EURO AREA
Outlook 2010: Headwinds Good work Euro strength may prolong euro-area weakness Liquidity withdrawal roadmap Economic outlook: Constrained recovery 19 20 22 24 25

UNITED KINGDOM
Outlook 2010: Walking the policy tightrope Q&A on MPC quantitative easing Economic outlook: Better prospects, but risks persist on both sides 26 27 29

JAPAN
Outlook 2010: Shift to steady export-led growth in H2 Stimulus measures boost consumer spending A policy mix to overcome deflation Capacity and personnel cost adjustments Economic outlook: More aggressive policy in store 30 31 33 35 36

ASIA
Outlook 2010: China-led paradigm shift China: Dispelling some myths Asian monetary policy: A fear of the exit Asia rebalancing Australia economic outlook: A two-speed recovery China economic outlook: One of the best years in decades Hong Kong economic outlook: Twin engines of China and the HKD peg India economic outlook: Heading back to 8% Indonesia economic outlook: Domestic demand to lead robust growth Malaysia economic outlook: Private sector to lead the recovery Philippines economic outlook: Too much fiscal hype Singapore economic outlook: Tourism to drive momentum South Korea economic outlook: Inflationary recovery Taiwan economic outlook: Cross-straits moves to raise business confidence Thailand economic outlook: Political uncertainty Vietnam economic outlook: An overheated economy 37 39 40 42 43 44 45 46 47 48 49 50 51 52 53 54

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2010 Global Economic Outlook

EMERGING EUROPE, MIDDLE EAST AND AFRICA
Outlook 2010: Differentiated growth woes Towards EMU: New convergence anchor Debt (un)sustainability Election fever Russia economic outlook: Animated by oil South Africa economic outlook: Conflicting signals on growth, mandate change Turkey economic outlook: The comeback king Rest of Emerging Europe economic outlook: Ukraine, Kazakhstan, Romania Middle East economic outlook: Egypt, Israel, Saudi Arabia 55 56 58 60 61 62 63 65 66

Central and Eastern Europe economic outlook: Hungary, Czech Republic, Poland 64

LATIN AMERICA
Outlook 2010: An uneven recovery Brazil 2010 election outlook Brazil economic outlook: Growth set to accelerate Mexico economic outlook: A recovery burdened by long-term worries Rest of Latin America economic outlook: Argentina, Chile, Columbia 67 69 71 72 73

FOREIGN EXCHANGE
Outlook 2010: Beyond peak performance 74

EQUITY MARKET
Outlook 2010: Still bullish 77

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Forecast Summary

The World at a Glance
Real GDP % over a year ago 2009 2010 2011 -0.9 4.2 4.2 -3.4 2.0 2.2 2.0 6.6 6.4 4.7 8.4 8.0 -2.5 3.1 2.8 -2.5 2.7 2.6 -2.6 2.0 2.9 -2.6 4.6 3.4 -2.3 2.5 3.0 0.1 5.4 3.1 -1.5 4.7 4.0 0.1 3.3 4.0 -7.0 4.6 3.9 3.2 6.9 6.8 -5.4 1.3 1.7 1.0 2.8 3.2 5.5 8.4 8.2 8.5 10.5 9.8 -2.6 5.6 4.4 6.5 8.0 8.2 4.6 5.9 6.2 -2.2 4.5 5.2 1.0 5.5 6.0 -2.0 5.5 5.5 0.0 5.5 4.0 -3.0 4.8 5.2 -3.0 3.0 5.0 5.1 6.5 6.6 -4.1 1.2 1.8 -3.9 1.1 1.7 -2.3 1.2 1.7 -4.8 1.6 2.0 -4.8 1.1 1.5 -4.0 1.2 1.5 -3.6 -0.2 1.4 -4.6 1.4 2.4 -3.2 3.7 3.9 -4.0 0.8 1.8 4.8 5.2 5.5 1.7 7.9 5.4 -6.9 -1.5 2.0 0.3 2.7 3.8 -1.5 3.5 5.0 1.6 2.1 3.5 -7.0 2.8 3.1 -7.5 3.5 4.4 -1.6 3.0 3.5 -5.8 4.4 4.5 -14.0 3.6 4.0 Consumer Prices % over a year ago 2009 2010 2011 1.4 2.8 2.9 0.0 1.3 1.1 3.1 4.6 4.8 2.3 4.5 4.9 1.0 2.5 2.1 -0.3 1.9 1.0 0.4 1.5 1.8 4.8 4.4 5.1 5.5 8.0 8.0 4.9 4.2 5.3 1.5 2.1 3.0 4.1 3.2 4.0 5.3 3.9 4.5 0.3 2.8 3.3 -1.3 -1.3 -0.5 1.8 2.4 2.6 0.6 3.9 4.2 -0.7 2.5 3.5 0.5 3.2 2.9 1.9 7.0 6.2 4.9 6.1 6.3 0.6 2.7 3.6 3.2 5.4 5.7 0.3 3.0 2.7 2.8 3.3 3.2 -0.8 1.5 1.8 -0.9 2.7 3.3 6.7 12.4 11.2 0.6 1.3 1.4 0.3 1.2 1.5 0.1 1.2 1.4 0.3 0.9 1.4 0.8 1.3 1.6 1.0 0.4 1.2 -0.2 1.3 1.6 2.1 2.0 1.2 7.3 6.3 6.0 1.0 2.0 2.0 12.2 12.5 8.1 5.8 6.8 7.4 4.2 3.7 3.0 2.7 3.0 2.9 7.1 6.1 6.0 3.5 3.1 2.5 5.8 4.0 3.6 11.7 8.9 8.0 7.2 6.1 6.6 6.2 6.4 5.4 16.7 10.3 8.7 Policy Rate % end of period 2009 2010 2011 2.68 3.28 4.12 0.52 0.65 1.45 5.23 6.24 7.02 6.15 7.03 7.88 1.73 2.28 3.08 0.13 0.13 1.00 0.25 0.75 1.75 6.84 8.84 9.31 11.50 13.00 13.00 8.75 11.75 12.50 0.50 4.00 5.00 3.50 5.00 5.50 4.50 5.25 5.50 3.59 4.40 5.25 0.10 0.10 0.25 3.75 4.25 4.50 4.47 5.45 6.42 5.31 6.12 7.20 0.30 0.40 1.15 4.75 6.00 7.00 6.50 7.50 7.50 2.00 2.50 3.00 4.00 5.00 6.00 0.70 1.25 1.75 2.00 3.50 4.50 1.25 1.75 2.25 1.25 1.75 3.00 8.00 11.00 12.00 0.92 1.16 2.12 1.00 1.25 2.25 1.00 1.25 2.25 1.00 1.25 2.25 1.00 1.25 2.25 1.00 1.25 2.25 1.00 1.25 2.25 0.50 0.75 1.50 5.56 6.04 6.59 1.00 3.00 3.50 8.25 9.00 10.00 0.13 0.13 1.00 6.00 5.50 7.50 1.00 2.50 3.50 7.00 7.00 7.25 3.50 4.50 5.00 8.00 7.00 6.50 9.00 8.00 8.00 7.00 7.50 9.00 6.50 7.75 8.75 10.25 9.00 9.00

Global Developed Emerging Markets BRICs Americas United States* Canada Latin America Argentina Brazil Chile Colombia Mexico Asia/Pacific Japan Australia Asia ex Japan, Aust. China Hong Kong*** India** Indonesia Malaysia Philippines Singapore*** South Korea Taiwan Thailand Vietnam Western Europe Euro area France Germany Italy Netherlands Spain United Kingdom EEMEA Czech Republic Egypt GCC Hungary Israel Kazakhstan Poland Romania Russia South Africa Turkey Ukraine

Note: Aggregates calculated using purchasing power parity (PPP) adjusted shares of world GDP; Real GDP and CPI are reported as annual average growth rates; Developed countries comprise the United States, Canada, Japan, Australia, Hong Kong, Singapore, the Euro area, and the United Kingdom - all other countries are considered Emerging Markets; BRICS: Brazil, Russia, India and China; EEMEA: Emerging Europe, Middle East and Africa; Gulf Cooperation Council (GCC): Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates; all values are forecasts. * 2009 policy rate forecast is midpoint of 0–0.25% target federal funds rate range; ** Inflation refers to wholesale prices. ***For Hong Kong and Singapore, the policy rate refers to 3M Hibor and 3M Sibor, respectively. Source: Nomura Global Economics.

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Our View on 2010 in a Nutshell
Global
• The developed-world recovery looks set to be weak given de-leveraging forces and other legacies of the crisis. • With good fundamentals and a lack of aftermath issues, the emerging world, particularly Asia, is set to grow strongly. • Developed-world inflation should stay low amid ample spare capacity, but exchange-rate-targeting central banks risk bubbles. • The main downside risks include a re-eruption of financial distress, a commodity price bubble and premature fiscal tightening. • A possible upside surprise: animal spirits stir and, with monetary conditions super-loose, help release pent-up demand. • We forecast an average Brent oil price of $72 in 2010 and $75 in 2011, after $62 in 2009. • We expect further dollar weakness, especially vs EM, but the yen should gradually trade weaker on MOF intervention.

United States
• The “Great Recession” has ended, but the after-effects of the financial crisis are likely to weigh on the recovery. • Job market conditions are improving, but business uncertainty should limit job growth and keep the unemployment rate high. • Typical of the first phase of recovery, ample capacity is likely to put downward pressure on inflation. • We expect the Fed to focus on an orderly exit from credit easing, but not to hike rates until early 2011. • Proposals for a jobs-focused fiscal policy must overcome resistance from those worried about adding more to a record deficit.

Europe
• • • • • We expect sub-par growth given household de-leveraging in the UK and feeble domestic momentum in the euro area. The fiscal policy challenge: deliver short-term stimulus within a credible framework of medium-term consolidation. Headline inflation is set to rise in the UK and euro area, but underlying inflation is likely to stay very weak. We expect the ECB to start gradually removing exceptional liquidity measures but not to start hiking rates until October 2010. The BoE MPC faces uncertainties on both sides and we do not expect rate hikes until November 2010.

Japan
• • • • We expect the Japanese economy to slow again through H1 2010 but for growth to pick up again in the second half. Faster-than-expected excess supply corrections and expanding exports, particularly to Asia, should drive a recovery in H2. Given a wider negative output gap, we expect CPI deflation to persist for the foreseeable future. The BOJ is likely to adopt additional easing measures, such as increasing long-term JGB purchases, in H1 2010.

Asia
• • • • • • Things look ripe for a paradigm shift – domestic demand is replacing exports as the main growth driver, led by China. China: The investment and consumption booms are set to continue and to deliver double-digit growth. Korea: We see an inflationary economic recovery in 2010, driven by a prolonged macro stimulus and strong China demand. India: With both growth and inflation headed towards 8%, we expect the RBI to lead Asia in tightening monetary policy. Australia: Despite less expansionary policies, we see GDP growth quickening on stronger capex, exports and housing. SE Asia: Bullish on Indonesia, Singapore and the Philippines; less so on Thailand and Malaysia; concerned about Vietnam.

EEMEA (Emerging Europe, Middle East and Africa) and Latin America
• • • • • • • Key themes in 2010 are the removal of supranational support, fiscal sustainability and the effects of exit strategies on rates. CEE will likely be the slowest region to recover. Vulnerabilities persist, especially with banks’ NPLs set to peak in Q2 2010. Elections in CEE are a risk, with knock-on effects for fiscal policy sustainability. We see Poland entering ERM-II in Q4 2010. South Africa: World Cup and restocking will mask a weak recovery in consumption; we see a change in the SARB mandate. Russia should return to stable, if subdued, growth in 2010, supported by oil prices and pent-up domestic demand. Turkey should show a strong rebound in 2010, allowing some policy normalisation. Inflation should remain in check. Middle East: The Dubai story is a key test of investor confidence in the region; growth momentum should be maintained. LatAm: Strong growth in Asia and expansive monetary and fiscal policy are leading to a cyclical recovery.

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2010 Global Economic Outlook

Global ⏐ Outlook 2010

Paul Sheard

A tale of two recoveries
We expect a strong recovery in most of EM but a shallow one in the developed world.
EM weathered the crisis well...

Two key features of the global economy evident since the financial crisis of 2008 inform our global economic forecast for 2010. The first is that the developed economies, particularly the US and Europe, experienced their worst financial crisis since the Great Depression. The aftermath will cast a long shadow on their recovery. The second is that emerging markets (EM), particularly emerging Asia, after absorbing the initial hit to exports from the crisis-induced collapse in developed-world domestic demand, have performed remarkably well. Continuing this trend, EM economies are likely to post strong domestic demand-driven growth in 2010 (Figure 1). Looking back, the growth numbers that we expect for the full year of 2009 speak for themselves. The global economy overall likely contracted by almost 1% in 2009, but developed-world GDP likely fell by 3.4% while EM economies expanded by 2.0%. Within EM, there was notable differentiation: EEMEA (Emerging Europe, Middle East and Africa) and Latin America likely contracted by 3.2% and 2.8%, respectively, while Asia looks likely to hit 5.5% growth. China’s expected 8.5% growth in 2009, in such a challenging global environment, stands out. As well as benefiting from strong domestic growth momentum associated with a 30-year economic development take-off, China, at the outset of the crisis, moved quickly to re-peg its currency against the US dollar and engineer a fiscally and credit-driven investment boom. But India’s expected 6.5% growth in 2009 also merits attention. The world’s two most populous economies were the fastest growing in 2009 and together look like contributing 1.5 percentage points (pp) to likely global growth of -0.9% (put another way, and a bit too simply, had these two economies stood still rather than grown, global growth would have been -2.4% in 2009) (Figure 2). Looking to 2010, the first point to note is that the global recession is over – the quarter-onquarter contractions in global GDP having ended in Q2 2009 (for the G10, Q3) – and we think will stay over. Recessions are not the natural state for an economy and tend to self-correct over time, with counter-cyclical macro policy hastening the process. This recession threatened to throw the developed world economy in particular into a great depression and deflation, but concerted and unprecedented monetary, fiscal and financial-system policy action headed that prospect off at the pass. Absent another major shock, which we do not expect, the global economy should continue on its recovery path. We forecast global growth of 4.2% in 2010.

... particularly emerging Asia

China and India stand out

The recession is over – and we expect it to stay over

Developed world recovery weak
We expect the developed world to grow 2% in 2010

But developed world growth stands to be much weaker (2.0%) than growth in emerging economies (6.6%). The recovery we forecast will not even make up the output lost in the recession (Figure 3). This is not just a matter of emerging economies having much higher potential growth rates than developed ones, which is the case. Coming out of such a severe recession, growth rates can be well above potential for a sustained period until the spare
Figure 2. GDP path: 2008-2011, key countries/regions 2009 Global growth (% y-o-y) Contributions to growth (pp): Developed United States Western Europe Japan Emerging Markets China India -1.8 -0.6 -0.8 -0.4 0.9 1.1 0.4 1.1 0.6 0.2 0.1 3.1 1.5 0.5 1.1 0.6 0.3 0.1 3.1 1.5 0.5 -0.9 2010 4.2 2011 4.2

Figure 1. GDP growth forecasts: 2010, key countries/regions

% y-o-y 12 10 8 6 4 2 0 WE Japan US EEMEA LatAm ROA India China
Note: WE is Western Europe; ROA is Rest of Asia. Source: Nomura Global Economics.

See note to “The World at a Glance” table on p2 for definitions of Developed and EM. Source: Nomura Global Economics.

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2010 Global Economic Outlook

Fiscal forces

Paul Sheard

The deterioration in fiscal positions is necessary as governments dis-save to absorb private sector surplus savings. One of the big casualties of the recent financial crisis and global recession has been the fiscal positions of governments around the world (Figure 1). Fiscal deficits ballooned as tax revenues fell because of the recession and expenditures rose because “automatic stabilizers” kicked in (notably rising unemployment benefits and social welfare payments) and governments implemented large-scale fiscal stimulus packages and bank-bailout schemes. The numbers are startling. The US fiscal deficit went from 3.2% of GDP in 2008 (FY basis) to 10.0% in 2009; in the euro area, from 1.9% of GDP in 2008 to 6.9% in 2009; in the UK from 5.5% to 11.9%; and in Japan from 6.9% to 9.1% (FY basis). We forecast budget deficits to worsen in the euro area in 2010 and to stay very high in the US, UK and Japan (Figure 1). Despite some improvement, except in Japan, we expect fiscal deficits in 2011 to remain gaping. This deterioration in fiscal finances is a (longer-term) concern to be sure, but it is important to put it in context. In our view, and in the view of most economists, an aggressive fiscal policy response, on top of relying on automatic stabilizers, is a necessary part of the policy response in a financial crisis or serious recession. Keynes would be smiling from his grave. In a recession, particularly a very serious one which risks morphing into a great depression, private sector net savings go up as households save more and corporations reign in capital investment. This spike in net savings of the private sector threatens to throw the economy into a tail-spin unless another sector of the economy – the government sector or the external sector (the rest of the world) – absorbs those surplus savings. There are limits to the rest of the world’s ability to absorb the surplus savings, particularly if the recessed economy in question is large and if the recession is happening on a global scale. The way that those surplus savings can be absorbed is by the government increasing its budget deficit, or going from a budget surplus to deficit – that is, by dis-saving. All of this follows from the basic macro identity, the workhorse of macroeconomics, which states that private (household, corporate and financial) sector net savings plus government net savings must equal the current account balance (which in turn is the change in the net claim of the country on foreigners). Being an identity, this relationship must always be true, although, equally, it is not possible to ascribe direct causality between changes in the components. That the huge rise in government deficits is largely just the counterpart to the surge in private net savings can be seen by looking at what is happening to current account balances around the world. By and large, these are narrowing. We forecast the current account deficit in the US to narrow by 1.2pp between 2008 and 2010, from 4.6% of GDP to 3.4%. Likewise we expect the euro area current account deficit to improve by 1.4pp in the same period, from 1.6% of GDP to 0.2%, and the UK current account deficit to improve by 0.5pp from 1.9% of GDP to 1.4%. If current account deficits are narrowing while fiscal deficits are worsening, from the macro identity it must be that private sector net savings have rocketed, which indeed is the case (Figure 2). The exception in Figure 2 is China, where a decline in private net savings and an increase in the government deficit are combining to reduce the current account surplus from 9.8% in 2008 to 5.0% in 2010, on our forecasts. Japan provides an instructive application of the macro identity. Japan has been running huge fiscal deficits for years but it has been running big current account surpluses for even longer, meaning that Japanese are saving so much that they can finance large government deficits and still have a lot left over to lend to the rest of the world.
Figure 1. Fiscal deficits of major developed economies
% GDP 0 -2 -4 -6 -8 -10 -12 -14 US 2008 Euro area 2009 UK 2010 Japan 2011

Figure 2. Change in private sector net savings, 2008 to 2010

% GDP 8 6 4 2 0 -2 -4 US Euro area UK Japan China
Note: Private sector net savings is measured as current account balance minus fiscal balance. Japan and US fiscal balance is FY basis; Source: Nomura Global Economics.

Note: Japan and US budget balances for fiscal years; Source: Nomura Global Economics.

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2010 Global Economic Outlook

capacity created by the recession is fully used up. But demand, not supply, is the constraint on growth and we expect demand growth in the crisis-hit developed economies, notably the US, Europe and (for somewhat different reasons) Japan, to be muted for some time.
We see five headwinds

We identify five main reasons to expect weak demand growth in developed economies: “De-leveraging” forces: Households, particularly in the US, took on too much debt in the runup to the crisis on the premise that they were richer than they turned out to be – and now need to reduce debt levels and rebuild savings. Some parts of the financial and corporate sectors are in the same boat. This makes monetary policy less effective than it would normally be. Constraints on credit availability: While much progress has been made in quelling financial distress and in dealing with the underlying asset and potential insolvency problems, financial balance sheets in much of the developed world are still impaired and the flow of credit impeded. Not all potential borrowers are willing to borrow, but not all willing borrowers are able to. Continued high uncertainty: The financial crisis led to a spike in uncertainty about the future, as “tail risk” events became front-page news, dealing a blow to confidence. A year on from the crisis, uncertainty about the future remains unusually high and is likely to keep putting a damper on big-ticket consumer durable goods purchases and business investment decisions. Potential fiscal drag: The recession would have been much worse had it not been for governments using fiscal policy aggressively to fill the void in private sector demand created by the spike in net savings (see Box: Fiscal forces). But with fiscal deficits ballooning as a result, and concerns escalating about mounting public debt levels, fiscal drag looms as a medium-term check on growth as governments turn their attention to repairing public sector balance sheets. Constraints on exchange rate adjustments: The global economy needs to “rebalance” domestic demand growth away from the developed to the developing world; this is taking place, and is being reflected in narrowing current account balances. This rebalancing needs facilitating movements of currencies: those of deficit countries weakening, those of surplus countries appreciating. Some EM monetary authorities are resisting upward pressure on their currencies by intervening in the FX market, so this “external adjustment” is impeded and the contribution of net exports to developed world growth stands to be less than it would otherwise be.

Emerging world recovery strong
EM does not have crisis-aftermath issues to deal with...

The picture is very different in the emerging world. Emerging economies were hit by the financial crisis and global recession but, by and large, they suffered collateral not intrinsic damage. They are not left with the same aftermath issues to deal with that the economies at the “epicenter” of the financial crisis are. Many of these economies, having absorbed the demand shock, or having offset it with stimulatory macro policy, can return more or less to pre-crisis growth rates. Of course, the external environment for emerging economies has changed, perhaps permanently. The “more or less” above relates to the fact that emerging economies like China will need to rely more on domestic demand growth and less on export growth. And that is exactly
Figure 4. Estimated bank losses by region: 2007-2010

... plus domestic demand is strong

Figure 3. GDP path: 2008-2011, key countries/regions

Index, Q1 2008 = 100 135 US 130 Euro area 125 Japan 120 India 115 Korea 110 105 100 95 90 Mar-08 Mar-09

$bn Forecast 1,200 1,000 800 600 400 200 0 United States Mar-10 Mar-11 Euro area United Kingdom Other mature Europe Asia Expected losses Realized losses

Source: Nomura Global Economics.

Source: IMF, Global Financial Stability Report, Oct 2009, p.12.

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2010 Global Economic Outlook

GEMaRI: Vulnerability remains

Peter Attard Montalto ⏐ Rob Subbaraman

A wide range of vulnerabilities in Emerging Markets after this crisis should make 2010 a year of country comparisons. With investors currently very attuned to risk, we think there is a need to step back to assess macro risks in Emerging Markets (EM) objectively and quantitatively. Our early-warning system, the Nomura Global Emerging Markets Risk Index, or GEMaRI, is intended to do just that. GEMaRI is based on 16 macroeconomic and financial indicators across 35 countries that, in back tests, have performed well in predicting past financial crises, especially exchange-rate crises, in Asia, Europe and Latin America. GEMaRI would have rung alarm bells before previous major financial crises in Chile, Iceland, Korea, Malaysia, the Philippines, Poland, Russia, Thailand, Turkey and Ukraine. We think GEMaRI will prove useful as the focus shifts back to sovereign risk, given recent events in Dubai, Greece and Vietnam. Helped by unprecedented macro policy easing, the performances of economies and asset classes were highly correlated in 2009; in 2010, these correlations are likely to weaken as investors search for alpha through macro and relative value trades. GEMaRI could help in this search. Indeed, despite strong capital inflows to EM in 2009, and the outperformance of its equity markets vis-à-vis advanced economies, the latest GEMaRI scores diverge widely (Figure 1). The top ranked country for risks is Iceland, showing the degree of stress underneath its current exchange rate controls. Scores are also high for Bulgaria, Lithuania, Latvia and Hungary, which have been hard hit by the crisis and where, in the case of those with IMF programmes, many private-sector vulnerabilities have been transferred to the government. At the other end of the scale, scores are zero for Peru and very low for Colombia, Argentina, Taiwan, Indonesia, Russia, Mexico, Kazakhstan and Hong Kong. The scores for several countries – Ukraine, Poland, Peru, Bulgaria, Serbia, Turkey, Vietnam and the Czech Republic – have fallen sharply in recent quarters. This partly reflects a kind of cleansing process from the global financial crisis and recession. Large contractions in GDP and depreciating currencies have helped reduce, and in some cases eliminate, sizeable current account deficits, while policy responses have reduced risk in banking sectors (albeit at the cost of worsening fiscal positions). With a slow recovery in the EEMEA region from this crisis, any move back to imbalances on this front should be slower than elsewhere. Scores for a few countries have risen significantly in 2009 or remained sticky at high levels. This is true for Croatia, owing to its exposed nature but no IMF programme. Other countries such as India and Malaysia are experiencing recoveries helped by large fiscal stimulus, which has worsened already weak fiscal positions, contributing to a rise in their GEMaRI scores. In the case of the Baltics, the large falls in GEMaRI scores give some idea of the level of internal adjustment that has taken place to reduce external imbalances. By contrast, most Asian countries have current account surpluses and the region’s sound fundamentals are attracting strong net capital inflows, putting upward pressure on currencies. Rising GDP growth, excess liquidity and central banks slow to raise rates are ideal conditions for asset price bubbles, which could eventually lead to financial crises. Hong Kong and China, with highly rigid exchange rates, seem most at risk. Some countries, notably China, Brazil and South Africa, have suffered less than others, missing the banking crisis and enjoying government-led investment programmes to boost demand. Each has remained higher and more stable in the GEMaRI index across this cycle than other countries without recession to aid the cleansing of vulnerabilities. One example is China’s domestic credit boom which could create a prolonged asset price bubble. Another key theme in this crisis has been the nationalisation of risk and vulnerabilities. There have been bail-outs, as previously private balancesheet risks and vulnerabilities have shifted to the state, resulting in higher budget deficits. A flurry of external debt issuance through Q2 and Q3 2009 to fund these vulnerabilities has caused some stickiness in country risk scores.
Figure 1. GEMaRI scores for Q3 2009

Scores 100 79 75 50 25 0 67 64 62 60 58 54

1-in-2 chance of a currency crisis 1-in-3 chance of a currency crisis 37 36 31 30 30 27 25 25 25 25 23 23 19 19 19 16 16 15 14 13 13 3 Ukraine Romania Turkey Israel Malaysia Croatia Mexico 3 0 Colombia Peru

48 46 45 44

Iceland

India

Kazakhstan

Hong Kong

Philippines

Singapore

Indonesia

Estonia

Hungary

Thailand

Vietnam

Bulgaria

Lithuania

Russia

Poland

South

Brazil

South

China

Egypt

Chile

Serbia

Latvia

Taiwan

Source: Nomura Global Economics. Note: The key levels on the graph are 100 = 1-in-2 chance of a crisis, and 73= 1-in 3 chance. See the appendix of GEMaRI: Vulnerability remains 10 December 2009 for full details.

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Argentina

Czech

2010 Global Economic Outlook

what they seem to be doing, particularly in Asia. Of the 4.2% growth that we forecast for 2010, 3.1pp is attributable to emerging markets and a full 2.0pp to just China and India (Figure 2).
Emerging Asia leads the rest of EM

Just as there was marked differentiation in Asian and EM growth in the crisis, we expect similar in the recovery. We forecast very strong growth in Asia, of 8.4% in 2010 and 8.2% in 2011, led by China (10.5% and 9.8%, respectively) but less impressive growth in LatAm (4.6% and 3.5%) and EEMEA (3.7% and 3.9%). Our Global Emerging Markets Risk Index, GEMaRI, which measures the risk of currency or balance-of-payments crises in EM, points to some vulnerable spots in the EM landscape, particularly in EEMEA (see Box: GEMaRI: Vulnerability remains).

Inflation and monetary policy
We see inflation remaining low in the developed world

Given our forecast and interpretation of quantitative easing (QE) as being consistent with central banks’ price stability mandates, we continue to see little inflation risk in the developed world (see Box: QE: Back to basics). We forecast annual consumer price inflation in the developed world to be 1.3% y-o-y in 2010 and 1.1% in 2011, after being flat in 2009. Given persistent large output gaps, a benign inflation outlook and still-weak financial systems, we see major central banks being very slow to start to hike rates (our weighted average policy rate forecast for end-2010 is 0.65%, up only slightly from end-2009’s expected 0.52%). Notably, we forecast the European Central Bank to make its first rate hike in October 2010 and the Bank of the England in November. We do not expect the Fed to move until Q1 2011 and the Bank of Japan even later. The monetary landscape looks different in EM. Many countries, particularly in emerging Asia, continue to manage their exchange rates against the US dollar, intervening heavily at times against currency appreciation. The combination of the resulting very loose monetary policy conditions and strong domestic demand growth set the stage for potential asset price bubbles.

Exchange rate targeting risks bubbles in Asia

Risks to the forecast
Financial distress re-erupting is the main downside risk

We continue to see the main downside risk to our forecast being another breakout of financial system distress, which in turn exerts negative feedback onto the real economy and pushes the developed world economy back into recession. The Japanese experience of there being many false dawns as financial distress periodically re-erupted over more than a decade provides some caution against over-confidence in calling the financial crisis all-clear. There are a number of potential triggers: latent banking system problems resurfacing in the US as commercial real estate prices continue to fall, or home prices start to again; the withdrawal of policy support exposing weak underlying private sector demand growth and that weakness feeding back into financial system distress; or continued write-offs exposing banking system undercapitalization and, in the US case, showing that the big repayment of TARP funds was too hasty by half (Figure 4). A re-eruption of financial distress would likely clobber domestic demand via confidence effects and ricochet around the global economy again, shades of Q4 2008. Policy credibility would take a few knocks too, undermining its subsequent efficacy. That said, we do not expect a financial crisis to re-erupt. The reason is that the US and Europe in the late 2000s is not Japan in the mid-1990s. The lessons from Japan, that is, the lessons from what Japan did not do – when faced with a financial crisis, act quickly, forcefully and across the board – were learned and applied in this crisis. Japan’s financial crisis re-erupted many times because the balance sheet problems were not tackled, but rather kicked down the road either for time to heal (which it did not) or to land in someone else’s in-tray (which they did). Another downside risk is a possible commodity price shock, including oil, given strong growth in commodity-hungry China and loose global monetary conditions. This could start to un-anchor inflation expectations and put developed world central banks in the uncomfortable situation of having to tighten monetary policy faster than they would otherwise like. There are also political risks, amid a busy election calendar, and geopolitical risks, which by their nature tend to be to the downside (see Box: Key political issues for 2010). The main risk on the upside is that developed world growth turns out to be much stronger because confidence and animal spirits – the hardest part of any economy to forecast – return faster than we expect. Then, with monetary policy very accommodative, households might go on a spending spree to close the demand gap between the current depressed levels of housing and consumer durables, and long-term average levels.

Write-offs eroding bank capital could be a trigger

But we think aggressive policy has done the job

A commodity price shock is another downside risk

Beware geopolitics

The main upside risk hinges on animal spirits

Nomura Global Economics

9

16 December 2009

2010 Global Economic Outlook

QE: back to basics

Paul Sheard

If, when and how major central banks exit from quantitative easing (QE) in 2010 will be a key focus of investor attention. But a good deal of mystery – and, we would submit, misunderstanding – surrounds QE. Here, we try to demystify. To understand QE, it is important to go back to the basics of how a central bank balance sheet works and how central banks normally operate. Precise details of components and operations differ from country to country, but a simplified central bank balance sheet is composed of assets acquired (eg, government debt) or credit provided (lending) on the asset side and three components on the liability side: bank reserves (banks’ deposits with the central bank); government deposits (the central bank is usually the government’s banker); and banknotes in circulation (the money in your wallet or under the mattress). Being a balance sheet, the following identity must hold: Central bank assets/credit provided (CBA/C) = bank reserves (BR) + government deposits (GD) + banknotes (BC). This identity immediately yields a few insights: 1) if CBA/C and GD do not change, BR goes down when BC goes up, and vice versa; 2) if GD and BC do not change, BR goes up when CBA/C goes up, and vice versa; 3) if CBA/C and BC do not change, BR goes down when GD goes up, and vice versa; 4) if BR and BC do not change, CBA/C goes up when GD goes up, and vice versa.

Point 1 highlights the pivotal role that bank reserves play in a money economy: when people take money out of the bank, bank reserves fall; it is by topping up the depleted bank reserves (operation 2) that central banks supply cash to the economy. Point 3 highlights the key fact that government transactions with the private sector (e.g., taxes and welfare payments) either drain or add to bank reserves. Point 4 occurs when the government issues debt directly to the central bank. Points 1 and 3 are, in central bank jargon, called “autonomous factors”: they influence the level of reserves but are beyond the central bank’s direct control. Together, these balance sheet relationships show that, conditional on the observable autonomous factors, the central bank, by adjusting its provision of credit, can determine aggregate reserves in the banking system. This point bears repeating: the central bank, not banks, controls the overall level of bank reserves. How does a central bank normally use its balance sheet to achieve its objective of maintaining price stability? It sets an overnight interest rate (in the inter-bank market for lending and borrowing reserves), doing so by adjusting the aggregate level of reserves: withdrawing reserves if there are too many (thus removing downward pressure on the overnight rate), adding reserves if there are too few (thus exerting downward pressure). But what is the level of reserves that achieves that balance? In a nutshell, the level of reserves that the banks want to hold, either because minimum reserve requirements (linked to the amount of deposits in the banking system) require them to or because of precautionary demand for central bank “liquidity”. Because reserves (an asset for the banks) either pay no interest or a very low rate (up to the policy rate), banks typically want to hold as few reserves as possible. So, in normal times, when the central bank is setting a positive interest rate, reserves are relatively low, the central bank does not target or directly control the size of its balance sheet, and the size of the balance sheet tends to be quite stable (grow only slowly) over time. All of this changes under QE. Exploiting Point 2 above, the central bank can unilaterally expand the size of its balance sheet by creating more reserves. Indeed, targeting a higher than usual level of reserves or of the overall balance sheet is the definition of QE. Note two things. One, because a balance sheet has two sides, and they must balance, it is possible to characterize QE in terms of the central bank expanding reserves (as the Bank of Japan did in 2001-06) or in terms of it increasing the asset side of its balance sheet (as the Fed has done with its “credit easing”) or both (as the Bank of England has done with its asset purchases, where it has emphasized that these will be financed by the creation of reserves). Second, because interest was not usually paid on reserves, QE implied a zero interest rate policy. But now, with more of them paying interest on reserves, central banks are able to divorce the QE decision from the interest-ratesetting decision, giving the Fed, for example, the flexibility to raise interest rates before shrinking its balance sheet. So how does QE work? Essentially via two mechanisms (on top of the lender-of-last resort aspect of preventing a collapse of the financial system): by changing relative asset supplies and creating “portfolio rebalancing effects”, and by working positively on confidence and (anchoring inflation) expectations. Under QE, rather than just target a single interest rate (the overnight rate), a central bank can leverage its balance sheet (both its size and its composition) to try to influence a range of interest rates and asset prices. Because banks in aggregate end up with a very liquid balance sheet under QE, having swapped risk assets for reserves, they may endeavor to rebalance their portfolios back toward higheryielding assets, thereby helping to buoy asset prices and create positive wealth effects. But, contrary to much common commentary, QE does not work through a mechanical credit multiplier process: banks cannot “take” their reserves and “lend them out”, as if reserves were money waiting to flow through the economy. Banks create credit by simultaneously creating loans and deposits, not by re-directing reserves (it is only subsequently, via Point 1, that reserves are depleted).

Nomura Global Economics

10

16 December 2009

2010 Global Economic Outlook

Key political issues for 2010

Alastair Newton

We judge that political/geopolitical risk has continued to subside during the second half of 2009. However, major downside (and some upside) risks – “local”, regional and global – persist, which stand to impact financial markets. Set out below is a checklist of our “Top 10” political and geopolitical issues for 2010 (which we intend to cover in more detail in our geopolitical risk forecast for 2010 due for publication in early January). The order reflects our subjective judgment of the importance of each of the issues to market participants. 1. United States: The economy – especially unemployment (which we expect to amplify protectionist pressures and therefore trade frictions with China) and the fiscal deficit – looks set to be the dominant issue in the 2 November Mid-Term elections. We expect the Democrats to be able to manage to retain a majority in both houses of Congress, but judge it likely that they will lose their super-majority in the Senate. Assuming healthcare reform is passed (by no means certain), congressional attention will then turn to financial regulation (see Issue 4 below) and climate change legislation (Issue 7). USD-focused market attention will also be directed to the Administration’s budget proposals, due in February, and in particular, plans for reining-in the fiscal deficit. 2. The Middle East: A further round of UN sanctions is likely to result from Iran’s intransigence over its nuclear programme, but we doubt that these will deflect Tehran from its aspirations, in which case military intervention is likely to remain firmly on the table in Israel. More widely in the region, significant progress looks unlikely with the Middle East Peace Process; the US is committed to withdrawing all its combat troops from Iraq by August; Egypt prepares for legislative elections in October amid rising speculation over the presidential succession; and al Qa’ida, now established in troubled Yemen, poses a real terrorist threat across the region. 3. Afghanistan/Pakistan: Despite President Barack Obama’s decision to commit additional troops to Afghanistan, we judge the political will in the West to continue the struggle there to be slowly draining. This has potentially significant implications for the future stability of Pakistan which, although it appears to have improved somewhat both economically and politically since early 2009, remains fragile. Further terrorist attacks in India backed by elements in Pakistan cannot be ruled out, although for now at least markets seem to be judging India purely on its own merits. 4. G20: With G20 leaders now not due to consider recommendations on regulatory and institutional reform until November, we are concerned that the process will lose political momentum to the point where agreements in principle fail to translate into practice. Nevertheless, we expect the EU largely to implement its de Larosière reform agenda by mid-2010. We are less sanguine about reform prospects in the US, however, which stand to be gridlocked and/or diverted by the contentious issue of political oversight of the Federal Reserve. 5. United Kingdom: Opinion polls suggest that the general election (which must be held by early June) will return the main opposition Conservative Party to power. But a hung parliament (which we would see as negative for market sentiment and likely to lead quickly to a further election) cannot be ruled out. The main election issue is set to be the “right” balance between sustaining economic growth and reining-in the UK’s fiscal deficit though, in practice, there may be less between the two main parties than they try to suggest. 6. Turkey/EU: Failure to achieve real progress towards reuniting Cyprus by April stands to throw up a major hurdle in Turkey’s already troubled path to EU membership. We judge that the accession process will not be derailed entirely but will probably be frozen if the Cyprus negotiations fail. 7. Climate change: Assuming a political-level agreement does emerge from the December 2009 climate change summit, attention will then focus in 2010 on turning this into a binding successor treaty to the Kyoto Protocol (to come into force in 2012). Absent such a treaty, experts agree that the private sector will continue to lack the framework needed to drive up investment commensurate with moving to a low-carbon economy. 8. Thailand: Markets appear to have factored in continued political sclerosis in Thailand but could still to be moved by domestic developments (as happened in October 2009) or by an “out-of-left-field” event such as deepening tensions with Cambodia exploding again into border skirmishes. 9. Ukraine: We see little likelihood of Russia engineering a gas crisis in the run-up to the 17 January Ukrainian presidential election, which looks like heading to a run-off between Prime Minister Yuliya Tymoshenko and main opposition leader Viktor Yanukovych. But a domestic political and/or economic crisis cannot be discounted. The incoming president will face major economic challenges but can expect improved relations with Moscow. 10. Russia: President Dmitry Medvedev has recently begun setting out a vision for Russia’s economic development which we believe stands to differ significantly from that of Prime Minister Vladimir Putin, and which would stand ultimately to boost Russia’s economy. But it remains to be seen whether he can push ahead with his agenda in 2010 – and, if he can, what that may imply for the presidential election in 2012.

Nomura Global Economics

11

16 December 2009

2010 Global Economic Outlook

United States ⏐ Outlook 2010

David Resler

The slow road from recession
The US economy is growing again, but it will take a long time for activity to return to prerecession levels.
This has been a downturn like no other

In terms of depth and duration, the recession of 2007-09 has no precedent in the post-war US experience but in its first phase – through the first three quarters of 2008 – the downturn did not differ markedly from previous post-war recessions. The recession took on an entirely different character when the financial system seized up after the fall of Lehman Brothers in September 2008. The ensuing decline in real GDP from Q4 2008 to Q2 2009 was the sharpest since the Great Depression, leaving the financial system itself profoundly damaged and incapable of playing its usual supportive role in any prospective recovery. Aggressive and innovative policy actions have mitigated the damage, but the corrective forces required to set the economy right must still run their course – a course that is likely to be long and arduous (Figure 1).

The “Great Recession” has ended
The NBER will determine the recession’s end

Nonetheless, it now seems likely that the ”Great Recession” probably ended in the third quarter, when real GDP grew at a 2.8% rate after four straight quarters of decline. Of course, growth in real GDP is not the only – or even the decisive – metric of business-cycle turning points. Ultimately, the National Bureau of Economic Research will determine when the economy hit its nadir. Amid persistent weakness in the jobs market and the feeble 0.1% net advance from the June low in the Conference Board’s index of coincident indicators, the NBER is unlikely to make that determination anytime soon. But with most recent data pointing to an advance of nearly 3% in real GDP in the current quarter, we suspect the NBER will eventually confirm that the longest and deepest slump since the Great Depression did indeed end sometime in the third quarter. The moderate rate of Q3 growth also seems likely to be a signal of things to come. Accordingly, after a Q4 2009 growth spurt of 3.5%, we forecast that real GDP growth over the four quarters of next year will match the 2.8% pace of Q3 2009. Instead of the snap-back, V-shaped rebound that has been typical after previous deep recessions, we think a much shallower growth trajectory lies ahead (Figure 1). The shallow recovery that we envision rests on a different precedent than the rebounds that have followed other post-war US recessions. Namely, the more relevant antecedents of the current slump – the deep contractions experienced in other economies that have weathered crippling financial crises – suggest a much slower and more drawn-out recovery. In short, we believe that, although the economy will no longer be contracting, activity in such key sectors as housing and motor vehicles will be far below the levels typical of previous expansions. Similarly, the unemployment rate looks likely to remain well above 9% in the year ahead, not falling below 9% until late in 2011. Maintaining the accommodative mix of fiscal and monetary policy should prevent a reversion into economic decline but cannot, in our opinion, fully counter the effects of the financial rebalancing that lies ahead.
Figure 2. Forecast sector contributions to recovery

Q3 growth sets the standard for coming quarters

In a slow recovery, key metrics will remain below normal

Figure 1. This recession compared to previous ones

GDP Index, Peak = 100 108 1973-75 106 104 102 100 98 96 0 1 2 3 4 5 6 7 8 9 10 11 Quarters after GDP Peak
1981-82 1990-91 2001 2008- ??? Peak level

pp 2.0 1.5
First quarter of expansion
1st 6 qtrs. 2011

1.0 0.5 0.0 -0.5 -1.0
Government Consumption Equipment Housing Trade Inventories Structures

Source: Bureau of Economic Analysis; Nomura Global Economics.

Source: BEA; Nomura Global Economics.

Nomura Global Economics

12

16 December 2009

2010 Global Economic Outlook

As is typical of most recoveries, a rebound in consumer spending, residential investment and inventory investment will likely provide the main impetus to recovery. Together, these three segments should contribute about three percentage points to forecast real GDP growth during the first six quarters of the economic recovery (Figure 2). However, we expect the deepening downturn in non-residential construction, which was buoyant during the first third of the overall recession, to offset about 0.5pp of the boost from the aforementioned sectors. In contrast to cuts in spending for structures, forecast growth in business investment in equipment and software provides progressively greater support for the expansion. Despite the weaker dollar and improving economic conditions overseas (especially in China and other Asian economies), the US trade balance should provide only limited support for the recovery in 2010 and H1 2011. It was not enough to counter the net drag on growth in Q3 2009 and looks unlikely to do so in Q4.
The upside of the inventory cycle is under way

In one important respect, the first phase of the forecast upturn resembles the early stages of previous recoveries. Although the inventory liquidations during this recession have been large, they have accounted for only about one-fourth of the 3.8% drop in real GDP from its Q2 2008 peak – a much smaller impact on overall economic activity than in most post-war contractions. However, we expect the reversal of the inventory cycle to follow the patterns of the past and to largely reverse their six-quarter drag on growth with offsetting contributions to the recovery over the year ahead. From Q1 2008 through Q2 2009, falling inventories subtracted an average of about 0.9pp from quarterly GDP growth and we expect a rebound in inventory investment, already under way, to contribute a like amount to real GDP through the end of 2010.

Debt unwind to limit pace of recovery
While most economic downturns rectify imbalances that emanate from the markets for goods and services, this recession was simply the first step toward correcting the imbalances that developed during the debt-financed housing boom. Until financial institutions have strengthened their balance sheets, they are likely to limit new lending to the business and household sector (See Box: Financial stress). The modest improvement in those imbalances during the recession itself represents merely the down-payment of a corrective process of deleveraging, particularly in the financial and household sectors, that is likely to play out over a period of several years.
Wealth losses undercut spending options

The recession took a devastating toll on consumer balance sheets and the greatest impediment to a quick, V-shaped recovery will be the household sector’s need to strengthen its finances. From the Q3 2007 peak to the Q2 2009 trough, household net worth declined by about $14.2 trillion, with declines in financial assets accounting for about $10.7tr (more than 75%) of the total. More than half the drop in financial asset valuations occurred in Q4 2008 and Q1 2009 but the implosion of household wealth appears to have ended in Q1 2009. With the steep slide in real estate values apparently arrested and the stock market rebound that began in the spring boosting equity market values, households had recovered nearly $5tr of their net wealth losses by the end of Q3 2009. Nonetheless, the two-year wealth losses still totalling about $9tr will likely continue to exert a drag on consumer spending. Conventional estimates of the “wealth effect” suggest that these losses will reduce long-run consumer spending by about $300bn to $700bn, enough to erase more than a year’s worth of average spending growth.
Figure 4. Inflation declines in early phase of recoveries

Figure 3. Housing starts: Actual and forecast path

m saar 2.5 2.0 1.5 1.0 0.5 0.0 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10
Source: Census Bureau; Nomura Global Economics.

Change in % y-o-y rate, pp 1.5 1.0 0.5 0.0 -0.5
Lowest of past recessions
All items Core

-1.0 -1.5 -2.0 -2.5 t-6 Trough t+6 t+12 t+18 t+24 Months from recession trough
Note: Average of past eight recessions; Source: BLS; Nomura Global Economics.

Nomura Global Economics

13

16 December 2009

2010 Global Economic Outlook

Financial stress
The worst of the financial crisis has likely passed, but worries about hidden dangers persist.

David Resler

The worst financial crisis since the Great Depression has understandably left a legacy of worry that the “too big to fail” doctrine will not be able to head off a new systemic threat. Some observers have criticized the “stress tests” as too narrowly focused on just 19 large financial institutions. They also contend that the stress tests were not sufficiently rigorous to assess systemic risks accurately. Others note with alarm the fragile state of smaller banks and worry that a failure of one that is deemed not quite big enough to rate as system-critical could again set off a chain reaction that brings the system to its knees. Unfortunately, none of these concerns can be dismissed out of hand. After all, they reflect the new-found appreciation of the “tail risks” embedded in a highly complex and interconnected financial system. Indeed, many of the worries are grounded in inescapable facts. Despite the extraordinary measures by the Federal Reserve, Treasury and Federal Deposit Insurance Corporation (FDIC), the authorities so far this year have closed or assisted in the takeover of some 141 institutions. With another 552 insured depository institutions housing $346 billion in assets currently classified as “problem institutions,” more failures seem likely before the end of 2009 (Figure 1). Although this is far fewer than the number of bank resolutions in 1985-1992, the 2009 failed depositories housed almost $2.1trn in assets, representing about 15.6% of all assets at insured depositories, about 4 1/2 times the proportion in the worst year of the earlier crisis. Most of the bank failures cited above have been among banks with less than $1bn in assets and the deepening recession in the commercial property market aggravates the financial stress for these institutions. With commercial real estate prices still falling – precipitously in some markets – memories of how real estate loan problems at smaller institutions in Japan spread to larger ones during the 1990s has kept markets fearful. The real estate risk exposure of small banks is considerable. In contrast to the 16.6% share at the nation’s 25 largest banks, commercial real estate loans comprise about 41.7% of loans at all other US chartered banks. As Figure 2 shows, banks in this size category have not raised their loss provisions as much or as rapidly as their larger counterparts. But hundreds of the smaller institutions have shored up their capital base with funds from the Troubled Asset Relief Program (TARP). Moreover, the FDIC has a permanent credit line from the Treasury of $100bn and, in an emergency, is able to tap up to another $400bn. With none of this used yet, the FDIC has ample capacity to deal with a much larger increase in bank failures than we believe to be likely in the year ahead. That extra capacity for assistance from the FDIC should also mitigate the risks of contagion. The increased FDIC Treasury credit line, along with other policy innovations, such as the Term Asset Lending Facility (TALF), make it less likely that the US will see a replay of the Japan-style contagion that spread much more slowly than the crisis in the US. For instance, more than two years elapsed between the first Japanese bank failure in the post-war era (August 1995) and the collapse of Yamaichi Securities (November 1997). Although the Japanese authorities tapped public funds to capitalize banks shortly after the Yamaichi collapse, they failed to evaluate the systemic stress that contagion might pose. While the US crisis developed much more quickly – just six months between the forced absorption of Bear-Stearns into JPMorgan-Chase and the Lehman Brothers bankruptcy – authorities responded quickly and more forcefully. Moreover, the “stress tests” conducted by Fed last spring have helped restore confidence in the banking system. Despite the criticism that the tests were not sufficiently rigorous, the fact that some of the, presumptively, most troubled large banks have repaid or petitioned the Treasury to repay TARP funds supports our belief that the US will avoid the mistakes that magnified and prolonged Japan’s financial crisis. Nonetheless, the financial fall-out that followed Lehman’s bankruptcy underscores the uncertainties inherent in today’s complex, interconnected financial system.
Figure 1. Failed and “problem” banks Figure 2. Credit loss provisions by bank size

Number 1,600 1,400 1,200 1,000 800 600 400 200 0 1980 1987 1994 2001 2008 Failed "Problem Institutions"

% 2.5 >$10bn 2.0 1.5 1.0 0.5 0.0 Mar-00 $1bn to $10bn $100mn to $1bn <$100m

Mar-03

Mar-06

Mar-09

Source: FDIC: Nomura Global Economics.

Note: Insured commercial banks (excludes savings banks) Source: FDIC, Nomura Global Economics.

Nomura Global Economics

14

16 December 2009

2010 Global Economic Outlook

Corrective forces require household debt reduction

The wealth losses alone would exert a potent drag on spending, but even if asset valuations continue to recover, the legacy of the massive debt incurred during the past decade will limit household spending. As real estate prices soared during the early part of this decade, innovations in housing finance made it ever easier to draw on the rapidly rising equity in their homes (see Box: Constrained by debt). Consequently, households spent a much larger share of current income than ever before. At the height of the housing-finance boom and well before the first leaks in the bubble, the saving rate hit a record low of just 1.4% of disposable income in 2005. The debt incurred during this period has left households too weak to support the sort of spending rebound that has typically followed past recoveries. With the jobless rate forecast to remain above 9% until late in 2011 – an unprecedented stretch at such a high level – sluggish growth in wage and salary income are also set to curb spending. The high unemployment rate will also likely remain a source of political angst and stir debate about the eventual return to a “new normal.” The prospect of another “jobless recovery” seems likely to spawn debate about whether or not the recession and the de-leveraging that lies ahead has raised the unemployment rate that defines “full employment” and, if so, how this might affect monetary policy during the recovery. The strained financial condition of the household sector is also likely to retard the pace of recovery in home-building. Though the production cuts of the past year and a modest rebound in sales have depleted the inventory of unsold new homes, the record number of unoccupied rental property and the threat of rising foreclosures should swell further the inventory of existing homes for sale. The likely result will be a grudging recovery that will keep housing starts at levels below those of previous recessions. For instance, housing starts at our forecast Q4 2011 peak are nearly 13% below the average of all past downturns. Indeed, we do not expect starts to surpass the lowest level of all past recessions until Q3 2011 (Figure 3).

A weak jobs market will slow income growth

Problem debt will also restrain housing recovery

Subdued inflation but daunting challenges for the Fed
While many seem to believe that inflation pressures develop quickly in a recovery, past experience proves otherwise. Twelve months into recovery, the 12-month rate of CPI inflation has been lower than at the business cycle trough by an average of 1.9pp (Figure 4). In the only exception to that pattern (after the 2001 downturn), core inflation fell by about 0.4pp. With the unemployment rate likely to remain stubbornly high, indicating persistent excess capacity, it seems unlikely that these historical tendencies will be violated. Embracing the implications of excess supply in the early phase of recovery, we expect inflation to continue its cyclical retreat, with the four-quarter growth in the core CPI continuing its slide from a recession high of 2.4% (Q1 2008) to a low of 0.9% by mid-2011. Though understandable, fears that the Fed’s massive balance sheet expansion will inevitably spawn uncontrollable inflation seem ill-grounded. For that to occur, two conditions would need to be met. First, the excess reserves (Fed liabilities) associated with the increased Fed assets would need to be quickly transformed into a rapid expansion of bank credit and into a transactional – rather than a precautionary – demand for money balances. Second, some impediment must prevent the translation of that monetary-induced demand from beckoning forth more goods and services. We see no evidence of such an impediment and we believe the Fed stands ready to forestall any rapid expansion of bank lending if some barrier prevented an increase in production in response to a rise in demand supported by greater bank lending.
We do not see the Fed starting to hike until Q1 2011

Nonetheless, the Fed faces daunting policy challenges. The FOMC has declared that “low rates of resource utilization” combined with “subdued inflation trends, and stable inflation expectations” justify an “exceptionally low” federal funds rate for an “extended period.” We expect that period to extend through 2010 and into the first quarter of 2011; only then is the FOMC likely to begin raising interest rates above current emergency levels. But even though we see no imminent threat to price stability, fears of inflation lie just under the surface and are likely to percolate into the markets well before any evidence of inflation pressures emerges. We believe that the Fed will strive (successfully) to contain those fears by diligently and transparently implementing the “exit strategy” from quantitative easing that it has been carefully outlining in recent months (see Box: The Fed’s balance sheet). To succeed, however, the Fed must navigate a perilous path between nervous markets on one side and a vengeful political establishment increasingly suspicious of it on the other. We note only that the conduct of monetary policy is an art and that beauty is always in the eye of the beholder.

Nomura Global Economics

15

16 December 2009

2010 Global Economic Outlook

Constrained by debt
The heavy burden of debt, a legacy of the housing boom, will likely limit consumer spending.

David Resler

Decades of excessive borrowing have left the household sector with an onerous debt burden that must be reduced. The need to reduce that debt – and to restore a level of savings that provides the foundation for lifetime wealth accumulation – should restrain spending growth even as employment and incomes begin to rise again. Since the mid-1980s, household debt has consistently grown faster than disposable income. From a decades-long range of 0.6 to 0.7 times prior to 1980, the ratio of household debt to disposable income (DYR) rose steadily and, by mid-2001, exceeded unity for the first time (Figure 1). With innovations in mortgage and other consumer-debt financing making access to debt more convenient and readily available than ever before, household debt grew rapidly, pushing the ratio to a record 1.36 times in Q4 2007. In contrast to previous recessions when this ratio has risen slightly, throughout this recent downturn it has fallen sharply. With consumer debt (including mortgages) down about 3.2% from its Q3 2008 peak and disposable income up about 1.4% over the same period, the DYR fell to a four-year low in Q3 2009. To reduce the debt-to-income ratio to unity – a value first breached less than eight years ago – by the end of 2011, household debt would need to contract at nearly twice the rate that disposable income grows. The burden of household debt has paralleled the rise in overall debt. The household debt-service ratio (DSR) compares the principal repayments and interest payments required on currently outstanding mortgage and consumer debt to disposable personal income. As shown in Figure 2 (in percentage terms), the DSR peaked in Q4 2007 and has retreated slightly since then, reflecting the contraction of household credit outstanding as well as the decline in interest rates since the recession began. At its most recent (Q2 2009) reading of 13.1%, the DSR remains well above its 30-year average of 12.1%, primarily the result of the high level of mortgage debt. However, as a result of the sharp drop in interest rates and the consumer credit contraction, the share of disposable income devoted to interest payments on non-mortgage debt fell below 2% for the first time in 30 years in the second quarter of 2009 and is continuing to decline, albeit at a slower rate. The secular downtrend in interest rates on consumer and mortgage debt has partly mitigated the impact of growing indebtedness on household finances. Consequently, the ratio of debt service costs to household debt, which serves as a proxy for average overall household borrowing costs, has declined to a new historical low (also shown in Figure 2). With lending rates on new debt, including refinanced mortgages, generally lower than the rates on existing debt, average borrowing costs are likely to continue their long-running downtrend, but unless households further reduce their overall indebtedness, debt servicing payments should continue to absorb a relatively high share of disposable income. While caution and risk aversion underpin much of this debt contraction, foreclosures or forced debt restructuring under bankruptcy proceedings should also play a role. Debt write-downs by lenders are at record levels and look likely to increase further. For instance, the delinquency rate on consumer (non-mortgage) loans at US commercial banks reached a record 4.0% in Q2 2009 while the delinquency rate on residential real estate loans has risen from 7% in Q3 2008 to 9.6% in Q3 2009. With a record 4.5% of all mortgages currently in foreclosure proceedings, further increases seem all but certain. Whether voluntary or forced, the imperative to reduce debt should remain a significant constraint on aggregate spending for a long time. We believe this pattern of debt reduction reflects an important legacy of the financial crisis – a marked increase in risk aversion – that will continue for the foreseeable future.
Figure 1. Ratio of household debt to annual income Figure 2. The household debt burden

Ratio 1.4 1.3 1.2 1.1 1.0 0.9 0.8 0.7 0.6 Mar-80 Mar-85 Mar-90 Mar-95 Mar-00 Mar-05
Source: Federal Reserve; BEA; Nomura Global Economics.

Ratio 14

Ratio 18

13

16

12

14

11

12

10 10 Mar-80 Feb-85 Jan-90 Dec-94 Nov-99 Oct-04 Debt service/income (lhs) Debt service/debt (rhs)
Note: Debt service/debt ratio calculated by dividing DSR by DYR. Source: Federal Reserve; BEA; Nomura Global Economics.

Nomura Global Economics

16

16 December 2009

2010 Global Economic Outlook

The Fed’s balance sheet

Zach Pandl

The Fed’s balance sheet will continue to evolve in 2010 but we think a complete exit from credit easing remains far off. In an effort to stem the financial crisis, the Federal Reserve augmented its interest rate cuts over the past two years with aggressive use of its balance sheet – a policy Chairman Bernanke termed “credit easing”. The Fed purchased securities outright in order to raise prices and lower interest rates (particularly mortgage rates) and created targeted lending programs to ease the strains in distressed markets. These efforts made monetary policy looser than it would have been otherwise, and as the economy recovers, the Fed will need to decide how and when to withdraw this additional stimulus. Although the composition of the Fed’s balance sheet will change in 2010, we expect its overall size to remain very large at around $2.5trn, and for the stimulus to the economy from credit easing to remain largely in place. We expect the Fed to shrink its balance sheet in earnest only in 2011 and beyond, well after it has begun raising interest rates. Over the near term, the Fed’s assets are likely to continue to grow as it completes its mortgage-related buying programs (Figure 1). To date, the Fed has purchased $156bn in agency debt and $1,071bn in agency MBS. It plans to purchase a total of $175bn and $1,250bn respectively by the end of Q1 2010. It is difficult to overstate the significance of these programs. If the Fed concludes its purchases as scheduled, its holdings of agency MBS alone will be 60% greater than the total size of its balance sheet before September 2008. Once it reaches the purchase targets, we expect the Fed’s security portfolios to be little changed throughout 2010, although it may reintroduce MBS purchases if growth disappoints. After 2010, the Fed’s holdings will gradually mature or pre-pay and it may even choose to sell assets at some point. We expect borrowing through the Fed’s short-term liquidity programs – the other major component of its assets – to continue to decline. However, this should primarily be a demand-driven phenomenon, not a concerted policy tightening. The lending programs are designed in such a way as to make them unattractive in a normal market environment. As market conditions have healed over the last year, for example, borrowing has fallen from about $1.5trn to just $136bn. With limited borrowing, the Fed is likely to begin winding down many of its emergency facilities. Lending through the programs authorized by section 13(3) of the Federal Reserve Act is already quite low, and we expect these facilities to close as scheduled on 1 February 2010. Section 13(3) requires that the Fed demonstrate “unusual and exigent circumstances” before lending to non-standard counterparties, so as long as money market conditions remain normal it will be difficult for the Fed to continue making this claim. We look for the Term Auction Facility (TAF) to remain in place but for its use to gradually decline. The Term ABS Loan Facility (TALF) should remain open through Q2 2010, but it is unlikely to grow to as a large a scale as originally envisioned (for more, see “The Fed’s bulging balance sheet”, Global Weekly Economic Monitor, 30 October 2009). The Fed is also likely to change the composition of its liabilities in 2010, but from the perspective of the broader economy we judge this is not particularly important (Figure 2). The Fed’s authority to pay interest on reserves allows it to influence short-term interest rates even if reserves remain well above minimum required levels. Hiking interest rates while excess reserves remain high would be unusual, but other central banks (e.g., in Norway and New Zealand) have operated under this type of system for some time. Changing the composition of the Fed’s liabilities is also unlikely to constrain credit creation. Instead of holding overnight deposits with the Fed, banks will own repurchase agreements (repos), Treasury Supplementary Financing Program (SFP) bills, and/or term deposits. Substituting one short-term, low-yielding, risk-free asset on banks’ balance sheets for another should not make banks any less willing to lend, or customers less willing to borrow. The Fed’s reserve draining operation could help control the spread between the fed funds rate and the excess reserves rate, but would accomplish little more, in our view.
Figure 1. The Federal Reserve’s assets Figure 2. The Federal Reserve’s liabilities

$bn 2,750 2,500 2,250 2,000 1,750 1,500 1,250 1,000 750 500 250
Liquidity programs, TALF and emergency aid

Forecast All other assets

$bn 2,750 2,500 2,250 2,000 1,750

Forecast All other liabilities Treasury deposits Overnight bank deposits Term deposits

Agency debt and MBS

1,500 1,250 1,000 750 500 250

Treasuries

Reverse repos Notes in circulation

0 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10
Source: Federal Reserve, Nomura Global Economics.

0 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10
Source: Federal Reserve, Nomura Global Economics.

Nomura Global Economics

17

16 December 2009

2010 Global Economic Outlook

United States ⏐ Economic Outlook

David Resler ⏐ Zach Pandl ⏐ Aichi Amemiya

Strong finish to 2009, but cooler growth ahead
The US economy is ending 2009 on an upbeat, but persistent debt woes in the household and finance sectors are likely to prevent further acceleration. Activity: A revival of consumer spending, a rebound in residential investment, and a slower drawdown of inventories lifted the economy out of recession in Q3 2009. Although the revised 2.8% growth was slightly less than first estimated, subsequent developments suggest the overall pace of growth will accelerate in Q4 before moderating to a sustainable pace averaging about 2.8% in 2010. Key to this more confident outlook has been the improvement in the job market. Payrolls have not risen in two years, but staffing cutbacks have subsided and more firms have resumed hiring. We expect continuing improvement – and finally, gains in employment – to form the foundation of a sustained expansion. In the first few months of the year, hiring of upwards of 1 1/4 million workers for the 2010 Decennial Census is likely obscure the sustainable recovery of permanent jobs. While the economy is no longer contracting overall, activity, especially in such key sectors as housing and autos, is likely to remain far below the levels that have been customary for the past two decades. Consequently, the unemployment rate looks likely to remain well above 9% in the year ahead, not falling below this until Q3 2011. Inflation: The excess productive capacity evident in the stubbornly high jobless rate is likely to exert persistent downward pressure on wages and prices. Under conditions of persistent excess capacity, the massive expansion of the Fed’s balance sheet poses little imminent inflation threat. Consequently, we expect core inflation to continue its cyclical slide, reaching 1% by the end of 2010 and edging still lower during 2011 Policy: We believe the Fed will maintain an “exceptionally low” set of interest rate targets into early 2011. With financial market conditions improving steadily, we believe the Fed will not need to undertake any further expansion of its credit easing programs and will be able to manage an orderly exit strategy as conditions warrant. Proponents of further fiscal stimulus face a difficult challenge of persuading those fearful of the long-run implications of large budget deficits. The evolution of labor market conditions in the early months of 2010 could prove decisive in the debate over fiscal policy. Risks: Rising unemployment could undermine the expected recovery in housing and consumer spending. Additionally, if long-run inflation expectations shift downward or potential output proves resilient, a deflation problem more serious than we currently expect could develop. Details of the forecast
% Real GDP Personal consumption Non residential fixed invest Residential fixed invest Government expenditure Exports Imports Contributions to GDP: Domestic final sales Inventories Net trade Unemployment rate Non-farm payrolls, 000 Housing starts, 000 saar Consumer prices Core CPI Federal deficit (% GDP) Current account deficit (% GDP) Fed funds 3-month LIBOR TSY 2-year note TSY 5-year note TSY 10-year note 30-year mortgage 0-0.25 0.29 0.95 2.31 3.31 5.04 0-0.25 0.25 0.80 2.25 3.50 4.95 0-0.25 0.25 0.95 2.40 3.55 5.00 0-0.25 0.25 1.10 2.50 3.60 5.05 0-0.25 0.30 1.20 2.60 3.65 5.05 0-0.25 0.45 1.40 2.80 3.80 5.20 0.50 0.70 1.70 2.95 3.95 5.35 0.75 0.90 1.80 3.05 4.00 5.40 3Q09 2.8 2.9 -4.1 19.5 3.1 17.0 20.8 2.8 0.8 -0.8 9.6 -199 589 -1.6 1.5 4Q09 3.5 2.3 -6.1 13.6 0.1 17.0 14.5 1.4 2.2 -0.1 10.1 -57 585 1.5 1.8 1Q10 2.9 2.7 -5.0 12.5 0.1 7.8 4.8 1.8 0.9 0.2 10.1 163 642 2.5 1.6 2Q10 2.6 2.4 -3.1 17.7 0.8 6.1 5.2 2.0 0.6 -0.1 9.9 286 722 2.3 1.3 3Q10 2.8 2.1 0.7 15.2 0.2 8.7 6.9 2.0 0.8 0.0 9.6 -5 763 1.6 1.2 4Q10 2.7 2.1 3.2 9.3 0.3 9.1 5.0 2.1 0.3 0.3 9.3 250 794 1.0 1.0 1Q11 2.4 1.4 5.0 8.7 -0.4 8.1 4.1 1.6 0.4 0.4 9.2 250 833 0.9 1.0 2Q11 2.4 2.2 5.3 8.4 -0.6 6.2 4.6 2.2 0.2 0.1 9.0 250 863 1.0 0.9 2009 -2.5 -0.5 -18.1 -20.0 2.0 -10.0 -14.0 -2.8 -0.7 1.0 9.3 -344 561 -0.3 1.7 -10.0 -3.1 0-0.25 0.25 0.80 2.25 3.50 4.95 2010 2.7 2.3 -3.9 12.0 1.0 9.6 7.4 1.8 0.9 0.0 9.7 174 730 1.9 1.3 -9.5 -3.4 0-0.25 0.45 1.40 2.80 3.80 5.20 2011 2.6 2.1 4.1 10.7 -0.2 7.2 5.1 2.1 0.3 0.1 8.8 238 900 1.0 0.9 -7.3 -3.4 1.00 1.20 2.10 3.25 4.10 5.50

Notes: Quarterly real GDP and its contributions are seasonally adjusted annualized rates (saar). Unemployment rate is a quarterly average as a percentage of the labor force. Nonfarm payrolls are average monthly change during the period. Inflation measures and calendar year GDP are year-over-year percent changes. Interest rate forecasts are end of period. Housing starts are period averages. Numbers in bold are actual values, others forecast. Forecasts reflect data as of 16 December. Source: Nomura Global Economics.

Nomura Global Economics

18

16 December 2009

2010 Global Economic Outlook

Euro area ⏐ Outlook 2010

Laurent Bilke ⏐ Maxime Alimi

Headwinds
The headwinds that we expected to sow the seeds of a very sluggish recovery have proven less forceful than anticipated – but the recovery will still be a long haul through 2010. We paint a fairly balanced picture of the euro-area economy in 2010. Among the developed economies, the euro area as a whole is not where the deleveraging burden will be the strongest, and a soft recovery seems already underway. But a strong euro and the beginning of a tightening of monetary conditions will prevent the economy from reaching cruising speed by the end of 2011. Still, we revise up our GDP growth forecasts to -3.9% in 2009, to 1.1% in 2010 and to 1.7% in 2011 (from -4.0%, 1.0% and 1.3%, respectively; Figure 1).

Positive momentum
The euro area officially pulled out of recession in Q3 2009, with GDP expanding by 0.4% q-o-q (non-annualised). Since our last forecasts (see Long convalescence, 10 July 2009), surprises have been to the upside. Short-term effects have pushed activity above trend and a slowdown is likely in the coming quarters, but we see no reason to expect a relapse. In particular, automatic stabilisers, which account for most of the fiscal response in the region, do not add volatility in the same way that discretionary interventions would.
The economy is still driven by exports

The euro area is well positioned to benefit from recovering emerging economies and this will play an important role in jumpstarting the economy, despite the strength of the euro (Figure 2). While the strong rebound in foreign demand in Q3 2009 was probably due to trade disruptions in the first half, the euro area remains geared to benefit from a pick-up in infrastructure-led investment, especially in Asia. According to Bundesbank data, the share of German exports to Asia has risen from 10% in 1999 to 14% in 2009. Looking ahead, we expect the trade surplus to continue expanding in the short term and net trade to add 0.8pp to GDP growth in 2010. On the domestic side, recent labour market developments have clearly been better than anticipated, largely because of proactive government measures (see Box: Good work). A largerthan-usual share of the burden of the adjustment in the workforce has relied on hours worked rather than headcount. Moreover, the rise between the low-point in March 2008 (7.2%) and the latest print (9.8% in October 2009) is sizable, but reflects mostly events in Spain; labour markets in the other economies have held up remarkably well (Figure 3). These revisions in employment as well as the general improvement in economic conditions lead us to revise our forecast for the unemployment rate drastically: we believe the unemployment rate is now topping out, peaking at 10.1% in H1 2010, before a very gradual decline to 9.4% by the end of our forecast horizon.

Hours worked, rather than the number of jobs, have fallen

More balanced investment
A specific reason to be more positive (or more precisely, less negative) on the investment outlook is credit conditions. We previously were negative on investment growth due to concerns that credit supply might be restricted. Our baseline scenario also incorporated a spread on bank interest rates. A few months on, it is difficult to find any compelling evidence of the materialisation of either. By most measures, the credit slowdown did not seem to go beyond a
Figure 1. Main forecast changes
% July 2009 Real GDP growth HICP inflation Unemployment rate ECB policy rate 10-y Bund yield Fiscal balance -4.5 0.4 10.4 1.00 3.10 -5.9 2010 0.6 1.1 11.4 1.25 3.50 -6.9 2011 1.3 1.5 11.6 1.75 3.75 -5.9 2009 -3.9 0.3 9.4 1.00 3.20 -6.4 December 2010 1.1 1.2 10.0 1.25 3.60 -6.9 2011 1.7 1.5 9.6 2.25 3.80 -6.4

Figure 2. Foreign demand

% y-o-y 15 10 5 0 -5 -10 -15 July December

Annual averages, except unemployment rate and interest rates which are end of period. Unemployment rate is % labour force and fiscal balance is % of GDP.

-20 1Q06 4Q06 3Q07 2Q08 1Q09 4Q09 3Q10 2Q11
Source: Eurostat, ECB, Bloomberg, Nomura Global Economics. Source: Nomura Global Economics.

Nomura Global Economics

19

16 December 2009

2010 Global Economic Outlook

Good work

Laurent Bilke ⏐ Maxime Alimi

European governments have reacted swiftly to the global downturn by adopting measures that have helped damp the rise in unemployment. We have therefore revised our labour market outlook significantly. Recent labour market developments have been clearly better than anticipated. Back in July, we were expecting the unemployment rate for the euro area as a whole to rise from 8.7% in Q1 2009 to 10.4% in Q4 2009 and to peak at 11.6% in mid-2011. But the outcome has been much better than we expected, with unemployment at 9.8% in October. Apart from Spain, labour markets in the largest economies have held up remarkably well.

Cutting hours, not headcount
Some might argue that the adjustment has just been postponed, that further deterioration of the labour market lies ahead. But we see good reason for the resilience of the labour market: policies. Proactive government measures, exemplified by Germany’s short-shift scheme, have helped avert a sharp rise in layoffs. The German scheme has allowed firms to keep workers in employment on reduced hours (700,000 workers were participating in the scheme at the peak, in February 2009, according to the German labour agency), curbing the rise of outright unemployment. Italy has taken a similar approach: the “Wage Supplemental Fund” (CIG), a government scheme that compensates workers for part of the loss of income stemming from reduced hours, has been extended to additional categories of workers. In France, too, employment policies have been key to capping the rise in unemployment. One scheme provides subsidies to firms to allow them to make temporary cuts in working hours without major income losses on employees (90% of net compensation is maintained). About 157,000 people benefited from the scheme in Q1 2009, rising to 320,000 people in Q2. Labour costs have been targeted as well: all new hiring (or extension of temporary work) by small firms has been largely exempted from social security contributions – with full-exemption at the minimum wage level. The measure has benefited more than 600,000 people and is scheduled to remain in place until June 2010. A number of other schemes have also been deployed, including support for job reconversion or business creation. Conversely, Spain has registered very heavy job destruction since early 2008, boosting the unemployment rate to close to 20% (Figure 1). This stems from the collapse of labour-intensive sectors such as construction, where most workers were employed on a temporary basis and their contracts not renewed. The reallocation of these workers towards growing sectors will likely be a slow process. So, the smaller-than-expected rise in the unemployment rate does not mean that labour adjustment has not occurred. Rather, it has occurred in a different way: less through a reduction of headcount (layoffs) and more through a reduction of hours (short shifts). This is confirmed by Eurostat data on average weekly hours worked (Figure 2). This is probably a better balance for the economy as less work is better for confidence than no work at all. We see this extraordinary policy reaction as the main reason why the rise in unemployment has been relatively contained in the euro area and looks likely to remain so. We would expect the reversal of these schemes to be very gradual, if at all, and we acknowledge that our negative view on labour market developments a few months ago may not have been entirely warranted. Adding this factor to the general improvement in economic conditions leads us to revise significantly our forecast for unemployment: we now expect the rate to peak at 10.1% in the first half of 2010, followed by a very gradual decline to 9.4% by the end of our forecast horizon.

Figure 1. Unemployment in the euro area

Figure 2. Average weekly hours worked

Contribution to % change y-o-y 30 25 20 15 10 5 0 -5 -10 -15 Jan-06 Aug-06 Mar-07 Oct-07 May-08 Dec-08 Jul-09
Source: Eurostat and Nomura Global Economics.

Hours / week 38.5 38.0 37.5 37.0 36.5 36.0 2Q99 1Q01 4Q02 3Q04 2Q06 1Q08
Source: Eurostat and Nomura Global Economics.

Other Spain Italy France Germany

Nomura Global Economics

20

16 December 2009

2010 Global Economic Outlook

normal, albeit severe, cyclical downturn. A very detailed survey conducted by the ECB in September 2009 on the access to financing provided some interesting evidence previously missing from the picture (Figure 4). Risk premia on bank loan interest rates (or margins) have also come in much lower than we previously anticipated.
Investment growth is likely to stay muted

That said, we are not yet ready to declare the corporate sector all-clear. There are balancesheet adjustments to be made by non-financials in some countries, notably France and Spain (see “Europe Inc: Protracted belt-tightening” in Long convalescence, 10 July 2009). The persistence of spare capacity in the productive sector will not accelerate the recovery either. Overall, we forecast investment growth to recover only slowly, declining by 1.3% in 2010 and growing again by 1.5% in 2011.

Euro problem
Exports have been the motor of the euro-area economy in recent years, making the current recovery crucially dependent on foreign demand. Since 2003, wage moderation has contained private consumption but improved competitiveness and fuelled export performance, positively looping back on investment and employment. We see no real reason for more domestically driven momentum today and we expect exports, not consumption, to kick-start the economy. For this reason, the current euro appreciation comes at an inopportune time: just as foreign demand is needed to help put the economy on a proper recovery path.
The euro is a powerful negative drag

Our FX strategy team forecasts the euro to stay at its current elevated level in trade-weighted terms for another year, as its appreciation against the US dollar (which would reach 1.60 in Q4 2010) would offset any depreciation against other currencies (see Box: Euro strength may prolong euro-area weakness). The currency effect is likely to take its toll on economic activity in both 2010 and 2011, given the usual transmission lags. It is reinforced by the other lag between import and export growth in an externally driven recovery, as exports rise first and imports catch up later when domestic demand improves. Hence the contribution of net trade to growth is significantly reduced in our model in 2011.

Muted inflation in 2010
We see inflationary pressures emerging only in 2011

The inflation outlook is likely to remain benign for most of 2010, especially on the assumption that the oil price would stay stable at the current level until the end of our forecast horizon. We do not expect external inflationary pressures to contribute positively to inflation before the start of EUR depreciation, in early 2011. On domestic inflationary pressures, the process by which a weak economy translates into low inflation is a very protracted one. Hence, we forecast core inflation (excluding food, energy, alcohol and tobacco) to bottom only late in 2010 and start to accelerate only very gradually in 2011 as wage pressures and margins improve. As such, we see core inflation decelerating further from 1.4% in 2009 to 1.1% in 2010 and accelerating modestly to 1.2% in 2011. In our forecasts, headline inflation reaches 0.3% in 2009, 1.2% in 2010 and 1.5% in 2011 (Figure 5).

Undeclared monetary policy tightening...
At a time when most central banks are gradually becoming more concrete about their exit strategies, the ECB stands out as the central bank that has started to withdraw some of its
Figure 3. Unemployment rate forecasts
Euro area July 2008 2009 2010 2011 7.6 10.4 11.4 11.6 Euro area Germany France December 7.6 9.4 10.0 9.6 7.8 8.3 8.9 8.5 7.4 9.2 9.8 9.4 Italy Spain

Figure 4. Limited mismatch between loan demand and supply

%, obtained loan 50 40 GE 30 FR Oth. SP IT SP IT GE

6.8 7.6 8.4 8.0

11.4 18.3 20.0 19.3

20
% of labour force, annual average

10 10
Source: Eurostat, ILO, Nomura Global Economics.

FR 20 30 40

%, needed loan 50

Note: Diamonds signify large firms; circles signify SMEs. Source: ECB, Nomura Global Economics.

Nomura Global Economics

21

16 December 2009

2010 Global Economic Outlook

Euro strength may prolong euro-area weakness

Maxime Alimi

With the euro appreciating and looking set to stay high throughout our forecast horizon, we expect a negative currency impact on euro-area activity and prices in 2010 and 2011. For an economy heavily reliant on exports to foster GDP growth, significant currency appreciation can seriously threaten economic prospects, particularly in a fragile recovery phase. The euro has appreciated for several reasons over the past few months (see Nomura FX Outlook 2010, Beyond peak performance) and we expect this strength to persist into 2010, affecting activity through trade, prices through imports and, possibly, monetary policy. From an economic point of view, what matters most is the effective, or trade-weighted, exchange rate of a currency, rather than any individual bilateral rate. On this measure, the euro had appreciated by 8.6% y-o-y in November against a basket of its 21 main trading partners’ currencies, reaching its highest level since the ECB series started in 1993. Nomura FX strategists expect this trend to fade in 2010, but the euro should remain high throughout 2010 before experiencing a gradual correction in 2011 (Figure 1). This would still leave the euro significantly above most structural fair value measures until the end of our forecast horizon. When compared with our July forecast, the revision represents a 10% appreciation in December 2010 and 3% as of Q4 2011. In our Nomura Euro-area Economic Model (NEEM) model for the euro area, FX assumptions are exogenous and taken into account through various channels: (i) on the activity side, a strong euro curbs exports and fosters imports as prices do not adjust immediately; (ii) on the prices side, the currency affects import and export prices, including commodity prices. Consequently, our new profile for the euro has a clear negative impact on both activity and inflation: Figure 2 shows the FX contribution to the revisions we make to GDP and inflation in the euro area compared to our July European Economic Outlook. Given lags in the transmission of currency moves to prices, the impact that we expect in our inflation forecast should be felt both in 2010 and 2011, despite the contemporaneous cooling of the euro. For the growth outlook, euro strength dampens our baseline scenario of a largely export-led recovery: the model predicts a 1.5pp negative impact from the currency on real exports in 2010, crucially looping back on investment and employment. The net trade contribution to GDP is reduced from 1.2pp to 0.9pp in 2010. On the prices side, the euro appreciation is slower but has even more of an impact on our forecast, trimming 0.2pp and 0.8pp from 2010 and 2011 inflation. This magnitude is explained not only by the import prices channel, but also by our model’s assumption that second-round effects allow wages to adjust to inflation shocks over two quarters – a somewhat extreme assumption that keeps the model stable in the longer run. Because of exchange rate developments and very gradual rises in commodity prices (be they for energy, food or metals), external price pressures remain limited in our forecast (import prices drop 5.2% in 2010 and rise 1.2% in 2011). Exchange rate developments could also result in heightened divergences within the region, already driven by contrasting economic outlooks. Because of differences in trade specialisation, competitiveness and mark-up flexibility, countries like Germany could be less affected than others (e.g., Spain and Greece) that rely on price more than product competitiveness. For instance, capital goods, which are less sensitive to currency developments, account for 28% of German exports, but only 17% for Portugal, 14% for Spain and 11% for Greece. Against this backdrop, the euro burden is unlikely to be shared equally.

Figure 1. Trade-weighted euro against 21 trading partners

Figure 2. FX contribution to GDP and inflation revisions

Index 120

Baseline July forecast

0.0 -0.1 -0.2

110

-0.3 -0.4

100

-0.5 -0.6
2010 2011

90

-0.7 -0.8

80 Jan-93 Mar-96 May-99 Jul-02 Sep-05 Nov-08
Note: Lower is weaker. Source: ECB and Nomura FX Strategy.

-0.9 pp

GDP growth

Inflation

Source: Nomura Global Economics.

Nomura Global Economics

22

16 December 2009

2010 Global Economic Outlook

exceptional support. We see a good chance that it will complete this process before the end of 2010. Albeit gradual, the removal of these measures (see Box: Liquidity withdrawal roadmap) should have two sizeable effects: it will cause short-term interest rates to rise and it will tighten European banks’ financing conditions. Indeed, the ECB’s liquidity policy has had two major, largely inseparable consequences. First, it was the equivalent of about 75bp of rate cuts on the overnight rate. Owing to the ECB’s liquidity provision policy, all money-market rates tended to settle lower than they would normally have done relative to the ECB main refinancing rate. But it is on the short end (overnight) that the strongest effect was felt. The second effect has been to secure banks’ funding, as the ECB provided ample liquidity at unusually long maturities. While the first effect was remarkable, it was actually just a by-product of the central bank’s intention to secure banks’ funding, thereby contributing to financial stability at a time of extreme tension.
The normalization of ECB operations means higher rates

The ECB now sees drawbacks in maintaining its generous liquidity provisions. There is a presumption that, if maintained for too long, these conditions would prevent some banks from doing what is required – writing-off losses, raising new capital and conducting the necessary restructuring that the change in their business models should dictate. Therefore it ought to be expected that the ECB normalizes the conditions under which it provides liquidity, even though this is the (partial) equivalent of a rate hike. Such normalization is likely to be completed, in our opinion, around the end of Q3 2010: in September 2010 the overnight rate would be above the ECB main rate (1%), settling in somewhere between 1.05% and 1.15%. We account for most of the interest rate effect on the economy as short-term interest rates move up around mid-2010, causing banks’ interest rates to rise. Some of the tightening will likely come by euro strength as well. The effect on banks financing conditions is more difficult to capture. We have assumed little effect, presuming that the removal of ECB support will cause difficulties for only minor, non-systemic banks – actors that would not have contributed to a peak in credit anyway. But this is still a source of downside risk to our baseline.

... and declared tightening
We bring forward the first rate hike from December 2010 to October

Given the effect on money-market rates, such an unheralded tightening would leave only little room for an announced tightening. But the ECB likes to keep liquidity policy separate from monetary policy, viewing the two areas as distinct; a debatable stance, but we accept it as a given for our forecasting purposes. Thus, in the face of persistent rhetoric, the general improvement in economic conditions and the ECB’s commitment to perform a timely exit, we bring forward our expected date for the first rate hike from December 2010 to October 2010. We do expect rising inflationary pressure toward the end of our forecast horizon as headline inflation reaches 1.9% y-o-y in December 2011. We have previously highlighted that an easing in the cost of financing would be an important force driving the economy out of recession. The assessment is straightforward this time around: interest rates can only go up from here and the ECB is likely to make this a real prospect. Taking into account exchange rates and interest rate developments, monetary conditions eased continuously through 2009, despite the appreciation of the euro (Figure 6). Looking at 2010 and 2011, monetary conditions are likely to contribute negatively to growth in Europe.

Interest rates can only go up

Figure 5. Inflation forecast

Figure 6. Monetary condition index

% y-o-y 5.0 4.0 Headline Core

Index 160 Tighter

Exchange rate Corporate bond spreads Bank interest rates

120 3.0 2.0 1.0 40 0.0 -1.0 Jan-06 Dec-06 Nov-07 Oct-08 Sep-09 Aug-10 Jul-11
Source: Eurostat and Nomura Global Economics.

80

0 Dec-96

Jul-99

Feb-02

Sep-04

Apr-07 Nov-09

Source: Nomura Global Economics.

Nomura Global Economics

23

16 December 2009

2010 Global Economic Outlook

Liquidity withdrawal roadmap

Laurent Bilke

The ECB’s unwinding of liquidity support is set to have large effects on interest rates, even before the first main rate hike. In the euro area, unconventional monetary policy has taken a very specific form and, we would argue, with some success (in spite of a late start). The central bank has exploited a specific aspect of credit provision in Europe: it is predominantly done by banks, rather than by capital markets, and off its own balance sheet structure; it mainly makes loans to banks rather than purchases securities. The exceptional measures deployed by the ECB during the crisis have targeted banks and relied on: 1) the provision of ample liquidity (through lending) in order to fully satisfy banks’ extraordinary demand (“full allotment”); 2) at longer maturities than usual (up to one year, as opposed to 3 months before the crisis); and 3) against a wider range of collateral. These policies have helped banks secure funding. But they also have had some sizeable effects on money-market interest rates. The “full allotment” policy implied that the overnight market rate was actually pushed down towards the level at which the ECB takes back liquidity, which is the deposit rate (0.25% as of December 2009), while longer term money-market rates were anchored at the main rate (1%). The ECB started the unwinding in December 2009 and will implement it in several steps, most likely finishing by the end of 2010. As of December 2009, the ECB is committed to keeping the full allotment policy until at least mid-April 2010; to lower, or stop altogether, the number of liquidity provision operations at the longest maturities (6 and 12 months); and to conserve an extended collateral base until the end of 2010. We see this as preparatory work ahead of policy unwinding, which is likely to be implemented in three steps: In Q1 2010, liquidity conditions will be comparable to those prevailing at the end of 2009. Hence, the spread between the overnight rate and the ECB main rate is likely to persist, while there is some possibility that the Euribor 12M starts to de-anchor from the ECB rate (also incorporating some rate hike expectations); In Q2 2010, we assume that the ECB will stop the 6M operations and reduce the 3M ones, but carry on with full allotment at the 1-week maturity. As long as the last element is in place, the overnight rate should be comfortably below the main rate, but the longer end would more clearly de-anchor. From Q3 2010 on, excess liquidity would be gradually removed. As a result, the overnight rate would move above the main rate, which presumably would still be 1% at that time. There are two risks associated with this scenario. The first is that stage three starts earlier, in Q2 2010. One indicator which is going to be decisive in that respect is the Libor-OIS spread: a return to pre-crisis levels (not our baseline) by mid-2010 would likely trigger more forceful action. The second source of risk stems from uncertainty regarding the transmission channel. There has not been a linear relationship between excess liquidity and the EONIA-ECB rate spread under this regime in 2009 (Figure 1). We assume that the spread could be maintained as long as the ECB carries on with the full allotment policy at 1-week operations, but a level shift as excess liquidity diminishes below a certain, unpredictable, level cannot be ruled out. So the increase in the overnight rate may not be as smooth as we forecast. All in all, we assume than the overnight will start a long and gradual march up, from Q2 2010 onwards (Figure 2), reaching 1.30% by end-2010, up from 0.35% a year earlier. By the end of 2011, outright monetary policy would be dominant, bringing the overnight rate up by another 100bp higher, to about 2.30%.
Figure 1. Excess liquidity and spread to main rate Figure 2. Interest rates forecasts

€ bn 300 250 200 150 100 50 0 02/01/09 02/04/09 02/07/09 02/10/09

bp 20 0 -20 -40 -60 -80 -100 Excess liquidity (lhs) EONIA- ECB main rate spread (rhs)

% 3.00 2.50 2.00 1.50 1.00 0.50 0.00 3Q09 1Q10 3Q10 EONIA 1Q11 3Q11 3mth Libor ECB main rate

Source: ECB, Bloomberg and Nomura Global Economics.

Source: ECB, Bloomberg and Nomura Global Economics

Nomura Global Economics

24

16 December 2009

2010 Global Economic Outlook

Euro area ⏐ Economic Outlook

Laurent Bilke ⏐ Maxime Alimi

Constrained recovery
We expect a constrained recovery in 2010, with modest growth driven mostly by external demand. Nevertheless, and despite muted inflation, the ECB looks set to start tightening. Activity: The recession ended in Q3 2009 and we are looking for positive, albeit modest, growth in Q4 and throughout 2010. We expect a slowdown in the first quarter because of the payback of expiring car-scrappage programmes in various countries and fading catch-up boosts. Trend growth should settle at sub-potential levels as fixed investment remains weak, consumers cautious and as governments rein in fiscal stimuli. Exports, set to remain the first motor of the economy, may be impaired by a strong euro. An important theme for 2010 is divergence in the region, as already illustrated in sovereign debt markets. While Germany may outperform, we expect several countries, including Spain, to register falls in GDP for the whole year. Inflation: Headline inflation is likely to remain subdued in 2010. Externally, we expect no substantial commodity price inflation and a strong euro will push down import prices. Domestically, limited room for mark-ups, still-large spare capacity in the manufacturing sector and high unemployment should keep wages and inflation in check. We forecast HICP to average 1.2% in 2010 and core inflation to remain below that, at 1.1%. Policy: On the monetary policy side, the ECB is initiating a withdrawal of its liquidity support, which is a form of monetary policy tightening, though the central bank does not present it that way. The exceptional provision of liquidity had sizeable effects on money-market interest rates. Hence, when the ECB embarked on a withdrawal of liquidity support in December 2009, in a slightly more aggressive way than expected, it did initiate a tightening. We expect the bulk of the upside effect on money-market rates to appear in Q3 2010, though, and the first hike in the main policy rate could take place in October 2010, on our forecasts. On the fiscal side, the withdrawal of support is set to be smoother and slower than in the case of monetary policy because of the significant role played by automatic stabilisers. Risks: Risks look balanced: to the upside, inventory rebuilding and a lower euro than we assume could boost activity further next year; to the downside, a larger-than-expected commodity price recovery and further damage to the banking system are the main risks (possibly in relation to a too prompt removal of the central bank liquidity facility).

Details of the forecast
% Real GDP Household consumption Fixed investment Government consumption Exports of goods and services Imports of goods and services Contributions to GDP: Domestic final sales Inventories Net trade Unemployment rate Compensation per employee Labour productivity Unit labour costs Fiscal deficit (% GDP) Current account deficit (% GDP) Consumer prices Core consumer prices ECB main refi. rate 3-month rates 10-yr bund yields $/euro -0.4 1.3 1.00 0.72 3.22 1.46 0.5 1.2 1.00 0.65 3.20 1.55 1.2 1.2 1.00 0.80 3.30 1.52 1.1 1.1 1.00 0.90 3.50 1.55 1.2 1.2 1.00 1.23 3.60 1.57 1.1 0.9 1.25 1.45 3.70 1.60 1.2 1.0 1.50 1.70 3.70 1.55 1.3 1.1 1.75 1.95 3.75 1.50 3Q09 1.5 -0.9 -1.5 2.1 12.2 10.8 -0.4 1.3 0.6 9.6 -0.3 0.8 -1.1 4Q09 1.5 0.0 -1.5 2.0 10.8 9.1 0.1 0.6 0.7 9.8 0.0 0.7 -0.7 1Q10 0.7 -1.0 -2.1 2.0 5.0 0.9 -0.6 -0.4 1.7 10.1 0.4 0.4 0.0 2Q10 1.4 0.9 -0.2 2.0 4.5 3.6 0.9 0.1 0.4 10.1 0.3 0.5 -0.1 3Q10 1.4 1.2 0.7 2.0 3.1 3.8 1.2 0.4 -0.2 10.0 0.5 0.4 0.1 4Q10 1.4 1.3 1.3 2.0 3.1 3.9 1.4 0.3 -0.3 9.9 0.6 0.4 0.2 1Q11 1.7 1.3 1.8 2.0 5.2 4.4 1.5 -0.2 0.4 9.8 0.6 0.4 0.2 2Q11 1.9 1.2 2.0 2.0 6.1 4.9 1.5 -0.1 0.6 9.7 0.7 0.5 0.2 2009 -3.9 -1.0 -10.0 2.4 -13.4 -11.2 -2.2 -0.6 -1.1 9.8 1.1 -1.3 2.4 -6.4 -0.6 0.3 1.4 1.00 0.65 3.20 1.55 2010 1.1 0.0 -1.3 2.1 5.8 3.8 0.3 0.0 0.8 9.9 0.5 0.4 0.0 -6.9 -0.2 1.2 1.1 1.25 1.45 3.70 1.60 2011 1.7 1.2 1.5 2.0 4.9 4.3 1.4 0.0 0.3 9.4 0.7 0.5 0.3 -6.4 0.0 1.5 1.2 2.25 2.45 3.80 1.40

Notes: Quarterly real GDP and its contributions are seasonally adjusted annualized rates. Unemployment rate is a quarterly average as a percentage of the labour force. Compensation per employee, labour productivity, unit labour costs and inflation are y-o-y percent changes. Interest rate and exchange rate forecasts are end of period levels. Numbers in bold are actual values, others forecast. Source: Eurostat, ECB, Datastream and Nomura Global Economics.

Nomura Global Economics

25

16 December 2009

2010 Global Economic Outlook

United Kingdom ⏐ Outlook 2010

Peter Westaway ⏐ Takuma Ikeda

Walking the policy tightrope
The UK economy should start growing in 4Q09 but the recovery looks fragile and uncertainties around fiscal and monetary policy mean there is more scope for policy errors than usual.

The precarious path back to full capacity
We expect growth to be anaemic

Having fallen by nearly 6% we expect UK GDP to begin growing again in the final quarter of 2009. Many short-term forward-looking indicators have been positive and we expect net trade to make an increasing contribution to growth as the influence of the recovering global economy is reinforced by the depreciation of sterling’s real effective exchange rate by over 20% since mid2007 Even so, we still expect growth over the forecast period to be anaemic as the upward impetus from the re-stocking cycle and the uplift from fiscal policy measures both fade. Thereafter, the broad shape of the recovery is dominated by weak growth in consumption and investment as firms and households deleverage and banks continue to restrict lending in an effort to rebuild their balance sheets. By the end of the forecast period, the impact of the beginning of an extended period of fiscal consolidation is also likely to be detracting from growth. As a consequence, we expect growth to remain well below potential in 2010 and only just up to 2.5% through 2011 (Figure 1). In fact, we estimate that the level of UK potential output has suffered a 4% permanent loss from the recession, relative to where it would have been (we think slightly less than the loss estimated by the Bank of England). We estimate that potential growth is some 0.5% per annum lower for the rest of the forecast period; yet despite this the output gap is set to persist and to remain above 3% at the end of 2011. As a result, there is underlying deflationary pressure in the economy. So despite the sharp increase in headline CPI inflation to 2.7% in early 2010 as the VAT rate cut is reversed and as the oil price reaches its full effect, inflation is then set to fall back to around 1% before rising gently to 1.5% through 2011 (Figure 2).

Inflation is set to fall back in 2011

A stronger picture
We see three positives

This outlook for activity and inflation is now somewhat stronger than we outlined in July, although we have upgraded our forecasts by less than the MPC did in its November Inflation Report. This has been driven by three main influences: Higher asset prices, driven by the continuing effects of extremely loose monetary conditions and by the additional actual and potential asset purchases, have helped to drive down bond yields and credit spreads and boost equity prices (up 27% since July) and house prices (up 3.4% since July relative to an expectation they would fall by 0.4%). The resulting wealth effects are the main transmission mechanism of the quantitative easing measures that the MPC has implemented (see Box: Q&A on MPC quantitative easing). But we judge that historically estimated elasticities exaggerate the strength of these effects at a time when the banking system is impaired.

Higher asset prices, …

Figure 1. GDP growth forecast

Figure 2. CPI inflation forecast

% y-o-y 6 4 2 0 -2 -4 -6 2001 2003 2005 2007 2009
Nomura as of Jul 09 BoE's forecast as of Nov 09 Nomura as of Dec 09

%y-o-y
F
6
CPI inflation

F

5 4 3 2 1 0

BoE projection as of Nov 09

2011

2003

2005

2007

2009

2011

Source: ONS, BoE and Nomura Global Economics.

Source: ONS, BoE and Nomura Global Economics.

Nomura Global Economics

26

16 December 2009

2010 Global Economic Outlook

Q&A on MPC quantitative easing

Peter Westaway

Extraordinary monetary easing by the Bank of England has worked, although communication of the transmission mechanism has sometimes confused. Looking forward, the exit strategy is just as challenging but the FSA may help out. Why was QE necessary? By the beginning of 2009, it had become clear that unconventional monetary policies were necessary to augment the already low level of Bank rate set by the Monetary Policy Committee (MPC). A simple Taylor rule would have suggested that policy rates be cut to a negative rate of between -2% and -3% (Figure 1). So in March 2009, as well as cutting Bank rate to 0.5% (deemed to be the effective minimum rate), the MPC embarked upon a series of asset purchases, initially of up to £75bn. By November 2009, the MPC had increased the amount deemed necessary to provide the appropriate additional degree of monetary stimulus to £200bn, comprised almost entirely of gilts. Importantly, these were financed by creating central bank reserves: the modern equivalent of printing money. What is the transmission mechanism of QE? Broadly, there are two. The quantity channel, initially emphasised by the BoE in its communications, is a straightforward monetarist one, positing that the additional reserves on the balance sheets of banks induce them to lend more. But at a time when banks have strong incentives to build up their capital bases and demand for credit is weak, this argument was unconvincing. Even so, its simplicity helped the MPC convey the message that it would do whatever it took. The price channel, now emphasised more by the Bank, works via a portfolio substitution effect driving down the yields of gilts in lower supply (see Figure 2) and driving up the prices of other assets (e.g. equities or foreign assets). The resulting wealth effects drive up demand and stimulate the economy. Isn’t printing money like this inflationary? Yes, but only in the sense of helping the BoE to achieve its inflation target. In the context of a threat of deflation, the MPC wanted to generate some forces acting in an upward direction on prices to help it to return inflation towards its target of 2%. If QE were to be continued indefinitely it would be inflationary, but that is not what an inflation-targeting central bank like the BoE would do. Is this monetising the fiscal deficit? In a way, but all in a good cause – to prevent deflation – and only for as long as necessary. QE will be reversed once the need for extraordinary monetary accommodation is past. Does QE work on monetary conditions as a stock or a flow? The price channel described above predicts that the degree of monetary stimulus will be preserved at a constant level even if the flow of asset purchases is stopped (as we expect it will be from February). So the stock matters. But if the price of gilts is also affected by the balance between demand from the BoE and gilt issuance by the DMO, gilt yields may increase if the flow of QE is stopped, even if the stock is maintained. This is an awkward source of uncertainty for the MPC in determining the start of its exit strategy. When will asset purchases be reversed? The MPC has made it clear that it is in no hurry to sell the gilts back into the market (a prospect that unsettles gilt market participants). We think policy tightening is most likely to take place via rate hikes, partly because their effects are better understood. But when the stock of asset purchases is unwound, the asset price effects described above can be expected to reverse, although the timing of those effects is highly uncertain. Will the proposed new FSA liquidity regulations matter? They could. The proposal for pension funds to hold around £100bn of additional gilts as part of new prudential liquidity regulations could provide a fortuitous way to avoid the Bank having to force feed the gilt market with the gilts it has accumulated during the QE period. However, the timing and scale of this is still uncertain so there is still scope for market indigestion and disruption.

Figure 1. Warranted UK policy rates are negative

Figure 2. QE-induced relative fall in UK gilt yields
bp, change since 1 February 2009 40 20 0 -20 -40

% 10 8 6 4 2 0 -2 -4 1997 2000

Bank rate Nomura forecast Taylor rule

-60 -80

Intended QE effect 2003 2006 2009

-100 Feb-09

Apr-09

Jun-09

Aug-09 UK

Oct-09 US

Dec-09

Euro area

Source: ONS and Nomura Economics.

Note: 5-year government bond yield - 5-year OIS swap rate Source: Bank of England and Nomura Global Economics.

Nomura Global Economics

27

16 December 2009

2010 Global Economic Outlook

… a lower exchange rate …

Another expansionary influence on activity growth has been the 5% depreciation of sterling’s effective exchange rate since July. This, together with the larger depreciation of some additional 15% since mid-2007 and the improving prospects for the global economy (forecast to grow by about 1% per annum more strongly over the forecast period), has helped to boost the contribution of net trade to growth by around 0.5% per annum (Figure 3). The third positive influence has been the benign response of the labour market during the recession. Unemployment has risen to just below 8% but given the size of the drop in activity, it might have been expected to rise more steeply given labour market performance in previous downturns. This can partly be attributed to a reduction of hours worked rather than of employee numbers. But there is also evidence that real wages per head have become more responsive to the cycle, helping to mitigate rises in unemployment. Given the effect this has on consumer confidence and associated effects, we estimate this may have boosted consumer spending by around 0.5pp.

… and a more benign labour market

Risks on both sides
The MPC and the Chancellor face difficult judgements in balancing the considerable risks on both sides of our central forecast.
How much inflationary pressure exists is uncertain

There is considerable uncertainty about the output gap. If at one extreme, no capacity has been destroyed (as in the “no-loss assumption” in Figure 4) then the degree of deflationary pressure could be much larger and the risk is that tightening is premature. But if even more capacity has been destroyed, for example through the scrapping of capital during the recession, then the output gap may close more rapidly and inflation could re-emerge more quickly (for more, see “Icebergs to port and starboard” in the Global Weekly Economic Monitor, 20 November 2009). There is also a delicate judgement to be taken on the stance of fiscal policy. By withdrawing fiscal stimulus too soon, the nascent recovery may be snuffed out before private sector demand growth has time to recover. On the other hand, in the absence of a credible commitment to undertake future fiscal consolidation, the risk premium on UK gilts might rise and a loss of confidence might lead to a sterling crisis. The updated plans set out by Chancellor Alistair Darling in his recent pre-Budget report, largely unchanged from Budget 2009, have not resolved this uncertainty.

Managing fiscal policy is tricky

Judging the exit strategy
Considerable risks exist on either side of our call

The MPC has made it clear that it will begin its exit from the extraordinary monetary easing by raising interest rates first and by selling the stock of gilts back into the market much later (see Box: Q&A on MPC quantitative easing) The MPC forecasts inflation to be broadly on target at the two- to three-year horizon, conditioned on a market interest rate curve factoring in rate rises beginning around August 2010. Since our forecast is slightly softer, we see the first rate hike coming later, probably at the time of the November 2010 Inflation Report and to raise rates gradually thereafter to 1.5% by the second half of 2011. But there are considerable risks to that call in both directions.

Figure 3. Net trade contribution vs GBP effective exchange rate

Figure 4. Output gap under no-loss and 4%-loss assumptions

pp 3 2 1 0 -1 -2 -3 -4 -5 Dec 09 Jul 09 Dec 09 effective exchange rate (rhs)

Index 70 75 80 85 90 95 100 105 110

% 2 0 -2 -4 -6 -8 -10 2005 2006 2007 2008 2009 2010 2011 No loss of potential 4% loss + slower potential growth

1990 1993 1996 1999 2002 2005 2008 2011
Source: ONS and Nomura Global Economics.

Source: ONS, BoE and Nomura Global Economics.

Nomura Global Economics

28

16 December 2009

2010 Global Economic Outlook

United Kingdom ⏐ Economic Outlook

Peter Westaway ⏐ Takuma Ikeda

Better prospects, but risks persist on both sides
We and the MPC have raised our forecasts for UK activity and inflation. But the MPC split vote has emphasised the uncertainties facing fiscal and monetary policy. Activity: Forward-looking PMI indicators are consistent with a return to positive growth in Q4. We expect GDP to be around 1.5pp higher on average in 2010 relative to 2009. Activity is being boosted by strong asset prices and an increasing contribution from net trade, driven by the recovering global economy and sterling depreciation. But with no immediate prospect of a return to potential growth, let alone above-potential growth, we expect the significant output gap to persist. Consumption growth, once the main engine of growth, looks likely to remain weak amid earnings deterioration and as households continue to deleverage. Inflation: We expect CPI inflation to rise from October‘s 1.5% as the energy price base effect pushes the numbers up on a year-on-year basis. We expect CPI to reach 2.8%, well above the 2% target, in January 2010 as the temporary VAT rate cut expires at end-December 2009. But further out, a persistently negative output gap should cause CPI inflation to fall below target. Policy: The BoE has left the Bank rate at 0.5% and intends to increase its programme of asset buying by £25bn to £200bn by early 2010, though tapering off the rate at which these asset purchases occur. The most recent MPC minutes revealed an unusual 1-7-1 split on the decision emphasising the risks on both sides, with one member favouring a greater extension of £40bn to insure against the continuing downside risks, and another voting for an outright pause, drawing attention to the upside risks if policy were made more accommodating. The MPC is likely to review its policy stance at the time of the February 2010 Inflation Report, when we expect it to announce a pause in asset purchases. Comments in the minutes from Chief Economist Spencer Dale suggest the MPC is becoming more alert to inflationary risks. But we think the Bank is too optimistic about the pace of recovery. As such, we think interest rates will stay on hold until November 2010, when we expect a 25bp hike, although there are risks on both sides to this call. Risks: The risks to our upgraded forecasts are more balanced. It is possible that optimistic official forecasts are right and consumption and investment could recover more strongly. But uncertainty about the banking sector and households’ saving behaviour are likely to persist, reinforced by worries about further fiscal tightening, so we see considerable downside risks, too.

Details of the forecast
% Real GDP Private consumption Fixed investment Government consumption Exports of goods and services Imports of goods and services Contributions to GDP: Domestic final sales Inventories Net trade Unemployment rate Fiscal deficit (% GDP) Current account deficit (% GDP) Consumer prices (CPI) Retail prices (RPI) Official Bank rate 10-year gilt £ per euro $ per £ 1.5 -1.4 0.50 3.59 0.89 1.63 1.9 -0.6 0.50 3.75 0.90 1.72 2.8 2.4 0.50 3.75 0.90 1.69 2.4 2.9 0.50 4.00 0.86 1.80 1.6 2.4 0.50 4.30 0.84 1.87 1.1 2.6 0.75 4.60 0.82 1.95 1.0 2.9 1.00 4.70 0.82 1.90 1.2 3.1 1.25 4.80 0.81 1.85 3Q09 -1.2 -0.1 -1.1 0.9 2.0 5.2 -0.2 -0.1 -0.9 7.8 4Q09 2.2 1.4 -6.6 0.8 4.1 -0.2 -0.1 1.2 1.1 8.0 1Q10 1.6 -0.1 -3.9 0.4 4.5 -1.1 -0.6 0.8 1.4 8.1 2Q10 2.1 2.1 -3.2 0.8 4.9 1.8 1.0 0.4 0.7 8.1 3Q10 2.6 2.2 1.2 0.8 5.3 3.1 1.7 0.4 0.5 8.0 4Q10 2.8 1.7 6.1 0.4 5.3 3.7 2.0 0.4 0.4 8.0 1Q11 2.2 0.7 7.4 0.4 5.3 2.9 1.6 0.0 0.6 8.0 2Q11 2.5 2.3 5.7 0.0 5.3 4.2 2.3 0.0 0.2 7.9 2009 -4.6 -2.9 -14.4 1.9 -10.7 -12.6 -4.1 -1.4 0.9 7.6 -13.0 -2.1 2.1 -0.8 0.50 3.75 0.90 1.72 2010 1.4 0.8 -3.8 0.8 3.7 0.7 0.0 0.6 0.7 8.1 -11.9 -1.4 2.0 2.6 0.75 4.60 0.82 1.95 2011 2.4 1.7 4.9 0.3 5.3 3.4 1.8 0.1 0.4 7.9 -9.6 -0.9 1.2 3.0 1.50 4.80 0.80 1.75

Notes: Quarterly figures are % q-o-q changes at a seasonally adjusted annualised rate. Annual figures are % y-o-y changes. Inventories include statistical discrepancy. Inflation is % y-o-y. Interest rates and currencies are end-of-period levels. Fiscal deficit is based on the European commission's definition. Numbers in bold are actual values, others forecast. Source: ONS, Bank of England, Datastream and Nomura Global Economics.

Nomura Global Economics

29

16 December 2009

2010 Global Economic Outlook

Japan ⏐ Outlook 2010

Takahide Kiuchi

Shift to steady export-led growth in H2
We expect the growth in the Japanese economy to slow in H1 2010, but to then expand steadily in H2, driven by increasing exports to Asia.
We expect steady growth in H2 after slowing in H1

In spring 2009, the Japanese economy emerged from the fallout from the global financial crisis and subsequently recovered more steadily than we had initially projected. Real GDP growth in Q3 2009 was 1.3% annualized, after 2.7% in Q2. The deflationary trend, however, is gaining momentum as the output gap widened sharply. The domestic demand deflator in Q3 hit -2.8% y-o-y – its sharpest decline in 52 years, since Q3 1957. While Japan ends 2009 amid a distinctive mix of strong growth and intensifying deflation, we expect growth to slow in H1 2010 as exports temporarily lose steam owing partly to JPY appreciation and the adverse effects of stimulus measures. We expect declining growth amid deflation to spur the government to adopt fiscal policies targeting economic growth and the Bank of Japan (BOJ) to take further easing measures. We think these measures will prepare the way for the economy to improve in H2 2010, supported partly by their influence on financial markets, including stabilizing forex market. For Japan, we expect 2010 to be a year of dynamic interplay between the three forces of economic conditions, policy responses and financial markets. We believe that the economy, having been rocked more severely than some by the global financial crisis, will finally move into steady, export-led growth in H2 2010.

Growth to slow in H1
Growth should be strong amid deflation

The CPI (excluding fresh food) has been declining year-on-year since March 2009, a trend we project will continue through to early 2012. Both the government and the BOJ have already acknowledged officially that the economy is in deflation. Consumer confidence surveys also point to expectations of renewed slippage in prices (Figure 1). Although falling prices could support consumer spending by raising real incomes and increasing purchasing power, there was no clear evidence of such benefits in the deflationary period from the end of the 1990s. Falling prices depress corporate earnings, prompting companies to rein-in personnel expenses and raising concerns that real wages will decline as wages fall faster than prices. Those concerns mean that households are likely to reduce spending in times of deflation. With deflation tending to weigh on domestic demand, and particularly consumer spending, the economy’s ability to sustain strong growth hinges largely on two external factors: expanding exports (driven by a global economic recovery) and economic stimulus measures. GDP statistics for Q3 2009 show real exports at 6.5% q-o-q in annualized terms, maintaining the strong growth momentum of the previous quarter, when they grew at the same pace. Trade statistics show exports over the period expanding strongly to a broad range of regions, particularly Asia.

Figure 1. Household sector’s outlook on prices

Figure 2. Real exports and the export orders index

DI, pp 90 80 70 60 50 40 30 20 10 0 02 03

Price outlook (lhs) Oil price (rhs)

% y-o-y 70 50 30 10 -10 -30 -50

DI, pp 60 55 50 45 40 35 30 25 20 02 03 04 05 06 07 08 09 Manufacturing export order PMI (lagged 3-month) Real exports (3-month mov avg, rhs)

% y-o-y 20 15 10 5 0 -5 -10 -15 -20 -25 -30 -35 -40 -45 CY

04

05

06

07

08

09

-70 CY

Notes: 1) Price outlook for all households one year from now. Figure is the % of respondents expecting prices to rise minus the % expecting them to fall. 2) Figures from March 04 are estimates using old-basis statistics. Source: Nomura, based on Consumer Confidence Survey.

Note: Seasonally adjusted values. Source: Nomura, based on Markit Economics’ materials.

Nomura Global Economics

30

16 December 2009

2010 Global Economic Outlook

Stimulus measures boost consumer spending

Mika Ikeda

Consumer spending has been firm thanks to the previous government’s stimulus measures. New measures by the DPJ are expected to have a similar impact but the government’s hands could be tied by the poor state of public finances. Real private-sector final consumption expenditure rose 0.9% q-o-q in Q3 2009, marking the second straight quarter of relatively strong growth after the 1.2% increase in Q2. We think brisk consumption at a time when the employment situation is unfavorable largely reflects the impact of government stimulus. Government cash handouts appear to have been behind the sharp increase in consumer spending in Q2 and, with this impact dropping out in Q3, other measures designed to stimulate spending such as the eco-point and eco-car schemes seem to have had some success. Under the eco-point scheme, consumers can use points that come with purchases of energy-efficient consumer electronics (including digital terrestrial TVs, air conditioners, and refrigerators) to buy other products and services. Based on applications for eco-points, we estimate that purchases of qualifying consumer electronic appliances totaled around ¥340bn at end-September 2009 (equivalent to 0.12% of nominal private-sector final consumption expenditure), and reached roughly ¥630bn (0.22%) at end-November. Under the eco-car scheme, subsidies are available for the purchase of cars that meet certain environmental efficiency criteria, and additional subsidies are available if the car is being purchased to replace a car used for longer than 13 years. We estimate that the value of cars purchased using the eco-car scheme totaled around ¥1trn as of 28 September (0.36%), and has continued to rise since, reaching an estimated ¥1.9trn (0.68%) as of 4 December. We think consumer spending is again likely to be boosted by the eco-point and eco-car schemes in Q4. Both schemes are due to end in March 2010, but the government extended the eco-point scheme until December and the eco-car scheme until September. Thus a potential pull-back in consumer spending in Q2 2010, which has been a concern, could be avoided. The new Democratic Party of Japan (DPJ) government has said it intends to implement various policies aimed at lifting household incomes, under the slogan Putting People’s Lives First: a new childcare benefit scheme, the effective elimination of public high school fees, and an end to provisional tariffs for gasoline. We have estimated the direct impact of these measures on household incomes and the potential boost to consumer spending (Figure 1 has our assumptions). Many of these new measures are due to be implemented in Q2 2010, and we forecast only a limited impact to start with. However, we expect benefits to emerge from H2 2010 (Figure 2). Nevertheless, we think any policy effect will be cancelled out in FY10 by the downward pressure on consumer spending from the eco-point and eco-car schemes being scaled back and eliminated. We expect this negative impact to disappear in FY11, when we expect the new measures to provide a noticeable boost to consumer spending. Many details of the new measures are also still undecided. Tax revenues have fallen sharply in FY09 amid deteriorating corporate earnings, and new JGB issuance is projected to climb past ¥50trn. The DPJ has therefore started looking at ways to save money, including revisiting the kind of measures above that it pledged to implement in its pre-election manifesto. With the government also searching for new sources of revenue, proposals for tax increases not included in the manifesto have emerged. The manifesto referred to the abolition of tax deductions for spouses, only with respect to income tax, but the government now wants to extend this to residence tax as well. Plans are also on the table to hike cigarette taxes. The debate will also probably focus on reductions to specified dependent tax deductions and the creation of new green taxes. The impact of these measures, if implemented, would depress our estimate for the boost to consumer spending shown in Figure 2. Assuming the government implements new green taxes in FY11 equivalent to the amount of tax eliminated via the abolition of provisional tariffs, we estimate the boost to consumer spending in FY11 would be halved. Against this backdrop, we see a real concern that the parlous state of public finances could hamper the DPJ government’s ability to implement new stimulus measures.
Figure 1. Assumptions underlying our estimates of policy effects
DPJ polices aimed at stimulating consumption 50% of annual allowance to be paid in April 2010–March 2011 Child allowances Full amount paid from April 2011 Existing child benefits To be discontinued after March 2010 payment Effectively free public From FY10 high school tuition Income tax deductions To be abolished from 2011 Cuts to public sector Phased in gradually from FY10 and completed in FY13 personnel costs Abolition of provisional tax on gasoline, etc, from April 2010. Whole Abolition of provisional amount factored in as the individual and corporate portions cannot tax rates be separated Income support for To start from FY11 agriculture Not included in our calculations, as it is difficult to separate Elimination of highway individual use from commercial use, and as the schedule for tolls implementation is not yet clear Other policies to stimulate consumption Eco-point scheme Extended to end-December 2010 Eco-car subsidies Extended to end-September 2010

Figure 2. Estimated boost to consumption from government measures that will affect household income

% y-o-y 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 08 09
Other consum ption stim ulus policies DPJ policy ef f ects Cash handouts Total policy ef f ects Real priv ate consum ption expenditure

Est

10

11

12 CY

Source: Nomura, based on Ministry of Economy, Trade and Industry, Ministry of Internal Affairs and Communications, and Cabinet Office data, and the DPJ manifesto.

Source: Nomura, based on Ministry of Economy, Trade and Industry, Ministry of Internal Affairs and Communications, and Cabinet Office data, and the DPJ manifesto.

Nomura Global Economics

31

16 December 2009

2010 Global Economic Outlook

Exports are set to lose steam temporarily

We expect economic growth to slow apparently in H1 2010, as the underlying weakness of domestic demand, eroded by deflation, temporarily emerges. We see the main factors likely to weigh on growth as being a lull in exports after an extended robust expansion and the adverse effects of stimulus measures. We expect economic rebounds in the developed countries to slow from end-2009 through early 2010. Add to that the negative impact of yen appreciation, and we expect a sharp drop in export momentum in H1 2010. That the Japanese manufacturing PMI index’s export orders index, a roughly three-month leading indicator of real exports, declined in October and November 2009 also suggests that export growth momentum will fade (Figure 2). That, in turn, is likely to feed through to slowing growth momentum for industrial production, which has been expanding rapidly. Real consumer spending in Q3 2009 was 0.9% q-o-q, followed by a second quarter of strong growth of 1.2% in Q3. We attribute firm consumer spending amid the depressed job environment largely to benefits from stimulatory measures, with support from government cash handouts in Q2, and from the eco-points system and subsidies to trade in old cars in Q3 (see Box: Stimulus measures boost consumer spending). We expect the adverse effect from stimulus measures to hit in H1 2010.

We expect pay-back in H1 from this year’s stimulus boost

Stepping up the policy response
We expect joint action from the government and BOJ

With growth slowing in H1 2010 and the yen likely appreciating, we expect the Hatoyama government and the BOJ to work more closely to combat deflation and use fiscal and monetary policy to that end (see Box: A policy mix to overcome deflation). At an unscheduled policy board meeting on 1 December, the BOJ decided to adopt new fund supply measures (¥10trn at an interest rate of 0.1% for three months). Meanwhile, the government announced a second supplementary budget for FY09 including new spending of ¥7.2trn or 1.5% of nominal GDP. Although the direct impact of both moves is likely to be limited, closer government-BOJ coordination to fight deflation should boost confidence among companies and consumers and in the financial markets, which in turn, should have a positive impact on the economy. Manifesto pledges on a range of measures made by the DPJ (Democratic Party of Japan) in the August 2009 Lower House election are due to move into the implementation stage, including an increase in childcare benefits from April 2010. We expect this to provide a fillip to the economy from H2 2010. If economic growth slows and the yen appreciates, we see a possibility that the government, with an eye on July 2010 Upper House elections, will put together a large package of economic stimulus measures in the form of a FY10 supplementary budget in Q2 2010. Government finances have been deteriorating steadily amid a large shortfall in tax revenues (Figure 3). However, with the economy taking a stronger deflationary hue and fund surpluses growing in the corporate sector, we expect the current account surplus to continue growing even if the fiscal deficit keeps expanding. Assuming no change in Japan’s fund surplus position, therefore, we find it hard to project a sharp increase in long-term interest rates solely on the deterioration in public finances. There is a risk that looser fiscal discipline could have a serious impact on the economy over the longer term, but we see benefits in the near term from government fiscal management that emphasizes the macro economy but also allows deficits to expand.

Figure 3. General account: JGB issuance (FY basis)

Figure 4. Projected impact of the strong yen on real export growth

¥trn 50 45 40 35 30 25 20 15 10 5 0

JGB issuance (projected) (lhs) JGB issuance (lhs) As % of nominal GDP (projected) (rhs) As % of nominal GDP (rhs)

% 10 8 6 4 2

pp impact on q-o-q grow th 1.0 0.5 0.0 -0.5 -1.0 -1.5 09
Source: Nomura.

CY Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 10 11 12

0 65 69 73 77 81 85 89 93 97 01 05 09 FY

Source: Nomura, based on Ministry of Finance.

Nomura Global Economics

32

16 December 2009

2010 Global Economic Outlook

A policy mix to overcome deflation
The government and the BOJ are finally taking coordinated action to fight deflation.

Shuichi Obata

In November, the government and the Bank of Japan (BOJ) finally admitted that deflation had taken hold again, and in doing so acknowledged the concerns of the market. This acknowledgement was soon followed (on 1 December) by an unscheduled policy meeting at which the BOJ decided to launch a new fund-supplying operation. The new facility is aimed at increasing the supply of short-term funds and guiding longer-term interest rates (up to three months) on the short-term money markets down toward the policy rate target (0.1%). While we expect the new facility to have some effect in terms of lowering short-term interest rates, we think it is unlikely to have much impact on the economy, consumer prices and exchange rate trends. In our opinion, the significance of the BOJ’s action is that it has now positioned itself to implement further monetary easing, if it determines that business confidence could be negatively affected by yen appreciation and falling prices, without revising its view of the economy and financial environment.

All eyes on coordinated action by the BOJ and the government
Of particular interest is whether the government will intervene in the forex (FX) market, and how the BOJ will respond if it does. We forecast the exchange rate to be at USD/JPY 83 at end-March 2010; we think the government will intervene to buy dollars and sell yen if the yen appreciates through the 85 level. In this situation, we would expect the BOJ to allow intervention to go unsterilized (that is, release the intervention funds into the market without offsetting purchases, thereby increasing bank reserves). In the earlier period of quantitative easing, the target for current account deposits rose virtually in line with the cumulative amount of forex intervention. As a result, the increase in base money (current account deposits plus cash-in-circulation) was consistent with the cumulative amount of funds used in FX intervention (Figure 1). We thus think it is recognized within the BOJ that there is a close affinity between quantitative easing and forex intervention. It remains unclear whether the BOJ this time will make an explicit shift to quantitative easing, as it did last time, based on targets for current account balances. However, BOJ Governor Masaaki Shirakawa stated at his press conference that the latest facility may also fall in the broad category of quantitative easing, and as such we think the monetary policy of the BOJ is likely to be increasingly characterized by quantitative easing. As of June 2009, the temporary borrowing ceiling for foreign exchange funds was ¥140trn, against which the outstanding balance of foreign exchange fund bills was around ¥108.2trn, in theory leaving the government around ¥31.8trn in ammunition for immediate intervention on the forex markets (Figure 2). On paper, therefore, the government has the ability to intervene on a similar scale to that seen between January 2003 and March 2004. If the entire amount of such intervention were unsterilized, then the BOJ’s balance sheet would expand by just under 30%. Based on the statements of Governor Shirakawa, the BOJ seems reluctant to step up long-term JGB purchases as a means of boosting the supply of funds. Mr Shirakawa appears to be concerned that increasing long-term JGB purchases would be seen as holding up long-term interest rates or as fiscal financing (monetization). As well as its FY10 budget, the ruling Democratic Party of Japan is currently compiling a second supplementary budget for FY09 to provide additional economic stimulus. To end deflation it will be necessary to close the negative supply-demand gap, and this will be difficult to achieve by monetary easing alone. This has prompted calls from some for additional economic stimulus measures, but there are also concerns that fiscal deterioration could lead to a sharp rise in long-term interest rates. In these circumstances, despite the BOJ’s reluctance, we see a strong possibility that it will increase its long-term JGB purchases. The BOJ’s current policy is to lower interest rates from the front end of the yield curve. However, if policy is to have a more direct impact on the economy and a greater easing effect, we think long-term interest rates will need to be pushed down. Considering the likely overall impact, including the announcement effect, we still think it quite likely that the BOJ will increase long-term JGB purchases in the first half of next year with the aim of gaining a duration-driven policy effect.
Figure 1. Forex intervention and quantitative easing Figure 2. Budgetary limits for forex intervention
End o f zero interest rate po licy

(¥trn) 70 60 50 40 30 20 10 0 -10 99 00

Change in current acco unt balance Change in base mo ney Cumulative fo rex interventio n amo unt Intro ductio n o f quantitative easing

(¥trn) 160 140 120 100 80 60 40 20 0

Upper limits o n fo reign exchange fund bills and transfer fro m natio nal treasury surplus

D if f e re nc e : ¥3 1. 8 t rn

Outstanding balance o f fo reign exchange fund bills and transfer fro m natio nal treasury surplus

Outstanding balance o f fo reign exchange fund bills

01

02

03

04

05

06 (CY)

91

93

95

97

99

01

03

05

07

09 (CY)

Note: Amounts are cumulative amounts from January 1999. Source: Nomura, based on BOJ and MOF data.

Source: Ministry of Finance and Nomura.

Nomura Global Economics

33

16 December 2009

2010 Global Economic Outlook

The BOJ could step up quantitative easing

Our FX team projects a USD/JPY rate of 83 at end-March 2010. There are concerns that further yen gains could accelerate deflation by lowering the price of imported products and weighing on exports (Figure 4). Some are therefore looking to the government to stabilize exchange rates as part of a wider effort to combat deflation. The government could intervene to halt yen appreciation, and this may be implemented in conjunction with unsterilized measures by the BOJ, allowing its current account balance to rise as it halts the recovery of yen funds from banks. We think this coordinated effort by the government and the BOJ would help to stabilize forex markets and underline their joint commitment to combating deflation, contributing to improved confidence in financial markets. We also expect the BOJ to incrementally step up quantitative easing from H1 2010, including increased purchases of long-term JGBs. In addition to the positive economic impact of these coordinated fiscal and monetary measures, we think they will create an environment – via greater stability in forex and stock markets – for stable export-led growth from H2 2010.

Stable growth amid deflation
Excess supply problems are set to ease

We see an easing in excess supply as one factor that should support stable growth from H2 2010. Companies have faced serious overcapacity and excess employment as a result of the global financial crisis. Subsequent efforts to correct this by holding back investment and paring headcount crimped domestic demand, and this has been one obstacle preventing the Japanese economy from righting itself. However, the correction in production capacity and personnel expenses is progressing at a faster pace than we initially projected. Our estimates now show that the correction in both should largely be completed by mid-2010, providing another factor to support stable growth (see Box: Capacity and personnel cost adjustments). We look for exports to take an increasingly important role again in driving economic growth from H2 onwards, on the back of a sustained global recovery and as the negative impact of yen strength recedes. We also expect Japan to benefit strongly from expansion in Asia, in particular China, with this acting as another driver for the domestic economy. In recent years there has been a striking rise in the weighting of Japanese exports to Asia. Between the mid-1980s and the late 1990s there was a sharp increase in the weighting of exports to NIEs3 (Korea, Taiwan, Singapore) and Southeast Asia, while from the late 1990s until recently there has been a considerable rise in the weighting of exports to China (including Hong Kong) (Figure 5). Internationally, Japan also has one of the highest export exposures to Asia (Figure 6). We expect the economy to expand even amid deflation, provided the export environment is healthy. However, we think it will be quite some time before there is a self-sustaining recovery in domestic demand, particularly consumer spending. We doubt that in 2010 Japanese households will feel that the economy is recovering. Signs of a self-sustaining recovery in consumer spending, even amid deflation, as the benefits of export expansion feed through to the household sector, are likely to come in 2011 at the earliest, in our opinion.
Figure 6. Asia export weightings
Singapo re Japan Ko rea A ustralia New Zealand India US Wo rldwide B razil Switzerland Russia UK Germany France Finland Sweden Italy Denmark Canada Netherlands No rway B elgium Greece 33.0 33.9 26.3 1 4.8 38.0 23.3 23.8 22.2 23.1 1 .9 1 5.2 1 7.1 1 2.5 4.5 1 7.0 1 5.0 1 5.2 8.4 9.7 7.3 7.4 5.0 6.9 4.9 6.8 4.7 6.2 4.4 6.1 3.6 5.2 3.8 5.0 3.8 4.9 4.2 4.6 2.9 3.8 2.6 3.5 2.6 2.9 1 .7 1 4.1 25.3 47.9 58.3

We expect exports to drive growth again from H2 onwards

Deflation should not be overcome until 2011 at the earliest

Figure 5. Breakdown of Japanese exports by country

% 40 35 30 25 20 15 10 5 0

Asia (excluding China) China (including Hong Kong) US EU Resource-producing countries

41 .1 38.9

Other goods Parts

CY 85 87 89 91 93 95 97 99 01 03 05 07 09

%

0

5 10 15 20 25 30 35 40 45 50 55 60

Source: Nomura, based on Ministry of Finance statistics.

Note: 1) Shows exports to Asia as % of total exports. 2) Asia is total of China (inc HK), NIEs3 and Southeast Asia. 3) 2008 data for all countries except Korea (2007 data). 4) Our classifications for parts and other goods are based on BEC codes. Source: Nomura, based on UN data.

Nomura Global Economics

34

16 December 2009

2010 Global Economic Outlook

Capacity and personnel cost adjustments

Ryota Sakagami

Firms are likely complete the adjustments to their capacity and personnel costs in the first half of 2010. Economic expansion in Japan since Q2 2009 has gone hand-in-hand with an increase in exports. However, there has been no clear sign of recovery in domestic capital expenditure or household income. In our view, one reason why the pickup in exports and production has not fed through to capex and consumer spending to a greater extent is that companies have been adjusting their surplus production capacity and reducing personnel costs. The production capacity DI and the employment conditions DI in the latest (September 2009) Tankan indicate that many companies still think they have too much production capacity and too many employees. Some people have compared the current situation, in which companies saddled with surplus production capacity and excessive personnel costs are working to reduce them, thereby preventing the economic recovery from feeding through to domestic demand, with Japan’s situation in the 1990s. These observers expect surplus production capacity and excessive personnel costs to weigh down the economy for an extended period. However, we see a major difference between the Japan of the 1990s and the Japan of today: the absence of a housing bubble. Since 2002, a period not accompanied by a domestic asset price bubble, Japanese companies have been more moderate in their expansion of production capacity and workforces than in the second half of the 1980s. Accordingly, we think there has been less need for firms to adjust their capital stock in this recession. To give a clearer view, we have estimated appropriate levels for companies’ production capacity and personnel costs, enabling us to determine the potential for further adjustment. On our estimates, production capacity as of September 2009 was 3.4% in excess of the appropriate level in our standard scenario. Companies have been cutting their production capacity by about 0.4% a month since January 2009. If they continue to do so, production capacity should reach the appropriate level by April 2010 (Figure 1). Similarly, we have calculated that personnel costs were 3.5% above the appropriate level (standard scenario) in Q2 2009. Assuming the pace of adjustment to date is sustained, we calculate that personnel costs will reach the appropriate level in Q2 2010 (Figure 2). Accordingly, we project that capacity and personnel cost adjustments will run their course in Q2 2010. Hence, we think pressure to adjust production capacity and personnel expenditure will ease in H2 2010 and beyond, paving the way for the export-led economic recovery to feed through to domestic demand.

Figure 1. Estimates of appropriate production capacity

Figure 2. Estimates of appropriate personnel expenses

2005 = 100 112.5 110.0 107.5 105.0 102.5 100.0 97.5 95.0 92.5 90.0 87.5 85.0
A ppro priate pro ductio n capacity o ptimistic scenario : 1 02.9 A ug 09: 1 04.5 Dec 09

1 .5% 3.4% A ppro priate pro ductio n capacity standard scenario : 1 00.9 A pr 1 0 1 6.3%

A ppro priate pro ductio n capacity pessimistic scenario : 87.5

Simulatio n

CY 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Note: (1) Appropriate production capacity estimated by Nomura. Our assumptions for industrial production are: optimistic scenario—FY10: +12.3%; FY11: +7.3%; standard scenario— FY10: +8.7%; FY11: +9.2%; pessimistic scenario—FY10: +2.9%; FY11: 0.0%. (2) Our simulation assumes that production capacity is cut by an average of 0.4%/month. Source: Nomura, based on Cabinet Office, BOJ and Ministry of Finance data.

Note: (1) Appropriate personnel expenses estimated by Nomura. Our assumptions for industrial production are: optimistic scenario—FY10: +12.3%; FY11: +7.3%; standard scenario— FY10: +8.7%; FY11: +9.2%; pessimistic scenario—FY10: +2.9%; FY11: 0.0%. (2) Our simulation assumes that personnel expenses continue to change at the same average q-o-q rate (–1.1%) as from the most recent peak to Q2 2009. Source: Nomura, based on Cabinet Office, BOJ and Ministry of Finance data.

Nomura Global Economics

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
35 16 December 2009

¥trn, annualized P erso nnel expenses 190 A ppro priate level o f perso nnel expenses 09 Q2: ¥1 72trn o ptimistic scenario : ¥1 75trn 185 180 175 170 1 Q2 0 3.5% 165 A ppro priate level o f perso nnel expenses standard scenario : ¥1 66trn 8.4% 160 155 A ppro priate level o f perso nnel expenses 1 Q2 1 pessimistic scenario : ¥1 58trn 150 145 140 Simulatio n 135 130 125 CY 120

2010 Global Economic Outlook

Japan ⏐ Economic Outlook

Takahide Kiuchi

More aggressive policy in store
We expect GDP growth to ease in H1 2010, but further fiscal and monetary action should help growth rates pick up again in H2. Activity: Real GDP growth was +1.3% q-o-q annualized in Q3 2009 (second preliminary estimate), indicating that the economy has maintained the growth seen in Q2. We estimate that GDP growth will ease markedly in H1 2010 as yen appreciation causes exports to temporarily lose momentum after recent strong growth, and as the boost from government stimulus measures drops out of the picture. We see a possibility that the economy could actually contract slightly in H1. From H2, however, we think Japan will move to a phase of stable, sustainable economic growth, driven by expanding exports, particularly to Asia. Inflation: Deflation has made a full-fledged return in 2009, owing primarily to the wide supplydemand gap that opened up following the global financial crisis. Not only do we think it will be difficult to eliminate deflation, but we think that even a clear easing of deflationary pressures may be unlikely during 2010. Policy: In our opinion, declining economic growth and yen appreciation are likely to prompt the authorities to take more aggressive fiscal and monetary policy action in 2010. Against a backdrop of fiscal deterioration, we expect to see a fairly tight main budget for FY10. However, if the economy were to deteriorate, the government could implement additional stimulus measures from around spring, with an eye on the Upper House elections scheduled for July. We also see a possibility that the Bank of Japan could push ahead with quantitative easing via unsterilized intervention on the forex markets and increased purchasing of long-term JGBs. Risks: If exports remain firmer than we currently envisage on the back of economic recovery in emerging nations, particularly in Asia, then Japan’s GDP growth may not decline as much as we expect in H1 2010. On the other hand, we see a risk that sharp yen appreciation could slow the economy by more than we currently anticipate. A stronger yen would not only make for an adverse export environment, but it could also exacerbate deflation by lowering import prices. We also see a possibility that the adverse impact on the stock market could have a damping effect on consumer spending.

Details of the forecast
% Real GDP Private consumption Private non res fixed invest Residential fixed invest Government consumption Public investment Exports Imports Contributions to GDP: Domestic final sales Inventories Net trade Unemployment rate Consumer prices Core CPI Fiscal balance (fiscal yr, % GDP) Current account balance (% GDP) 3Q09 1.3 3.8 -10.6 -28.1 -0.5 -6.3 28.6 13.9 -0.7 0.4 1.6 5.5 -2.2 -2.3 4Q09 1.5 -0.8 9.3 -3.6 1.2 15.4 10.4 13.9 1.7 -0.2 0.0 5.3 -2.0 -1.6 1Q10 0.7 0.3 4.5 1.9 0.8 6.5 4.5 6.4 1.2 -0.5 0.0 5.3 -1.2 -1.1 2Q10 -0.2 -0.2 -2.4 1.7 0.8 -1.8 6.6 2.7 -0.3 -0.5 0.6 5.4 -1.5 -1.4 3Q10 2.2 0.8 3.5 2.1 0.8 -6.4 10.0 -1.2 0.9 -0.2 1.5 5.5 -1.4 -1.2 4Q10 1.9 0.7 6.4 3.3 0.8 -9.0 10.0 4.8 1.2 -0.2 0.9 5.4 -1.0 -1.1 1Q11 1.8 1.2 5.9 3.6 0.8 -9.3 8.2 5.8 1.3 -0.1 0.6 5.4 -1.0 -1.0 2Q11 1.3 1.0 5.7 3.9 1.0 -15.1 8.7 7.4 0.8 0.0 0.5 5.3 -0.4 -0.4 2009 -5.4 -1.1 -19.1 -13.7 1.4 7.6 -24.8 -16.4 -3.1 -0.2 -2.1 5.1 -1.3 -1.2 -11.3 2.7 2010 1.3 0.8 0.3 -5.9 0.8 3.0 10.9 5.4 0.8 -0.4 0.9 5.4 -1.3 -1.2 -9.1 3.4 2011 1.7 0.9 5.2 3.5 0.9 -10.7 9.3 5.1 1.0 -0.1 0.8 5.3 -0.5 -0.5 -9.4 4.2

0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.25 0.10 Unsecured overnight call rate 0.70 0.65 0.80 0.90 1.00 1.05 1.05 0.70 1.00 1.10 0.60 JGB 5-year yield 1.25 1.20 1.35 1.45 1.55 1.60 1.60 1.25 1.55 1.65 1.30 JGB 10-year yield 86.0 83.0 85.0 87.0 87.0 89.0 91.0 86.0 87.0 93.0 89.7 JPY/USD Notes: Quarterly real GDP and its contributions are seasonally adjusted annualized rates. Unemp. rate is as a percentage of the labor force. Inflation measures and CY GDP are y-o-y percent changes. Interest rate forecasts are end of period. Fiscal balances are for fiscal year and based on general account. Table last revised 11 Dec. All forecasts are modal forecasts (i.e., the single most likely outcome). Numbers in bold are actual values, others forecast. Source: Cabinet Office, Ministry of Finance, Statistics Bureau, BOJ, and Nomura Global Economics.

Nomura Global Economics

36

16 December 2009

2010 Global Economic Outlook

Asia ⏐ Outlook 2010

Rob Subbaraman

China-led paradigm shift
For the first time in more than a decade, things look ripe for a strong, internally led expansion.
Asia’s economies have bounced back strongly

Asia ex-Japan is recovering faster than other regions, but even more encouraging, 2009 marked the discovery by Asian policymakers that the region has outgrown its export-led growth model. We expect a paradigm shift wherein, for the first time since the Asian crisis, regional domestic demand, led by China, becomes the main driver of Asian growth. In the next two years, we forecast average annual GDP growth of 8.3% in Asia ex-Japan, led by 10.2% growth in China.

This time is different
The largest-ever collective easing of Asia’s policies ...

Asia’s policy response to this global crisis was the opposite of its response to the 1997-98 Asian crisis. Back then, the currency crisis forced central banks to raise rates and the IMF prescribed tighter fiscal policies. Domestic policies became so tight that most of Asia had little choice but to depend on undervalued currencies and exports for growth. They stuck to an export-led growth model for the next decade, with the region’s export-to-GDP ratio rising from 30% in 1997 to 47% in 2007 as a result. This goes a long way to explaining why the economies were initially hit so hard by the global financial crisis. This, we think, was a big wake-up call for Asian policymakers, prompting them to implement the largest-ever collective loosening of macro policies. From peak to trough, Asia’s GDP-weighted average policy interest rate has fallen by nearly 300bp, while, on our estimates, the aggregate fiscal deficit widened by 3.6 percentage points of GDP in 2007-09. The other big difference relative to 1998 is that this crisis did not originate in Asia: after more than a decade of reform, Asia’s fundamentals – ranging from external vulnerability indicators to the health of the corporate and banking sectors – are in much better shape than those of other regions. Lean inventories, rising asset prices, falling unemployment and closing output gaps are all contributing, but we judge that the main reason for Asia’s quick bounce-back is the powerful combination of sound fundamentals and record loose macro policies. A quarterly GDP expenditure breakdown is not available for China, but for the rest of the region it is encouraging that the recovery is being led by domestic final demand, notably consumption (Figure 1). However, bouncing back from recession is relatively easy; sustaining expansion more difficult. Inventory rebuilding and fiscal stimulus are temporary supports that will fade, while higher oil prices are eroding producers’ profit margins. And the official leading economic indexes for countries such as Taiwan and Malaysia, after rising sharply, are rolling over. Reflecting these factors and other ones, our global FX strategy team is expecting a temporary rise in global risk aversion in Q1. However, while financial markets may swoon, we do not expect a major relapse in the global economy, given that policymakers have pledged to do whatever it takes to avoid such an outcome. For Asia, we are particularly sanguine because of a new structural force that we expect to have a bigger positive impact on the rest of the region than many realize: China.
Figure 2. Nomura’s forecasts of consumption versus gross fixed capital formation in 2010; circles = size of nominal GDP
25 20 Growth of GFCF 15 10 5 0 -5 UK 0 Australia Russia Brazil Philippines Korea India Vietnam Indonesia Poland US Euro area -5
Sep-09

... and sound fundamentals are a powerful combination

We are optimistic that Asia can sustain its robust growth

Figure 1. Contributions to aggregate real GDP growth in Asia (excluding Japan and China)
Percentage points contribution to year-on-year grow th 25 20 15 10 5 0 -5 -10 -15 -20 Sep-97 Gross exports Inventories Sep-00 Sep-03 Consumption Investment Sep-06

China

-10

Japan 5 10 15 20

Grow th of private consumption

Note: Asia includes Korea, Taiwan, HK, India, Singapore, Malaysia, Indonesia, Thailand and the Philippines. Source: CEIC and Nomura Global Economics.

Note: The bubbles represent the size of nominal GDP for each country in 2008 measured in USD at current exchange rates. Source: World Bank, CEIC and Nomura Global Economics.

Nomura Global Economics

37

16 December 2009

2010 Global Economic Outlook

China’s re-emergence
China’s investment boom is far from over

We are bullish on China, forecasting GDP growth of 10.5% in 2010 and 9.8% in 2011 (for details see China Economic Outlook: “One of the best years in decades”, in this issue). Our assessment is that after adding on the investments being implemented by local governments and state-owned enterprises, which are largely financed by the banks, the true size of the public investment stimulus is roughly double the RMB4tr that Beijing announced in November 2008. Being mostly multi-year infrastructure projects, more rounds of bank financing will be needed to complete them. Indeed, as of November 2009, the funds needed to complete ongoing urban fixed-asset investment projects reached RMB22tr, or 73% of China’s 2008 GDP. We doubt that China will tighten monetary policy aggressively in 2010, as CPI inflation is so low and if ongoing public projects are starved of ongoing financing, non-performing loans could quickly rise; alternatively, if banks give priority to public projects, private investment could be crowded out. Unlike the consensus, we think a major overcapacity problem in 2010-11 is unlikely; rather, we see a major asset price bubble forming from too loose monetary policy. Most of the investment is directed at China’s poorer inland regions, where there is still plenty of room for development. Consumption and property booms are also under way. Personal incomes are at the point where demand for durable goods is taking off. Policymakers are promoting consumption by spending more on welfare, easing restrictions on urbanization, and reducing bottlenecks for rural spending. If our 2010 consumption and investment forecasts are right, China will be the outlier (Figure 2). China’s burgeoning demand is starting to have a big impact on the rest of Asia. Put simply, China’s economy is now so big that its high compound growth rates really matter (see Box: China: Dispelling some myths). To illustrate, consider China’s so-called “ordinary” imports (goods catering to China’s own demand, rather than exports). They are on track to total USD0.5tr this year, whereas US goods imports are set to be three times larger (USD1.5tr). But in 2006-08, China’s ordinary imports grew at an average annual rate of 27% versus 8% for US imports. At this pace, China’s ordinary imports will double to USD1.0tr, equal to more than half of forecast US imports (USD1.9tr) by 2012. They should exceed US imports by 2016 (Figure 3).

It is being joined by a consumption boom

China’s rapid reemergence is helping the rest of Asia

Policy dilemma
Asia could face a tsunami of capital inflows in 2010

Policy rates in Asia being raised only slowly is also bullish for domestic demand (see Box: Asian monetary policy: A fear of the exit). Our base case is for shallow recoveries in the G3 economies, with the Fed not raising rates until early 2011. This alone could fuel strong capital inflows to Asia, but with the region being the stellar growth performer in the world, 2010 inflows could be more like a tsunami. Asia has already experienced a turnaround in foreign capital, from net outflows totaling USD262bn in July 2008-March 2009, to net inflows of USD241bn in April-September 2009, putting upward pressure on Asian currencies (Figure 4). Policymakers in most Asian countries seem unwilling to tolerate anything other than gradual currency appreciation because they are concerned about a G3 relapse and know the region’s high export exposure cannot be reduced quickly. But capital flows rarely trickle in – they come in waves. So Asian central banks have intervened heavily, boosting FX reserves from USD3.3tr in March to USD3.9tr in October.
Figure 4. Asia ex-Japan’s aggregate balance of payments
US$bn 250 200
+8% p.a.

Figure 3. China’s ordinary imports and US good imports
USD trillion 2.8 2.4 2.0 1.6 1.2 0.8 0.4 0.0 1994 +27% p.a. China's ordinary goods imports US goods imports Projections

Capital account Current account BOP

150 100 50 0 -50 -100 -150 Sep-97

1997

2000

2003

2006 2009e

2012

2015

Sep-00

Sep-03

Sep-06

Sep-09

Note: Ordinary imports cater to China’s own demand; i.e. they are not inputs used to produce goods for export. Source: CEIC and Nomura Global Economics.

Note: The capital account includes net foreign direct investment, debt and equity portfolio flows and international bank lending. Source: CEIC and Nomura Global Economics.

Nomura Global Economics

38

16 December 2009

2010 Global Economic Outlook

China: Dispelling some myths

Mingchun Sun

It is time to scrutinize some of the conventional wisdom and correct some misunderstandings about China’s economy. In 2009, China, with its massive fiscal stimulus package and strong V-shaped economic recovery, became the focus of the world. In 2010, we expect even more attention, as, based on our 2010 GDP growth and currency forecasts, China is set to surpass Japan as the world’s second-largest economy at market exchange rates. The world needs to know China better. We attempt a modest contribution by challenging some of the conventional wisdom: 1. China is a “small” economy. For years, policymakers and most observers, inside and outside of China, have analyzed China using the “small open economy” framework – namely viewing China as a price taker with little impact on world prices, interest rates or incomes. This wisdom was challenged in 2009 as China’s V-shaped recovery clearly spilled over into other Asian economies, Australia, and the effects were felt even as far as Latin America, as orders from China boosted production and commodity prices. Being the second-largest economy in the world in 2010, China’s impact on the rest of the world should be even more obvious as the investment and consumption booms continue into 2010. 2. Exports are the main growth engine. Many observers draw this conclusion by looking at the ratio of exports to GDP, which was 33% in 2008. However, often ignored is the fact that half of China’s exports are so-called processing and assembly trade, which requires imports of raw materials and components before the finished goods are exported. The GDP share of net exports – namely, the difference between exports and imports – is much smaller (8% in 2008). In terms of contribution to real GDP growth, net exports have accounted for only 10% over the last 17 years (Figure 1) – much smaller than in Japan (23.8%) and Germany (28.8%). In other words, domestic demand has long been the main growth engine in China (see “China: Gauging the importance of exports”, Global Weekly Economic Monitor, 27 March 2009). 3. Private consumption is weak. Such an impression may come from the low share of household consumption in China’s GDP (36.8% in 2008). But in actual fact, China’s real consumption growth has been one of the strongest in the world over the last 13 years (7.2%) – stronger than in the US (3.3%), Japan (0.9%), Brazil (4.0%) and India (5.5%). It was even stronger investment growth that drove down the consumption ratio. For developing economies, robust investment growth is needed for urbanization and industrialization purposes and it can be justified theoretically and empirically (see China consumption outlook: Surprises from consumers, 20 May 2009). 4. High money supply growth leads to high CPI inflation. While this sounds like a given, the conventional wisdom is not supported by the data. Over the past 15 years, China’s M2 money supply growth averaged 18.8% per year, but CPI inflation averaged only 2.0%. Why the large discrepancy? Rapid credit expansion has been mainly used to increase production capacity in the manufacturing sector, which helped relieve supply bottlenecks. Abundant, or even excess capacity, fuels price competition and prevents producers from raising prices, even in the face of rising costs. Fortunately, rapidly rising labour productivity – about 20% growth pa during 1994-2008 – helps producers absorb cost increases and stay profitable (see “CPI inflation outlook”, Global Weekly Economic Monitor, 11 September 2009). 5. The investment stimulus exacerbates overcapacity problems. This criticism is superficial as it ignores the direction of the investment stimulus in 2009. Overcapacity has existed for many years, but mainly in the manufacturing sector, due to strong investment growth in the sector over the past investment boom (Figure 2). However, 2009’s investment boom was mainly driven by infrastructure projects – especially in central and western regions – and thus is unlikely to exacerbate any overcapacity (see Not just an investment boom, Asia Special Report, 9 November 2009).

Figure 1. Contribution to real GDP growth in China

Figure 2. Fixed-asset investment growth by sectors

Percentage point contribution 20 16 12 8 4 0 1991 1993 1995 1997 1999 2001 2003 2005 2007
Source: CEIC and Nomura.

% y-o-y Domestic demand Net exports 60 50 40 30 20 10 2005 2006 2007 2008 2009 Jan-Nov Infrastructure Property Manufacturing

Source: CEIC and Nomura.

Nomura Global Economics

39

16 December 2009

2010 Global Economic Outlook

Asian monetary policy: A fear of the exit

Young Sun Kwon ⏐ Sonal Varma

Asian policymakers risk falling behind the curve in 2010 due to a fear of currency appreciation and a preference to accelerate growth. A delayed exit would leave problems with the lack of credibility and late rapid tightening. After an unprecedented policy stimulus, Asian growth and asset prices rebounded fast from the global recession. Asian policymakers now face the difficult challenge of sustaining the recovery, while keeping inflation in check. So far, governments have preferred to impose administrative measures, rather than use blunt rate hikes, to limit rapid asset price reflation. For instance, mortgage loan-to-value ratios have been lowered in Hong Kong and Korea. We look for more piecemeal measures – and do not rule out restrictions on capital flows – but judge that they will have only shortlived effects. We also expect CPI inflation to rise and, apart from China, see a risk of output gaps closing faster than we initially thought. As policymakers come to recognize that their exit policies have been too slow, we expect them to move to eventually catch up by implementing more aggressive rate hikes.

Three reasons for fearing an exit
• • Fear of currency appreciation: Policymakers are likely to prevent their currencies from appreciating too fast, given their lack of confidence over the export outlook, risking competitive devaluation for an extended period. Political preference: Given that central bank independence is not well established in Asia, pressures to delay rate hikes will likely remain due to political priorities to support weaker economic segments (such as small and mediumsized enterprises), still-sluggish job markets and a risk of larger capital inflows associated with interest rate arbitrage. Self-insurance: Some Asian countries experienced sharp currency devaluation during the post-Lehman crisis as they were unable to borrow overseas in their own currencies (often referred to as the “original sin”). In response, Asian countries are likely to build up FX reserves further as “self-insurance” against future potential external shocks.

Three potential risks
In 2010, we expect a total of 100bp of nominal aggregate policy rate hikes in Asia ex-Japan. However, given our forecast that aggregate CPI inflation will rise to 3.9% from 0.6% in 2009, real policy rates are estimated to fall to 1.3% from 3.9% in 2009 (Figure 1). Such a delayed exit leaves room for potential problems in macro risk management, in our opinion. • Asset price inflation (or bubbles): As firms, facing global overcapacity, hold investment in check, easy monetary conditions, including lower real borrowing costs, and a strong recovery in incomes could prompt households to take on excess debt. Given our view that the negative output gap closes in 1H10 and asset price inflation accelerates, we expect central banks to quicken the pace of interest rate hikes in 2H10. The biggest concern is that this would lead to bad loan problems and asset market corrections if it proves that Asian asset prices are substantially overvalued. Speculation: Keeping currencies undervalued by accumulating FX reserves could encourage speculative positions amid ample global liquidity as the markets position for eventual Asian currency appreciation (Figure 2). On the other hand, extraneous FX changes between USD and other major currencies (especially JPY) could trigger a sizable unwinding of arbitrage positions given Asia’s de facto soft USD pegging. Capital controls: In an extreme scenario of too large capital inflows or outflows, we do not completely rule out the imposition of capital controls given that regional currency swap agreements are relatively small (USD120bn).
Figure 2. NEER and FX reserves in Asia ex-Japan

Figure 1. Asia ex-Japan’s weighted-average policy rates

% y-o-y 8 6 4

Real policy rates Nominal policy rates

US$tr 4.5

FX reserves, lhs

Index (2005 = 100) 112 NEER, rhs 108

3.5

2.5 2 0 -2 Mar-00 1.5

104

100

Mar-02

Mar-04

Mar-06

Mar-08

Mar-10

0.5 96 Mar-00 Oct-01 May-03 Dec-04 Jul-06 Feb-08 Sep-09
Note: Lower value of nominal effective exchange rate (NEER) indicates nominal trade-weighted exchange rate depreciation. Source: BIS, IMF and Nomura Global Economics.

Note: Weighted by GDP (on a purchasing power parity basis). India inflation refers to wholesale price index. Source: CEIC, IMF and Nomura Global Economics.

Nomura Global Economics

40

16 December 2009

2010 Global Economic Outlook

Excessively low real rates could result, fueling asset bubbles

Resisting currency appreciation is reviving the so-called “Impossible Trinity”, involving a fixed exchange rate, free-flowing capital and control over interest rates: a central bank can maintain only two of these at any given time. By managing the exchange rate, central banks risk keeping rates too low for too long (raising them could provoke even stronger capital inflows), and with our forecast of rising CPI inflation we see real policy rates turning negative in most countries. This situation looks ripe to fuel asset price bubbles (most notably in Hong Kong and China). To lean against bubbles more administrative measures are likely, but we doubt that they will be as effective as rate hikes. Over time, we believe Asia will allow significant currency appreciation, as reflected in our FX strategy team’s end-2011 forecasts; otherwise a protectionist backlash seems likely given that the region’s slice of the global economic pie is growing fast (Figure 5).

Two downside risks
An oil price boom, or a G3 relapse are two key downside risks

We see two major downside risks to bullish Asian growth forecasts: another oil price boom and a major relapse in the G3 economies. We try to quantify these under two scenarios (Figure 6). Our base case is that the price of Brent oil averages USD72/bbl in 2010 and USD75/bbl in 2011, but if it were to average USD100/bbl instead (Scenario A), we estimate that the region’s total 2010 GDP growth would be 0.7 percentage point (pp) below our base case, with Korea, Thailand and the Philippines hurt most; Australia and Malaysia would actually benefit. Alternatively, if growth in the G3 economies were to be 0% in 2010 rather than our forecast 1.9%, and the recovery in 2011 shallow (Scenario B), Asian 2010 GDP growth could be 1.3pp below our base case. Notably, under both scenarios the most resilient country by far is China.

Five key themes
Watch for upside surprises from the Asian consumer

We would highlight five big picture macro themes: China’s goldilocks year. With strong GDP growth and low CPI inflation, 2010 should be one of the best years in decades for China’s economy. We do not expect major overcapacity problems because the poorer inland regions need more investment, and we forecast a consumption boom. Korea and Taiwan switch. Korea’s central bank is falling behind the curve and household releveraging should drive 2010 GDP growth higher than in Taiwan, where large excesses remain. But we expect the reverse in 2011, as the Bank of Korea plays catch-up with aggressive rate hikes and as Taiwan starts to reap the benefits of closer economic ties with China. India and South-east Asia. Overall, we expect the rate of potential growth in the region to rise on improved economic fundamentals, growing links with China, rapid urbanization and average income per capita having risen to the point where demand for durable goods is taking off. Emerging disparities. We are bullish overall, but there are some gaps. A balance of payments crisis in Vietnam cannot be ruled out; the Thai economy is being held back by political uncertainties, which could worsen; and Malaysia is struggling to keep export competitiveness. Consumption surprises. Supportive policies, rising asset prices, a growing middle class and a need for global rebalancing set the stage for a consumption boom (see Box: Asia rebalancing).

Figure 5. The sizes of the economies of Asia ex-Japan, the US and Japan (GDP in USD at current exchange rates)
US$tr 16 14 12 10 8 6 4 2 0 1995 1997 1999 2001 2003 2005 2007 2009E 2011F China Rest of Asia India US Korea Japan

Figure 6. Nomura’s baseline GDP forecasts and two other less rosy scenarios, % y-o-y growth
Base Case
2009E 2010 2011

Scenario A: Oil price boom
2010 2011

Scenario B: G3 relapse
2010 2011

China Hong Kong India Indonesia Malaysia Philippines Singapore Korea Taiwan Thailand Vietnam Asia ex Japan Australia

8.5 -2.6 6.5 4.6 -2.2 1.0 -2.0 0.0 -3.0 -3.0 5.1 5.5 1.0

10.5 5.6 8.0 5.9 4.5 5.5 5.5 5.5 4.8 3.0 6.5 8.4 2.8

9.8 4.4 8.2 6.2 5.2 6.0 5.5 4.0 5.2 5.0 6.6 8.2 3.2

10.0 4.9 7.2 5.6 4.7 4.0 4.7 4.0 4.0 1.5 6.0 7.7 3.3

9.3 4.2 7.4 6.2 5.4 4.5 5.2 3.0 5.1 3.5 6.1 7.5 3.9

9.9 2.9 6.5 4.9 2.0 3.0 2.2 2.5 2.3 1.0 5.5 7.1 0.8

9.2 3.6 7.2 5.0 3.8 4.0 4.0 4.5 4.1 3.0 5.8 7.3 2.5

Note: 2010 and 2011 are Nomura’s forecasts of GDP growth and exchange rates. Source: CEIC and Nomura Global Economics.

Source: Nomura Global Economics.

Nomura Global Economics

41

16 December 2009

2010 Global Economic Outlook

Asia rebalancing

Tomo Kinoshita ⏐ Tetsuji Sano

Asia’s rebalancing from reliance on export demand to domestic demand has finally started. Although we maintain our view that Asia is still vulnerable to a decline in demand in G3 economies, we believe that Asia’s long-overdue rebalancing has finally started to materialize. In fact, we forecast that Asia’s current account as a percentage of GDP will decline by 1.8pp in 2010, which would be the largest decline in the past two decades, followed by a further fall of 1.2pp in 2011. Although 0.7pp of the total 1.8pp decline in 2010 is directly due to higher fuel prices, the rest should be contributed by a rise in Asia’s own demand, led by China. We expect China to grow 10.5% in 2010, even while demand for exports remains relatively weak. In light of this, we expect Asia’s aggregate current account surplus as a percentage of GDP to drop significantly from the peak level of 7.1% in 2007 to only 2.5% in 2011 (Figure 1).

Regional demand, led by China, to lead regional growth
In 2010, Asia’s move toward rebalancing should be driven by both short-term and structural factors, in our view. The short-term factors are likely to play more important roles. Investment should accelerate in 2010 in most of the economies. Although the output gap in the global economy should still be significant, the output gap in Asia is likely to close in 2010, which should lead to sizable demand for investment in domestic markets. Despite the expected rate hikes across Asia, monetary policy, when measured in terms of inflation-adjusted real interest rates, should remain relatively loose, which would also support investment. We expect China’s investment boom to continue with fixed asset investment growing rapidly in 2010, at 30.0%. Given the size of China’s economy, which is set to become the second largest in the world in 2010, high investment growth in China is also likely to stimulate demand in the rest of Asia. Another important short-term catalyst for Asia’s rebalancing is an acceleration of private consumption growth as a result of improving employment conditions and consumer sentiment. There have been growing signs of private consumption across Asia accelerating, supported by both pent-up demand and wealth effects from higher prices of stocks and property. Reflecting the recovery in consumer sentiment, the number of intra-regional travelers also appears to be recovering quickly. This is particularly good news for the economies whose net travel receipts are high relative to GDP, notably Thailand (5.5% in 2008) and Malaysia (3.8%). Two major structural factors should also support Asia’s move towards rebalancing. First, tariff reductions for intraregional trade should spur homegrown demand in Asia. Although a tariff reduction does not directly increase regional demand, a lower trade barrier is likely to induce additional final demand in Asia through multiplier effects, as increased trade encourages firms to hire more workers and expand capacity. The most notable development among various trade initiatives should be the tariff reduction set by the China-ASEAN (Association of Southeast Asian Nations) Free Trade Agreement. According to the agreement, China and the six original ASEAN member countries are, in principle, obliged to eliminate all tariffs for Normal Track tariff lines, which accounts for more than 90% of trade in 2010. Second, a rise in the middle-class population is likely to support sustained consumption growth in Asia. Asia’s middleincome population is on the rise especially in the relatively low-income economies such as China, India and Indonesia, supported by robust economic growth, currency appreciation and urbanization. As middle-income consumers tend to spend more on service items than do low-income consumers, a sustained rise in service-sector investment and consumption can be expected over time. In fact, per capita GDP in low- to middle-income Asian economies has risen sharply over the past five years (Figure 2).

Figure 1. Current account balance in Asia ex-Japan

Figure 2. Per capita GDP in low- to middle-income economies in Asia

%, GDP 8 7 6 5 4 3 2 1 0 -1 -2

Current account (rhs) Current account as % of GDP (lhs) F

USDbn 800 700 600 500 400 300 200 100 0 -100 -200
Low to middle income group China India Indonesia Philippines Vietnam Thailand Malaysia High income group South Korea Taiwan Australia Hong Kong Singapore USD 997 1,269 535 1,100 973 489 2,261 4,400 17,071 13,451 13,546 26,371 23,559 22,651 2003

Per capita GDP 2008 USD 2,285 3,258 1,052 2,247 1,845 1,051 4,299 8,008 25,967 19,111 17,060 46,651 30,863 37,597 Average annual rate of growth from 2003 to 2008 % 18.0 20.7 14.5 15.4 13.7 16.6 13.7 12.7 8.8 7.3 4.7 12.1 5.5 10.7

Population 2008 million 2,978 1,328 1,154 229 90 86 63 28 105 49 23 22 7 5

90 92 94 96 98 00 02 04 06 08 10
Note: Asia ex-Japan includes China, India, Taiwan, Korea and ASEAN6. Source: Nomura Global Economics from CEIC and IMF.

Source: CEIC and Nomura Global Economics.

Nomura Global Economics

42

16 December 2009

2010 Global Economic Outlook

Australia ⏐ Economic Outlook

Stephen Roberts

A two-speed recovery
Less accommodating policy settings will limit the pace of growth in consumer spending in 2010, while business investment and exports should grow strongly helped by Asia’s strong recovery. Activity: Real GDP growth should accelerate more than we originally forecast in 2010, to 2.8% y-o-y and to 3.2% in 2011, reflecting burgeoning Asian demand for commodities driving a Vshaped recovery in exports and business investment, especially mining sector investment. Housing construction activity is also likely to accelerate in 2010 in a lagged response to the government incentives for first-time homebuyers that ran from October 2008 and through much of 2009. However, we believe the economic recovery in 2010 and 2011 will be a two-speed affair, with household consumption growing only modestly as the highly leveraged household sector adjusts to increased debt-servicing payments on higher interest rates, while the end of fiscal support payments in 2009 will sharply reduce growth in household income in 2010. Inflation: We expect a slow rise in CPI inflation through 2010 and 2011 – and in the two RBA underlying inflation measures from late 2010 – but moving comfortably within the RBA’s 2%-3% target band through 2H10 and 2011. We forecast a stronger AUD through 2010 containing import prices and offsetting scattered domestic inflation pressure points, mostly in utility charges. Wages growth should remain low through 2010, with some acceleration in 2011 as the labour market tightens to the point where the unemployment rate starts to fall more consistently. Policy: Fiscal stimulus spending peaked in 2Q09 with the concentration in that quarter of the biggest “cash splash” transfer payments to households. Although government infrastructure spending will rise in 2010, the declining total stimulus will, on our estimate, subtract 1.3pp from GDP growth in 2010, compared with 2009. We also see the RBA continuing to reduce monetary policy accommodation in 2010, but at a slow pace given the lack of an inflation “smoking gun” that might drive the need for a quicker return to a neutral cash rate setting. Also, with banks starting to raise their home loan rates by more than the RBA’s cash rate hikes, there is less need for the RBA to raise rates aggressively. We forecast two 25bp cash rate hikes in 2010; one in 1Q10 and another in 4Q10, taking it to 4.25%. Risks: In our view, greater deleveraging by the heavily indebted household sector is the biggest downside growth risk. On positive risk, if the economic recovery in Asia ex-Japan accelerates more than we forecast, it would drive stronger exports and business investment spending. Details of the forecast
% y-o-y growth unless otherwise stated Real GDP - % q-o-q saar - % q-o-q, sa - % y-o-y Household consumption Government (total spending) Investment (private) Exports imports Contributions to GDP growth (% points): Domestic final sales Inventories and statistical discrepancy Net trade Unemployment rate Employment, 000 Consumer prices Trimmed mean Weighted median Federal deficit (% of GDP) FY end-June Current account deficit (% GDP) Cash rate 90-day bank bill 3-year bond 10-year bond AUD/USD 3Q09 2.6 0.7 0.9 1.8 1.6 -3.0 -0.2 -8.3 0.6 -1.7 2.0 5.8 17.9 1.3 3.2 3.8 4Q09 2.5 0.6 2.3 1.9 2.4 -1.0 3.9 0.9 1.3 0.4 0.6 5.9 15.0 2.0 3.1 3.5 1Q10 2.9 0.7 2.6 1.6 3.5 5.0 5.8 10.6 2.9 0.9 -1.2 6.1 15.0 2.4 2.7 2.9 2Q10 2.9 0.7 2.7 1.1 3.6 6.2 6.6 10.7 2.9 0.8 -1.0 6.3 18.0 2.5 2.4 2.6 3Q10 2.8 0.7 2.8 1.2 3.0 6.4 10.8 7.0 2.9 -0.3 0.2 6.3 18.0 2.4 2.3 2.5 4Q10 2.8 0.7 2.9 1.3 3.1 5.8 9.4 8.5 2.9 0.0 0.0 6.3 18.0 2.3 2.4 2.5 1Q11 3.2 0.8 3.0 1.7 3.4 6.3 7.6 9.6 3.1 0.5 -0.6 6.2 22.0 2.3 2.5 2.6 2Q11 3.2 0.8 3.0 1.5 3.1 5.9 8.1 9.4 3.0 0.5 -0.5 6.0 25.0 2.5 2.7 2.8 2009 2010 2011

1.0 1.5 2.4 -2.0 1.3 -7.8 0.9 -2.1 2.2 5.7 4.2 1.8 3.5 4.0 -2.3 -4.6 3.75 4.10 4.65 5.50 0.94

2.8 1.3 3.3 5.8 8.1 9.2 2.9 0.3 -0.4 6.3 17.2 2.4 2.5 2.6 -3.4 -4.6 4.25 4.70 5.50 6.40 1.00

3.2 1.6 2.8 5.9 8.3 9.1 3.0 0.5 -0.3 5.9 24.8 2.6 2.8 2.7 -2.2 -3.8 4.50 4.80 5.40 6.20 1.00

3.00 3.39 4.84 5.44 0.88

3.75 4.10 4.65 5.50 0.94

4.00 4.15 5.00 5.70 0.90

4.00 4.50 5.30 6.20 0.96

4.00 4.50 5.40 6.30 0.98

4.25 4.70 5.50 6.40 1.00

4.50 4.90 5.60 6.50 1.00

4.50 4.90 5.60 6.50 1.00

Note: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are period average. All forecasts are modal forecasts (i.e., the single most likely outcome). Table last revised 16 December 2009. Source: Australian Bureau of Statistics, Reserve Bank and Nomura Global Economics.

Nomura Global Economics

43

16 December 2009

2010 Global Economic Outlook

China ⏐ Economic Outlook

Mingchun Sun

One of the best years in decades
Barring an aggressive policy tightening, 2010 will likely prove one of the best years in decades for the Chinese economy, characterized by strong GDP growth and mild CPI inflation. Activity: Real GDP growth should rise to 10.5% in 2010 – peaking at 12.0% y-o-y in Q1 – from an estimated 8.5% in 2009. Investment should continue to be the main driver – contributing 6.8 percentage points (pp) to real GDP growth – as public investment remains strong and private investment picks up. The contribution from private consumption to GDP growth should rise to 4.6pp from 4.0pp in 2009, as the credit boom boosts households’ real purchasing power in a low-inflation environment and the government strikes further to boost consumption through income transfers and fiscal subsidies. Government consumption may contribute only 1.5pp as the strong economic recovery reduces the need for fiscal stimulus. We expect exports to return to double-digit growth (11%), on a low base created by massive global destocking in 2009. We expect import growth to be even stronger (20%), due to strong domestic demand from the investment and consumption booms. Net exports will again be a negative factor (-2.4pp) in 2010. Inflation: We expect significant PPI inflation of 6.0% – mainly due to strong demand for raw materials and capital goods from the investment boom – but mild CPI inflation of 2.5% in 2010. In our view, the existence of overcapacity in the manufacturing sector and rapid growth in labour productivity should prevent high PPI inflation from being transmitted into CPI inflation. Policy: We expect tightening policies to be introduced gradually in early 2010, in response to signs of economic overheating. While we only see a 5% chance of an aggressive tightening (if the PBC employs loan quotas and limits them strictly to below RMB7-8trn), the damage low loan quotas could do to the real economy may be extensive given the massive investment projects started this year. That said, without a real CPI inflation threat, policy tightening will (95% chance) be mild – we expect to see only 81bp of rate hikes, 100bp of reserve ratio requirement (RRR) hikes and window guidance. With growth as less of a concern, we believe 2010 will allow policymakers to conduct structural reforms aimed at improving the quality of growth. Risks: In our view, the 5% chance of aggressive tightening is the main risk that could prevent the economy from enjoying one of its best years in decades. There is a chance that, having delayed tightening for too long, policymakers over-react to some signs of overheating in 2010. If this happens, the economy could face a hard landing. The development of an asset price bubble is another risk, as abundant liquidity could ignite inflation expectations and a benign economic environment may boost investor confidence to unreasonable levels. That said, there is hope that if the government can limit the use of leverage in asset purchases successfully, the damage of a bubble to the real economy could be reduced significantly. Details of the forecast
% y-o-y growth unless otherwise stated Real GDP Consumer prices Core CPI Retail sales (nominal) Fixed-asset investment (nominal, ytd) Industrial production (real) Exports (value) Imports (value) Trade surplus (US$bn) Current account (% of GDP) Fiscal balance (% of GDP) 1-yr bank lending rate (%) 1-yr bank deposit rate (%) Reserve requirement ratio (%) Exchange rate (CNY/USD) 3Q09 8.9 -1.2 -1.5 15.4 33.4 12.3 -20.3 -11.8 24.1 4Q09 11.0 0.6 0.1 16.2 34.0 18.4 -2.8 14.3 70.6 1Q10 12.0 1.6 0.5 17.3 36.0 22.0 15.5 36.5 33.3 2Q10 10.5 2.5 0.8 19.3 38.0 16.3 15.2 21.0 26.3 3Q10 9.9 3.0 1.2 19.7 32.0 13.3 7.8 12.3 29.5 4Q10 9.6 2.9 1.6 18.0 30.0 12.3 7.5 16.3 51.8 1Q11 9.4 3.4 2.0 20.0 26.0 12.0 4.1 15.0 7.6 2Q11 9.7 3.5 2.4 18.0 24.0 11.5 8.6 15.8 7.4 2009 8.5 -0.7 -0.9 15.4 34.0 11.3 -15.6 -9.5 207 7.2 -3.7 5.31 2.25 15.50 6.82 2010 10.5 2.5 1.0 18.6 30.0 16.0 11.0 20.0 141 5.0 -2.5 6.12 3.06 16.50 6.45 2011 9.8 3.5 2.0 18.0 25.0 13.8 8.3 15.0 73 3.5 -1.3 7.20 4.14 17.00 6.10

5.31 2.25 15.50 6.83

5.31 2.25 15.50 6.82

5.58 2.52 16.00 6.82

5.85 2.79 16.50 6.68

6.12 3.06 16.50 6.55

6.12 3.06 16.50 6.45

6.39 3.33 17.00 6.40

6.66 3.60 17.00 6.35

Notes: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are period average. All forecasts are modal forecasts (i.e., the single most likely outcome). Table last revised 16 December 2009. Source: CEIC and Nomura Global Economics.

Nomura Global Economics

44

16 December 2009

2010 Global Economic Outlook

Hong Kong ⏐ Economic Outlook

Tomo Kinoshita ⏐ Robert Subbaraman

Twin engines of China and the HKD peg
The economy should rebound strongly, and lack of monetary control could fuel an asset bubble. Activity: The Hong Kong economy is gaining further traction. The wealth effects arising from higher property and stock prices, the pent-up demand for durable goods and improving job and income prospects appear to be driving consumption growth. Retail sales are recovering quickly with October sales volumes having risen by 8.2% y-o-y. We expect retail sales to strengthen further in the short run and now forecast private consumption growth to accelerate to 7.0% in 2010 from 0.6% in 2009. We also expect the growth in gross fixed capital formation (GFCF) to rebound to 10.0% in 2010 from -4.3% in 2009. GFCF growth surprisingly turned positive at 1.4% y-o-y in 3Q09 as business sentiment/activity improved and public investment (mainly on infrastructure) increased. A rebound in visitor arrivals, led by visitors from the Mainland, looks set to buoy Hong Kong’s exports of services. We believe that the acceleration of economic growth in China and abundant liquidity conditions – because of the HKD peg, Hong Kong has imported quantitative easing from the US – should further drive optimism in Hong Kong in 2010. Inflation: We expect headline CPI inflation to rise but to a still subdued rate of 3.2% in 2010, as imported food and oil/commodity prices rise, policy effects gradually wane, consumer demand recovers and the housing component of the CPI adjusts to higher residential rents, with a lag. Given that the economy is still operating below full capacity and our assumption that oil prices will remain around current levels, we are not forecasting an inflation problem, although we would highlight it as an upside risk given the surfeit of liquidity and the possibility of higher oil prices.. Policy: We expect the 2010 budget to focus on sustainable economic development strategies, particularly via promoting new niche industries, cooperation with China/Guangdong and Taiwan, and infrastructure projects, while providing assistance to the disadvantaged. We do not expect any large fiscal stimulus, as the recovery gains traction and as the government strives for fiscal prudence. On the monetary front, capital inflows under the HKD peg have resulted in ample interbank liquidity and a surge in the monetary base to a growth rate of over 200% y-o-y. To guard against the formation of property and equity price bubbles, the Hong Kong Monetary Authority (HKMA) has required banks to comply with prudent lending practices, including raising the down-payment for luxury properties costing over HKD20 million to 40% from 30%. Risks: Given Hong Kong is a small, open economy, and a regional financial hub, a setback to the global recovery remains a key risk. Until it bursts, an asset price bubble is an upside risk, while sudden capital outflows would tighten interbank liquidity and could cause an interest rate shock. The risk of a more virulent swine flu outbreak still hangs in the air.

Details of the forecast
% y-o-y growth unless otherwise stated [sa, % q-o-q; annualized] Real GDP Private consumption Government consumption Gross fixed capital formation Exports (goods & services) Imports (goods & services) Contributions to GDP: Domestic final sales Inventories Net trade (goods & services) Unemployment rate (sa, %) Consumer prices Exports Imports Trade balance (US$bn) Current account (US$bn) Current account (% GDP) Fiscal balance (% of GDP) 3-month Hibor (%) Exchange rate (HKD/USD) 3Q09 1.6 -2.4 0.2 3.3 1.4 -10.7 -7.8 0.6 4.3 -7.3 5.3 -0.9 -13.8 -9.9 -9.4 4Q09 15.6 3.3 9.2 3.5 10.9 -2.0 0.8 7.5 1.5 -5.7 5.2 1.4 -3.7 0.2 -8.1 1Q10 4.6 8.7 9.8 1.5 11.9 14.8 15.8 8.4 0.1 0.1 5.1 1.8 16.8 18.0 -5.9 2Q10 2.9 6.2 6.2 1.8 13.4 6.3 7.3 6.7 0.8 -1.4 5.0 3.1 6.7 9.0 -8.0 3Q10 0.9 5.5 6.9 0.8 8.8 4.8 5.7 5.9 1.0 -1.4 4.8 4.7 6.1 7.0 -10.8 4Q10 1.7 2.4 5.5 0.5 6.4 3.9 5.5 4.6 0.3 -2.5 4.6 3.2 4.2 6.5 -10.6 1Q11 6.0 2.9 4.6 0.8 4.4 7.2 8.2 3.8 0.1 -0.9 4.4 2.7 8.2 9.6 -7.6 2Q11 7.8 4.0 4.4 0.6 8.7 8.0 8.5 4.7 -0.4 -0.3 4.0 2.8 8.9 9.7 -9.3 2009 -2.6 0.6 2.5 -4.3 -10.6 -9.6 -0.3 0.9 -3.2 5.3 0.5 -12.7 -11.4 -27.5 24.9 11.7 -3.7 0.30 7.75 2010 5.6 7.0 1.1 10.0 7.1 8.1 6.3 0.6 -1.3 4.9 3.2 7.9 9.6 -35.3 19.9 8.6 -3.0 0.40 7.75 2011 4.4 4.9 0.7 7.6 8.2 8.7 4.7 0.0 -0.3 4.0 2.9 9.2 9.9 -41.2 17.5 7.1 -1.1 1.15 7.75

0.22 7.75

0.25 7.75

0.25 7.75

0.27 7.75

0.30 7.75

0.40 7.75

0.60 7.75

0.80 7.75

Notes: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are period average. All forecasts are modal forecasts (i.e., the single most likely outcome). Table last revised 16 December 2009. Source: CEIC and Nomura Global Economics.

Nomura Global Economics

45

16 December 2009

2010 Global Economic Outlook

India ⏐ Economic Outlook

Sonal Varma

Heading back to 8%
A rebound in private demand, rising inflationary pressures and a surge in capital inflows have set the stage for policy reversal in 2010. But managing the fiscal deficit will remain a challenge. Activity: India has weathered not just the global crisis, but also weak monsoons, and is likely to post 6.5% y-o-y GDP growth in 2009. Buoyed by loose macro policies, we expect growth to rebound to 8% in 2010 and 8.2% in 2011. Domestic private consumption is picking up due to lower interest costs, rising confidence and better job prospects. As consumer demand rebounds and the global economy stabilises, increased business confidence should propel greenfield investments. We expect the economy to rebalance towards a more normalised growth path, with the decline in government consumption easily offset by accelerating private demand. Inflation: Food inflation is a concern. We believe that food prices could remain high in 2010 due to hoarding ahead of the next monsoons. Non-food inflationary pressures are also building due to higher oil prices, and the economic recovery could soon lead to demand-side price pressures. High input prices and rising demand are likely to prompt firms to gradually pass on more of their increased costs to consumers. Therefore, the fundamental driver of inflation is likely to shift from the supply side to the demand side in coming quarters. We expect wholesale price inflation to rebound to 7.0% y-o-y in 2010 from 1.9% in 2009. Policy: With both growth and inflation heading towards 8%, we expect the Reserve Bank of India (RBI) to start normalising its policy rates in January, and hike its repo and reverse repo rates by 125bp each in 2010. We expect the rupee to appreciate due to rising net capital inflows and the RBI’s inflationary concerns. However, weak external demand suggests that the RBI will continue to intervene in order to prevent too sharp INR appreciation, and to mop up the resulting excess liquidity through cash reserve ratio hikes and market stabilisation schemes. Stricter prudential norms to prevent too rapid an increase in asset prices and select controls on debt capital inflows are also likely. On the fiscal side, we are sceptical about any public expenditure cuts and instead expect higher revenue buoyancy, a reversal of tax cuts and disinvestment to lower the fiscal deficit. Still, gross borrowings are likely to be substantial and, combined with higher inflation and rising policy rates, are likely to put upward pressure on long-term yields. Risks: Higher oil prices, a double-dip and global financial instability are the key downside risks, while strong net capital inflows and a sharp rebound in investment are the key upside risks. Details of the forecast
% y-o-y growth unless otherwise stated Real GDP (sa, % q-o-q, annualized) Real GDP Private consumption Government consumption Fixed investment Exports (goods & services) Imports (goods & services) M3 money supply Non-food credit Wholesale price index Consumer price index Merchandise trade balance (% GDP) Current account balance (% GDP) Fiscal balance (% GDP) Repo rate (%) Reverse repo rate (%) Cash reserve ratio (%) 10-year bond yield (%) Exchange rate (INR/USD) 3Q09 11.4 7.9 5.6 26.9 7.3 -15.0 -29.8 19.8 14.7 -0.1 11.8 -7.7 4Q09 2.4 6.5 5.0 5.0 6.0 3.0 -2.0 18.6 11.1 4.0 11.5 -9.6 1Q10 9.7 7.5 6.0 5.0 8.0 6.0 9.0 18.1 14.8 7.5 11.3 -7.0 2Q10 8.5 7.9 6.5 5.0 7.8 14.5 14.0 18.0 15.2 7.4 10.4 -6.7 3Q10 10.9 8.1 7.0 3.5 8.2 14.9 8.4 18.5 17.3 6.3 5.8 -6.6 4Q10 4.7 8.3 7.0 6.0 9.2 9.5 11.5 18.4 19.7 6.7 5.3 -9.7 1Q11 6.9 7.7 7.6 5.0 9.5 9.0 10.5 17.3 21.1 7.0 5.5 -5.5 2Q11 9.3 8.0 7.8 3.0 8.0 10.2 10.0 17.5 22.6 6.4 5.6 -6.6 2009 6.5 3.8 14.9 6.0 -5.8 -14.5 19.6 15.1 1.9 10.4 -6.9 -0.8 -6.8 4.75 3.25 5.25 7.00 45.8 2010 8.0 6.6 5.0 8.3 10.9 10.7 18.3 16.8 7.0 8.0 -7.6 -0.7 -6.2 6.00 4.50 6.25 7.75 42.3 2011 8.2 7.7 3.6 10.1 10.2 11.8 17.8 22.6 6.2 5.8 -7.1 -1.3 -4.9 7.00 5.50 7.25 8.40 39.0

4.75 3.25 5.00 7.34 48.0

4.75 3.25 5.25 7.00 45.8

5.00 3.50 5.50 7.25 46.2

5.25 3.75 5.75 7.30 45.0

5.50 4.00 6.00 7.50 43.7

6.00 4.50 6.25 7.75 42.3

6.25 4.75 6.50 8.00 40.5

6.50 5.00 6.75 8.20 40.0

Notes: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are period average. CPI is for industrial workers. Fiscal deficit is for the central government and for fiscal year, eg, 2009 is for year ending March 2010. Table last revised on 16 December 2009. Source: CEIC and Nomura Global Economics.

Nomura Global Economics

46

16 December 2009

2010 Global Economic Outlook

Indonesia ⏐ Economic Outlook

Tomo Kinoshita

Domestic demand to lead robust growth
Private consumption and natural resources-related investment should help the economy to achieve about 6% growth in 2010-11. Activity: After sailing through 2009 relatively unharmed by the global financial crisis, the resource-rich Indonesian economy is likely to maintain strong economic momentum in 2010. We revise up our growth forecast for Indonesia in 2010 to 5.9% from the previous 5.1% on stronger private consumption and investment. We expect private consumption to maintain its robust growth rate of 5.1% in 2010, with the latest reading of the consumer sentiment index still hovering around the highest level since 2004. Wage increases and moderate inflation, the former being bolstered by minimum wage hikes, should support consumption strength. Now that the ruling coalition controls 423 of the 560 seats in the House of Representatives (DPR) as a result of elections held in 2009, President Yodoyono ought to be more capable of passing his legislative agenda through the DPR. This ease of legislative passage should support economic reform and encourage greater domestic and foreign investments, particularly in natural resources. We forecast that growth in gross fixed capital formation will accelerate to 8.0% in 2010 from 4.4% in 2009. Inflation and monetary policy: Headline CPI inflation is expected to rise from 4.6% in 2009 to 6.1% in 2010, a more normal level for Indonesia in the absence of favourable base effects. As the economy is expected to gain further traction in 2010 with moderate inflationary pressures, we expect Bank Indonesia to raise its policy interest rate by 25bp in 2Q, followed by three more 25bp hikes during 2H10. Fiscal policy: After implementing a fiscal stimulus policy, in 2009, we expect the Indonesian government to become more conservative on this front. The 2010 budget proposal agreed by the government and the House of Representatives plans only a 4.2% y-o-y increase in fiscal spending. We forecast the fiscal deficit-to-GDP ratio to fall to 1.9% in 2010 from 2.6% in 2009. Risks: We remain cautious about the effects of a slower-than-expected recovery on external demand. We also note that a substantial and unexpected rise in international oil prices could trigger a gasoline price increase, which would likely lead to an inflation problem. The government recently announced that it was considering measures to curb foreign ownership of short-term SBI securities. Although the actual introduction of such a restriction may be negative for the overall investment climate, we would not expect such a move to cause large fluctuations in asset prices as long as it is implemented in a reasonable manner.

Details of the forecast
% y-o-y growth unless otherwise stated Real GDP Private consumption Government consumption Gross fixed capital formation Exports (goods & services) Imports (goods & services) Contributions to GDP: Domestic final sales Inventories Net trade (goods & services) Consumer prices index Exports Imports Merchandise trade balance (US$bn) Current account balance (% of GDP) Fiscal Balance (% of GDP) Bank Indonesia rate (%) Exchange rate (IDR/USD) 3Q09 4.2 4.7 10.2 4.0 -8.2 -18.3 4.4 0.1 3.4 2.8 -19.4 -10.7 3.1 1.2 6.50 9681 4Q09 5.6 4.8 8.7 7.4 -5.1 -4.9 5.6 0.7 -0.6 3.1 -2.7 20.8 1.7 -4.3 6.50 9300 1Q10 5.4 4.9 5.2 8.3 3.0 3.6 5.2 0.1 0.1 4.6 13.8 44.0 4.1 -0.6 6.50 9450 2Q10 6.0 5.2 4.5 8.2 4.1 4.2 5.2 0.3 0.4 6.1 9.3 11.0 4.8 1.9 6.75 9200 3Q10 6.0 5.3 4.3 7.9 4.8 5.1 5.2 0.3 0.5 6.9 6.6 7.2 3.2 1.1 7.25 9000 4Q10 6.2 5.1 4.5 7.8 5.0 5.1 5.4 0.3 0.4 7.1 5.2 6.9 1.3 -4.0 7.50 8750 1Q11 6.2 5.2 5.0 7.8 5.9 4.6 5.2 0.0 1.0 6.8 7.2 6.9 4.4 -0.3 7.50 8622 2Q11 5.9 5.2 5.0 7.6 6.1 4.9 5.2 -0.3 1.0 6.6 8.6 8.4 5.3 1.9 7.50 8528 2009 4.6 5.1 13.1 4.4 -11.9 -18.6 5.0 0.0 1.5 4.9 -20.7 -17.6 17.2 0.2 -2.6 6.50 9300 2010 5.9 5.1 4.6 8.0 4.3 4.5 5.3 0.3 0.4 6.1 8.4 14.2 13.3 -0.4 -1.9 7.50 8750 2011 6.2 5.2 5.0 7.8 6.4 5.0 5.3 -0.2 1.1 6.3 9.2 8.9 14.8 -0.1 -1.5 7.50 8250

Notes: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are period average. All forecasts are modal forecasts (i.e., the single most likely outcome). Table last revised 16 December 2009. Source: CEIC and Nomura Global Economics.

Nomura Global Economics

47

16 December 2009

2010 Global Economic Outlook

Malaysia ⏐ Economic Outlook

Tetsuji Sano

Private sector to lead the recovery
Domestic demand, especially from the private sector, should lead the recovery, as the government strives to rein-in the large fiscal deficit. Activity: We expect real GDP growth to rise to 4.5% in 2010 led by domestic demand. The main contributor to GDP growth should be private consumption, adding 2.4 percentage points (pp) as labour markets improve. In addition, we expect a significant increase in the number of tourists, which should further boost GDP growth via service receipts. In the balance of payments, travel receipts accounted for 8.1% of GDP for the first three quarters of 2009. The year-to-date number of tourists increased 7.2% y-o-y in October, while we expect tourist numbers to grow at a double-digit pace in 2010. We expect a milder GDP contribution from investment, of 1.3pp, as we assume negative growth in public investment, while still significant spare economic capacity is likely to restrain the recovery in private investment. We expect government consumption to contract following a tightening of fiscal policy. Overall, we expect the private sector to lead the economy in 2010. In fact, of the MYR67bn stimulus package, the government had disbursed just MYR8.2bn by end-September. This suggests that the economy has not been dependent on the stimulus package, implying that the private sector has already started to lead the recovery. Net exports should subtract 0.7pp from GDP growth due to higher growth of imports than that of exports, following the recovery of domestic demand. Inflation: We expect CPI inflation to pick-up to 2.7% in 2010 for three main reasons. The first is an increase in food prices, as food is weighted at 31% of the CPI basket. Higher oil prices, with the transport category weighted at 16% of CPI, will also put upside pressure on inflation. The third is that we expect a narrower output gap in 2010. Although talk of a goods and services tax (GST) tax has been mooted, the government is not expected to implement a GST until late 2011. Policy: On fiscal policy, the government announced a tighter policy stance in its 2010 fiscal budget, by cutting its expenditure budget for 2010. The growth rate of operating expenditure, which accounts for 93% of total expenditure, will be lowered to -13.7% after a 4.3% increase in 2009. Development expenditure growth will be cut to -4.4% from a 25.0% increase in 2009. On monetary policy, we expect Bank Negara Malaysia (BNM) to start to hike rates in 2Q10. BNM should raise its policy interest rate cautiously by just 50bp in 2010, keeping real rates negative. Risks: Unlike the rest of Asia, higher commodity prices have a positive direct effect on Malaysia, since it is a large net exporter of crude oil, palm oil and natural gas. However, if commodity prices increase too rapidly, particularly if driven by speculation of supply-side factors, GDP growth may suffer indirectly through a decline in exports if there is a major relapse in global demand. In addition, consumer sentiment may deteriorate through a decrease in household purchasing power in real terms.

Details of the forecast
% y-o-y growth unless otherwise stated Real GDP Private consumption Government consumption Gross fixed capital formation Exports (goods & services) Imports (goods & services) Contributions to GDP: Domestic final sales Inventories Net trade (goods & services) Unemployment rate (%) Consumer prices index Exports Imports Merchandise trade balance (US$bn) Current account balance (% of GDP) Fiscal Balance (% of GDP) Overnight policy rate (%) Exchange rate (MYR/USD) 3Q09 -1.2 1.5 10.9 -7.9 -13.4 -12.9 0.3 0.7 -2.3 3.6 -2.3 -25.6 -21.8 7.7 14.6 2.00 3.45 4Q09 2.5 3.0 2.5 12.0 0.0 2.5 4.5 0.5 -2.5 3.5 -0.1 9.4 10.0 9.9 15.9 2.00 3.35 1Q10 6.2 5.3 -2.5 8.0 8.7 14.4 4.4 4.6 -2.7 3.4 2.0 17.7 22.2 9.5 18.1 2.00 3.38 2Q10 4.4 3.9 -3.0 6.0 10.5 12.5 3.0 1.5 -0.1 3.3 2.8 17.0 21.0 7.6 16.1 2.25 3.31 3Q10 3.7 4.1 -4.0 6.0 11.5 12.8 2.9 0.7 0.0 3.2 3.0 18.5 18.5 9.1 15.2 2.50 3.24 4Q10 3.7 4.1 -3.7 4.0 4.0 4.5 2.4 1.6 -0.3 3.2 3.0 9.0 9.0 10.8 14.6 2.50 3.15 1Q11 4.7 4.0 7.0 8.0 4.2 6.2 4.7 1.0 -1.0 3.1 3.2 9.2 9.2 10.4 16.1 2.75 3.09 2Q11 4.7 4.2 7.0 8.0 5.2 7.2 4.8 1.0 -1.2 3.1 3.5 10.2 10.2 8.4 13.6 3.00 3.04 2009 -2.2 1.1 4.1 -4.7 -11.8 -13.5 0.1 -2.6 0.2 3.7 0.6 -21.0 -21.2 34.0 17.0 -8.1 2.00 3.35 2010 4.5 4.3 -3.4 5.9 8.7 10.7 3.1 2.0 -0.7 3.3 2.7 15.2 17.0 36.9 15.9 -5.4 2.50 3.15 2011 5.2 4.4 7.0 8.0 6.1 7.9 5.1 1.1 -0.9 3.1 3.6 11.3 10.9 41.6 13.9 -5.3 3.00 2.92

Notes: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are period average. All forecasts are modal forecasts (i.e., the single most likely outcome). Table last revised 16 December 2009. Source: CEIC and Nomura Global Economics.

Nomura Global Economics

48

16 December 2009

2010 Global Economic Outlook

Philippines ⏐ Economic Outlook

Robert Subbaraman

Too much fiscal hype
The fiscal deficit should remain large in 2010, but otherwise the fundamentals are in good shape. Activity: The Philippines weathered the global crisis relatively well, escaping recession. The modest downturn means that the economy is not lumbered with large excesses of labour and capital, and so should be able to bounce back strongly. We are forecasting GDP growth to rise to 5.5% in 2010 and 6.0% in 2011. This may seem aggressive, but over 2004-07 average annual GDP growth was 5.9%. There are four other reasons for our bullish outlook. First, we expect macro policies to remain accommodative, especially fiscal policy ahead of the May 2010 election. Second, with the global economy recovering, remittances by the 8.7 million Filipino overseas workers should strengthen, and they account for a hefty 10% of GDP. Also, as large companies around the world strive to reduce costs, the business process outsourcing industry of the Philippines should continue to blossom. Third, output of the agricultural sector, which makes up 17% of GDP and employs one-third of all workers, was weak in 2009 due to low food prices early in the year and natural disasters in the latter half. We expect agricultural output to rebound in 2010. And fourth, there is an urgent need to upgrade the capital stock. The investment-GDP ratio has fallen to just 15%, but with much-improved fundamentals we expect it to rebound. Fundamentals: Concerns have been raised about the increased fiscal deficit, which will likely remain around 4% of GDP in 2010. However, in the global scheme of things this is not large, and Philippine public debt has fallen to 60% of GDP from 95% in 2004. If the economy quickly returns to high growth – as we expect – the fiscal finances should not be a problem. Other fundamental indicators are healthy: the loan-deposit ratio, at 66%, is among the lowest in Asia; the current account is in surplus; external debt has fallen to 33% of GDP from 72% in 2003; and FX reserves are at a record high of USD36bn, equal to ten months of import cover. Inflation and monetary policy: After plunging to almost 0% in August 2009, CPI inflation rose to 2.8% y-o-y in November, and we expect it to continue rising, to average 5.4% in 2010. However, we do not expect Banko Sentral ng Pilipinas to start hiking rates until 2Q10, and only by a total of 75bp by the end of 2010. We see a number of reasons for the slow policy response: inflation is rising from a very low level and is partly driven by higher costs of food and energy; the elections may delay rate hikes; commercial bank lending rates are already quite high; and peso appreciation will do some of the tightening of overall monetary conditions. Risks: A surge in commodity prices (the Philippines is a large net importer of oil and rice) and social unrest around election time are downside risks. On the upside, if growth picks up in 2010 as we expect, the Philippines’ favourable interest rate differential and relatively sound economic fundamentals could attract strong capital inflows and possibly a sovereign credit rating upgrade. Details of the forecast
% y-o-y growth unless otherwise stated Real GDP [sa, % q-o-q, annualized] Real GDP Private consumption Government consumption Gross fixed capital formation Exports (goods & services) Imports (goods & services) Contribution to GDP growth (% points): Domestic final sales Inventories Net trade (goods & services) Exports Imports Merchandise trade balance (US$bn) Current account balance (US$bn) (% of GDP) Fiscal balance (% of GDP) Consumer prices Unemployment rate (sa, %) Reverse repo rate (%) 91-day T-Bill yield (%) Exchange rate (PHP/USD) 3Q09 4.1 0.8 4.0 7.8 -1.6 -13.7 0.3 3.4 -1.8 -7.9 -21.5 -28.5 -0.9 2.0 5.1 0.3 7.6 4.00 4.40 47.6 4Q09 4.8 1.7 2.9 7.0 4.1 0.0 5.0 3.3 0.6 -2.2 2.0 13.0 -2.5 1.4 3.0 2.9 7.8 4.00 4.40 46.3 1Q10 7.8 5.9 4.0 10.0 13.9 4.0 8.0 6.2 1.0 -1.3 5.0 13.0 -2.5 1.3 3.1 3.0 7.5 4.00 4.50 46.8 2Q10 8.3 6.2 4.0 10.0 14.2 6.0 7.0 6.7 0.0 -0.4 8.0 15.0 -2.3 1.5 3.3 5.0 7.0 4.25 4.75 45.7 3Q10 0.3 5.2 3.5 3.0 19.1 7.0 9.0 6.3 0.0 -1.0 8.0 16.0 -1.9 2.5 5.3 7.0 7.0 4.50 5.00 44.7 4Q10 2.1 4.6 5.0 3.0 13.3 7.0 9.0 6.2 0.0 -1.7 10.0 17.0 -3.6 1.5 2.7 6.5 6.5 5.00 5.25 43.7 1Q11 8.0 4.6 3.0 2.0 13.2 8.0 9.0 4.8 0.0 -0.3 11.0 17.0 -3.5 1.5 3.1 6.0 6.0 5.50 5.75 43.0 2Q11 15.5 6.3 5.0 5.0 14.3 8.0 10.0 7.2 0.0 -0.9 11.0 17.0 -3.3 1.8 3.3 6.0 6.0 6.00 6.00 42.4 2009 1.0 3.4 7.3 -2.3 -12.3 -3.8 2.7 -1.0 -4.0 -22.5 -21.5 -6.5 7.3 4.6 -4.0 3.2 7.7 4.00 4.40 46.3 2010 5.5 4.2 6.7 15.1 6.1 8.3 6.3 0.2 -1.1 7.9 15.4 -10.3 6.7 3.6 -4.0 5.4 7.0 5.00 5.25 43.7 2011 6.0 4.8 4.3 14.6 8.8 9.8 6.8 0.0 -0.8 11.0 17.0 -14.6 6.8 3.0 -3.3 5.7 6.0 6.00 6.50 41.0

Notes: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are period average. All forecasts are modal forecasts (i.e., the single most likely outcome). Table last revised 16 December 2009. Source: CEIC and Nomura Global Economics.

Nomura Global Economics

49

16 December 2009

2010 Global Economic Outlook

Singapore ⏐ Economic Outlook

Tetsuji Sano

Tourism to drive momentum
Singapore’s economy should accelerate through 2010, supported by domestic demand. Tourism is likely to help private consumption and improve the current account balance. Activity: We expect real GDP growth to rise to 5.5% in 2010 led by domestic demand. The main driver will be investment, contributing 2.7 percentage points (pp) to GDP growth in 2010, with strong investment in the biomedical sector set against an accommodative fiscal policy backdrop. The government will continue to strive to attract foreign direct investment and global talent, especially to the biomedical sector. Private consumption looks set to contribute 1.9pp to growth in 2010 as the labour market improves. In addition, we expect a large increase in the number of tourists to improve consumer sentiment and boost service exports. In the balance of payments, travel receipts made up 5.6% of GDP for the first three quarters of 2009. We expect the number of tourists to increase at a double-digit pace in 2010 as the global economy recovers, although the year-to-date number fell 6.9% y-o-y in October. The two integrated resorts (IRs) including casinos, start operations in 2010 and should attract added tourist numbers. Furthermore, higher asset prices should have positive wealth effects and improve consumer sentiment. Inflation and monetary policy: We expect CPI inflation to rise to 3.0% in 2010 as we expect the housing segment to rise, largely due to technicalities: the government will raise its expected market rental prices of all Housing Development Board (HDB) flats, effective from 1 January 2010 to reflect prevailing HDB rentals. Excluding this technical issue we would expect a 1.8% increase in CPI inflation. On the monetary policy front, we expect the Monetary Authority of Singapore to shift to a tightening stance of its exchange rate policy in April 2010. Fiscal policy: We expect the accommodative stance to continue through 2010 with ongoing infrastructure development, although we do not assume an additional stimulus package. The government has decided to extend the job credit scheme – under which employers receive a 12% cash grant on the first SGD2,500 of each month’s wages for each employee on their Central Provident Fund payroll – until the end of June 2010. A cut in the corporate tax rate to 17% from 18% will take effect in FY10, giving the Lion City the second-lowest tax rate in Asia next to Hong Kong, at 16.5%. Risks: Given that Singapore is Asia’s most open economy, the most significant downside risk is a renewed slump in the global economy. We also note that the historically volatile biomedical sector, which showed strong growth in 2Q09 and 3Q09, offers both upside and downside risks to economic momentum, although we expect biomedical production to increase annually in 2010.

Details of the forecast
% y-o-y growth unless otherwise stated Real GDP [sa, % q-o-q, annualized] Real GDP Private consumption Government consumption Gross fixed capital formation Exports (goods & services) Imports (goods & services) Contributions to GDP: Domestic final sales Inventories Net trade (goods & services) Unemployment rate (sa, %) Consumer prices index Exports Imports Merchandise trade balance (US$bn) Current account balance (% of GDP) Fiscal Balance (% of GDP) 3 month SIBOR (%) Exchange rate (SGD/USD) 3Q09 14.2 0.6 -0.9 10.2 0.3 -10.9 -11.4 0.7 -0.5 -1.6 3.4 -0.4 -22.3 -25.0 6.7 13.0 0.68 1.42 4Q09 -2.9 4.3 1.9 10.0 6.2 0.1 0.0 3.5 0.6 0.2 3.4 -0.1 10.4 12.3 1.0 10.2 0.70 1.38 1Q10 4.9 9.1 6.4 12.0 11.8 9.0 9.6 7.7 1.3 0.1 3.2 2.5 25.4 29.5 2.9 12.6 0.70 1.38 2Q10 5.5 5.2 4.7 8.0 7.7 9.0 11.5 4.8 3.6 -3.1 3.0 3.3 18.4 23.0 4.0 14.4 0.75 1.36 3Q10 4.6 3.0 4.1 8.0 9.0 9.0 11.5 4.8 1.3 -3.2 2.8 3.3 11.7 13.8 6.1 13.0 1.00 1.33 4Q10 5.9 5.2 4.2 8.0 10.2 5.0 6.5 5.3 2.7 -2.8 2.6 3.1 8.1 8.3 0.9 8.2 1.25 1.30 1Q11 4.7 5.2 4.4 8.0 12.0 6.0 7.8 6.4 1.8 -3.0 2.5 1.9 8.9 10.5 2.1 11.1 1.25 1.28 2Q11 6.5 5.4 4.7 8.0 12.0 6.6 8.2 6.1 1.6 -2.3 2.4 3.0 12.8 14.3 3.4 13.1 1.50 1.27 2009 -2.0 -1.7 3.4 -4.6 -12.2 -12.3 -1.6 0.2 -2.2 3.4 0.3 -20.5 -21.3 17.3 12.3 -3.5 0.70 1.38 2010 5.5 4.8 9.3 9.6 8.0 9.7 5.6 2.2 -2.3 2.9 3.0 15.1 17.6 13.8 12.0 -3.2 1.25 1.30 2011 5.5 5.0 8.0 12.0 6.7 8.3 6.3 1.7 -2.5 2.4 2.7 12.1 13.5 11.6 11.0 -2.7 1.75 1.23

Notes: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are period average. All forecasts are modal forecasts (i.e., the single most likely outcome). Table last revised 16 December 2009. Source: CEIC and Nomura Global Economics.

Nomura Global Economics

50

16 December 2009

2010 Global Economic Outlook

South Korea ⏐ Economic Outlook

Young Sun Kwon

Inflationary recovery
We see an inflationary economic recovery in 2010, driven by a prolonged macro stimulus rather than productivity gains. A large balance of payment surplus should boost asset prices in 2010. Activity: Korea’s 3Q09 real GDP gained 3.2% (sa) q-o-q or 0.9% y-o-y, bringing the level higher than the previous 3Q08 peak. As the production utilization rate fully recovers, sequential quarteron-quarter GDP growth rates will likely be smaller, but still positive, meaning the recovery remains on track. In 2010, despite sluggish recoveries in the G3 we are positive on the export outlook, because of strong emerging market demand, particularly from China. Long-term growth for Korea’s oil, gas and power plant exports to the Gulf looks intact. A weaker KRW/JPY should help maintain export price competitiveness. Domestically, we expect consumption to recover as pent-up demand is unleashed, helped by positive wealth effects, negative real policy rates and household re-leveraging. A large 2009 current account surplus (we estimate USD41bn or 5% of GDP) should have multiplier effects on the domestic economy in 2010. In sum, we expect delayed rate hikes, an undervalued KRW, strong China demand and consumer re-leveraging to all support growth in 2010, but the Bank of Korea (BOK) eventually tightening aggressively to get back ahead of the curve is likely to lower growth in 2011. We forecast above-the-consensus 5.5% GDP growth in 2010, but below-the-consensus 4.0% growth in 2011. Inflation: We expect CPI inflation to rise to 3.3% in 2010 from 2.8% in 2009 as the negative output gap closes and nominal wages increase. Inflation expectations are relatively elevated. Deeply negative real interest rates in 1H10 and rising money supply should support asset prices. Policy: Although impressive data suggest that a rate hike is possible any time soon, we expect the BOK to move late, with a 25bp rate hike in June, given the central bank’s benign inflation outlook, its new, wider inflation target and a political preference to accelerate growth. We then expect an aggressive 125bp of catch-up hikes in 2H10 to 3.50%. After adjusting for the cyclical upswing, we judge that structural fiscal tightening should be only modest. The government decided to extend its financial support for small and medium sized enterprises until end-June. Risks: Upside risks are stronger-than-expected recoveries in the G3, lower oil prices, and higher productivity in Korea, which would help firms’ profitability and limit inflationary pressure. Successful structural reforms and more prudent macro policy are long-term positives. Downside risks include worse-than-expected G3 demand, higher oil prices or a weaker JPY, which would worsen the balance of payments. Uncertainty surrounding North Korea is a wild card. Recordhigh FX reserves (USD271bn in November) and unused currency swap lines with the Fed (USD29bn) should help buttress the economy from any renewed global financial turmoil. Details of the forecast
% y-o-y growth unless otherwise stated Real GDP (sa, % q-o-q, annualized) Real GDP (sa, % q-o-q) Real GDP Private consumption Government consumption Business investment Construction investment Exports (goods & services) Imports (goods & services) Contributions to GDP growth (% points): Domestic final sales Inventories Net trade (goods & services) Unemployment rate (sa, %) Consumer prices Current account balance (% of GDP) Fiscal balance (% of GDP) Fiscal balance ex-social security (% of GDP) Money supply (M2) House prices (% q-o-q) BOK official base rate (%) 3-year T-bond yield (%) 5-year T-bond yield (%) Exchange rate (KRW/USD) 3Q09 13.6 3.2 0.9 0.8 5.0 -7.4 2.7 1.2 -8.7 1.0 -5.4 5.3 3.8 2.0 4Q09 0.6 0.2 6.3 6.2 3.6 9.0 3.8 12.3 8.6 4.8 -0.7 2.1 3.4 2.5 1Q10 4.5 1.1 7.3 7.0 0.7 24.0 -1.8 19.7 22.1 5.7 1.4 0.3 3.4 3.4 2Q10 6.1 1.5 6.1 4.7 0.5 13.7 -2.5 9.5 16.2 3.4 4.4 -1.7 3.4 3.3 3Q10 4.5 1.1 3.9 4.2 2.3 2.0 -1.5 6.1 10.9 2.5 2.7 -1.3 3.4 3.3 4Q10 4.1 1.0 4.8 4.7 3.6 1.0 0.5 8.2 12.5 3.2 2.7 -1.1 3.3 3.4 1Q11 3.6 0.9 4.6 4.6 3.9 1.0 1.5 7.7 10.4 3.6 1.7 -0.7 3.3 3.2 2Q11 3.6 0.9 4.0 4.2 4.1 0.5 0.5 8.2 8.4 3.1 0.4 0.4 3.3 3.2 2009 0.0 0.4 5.7 -10.1 2.8 -0.5 -8.4 1.4 -4.7 3.3 3.7 2.8 5.0 -2.1 -4.9 10.8 1.2 2.00 4.20 4.70 1140 2010 5.5 5.1 1.8 9.4 -1.3 10.6 15.2 3.8 2.7 -0.9 3.4 3.3 2.0 -0.4 -2.9 12.3 3.0 3.50 5.00 5.50 1050 2011 4.0 4.3 4.0 2.4 1.4 8.0 8.6 3.4 0.3 0.3 3.3 3.2 0.5 0.2 -2.3 11.0 2.0 4.50 4.70 5.00 950

10.0 1.3 2.00 4.39 4.81 1189

10.5 0.5 2.00 4.20 4.70 1140

11.0 0.5 2.00 4.35 4.85 1155

12.0 0.7 2.25 4.50 5.00 1120

14.0 0.8 2.50 4.90 5.35 1080

12.0 1.0 3.50 5.00 5.50 1050

11.0 0.5 3.75 5.00 5.35 1025

11.0 0.5 4.00 5.00 5.25 1000

Notes: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are period average. All forecasts are modal forecasts (i.e., the single most likely outcome). Table last revised 16 December 2009. Source: Bank of Korea, CEIC and Nomura Global Economics.

Nomura Global Economics

51

16 December 2009

2010 Global Economic Outlook

Taiwan ⏐ Economic Outlook

Tomo Kinoshita ⏐ Robert Subbaraman

Cross-straits moves to raise business confidence
A rise in consumer and business sentiment should fuel growth. Activity: We expect the Taiwan economy to be on a firm recovery trend in 2010. Private consumption has been improving on the back of improving sentiment and rising wealth effects with the consumer confidence index having recovered to 62.5 in November 2009, up from the bottom of 48.4 recorded in February 2009. Wealth effects on consumption are powerful in Taiwan, since portfolio investment (of which the share of stocks is substantially larger than others, in our view) accounted for about 37% of household assets according to the most recent government survey (as of end-2007). Another recent government survey revealed that companies intend to hire around 48,000 people during December 2009-January 2010. As the government separately intends to create 15,000 jobs during 1H10, the number of unemployed people should decrease notably from the seasonally-adjusted level of 661,000 in October 2009, which should further lift consumer sentiment. Investment also appears to be recovering as business sentiment rises and the capacity utilisation rate in major industries appears to have picked up substantially from the bottom. Business sentiment should improve thanks to the Economic Cooperation Framework Agreement (ECFA) which Taiwan is trying to conclude with the mainland some time in 1Q10. Given the above expectations, we have raised our growth forecast for 2010 to 4.8% from the previous 4.4%. Monetary policy: We expect headline CPI inflation to rise to 1.5% in 2010 from -0.8% in 2009, reflecting a decent economic recovery. The central bank has been warning against the risk of a housing bubble and nonperforming loans, fuelled by fierce competition in mortgage lending. To curb hot money inflows, the authorities have banned foreign investors from placing funds in the banking sector’s time deposits. We expect the central bank to scale up its open market operations to drain excess bank liquidity and to start raising the policy interest rate in 2Q10. Fiscal policy: In an effort to consolidate fiscal policy after an expansionary budget in 2009, central government expenditure is budgeted to drop by 4.1% for 2010. However, including the special budgets for public construction, flood control and reconstruction, actual underlying government spending is likely to be close to 2009 levels. Risks: Rising consumer confidence and the powerful asset price-driven wealth effects in Taiwan pose risk of stronger-than-expected private consumption growth. The sustainability and strength of the global recovery is still uncertain, with volatile capital flows posing challenges to FX policy. A delay in cross-strait economic liberalisation may disappoint financial markets, while successful integration could raise the potential rate of growth over the medium term. Details of the forecast
% y-o-y growth unless otherwise stated Real GDP [sa, % q-o-q, annualized] Real GDP Private consumption Government consumption Gross fixed capital formation Exports (goods & services) Imports (goods & services) Contributions to GDP: Domestic final sales Inventories Net trade (goods & services) Exports Imports Merchandise trade balance (US$bn) Current account balance (US$bn) (% of GDP) Fiscal balance (% of GDP) Consumer prices index Unemployment rate (%) Discount rate (%) Overnight call rate (%) 10-year T-bond (%) Exchange rate (NTD/USD) 3Q09 8.3 -1.3 2.2 3.6 -6.2 -8.5 -12.6 0.5 -3.1 1.3 -20.8 -29.5 6.5 5.7 6.2 -1.3 6.1 1.25 0.10 1.40 32.20 4Q09 7.1 5.1 3.5 2.3 13.2 11.8 13.0 4.7 -0.5 0.9 10.2 15.2 4.9 6.1 5.7 -0.8 6.0 1.25 0.10 1.45 32.10 1Q10 2.5 9.0 3.9 -1.3 17.6 22.1 26.0 5.4 2.6 1.0 22.1 33.5 6.7 11.9 11.6 1.0 5.7 1.25 0.15 1.50 32.30 2Q10 2.1 4.9 4.5 0.4 11.6 11.9 14.0 4.4 0.0 0.5 11.9 18.9 5.0 7.3 7.4 1.3 5.5 1.50 0.30 1.60 31.70 3Q10 1.1 3.2 4.3 -0.2 4.5 8.1 9.8 2.4 0.5 0.3 8.1 11.7 5.3 6.3 6.0 1.6 5.4 1.63 0.40 1.75 31.10 4Q10 5.0 2.7 2.8 1.4 4.9 6.8 8.2 2.6 -0.1 0.1 6.8 8.4 4.5 5.7 4.9 2.0 5.3 1.75 0.50 1.85 30.50 1Q11 7.3 3.8 2.8 0.0 5.2 8.3 9.5 3.0 0.4 0.4 10.6 13.0 6.4 11.6 10.0 1.9 5.1 1.88 0.60 1.95 29.91 2Q11 5.4 4.7 3.6 -0.1 8.0 8.3 9.9 3.7 0.8 0.2 12.3 14.2 4.7 7.1 6.2 1.8 4.9 2.00 0.70 2.05 29.43 2009 -3.0 0.9 3.4 -11.6 -10.9 -14.2 -1.3 -2.3 0.6 -21.7 -27.9 26.9 37.2 9.8 -3.0 -0.8 5.9 1.25 0.10 1.45 32.10 2010 4.8 3.6 0.2 8.9 11.5 13.6 3.6 0.7 0.4 11.5 16.4 21.5 31.2 7.4 -2.7 1.5 5.7 1.75 0.50 1.85 30.50 2011 5.2 3.0 0.1 9.9 10.4 10.9 3.5 0.6 1.1 13.2 15.4 19.8 29.6 6.1 -1.2 1.8 4.4 2.25 1.00 2.30 28.50

Notes: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are period average. All forecasts are modal forecasts (i.e., the single most likely outcome). Table last revised 16 December 2009. Source: CEIC and Nomura Global Economics.

Nomura Global Economics

52

16 December 2009

2010 Global Economic Outlook

Thailand ⏐ Economic Outlook

Tetsuji Sano

Political uncertainty
The economy should continue to recover gradually, but economic sentiment may be dented by political uncertainty. We expect loose macro policies to continue. Activity: We expect real GDP growth to rise to 3% in 2010 led by domestic demand amid loose macro polices. We expect domestic demand to contribute 2.6 percentage points (pp) to GDP growth in 2010, mainly due to a low base in 2009. The pace of the Thailand’s recovery is expected to be the mildest in Asia, largely because the political impasse between pro- and antiThaksin factions is expected to continue to hurt sentiment. Private investment has also been negatively affected by events surrounding the Map Ta Phut industrial area. On 29 September 2009 the Central Administrative Court ordered the suspension of operations at 76 projects in the Map Ta Phut area. On 2 December, the Supreme Administrative Court ruled that 65 of the 76 projects should remain suspended. Following the ruling, we believe manufacturers will take a cautious stance on investment in 2010. We expect overall investment to grow at only 3.7% y-o-y as weak private investment is offset by strong public investment. We expect the contribution of net exports to GDP growth to slow to 0.5pp in 2010, again mainly on a low base in 2009. Inflation and monetary policy: We expect CPI inflation to rise to 2.7% in 2010 on higher crude oil prices. Demand-pull inflationary pressure should remain weak due to the still-remaining output gap. On monetary policy, we expect the Bank of Thailand (BOT) to start hiking rates in 2Q10 following a pick-up in CPI inflation. We expect the BOT to raise its policy interest rate by only 50bp in 2010, as downside risks to economic growth will persist. As a result, we expect the real interest rate to remain negative through 2010. Fiscal policy: The government plans to cut the expenditure budget to THB1.7trn for FY10 (starting October 2009), compared to the final THB1.95trn budget for FY09. The government has started its THB1.43trn fiscal stimulus package for FY10-12, aimed largely at developing infrastructure. The package is to be financed mainly from non-budgetary accounts, such as state-owned enterprises; THB431bn has been allotted for FY10. Overall, we expect accommodative fiscal policy to support the economy in 2010. Risks: We have already mentioned some of the political risks, and the general election, which must take place before 23 December 2011, is another. Prime Minister Abhisit seems to believe that an early election would calm political tensions between pro- and anti-Thaksin groups, but it could backfire. Moreover, if the incumbent coalition parties do lose in the election, a new government may review and alter the stimulus package. Another downside risk, is a sharp rise in oil prices, given that Thailand is Asia’s largest net importer of oil once scaled by GDP. The main upside risk is a quick resolution of the political impasse, which would allow investors to refocus on the economy, whose fundamentals are in good shape. Details of the forecast
% y-o-y growth unless otherwise stated Real GDP [sa, % q-o-q, annualized] Real GDP Private consumption Public consumption Gross fixed capital formation Exports (goods & services) Imports (goods & services) Contribution to GDP (%points): Domestic final sales Inventories Net trade (goods & services) Exports Imports Merchandise trade balance (US$bn) Current account balance (US$bn) (% of GDP) Fiscal balance (% of GDP, fiscal year basis) Consumer prices Unemployment rate (sa, %) Overnight repo rate (%) Exchange rate (THB/USD) 3Q09 5.5 -2.8 -1.3 4.7 -6.3 -15.0 -9.2 -1.6 -4.5 3.2 -17.7 -28.0 4.8 3.7 5.6 -2.2 1.4 1.25 33.5 4Q09 4.6 3.1 -0.3 3.0 3.7 1.5 0.5 0.9 1.5 0.7 4.5 4.2 -1.4 -0.8 -1.1 1.8 1.4 1.25 33.1 1Q10 2.2 5.3 3.0 3.0 2.2 10.0 14.0 2.3 2.3 0.7 14.4 23.2 5.7 8.9 12.4 3.2 1.3 1.25 33.3 2Q10 1.1 3.3 2.4 3.0 3.6 12.5 14.7 2.4 0.0 0.9 14.1 20.7 2.5 1.3 1.8 2.8 1.3 1.50 32.6 3Q10 1.1 2.2 1.5 3.0 4.0 10.0 13.5 2.0 0.0 0.2 10.6 13.2 4.3 3.2 4.4 2.6 1.2 1.75 32.0 4Q10 1.6 1.5 0.8 -1.0 5.0 6.0 7.0 1.4 0.0 0.1 5.0 8.1 -2.8 -1.9 -2.5 2.2 1.2 1.75 31.5 1Q11 5.7 2.3 1.0 -1.0 10.7 6.0 10.0 2.4 0.3 -0.4 7.6 10.2 5.3 8.9 11.2 2.5 1.1 2.00 31.1 2Q11 8.4 4.1 2.5 -1.0 12.5 7.5 11.5 4.0 1.0 -0.9 10.8 15.5 1.0 -0.1 -0.1 3.0 1.1 2.50 30.8 2009 -3.0 -1.6 5.3 -7.3 -13.3 -19.9 -1.9 -2.8 1.9 -15.8 -24.5 14.3 15.3 6.0 -5.7 -0.9 1.5 1.25 33.1 2010 3.0 1.9 2.1 3.7 9.5 11.9 2.0 0.6 0.5 10.7 15.3 9.7 11.5 4.0 -3.9 2.7 1.3 1.75 31.5 2011 5.0 3.5 -1.0 13.9 7.7 11.5 4.7 1.0 -0.7 10.6 14.4 4.8 7.6 2.3 -3.6 3.3 1.1 3.00 30.0

Notes: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are period average. All forecasts are modal forecasts (i.e., the single most likely outcome). Table last revised 16 December 2009. Source: CEIC and Nomura Global Economics.

Nomura Global Economics

53

16 December 2009

2010 Global Economic Outlook

Vietnam ⏐ Economic Outlook

Sonal Varma

An overheated economy
Vietnam needs to correct the macro-economic imbalances of excess credit growth, high fiscal and current account deficits and rising inflation to avoid another crisis. Activity: An aggressive fiscal stimulus, spearheaded by the interest-rate subsidy scheme, has underpinned a domestic-led economic recovery that looks to be gaining momentum. Domestic demand indicators such as auto sales, industrial production and retail sales have accelerated. However, Vietnam is at risk of having over-stimulated the economy. Credit growth has already accelerated 36% y-o-y in November (year-to-date), which is even higher than that in China, and we see a growing risk that some of these loans are being used for unproductive purposes, such as investment in asset markets. Higher credit growth and loose fiscal policies are likely to stimulate private demand and boost GDP growth from 5.1% y-o-y in 2009 to 6.5% in 2010. However, with foreign investor confidence flagging as a result of the twin deficits, we expect aggressive policy action to curtail these imbalances. This should anchor GDP growth at 6.6% in 2011, below Vietnam’s real potential. Inflation: Both demand and supply side factors suggest that inflation is likely to revert to doubledigits in 2010. Rising global commodity prices are putting upward pressure on raw material costs. Meanwhile, accelerating growth and credit off-take are fuelling demand-side inflationary pressures. We expect CPI inflation to average 12.4% y-o-y in 2010, up from 6.7% in 2008, shifting the policy focus to inflation. Policy: External sector pressures are gradually building up as a result of the widening trade deficit and a sharp decline in foreign direct investment commitments, which have eroded the balance of payments position. Amid media reports of growing black-market speculation that the dong will be devalued again, the State Bank of Vietnam (SBV) has depleted its FX reserves to fewer than three months of import cover to defend the currency. We expect another round of devaluation some time in 2010. This is likely to add to inflationary pressures and increase the need for additional rate tightening. Therefore, we expect the SBV to hike policy rates by 300bp in 2010. Administrative measures to curtail lending amid growing concerns about the health of the banking system and measures to reduce imports also look likely in the coming months. Risks: High inflation, rising credit growth, loose fiscal policy and a widening trade deficit – all sings of economic overheating – are the key challenges facing policymakers. If confidence continues to decline, a vicious spiral could develop, ultimately leading to a balance of payments crisis. In our view, policies need to be tightened aggressively to reduce these risks. Details of the forecast
% y-o-y growth unless otherwise stated 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 2009 2010 2011

Real GDP [sa, % q-o-q, annualized] 8.7 8.0 4.9 5.8 5.9 5.6 4.7 8.1 Real GDP 5.8 6.4 8.0 6.6 6.3 5.7 5.4 6.0 5.1 6.5 6.6 Private consumption 7.0 8.0 8.2 Public consumption 10.0 8.0 6.0 Gross fixed capital formation 3.5 7.8 9.0 Contribution to GDP growth (% points): Domestic final sales 6.8 9.1 9.6 Inventories -1.0 0.7 0.8 Net trade (goods & services) -0.7 -3.3 -4.0 Exports -21.7 -6.7 5.0 12.0 13.3 14.1 12.3 13.1 -12.5 11.1 13.3 Imports -4.5 18.6 5.0 10.0 29.2 19.2 11.0 15.5 -16.1 17.0 14.7 Merchandise trade balance (US$bn) -4.4 -5.9 1.7 -3.8 -8.0 -7.7 2.1 -4.8 -12.4 -17.8 -21.3 Current account balance (US$bn) -10.0 -10.7 -11.8 (% of GDP) -10.8 -10.1 -9.6 Fiscal balance (% of GDP) -8.5 -6.0 -5.5 Consumer prices 2.6 4.7 8.9 12.6 14.2 13.2 12.2 11.6 6.7 12.4 11.2 Unemployment rate (%) 6.0 5.5 5.0 Base rate (%) 7.00 8.00 9.00 10.00 10.00 11.00 11.00 11.50 8.00 11.00 12.00 Refinance rate (%) 7.00 8.00 9.00 10.00 10.00 11.00 11.00 11.50 8.00 11.00 12.00 Exchange rate (VND/USD) 17,841 18,500 18,500 18,500 19,000 19,000 19,000 19,000 18,500 19,000 19,380 Notes: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are period average. All forecasts are modal forecasts (i.e., the single most likely outcome). Table last revised 16 December 2009. Source: General Statistics Office of Vietnam, State Bank of Vietnam, World Bank, CEIC and Nomura Global Economics.

Nomura Global Economics

54

16 December 2009

2010 Global Economic Outlook

EEMEA ⏐ Outlook 2010

Ivan Tchakarov ⏐ Peter Attard Montalto ⏐ Olgay Buyukkayali

Differentiated growth woes
EEMEA will continue to display many areas of vulnerability, including debt sustainability, although we expect relative policy credibility to lead to differing growth levels across the region.
EEMEA will continue be the weakest EM link in 2010

Cheap credit, strong capital inflows and financial sector liberalisation together with the prospects of EU convergence fuelled growth in the EEMEA (Emerging Europe, Middle East and Africa) economies in the run-up to the financial crisis (Figure 1). However, the unravelling of the current account and external imbalances, as well as exposure to Western Europe, meant EEMEA suffered disproportionally in 2009 relative to other emerging market (EM) economies in Asia and LatAm. Even though this weighed heavily on the investor psyche, leading to frequent predictions that the EEMEA economies were on the road to perdition, an Armageddon-type scenario failed to materialise, mainly because of the generous supranational cushion that these economies have enjoyed. With its challenging domestic policy environment, EEMEA likely will continue to be the most vulnerable region in EM, but we expect it to return to modest growth in 2010.

New supranational cover
The IMF and EU provided key support in 2009 ...

Despite being the weakest link in the EM universe, EEMEA was cushioned in 2009 by strong and flexible support by the IMF and EU. Supranational institutions were open to negotiating significant revisions to support programmes where there was political resistance (Ukraine, Latvia, Romania, Hungary). They were likely concerned that any slip-ups in these economies could spill over to the rest of the region, jeopardizing economic stability and heightening the risk of a crisis. However, now that the worst may be over, the risk/reward trade-off between the necessity to provide country support and the desire to avoid moral hazard is shifting in favour of a more individual approach to country circumstances. In that sense, we expect to see a transition from a hard to soft supranational cover, defined as close monitoring of specific country situations with a view to providing financial support while, at the same time, exacting stronger compliance with the IMF/EU programmes. We have started to see this shift in Ukraine and Romania, where the programmes have been delayed, and Latvia, where international institutions stood their ground against the government’s attempt to loosen the strings of the 2010 budget. However, we expect that, while supranational cover provided by the IMF and EU may fade in importance, it will be replaced by a new supranational anchor: the ERM-II. As countries exit the crisis we believe they will turn back towards euro adoption and that the EU Commission sees this as a key way to stabilise its periphery. The EU and CEE countries need to learn the lessons of previous troubled entries to EMU, especially given that policymaker credibility was easier to achieve before the crisis when credit was easy. As countries exit the crisis, timetables and fiscal policy need to adjust and be made more credible. Adoption dates may be some way off, but with Poland set to join ERM-II next year, in our view, and Estonia possibly applying to the ECB in Q2 2010 for an assessment of its compliance with the Maastricht criteria, we think this theme will be key in providing a floor for EEMEA economic performance leading into 2010 (see Box: Towards EMU: New convergence anchor).
Figure 2. Potential growth across the crisis

... but they will become more exacting in 2010 ...

... leading to new supranational cover provided by ERM-II

Figure 1. West European banking credit exposures to the East

USD bn 1,600 1,400 1,200 1,000 800 600 400 200

Amount of exposure Proportion of exposure as % of total exposure (rhs)

% 7 6 5 4 3 2 1

% y-o-y 8 7 6 5 4 3 2

Hungary Czech SA

Poland Russia Turkey

0 0 Mar-05 Dec-05 Sep-06 Jun-07 Mar-08 Dec-08
Source: Nomura Global Economics;.

Pre-crisis Our pre- Short run Medium Long run potential run crisis average (next 5 potential (in potential growth years) 10 years) estimate (19992007) (1999-2007 average)
Source: Nomura Global Economics

Nomura Global Economics

55

16 December 2009

2010 Global Economic Outlook

Towards EMU: New convergence anchor

Peter Attard Montalto

ERM-II and euro adoption is likely to be a key theme and important anchor for markets and policymakers in 2010. The last wave of interest in euro convergence was during the boom of 2004-06, when easy credit was expected to lead to accelerated convergence into the eurozone. The arrival of more credible policymakers and EU entry for much of Emerging Europe in 2004 also looked set to help emerging Europe along the road to convergence. However, the global economic downturn has made the Maastricht criteria look increasingly unattainable, and government timetables have slipped. Supranational support took over as a key anchor for the region, markets and its policymakers. However, coming out of the crisis as this support starts to be removed we expect ERM-II and euro-convergence to become the new anchor for Europe’s periphery. We also believe that policymakers in Brussels see the euro as an important support for such countries as they exit the crisis, and so we think this whole process should have strong political backing. Our Maastricht scorecard assesses the economic positions of EMU aspirants. The global economic crisis has affected government balances and long-end rates as well as inflation, making it difficult for many countries to meet the criteria. Also, the criteria have changed (or rather, our view of how the ECB will assess the present situation) as a result of changes in the euro-area economies and their interest and inflation rates on which the criteria are based. Poland and the Czech Republic, for instance, need to bring budget deficits down – a task that looks uncertain in 2011 and beyond without austerity measures designed specifically to meet EMU-entry criteria. Long-end rates should converge as countries adopt credible timetables for entry, but given that absolute debt levels and external vulnerability metrics remain high, such moves in rates will likely be gradual. Hungary, in particular, has a long way to go on the debt front and may need to adopt a difficult policy of net debt repayment to set a sustainable trend towards target. All in all, the global crisis means specific government policy and coordination will be required to set countries on the right path. In our view, a slow recovery by emerging Europe will mean that countries will stay in ERM-II for more than two years as they strive to meet the criteria. Markets will likely reward governments that put in the effort on this front with a convergence of long-run rates. The scorecard also presents our forecast for ERM-II central parity rates (centre of the +/-15% band) and when we think countries will join ERM-II and the euro. We expect Poland to join ERM-II at the very end of 2010 or start of 2011, after the presidential election is out of the way and loose fiscal policy can be reined back in. For Hungary we believe the likely new FIDESZ government in 2010 will want to join the euro at the end of its first term in office and so start talking early on about convergence, entering ERM-II in 2011and the euro in 2015. In the Czech Republic, given political difficulties and the fact that the euro is a much more divisive issue there, we expect the whole process to be significantly delayed until a government with a strong political mandate emerges. As for central parity levels, we see Hungary and Czech rates at around current spot levels at 280 and 26 vs the euro, respectively. Given the zloty’s undervaluation relative to fundamentals, we think the EU council is unlikely to accept Poland’s wish to join just below spot (it has recently posited EURPLN 4.0). Instead, we think 3.70, a less competitive level, would be more acceptable to the rest of the eurozone. Things are a little more complex in the Baltics. The EU appears to have a very strong political commitment to the region, but imbalances are large. Estonia looks most ready to join; we think it could apply to the ECB in May 2010 for a Maastricht assessment and setting of the permanent lock-in rate ready for euro adoption in January 2011. Its two neighbours could have more difficulty and may have to delay for a year. However, a flexible ECB may be less strict if it judges that a country is on a strong path towards meeting the criteria. Overall, we believe policymakers and markets should keep this theme in mind when analysing policy.
Figure 1. Nomura`s Maastricht scorecard
Convergence criteria HICP Inflation rate <3.2% 0.2 5.2 3.8 -2.1 -1.2 1.5 0.9 2.4 1.9 Last Government finances annual gov gross gov deficit to debt to GDP GDP -3%< -5.5 -4.2 -5.5 -3.0 -9.0 -6.8 0.8 -5.2 -12.7 2010 forecast <60% 37.8 79.8 56.6 9.0 44.8 35.4 17.5 49.2 67.9 2010 forecast Long Interest rate <6.5% 4.3 7.6 6.2 n.a. 7.5 7.5 2.7 1.3 4.1 Last Obligation to adopt Forecast dates Forecast FX ERM II central parity rate Currency spot rate

Country

In ERM II

ERM II

Euro

Gap

Criteria Czech Hungary Poland Estonia Latvia Lithuania Denmark Sweden UK

2 years No No No 5 years 4 years 5 years 10 years No No Current Yes Yes Yes Yes Yes Yes No, Referendum Yes No 2012 2011 2010/11 2004 2005 2004 1999 After referendum Not set 2017 2015 2013/4 2011 2011/2 2011/2 Soon after referendum Not set Not set Forecasts 26.00 280.00 3.70 15.65 0.70 3.45 26.25 276.69 4.17 15.65 0.70 3.45 1.0% -1.2% 11.3% 0% 0% 0%

Forecasts

Source: Nomura Global Economics, EU Commission, IMF.

Nomura Global Economics

56

16 December 2009

2010 Global Economic Outlook

Growth woes…
We see muted growth

On growth, we expect EEMEA to underperform its EM peers for three main reasons: • Pre-crisis growth was fuelled by rapid credit expansion, financed from external sources. While domestic credit has been maintained in many countries given EU agreements, post-crisis growth is likely to remain constrained as parent banks continue to focus on building up liquidity buffers and strengthening balance sheets. Equally, easy money flowing into equity markets will discontinue, which will be another drag on growth. Exports will remain subdued as Western Europe will be slow to recover. While some countries are trying to diversify their exports into Asia and other EM countries, this is more likely to materialize in the more distant future. Domestic demand will also be subdued because of the slow recovery in the external sector, in particular for the more open economies in the CEE. In addition, time lags from 2009 such as unemployment and nonperforming loans not peaking until Q2 will provide a continued source of stress for the region.

… but with a tinge of differentiation
However, some countries will do better than others

However, there is a lot of differentiation in terms of growth performance and we expect some countries – Russia, Kazakhstan, Poland, Israel, Turkey, South Africa – to perform better than others: Czech, Hungary, Romania and Ukraine. In CEE, Poland remains the outperformer, having avoided recession in 2009 due to the more closed nature of its economy, the higher efficacy of interest rate cuts and an expansionary fiscal policy. Hungary is set to be one of the few countries to contract in 2010 as it implements HUF900bn of budget cuts to keep public sector debt in check. Czech remains in between, although given the very open nature of its economy it will bear the brunt of the slow recovery in Western Europe. In South Africa we see a large bounce-back in growth, supported by rising exports to Asia and the soccer World Cup adding 0.7pp to GDP, although underlying consumption growth should pick up only slowly. Turkey has the highest potential output in the region, with a reasonable chance to attain investment grade status in the next two years, while Israel may benefit from a global recovery due to its dependence on technology-intensive export goods. As Turkey and Israel entered the crisis with strong initial conditions and were fairly aggressive with their policy stimulus, their recoveries should also be swift. Russia and Kazakhstan should gain substantially from the recent run-up in energy prices and from a proactive policy response, where prudent fiscal policy in the upswing has allowed the pursuit of countercyclical policy in the downswing. Romania will continue to be vulnerable because of an uncertain political backdrop, although we expect a modest recovery once this stabilizes. Ukraine is the most risky economy, but the gradual improvement in the economic environment, the strengthening of its external position and, hopefully, a clearer political picture after January’s presidential election should lead to modest growth in 2010.

Risks are slanted to the downside

Overall, the balance of risks is tilted slightly to the downside. On the one hand, a better-thanexpected recovery in Western Europe may spur net exports, boosting growth. On the other, another bout of global risk aversion could again focus market attention on underlying
Figure 4. End-2010 policy rates: Taylor rules vs forecasts

Figure 3. Debt levels in 2009

Public debt to GDP, % 90 80 70 60 50 40 30 20 10 0 0 RUB 50 ZAR RON UAH KZT TRY CZK PLN ILS HUF

%, policy rate 10 End-2010 forecast 8 6 4 2 0 End -2010 Taylor rule

100 150 External debt to GDP, %

Czech Hungary Poland South Republic Africa
Source: Nomura Global Economics.

Turkey

Israel

Source: Nomura Global Economics.

Nomura Global Economics

57

16 December 2009

2010 Global Economic Outlook

Debt (un)sustainability

Ivan Tchakarov

Public and external debt in EEMEA appears broadly sustainable, but shock scenarios reveal important vulnerabilities. Global risk aversion began to decline in early March as the conviction of market participants strengthened that the world should be able to avoid the gloom-laden scenario that loomed so large at the start of the year. EEMEA, usually cited as the emerging market region with the most acute economic problems, has also benefited from this more benign global backdrop. However, with fears of a full-scale financial crisis receding, attention has focused on the ability of these economies to return to a more sustainable path of medium-term economic growth. A significant impediment to achieving this goal could be the potential medium-term debt sustainability concerns arising from the need for strong countercyclical fiscal policies to cushion the adverse impact of the global crisis on domestic demand. In order to assess the sustainability of public and external debt, we develop a quantitative framework that can account for the different factors that contribute to the changes in the level of debt-to-GDP ratios. In particular, we consider the combined effect on that ratio of one standard deviation shocks to: the interest rate; GDP growth; and the current account (fiscal balance in the case of public debt-to-GDP ratio). We call this scenario the “worst-case scenario” as it studies the impact of all the shocks rather than considering the effect of each individual shock in isolation. The public debt-to-GDP ratio is set to peak in 2010 in the baseline scenario (Figure 1), although under the worst-case scenario the ratio rises sharply to 55% in 2013 compared with the baseline projection of 39%. The fact that the ratio is on a distinct upward trajectory is worrying, suggesting that under the worst-case scenario public debt might be unsustainable. Although even the worst-case scenario falls short of the Maastricht criterion of 60% that is usually cited as the appropriate benchmark for public debt sustainability, the widening gap between the baseline and the most stressful scenario is indicative of the possible risks associated with a long-drawn-out, sub-par recovery, characterised by severely depressed economic activity, subdued fiscal revenues and higher interest rates. It is also comforting that, even in the worst case, the ratio compares favourably with that in the aftermath of the Asian crisis. Looking at the average level of public indebtedness in the region masks important differences in levels of public debt of individual countries and their ability to withstand unfavourable macroeconomic conditions. We are less concerned about Russia and South Africa. Even though Hungary’s debt is the highest, we think the straightjacket imposed by the IMF and the government’s effort to rein in fiscal excesses should pay off over the medium term. We are more concerned about the Czech Republic and Poland, where public debt levels are projected to rise over the medium term and where shock scenarios reveal that public indebtedness may reach levels that are dangerously close to the 60% Maastricht criterion. On the eve of the crisis, EEMEA, with its large current account deficits and bulging foreign borrowing, was heavily exposed to a “sudden stop” phenomenon. However, current account balances and external financing conditions have now improved. Nevertheless, the ability to service foreign debt remains impaired notwithstanding the projected decline in the baseline external debt-to-GDP ratio beyond 2009. At the same time, the worst shock scenario suggests that by 2012 the ratio may rise to 61% relative to the baseline of 45% (Figure 2). It may also outstrip that during the Asia crisis. Hungary stands out: its debt has almost doubled as a share of GDP and is projected to remain above 100% in the medium term. Israel and Poland will likely continue to exhibit external debt levels of about 50% of GDP. In South Africa and Russia, foreign debt should be less of a concern. However, under shock conditions, the 2012 debt ratio almost doubles relative to baseline in South Africa and Russia, and rises a lot in Israel and Turkey. The Czech Republic and Poland seem to be the most resilient to shocks, with relatively minor increases in debt even in the worst-case scenario.
Figure 1. Public debt across crises Figure 2. External debt across crises

% of GDP 60

% of GDP 80

Asian crisis countries 1997-02 EEMEA baseline 2007-12 EEMEA w orst scenario 2007-12

50

70

40 Asian crisis countries 1997-03 EEMEA baseline 2007-13 EEMEA w orst scenario 2007-13 20 1 2 3 4 5 6 7
Source: Nomura Global Economics; Note: Year 1 is 1997 in Asia, 2007 in EEMEA; Asia is average of Thailand, Korea, Malaysia, Philippines.

60

30

50

40 1 2 3 4 5 6
Source: Nomura Global Economics; Note: Year 1 is 1997 in Asia, 2007 in EEMEA; Asia is average of Thailand, Korea, Malaysia, Philippines.

Nomura Global Economics

58

16 December 2009

2010 Global Economic Outlook

weaknesses. In addition, policy mistakes, in particular on the fiscal side, may lead to a reappraisal of risk perception. A turnaround in trade balances in 2010 from 2009’s large surpluses will also be a drag, but much will depend on the ability of inventory rebuilding and consumption to offset this. Potential growth may also be dented by decreasing labour force growth, declining productivity and falling investment rates (Figure 2). A post-crisis creditconstrained world will be another headwind, and overall we see potential as lower than it was before. Hungary, however, stands as an important example of how a country can specifically target potential growth, improving structural reforms in order to boost medium-term growth.

Debt (un)sustainability
Public debt sustainability is a key vulnerability ...

Public debt sustainability. EEMEA has certainly benefited from the more benign global backdrop in recent months as fears of a full-scale financial crisis reoccurring have eased. However, new macroeconomic concerns are taking centre stage as investors become increasingly worried about the return to more stable and sustainable medium-term growth. This is best exemplified in public debt sustainability as the EEMEA economies try to balance the need for aggressive shortterm cyclical stimuli against concerns that such actions might lead to unsustainable levels of public indebtedness, thus posing dangers for medium-term growth (Figure 3). Although the majority of countries were able to reduce public sector debt over 2002-08 – with Russia, South Africa and Czech standing out – deteriorating growth prospects have brought slumping revenues, worsening fiscal positions and higher public sector service requirements. As a result, public debt-to-GDP ratios are set to rise in the next few years, with shock scenarios revealing concerns in Czech and Poland, where indebtedness may reach levels dangerously close to the 60% Maastricht criterion (see Box: Debt (un)sustainability). In addition, a plethora of elections next year may further complicate the debt sustainability picture (see Box: Election fever). In that sense, policymaker credibility will constitute a key test for the ability of many EEMEA economies to tackle fiscal sustainability issues. External debt sustainability. This seems to pose fewer dangers given significant turnarounds in current accounts, as domestic demand has compressed, and sizable improvements in external financing conditions. Nevertheless, external debt-to-GDP ratios will still be at risk given subdued growth and limited export growth. Adverse shocks would affect Hungary the most, with Kazakhstan, Ukraine and Poland likely to continue to have external debt levels of about 50% of GDP. In South Africa and Russia, foreign debt should be less of a concern.

… and external debt risks may re-emerge

Different monetary policy cycle
Monetary policy exit will be much slower than in other EMs ...

EEMEA economies are, in general, at a different stage of the monetary policy cycle relative to Asia and Latam, with many countries still to cut rates (Russia, Romania, Hungary, Ukraine). This is driven by still-muted inflationary pressure, reflecting subdued domestic demand and looser capacity constraints. Even those countries that are tightening are doing less so than Asian and LatAm peers. One important avenue through which interest rates may increase has more to do with the aforementioned fears related to weak public sector balances. A number of monetary policy committees (MPCs) have raised this, with Poland standing out in this regard. In reality, central banks in the region are broadly split into three separate groups. Some, such as those in the Czech Republic, Poland and Turkey, which we see starting to hike rates in Q2 2010, will be looking to normalise rates from historically low levels. Others, such as in South Africa, will likely start hiking only from Q4, although we do not see this as a normalisation in the rates and monetary policy cycle. Finally, others will likely continue the cutting cycle, with central banks in Hungary and Romania reducing rates through to Q2 given a continued slowdown in their domestic economies. Russia and Ukraine are also looking to cut rates from still very high levels. On monetary policy, one of the biggest events to watch in 2010 will be South Africa’s shift to a dual mandate, although we do not believe this will affect an already highly flexible MPC (Monetary Policy Committee). For most of the countries that plan to hike, we see central banks doing less than that implied by our Taylor rule-based interest rate forecasts (Figure 4). Capital controls are unlikely to be important for EEMEA, although soft versions, including making it more onerous for corporates to borrow abroad, are possible in Russia. The authorities seem genuinely committed to elevating the status of the rouble internationally and, in that sense, any harder capital controls (after Brazil’s example) would appear unlikely. In South Africa, some relaxation of controls on capital outflows is also likely in a bid to curb rand appreciation.

... with a clear differentiation in the timing of the exit

Capital controls are unlikely

Nomura Global Economics

59

16 December 2009

2010 Global Economic Outlook

Election fever

Peter Attard Montalto ⏐ Ivan Tchakarov ⏐ Olgay Buyukkayali

Elections across EEMEA in 2010 are a key risk to the region’s exit from this crisis, particularly for the fiscal outlook. There are key elections in all three CEE countries, which will likely have important implications for both short-run market noise and longer-run policy direction for fiscal policy and structural reforms. With investors increasingly looking to differentiate between countries and policy sustainability being an important issue, elections will be major focus for markets. Poland has a presidential election scheduled in November, which looks set to be a close race between incumbent Lech Kaczyński and current Prime Minister Donald Tusk. However, having led Poland through this crisis without going into recession, Mr Tusk looks to be ahead of his rival and this could improve as growth rebounds. The key impact on policy is that Mr Tusk’s PO party has allowed the budget to slip in order to maintain spending into the election. It now risks breaching the key 55% of GDP public debt rule which would mean implementing a painful (in growth and political terms) austerity package just before the election. Hence, long-run structural reforms have recently been curtailed and other spending cuts have been announced. The passing of the election and the possibility of a new prime minister (perhaps former PM Jan Krzysztof Bielecki if Mr Tusk were to become president) should allow a fresh look at the fiscal situation and a reduction in spending as well as entry into ERM-II. The election is also important because the current president is opposed to many of Mr Tusk’s privatisation plans which are a key pillar for revenue next year. In Hungary, the technocratic government should come to an end with parliamentary elections in May. Support for the current majority holder of seats, the MSZP, has fallen to around 35% in recent polls and current opposition FIDESZ is expected to take over under new Prime Minister Victor Orban. The MSZP will be a hard act to follow, given present Prime Minister Bajnai’s strong relationship with markets. FIDESZ is expected to try to alter next year’s budget when it takes office, testing or even breaking IMF deficit limits in order to cut taxes and stimulate the economy for a year. Such a move risks damaging the positive sentiment Hungary now enjoys. However, we do not expect a budget blowout, simply a deficit of around 4.5% of GDP and spending rotated to the FIDESZ priority areas of education and health. After the postelection stimulus programme, the budget should come back. We are more concerned about a lack of long-run reforms from FIDESZ. However, we do not think concerns about next year should be exaggerated, although FIDESZ needs to communicate more with markets, who are still uncertain of the party’s full plans for office. In the Czech Republic, elections are due in Q2 after an attempt to pull them forward to this year failed in the constitutional court. The current interim administration is composed of both ODS and CSD opposing parties and they are neck-and-neck in the polls. Other smaller parties will be key to the formation of a new government, but it is generally difficult to form coalitions in the Czech Republic and we would not be surprised to see the current arrangement continue – indeed markets should not underestimate the probability of this occurring. If a government does form a coalition, a centre-left one is slightly more likely, in our view, which would result in slower budgetary adjustment. We are concerned that the budget deficit may not be dealt with as the political deadlock in the cabinet and parliament means pre-crisis spending levels are still in place. While the country certainly needs sharp spending controls given its large structural budget deficit, we doubt such a move will be forthcoming until at least 2011. We think the Czech Republic can run this dangerous course for now given its low level (stock) of vulnerabilities (debt levels) but it cannot continue forever. Ukrainian presidential elections are scheduled for 17 January. There appears little likelihood that the incumbent Viktor Yushchenko will win and the key battle is likely to be fought between the Prime Minister Yulia Tymoshenko and the leader of the opposition Viktor Yanukovich. Although Ms Tymoshenko has traditionally been associated with a more proEuropean policy view while Mr Yanukovich has been a proponent of stronger ties with Moscow, the candidates have recently moved much closer together, recognising the need for good policy relationships with both Europe and Russia. In that sense, the differences between the two candidates seem to be much less pronounced as both will likely strive to strike a conciliatory tone with Moscow while maintaining a pro-European bias in foreign policy. The key issue after the elections will be resolving the difficult economic situation in Ukraine, which is still, in our view, the most vulnerable economy in EEMEA. Non-compliance with key conditions in the IMF programme has led to the disbursement of a critical tranche of funding being delayed in November, and the next leadership’s paramount objective should be to ensure a resumption of negotiations with the IMF. Elections in Latvia, due in October, will be a key test of both the popularity of the current five-party coalition and the ability of the IMF and EU to accept further push-back from a new government on budget austerity conditions in its aid package. Turkish elections are not scheduled until 2011 but the deteriorating unemployment trends have encouraged the idea that they may be brought forward to 2010. Early elections are not our base case and we doubt the current government will bring them forward. Prime Minister Recep Tayyip Erdogan has so far dismissed this. Back in 2001 the AKP benefited from a disgruntled voter-base which protested against early elections during the job market deterioration.

Nomura Global Economics

60

16 December 2009

2010 Global Economic Outlook

Russia ⏐ Economic Outlook

Ivan Tchakarov

Animated by oil
After the marked slowdown in 2009, Russia is poised to return to stable, if somewhat subdued, growth in 2010, supported by the benign oil price outlook and pent-up domestic demand. Activity: Years of strong economic growth were superseded by lacklustre performance in 2009. The country was disproportionally affected by the global financial crisis because of a confluence of adverse shocks – unwinding terms-of-trade gains, disappearing external demand and drying up capital flows. However, the faster-than-expected recovery in oil prices and the very proactive fiscal policy have paved the way for an improving output performance, starting from the second half of 2009. We expect the growth momentum to continue through the next year, with GDP recovering strongly from -7.5% in 2009 to 3.5% in 2010. Growth should be primarily driven by domestic demand, with consumption and investment contributing 1.0% and 1.4% to growth, respectively. Pent-up domestic demand and inventory re-stocking, underpinned by improving confidence indices, should be the key supporting factors. However, in our view, the balance of risks is slanted to the upside, as the potential for energy prices to outperform should provide an important tailwind for growth. Inflation: After the temporary bump in inflation in Q12009, reflecting the rouble devaluation, price growth has been steadily decelerating ever since, falling to single y-o-y digits in October 2009. We see inflation continuing to drop over the next year from an average of 11.7% in 2009 to 8.9% in 2010 as subdued wage growth and loosening capacity constraints weigh on price pressures. Policy: Prudent fiscal policy in the upswing has allowed the pursuit of countercyclical policy in the downswing. Fiscal policy will likely be consolidated, but should continue to support growth as the federal budget should improve from a deficit of 6.8% of GDP in 2009 to a deficit of 5% in 2010. Part of the deficit would be financed by tapping the international financial market, although the magnitude of the financing should be significantly less than originally envisioned (around USD5-6bn vs USD18bn). The central bank navigated well the abrupt currency movements at the start of 2009, although this was greatly facilitated by the loss of a third of foreign reserves. Importantly, monetary policy seems to be on a transition course with regard to exchange rate policy, with a gradual, yet arguably committed, move from exchange rate targeting to inflation targeting. Our fair value currency calculations suggest that the rouble is now undervalued from a fundamental perspective, and the upward pressures on the currency may intensify in 2010 should oil prices continue to rise and GDP surprise on the upside. Politics: The strengthening signs of recovery have instilled fresh confidence in the Kremlin that the economy is on the rise. We think any concerns about the possible souring of the relationship between Prime Minister Putin and President Medvedev are premature. In our view, recent, and any forthcoming, diverging policy messages emanating from them should rather be seen as a reflection of a well-orchestrated campaign to address two different parts of the electorate, with Putin appealing to older voters while Medvedev appealing to the younger population.

Figure 1. Details of the forecast
2008 Real GDP % y-o-y Contributions to GDP (pp) Consumption Gross investment Net exports CPI % y-o-y ** Federal budget % GDP Current account % GDP FX reserves, gross USD bn CRB policy rate %* RUB Basket*** USDRUB* USDRUB** 5.6 5.9 3.4 -3.7 14.1 3.8 5.8 431.3 13.00 35.30 25.0 29.4 2009 -7.5 -3.5 -5.1 1.0 11.7 -6.8 3.8 426.0 9.00 35.20 28.2 31.3 2010 3.5 1.0 1.4 1.1 8.9 -5.0 3.5 484.2 8.00 33.00 26.0 27.3 2011 4.4 2.7 2.2 -0.5 8.0 -4.1 5.1 574.8 8.00 31.00 26.3 26.2

Figure 2. GDP now vs 1998 crisis
% q-o-q saar forecast 99q1 99q2 20 00q1 99q4 07q4 00q2 00q3 08q1 99q3 00q4 98q4 09q2 10 08q2 09q4 10q2 97q4 08q3 09q3 10q310q4 0 10q1 98q2 08q4 -10 -20 -30 -40 98q1 98q3 09q1
1997-2000 2007-2010

*End of period, **Period average, Bold is actual data ***45% EURRUB and 55% USDRUB

Source: Nomura Global Economics.

Source: Nomura Global Economics.

Nomura Global Economics

61

16 December 2009

2010 Global Economic Outlook

South Africa ⏐ Economic Outlook

Peter Attard Montalto

Conflicting signals on growth, mandate change
Strong headline growth numbers driven by the World Cup and the inventory cycle are set to mask weak consumption. We expect sticky deficits, noisy politics and a change in the SARB mandate. Activity: Despite very poor sentiment locally, South Africa has come through the crisis with a much shallower and not particularly long slowdown relative to its peers. The economy was cushioned by public sector investment programmes, government spending (though it had no specific stimulus package) and trade surpluses. Consumption, however, was hit hard as unemployment increased and the credit supply contracted. Into 2010, South Africa is set to bounce back strongly in headline-growth terms amid continuing infrastructure spending, a contribution from net trade and restocking from low levels. On top of this, the World Cup will add 0.7pp to growth from short term consumption and investments, on our estimates. Consumption, however, looks set to remain lacklustre (around 0.2% y-o-y ex World Cup, from -3.3% this year and 2.4% in 2008) as households remain constrained by unemployment, debt and wealth effects, though still-high real wage increases should provide a small buffer. We do not expect a full recovery on this front until 2011, when employment should start rising again. Investment growth should slow to 2.7% (compared with 11.7% in 2008 and 3.9% in 2009) because, although public-sector investment volume remains very high, little new money will be available to fund the same level of rapid growth. Given long-run structural rigidities on the supply side, we estimate potential growth in the economy in the medium term at around 3.5%, a slight drop over this crisis. Inflation and rates: We expect CPI to bob around the upper end of the target band (6%) through 2010 as low demand pressures are offset by another large rise in electricity prices (we expect the regulator to grant Eskom slightly less than its 35% tariff-hike application) as well as the compounding second-round effects of wage growth and energy price rises into 2011. We expect interest rates to remain unchanged until Q4 2010. The SARB’s monetary policy committee sees inflation pressures remaining broadly under control until then, but we believe it will be surprised by growth and inflation into end-2010 and revise its forecasts accordingly. Our key call for next year is that, following a tri-partite alliance report in February, the SARB MPC’s mandate will change to a dual mandate, with a clause on inflation-targeting and a clause on promoting growth and employment. Given that the MPC is already so flexible, looking strongly at growth, we do not expect this shift to affect the way the MPC decides interest rates. As such, it looks like an easy political win for the ANC without fundamentally affecting policy credibility. That said, there may well be a strong market reaction in the short term and a strong communication strategy will be needed. We believe new Governor Gill Marcus will handle this with aplomb. Politics: Since Jacob Zuma’s election as president in April 2009, there has been little new policy and no shift to the left. That said, political debts will come due in 2010 and we see much of this year’s political noise from the left continuing, with increasing in volume, into the New Year. However, we still see no fundamental shift in policy. Budget plans look credible but are based on no significant new legislation. Given new housing, education and national insurance bills as well as a sluggish recovery in revenues, we look for the fiscal deficit to remain very sticky in 2010.

Figure 1. Details of our forecast
2008 Real GDP % y-o-y Current account % GDP PSCE % y-o-y* Fiscal balance % GDP FX reserves, gross USD bn* CPI(X) % y-o-y * CPI(X) % y-o-y ** Manufacturing output % y-o-y Retail sales output % y-o-y SARB policy rate %* EURZAR* USDZAR* 3.1 -7.4 13.6 -1.2 34.5 10.4 11.3 0.9 0.3 12.00 12.9 10.2 2009 -1.6 -4.6 0.1 -7.9 40.8 6.5 7.2 -12.7 -4.7 7.00 10.9 7.70 2010 3.0 -6.1 9.7 -6.2 45.1 6.0 6.1 3.2 1.2 7.50 14.4 9.00 2011 3.5 -5.5 10.0 -5.2 49.1 7.1 6.6 5.5 2.2 9.00 13.3 9.50

Figure 2. Real GDP growth: Forecast with probability bands
8 7 6 5 4 3 2 1 0 -1 -2 -3 % y-o-y Government growth target

Long run potential

*End of period, **Period average, Bold is actual data PSCE- Private sector credit extentions

Mar-06

Mar-07

Mar-08

Mar-09

Mar-10

Mar-11

Source: Nomura Global Economics.

Source: Nomura Global Economics. Note: 10% probability per band.

Nomura Global Economics

62

16 December 2009

2010 Global Economic Outlook

Turkey ⏐ Economic Outlook

Olgay Buyukkayali

The comeback king
2010 should bring a rapid recovery and a start of normalization in monetary policy. Fiscal normalization will be key for upgrades of the sovereign ratings. Activity: Turkey has one of the highest potential output rates in EEMEA. We see its potential output as being 6% for the medium term. 2009’s growth slowdown of 5.8% y-o-y drove the output gap as wide as 10% at its peak. In 2010, we see GDP growing at 4.4% y-o-y. Inventories should contribute some 2.3pp to growth. Losses on the private investment side in 2009 (4.4pp) should be recovered only by end-2011. We would expect to see domestic demand and lending recover somewhat in 2010. Nevertheless, the nearly double-digit real wage decline in 2009, an unemployment rate rising in the first half of 2010 and domestic roll-overs (likely around 105%) are all likely to crowd out private investment, likely dragging on growth through 2010. The relatively fragile state of the recovery, the output gap closing fairly slowly and the partly technical recovery could still prompt the AKP government to resort to an IMF program. We project a USD25bn stand-by to add 2.5pp to GDP in the next two years (to our base case), which is likely to stop the deterioration in the labour market as early as the second quarter of 2010. Inflation: Broad-based disinflation continued in 2009 despite a rise in the year-on-year headline inflation rate at end-2009. We expect to see some volatility in inflation during H1 2010 and project CPI to peak at 7.2% y-o-y in April (from a bottom of 5.1% in October 2009) before falling back to 5.6% by end-2010, below the 6.5% target rate. Note that commodity prices, food and oil prices are all big contributors to the rise, while administered prices should help the correction. We do see some monthly declines in housing rent, which is important given the sticky nature of double-digit rents. We expect core inflation to remain below 5% y-o-y throughout 2010. Policy: The Central Bank of Turkey (TCMB) launched an aggressive monetary easing campaign, cutting short-term interest rates from 16.75% in October 2008 to 6.50% in November 2009. The deepening recession and disinflation justified lower interest rates and discretionary policy, in our view, and we believe the TCMB did well to stay ahead of events. This resulted in a sharp closing of the credibility gap between inflation expectations and inflation targets. We now expect a long pause at 6.5% until June 2010. Then, following a period of normalisation and improving growth prospects, we expect 125bp of hikes to 7.75% by end-2010 and a further 100bp to 8.75% by end-2011. This is a gradual normalization effort and we expect rates in 2010 and 2011 to be 150bp and 75 bp below the Taylor rule level projection. Fiscal policy should also start to normalize with a gradual tightening. We expect the pace of fiscal tightening to determine the speed of convergence to investment grade ratings. If we are right about an IMF program, we would expect this to occur within two years. Risks: Commodity prices are always a risk for inflation and the current account – though the post-crisis environment allows a lower current account trajectory. We find fiscal risks more important for 2010. Also, there will likely be some speculation around early elections, although this is not our base case as we continue to expect elections to be held in May 2011.
Figure 1. Details of the forecast
2008 Real GDP % y-o-y Consumption % y-o-y Gross investment % y-o-y Exports % y-o-y Imports % y-o-y CPI % y-o-y * CPI % y-o-y ** Budget balance % GDP Current account % GDP FX reserves, gross USD bn TCMB policy rate %* USDTRY* 0.9 0.3 -7.1 2.6 -3.1 10.1 10.4 -2.0 -5.6 72.1 15.00 1.54 2009 -5.8 -2.9 -22.5 -7.9 -16.1 6.2 6.2 -6.3 -1.7 71.5 6.50 1.50 2010 4.4 3.4 7.7 6.4 10.4 5.6 6.4 -4.5 -2.5 73.5 7.75 1.35 2011 4.5 2.9 11.0 9.2 13.0 5.3 5.4 -3.8 -2.8 76.0 8.75 1.40

Figure 2. CPI, Policy rate, Output gap

20 18 16 14 12 10 8 6 4 2

%

% 10 5 0 -5 -10 CPI Policy rate Output gap (monthly IP proxy, rhs) -15 -20 -25

*End of period; **Period average; Bold is actual data

0 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
Source: Nomura Global Economics. Source: TCMB,TUIK, Nomura Global Economics.

Nomura Global Economics

63

16 December 2009

2010 Global Economic Outlook

Central and Eastern Europe ⏐ Economic Outlook

Peter Attard Montalto

Hungary: Political uncertainty, second year of slowdown
The actions of the new government will be key to Hungary’s long-run prospects.
2008 2009 2010 0.7 Real GDP % y-o-y -6.9 -1.5 158.6 Nominal GDP USD bn 120.5 126.8 -8.7 Current account % GDP -0.7 -2.9 -3.4 Fiscal balance % GDP -3.9 -4.1 3.5 CPI % y-o-y * 5.7 3.0 6.1 CPI % y-o-y ** 4.2 3.7 9.93 Population mn 9.91 9.88 8.0 Unemployment rate % 12.0 9.5 23.6 Reserves USD bn *** 26.5 27.5 113.1 External debt % GDP*** 129.0 116.2 72.6 Public debt % GDP 78.1 79.9 10.00 MNB policy rate %* 6.00 5.50 265.6 EURHUF* 270 270 *End of period, **Period average, Bold is actual data ***Includes IMF/EU funds 2011 2.0 141.2 -4.5 -3.5 3.0 3.0 9.85 8.5 24.2 106.2 73.7 7.50 260

The economy is set to contract for a second year given the HUF900bn of government spending cuts. The external sector should start to recover, however. We see a return to positive growth in Q4. Investment is likely to remain soft. The fiscal policy outlook remains highly uncertain, given the likely switch to a FIDESZ government in the Q2 elections. The party currently wants tax cuts and a stimulus package which would conflict with the IMF package. We expect a small increase in the budget deficit, but a stalling of long-run reforms would be of greater concern. Inflation is likely to remain subdued with no demandside pressures to year-end. We see inflation rising towards target. After a December cut we expect one more rate cut in Q1 and then rates on hold till a hiking cycle starts in early 2011.

Source: HSCO, MNB, Nomura.

Czech Republic: Political deadlock continues
High risks of a “W”’ shape
2008 2009 2010 2.6 Real GDP % y-o-y -4.0 0.8 216.5 Nominal GDP USD bn 182.0 185.6 -2.9 Current account % GDP -1.1 -2.4 -2.3 Fiscal balance % GDP -8.8 -5.4 3.6 CPI % y-o-y * 0.7 2.9 6.4 CPI % y-o-y ** 1.0 2.0 10.2 Population mn 10.2 10.1 5.4 Unemployment rate % 9.5 10.0 37.0 Reserves USD bn *** 39.5 40.8 37.5 External debt % GDP 39.0 39.4 27.4 Public debt % GDP 34.2 37.7 2.25 CNB policy rate %* 1.00 3.00 25.0 EURCZK* 26.2 26.5 *End of period, **Period average, Bold is actual data 2011 1.8 193.7 -3.2 -5.0 2.0 2.0 10.1 9.0 42.3 41.2 39.8 3.50 26.0

A slow recovery in the Eurozone should affect Czech Republic the most and we see continued spillover effects from the external slowdown into the domestic economy. Full growth momentum is unlikely before 2011 and much will depend on external investment. We see inflation increasing back to target from near 0% thanks to base effects from here but there are few underlying inflation pressures. Rate hikes could start in Q2 in a normalisation back to neutral rates. Ongoing political uncertainties lead us to be concerned about fiscal policy sustainability and the interim government. The budget deficit is likely to remain unsustainably wide until the political deadlock ends. We see a high probability of the current interim government continuing after spring elections.

Source: CSO, CNB, Nomura.

Poland: Momentum-hidden risks
Politically induced fiscal slippage remains a big concern. Watch for ERM-II entry at the end of the year.
2008 2009 2010 4.8 Real GDP % y-o-y 1.6 2.1 525.7 Nominal GDP USD bn 418.7 477.8 -5.6 Current account % GDP -1.8 -3.0 -3.9 Fiscal balance % GDP -6.5 -5.5 3.3 CPI % y-o-y * 3.7 3.5 4.2 CPI % y-o-y ** 3.5 3.1 38.0 Population mn 38.1 38.0 9.5 Unemployment rate % 12.0 9.0 59.3 Reserves USD bn *** 41.8 47.4 45.4 External debt % GDP 50.6 48.8 47.8 Public debt % GDP 54.5 56.6 5.00 NBP policy rate %* 3.50 4.50 4.15 EURPLN* 4.10 3.80 *End of period, **Period average, Bold is actual data 2011 3.5 536.2 -4.3 -4.5 2.5 2.5 38.0 9.0 54.5 46.9 54.6 5.00 3.75

Poland should be able to maintain its momentum through 2010 as investment bounces back, inventories are built up and consumption continues. As one of the only economies with residual demand pressures, inflation should remain sticky and fall to target. With the NBP surprised to the upside by growth we expect the new MPC to hike rates in a normalisation cycle from Q2. The presidential election in Q4 is key. It has been responsible for fiscal slippage through 2009. The 55% public debt limit risks being breached in 2010 and we expect a budget amendment package to be implemented in January otherwise we see a real risk of an austerity package around election time. Should current PM Tusk become president, a new prime minister would likely rein in the budget and set Poland on the road to the euro by joining ERM-II.

Source: CSPO, NBP, Nomura.

Nomura Global Economics

64

16 December 2009

2010 Global Economic Outlook

Rest of Emerging Europe ⏐ Economic Outlook

Ivan Tchakarov

Ukraine: Muddling through
Resumption of the IMF programme is the key to growth recovery
2008 Real GDP % y-o-y Contributions to GDP (pp) Consumption Gross investment Net exports CPI % y-o-y ** Consolidated budget % GDP Current account % GDP FX reserves, gross USD bn NBU discount rate %* USDUAH* 2.1 8.8 3.6 -10.3 25.2 -1.0 -6.7 31.5 12.00 7.9 2009 -14.0 -14.8 -6.5 7.3 16.7 -6.0 -0.6 29.1 10.25 8.3 2010 3.6 4.0 1.8 -2.1 10.3 -4.0 -1.0 26.7 9.00 8.0 2011 4.0 4.5 1.9 -2.3 8.7 -2.5 -1.5 25.1 9.00 7.0

Ukraine continues to be the most vulnerable economy in the EEMEA, still feeling the adverse impact of the global financial crisis. However, signs are emerging that the economy is not only stabilising, but returning to a positive, yet still very subdued and fragile, growth. The outlook for 2010 hinges on the result of the January presidential elections and the resumption of the IMF programme. Provided that these develop in a positive fashion, the growth risks should be tilted to the upside in an environment of pent-up domestic demand.

*End of period, **Period average, Bold is actual data

Source: Ministry of Statistics

Kazakhstan: Looking up
Resolution of banking sector foreign debt problems should spur growth
2008 Real GDP % y-o-y Contributions to GDP (pp) Consumption Gross investment Net exports CPI % y-o-y ** Republican budget % GDP Current account % GDP FX reserves, gross USD bn NBU official rate %* USDKZT* 3.2 2.9 2.5 -2.9 17.3 -2.1 6.8 19.4 10.0 120.79 2009 -1.5 1.4 1.0 -3.9 7.1 -3.4 -3.4 22.1 7.00 148 2010 3.5 2.8 2.1 -1.4 6.1 -2.6 0.5 30.1 7.00 135 2011 5.0 3.0 2.8 -0.8 6.0 -1.1 1.3 38.5 7.25 135

The resolution of the banking sector external debt problems should reduce external vulnerabilities and provide a new impetus for stalled credit lending. The revival in commodity prices should support the balance of payments and replenish foreign reserves. As a result, we think the economy should return to growth, with the balance of risks slanted to the upside should commodity prices outperform. The combination of stronger growth and commodity prices should put upward pressure on the currency, increasing the likelihood of a tenge revaluation at the start of the year.

• •

*End of period, **Period average, Bold is actual data

Source: Ministry of Statistics.

Romania: A challenging road ahead
Twin deficits leave little room for supporting growth

2008 Real GDP % y-o-y Current account % GDP Fiscal balance % GDP CPI % y-o-y * CPI % y-o-y ** NBR policy rate %* EURRON* 7.1 -12.3 -5.2 6.3 7.8 10.25 4.0 2009 -7.0 -4.9 -8.0 4.7 5.8 8.00 4.2 2010 2.8 -5.7 -7.4 3.6 4.0 7.00 4.0 2011 3.1 -6.1 -4.5 3.2 3.6 6.50 3.8

The political background will remain testing at the start of the year, increasing fiscal challenges and heightening risk perceptions. However, the formation of a new government should pave the way for a re-establishment of the relationship with the IMF. This should help bring growth into positive territory, although the recovery will likely be subdued by historical standards. Inflation should continue to ease given excess capacity and reduced wage pressures, creating more room for interest rate cuts.

*End of period; **Period average; Bold is actual data

Source: Ministry of Statistics.

Nomura Global Economics

65

16 December 2009

2010 Global Economic Outlook

Middle East ⏐ Economic Outlook

Peter Attard Montalto ⏐ Olgay Buyukkayali

Egypt: Bounce back
Economic and political imbalances remain a key concern
2008 Real GDP % y-o-y Unemployment rate % CPI % y-o-y * CPI % y-o-y ** Budget balance % GDP Current account % GDP FX reserves, gross USD bn Policy rate %* USDEGP* 6.5 8.9 18.3 18.8 7.0 0.8 34.5 11.50 5.54 2009 4.8 9.5 16.5 12.2 -9.5 -3.0 30.0 8.25 5.44 2010 5.2 10.0 8.3 12.5 -8.5 -2.5 28.5 9.00 5.30 2011 5.5 9.0 7.6 8.1 -8.5 0.5 30.0 10.00 5.30

The economy has fared well through the crisis, supported by wider Middle East linkages. But growth will likely remain subdued in a credit-constrained post crisis-environment and is unlikely to reach the key 5.5% level needed to absorb new labour until 2011, potentially adding to social instability. Inflation looks set to remain sticky given domestic demand and oil moves, with large upside risks from any shift in commodity prices and removal of subsidies. The CBE stopped cutting rates earlier than we expected amid stronger growth and inflation. We think a hiking cycle will begin in Q1, with its pace dependent on inflation. Parliamentary elections in October will be a key risk event, with noise from the Muslim Brotherhood and a resurgence of the Mubarak succession debate.

*End of period, **Period average, Bold is actual data

Source: Nomura Global Economics.

Israel: Stable recovery
Global recovery should allow policy normalization.
2008 Real GDP % y-o-y Consumption % y-o-y Gross investment % y-o-y Exports % y-o-y Imports % y-o-y CPI % y-o-y * CPI % y-o-y ** Budget balance % GDP Current account % GDP Policy rate %* USDILS* 4.1 4.2 4.3 3.7 3.2 3.8 4.6 -0.6 1.2 2.50 3.80 2009 0.3 -0.3 -6.5 -7.8 -5.0 2.8 2.7 -5.3 2.8 1.00 3.70 2010 2.7 3.0 2.5 2.5 3.3 2.9 3.0 -4.3 2.4 2.50 3.45 2011 3.8 3.5 3.2 3.8 4.0 3.0 2.9 -3.8 1.7 3.50 3.75

Israel’s economy looks well placed to benefit from a global recovery given the multi-pillared policy response and the stable conditions that prevailed ahead of the crisis. Inflationary pressures should be fairly high, stemming from a domestic demand recovery, the housing market (which did not contraction much) and commodity prices. We think the Bank of Israel is likely to hike by 150bp in 2010 to contain inflationary expectations. Risks appear limited on the fiscal side as the external backdrop remains healthy and employment conditions seem stable.

*End of period, **Period average, Bold is actual data

Source: Nomura Global Economics.

Saudi Arabia: From oil bust to sustainable growth
The bursting of the oil bubble has brought an end to the country’s longest-ever stretch of growth.
2008 Real GDP % y-o-y Hydrocarbon % y-o-y Nonhydrocarbon % y-o-y CPI % y-o-y * CPI % y-o-y ** Budget balance % GDP Current account % GDP Short-term interest rates % USDSAR* 4.6 4.8 4.3 9.8 9.9 33.3 28.8 0.50 3.75 2009 -1.0 -8.8 2.5 5.0 5.3 -5.5 4.1 0.13 3.75 2010 3.5 3.0 3.7 5.4 6.4 4.0 14.5 0.25 3.75 2011 3.9 3.8 4.0 5.6 6.8 15.0 20.3 1.00 3.75

A slow recovery in the US should keep oil’s contribution to GDP, the current account and fiscal balances muted over the next two years, though we do expect a recovery. This will be a key test of the nonhydrocarbon sector and we see its growth and share of output continuing to increase over the next five years, driven by government-led infrastructure spending. The Saudi economy should continue to be a growth engine for the region. The crisis has been a key test of the economy and it has pulled through on its large cash reserves. Although Saudi Arabia is on a path to a more sustainable economy, progress remains slow. It should avoid the problems of Dubai, however, given its more closed financial markets.

*End of period, **Period average, Bold is actual data

Source: Nomura Global Economics.

Nomura Global Economics

66

16 December 2009

2010 Global Economic Outlook

Latin America ⏐ Outlook 2010

Tony Volpon

An uneven recovery
We expect the region to continue the cyclical recovery begun in 2009. Stronger growth should also lead to wider current account deficits, although inflation should remain tame.
Asian strength and easy policy have helped LatAm

Most Latin American (LatAm) economies have exceeded forecasts made at the beginning of 2009. Except for Mexico, which suffered from its close relationship with the crisis-hit US economy and a swine flu outbreak, large economies in the region benefited from Asia’s strong growth and the implementation of anti-cyclical fiscal and monetary policy to boost growth. Now that cyclical recoveries seem to be firmly in place (Figure 1), the challenge for policymakers will be to signal an orderly exit from the current policy stance to avoid higher inflation or a rapid widening of current account deficits. We also see risks that the deterioration in fiscal policy in, for example, Brazil, justified at the time of implementation as a temporary response to the economic crisis, will become permanent, perhaps as an outcome of the 2010 presidential election.

Brazil
Brazil leads the way

Brazil has posted the strongest recovery in the region but may face the trickiest exit from its current policy stance, which remains very accommodative even as aggregate demand accelerates strongly: • • Real policy rates (Selic) are at a low of 4.21%, compared with an average of 9.16% over the past five years. The nominal budget balance has moved from a 1.25% of GDP deficit before the crisis to 3.34%, even as interest payments on the government’s debt fell from 5.6% of GDP in October 2008 to 5.18% of GDP in June 2009. The government has taken a series of “capitalization” transactions to boost the lending power of state-owned financial institutions. This has helped boost gross debt from 51% of GDP in September 2008 to 65.5% in December 2009. Credit markets have been well supported during the crisis, with the total credit-to-GDP ratio rising from 38.7% in October 2008 to 45.7% in December 2009. After briefly rising, unemployment is set to end 2009 lower than in October 2008 at 7.7%, only 0.2pp off its all-time low.

• •

Figure 1. Standardized measures of the output gap in four LatAm economies, using industrial production and retail sales
std dev 2 1 0 -1 -2 -3 -4 -5 -6 Jan-06 Sep-06 May-07 Jan-08 Sep-08 May-09 Industrial Production Retail Sales
0.5 0.0 -0.5 -1.0 Industrial Production

Brazil

std dev 1.5 1.0

Mexico

Retail Sales -1.5 Jan-06 Aug-06 Mar-07 Oct-07 May-08 Dec-08 Jul-09

std dev 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 Jan-06 Sep-06

Chile

std dev 10 8 6 4

Colombia

Industrial Production Retail Sales

Industrial Production Retail Sales

2 0 -2 -4 Jan-06 Sep-06 May-07 Jan-08 Sep-08 May-09

May-07

Jan-08

Sep-08

May-09

Note: Data standardized (12-mth), seasonally adjusted and de-trended using HP filter. Source: Nomura Global Economics.

Nomura Global Economics

67

16 December 2009

2010 Global Economic Outlook

These factors should ensure that the Brazilian economy performs strongly in 2010 – we forecast 5.4% – pushed higher by a strong recovery in investment spending. We expect that investment spending fell by 10.6% in 2009, but we forecast it to rise by 18.5% in 2010.
The risk in Brazil is of overheating ...

We see the risks to our forecast as being to the upside. After claiming that greater government spending as a response to 2008’s crisis was cyclical in nature, the government is giving no indication that it is considering tightening fiscal policy. This lack of an appropriate and timely response means that inflation and interest rates will likely have to rise. We expect the central bank of Brazil (BCB) to tighten rates in June 2010, taking the Selic policy rate from 8.75% to 11.75% by the end of the year. Inflation is also set to rise, from 4.34% in 2009 to 4.7% in 2010. Looser fiscal policy will very likely be driven by political considerations, as Brazil is set to hold a heavily contested presidential election in October 2010 (see Box: Brazil 2010 election outlook). This could delay a much-needed fiscal adjustment, which we expect to happen only in 2011, when we forecast the government’s fiscal balance to be -2.8% of GDP, after -4.0% in 2010. This late response should also generate an overshoot in growth that would widen out the current account deficit from 1.5% of GDP in 2009 to 3.5% in 2011, even as growth decelerates.

... due to loose fiscal policy

Mexico
Mexico’s economic outlook is still closely tied to US economic performance. We think the passing of the recent fiscal adjustment package, although criticized by some as not going far enough, is still laudable given the 7.0% drop in GDP that we expect for 2009.
Mexico still needs to deal with structural problems

We expect growth to rebound to 4.6% in 2010, but given the recession of 2009 this should not be viewed as an exceptional performance. Longstanding structural problems still need to be tackled to raise potential growth. For example, underinvestment by the state-owned Pemex because of a restrictive legal framework has caused the production of petroleum to fall (Figure 2), helping lead to the current public finance crisis. Restrictive labor laws and lack of competition in the economy are also widely seen as impediments to higher growth. Pension liabilities and funds devoted to social spending are growing strongly. Pension liabilities, for example, are projected by the Ministry of Finance to rise from around 2.25% of GDP in 2009 to 4% in 2010. Mexico, unlike other Latin American economies, has suffered from Chinese competition in the 1 manufacturing of goods, losing jobs and markets in the process. A World Bank study estimates that around 250,000 manufacturing jobs have been lost since 2000 because of the relocation of manufacturing plants to Asia. Recent fiscal reform law goes some way to addressing Mexico’s budget woes, but approved tax hikes could add about 0.7pp to inflation. This should help take inflation from 3.62% in 2009 to 4.81% in 2010 and should also lead the monetary authorities to tighten interest rates from the current 4.50% to 5.25% at the end of 2010 to keep inflationary expectations stable. Perhaps the only positive is the current competitive level of the exchange rate, as Mexico, unlike most other countries in the region, avoided the large appreciation seen in 2009. A permanent shift lower in the real exchange rate now looks to be a necessary component of an eventual return to more robust economic growth.

Figure 2. Mexican production of crude petroleum (12-mth ma)
Thous.Bbls 3,600 /Day 3,400 3,200 3,000

Figure 3. Chilean merchandise exports (3-mth ma)

7,000 6,000 5,000 4,000 3,000

$mn

2,800 2,600 2,400 Feb-02 Jun-03 Oct-04 Feb-06 Jun-07 Oct-08

2,000 1,000 0 Feb-02 Jun-03 Oct-04 Feb-06 Jun-07 Oct-08
Source: Haver Analytics, Nomura Global Economics.

Source: Haver Analytics, Nomura Global Economics.

Nomura Global Economics

68

16 December 2009

2010 Global Economic Outlook

Brazil 2010 election outlook

Tony Volpon

Brazil’s 2010 presidential election is set to be heavily contested. We look at how the election is shaping up, the history of the main candidates, their policy preferences, and possible market impact. On 3 October 2009, followed by a possible run-off second round on 31 October, Brazil will choose its next president. Current opinion polls show this election promises to be heavily contested: although the main opposition candidate Jose Serra currently holds a large lead, President Lula’s favored candidate Dilma Rousseff, his current chief of staff, is inching closer on the back of Lula’s popularity and the strong economy. President Lula cannot run for a third term under current law. Lula’s choice of Ms Rousseff was seen as bold given her lack of political experience and lack of charisma. There is some debate as to whether Lula can boost the level of support for her much more than the 20% or so of the vote that she has already gained.

Jose Serra
Jose Serra, 67 years old, is the current governor of the state of Sao Paulo. He was president of the national student union in the 1960s and left Brazil after the military coup of 1964. He has lived in numerous countries and completed his PhD in economics at Cornell University in 1976. He returned to Brazil in 1978 and began a political career that culminated in a successful term as health minister in the Fernando Henrique Cardoso government from 1998 to 2002. Serra is seen as an efficient administrator who would likely run tighter fiscal policy than the current government. He has criticized of current monetary and foreign exchange policy, although he has not as yet stated how he would change it.

Dilma Rousseff
Dilma Rousseff, 62 years old, is the chief of staff of Lula’s government. She was militant in urban guerilla groups during the military regime and spent two years in jail from 1970 to 1972. She studied economics but due to her political career has not completed her postgraduate studies. She occupied finance posts for the left-leaning PDT party in the southern state of Rio Grande do Sul, and was chosen by Lula to head the Energy Ministry at the beginning of his government, later being appointed chief of staff. Ms Rousseff has become the key minister of the current government after the so-called “mensalao” and other scandals brought down many key figures. During this period, after Finance Minister Antonio Palocci left office, government spending rose substantially and the state began to act more aggressively on many economic fronts. In particular, the government expanded state financing of consumption via public sector banks and of companies via the BNDES development bank; these institutions are being capitalized by debt issuance, which is pushing up the level of federal gross debt.

Electoral outlook
The main question in terms of the election outcome concerns the ability of President Lula, who enjoys personal favorable poll ratings above the 80% mark, to transfer his popularity to Ms Rousseff, who is still unknown to much of the population. The general view of political commentators is that this will happen if the population believes the chosen candidate will continue the work of the current office holder. The government’s present strategy is to rely on popularity transfer, a strong economy and a large lead in TV advertising time and campaign funds to win the election. The opposition is still divided about how to fight an election against such a popular president who has made the election of Ms Rousseff a personal priority. Although Mr Serra enjoys a large lead in the polls (the latest tally puts him at 38% against approximately 22% for Ms Rousseff), support for his candidacy is not unanimous, with fellow Social Democrat, governor of the state of Minas Gerais, Aecio Neves, making a run for the candidacy. Nonetheless, Mr Serra has the advantage of being a very well known figure with real executive experience and accomplishments, unlike Ms Rousseff whose main claim to fame is the management of the controversial “PAC” federal investment program these past few years, something she herself has largely abandoned to make her early run for office. In terms of political risk both main candidates present doubts. Ms Rousseff has been the government’s most powerful figure after Lula during a period when the Brazilian government has greatly increased spending and interference in the economy. Investors will want to know if a Rousseff government will continue on the current path, which would eventually raise questions about the country’s credit risk. In the case of Mr Serra, investors will want greater clarity as to how he wants to change the current monetary regime. The tighter fiscal policy Mr Serra is likely to favor would naturally allow for lower rates and a less expensive currency, but Mr Serra seems to want real changes in policy. Any attempts to force a regime of lower rates and a cheaper exchange rate could have a rapid negative effect on inflation, as the unsuccessful policies of Argentina make clear.

Nomura Global Economics

69

16 December 2009

2010 Global Economic Outlook

Chile
Chile, a small, open economy that is very exposed to trade and has the most developed credit market in the region, suffered more than most Latin American countries in the crisis. We expect growth to fall 1.5% in 2009, and the economy also faces 1.4% deflation. Nonetheless, while Chile may have suffered for its economic virtues, its stable policy framework has allowed it to pursue very aggressive anti-cyclical policy. Policy rates fell to 0.5%, with the Banco Central de Chile adopting a form of quantitative easing by providing term financing to the market. Fiscal policy has also been aggressive, as can be seen in the deterioration of the public sector balance from a vigorous 5.2% of GDP 2008 to an expected -3.4% in 2009.
Net exports are a plus ...

The current recovery scenario for Chile has one very positive component and one very negative one. First, exports have rebounded quite strongly already, providing a powerful boost to growth (Figure 3). Copper, the country’s largest commodity export, is only about 15% below its precrisis price, after having fallen as much as 60% in December 2008. On the negative side, the labor-intensive construction sector has been hit hard and bank credit dried up with the crisis (Figure 4). But the recent rise in business sentiment could lead to easier credit conditions and … but the more demand to kick-start durable goods and housing demand. We expect growth to reach construction sector is 4.7% in 2010, with inflation rising to 2.3%. This return to growth and inflation should allow the a minus Central Bank of Chile to normalize interest rates to 4.00% from 2Q 2010, as it has already signaled.

Colombia
As a commodity exporter, Colombia, like Brazil, has done well in 2009 thanks to a combination of Asia-led export demand and its ability to implement counter-cyclical policy. Policy rates fell to 3.5%, with the last rate cut taking the market by surprise, and the fiscal deficit at the end of 2009 is expected to be just 2.7%.
Political risks are affecting investor sentiment

Nonetheless the Colombian economy has been enduring something of a “hang-over” after a strong, investment-led boom that had lost steam even before the global economic crisis began (Figure 5). This has led to a less pronounced cyclical recovery than the other economies in the region (Figure 1) and better-than-expected inflation performance (we forecast 2.40% for 2009). To this we have to add the political risks that have lately weighed on the outlook. Tensions with Venezuela’s leftist regime are on the rise and are already affecting the country’s exports. The undefined status of the 2010 presidential election – it is still not clear whether the very popular President Uribe will run for a third term – should also add to the uncertainty. We expect these factors to damp the current cyclical upturn, at least compared with the other economies in the region, leading to GDP growth of 3.3% in 2010. Inflation should stay at a subdued 3.5%, leading to only a modest adjustment in policy rates, to 5.00%.
1.

Lederman, Daniel, Olarrega, Marcelo and Soloaga, Isidro. “The growth of China and India in world trade: Opportunity or threat for Latin America and the Caribbean?”, in China’s and India’s Challenge to Latin America, The World Bank, 2009, p.103. Figure 4. Chilean new building permits (12-mth ma) Figure 5. Gross investment in Colombia

units 15,000 14,000 13,000 12,000 11,000 10,000 9,000 8,000 Nov-02 Feb-04 May-05 Aug-06 Nov-07 Feb-09
Source: Haver Analytics, Nomura Global Economics.

% y-o-y 80 70 60 50 40 30 20 10 0 Sep-04 Jul-05 May-06 Mar-07 Jan-08 Nov-08

Source: Haver Analytics, Nomura Global Economics.

Nomura Global Economics

70

16 December 2009

2010 Global Economic Outlook

Brazil ⏐ Economic Outlook

Tony Volpon

Growth set to accelerate
Strongly pro-cyclical monetary and fiscal policy, buoyant capital markets and strengthening labor markets should make Brazil one of the strongest growth stories in LatAm in 2010. Activity: The recession seems to have ended in Brazil. While the main drivers of growth have so far been personal consumption and government spending, we expect business fixedinvestments to take up the slack, pushed higher by buoyant capital markets and an appreciating currency. This powerful combination should put 2009 GDP just north of zero – at 0.1%. For 2010, we forecast a return to very strong growth of 5.4%. However, we expect retrenchment in 2011 as interest rates rise and a newly elected government potentially reins in spending. Higher consumption and investment by both the private and public sector should push the trade balance into deficit in 2010 for the first time since 2000, with the current account deficit widening further. Nonetheless, ample portfolio and investment flows should more than cover the growing current account deficit, allowing BRL to appreciate. Inflation: Inflation, as represented by the central-bank-targeted IPCA index, looks likely to close below the central bank’s 4.5% target in 2009, but not in 2010. At the beginning of 2010, the effects of currency appreciation and wholesale price deflation should provide a strong anchor for inflation, but a rapidly closing output gap and electoral-year spending should drive inflation higher, to 4.7% by end-2010, even if the Central Bank of Brazil (BCB) hikes rates. Policy: Given concrete signs of a strong, broad-based growth in Brazil, we expect the BCB to begin to tighten rates in June, though an earlier hike in April is also possible. An earlier start to the tightening cycle is unlikely, as the near-term inflation outlook is positive even as the output gap is set to close. Strong private-sector growth and loose fiscal policy in an election year will likely push inflation expectations higher for the end of 2010 and 2011, eliciting tighter monetary policy. We see rates rising by 375bp into March of 2011, taking the Selic policy rate to 12.50%. We also expect that fiscal policy will be substantially tighter in 2011 after the recent deterioration. Risks: We see the risks to our overall scenario as being to the upside. Very loose fiscal policy, originally justified as a Keynesian-inspired “anti-cyclical” response to the crisis, looks set to continue into the 2010 election year. This could lead to above-potential growth, putting steady pressure on inflation and the current account deficit. We assume the BCB will be able to execute monetary policy without overt intervention and political pressure to control demand. We also assume that whoever wins the October 2010 presidential election will rein in spending at the beginning of 2011 from the current unsustainable pace. Any disappointment on these fronts could lead to higher inflation, a higher current account deficit and more volatile financial markets.

Details of the forecast
% y-o-y change unless noted Real GDP Personal consumption Fixed investment Government expenditure Exports Imports Contributions to GDP (pp): Industry Agriculture Services IPCA (consumer prices) IGPM (w holesale prices) Trade balance (US$ billion) Current account (% GDP) Fiscal balance (% GDP) Net public debt (% GDP) Selic % BRL/USD 8.75 1.77 8.75 1.75 8.75 1.83 9.25 1.71 10.50 1.64 11.75 1.60 12.50 1.60 12.50 1.55 3Q09 -1.2 3.9 -12.5 1.6 -10.1 -15.8 -6.9 -9.0 2.1 4.34 -0.40 27 4Q09 5.3 7.7 0.6 4.9 -3.3 -5.4 4.2 -0.3 6.3 4.34 -1.12 23 1Q10 7.5 10.9 22.0 3.8 13.8 26.3 6.1 4.9 5.4 4.21 0.59 18 2Q10 5.1 8.2 24.3 6.1 0.5 23.1 3.7 -0.1 4.0 3.78 1.58 11 3Q10 4.7 6.2 15.3 6.8 2.6 22.2 6.0 3.9 4.3 4.27 3.25 7 4Q10 4.6 6.3 13.9 6.8 1.5 21.6 6.1 1.5 4.5 4.70 4.59 -3 1Q11 5.1 5.6 12.4 2.2 4.8 13.2 7.3 6.1 4.5 5.12 4.91 -1 2Q11 3.7 5.2 7.2 1.2 4.8 12.2 3.3 5.2 4.0 5.43 5.27 -4 2009 0.1 4.0 -10.6 3.7 -10.0 -13.4 -5.5 -4.4 3.0 4.34 -1.12 23 -1.5 -4.0 45.1 8.75 1.75 2010 5.4 7.8 18.5 5.9 4.1 23.2 5.5 2.4 4.5 4.70 4.59 -3 -3.0 -4.0 47.0 11.75 1.60 2011 3.1 4.7 6.3 0.4 5.0 10.6 1.3 2.7 3.8 5.17 5.32 -8 -3.5 -2.8 46.0 12.50 1.55

Notes: Annual forecasts for GDP and its components are year-over-year average growth rates. Trade data are a 12-month sum. Interest rate and currency forecasts are end of period. Contributions to GDP do not include taxes. Numbers in bold are actual values, others forecast. Table last revised 11 December. Source: Nomura Global Economics.

Nomura Global Economics

71

16 December 2009

2010 Global Economic Outlook

Mexico ⏐ Economic Outlook

Tony Volpon

A recovery burdened by long-term worries
Mexico is set to recover from one of the worst recessions in Latin America, but the recovery will be hampered by long-standing structural impediments to higher growth. Activity: Mexico is set to have one of the worst growth performances in LatAm for 2009 of -7.0% as its close ties with the underperforming US economy and the swine flu outbreak hit both consumption and investment hard. We expect growth to bounce back to 4.6% in 2010, but this would not be an exceptional rate given the size of the recession in 2009. We forecast investment spending to grow a relatively low 5.6% in 2010 as long-standing structural impediments to higher potential output hinder greater investment. The recently approved fiscal package should help to close a serious revenue shortfall caused by, among other things, a drop in oil production by state-owned Pemex. Nonetheless, the adoption of more permanent measures is being pushed into 2010, and if questions of fiscal sustainability, labor market flexibility, opening up of the petroleum sector, and higher productivity are not addressed potential growth should remain low over the next few years compared with other economies in the region. One structural positive has been the recent depreciation of the currency, especially against other LatAm currencies, something that should help Mexico regain competitiveness. Inflation: Inflation is set to rise in 2010 to 4.81% as the economy recovers and the inflationary impact of recent tax hikes affect relative prices. The Mexican economy suffers from structural downward price-rigidities which prevented inflation from falling substantially in 2009 even though the economy faced one of the worst recessions in the region, making inflation more susceptible to any positive supply or demand shock. Policy: If our forecast is correct and Inflation in 2010 moves much higher than the Banco de Mexico’s 3% target and 1% tolerance interval, we think the monetary authorities could hike policy rates to 5.25% over 2010 even as the economy faces a tepid recovery. Risks: We see the risks to Mexico’s economic outlook as being balanced. A faster-thanexpected recovery in the US economy could have an immediate effect on economic activity in Mexico, although unfortunately so could any further problems in the US economy. The market expects the reform process to be slow and tortuous, so any positive surprise on the political front could help improve the current pessimistic views of Mexico’s potential growth rate.

Details of the forecast
% y-o-y change unless noted Real GDP Personal consumption Fixed investment Government expenditure Exports Imports Contributions to GDP (pp): Industry Agriculture Mining CPI Trade balance (US$ billion) Current account (% GDP) Fiscal balance (% GDP) Gross public debt (% GDP) Overnight Rate % MXN/USD 4.50 13.48 4.50 13.00 4.50 13.70 4.75 12.90 5.00 12.60 5.25 12.43 5.50 12.40 5.50 12.35 3Q09 -6.2 -8.0 -12.6 1.8 -7.0 -18.7 -6.6 -1.1 -6.5 4.89 -12 4Q09 -3.9 -6.6 -8.6 -0.2 -2.3 -10.5 -3.5 -1.3 -3.8 3.62 -7 1Q10 4.2 4.6 2.2 -1.3 15.1 16.8 3.2 6.6 4.7 3.61 -6 2Q10 6.2 6.2 8.5 3.2 3.6 14.3 6.3 -2.9 7.8 3.64 -7 3Q10 3.8 3.9 5.3 0.1 -1.1 5.9 4.7 11.5 3.8 3.98 -8 4Q10 4.4 4.5 6.2 1.8 -2.1 4.3 5.2 10.6 4.5 4.81 -11 1Q11 3.5 3.4 6.2 2.8 1.0 4.3 4.1 10.6 3.6 4.71 -12 2Q11 3.3 3.2 6.4 0.4 1.0 3.3 3.0 8.6 3.7 4.53 -13 2009 -7.0 -8.2 -11.0 1.5 -8.8 -15.5 -7.9 0.3 -7.0 3.62 -7 -1.0 -2.2 40.0 4.50 13.00 2010 4.6 4.8 5.6 0.9 3.2 10.0 4.8 6.1 5.2 4.81 -11 -1.5 -2.0 41.0 5.25 12.43 2011 3.9 3.9 6.3 2.1 3.9 8.4 4.3 8.2 4.1 4.00 -14 -2.0 -1.8 43.0 5.50 12.30

Notes: Annual forecasts for GDP and its components are year-over-year average growth rates. Trade data are a 12-month sum. Interest rate and currency forecasts are end of period. Contributions to GDP do not include taxes. Numbers in bold are actual values, others forecast. Table last revised 11 December. Source: Nomura Global Economics.

Nomura Global Economics

72

16 December 2009

2010 Global Economic Outlook

Rest of Latin America ⏐ Economic Outlook

Tony Volpon

Argentina: Riding Brazil’s coat-tails
Rapid recovery in Brazil is giving Argentina a boost, but political uncertainties could stunt investment.
Real GDP % y-o-y Consumption % y-o-y Gross Investment % y-o-y Exports % y-o-y Imports % y-o-y CPI % y-o-y * CPI % y-o-y ** Budget balance % GDP Current account % GDP Policy Rate % * USDARS * 2008 7.0 6.5 8.0 1.6 16.5 7.2 8.1 1.5 1.2 15.10 3.45 2009 -2.3 -5.0 -8.0 -3.0 -20.0 7.0 5.5 -1.5 3.2 11.50 3.80 2010 2.5 3.0 6.0 4.5 10.0 8.0 8.0 -2.0 2.5 13.00 4.50 2011 3.0 4.0 7.0 5.0 7.0 8.0 8.0 -2.5 2.0 13.00 5.00

Better growth in Brazil and a general easing of liquidity conditions is helping Argentina recover from one of the region’s most severe recessions. Nonetheless, continuing political and policy uncertainty will likely remain a drag on investment, so any rebound in growth is likely to be tepid. Fiscal policy remains expansive, with a widening deficit being driven by higher spending even as the recession hits revenues hard. We think serious fiscal reform is a precondition for any return to higher potential growth. The government has signalled a willingness to engage creditors and the IMF, and a new creditor proposal is expected soon. However, concrete success is still pending.

* End of period, ** Period average, Bold is actual data

Source: Nomura Global Economics.

Chile: Exports lead, investments to follow
Rebounding export demand is leading to a strong recovery that looks set to gather strength.
Real GDP % y-o-y Consumption % y-o-y Gross Investment % y-o-y Exports % y-o-y Imports % y-o-y CPI % y-o-y * CPI % y-o-y ** Budget balance % GDP Current account % GDP Policy Rate % * USDCLP * 2008 3.2 4.3 19.5 -4.8 3.1 7.1 8.7 5.2 -2.0 0.50 524.00 2009 -1.5 1.0 -13.0 -4.5 -16.0 -1.4 1.5 -3.4 0.8 0.50 495.00 2010 4.7 6.5 15.0 6.0 14.0 2.3 2.1 -2.0 0.7 4.00 458.00 2011 4.0 4.0 6.0 6.0 10.0 3.0 3.0 2.0 1.5 5.00 450.00

Chile’s economic recovery is being led by strong export demand, especially from Asia. This is already affecting business confidence positively and we expect investment demand to pick up soon, boosting overall growth. The labour-intensive construction sector remains a drag on growth, but easier credit conditions should help activity in this sector recover in 2010. The Central Bank of Chile is determined that recovery should be on a sure footing before monetary conditions are tightened. Nonetheless, it has already announced a phasing-out of its term lending facility and signalled that rates should begin to rise early next year. We expect rates to rise to 4.00% by the end of 2010.

* End of period, ** Period average, Bold is actual data

Source: Nomura Global Economics.

Colombia: Recovery dampened by politics
Rebounding export demand is helping growth but political uncertainties are taking their toll.
2008 2009 2010 2011 Real GDP % y-o-y 0.1 3.3 4.0 2.5 Consumption % y-o-y -0.5 3.5 4.2 2.3 Gross Investment % y-o-y -5.5 9.0 10.0 8.8 Exports % y-o-y -4.5 5.0 6.0 7.0 Imports % y-o-y -10.0 12.0 8.0 9.8 CPI % y-o-y * 2.4 3.5 4.0 7.7 CPI % y-o-y ** 4.1 3.2 4.0 7.0 Budget balance % GDP -2.7 -3.0 -2.5 -0.1 Current account % GDP -2.8 -2.5 -2.5 -2.8 Policy Rate % * 3.50 5.00 5.50 9.50 USDCOP * 2000.00 2000.00 1860.00 1820.00
* End of period, ** Period average, Bold is actual data

Stronger export demand from Asia and the effects of easier monetary policy are having a positive effect on growth in Colombia. We expect a rebound to 3.3% in 2010. Nonetheless, the pace of recovery has disappointed. This, alongside lower inflation, has allowed the Central Bank to surprise the market and cut policy rates to 3.5%. One factor behind the high uncertainty is rising political tension with Venezuela, which is already hurting exports. There is also uncertainty over the political future of President Uribe, who is attempting a third term in office.

Source: Nomura Global Economics.

Nomura Global Economics

73

16 December 2009

2010 Global Economic Outlook

Foreign Exchange ⏐ Outlook 2010

Ned Rumpeltin

Beyond peak performance
A summary of our main FX views follows below. Please see our 2010 Outlook piece, Beyond peak performance published on 30 November 2009 for more details.
Investor risk appetite is driven by the economic cycle

As in other asset classes, developments in investor sentiment and risk appetite have been crucial this year in understanding relative currency performance. We think this feature of the FX market is likely to continue into next year. Investor sentiment and risk appetite are conditioned heavily by developments in the economic cycle. To help guide our assessment of these, we have developed the Nomura Leading Indicators (NOLI) index, which has become an essential component of our overall “risk call”. In general, NOLI is positively correlated with risky FX. Our current risk assessment remains marginally positive. However, momentum seems to be fading and NOLI appears likely to peak as early as January 2010. Thus, we would expect risky currencies to suffer a setback following NOLI’s peak. That said, we do not expect this setback to be too deep or prolonged. We view it more as a natural correction after a solid run for risky assets. On top of weaker investor confidence providing a less-supportive backdrop, we think next year will be marked by a shift back to individual country fundamentals as the primary driver for currencies globally. Although the recent run-up in price and positioning suggests some shortterm vulnerability, neither seems especially stretched in our opinion. In addition, we expect the policy stance in key economies to remain supportive of risky asset performance long into 2010. One of the main casualties of the recovery in investor sentiment has been the US dollar (USD), which has weakened substantially against its major economy peers since equity markets bottomed in March. Looking forward, we acknowledge that a near-term setback for risk may provide some near-term support, but we expect USD to weaken further in 2010. In our view, the combination of an extraordinarily stimulative monetary policy from the Fed and structural headwinds are likely to keep the dollar on the defensive for the foreseeable future. Global capital markets are gradually healing, and many types of cross-border capital flows have normalized in the process. This is generally true in relation to capital flows in and out of the US also. But there is an important exception: foreign inflows into mortgage-backed (and other assetbacked securities) have dried up completely and are showing no signs of recovery. These inflows had been an important source of USD support in recent years and their disappearance is likely to keep the dollar on a weak footing well into 2010. In addition, while the US trade position has improved on lower oil prices and lower import volumes, the underlying structural deficit is still fairly high from a historical perspective and is unlikely to provide enough support to offset other USD-negative factors. We therefore recommend selling USD versus a diversified global basket of the Japanese yen (JPY), the euro (EUR), the Korean won (KRW), the Chilean peso (CLP) and the Russian ruble (RUB) (with respective weights of 20%, 25%, 15%, 15% and 25%). The euro remains at elevated levels against many currencies in the region. During the crisis, the euro gained on the back of a reversal of cross-border bank lending flows. As part of the deleveraging process, Eurozone banks cut back aggressively on lending into countries around the Eurozone. The resulting capital flows (positive for the Eurozone, negative for the peripheral countries) have pushed most European FX crosses higher. These flows helped amplify effects from the euro’s function as a “regional” safe-haven currency during the financial crisis, investors seeking refuge in the relative size and stability of the Eurozone. In our view, the euro looks set to retrace versus other European currencies as the support from banking flows fades. We therefore recommend selling EUR exposure versus an equal-weighted basket of the Norwegian krone (NOK), the Swedish krona (SEK) and the Polish zloty (PLN). In addition to the specific themes in relation to anchor currencies (both USD and EUR) it will be important to track the country-specific cyclical momentum within G10. In 2010 there is likely to be a period of further (if lackluster) recovery in the global economy and normalization of its financial system. We think increasing macroeconomic differentiation is likely to emerge as an increasingly important driver for G10 currencies. Accordingly, we believe relative value will play a bigger role in 2010 as cross-asset correlations decline. We see value in the British pound versus the New Zealand dollar: GBP/NZD is trading at multi-decade lows and may benefit from

We see an early 2010 correction in risk appetite

We expect the US dollar to weaken further in 2010

USD has lost a key support: foreign flows into MBS

The euro looks set to give back some of its strength

We see value in sterling vs the Kiwi dollar

Nomura Global Economics

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16 December 2009

2010 Global Economic Outlook

the Bank of England’s likely move to gradually normalize policy from late 2010 and the continued need for loose monetary policy in New Zealand.
A strengthening yen is likely to prompt MOF intervention

The Japanese yen is likely to remain under upward pressure in 2010 as global trade recovers, repatriation inflows increase and a decline in global risk appetite is not fully offset by a pickup in domestic portfolio outflows. In addition, Japan’s monetary policy remains relatively tight by international standards; the Bank of Japan has maintained a very low interest rate setting for several years, but did not significantly expand its balance sheet in response to the financial crisis. We think these pressures could push USD/JPY down to a low of 83 by the end of Q1 2010. However, this would leave Japanese authorities little choice but to intervene in the FX market – an option that policymakers have thus far been reluctant to employ. We believe that the Ministry of Finance may have some success in putting a floor under USD/JPY and pushing it back to around the 85 level before the cross gradually grinds back toward 87 by the end of next year. Aside from some of the idiosyncrasies in parts of Asia, several broad themes are likely to emerge in support of our broader regional outlook beyond Japan. First, less favourable global risk conditions will, in our opinion, be the main driver of a temporary weakness in Asia FX. A significant amount of foreign equity flows into the region in recent months has left Asia somewhat vulnerable to a retrenchment in risk appetite and a resultant decline in global equity markets. However, the region’s economies have grown less vulnerable overall to volatility in external financing, repatriation flows have ebbed and we do not view positioning by global investors as particularly stretched from a medium-term perspective. This leaves us confident that that any sell-off in Asia FX is likely to be temporary and limited. Next, we see the cyclical recovery in Asia supporting our view of further Asia FX appreciation in 2010. We see this theme bolstered by base effects as global growth rebounds and exports in particular continue to recover. Another support to our strengthening cyclical view is the region’s inventory cycle: our economists expect the inventory contribution to GDP growth to be positive across the region into the early part of next year. Generally loose monetary policies also should provide a boost to local growth and help fuel FX appreciation. Finally, China’s growth surge is also likely to support Asia and encourage regional currency strengthening. In our view, these factors are likely to increase pressure on authorities to allow for greater FX flexibility in 2010, but only in the wake of our forecast bout of risk aversion that we expect to occur around JanuaryFebruary, and once capital inflows return. One of our preferred trade ideas is to be long the Korean won (KRW). We remain bullish on KRW because its FX valuations (FEER/REER) are favourable, we see it as less vulnerable to macroeconomic risks than other currencies, the Korean economy is set to recover strongly, and we expect the monetary authorities to accommodate FX appreciation – and the implicit monetary tightening that results from it. In keeping with our emphasis on relative value opportunities in 2010, we note that while Indonesia remains fundamentally sound, it is beginning to diverge from India on several levels. First, the Reserve Bank of India, one of the most hawkish central banks in the region, does not appear to be overly concerned about foreign equity inflows – which constitute one of India’s main sources of foreign capital. Next, positioning in India’s financial markets does not appear particularly stretched versus heavy positioning by foreign investors in Indonesia’s SBI (central bank bills) and bond markets. Finally, the Indian rupee (INR) remains undervalued while the Indonesian rupiah (IDR) is overvalued, according to our FX valuation framework. Turning to the interest rate outlook for Asia, we retain a positive duration view on Asian interest rate markets into 2010. While the region’s economic recovery may be superior in relative terms, in absolute terms it is unlikely to justify the degree of inflation, and by extension, the rate hikes, priced into most regional curves. Moreover, because we expect a period of global risk aversion over the coming months, net received positions in Asian rates markets are even more attractive. Crucially, however, we do not believe a period of risk aversion will spark a recurrence of the 2007 to early 2009 Libor crisis. Hence, we do not expect received positions in front-end interest rate swaps (IRS) to be undermined by a sharp widening of bond-swap spreads, or between swap fixing rates and central bank policy rates. We continue to like trades which benefit from extracting excessive term premium in near- to medium-term interest rate futures contracts. In particular, we see the markets in Australia, New Zealand, Korea, Singapore and Thailand as offering particular value in this regard. We favour

We expect some temporary weakness in Asia FX ...

… but then for further appreciation to occur

We are bullish on the Korean won

We favour the Indian rupee over the Indonesian rupiah

We are positive on Asian interest rate duration

Nomura Global Economics

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16 December 2009

2010 Global Economic Outlook

taking advantage of this excessive term premium via a mix of IRS received positions, front end butterflies and forward-starting curve steepeners.
The return of the “inflation trade” is a risk

The key risk to our Asian rates outlook is a return of the “inflation trade” as base effects and high commodity prices are likely to push headline CPIs higher in several key economies in coming months. We are skeptical on the ability of high headline inflation rates to pass meaningfully through to actual core inflation, however, and expect the experience of 2008 to ensure that central banks are reluctant to tighten monetary policy due to price rises in nondiscretionary consumption items. We believe the worst is over for Emerging Europe, Middle East and Africa (EEMEA). With the region through the worst of its business cycle and most of the financial deleveraging process over, these economies are now showing signs of stability. A modest and gradual improvement in the outlook is our over-riding theme, beyond any Q1 risk retracement, with many of the pre-crisis excesses becoming less pronounced. Within this modest recovery in EEMEA, we expect plenty of macro differentiation in terms of growth and fiscal and current account developments. In particular, we see several compelling opportunities in currency and rate markets, which are set to enjoy a favourable technical and valuation backdrop into 2010. While the current account and inflation adjustments have reached a mature stage, the excesses of the period before the 2008 crash look like a story of the past. Accordingly, we recommend investing in growth, current account and valuation outperformers. In our view, this leads us to recommend buying the Turkish lira (TRY). Russian ruble, Kazakh tenge, and Israeli shekel. Against this, we would sell the Czech koruna (CZK), Hungarian forint (HUF) and South African rand (ZAR). We also recommend receiving 1yr swaps 1fwd in IRS space (TRY, ZAR with a view to include HUF) to protect currency longs. We expect PLN to outperform in a similar fashion to the Slovak koruna in 2008, as we expect Poland to enter ERM II in 2010. Furthermore, the currency’s valuation, growth differentials and competitiveness are favourable relative to EUR and CZK, and we recommend buying PLN against EUR and CZK.

The worst is likely over for EEMEA

LatAm is benefiting from ties to Asia and commodity prices

With respect to Latin America, we maintain a positive stance on the region’s major economies. The medium-term economic outlook for Latin America (particularly the southern cone) is underpinned by two positive structural factors. First, the rising trade links with high-growth Asia (especially China), and the impact that Asia has had on commodity prices explains both the absolute and relative performance of the economies in the region – specifically, we think this accounts for a meaningful degree of Brazil’s better economic performance compared with Mexico. The positive terms-of-trade shock and greater volume of export demand represent a net income transfer to these commodity producers, reducing the perception of risk in the region and generating a virtuous cycle of greater investments and consumption. Although a strong case can be made that a form of economic “decoupling” from the G3 business cycle has taken place, we expect local markets to continue to show high correlation to G3 markets. In addition, the outlook for 2010 looks much trickier than 2009, with the uncertain global environment, higher valuations and rising political and policy risk in Brazil and Colombia arguing in favour of lower-risk strategies. Still, we maintain a positive view of the region’s currencies against USD for 2010. The risk wobble we foresee in Q1 should have only a temporary impact on the region's currencies, and is not expected to derail the ongoing rally. That said, higher valuations do complicate matters and upcoming elections in Brazil and Colombia will heighten political and policy risk. We favour two medium-term positions: sell USD/BRL and sell USD/CLP. We expect the Brazilian real (BRL) to continue to lead the pack, but with much more volatility amid the impact of capital-control measures and a potential equity market sell-off in Q1 2010. We also recommend short USD/CLP as a way to diversify exposure to the region. In addition, the BRL/CLP cross may be a good vehicle in times of higher risk aversion. The market has priced in an aggressive expectation of policy rate hikes that we doubt will materialize; as a result, we also see good value in receiving rates in Brazil and look at specific “event triggers” to add to the trade.

We are positive on LatAm currencies against USD

The Brazilian real leads the pack

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2010 Global Economic Outlook

Equity Market ⏐ Outlook 2010

Ian Scott

Still bullish
We expect the global equity rally to continue but at a slower pace than the gains seen since March 2009. We forecast a local currency total return for global equities of 17%.

Strong support for stocks from a number of factors
We would characterise the positive forces in 2010 as the following:
Current loose policy could remain in place for a while yet

1) Continued policy support: For several reasons, we think the authorities in the major developed economies will err on the side of caution when considering moving away from the very loose policy stance that is in place at the moment: (i) the existence of a very large output gap, (ii) continued benign news on inflation, and (iii) lessons from Japan’s experience, where many now argue that policy support was removed too early after recovery had begun to take hold. In terms of unconventional measures too, Nomura’s Global Economics team expects support for markets to continue to rise, albeit modestly, well into 2010. 2) Valuations: We continue to feel that equity valuations are below where the current fundamentals suggest they ought to be. The debate regarding earnings multiples hinges on an assessment of where the mid-cycle earnings point is. Fitting a simple constant growth trend to historical earnings data suggests that current earnings are 45% below the mid-cycle point when treated in nominal terms (Figure 1). With the nominal trend, the current multiple is 19% below its 40-year average (Figure 2). Relative to government bonds, we think equities are favourably valued with an imbedded equity risk premium of about 5.5%, while relative to credit too, equity yields now look much more appealing than they did 12 months ago. One of the striking features of this current equity cycle is the continued very high free cash flow being generated by non-financial companies, well above that required to sustain their dividends. All in all then whether based on book values, earnings, free cash flows or dividends, we think that both absolute and relative equity valuations are appealing.

Valuations are lower than fundamentals suggest

Earnings should continue to grow in 2010 and 2011

3) Earnings: We think earnings will continue to grow in 2010 and 2011. Our forecasts suggest EPS growth of 24% which is below the current consensus of bottom-up analyst forecasts of 30% (Figure 3). We expect GDP, at the global level, to continue to grow at an accelerating pace in 2010 and 2011 despite the waning of policy stimulus. Our expectation of continued earnings growth leads us to expect a likely continuation of earning upgrades, although probably not at the same pace as over the past 11 months.

Asset allocation still favours cash

4) Asset allocation: We believe that asset allocation remains skewed in favour of cash and away from equities. The traditional owners of equity – institutions and households – have more cash as a proportion of financial assets than at any time over the past ten years Although we
Figure 2. Normalised global PE (price earnings) multiple

Figure 1. Global EPS (earnings per share) and trend

Index, Jan 1970 = 100 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 1970 1974 1979 1983 1988 1992 1997 2001 2006
Source: Nomura Strategy research.

Ratio 35 30 25 20 15 10 5 0 1970 1974 1979 1983 1988 1992 1997 2001 2006
Source: Nomura Strategy research.

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see no definitive reason why asset allocation ought to move back towards equities and away from cash, it is clear that in major developed economies, one of the intentions of asset-purchase programmes and quantitative easing is to encourage exactly such an asset allocation shift. Nonetheless, until that happens we think the potential remains for equity markets to be supported by asset allocation flows. We also see a number of negative forces at work on the equity market in 2010, the main one being the high levels of government borrowing, which will likely limit the scope for multiple expansion in 2010. Other factors include equity issuance, possible subdued institutional demand for equities and higher regulation.

Market forecasts
We expect a still healthy overall gain for equities

In Figure 4 we detail our index targets and market forecasts for 2010. We believe the overall gain for global equities will be less strong than it was since March 2009, but still healthy. As discussed above, this should be driven by continued earnings growth, low valuations, positive asset allocation and benign policy.

Regional outlook – a tactical shift to Japan
Unlike the position 12 months ago, when we began 2009 with some very large departures from the benchmark regional weightings, as 2010 approaches things do not seem quite as dislocated. Nevertheless, we think there are some opportunities to diverge from the benchmark (Figure 5).
We raise our weighting in Japanese equities

Japan: We are taking the opportunity to raise our recommended weighting in the Japanese equity market from a previous 7% to 16%, against a benchmark of 8%. There is undoubtedly a need for policy action, in our view. The strength of the yen has become a major problem for the market. By acting to stem the rise of the yen recently by increasing the amount of emergency liquidity available to the banking system and passing a supplementary budget, the new Japanese government has signaled an intention to respond to “excessive” yen strength, at around ¥85 to the US dollar. While the policy response is important, we see other supports for an Overweight position. Although the economy is weak, and once again in the grip of deflation, the situation may not be quite as bad as the market appears to think. Confidence, arguably the most important variable during times of crisis, has recovered more quickly than has been the case in the US, for example. Japanese output has recovered rapidly from a much larger decline as a sharper inventory adjustment combined with the strength of the yen and a larger underlying cyclicality. Nomura’s Japanese Strategy Team forecasts a rise in Topix earnings per share of 140% in 2010 and another 50% in 2011. If this transpires then the market is trading on 13.4 times 2011 expected earnings.

The US market should perform well again in 2010

US: The US market should perform well again in 2010 as the extreme policy measures implemented by the US administration bear fruit. The economy is expected to recover, and to grow above the GDP growth rate expected in Japan and the euro area. Although earnings are likely to continue to grow in 2010, we doubt that they will continue to surprise estimates in the way that they have done recently. A key element of our optimistic view on the US market is the
Figure 4. Index forecasts for major global indices, 2010 2010 30.0 18.5 28.0 14.6 140.0 23.7 23.9 78 44 2011 25.0 14.1 11.0 17.0 50.0 19.0 19.5 97.5 66 Notes: 1) S&P 500; 2) FTSE Europe ex UK; 3) FTSE 100; 4) Topix; 5) FTSE Asia ex Japan; 6) FTSE Emerging Markets. * As of 9 Dec 09 Source: Nomura Strategy research. Price indices Current* End 2010 US UK
1 2

Figure 3. Earnings (EPS) growth forecasts 2009 EPS* growth (% y-o-y) US UK Asia ex-Japan Japan Global
2 1

21.0 -15.0 -38.0 5.2 -58.5 -6.7 -3.2 60 18

Price return Local 18% 10% 13% 22% 11% 12% 15%

Total return Local 20% 14% 16% 25% 14% 14% 17%

Total return $ terms 20% 19% 25% 28% 21% 21% 21%

Europe ex-UK

1103 140 5311
4 5

1300 155 6000 1100 350 560 363

Europe ex-UK
3

Japan EM
6

899 316 502 316

Emerging Markets
3

Asia ex-Jap

EPS forecasts S&P Operating EPS ($) Topix (yen)

Global

Notes: * Earnings pre-extraordinary items. 1) S&P 500 Operating Earnings; 2) Topix; 3) FTSE AW World Index, Source: Nomura Strategy estimates.

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2010 Global Economic Outlook

expectation that the authorities will maintain a very accommodative stance for an extended period of time. In addition, the asset allocation position in the US is an extreme one, with both households and institutions holding relatively large amounts of cash. In 2010 we would expect to see a greater appetite for equities developing.
We recommend being underweight Europe ex-UK

Europe ex-UK: We are recommending an underweight stance in the Europe ex-UK market going into 2010. Although the region remains relatively cheaply valued on 12.4x consensus 12month forward earnings, we think there are some potential constraints. Earnings growth is likely to be constrained by the ongoing strength of the euro and a less aggressive attitude towards cost cutting than is evident elsewhere, especially in the US. As Figure 6 shows, unit labour cost growth contrasts with unit labour cost declines in the US. We forecast US profit growth to be 30% in 2010, current consensus estimates being 23.5%. In Continental Europe we anticipate 18.5% compared with consensus estimates of 28%. UK: We continue to overweight the UK market. The UK market has not been a defensive market in this equity cycle. The market has suffered disproportionally as a result of the financial crisis, as has sterling. We think this leaves an opportunity for investors to buy relatively cheap assets in a relatively cheap currency. Nomura’s Foreign Exchange research team anticipates an appreciation of the pound in 2010 to 1.95 versus the dollar, 1.6 versus the euro and 170 versus the yen. In addition, the UK market receives support from valuation – the estimated risk premium embedded in the UK equity market at 6.1% is 230 basis points above the risk premium embedded in the rest of the world. Emerging markets: We retain our modest underweight position in global emerging markets (EM). The region no longer offers investors a higher risk premium compared with developed markets. Profitability favours the emerging markets now, but we expect developed market earnings to rise more strongly in 2010 and 2011. Finally, there is the issue of fund flow and the currently buoyant sentiment towards EM. Based on the past three months of inflows, around $14.1bn of EM equity assets have been bought by mutual fund investors. Although such flows do not necessarily point to negative returns for investors in EM equities ahead, or even underperformance, they have been associated with less bullish performance than when investors buy into emerging markets following an exit of capital. Asia-ex-Japan: The developed Asia region has performed well in 2009, rising by 60% in US dollar terms. However, we think the time has come to reduce our recommended exposure to Neutral from Overweight. The region (as defined by FTSE) trades on 15.4x current consensus earnings for 2010. This compares with a 13.2x multiple for emerging Asian markets. The premium for developed Asian markets seems hard to justify.

The UK market is attractively valued we stay overweight

We retain a modest underweight in EM

We reduce our exposure to neutral in Asia ex-Japan

Figure 5. Recommended global market allocation

1

Figure 6. US and euro-area unit labour costs

North America Europe ex-UK UK Japan Asia ex-Japan Emerging Mkts Unit: % of index

Benchmark Recommend- Recommendation ed weighting 44 39 Underweight 20 9 8 8 12 11 18 16 8 8 Underweight Overweight Overweight Neutral Underweight

% y-o-y 7 6 5 4 3 2 1 0 -1 -2 -3 US -4 Mar-92 Mar-95 Mar-98 Mar-01 Mar-04 Mar-07 Euro area

Benchmark: FTSE All World index (USD). Source: Nomura Strategy research.

1

Note: Unit labour cost data for the US are for the non-farm sector while data for the euro area is for the entire economy. Source: Datastream, Bureau of Labour Statistics, EuroStat, Nomura Strategy research.

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2010 Global Economic Outlook

Contacts
Global
Paul Sheard Global Chief Economist paul.sheard@nomura.com 1-212-667-9306

North America
David Resler Aichi Amemiya Zach Pandl Chief Economist US david.resler@nomura.com aichi.amemiya@nomura.com zach.pandl@nomura.com 1-212-667-2415 1-212-667-9347 1-212-667-9668

Europe
Peter Westaway Laurent Bilke Takuma Ikeda Maxime Alimi Chief Economist Europe peter.westaway@nomura.com laurent.bilke@nomura.com takuma.ikeda@nomura.com maxime.alimi@nomura.com 44-20-7102-3991 44-20-7102-2566 44-20-7102-1605 44-20-7102-5846

Japan
Takahide Kiuchi Kenichi Kawasaki Mika Ikeda Ei Kaku Naokazu Koshimizu Masaki Kuwahara Takashi Miwa Takashi Nishizawa Minoru Nogimori Shuichi Obata Kohei Okazaki Ryota Sakagami Takayuki Urade Chief Economist Japan Senior Policy Analyst t-kiuchi@frc.nomura.co.jp k-kawasaki@frc.nomura.co.jp m-ikeda@frc.nomura.co.jp e-kaku@frc.nomura.co.jp n-koshimizu@frc.nomura.co.jp m-kuwahara@frc.nomura.co.jp t-miwa@frc.nomura.co.jp t-nishizawa@frc.nomura.co.jp m-nogimori@frc.nomura.co.jp s-obata@frc.nomura.co.jp k-okazaki@frc.nomura.co.jp r-sakagami@frc.nomura.co.jp t-urade@frc.nomura.co.jp 81-3-5203-0445 81-3-5255-0574 81-3-5203-0415 81-3-5255-1711 81-3-5203-0427 81-3-5203-0629 81-3-5203-0421 81-3-5203-0414 81-3-5203-0451 81-3-5203-3635 81-3-5203-0428 81-3-5203-0446 81-3-5203-0425

Asia
Rob Subbaraman Tomo Kinoshita Stephen Roberts Mingchun Sun Young Sun Kwon Tetsuji Sano Sonal Varma Chief Economist Asia Deputy Head, Asia Economics Chief Economist Australia Chief Economist China South Korea Philippines, Thailand India, Vietnam rob.subbaraman@nomura.com tomo.kinoshita@nomura.com stephen.roberts@nomura.com mingchun.sun@nomura.com youngsun.kwon@nomura.com tetsuji.sano@nomura.com sonal.varma@nomura.com 852-2536-7435 852-2536-1858 61-2-8062-8631 852-2252-6248 852-2536-7430 65-6433-6947 91-22-4037-4087

Emerging Markets
Peter Attard Montalto Olgay Buyukkayali Ivan Tchakarov Tony Volpon SA, CEE, Middle East Turkey, Israel Russia, Ukraine, Kazakhstan Latin America peter.am@nomura.com olgay.buyukkayali@nomura.com ivan.tchakarov@nomura.com tony.volpon@nomura.com 44-20-7102-8440 44-20-7102-3242 44-20-7102-9093 1-212-667-2182

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Analyst Certifications We, Paul Sheard, David Resler, Aichi Amemiya, Zach Pandl, Tony Volpon (Nomura Securities International), Peter Westaway, Laurent Bilke, Takuma Ikeda, Maxime Alimi, Peter Attard Montalto, Ivan Tchakarov, Olgay Buyukkayali, Ian Scott, Ned Rumpeltin (Nomura International plc London), Takahide Kiuchi, Naokazu Koshimizu, Masaki Kuwahara, Takashi Miwa, Takashi Nishizawa, Minoru Nogimori, Kogen Okada, Shuichi Obata, Ryota Sakagami, Takayuki Urade (Nomura Securities Company), Tomo Kinoshita, Rob Subbaraman, Mingchun Sun, Young Sun Kwon (Nomura International (HK) Limited), Stephen Roberts (Nomura Australia Limited), Tetsuji Sano (Nomura Singapore Limited), Sonal Varma (Nomura Financial Advisory and Securities (India) Pte Ltd), hereby certify (1) that the views expressed in this report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this report, (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report and (3) no part of our compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company. Online availability of research and additional conflict-of-interest disclosures:
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