Nordic Outlook

World is staggering under debt burdens but will avoid recession Germany and Nordic countries will be affected, despite underlying strength

Economic Research – August 2011

Contents
International overview The United States Japan Asia The euro zone The United Kingdom Eastern Europe The Baltics Sweden Denmark Norway Finland Economic data 5 14 19 20 23 28 29 30 32 38 40 44 46

Boxes A 30 per cent recession risk Commodity prices will be resilient Will the euro survive? What do falling petrol prices mean? Hukou an obstacle to urbanisation and growth Energy subsidies a heavy budget burden Euro zone crisis deepening Falling home prices often lead to lower GDP 7 8 10 16 21 22 27 34

Nordic Outlook – August 2011 | 3

Economic Research

This report was published on August 30, 2011. Cut-off date for calculations and foreasts was August 25, 2011.

Robert Bergqvist Chief Economist + 46 8 506 230 16 Daniel Bergvall Economist +46 8 763 85 94 Ann Enshagen Lavebrink Editorial Assistant + 46 8 763 80 77 Andreas Johnson Economist +46 8 763 80 32

Håkan Frisén Head of Economic Research + 46 8 763 80 67 Mattias Bruér Economist + 46 8 763 85 06 Mikael Johansson Economist + 46 8 763 80 93 Tomas Lindström Economist + 46 8 763 80 28

Gunilla Nyström Global Head of Personal Finance Research + 46 8 763 65 81 Susanne Eliasson Personal Finance Analyst + 46 8 763 65 88 SEB Economic Research, K-A3, SE-106 40 Stockholm

Ingela Hemming Global Head of Small Business Research + 46 8 763 82 97 Johanna Wahlsten Small Business Analyst + 46 8 763 80 72

Contributions to this report have been made by Thomas Köbel, SEB Frankfurt/M and Olle Holmgren, Trading Strategy. Stein Bruun and Erica Blomgren, SEB Oslo are responsible for the Norwegian analysis. Jakob Lage Hansen and Thomas Thygesen are responsible for the Danish analysis.

4 | Nordic Outlook – August 2011

International overview

World economy staggering under debt burdens
ƒ ƒ ƒ ƒ ƒ ƒ Slowdown, but no recession EM sphere showing decent resilience Falling inflation will allow policy flexibility Austerity and a new framework are needed to save the euro No ECB or Riksbank rate hike in 2012 Fed will carry out new stimulus
economic policy makers will utilise the stimulus measures that remain in their toolkits. The inflation outlook appears relatively stable, which will help create a degree of flexibility for interest rate policy makers. Large problems will remain in the euro zone, we believe that the political system will be capable of choosing a path that allows long-term stability, despite strains, but the uncertainty is substantial.

Global GDP growth

Year-on-year percentage change

Weak American economic data and greater uncertainty concerning the debt situation and political decision making capacity in the United States and the euro zone have contributed to the stock market decline and financial turmoil of the past few months. This uncertainty comes in a situation where resource utilisation remains low and room for traditional economic policy stimulus measures in the OECD countries is very limited. Meanwhile the financial system is in the midst of a sensitive restructuring process. Therefore our overall assessment is that uncertainty will persist in the near future, adversely affecting people’s inclination to consume and invest. Last spring’s slowdown, caused among other things by rising commodity prices and the impact of the Japanese natural disasters, was thus not merely temporary. In our main scenario, GDP growth in the OECD countries will slow to 1.7 per cent this year and 1.8 per cent in 2012. The US as well as the euro zone will see below-trend growth in both 2011 and 2012. Next year the OECD average will be pulled slightly upward by higher growth in Japan, which is regaining economic strength after its March 2011 natural disasters. Financial imbalances are most obvious in the US, Japan, the United Kingdom and various countries of southern Europe. However, we also expect the ongoing deceleration to lower growth in European countries with stronger fundamental economic balances, such as Germany and the Nordic countries. Emerging market (EM) economies will also be affected, but to a lesser extent. Due to the greater role of intra-regional trade and ample room for loosening economic policies if necessary, a soft landing with continued relatively high growth is the most probable scenario in this sphere, which implies that global GDP growth will remain at decent levels. Measured in purchasing power-adjusted terms, it will slow from 5.1 per cent in 2011 to 4.0 per cent this year and 3.5 per cent in 2012. In 2013 we expect growth to accelerate somewhat in the OECD countries. The forces that will restrain recovery during the next year will ease a bit, and by then the debt adjustment process will have made some progress. Our main scenario assumes that

2010 United States Japan Germany China United Kingdom Euro zone Nordic countries Baltic countries OECD Emerging markets World, PPP* World, nominal
Source: OECD, SEB

2011 1.5 -0.6 3.0 9.2 1.1 1.7 2.6 5.7 1.7 6.2 4.0 3.3

2012 1.8 2.9 1.3 8.4 1.6 1.0 1.9 3.7 1.8 5.5 3.5 2.8

2013 2.7 2.2 1.9 8.8 2.0 1.5 2.6 4.4 2.1 5.8 3.9 3.2

3.0 4.0 3.6 10.3 1.4 1.7 2.9 1.4 2.9 7.4 5.1 4.4

* Purchasing power parities

Economic policy faces complex challenges

There are several reasons for the instability that has plagued financial markets in recent months. A slowdown at a time when room for traditional stimulus measures is very limited raises many serious questions. The situation is being made worse because decision makers in a number of areas appear to have been blind-sided and confused by the major challenges they face. In the background are both ideological differences and conflicting national interests, but also a genuine uncertainty about what measures are actually needed in the complicated situation that has arisen in the aftermath of the 2008-2009 financial and economic collapse. These major challenges have revealed weaknesses in both the ability of the American political system to respond to largescale domestic problems and in the basic structure of the euro system. We foresee several dilemmas and challenges: ƒ Powerful fiscal tightening measures appear to be necessary in many countries simultaneously. There are obvious risks that this may choke off economic activity in a way

Nordic Outlook – August 2011 | 5

International overview

that reduces the final impact of budget improvements, while fuelling popular discontent and weakening governments. But a passive policy would lead to a further and unsustainable undermining of confidence. ƒ Today’s faltering euro system, with its common currency but weak political coordination and weak institutions at the euro zone level, seems to have reached the end of the road. The European Union must make a choice within the next couple of years: Either scrap the euro or else strengthen its common institutions in a way that will introduce federalist and supranational characteristics on a scale previously considered politically unacceptable. The global financial system is in a transformation phase. Regulation in various fields is moving towards implementation, with the ambition of increasing stability and reducing the risks of new crises, but past experience of large regulation projects − which often lead to unforeseen problems − is a bit unnerving. Global trade imbalances are a key fundamental cause of tensions in the world economy. There is also a need for greater economic policy coordination at the global level. Here, too, institutions are relatively weak. Decisions are often made at national level, further entrenching global imbalances. There is still room for unconventional stimulus alternatives. However, their consequences are uncertain, both in terms of effectiveness and any long-term adverse impact.

rent low level, 1.6 per cent, a downward recessionary spiral usually occurs. Below-trend growth leads to rising unemployment, which we have already seen to some extent in the past six months. This, in turn, reinforces the negative dynamic. Our US recession indicator, which summarises many macro and financial variables, points to a high probability of recession. This indicator may exaggerate the recession risk. It is largely based on sentiment data, and the gap between these and hard data is probably larger than usual.
Signs of European bank distress
Basis points
90 80 70 60 50 40 30 20 10 0 -10 06 07 08 09 10 11 90 80 70 60 50
(See GS Economics Analyst sep 7 2007)

Note: Try it as a regressor of employment growth. Should ge

ƒ

even after controlling for lagged emp.growth, lagged GDP gr

40 30 20 10 0

ƒ

-10

Swap spread, Europe (10-year) Swap spread, US (10-year)

Source: Reuters EcoWin, SEB

ƒ

Similarities and differences from 2008

There are obvious risks that the current slowdown may tip into a recession. Certain parallels can be drawn to events in 2007 and 2008. During the first period after the summer 2007 sub-prime mortgage crash, the US economy was characterised by subdued but positive GDP growth, which only turned into a deep recession after the Lehman Brothers bankruptcy a year or so later. During the initial phase, various countries showed significant resilience, fuelling the concept of a de-coupling between Western Europe and the US. Once the crash had spread and the financial crisis paralysed world trade, the recession became synchronised in most parts of the world. US: SEB recession indicator
Probability of a recession within a year
0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0

In Europe the recession risks appear somewhat different. Synchronised austerity programmes may choke off growth to a greater extent than we have anticipated in our main scenario, especially if they are not perceived as credible. Various countries must cope with continued high costs for new borrowing. Perhaps the most serious recession risk is that weaknesses in the banking system might lead to a tightening of lending, mainly to industrial companies. The situation is serious in the banking sector. Industrial companies, on the other hand, are more financially resilient than they were in 2008.
US: SEB Credit Conditions Index
5 4 3 2 1 0 -1 -2 71 74 77 80 83 86 89 92 95 98 01 04 07 10 5 4 3 2 1 0 -1 -2

CCI

Mean (1970-2009)
Sources: Federal Reserve, SEB, Reuters EcoWin

Source: SEB

At present, certain indications of recession are also discernible in US economic data. When GDP growth has fallen to its cur-

However, various other important factors make a recession unlikely. Cyclically volatile portions of the economy, which normally account for most of the decline in demand during a recession, are already deeply depressed. For example, the investment ratio in the American economy is at a record low and residential construction has fallen from more than 6 per cent of GDP to just above 2 per cent. Household debt retirement has also made considerable progress. Debt as a percentage of disposable income has dropped from 135 to 119 per cent. The current household savings ratio, around 5 per cent of income, represents a continued downward adjustment in debt. Taking

6 | Nordic Outlook – August 2011

International overview

into account other variables such as the decline in home prices, an equilibrium debt level could be reached in 3-4 years given the current rate of debt retirement. Strong balance sheets at industrial companies, especially in the US, also make an imminent recession less likely. In addition, the American banking and credit market situation looks substantially different from 2008, as our indicator clearly shows. A credit crunch that chokes off capital spending activity and contributes to large-scale order cancellations does not appear likely, especially in the US. Hard-earned experience from 2008 also means that central banks will be better prepared to react quickly if the threat of liquidity problems crops up in the financial system.

consumption will be squeezed by a downward price adjustment in Sweden’s expensive housing market. At present, it also looks as if a parliamentary deadlock will lead to relatively tight fiscal policy. Our overall assessment is that Swedish GDP growth will reach only 1.4 per cent in 2012. Danish growth will be relatively low in the near future. Given tight fiscal policy, a weak labour market and a lack of optimism among households and businesses, exports will be the only growth force. Next year, however, we expect fiscal policy to shift in a more expansionary direction. Meanwhile there is a pent-up need for both increased consumption and capital spending activity. GDP growth will thus be higher than in the euro zone. The Finnish economy, like that of Sweden, is also sensitive to variations in international demand. We thus expect a clear slowdown in export growth, but domestic demand will be resilient. Falling unemployment will stimulate consumption, while capital spending will rise from a depressed level. Finland will thus keep growing above trend in the next couple of years. The Norwegian economy will resist the international downturn next year. Solid public sector finances, oil income and good fundamentals in the mainland (non-oil- and shipping-related) economy will enable growth to remain above trend. Capital spending will be driven primarily by the oil industry and the housing market. Meanwhile household consumption will be sustained by good income growth and falling unemployment.

A 30 per cent recession risk in the OECD
To summarise the above discussion in the form of three risk scenarios, we are assigning a 55 per cent probability to our main scenario: a slowdown without a recession. We anticipate that such a scenario will probably require further stimulus measures from the Fed. It also assumes that crisis-ridden countries in the euro zone will implement their planned austerity measures. At the same time, we estimate the probability of a recession at about 30 per cent. There are several reasons why we view this risk as considerably higher than normal. A recession scenario would probably be milder in the initial phase than in 2008. On the other hand, it is likely to be lengthier, due to inadequate policy responses and more deep-seated uncertainty about future economic, political and financial fundamentals. A scenario in which growth more quickly resumes the pattern we foresaw before the summer cannot be ruled out either, but we estimate that this scenario has a low 15 per cent probability at present.
GDP, OECD countries
Index 2000=100
132.5 130.0 127.5 125.0 122.5 120.0 117.5 115.0 112.5 110.0 107.5 04 05 06 07 08 09 10 11 12 13
Source: OECD, SEB

GDP growth, Nordic and Baltic countries
Year-on-year percentage change

2010 Sweden Norway Denmark Finland Nordics Estonia Latvia Lithuania Baltics
Source: OECD, SEB

2011 4.3 1.4 1.4 2.9 2.6 6.5 4.0 6.5 5.7

2012 1.4 2.6 1.7 2.2 1.9 3.5 3.5 4.0 3.7

2013 2.6 2.7 2.3 2.8 2.6 4.0 4.5 4.5 4.4

5.7 0.3 1.7 3.6 2.9 3.1 -0.3 1.3 1.4

132.5

15%

130.0 127.5 125.0 122.5 120.0

30%

117.5 115.0 112.5 110.0 107.5

Moderate growth slowdown in the Baltics

Recession

Recovery

Slowdown

Varying effects on the Nordic countries

The Nordic countries have, albeit in varying degrees, relatively good potential to withstand the international slowdown by virtue of their rather strong underlying fundamentals. We nevertheless expect growth in Sweden and Denmark to reach below trend next year. The Swedish export sector normally shows great cyclical sensitivity to variations in international demand. In addition, private

The three Baltic countries are continuing their gradual recovery from the 2008-2009 crash. First half 2011 growth was surprisingly strong, especially in Estonia and Lithuania, where the year-on-year increases in GDP were 8.4 and 6.5 per cent, respectively. So far, leading indicators have also been resilient in the face of international instability. The upturn has mainly been driven by exports. Because of poorer global prospects, the export boom will fade in the next 6-12 months. Our forecast of a gradual upturn in domestic demand remains in place, however. High unemployment will slowly fall. We expect Estonia and Lithuania to implement certain stimulus measures after their earlier tightening.

Nordic Outlook – August 2011 | 7

International overview

In Latvia, budget austerity will continue, but in smaller doses. Relatively high inflation, driven by energy and food prices, will slow next year, stimulating purchasing power. Weighed together, growth will end up somewhat below its potential pace of 4-5 per cent next year. Estonia’s GDP will increase by 6.5 per cent this year and by 3.5 per cent in 2012. Latvia’s growth will cool from 4.0 per cent this year to 3.5 per cent in 2012. Our forecasts for Lithuania are 6.5 and 4.0 per cent, respectively. During 2013 a certain rebound will occur.

Money supply
Year-on-year percentage change
15.0 12.5 10.0 7.5 5.0 2.5 0.0 -2.5 90 92 94 96 98 00 02 04 06 08 10 15.0 12.5 10.0 7.5 5.0 2.5 0.0 -2.5

Inflation will fall

In recent months, inflation has shown mixed tendencies. Because of earlier upturns in commodity prices, Consumer Price Index (CPI) inflation stands at around 3 per cent in the OECD countries as a whole. Sustained commodity prices, despite weaker economic prospects, have contributed to the stagflationary tendencies we are now seeing. On the other hand, there are hardly any signs that high spot inflation has caused secondary effects, for example faster pay increases. Inflation expectations have fallen, yet there is a major difference compared to the situation in 2008, when strong deflationary expectations dominated the market for inflation-linked bonds. Monetary aggregates have also continued to normalise and are providing no recessionary or deflationary signals at present.

US, M2

Euro zone, M3
Source: Federal Reserve, ECB

In the dramatic macroeconomic environment where we have found ourselves in recent years, the perceived threats have changed dramatically a number of times: from deflation risks driven by low resource utilisation and lack of optimism to inflation risks driven by money-printing and monetary expansion. In spite of this, underlying inflation has shown a stable pattern. In our economic scenario, a rather calm inflation trend in the OECD countries appears likeliest. We expect CPI inflation to decline clearly during the first half of 2012. After that, inflation will run a bit below 2 per cent in the euro zone and quite close to 2 per cent in the US. Core inflation (CPI excluding

Commodity prices will be resilient

So far, the reactions in the international commodities market to financial turbulence have been mild. A minor price drop was noted for agricultural commodities, while the downturn for industrial metals was more significant. Rising copper prices nevertheless offset the impact on broader indices. There was a clear decline in energy prices earlier this year, but they have rebounded recently. Gold prices have climbed to new heights as investors have fled to “safe” assets in troubled times. Global commodity prices
Index
200 175 150 125 100 75 50 25 Jan May 08 Sep Jan May 09 Sep Jan May 10 Sep Jan May 11
Source: HWWI

of quantitative easing (QE3), to create good liquidity and to benefit commodities. A continued comparatively weak dollar points in the same direction. Despite the weakened economy, we have adjusted our oil price forecast (Brent) somewhat higher for next year. This is due to new information concerning supply conditions, with falling OECD reserves and shrinking extra capacity in the Organisation of Petroleum Exporting Countries (OPEC). Producers seem to be aiming for prices of around USD 110 per barrel, and Saudi Arabia is probably prepared to cut back production in order to keep prices around USD 100 or somewhat higher. Metal prices will move upward eventually. This is especially true of aluminium and copper. Prices have fallen closer to production costs. China is also expected once again to build up its copper reserves after earlier draw-downs. Prices of agricultural commodities are expected to level out during the coming year. We previously foresaw a downturn during the second half of 2011, continuing into 2012. But meteorologists are now warning of a repetition of the La Niña period that swept across the world during late 2010 and early 2011, which may adversely affect harvests. In the short term, agricultural prices will also be pushed higher by weaker US harvests in the wake of a hot summer. The risks in our commodities forecast are on the downside. If important OECD countries should slide towards a new recession, weaker pricing awaits. Cyclically sensitive commodities like industrial metals also risk price squeezes in an uncertain, turbulent economic and financial environment.

200 175 150 125 100 75 50 25

Industrial metals

Energy

Agricultural

We are sticking to our view that over the next couple of years, commodity prices will generally remain at high levels despite the economic slowdown in the OECD countries. This resilience will be due to fundamental factors on the supply side that will keep prices up, while rapid growth in China and other emerging economies will sustain demand. We expect continued low interest rates and new monetary stimulus measures from central banks, such as the Fed’s expected third round

8 | Nordic Outlook – August 2011

International overview

energy and food) has shown a rising trend in the US since late 2010. This trend will continue during the autumn to a level just above 2 per cent and then fall again. CPI inflation will fall
CPI, year-on-year percentage change
6 5 4 3 2 1 0 -1 -2 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
SEB forecast

6 5 4 3 2 1 0 -1 -2

The US and Japan are still running budget deficits of around 10 per cent of GDP, but the US cost-cutting package for the next 10-year period approved early in August represents a step towards more sober fiscal policy. Standard & Poor’s downgrading of its US sovereign debt rating has put some pressure on the political system. The details are still unclear, and further political decisions must be made. Given the shaky economic situation and the underlying political antagonisms, we expect US cost-cutting to be relatively minor next year, but more noticeable in 2013. In Japan, fiscal policy will be dominated in the near future by reconstruction programmes in the wake of last spring’s natural disasters. Medium-term cost-cutting programmes will therefore be postponed.

Fiscal tightening

Euro zone

US
Source: Eurostat, BLS, SEB

Change in structural balance as a percentage of GDP 2010 2011 2012 2013

The risks in our inflation forecast are mainly on the downside. In an environment of weak growth, low resource utilisation and little room for economic policy responses, it is not unthinkable that deflationary expectations may again gain a foothold. If the risk of recession increases further, it is likely that commodity prices will fall, which would reinforce deflationary impulses even more.

United States Japan United Kingdom Euro zone of which GIPS OECD
Source: IMF, SEB

-0.7 -0.5 0.3 0.4 2.4 -0.4

-0.6 -2.0 1.7 0.9 2.9 -0.5

0.8 -0.2 1.4 1.3 1.0 1.2

1.3 1.0 1.6 1.0 0.5 1.2

Tightening will hamper growth in 2012

Mounting debts and greater scepticism about the long-term sustainability of public sector finances, combined with weaker economic prospects, are creating difficult dilemmas for fiscal policy makers. They must choose between different fiscal consolidation strategies. If they emphasise cost-cutting in the next couple of years (front-loaded programmes), this has a bigger effect on market confidence but meanwhile implies greater pressure on the economy. Back-loaded programmes have less immediate direct impact on the economy, but on the other hand they increase debt even more. Uncertainty about how cost-cutting will be implemented may, in itself, also hold back consumption and capital spending.

In the Nordic countries, relatively strong public sector finances will mean that fiscal tightening can be avoided. Because of budget surpluses in Sweden and Norway, fiscal policy will remain expansionary. Due to greater international risks, combined with political disunity about suitable measures, the dose of stimulus in Sweden will be smaller than in our previous forecasts. In Denmark we expect a more expansive fiscal policy after the election, irrespectively of the election outcome. In Finland the situation is not as favourable; given moderate budget deficits, we expect a neutral fiscal policy. Overall fiscal policy in the OECD countries will shift in a contractive direction next year. We estimate this effect at 1.2 per cent of GDP in 2012 and about the same in 2013. Despite austerity measures, government debts will also continue to rise. By late 2011, developed-country debts will surpass 100 per cent of GDP for the first time since the Second World War. Not until the end of our forecast period will these debts level out.

Net lending
Per cent of GDP

2010 -10.6 -9.5 -10.4 -6.0 -7.7

2011 -9.9 -10.1 -8.0 -4.5 -6.7

2012 -7.4 -9.2 -6.5 -3.5 -5.6

Debt* 101 234 95 89 105

United States Japan United Kingdom Euro zone OECD
* Gross debt in 2012

Need for unconventional monetary policy

Source: European Commission, OECD, SEB

Fiscal cost-cutting places heavy responsibility on central banks to prevent a new recession. With key interest rates near zero in the US, Japan and the UK, there is a high degree of focus on the potential impact of unconventional monetary policy. So far, the US Federal Reserve has gone furthest when it comes to unconventional monetary policy. It has already allowed its balance sheet to grow massively by means of quantitative easing (QE): buying mortgage and government securities (QE1 was started in November 2008 and expanded in March 2009, and QE2 was initiated in November 2010). In addition, the Fed has pledged to keep its key interest rate near zero for an extended

We are now seeing how countries with major problems are being forced to act quickly. Crisis-plagued countries in the euro zone, as well as the United Kingdom, are implementing austerity measures in the range of 5-10 per cent of GDP in the space of a few years. Increased pressure on Italy has led to sizeable cost-cutting packages for the next two years. France has now also unveiled cost-cutting measures equivalent to 0.6 per cent of GDP in 2012.

Nordic Outlook – August 2011 | 9

International overview

period; in recent weeks it has specified an end date (summer 2013). The Fed now also has various other tools at its disposal. The most immediate step will be to issue a timetable, not only for its key rate but also for changes in its balance sheet. Another possibility is to extend the average maturity of its bond portfolio.

New bond purchases (QE3) will probably also be carried out if the labour market improvement derails, in line with our forecast. We expect the volume of QE3 to be equivalent to USD 1 trillion, probably with a focus on longer maturities. Looking ahead, other possible Fed measures are to establish a quantitative target for expansion of the monetary base or to

Will the euro survive?
The euro zone crisis rolls on, seemingly without end. Increased market scepticism about Italy and to some extent also France has given the crisis a new dimension. Emergency interventions to solve individual problems are apparently not sufficient to create stability and to calm financial markets and political leaders around the world. If the euro is to survive, major changes will be required at the national and European level. Acute short-term emergency actions include several different elements. In order to normalise the borrowing costs of crisis-plagued countries, further tough decisions are required. Budget-tightening programmes are under way in many countries, but these must probably be intensified and combined with more ambitious structural reforms. The European Financial Stability Facility (EFSF) needs expanded resources, among other things so that it can intervene in the sovereign bond market. Although we do not believe that Italy will finally need to seek a bail-out, it is important that the EFSF’s resources be expanded in such a way that Spain and Italy could also potentially be covered by its safety net (in addition to Greece, Ireland and Portugal). The participation of the International Monetary Fund (IMF) and the European Central Bank (ECB) is important in the short term. The IMF’s resources and expertise are needed in order to increase the credibility of the fiscal reform process. The ECB is the institution that can act quickly when the political process becomes lengthy. The euro zone countries probably need financial aid via the G20/IMF, in which especially China can play a role. Larger elements of financial regulation may also be necessary. Further debt write-downs are also likely, and if these are sizeable, recapitalisation of the banking sector will become necessary. A path towards preserving the euro. In the long term, however, the euro zone cannot be dependent on supervision by the IMF or emergency interventions from the ECB. The ECB has clearly declared its desire to return to a narrower monetary policy task. In order to make progress, steps that have so far been controversial will be necessary. Despite today’s unwillingness from various quarters to issue common euro bonds, a step has already been taken in this direction, since EFSF loans are guaranteed by all countries in the euro zone. This, in turn, should be combined with clear steps towards increased coordination and, in practice, supranational authority in fiscal policy. The proposals recently unveiled by Germany and France, including the establishment of an economic government in the euro zone, are examples of this. But these proposals do not fundamentally differ so much from the procedure known as the “European semester” − a cycle of economic policy coordination that is already on its way to being implemented. This, in turn, is alarmingly similar to the old Stability Pact. The fundamental dilemma is that the system is based on the concept of countries supervising each other on a more or less voluntary basis. To make the system stable a change is needed − shifting crucial fiscal policy decision making from individual countries to the euro zone level. Is this path feasible? For many years, the main economic argument against the euro has been that the euro zone is not an optimal currency area, since the differences between its member economies are so wide. Recent developments have confirmed this picture. The idea that the euro as such will drive the convergence process has also suffered a blow. Instead, imbalances have actually continued to worsen, aided by the supposed protection that the euro has provided. Shifting to a path that genuinely creates the underlying prerequisites for a common currency seems difficult to swallow in many ways. In the case of Germany, it is a matter of assuming an expanded economic and political responsibility for the whole euro zone. For many problem-plagued countries, it is a matter of giving up sovereignty over their own fiscal policy and thereby, in practice, accepting a kind of guardianship. Today it is obvious that there is a wide confidence gap between leading euro zone politicians and their domestic voters. The question now is whether financial pressures can help politicians create a greater understanding in their home countries for the measures that are required. Our risk scenario includes another alternative, in which the voters do not accept the path towards increased supranational authority, and the political forces that advocate such a path lose influence. What will happen if the euro system collapses? Our main scenario implies that the necessary steps will be taken and that the euro will be saved. In spite of everything, the political will to preserve the euro is strong. However, a scenario in which the political strains prove too great cannot be ruled out. Ending the euro project would naturally be associated with major problems and costs, which are difficult to foresee. The decision must be made abruptly and major bail-out measures must be available at the national level when debts and contracts are to be renegotiated. When additional debt restructuring follows in various countries, banks will undoubtedly need to be nationalised. New currency conversion rates must quickly be decided. A period of great financial uncertainty, with sizeable adverse impact on the real economy, will be unavoidable.

10 | Nordic Outlook – August 2011

International overview

intervene in the fixed income market in unlimited amounts to guarantee that a given yield level is not exceeded. Unconventional monetary policy is not problem-free. A long period of zero interest rates and generous access to money increases the risk of new financial imbalances. Low interest rates also delay the repairing of financial sector balance sheets and household debt retirement. In addition, the Fed risks international criticism for driving up commodity prices and contributing to persistent global imbalances. Domestic criticism, too, is growing − especially considering that the Fed’s stimulus measures may increase President Barack Obama’s chances of re-election in 2012. At present, however, these objections hardly carry sufficient weight. There is little risk of undesirably high inflation pressure due to the Fed’s unconventional policy. To date, the rapid expansion of the monetary base has not led to accelerating money supply growth. This is probably explained both by cautious lending practices and low borrowing demand. Studies by the Bank for International Settlements (BIS) confirm that changes in the Fed’s balance sheet have had little impact on monetary supply and inflation. Within the framework of unconventional policy, but partly outside the realm of central banks, more far-reaching interventions in the functioning of the market economy are also conceivable. Various types of regulation that imply direct monetary support to various economic sectors can be implemented. For example, securities companies can be compelled to invest a certain proportion of their portfolios in various kinds of credit instruments (both public and private), and yields can be determined by regulatory authorities. Similarly, lending institutions can be compelled to offer loans under predetermined conditions to selected economic sectors. Looking ahead, other dramatic changes in economic policy may be considered. More and more observers (for example, recently Kenneth Rogoff, former chief economist of the IMF) are beginning to ask whether today’s debt and asset imbalances are too large to be manageable in a low-inflation environment. Lowering the real-term value of debts and assets through higher inflation would be a way out of this dilemma. Such a shift naturally carries significant risks, and there are also large question marks as to the technical mechanisms. But in a situation where traditional methods for reducing debt imbalances are beginning to seem increasingly painful and problematical, the inflation argument may gain further support in public discourse and thus become a more integral element of market expectations.

ers of certain stimulus tasks. However, given our growth and inflation scenario, we see no reason for the ECB to continue its interest rate hikes. We thus believe that the ECB will leave its refi rate unchanged at 1.5 per cent for an extended period; we expect possible small rate hikes no earlier than the end of 2013.
Key interest rates
Per cent
7 6 5 4 3 2 1 0 00 02 04 06 08 10 12
Source: ECB, Fed, SEB

7 SEB forecast 6 5 4 3 2 1 0

Euro zone

US

In Sweden, the Riksbank faces a shift in interest rate policy. Weaker economic conditions and exceptionally low interest rates in other countries will result in a downward adjustment in the central bank’s projected key interest rate path. Because of fairly strong domestic economic data, the Riksbank’s change in policy will most likely occur gradually. Such action is also consistent with the Riksbank’s historical behaviour pattern of wanting to wait for clear confirmation of cyclical changes before realigning its monetary policy. We thus expect one more additional key rate hike this autumn to 2.25 per cent, after which the Riksbank will take a long pause.
Key interest rates
Per cent
7 6 5 4 3 2 1 0 00 02 04 06 08 10 12 SEB forecast 7 6 5 4 3 2 1 0

Euro zone

Norway

Sweden
Source: ECB, Riksbank, Norges Bank, SEB

Key interest rates will remain extremely low
Given the focus on unconventional monetary policy in the US, the UK and Japan, key interest rate hikes will not be considered in the foreseeable future. During the next couple of years, key rates in large portions of the industrialised world will thus remain close to zero. For the ECB, however, the situation is somewhat different. Relatively high capacity utilisation in Germany and certain other countries justify a higher key interest rate than in the US, for example. Various support mechanisms for crisis-affected countries in southern Europe relieve interest rate policy mak-

Norges Bank will go significantly further in its interest rate hiking cycle than other central banks. Because of Norway’s resilience during the 2008-2009 downturn, the labour market situation is already tight today. After hiking the deposit rate to 2.25 per cent in May, Norges Bank deviated from its earlier rate path and kept the rate unchanged, but we expect it to resume gradual rate hikes. Norges Bank has highlighted the risk of new imbalances as its justification for new hikes. Given the country’s significant domestic resilience, among other things because of persistently high oil prices, we foresee a need for continued monetary policy normalisation. By the end of 2013, the deposit rate will stand at 4 per cent.

Nordic Outlook – August 2011 | 11

International overview

Continued low government bond yields

Internationally, government bond yields have declined almost uninterruptedly during the past five months. This downturn accelerated during the July-August stock market slide. Since late July, both American and German 10-year yields have fallen by nearly one percentage point. In mid-August they reached record-low levels of 2.06 per cent in the US and 2.10 per cent in Germany. The US sovereign credit rating and Germany’s major obligations in the euro zone have thus not weakened the desire of investors to seek safety in German and American government securities. However, our assessment is that there is some room for government bond yields to fall further in the near future. Weak macro data and the likely launch of QE3 in the United States will push down yields a bit below 2 per cent during the autumn. After that, we believe that yields will climb moderately. Fixed income market pricing indicates a rather high probability of recession. This means that our low-growth scenario, without a recession, represents a certain potential for somewhat higher yields. We expect German 10-year yields to climb to 2.50 per cent in December 2012 and to 2.90 per cent by the end of 2013. The downward trend, especially in US long-term yields, raises the question of whether we are on our way into a Japanese scenario of permanent exceptionally low yields. This parallel is further reinforced by the Fed’s latest interest rate signal, which will mean that by 2013 the US key interest rate will have been parked at near zero for a total of at least five years. Traditional cycles thus seem to have been rendered inoperable. But the US trend still deviates in important respects from that of Japan. Inflation forecasts indicate that the chances of a genuine US deflation are quite remote. One important ingredient in the Japanese trend is continuous appreciation in the yen, which has made gradual deflation possible without major changes in competitiveness. In addition, demographic trends in the two countries differ greatly. Taken together, these differences have contributed to our main scenario, in which international bond yields will remain very low in historical terms yet still show a weakly rising trend. 10-year government bonds
Per cent
7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 SEB forecast 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0

Germany will move from today’s level of -10 basis points to 0 points at the end of this year, and then gradually climb to 2025 points by the end of 2013. Norwegian long-term yields have also fallen sharply in recent months as a consequence of general risk aversion and increased demand from foreign investors. Due to the very limited supply of Norwegian government bonds, yields on these have fallen below Norges Bank’s key interest rate. Norges Bank will resume its rate hikes, contributing to an upturn in yields next year. The spread against Germany will move from today’s 50 basis points to 65 points by December 2012.

Continued unstable stock market climate

During the first half of 2011, leading international stock markets moved sideways, even though the growth outlook began to dim last spring. The gap between equities and the fixed income market thus widened. Ever since the euro zone sovereign debt crisis broke out in the spring of 2010, we have seen an underlying trend towards lower yields, while share prices resisted this trend for many months. One interpretation of this is that fixed income markets gradually discounted the fact that central banks would be forced to maintain record-low key interest rates for an extended period. Meanwhile the stock market remained confident that such a stimulus policy would actually succeed in keeping the recovery alive and that high corporate profit levels could thus be preserved. The recent slide in equities is apparently a signal of increased doubts that economic policy ammunition will suffice to achieve this. During the recovery phase, the stock market upturn in the Nordic countries was more significant than elsewhere. So far this year, though, the Nasdaq OMX Stockholm − and to a great extent other Nordic exchanges as well − has underperformed other leading world stock markets. The cyclical sensitivity of the economy in general, and of the stock market in particular, has proved more important than good domestic fundamentals. Currency appreciation has played a role, although its effect should not be exaggerated.
Fixed income market often leads equities
Per cent, index
6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 07 08 09 10 11
Source: Reuters EcoWin, SEB

1600 1500 1400 1300 1200 1100 1000 900 800 700 600

10-year government bonds (LHS)

S&P 500 (RHS)

US

Germany
Source: Reuters EcoWin, SEB

Swedish 10-year yields reached a record-low 1.93 per cent in mid-August. Room for new lows is more limited in Sweden, since that the Riksbank will be carrying out key interest rate hikes later this autumn. We predict that the spread against

Looking ahead, we foresee continued stock market uncertainty. Macro forecasts will probably be revised further downward, squeezing corporate profit forecasts. The unstable economic policy environment and resulting recession risks will persist. Above all, the potential for more profound problems in the European banking sector poses a risk. Meanwhile there are many indications that stock market pricing has already discounted

12 | Nordic Outlook – August 2011

International overview

major recession risks. If our forecast of weak yet positive growth is correct, there is room for a slight recovery.

Fundamentals controlling FX market

Since the global recovery began in 2009, underlying fundamentals have been the most important driving force in the foreign exchange (FX) market. Countries with good growth, low debt ratios, rising central bank interest rates and current account surpluses have normally seen their currencies appreciate. This has resulted in a favourable trend for the Scandinavian currencies as well as those of various commodity-producing countries like Australia and Canada. In this environment, the US dollar has had difficulty in holding its own. Large deficits and the political disunity that contributed to the downgrading of the US government’s credit rating have reinforced investors’ doubts about the long-term stability of the dollar. The American central bank has pledged to keep its key interest rate near zero for another two years, which has not made things better. Recent developments have confirmed the same trend. According to the historical pattern, the sharp decline in risk appetite should have helped strengthen the USD, but no such appreciation occurred. Instead the dollar is being traded at close to historical lows in effective terms. Another negative factor for the USD is apparent from the statistics on non-US investors’ purchases of American securities. These indicate a diminished interest in buying American government securities in order to finance a budget situation that is unsustainable in the long term. USD and share index
1500 1400 1300 1200 1100 1000 900 800 700 600 Jan May 08 Sep Jan May 09 Sep Jan May 10 Sep Jan
Weaker USD Greek crisis

commodity-related currencies, have commanded record-high exchange rates in historical terms. Meanwhile currencies like the USD and the British pound have remained at low levels. But the question is how relevant a comparison of historical values is at present. We foresee no strong reasons why the same trend cannot continue towards new record levels. Currencies of Asian countries with low debt levels and relatively high growth should be able to keep attracting capital inflows. Continued current account surpluses in Japan and Switzerland, and uncertainty about developments in the euro zone and the US, will also lead to continued appreciation. New interventions will be necessary in order to soften the consequences in the real economy.
SEK, real trade-weighted exchange rate
Index
150 140 130 120 110 100 90 80 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
Source: BIS

150 140 130 120 110 100 90 80

72.5 75.0 77.5 80.0 82.5 85.0 87.5 90.0 92.5 95.0 97.5 May 11 Sep

S&P 500 (LHS)

USD index (RHS, inverted)

Source: S&P, Reuters EcoWin

Nor is the outlook for the euro especially encouraging, at a time when the entire euro project is in jeopardy and there is great uncertainty about the management of the European debt crisis. However, certain fundamentals favour the euro, among them generally lower budget deficits and especially a current account balance that is close to zero. Portfolio investment flows are also more favourable for the euro than for the USD. We thus end up with a forecast that points cautiously upward for the EUR/ USD exchange rate during the coming year. By mid-2012, we expect the EUR/USD rate to stand at 1.53. Looking even further ahead, we foresee a movement towards exchange rates that are more justified by fundamentals. We expect the EUR/USD rate to be 1.40 at the end of 2013. Due to the crises of recent years, currencies have moved towards extreme levels in a historical perspective. Defensive currencies like the Swiss franc and the yen, as well as attractive

The Norwegian krone (NOK) and the Swedish krona (SEK) will remain attractive alternatives. This summer’s financial market turmoil and increasing signs of approaching economic downturn have not weakened the Swedish krona to the extent that normally occurs. This confirms our view that Sweden’s strong balance sheet is transforming the krona from an extremely pro-cyclical currency to a somewhat more stable one. Sweden’s cyclical export structure nevertheless contributes to a squeeze on the SEK during periods of greater global economic weakness. Liquidity shortages will also help make it hard for the krona to fully hold its own in times of instability. We thus believe the EUR/SEK exchange rate will rise to 9.35 in the coming month. However, the krona is one of the few currencies with relatively strong fundamentals that is not overvalued. Looking further ahead, we are thus sticking to our forecast that the krona will strengthen to 8.70 per euro. The same pattern applies to the Norwegian krone, which will gain strength from persistently high, stable oil prices and widening interest rate differentials. We predict a movement in the EUR/ NOK exchange rate towards 7.50 by the end of 2012.

Nordic Outlook – August 2011 | 13

The United States

Walking a loose tightrope
ƒ ƒ ƒ ƒ Growth slowdown with risk of recession Unemployment will peak at 9.5 per cent Deflation risks gaining renewed attention Fiscal tightening, but stimulus from the Fed
0.8 0.7 0.6 0.5 0.4

SEB recession indicator
Probability of a recession within a year
0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0

The American economy is grappling with major difficulties. Temporary factors such as high energy prices and supply disruptions following the Japanese disaster explain some of the decline in growth during the first half, but the underlying strength of the economy was also less than estimated. This, combined with growing questions about the functioning of the political system and a shift towards fiscal headwinds, has contributed to our downward adjustment of the US outlook. GDP will grow 1.5 per cent this year, 1.8 per cent in 2012 and 2.7 per cent in 2013, clearly lower than consensus. Below-potential growth implies that unemployment will creep higher, but a falling labour supply will limit this upturn. The Federal Reserve will leave its key interest rate unchanged throughout our forecast period and will resort to further quantitative easing, even though inflation is high at present.
GDP growth below trend
5.0 2.5 0.0 -2.5 -5.0 -7.5 -10.0 07 08 09 10 11 12 13
Source: BEA, SEB

0.3 0.2 0.1

Note: Try it as a regressor of employment growth. Should gen

even after controlling for lagged emp.growth, lagged GDP gro

0.0 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

(See GS Economics Analyst sep 7 2007) Source: SEB

Recession risk in the short term

5.0 2.5 0.0

SEB forecast

The probability of a new recession within 3-9 months is 30 per cent, in our assessment. Year-on-year GDP growth is now 1.5 per cent. Historically, such weak growth figures often lead to new economic downturns. It is a troubling signal that unemployment has climbed this summer, since such upturns historically often create a negative, self-amplifying dynamic. The job creation trend is sending out similar signals. We assume that in late 2011 the US Congress will extend household tax cuts for another year, but if this is not the case, a blast of wintry fiscal weather in 2012 will also contribute to recession risks. In addition, there is a threat that the European debt crisis will escalate, leading to a global tightening of credit conditions affecting the US corporate sector as well.
Credit conditions are still easy
Index
5 5 4 3 2 1 0 -1 -2 71 74 77 80 83 86 89 92 95 98 01 04 07 10
Source: SEB

-2.5 -5.0 -7.5 -10.0

4 3 2 1 0 -1 -2

Annualised

Year-on-year percentage change

After the latest revision in GDP statistics, it is clear that the 2007-2009 downturn was the deepest of the post-war period and the subsequent recovery has been the slowest. GDP remains below its peak of 3½ years ago. GDP per capita is at the same level as in 2005. Despite both monetary and fiscal stimulus, GDP growth averaged a mere 0.7 per cent during the first half of 2011. Because of the continued large output gap, the threat of deflation may re-emerge in the months ahead.

Credit conditions index

Mean (1970-2009)

Due to several factors, a new recession is less likely than a continued recovery. Both our credit conditions index and our financial conditions index point towards an expansive financial environment. In addition, the American banking system has built up sizeable buffers during the past couple of years. Nor is the federal debt situation as serious as the grim political climate makes it seem. The US has no problems meeting its in-

14 | Nordic Outlook – August 2011

The United States

terest payments, especially at the record-low interest rates now prevailing. The most cyclical sectors in the economy, which ordinarily account for most of the GDP declines, are close to historical lows − an indication that the downside is limited. A third round of quantitative easing (QE3) may lift growth prospects and risk appetite, but meanwhile new monetary policy programmes such as this will probably have a diminishing impact.
The most cyclical sectors are close to the bottom
Per cent of GDP
27 26 25 24 23 22 21 20 19 18 17 16 50 55 60 65 70 75 80 85 90 95 00 05 10 27 26 25 24 23 22 21

one year ago was 30 per cent. The National Federation of Independent Business (NFIB) index has fallen five months in a row, to its lowest level since September 2010. Weak domestic demand, combined with continued difficulties in obtaining small businesses loans explain the depressed mood. Altogether, we believe that total fixed investment will increase by 5 per cent this year and about 7 per cent on average in 2012 and 2013. These figures include residential investments, which will increase by some 6 per cent in 2012 and 2013 after a further decline this year (the sixth straight year). Public sector consumption and capital spending, with state governments and the Defence Department as key elements, has shown a falling trend in recent years and further cutbacks are likely to occur.

Mean

20 19 18 17 16

Super-depressed households

Cyclical sectors

Source: BEA, SEB

If the economy can dodge short-term recessionary risks, there is reason for optimism further ahead. In the housing market, home prices have fallen more than 30 per cent from their 2006 peak and various valuation yardsticks indicate that homes are no longer overvalued. Looking ahead a year or so, households will probably be in a better position from the standpoint of savings and debts. In a slightly longer perspective, extremely strong corporate balance sheets also represent major upside potential once demand rebounds. One main reason for our positive growth scenario in earlier forecasts was that changes in private sector financial saving have historically provided a reliable signal about where consumption, and especially capital spending, is headed. Even if we now postpone this positive dynamic, this is one reason why 2013 may be a year of decent growth despite the fiscal tightening that lies ahead.

Household consumption has been the main driving force in the American economy over the past 30 years. When the economy has weakened, real interest rates have fallen. At that point, households − often using their homes as collateral − have increased their debt and consumption. Such a dynamic is not going to recur this time around. After a temporary dip in household saving last spring, when high petrol and food prices were undermining purchasing power, the savings ratio has rebounded again. Falling share prices and uncertainties about the labour market as well as the political rules of the game indicate that the trend towards higher household saving will persist: our forecast is that the savings ratio will reach 6.5 per cent by the end of 2012. Meanwhile household debt has fallen by 16 percentage points since its peak, from 135 to 116 per cent of disposable income. Home prices, as measured by the S&P/ Case-Shiller index, have fallen to their 2002 level. In 2002, indebtedness stood at 108 per cent of income, which indicates the need for continued debt retirement.
Households are still deleveraging
Per cent of disposable income
140 130 120 110 100 90 80 70 60 50 40 30 20 45 50 55 60 65 70 75 80 85 90 95 00 05 10 13 12 11 10 9 8 7 6 5 4 3 2 1

Shaky manufacturing sector

In recent months the downturn in the ISM purchasing managers’ index has been twice as dramatic as inNote: NBER dates 2010, when worries about an American double dip recession were also widespread. The downturn also has a global dimension this time around. The euro zone crisis has spread to larger countries in the common currency area, while the OECD’s leading industrial indicator has fallen below zero, indicating that prospects for global manufacturers have worsened. Despite the competitive dollar, American exports are falling by around 6 per cent compared to three months earlier (their worst decline since March 2009). Overall, we expect US industrial production to increase by 4.1 per cent this year, 2.3 per cent in 2012 and 4.1 per cent in 2013. The performance of small businesses is also important, since historically speaking, this is where the new jobs are created. According to a recent survey by the US Chamber of Commerce, fewer than 20 per cent of small enterprises plan to increase their labour force in the coming year. The corresponding figure

Household debt-to-income ratio (LHS) Personal savings ratio (RHS)

Source: Federal Reserve, BEA, SEB

Real consumption growth has fallen for three consecutive months, with the year-on-year rate decelerating to 1.8 per cent from 3.2 per cent at the end of 2010. Household confidence indicators signal a further weakening. In August, the Reuters/ University of Michigan consumer confidence index fell sharply to its lowest level in 31 years. During recessions this index averages 74 points; current levels are nearly 20 points lower. Interestingly, future expectations also fell to their lowest level since the early 1980s. The correlation with household consumption a few months later is 76 per cent.

Nordic Outlook – August 2011 | 15

The United States

On the other hand, the latest statistics related to automotive and retail sales, as well as the rebound in purchasing power after petrol prices fell this summer, indicate that consumption remains at decent levels. Household consumption will increase by an average of 1.7 per cent in 2011-2012 and somewhat more in 2013.

(63.9 per cent), unemployment would have ended up at 9.3 per cent instead, or 0.5 percentage points above its low of last spring. Such an upturn would have been an obvious recession signal, since all recessions since the 1970s have been preceded by upturns of this magnitude in the jobless rate.
GDP growth below 1.6 per cent is a warning sign
Year-on-year percentage change
15.0 12.5 10.0 7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5 50 55 60 65 70 75 80 85 90 95 00 05 10 15.0 12.5 10.0 7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5

What do falling petrol prices mean?
Lower oil and petrol (gasoline) prices justify a degree of optimism about growth. West Texas Intermediate, which peaked at USD 113 per barrel in May, is now being quoted at slightly above USD 80/barrel (about the same level as at the end of 2010). According to simple rules of thumb, an oil price decline of USD 10 lifts GDP growth by 0.2-0.3 percentage points. Petrol prices, which peaked at around 4 dollars per US gallon, are falling towards USD 3.25/gallon. This gives households USD 80 billion more in their wallets over a one-year period − a welcome boon at a time when the labour market is shaky and the stock market is falling.
Gasoline consumption is declining
Year-on-year percentage change
15 10 5 0 -5 -10 -15 70 75 80 85 90 95 00 05 10
Source: BEA, SEB

Source: BEA, SEB

15 10 5 0 -5 -10 -15

Over the past year, full-time employment has decreased by 0.5 per cent (143,000), while part-time jobs have risen by 3 per cent (461,000). Our interpretation is that companies had lowered their expectations even before the late-summer market turbulence. This, combined with slimmed-down organisational structures, indicates that the economy can cope with low growth figures without the negative dynamic gaining the upper hand this time around. Unemployment will drift up again
Per cent
11 10 9 8 7 6 5 4 3 97 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 SEB forecast 11 10 9 8 7 6 5 4 3

Note: NBER dates

Meanwhile lower demand is one important reason why oil and petrol prices have fallen; real petrol consumption fell at a year-on-year rate of 4.6 per cent, according to the latest figures. As the above chart illustrates, such low growth rates set off cyclical warning bells. Three years ago, oil prices fell from a peak of USD 145/barrel in July 2008 to USD 30/ barrel at the end of 2008, but that did not prevent the global recession.

Classic Okun

Unemployment rate

NAIRU

Source: CBO, BEA, SEB

Labour market is treading water

The latest labour market statistics are a mixed bag. After high levels during the summer, initial claims for unemployment benefits have fallen back some. Lay-off notices, on the other hand, increased by 80 per cent compared to three months earlier. The July employment report contains various bright spots, surpassing gloomy market expectations. Private sector employment rose by 154,000, indicating that the recovery is continuing at a decent pace. But the trend of private sector employment is still worrisome. Measured as three-month averages, job creation has fallen by more than half since April and is consistent with the trend just before the three latest economic downturns. In addition, the Household Survey indicates a substantial downturn in jobs. Unemployment fell to 9.1 per cent in July. But if labour force participation had not dropped to its lowest level since 1984

Long-term unemployment is a growing problem: 6.3 million Americans have been without a job for at least six months. For people in this category, the probability of landing a new job within one month is a low 10 per cent, according to a survey from the Bureau of Labor Statistics (BLS). For newly unemployed people, the corresponding probability is three times higher. Given youth unemployment of 25 per cent, social tensions may explode in the US as well. Deep recessions also affect lifetime income. Studies show that entry-level pay for those who actually land jobs is being pushed down by 25 per cent. Lower entry-level pay keeps down an individual’s income level for decades. One political aspect is that high unemployment will undermine Barack Obama’s chances of re-election. Never before has an incumbent president been returned to office when the election-day jobless rate has been above 7.8 per cent.

16 | Nordic Outlook – August 2011

The United States

Productivity curves are pointing downward. On a quarterly basis, productivity has fallen two quarters in a row, Measured year-on-year, productivity growth is falling towards zero after having peaked at 6.1 per cent last year (a 50-year record). Looking ahead, the ambition of businesses to turn around this productivity trend will restrain job creation. This year and in 2012, we predict employment gains averaging just below 100,000 per month. Such weak job creation is compatible with higher unemployment, but falling labour force participation has the opposite effect. Meanwhile our estimated association between GDP growth and changes in unemployment (Okun’s Law) shows that when growth is one percentage point below trend, unemployment rises by about four tenths. Our forecast is that employment measured as annual averages will be 9.1 per cent this year, 9.4 per cent next year and 9.1 per cent in 2013. Unemployment will peak at 9.5 per cent in 2012, and at the end of our forecast period will stand at 9 per cent.

ing at the federal level is just below 1 per cent of GDP in 2012 but total fiscal tightening will be slightly bigger since belttightening continues at the state and local levels.
Government spending and revenues
Per cent of GDP
25 24 23 22 21 20 19 18 17 16 15 14 13 12 55 60 65 70 75 80 85 90 95 00 05 10 25 24 23 22 21 20 19 18 17 16 15 14 13 12

Federal outlays, total

Federal receipts, total

Source: US Department of the Treasury, SEB

Lingering fiscal policy uncertainty

After months of negotiations, Democrats and Republicans reached a last-minute agreement on the US federal debt ceiling that avoided economic chaos. A budget stalemate would have triggered an economic crisis of historic proportions.
Government spending
Per cent of GDP
14 13 12 11 10 9 8 7 6 00 02 04 06 08 10 12 14 16 18 20 CBO forecast 14 13 12 11 10 9 8 7 6

The path to sustainable long-term public finances will be among the main themes of the November 2012 election. The debt agreement is also formulated in such a way that this issue will land on the president’s desk at regular intervals until the election. At present, no one knows exactly which expenditures will be cut. This, in turn, means that households and businesses are unsure about how federal budget constraints will affect them. Uncertainty about economic policy making rules will adversely affect consumption, capital spending and hiring plans and is one important reason behind the downward revision in our US economic forecast.
Lower inflation in 2012
Year-on-year percentage change
6 5 4 3 2 1 0 -1 -2 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 SEB forecast 6 5 4 3 2 1 0 -1 -2

Mandatory spending Discretionary spending

Discretionary with cuts
Source: CBO, SEB

In brief, the agreement stipulates that the federal debt ceiling will be raised in two steps and expenditures will be lowered correspondingly. The first increase in the ceiling, USD 900 billion, will suffice until early in 2012. The US Congress meanwhile approved spending cutbacks of the same magnitude. This autumn, a Congressional fiscal policy committee consisting of both Democrats and Republicans will try to reach an agreement on further spending cuts totalling USD 1.5 trillion, spread over nine years starting in 2013. If Congress fails to adopt the committee’s proposal before December 23 (non-entitlement) expenditures will automatically be slashed by USD 1.2 trillion. Entitlement-related spending − such as rapidly rising health care costs − will not be affected at all. In the short term, the debt agreement only marginally affects spending cutbacks. In 2012, federal cutbacks will increase by USD 20 billion. This means that fiscal tightening under to the current law will total USD 270 billion (1.7 per cent of GDP). However, we expect the economic situation to justify extensions of the 2011 tax cuts for households and of compensation to the long-term unemployed, although this will lead to new clashes between Democrats and Republicans. Fiscal tighten-

Core inflation

Inflation

Source: BLS, SEB

Inflation will slow down again

Inflation has climbed sharply during the past six months. The oil price upturn has played a large role; price formation in the US is significantly more sensitive to oil price fluctuations than in Europe. The weakening of the US dollar and last year’s economic acceleration may also partly explain the price upturn, but these factors are also firmly in the past. As base effects disappear from the statistics, inflation will thus drop sharply, but over the next six months we believe that inflation and core inflation will continue upward, peaking at 3.7 per cent and 2.2 per cent, respectively. Inflation will then fall to a low of 1.1 per cent (May 2012) and core inflation slightly higher. Measured as annual averages, inflation will amount to 3.1 per cent this year, 1.7 per cent in 2012 and 1.3 per cent in 2013. Annual average core inflation will end up at 1.6-1.7 per cent in 2011-12, and 1.2 per cent in 2013, at or just below the Fed’s target level.

Nordic Outlook – August 2011 | 17

The United States

Money multiplier still broken
Ratio, year-on-year percentage change
15.0 12.5 10.0 7.5 5.0 2.5 0.0 60 65 70 75 80 85 90 95 00 05 10 15.0 12.5 10.0 7.5 5.0 2.5 0.0

tougher measures at the top of their wish list. According to a recent CNBC survey, almost 50 per cent of the respondents expected the Fed to resume QE. Of those who believe in more QE, bond purchases are expected to average USD 628 billion. A third round of bond purchases (QE3) is one logical next step. According to our own indicator, which compares the current situation with that of a year ago, the financial developments and events in the real economy justify new purchases. But the picture is not entirely clear. Inflation is significantly higher today than in 2010, as is the Fed’s own measure of inflation expectations. On the other hand, it is not today’s inflation rate that is decisive, but the outlook a year or so down the road. According to the central bank’s forecasts, by that time inflation may be lower than its target. Also decisive is that not even the most optimistic forecasters are predicting full employment before 2015, since the Fed has a dual mandate. Our assessment is thus that further bond purchases, equivalent to USD 1 trillion, will occur during the coming six-month period. With a divided Federal Open Market Committee, opposition to further stimulus measures among politicians and the possibility that the growth slump may prove temporary, this forecast is hardly carved in stone. If the threat of recession creeps closer, the Fed can roll out its heavy artillery. In an effort to avoid a deflation scenario similar to that of Japan, Fed Chairman Ben Bernanke has discussed the possibility of a targeted long-term bond yield level (which in practice means unlimited bond purchases). Price level or nominal GDP targets are other alternatives, as are purchases of other assets besides mortgage and government bonds.

M2 money supply / monetary base M2 money supply

Source: Federal Reserve, ECB

Meanwhile there is great uncertainty. Leading inflation indicators, such as pricing plans among large and small businesses, have fallen sharply since their peak. Taking into account that the recovery began more than 2 years ago, the output gap is record-sized. In the housing and labour markets, there are strong forces that are pulling down prices. This is also true of the household sector, which continues to pay down its debts. The risk of even weaker economic growth, in a situation where potential forms of stimulus are very limited, also explains the Fed’s worries about falling prices, but the situation is not completely clear. During the first and second quarters of 2011, unit labour costs rose by 4.8 and 2.4 per cent on an annualised basis, respectively. In addition, growth in broad money supply aggregates has surged. However, the money supply multiplier is continuing to fall, implying that the expansion of the monetary base is not having a full impact on the economy.
US output gap moving sideways
Per cent of GDP
7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5 -10.0 60 65 70 75 80 85 90 95 00 05 10
Source: CBO, SEB

7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5 -10.0

New monetary stimulus measures

In a situation where fiscal policy makers have run out of ammunition, responsibility for maintaining growth rests with the Fed. The central bank predicts that its most important key interest rate will remain at a record-low 0-0.25 per cent for at least another two years. We predict that no key rate hikes will occur during our forecast period. Further quantitative easing appears likely. Although the Fed cannot lower its key interest rate, it can stimulate the economy in other ways. Its battery of “soft” measures includes a possible timetable for winding down the Fed’s balance sheet and an extension in the duration of its bond portfolio, but the Fed’s own analysis indicates that these measures would have a fairly minor impact. Market expectations certainly also put

18 | Nordic Outlook – August 2011

Japan

Clear signs that a recovery has begun
ƒ ƒ ƒ Above-trend growth due to reconstruction New stimulus package on the way Yen appreciation pressure will ease
government, there is a greater likelihood that Japan will eventually take steps to improve its weak government finances. To date, the natural disasters have not led to any greater economic policy consensus. Confrontations between government and opposition have delayed the legislation needed to finance the budget for the new fiscal year that started in April. Recently, however, a proposal to issue bonds to finance the deficit was approved. Two supplementary budgets (equivalent to 0.8 and 0.4 per cent of GDP, respectively) to cover urgent disaster assistance were presented earlier. The government is also putting together a third, far more extensive supplementary budget (around 2.1 per cent of GDP) to cover the actual reconstruction. Japan’s Statistics Bureau has unveiled a revised inflation index, aimed at better reflecting the prices that consumers encounter. The new index has led to a clear downward revision in CPI inflation. For example, the June figure was revised downward from 0.2 per cent to -0.4 per cent. Japan is thus still experiencing deflation and there are no signs that the inflation rate will begin rising to any great extent. Monetary policy has been further eased. The Bank of Japan (BoJ) credit facility for companies and the asset purchase fund were each expanded by JPY 5 trillion and together now total JPY 50 trillion (around USD 630 billion). The BoJ is also expected to keep its key interest rate at a record-low level (in the 0.00-0.10 per cent range) until the end of 2013. During recent financial market turbulence, the yen has reinforced its role as a safe haven currency. Since early July, it has appreciated about 5 per cent against the USD. Because this threatened exporters’ competitiveness, early in August the central bank began intervening in the foreign exchange market. Although the effect of this action was short-lived, signals from the BoJ and the finance minister indicate that further interventions will occur if the yen becomes stronger than 76-77 to the dollar. Japan is also to provide up to USD 100 billion from its foreign exchange reserves to support Japanese overseas investments and exports in an attempt to encourage capital outflows. Looking ahead, we expect appreciation pressure to ease somewhat, leading to a USD/JPY exchange rate of 75 at the end of 2011, 80 at the end of 2012 and 94 at the end of 2013.

As expected, the earthquake and tsunami disasters in March have severely affected growth in Japan. Measured quarter-onquarter, GDP fell 0.9 per cent in the first quarter and 0.3 per cent in the second. This means the economy has shrunk for three quarters in a row. The second-quarter decline was less than expected, however, and there are now clear signs of recovery. The purchasing managers’ index has rebounded, after a sharp decline following the natural disasters. Other indicators are also pointing towards a turnaround. Industrial production has begun to climb, although its June level was still nearly 10 per cent lower than before the earthquake. Retail sales, however, have now surpassed their pre-disaster level after an unexpectedly strong June figure.
Retail sales and industrial production rising again
Index 100=2007
105 100 95 90 85 80 75 70 65 07 08 09 10 11 105 100 95 90 85 80 75 70 65

Industrial production

Retail sales
Source: Ministry of Economy, Trade and Industry

Weak export performance explained most of the second-quarter GDP decline. In addition, there is a risk that Japan’s export recovery will be aborted by the record-strong yen, combined with global economic weakening. Continued energy supply problems also risk hampering the GDP recovery. In short, we expect growth to become positive again during the third quarter and then accelerate during the fourth quarter as the positive effects of reconstruction efforts intensify. In 2011 as a whole, however, we expect GDP to decline by 0.6 per cent. Reconstruction will help boost GDP growth to 2.9 per cent in 2012. Growth will slow to 2.2 per cent in 2013. Domestic political turbulence, focusing on Prime Minister Naoto Kan, has continued in recent months. After being severely criticised for weak crisis management, Kan has now stepped down after pressure both from the opposition and his own party. He is succeeded by the former finance minister, Yoshihiko Noda, who is regarded as a fiscal hawk. With Noda as head of

Nordic Outlook – August 2011 | 19

Asia

Buoyant growth with only a moderate slowdown
ƒ ƒ ƒ Growth is decelerating Inflation outlook still challenging in China Continued tightening in India
autumn as a consequence of tighter monetary policy, culminating food and commodity prices and the deteriorating global economic outlook. During the past year, currency appreciation has been an active means of inflation-fighting. Looking ahead, the appreciation pressure on Asian currencies is expected to persist. Higher interest rates and stronger growth prospects than in the OECD countries will lead to capital inflows in search of higher returns. Stronger Asian currencies are also an important element of efforts to reduce global economic imbalances. However, there is a risk that poorer global growth prospects and decreasing inflation problems will again cause decision makers to become more worried that stronger currencies will make their countries’ exports less competitive.

The role of Asian emerging countries as engines of the world economy is now becoming even more important as growth weakens in the OECD countries. Our forecast of a moderate deceleration is supported by incoming data. GDP growth slowed a bit further in most Asian economies during the second quarter of 2011. Purchasing managers’ indices have fallen in recent months, indicating that this deceleration will continue.
Growth is slowing in Asia
GDP, year-on-year percentage change
15.0 12.5 10.0 7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5 07 08 09 10 11 15.0 12.5 10.0 7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5

China: Growth is slowing

China India

Indonesia Malaysia

South Korea Thailand

Source: National statistical offices

Looking ahead, there is a risk that a clearly deteriorating US and European growth outlook will lead to a significant downturn in demand for the region’s export goods, but other factors may help sustain growth. Over time, the region has become less and less dependent on developments in the Western world. Domestic demand is also good, with strong growth in consumption. There is also some room for fiscal stimulus, although rising debt levels mean that less ammunition is available than in 2008. There is also potential to ease monetary policy in case of a sharp deceleration. By way of summary, we thus see good reasons to stick to our main scenario of a moderate slowdown in today’s high growth. In the short term, rising inflation may nevertheless pose a policy dilemma for Asian central banks. Inflation pressure has escalated further in countries like China, Malaysia and Vietnam. Rising core inflation indicates that in some places, higher food prices have now broadened into more general price increases. Monetary tightening has thus continued; India, for example, has hiked its key interest rate by 0.75 basis points since midJune. We expect such tightening to continue, although the pace and extent of rate hikes will depend on the outlook for global growth and financial markets. The outlook for inflation is uncertain but we foresee a decline in inflation pressure this

During the second quarter, China’s year-on-year GDP growth slowed to 9.5 per cent: a somewhat higher figure than expected. The purchasing managers’ index has fallen for three months in a row. In July it stood at 50.7, its lowest level since February 2009. Industrial production and retail sales have nevertheless shown stable year-on-year increases of 14 and 17 per cent, respectively. The deteriorating global economic outlook will speed up the deceleration in export growth that was already under way because of China’s transition to a more consumption-based growth model. So far, however, it is difficult to discern any cool-down in China’s trade data. In July, the yearon-year increase in Chinese exports was 20 per cent and the trade surplus rose to nearly USD 31.5 billion, the largest since January 2009. Stabilisation in export and import growth
Year-on-year percentage change
100 75 50 25 0 -25 -50 Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May 07 08 09 10 11 100 75 50 25 0 -25 -50

Exports

Imports

Source: National Bureau of Statistics

Domestic demand is stable. Retail sales figures have continued to show good increases despite rising inflation. Now that inflation is expected to fall, household purchasing power will climb. Capital spending is increasing at a healthy pace and is still the main driver of economic growth. We expect GDP to rise by

20 | Nordic Outlook – August 2011

Asia

9.2 per cent in 2011. In 2012, growth will be 8.4 per cent and in 2013, 8.8 per cent. Food prices, especially pork prices, have driven up inflation further in recent months. Price increases have been larger than expected. In July, inflation was 6.5 per cent year-on-year. Core inflation has also crept higher, but it was still a mild 2.5 per cent in June. We expect inflation to fall this autumn due to tighter monetary policy and culminating food and commodity prices. The central bank’s quarterly survey indicates that inflation expectations declined somewhat in the second quarter. We expect full-year inflation to end up at 5.6 per cent in 2011. In 2012, prices will climb by 5.2 per cent and in 2013 by 4.9 per cent.
The inflation rate has continued to climb
Year-on-year percentage change
25 20 15 10 5 0 -5 06 07 08 09 10 11 25 20 15 10 5 0 -5

for the sixth time this year and are now 21.5 per cent for most of the larger banks. Together with a control mechanism that penalises banks with excessively aggressive lending (introduced last spring), this has helped to slow bank lending. During the first seven months of 2011, new credits fell by nearly 10 per cent compared to the same period of 2010. In addition, growth in money supply (M2) seems to have stabilised around 15 per cent annual rate of increase. It is thus likely that the PBoC’s hikes in reserve requirements have now ended.
China: Key interest rate and reserve requirement
Per cent
22.5 20.0 17.5 15.0 12.5 10.0 7.5 5.0 07 08 09 10 11 22.5 20.0 17.5 15.0 12.5 10.0 7.5 5.0

Reserve requirement (large banks) Key interest rate

Source: The People's Bank of China

CPI

Core inflation

Food prices
Source: National Bureau of Statistics

Early in July, the People’s Bank of China hiked its key interest rate for the third time this year to 6.56 per cent. Although inflation pressure now appears to have culminated, inflation is far above the bank’s 4 per cent target for 2011. The PBoC will probably continue its tightening until inflation has clearly begun to slow. The bank has announced that it prefers to use the monthly change in CPI as its policy benchmark. We expect another two key interest rate hikes this autumn, resulting in a key rate of 7.06 per cent at the end of 2011. However, the PBoC’s key rate hikes serve primarily as a signalling mechanism; raising the bank reserve requirements is a more important policy tool. Reserve requirements were raised

During the summer, the financial situation at the regional level has become a focus of attention. The question concerns the scale of local authority debt and accompanying risks to the banking system. Discrepancies between various official figures have created uncertainty. Without getting into a discussion of the exact scale of debt, it is clear that lending to China’s local authorities increased sharply during 2009. This increase is explained by central government under-financing of infrastructure projects, which created a massive borrowing requirement at the local level. Such borrowing replaced fiscal programmes in response to the economic downturn, which should actually have been part of the central government budget. Although China’s total debt at local and central government levels has climbed as a percentage of GDP, it is not at an alarming level. If the banks themselves were forced to bear all potential losses that may be connected to local borrowing − an unlikely sce-

Hukou an obstacle to urbanisation and growth
Urbanisation in China remains an important driving force for growth. There is still a wide urban-rural gap in disposable income, which is driving migration to urban areas, but hukou − the Chinese family registration system − is an obstacle to this migration. The hukou system assumed its current shape in 1958. Every citizen has a passport-like document with basic information about the person’s family ties, marriages, divorces etc., but above all his/her place of birth. Hukou’s original purpose was to prevent poor rural peasants from moving into cities. Such a move required a formal application that had to be approved by the authorities. Over time, the system has been relaxed in order to allow migration of workers to urban areas. In practice, it is used today to control access to public social benefits and services such as unemployment compensation, health care and the right of children to attend school. Access to these benefits and services is tied to place of birth.

Despite the hukou system, a very large number of people have migrated from rural to urban areas without being granted access to basic social services in their new place of residence. One new trend, however, is that fewer migrants are returning after their home visits: a sign that conditions are improving in rural areas. The authorities have begun a cautious reform of the system. The main problem is that removing hukou would sharply increase the costs of social benefits and services in major urban areas. A counter-argument is that higher social expenditures will enable households to boost their consumption. This is consistent with China’s ambition to shift from a growth model based on exports and capital spending to a model based on consumption.

Nordic Outlook – August 2011 | 21

Asia

nario − this would indeed hurt their profitability, but we do not foresee a banking crisis. The increase in Chinese home prices has slowed further, strengthening our assessment that there is little likelihood of a hard landing in the housing market. In July, home prices rose month-on-month by a marginal 0.2 per cent (measured in 100 large cities). Further measures to stabilise the housing market will be unveiled during the autumn. So far, the central government initiative to complete 15 million homes for lowincome households has proceeded at a slow pace, but it will nevertheless provide future support to the construction sector. Since the beginning of 2011, the yuan has appreciated by more than 3 per cent against the US dollar. Signals last spring that Chinese authorities have become more inclined to allow faster appreciation in order to curb import costs have had an effect. Yuan appreciation has been especially rapid in recent weeks, which might be a sign that the authorities are prepared to allow a more rapid strengthening of the currency in response to the high inflation rate. We expect the yuan to continue appreciating, and the USD/CNY exchange rate will stand at 5.90 at the end of 2012.
12 10 8 6 4 2 0 -2 06

India: Inflation and key interest rate
Per cent
12 10 8 6 4 2 0 -2 07 08 09 10 11

Key interest rate

Inflation
Source: Ministry of Commerce and Industry, Reserve Bank of India

The Reserve Bank is not getting much help from fiscal policy makers in its efforts to slow inflation. Because of the rising cost of subsidies (see box), it is difficult for the central government to reduce its total spending level. Due to monetary tightening and the expected decline in growth, however, we expect inflation to fall towards the end of 2011. A normal monsoon season may help level out food prices, which have largely driven the inflation increase.

India: Inflation rate remains high

Signs of a deceleration in growth have recently become clearer. India’s GDP growth slowed to 7.8 per cent during the first quarter of 2011. Industrial production was weak in April and May but recovered in June. Indicators point towards continued deceleration ahead; the purchasing managers’ index in manufacturing has fallen significantly in recent months, and leading indicators have shown a similar trend. Car sales were weak in July, reinforcing the picture of deceleration. Despite its downturn, the purchasing managers’ index is close to its long-term level, and healthy export sales have reduced the trade deficit. India is a large, comparatively closed economy and thus has good potential to cope well with a weakening international economy. During 2012, however, monetary tightening will again help restrain growth. Due to structural problems related to corruption and regulation, India will have difficulty achieving growth rates of 9-10 per cent. We expect GDP to climb by 7.9 per cent in 2011 and by 7.5 per cent in 2012. In 2013 we foresee an acceleration to 8.3 per cent. The biggest macroeconomic challenge is the high inflation rate; in July it was 9.2 per cent. Core inflation is also moving upward, indicating that price increases are beginning to spread through the economy. The Reserve Bank of India thus finds itself in an awkward situation of high inflation and decelerating growth. The central bank has clearly declared its willingness to sacrifice short-term economic growth in order to slow price increases. It has hiked the key interest rate five times this year by a total of 1.75 percentage points to the current level of 8.0 per cent. Despite this tightening, the real key rate is still negative. As long as inflation has not clearly slowed, monetary tightening will continue. We believe that the key rate will be 9.0 per cent at the end of the first quarter of 2012. There is an increased risk that monetary policy will be tightened too strongly, leading to a hard landing.

Energy subsidies a heavy budget burden
India has a long tradition of central government energy subsidies. Today most of these subsidies are aimed at lowering the domestic price of oil-based products in order to protect the economy from volatile changes in world market prices. Another goal is to enable poor households without electricity to light their homes and cook with the help of cheap fuel. These subsidies are a sizeable burden to the government budget; the OECD estimates that in 2008 they were equivalent to 3.4 per cent of GDP. Rising subsidy expenditures and slower growth will make it difficult to reduce India’s budget deficit. Aside from burdening the budget, the subsidies lead to thefts, smuggling and corruption as well as energy waste. They also harm the environment, since they discourage the development of more efficient, environmentally friendly ways of supplying energy to poor households. The government has initiated a cautious reform of the system, however. Energy subsidies are important to poor households, and reforms may be difficult to implement if they worsen living standards. The 2011 budget thus proposes a system in which energy subsidies are replaced by cash payments to target groups with incomes below the poverty line.

22 | Nordic Outlook – August 2011

The euro zone

Sovereign debt crisis is slowing growth
ƒ ƒ ƒ ƒ The German economy is decelerating Inflation below 2 per cent by January New austerity programmes on the way ECB will take a long rate-hike pause
High energy and food prices will keep inflation, as measured by the Harmonised Index of Consumer Prices (HICP), in its current 2.5-3 per cent range this autumn and winter. However, the inflationary impact of energy and food will fade early next year, and HICP inflation will be back below 2 per cent as early as January 2012. This will give the European Central Bank manoeuvring room in a situation of low growth and mounting debt problems in southern Europe, with accompanying risks in the banking sector. We now expect the ECB to keep its key interest rate at 1.50 per cent until the second half of 2013, when it will be raised in two steps: the refi rate will stand at 2 per cent in December 2013.

The sovereign debt crisis in the euro zone is having a major impact on economic performance. During the summer, market scepticism about such large countries as Italy and Spain increased. There has also been greater uncertainty about the sustainability of economic growth in France, mainly due to large exposure among French banks to crisis-plagued countries in southern Europe. Looking ahead, crisis management will have to deal with various dilemmas. So far, budget-tightening measures have been approved in a number of countries, but further steps will be needed. Cutbacks are necessary in order to restore confidence, yet they will hamper growth and thereby increase the cyclical budget deficit. The sovereign debt crisis is also tightly interwoven with a European banking sector crisis. Excessive losses in the banking sector risk leading to a credit squeeze on non-financial companies in a way that may greatly weaken economic performance. Both short-term and long-term measures are needed and will be implemented to save the euro system.
Only 1 per cent growth next year
Percentage change
5.0 2.5 0.0 -2.5 -5.0 -7.5 -10.0 03 04 05 06 07 08 09 10 11 12 13 SEB forecast 5.0 2.5 0.0 -2.5 -5.0 -7.5 -10.0

The German economy is slowing

Germany is still the main locomotive of the euro zone, but export dependence makes its economy sensitive to weaker global demand. Today’s uncertain situation is well reflected in Germany’s IFO business sentiment index: still high figures for current conditions but a major decline in expectations for the future. The ZEW financial sector survey also shows an unusually wide gap between respondents’ current and future outlook. An unexpectedly large drop in the purchasing managers’ index (PMI) this summer and weak industrial production are signalling that the German economy is losing momentum as global demand falls. The historical connection between the ISM purchasing managers’ index in the United States and Germany’s IFO index also indicates a clear weakening in the near future. A continued decline in the IFO’s current business conditions index this autumn and winter seems very likely.
IFO index poised for a decline
Year-on-year percentage change (GDP), IFO index 2000=100
5.0 3.0 1.0 -1.0 -3.0 -5.0 125 120 115 110 105 100 95 SEB forecast 90 85 80 75 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Quarter-on-quarter, annualised Year-on-year percentage change Growth indicator (Euroframe)
Source: Euroframe, Eurostat, SEB

-7.0

The clear trend towards a two-speed euro zone economy, with a strong Germany and a debt-plagued southern Europe, has recently become somewhat more accentuated. However, German GDP growth decelerated during the second quarter to a mere 0.1 per cent compared to the previous quarter. It is now apparent that the euro zone crisis, combined with the American slowdown, is also hampering German growth. The French and Italian economies are also decelerating, while Greece, Ireland, Portugal and Spain (GIPS) will show zero aggregate growth in 2012. The overall euro zone economy will grow by 1.7 per cent this year, 1.0 per cent in 2012 and 1.5 per cent in 2013.

GDP, Germany (LHS) Current business conditions (RHS) Expectations (RHS)
Source: Federal Statistics Office, IFO, SEB

On the other hand, the German household sector is still being sustained by a strong labour market, with gradually falling unemployment. Consumer confidence is now at a four-year peak and is the highest in the whole euro zone. This indicates that private consumption will continue upward for another while. Today it is rising nearly 2 per cent year-on-year, but stronger domestic demand will not be enough to fully offset the

Nordic Outlook – August 2011 | 23

The euro zone

reduced contribution to growth from foreign trade. However, it will keep Germany’s deceleration under control.
70

Credit restriction index
Manufacturing sector
70 60 50 40 30 20 10 0 Jun 03 Jan 05 Jan 07 Mar 08 Mar Jul 09 Nov Mar Jul 10 Nov Mar 11 60 50

GDP

Year-on-year percentage change

2010 Germany 3.6 France 1.4 Italy 1.2 Spain -0.1 Greece -4.4 Portugal 1.3 Ireland -0.4 GIPS countries -0.7 Euro zone 1.7
Source: Eurostat, SEB

2011 3.0 1.6 0.9 0.5 -4.1 -2.0 -0.4 -0.6 1.7

2012 1.3 1.0 0.3 0.3 -0.5 -1.7 0.5 0.0 1.0

2013 1.9 1.5 0.8 1.0 0.5 0.3 1.4 0.9 1.5

40 30 20 10 0

Small companies Medium-sized

Large Total

Source: IFO

Unemployment will keep falling for a while

Overall, we foresee a slowdown in German GDP growth from 3 per cent this year to 1.3 per cent in 2012. This represents a clear downward revision from our May forecast. Growth will recover to 1.9 per cent in 2013. France will grow by 1.6 per cent this year, 1.0 per cent in 2012 and 1.5 per cent in 2013; Italy by 0.9, 0.3 and 0.8 per cent, respectively. In the GIPS countries, GDP growth will end up at -0.6 per cent this year, 0 per cent in 2012 and less than 1 per cent in 2013. The euro zone as a whole will grow by 1.7 per cent this year, 1.0 per cent in 2012 and 1.5 per cent in 2013, a clear downward revision for 2012 compared to our May forecast and below the consensus view. Private consumption will grow by about 1 per cent yearly in 2011-2013, while capital spending and exports will gain 4-5 per cent annually. Euro zone deceleration this autumn and winter
IFO (Germany) and ISM (US)
65 60 55 50 45 40 35 30 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 120 115 110 105 100 95 90 85 80

The recent relatively favourable labour market trend can continue, given the moderate slowdown in growth we foresee. The German labour market has gained further strength this year: unemployment is now at a 20-year low (6.1 per cent, according to Eurostat’s harmonised measure), and there are many indications that the downturn will continue for another while. Companies are still planning new hires, and a growing number of observers expect rising employment. The labour market reforms of recent years (Hartz I-V) have also made the German labour market more efficient, for example as reflected in better matching between job seekers and vacancies. German unemployment will continue downward at a somewhat slower pace next year but rise again in 2013.
Unemployment levels out
Per cent
22.5 20.0 17.5 15.0 12.5 10.0 7.5 5.0 00 01 02 03 04 05 06 07 08 09 10 11 12 13 SEB forecast 22.5 20.0 17.5 15.0 12.5 10.0 7.5 5.0

Germany France

Italy Spain

Euro zone
Source: Eurostat, SEB

US ISM (LHS)

IFO (RHS)

Source: IFO, ISM

Although our forecast has been adjusted downward and is somewhat below consensus, we still foresee a rather mild slowdown, in light of the huge challenges that the euro zone faces. Perhaps the most vital factor in enabling the euro zone to avoid a deeper downturn is whether bank lending to the corporate sector can function normally, despite losses in the banking system. So far, there have been few signs that disruptions in the banking system have led to tighter credit conditions for companies. The experiences of 2008 are probably helping decision makers to do everything they can to avoid such a development.

French unemployment has levelled out at around 9.6-9.7 per cent (as measured by Eurostat), where it will remain until March 2012 before starting to climb again. The Italian labour market has shown gradually lower joblessness despite low GDP growth. We expect a cautious downturn to less than 8.0 per cent early next year, then a weak upturn. Spain’s stratospheric jobless rate (now just above 20 per cent, with youth unemployment of around 40 per cent) fell temporarily late in 2010 but resumed its climb this year. Weak GDP growth is not enough to lower the number of unemployed people in the country’s rigid labour market. Overall, euro zone unemployment will fall to 9.5 per cent in December next year but then rebound to some 10 per cent in December 2013. Measured as annual averages, euro zone unemployment will end up at 9.9 per cent this year and 9.6 per cent in both 2012 and 2013, a upward revision compared

24 | Nordic Outlook – August 2011

The euro zone

to our May forecast and above consensus. Joblessness will thus be above the non-accelerating inflation rate of unemployment (NAIRU), or equilibrium unemployment, which we estimate at 8.5 per cent for the entire forecast period. Unemployment far above NAIRU
Per cent
11.0 10.5 10.0 9.5 9.0 8.5 8.0 7.5 7.0 6.5 6.0 00 01 02 03 04 05 06 07 08 09 10 11 12 13 SEB forecast 11.0 10.5 10.0 9.5 9.0 8.5 8.0 7.5 7.0 6.5 6.0

contribution from food prices will also diminish. HICP inflation will thus gradually decelerate and we expect it to bottom out at 1.2 per cent in April next year. The contribution of energy and food to inflation will then be around zero. Measured as annual averages, HICP inflation will reach 2.6 per cent this year, 1.5 per cent in 2012 and 1.6 per cent in 2013. Inflation will decelerate in 2012
Year-on-year percentage change
4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 01 02 03 04 05 06 07 08 09 10 11 12 13 SEB forecast 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0

Okun's Law

Unemployment

Source: Eurostat, OECD, SEB

NAIRU

Continued weak wage pressure

HICP inflation

Core inflation
Source: Eurostat, SEB

The recent upturn in inflation, combined with an improved German labour market, has raised the question of whether Germany is on its way into a period of higher wage and salary hikes. Last spring, unions in the German construction and chemical industries demanded pay increases of 6-7 per cent, but their collective agreements ended up at only about 3 per cent. Since then, weaker economic conditions have changed the negotiating situation and we expect this to lower pay demands. Overall, German wage and salaries will increase by about 2.5 per cent this year and a bit less than 3 per cent yearly in 2012 and 2013. Weaker wage pressure elsewhere in the euro zone, among other things because of the need to cut costs in southern Europe, indicates that pay increases will be much slower in the euro zone as a whole; we expect euro zone pay hikes of 1.5-2 per cent this year and about 2.5 per cent a year in 2012 and 2013. Pay increases of around 2.5 per cent in 2012-2013
Percentage points, year-on-year percentage change
-2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 00 01 02 03 04 05 06 07 08 09 10 11 12 13 SEB forecast 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5

Core inflation − HICP adjusted for energy and food − has climbed higher this year and is currently around 1.5 per cent. Because of the economic slowdown this autumn and winter, resource utilisation will remain relatively low. Output will be an estimated 3-4 per cent below potential during the next couple of years, which will ease underlying inflation pressure. Core inflation will average 1.4 per cent this year, 1.3 per cent in 2012 and 1.6 per cent in 2013.

Lower deficit than the OECD average

Despite the serious crisis that the euro zone is now undergoing (see the box below), its average budget deficit is substantially lower than in other major OECD economies: the US, Japan and the UK. Overall, the euro zone budget deficit will reach 4.4 per cent of GDP this year, 3.5 per cent in 2012 and 2.7 per cent in 2013. The level of central government debt is more worrisome. Overall, it will climb from 85 per cent of GDP in 2010 to nearly 90 per cent in 2013. Altogether, we expect euro zone austerity programmes to be equivalent to about 1 per cent of GDP in 2011 and 1-1.5 per cent in 2012 and 2013. In addition to austerity measures, improved public sector finances in Germany will help reduce budget deficits. Higher tax and privatisation revenue recently enabled the German finance ministry to adjust the borrowing requirement for 2012 downward to EUR 27.2 billion (compared to a projected EUR 30 billion this year). The German budget deficit will reach 1.9 per cent of GDP this year and about 1 per cent in 20122013. However, Germany may need strong public finances, considering all the burdens that the country faces in the next couple of years. Funding for the European Financial Stability Facility (EFSF) and other rescue mechanisms in the euro zone will squeeze both public finances and the patience of the German people towards events in the single currency union. Voter support for Germany’s Chancellor Angela Merkel and her CDU party is declining, and domestic German political developments will be highly important to the potential for keeping the euro project viable in the future.

Change in unemployment, shifted 1 year forward (LHS) Change in wage and salary cost in manufacturing (RHS)
Source: Eurostat, SEB

Lower inflation next year

Euro zone HICP inflation fell from 2.7 per cent in June to 2.5 per cent in July. The downturn was largely driven by slowing inflation in Italy, due to changed seasonal patterns. At present, energy is contributing some 1.4 percentage points to the inflation rate, mainly because oil prices were 50 per cent higher in July than a year earlier. The contribution from the energy item will gradually decline over the next six months, however. The

Nordic Outlook – August 2011 | 25

The euro zone

Public budget balance, selected countries
Per cent of GDP

Germany France Italy Spain Greece Portugal Ireland Euro zone

2010 -3.3 -7.0 -4.6 -9.2 -10.5 -9.1 -32.4 -6.0

2011 -1.9 -5.9 -3.9 -6.5 -8.3 -5.9 -10.5 -4.4

2012 -1.1 -5.0 -3.2 -5.2 -7.5 -4.8 -8.7 -3.5

2013 -1.0 -3.8 -2.7 -4.3 -5.7 -3.4 -5.6 -2.7

However, the ECB’s situation is not simple and includes various difficult dilemmas. Our analysis using the Taylor rule, which is also confirmed by a new Fed analysis, indicates that crisisplagued euro zone countries would need a negative key interest rate of -4 per cent. Meanwhile the analysis indicates that euro zone core countries, especially Germany, would need a higher key interest rate than today’s 1.5 per cent. The ECB nevertheless has other ways of improving the situation in crisis countries. As part of its Securities Markets Programme, by mid-August the ECB had bought nearly EUR 100 billion worth of government securities in an effort to restore orderly markets. The ECB’s credibility is adversely affected by the ability of crisis countries to obtain financing via the central bank’s balance sheet. The ECB is thus likely to make an effort to transfer the securities that it has bought so far to the EFSF, as much as possible. We expect the ECB to continue intervening in the secondary market until the EFSF, following approval by national parliaments of the July 21 EU crisis agreement, becomes operational and − using funds raised from newly issued EFSF bonds − until it can buy the government securities of crisis countries. This will help the ECB to draw a line between government debt and traditional monetary policy and enable it to resume its strict focus on price stability.

Source: European Commission, SEB

ECB will take a long pause

As expected, the European Central Bank left its refi rate unchanged at 1.50 per cent early in August. The ECB also helped lower expectations of further key interest rate hikes by emphasising that the risk of weaker euro zone economic growth has increased. However, it stuck to its view that short- and medium-term inflation risk remains on the upside. Given our growth and inflation scenario, we foresee few reasons for the ECB to continue key rate hikes. Our forecast implies faster economic deceleration than the ECB is predicting. In addition, we find it hard to foresee any major risks of secondary effects on the inflation front. We also predict greater risks associated with the problems of the banking sector. One illustration of these tensions is that TED spreads (the difference between interest rates on interbank loans and short-term government debt) have climbed in the euro zone in a way that deviates from the situation in such countries as the US and Japan. Another warning signal is that lending to non-financial organisations slowed sharply in June, although the IFO Institute’s measure indicates that the credit situation in the German manufacturing sector is continuing to ease. To summarise, we believe that the ECB will leave its key interest rate unchanged until the second half of 2013, when it will raise this rate in two cautious steps: the refi rate will stand at 2 per cent in December 2013. Signs of weaker credit growth
Year-on-year percentage change
15.0 12.5 10.0 7.5 5.0 2.5 0.0 -2.5 99 00 01 02 03 04 05 06 07 08 09 10 11
Source: ECB

15.0 12.5 10.0 7.5 5.0 2.5 0.0 -2.5

Credits

M3 money supply

26 | Nordic Outlook – August 2011

The euro zone

Euro zone crisis deepening
The sovereign debt crisis in the euro zone has deepened this past summer. The escalation of the Greek crisis, combined with sharply higher risk premiums for Spain and especially for Italy, has added new dimensions to the problem scenario. An extra European Union summit meeting on July 21 approved new loans to Greece totalling EUR 159 billion (109 from the EU/IMF, the rest from the banking sector) combined with debt reduction of 20 per cent. In addition, cheaper loans from the EFSF to Greece, Ireland and Portugal were approved, along with measures to prevent contagion to other countries. These steps resolved some of the acute problems but are far from sufficient to ensure the long-term stability of the euro system.
Yields on 10-year government bonds
Spread against Germany, percentage points
17.5 15.0 12.5 10.0 7.5 5.0 2.5 0.0 Oct 08 Apr Jul 09 Oct Jan Apr Jul 10 Oct Jan Apr Jul 11 17.5 15.0 12.5 10.0 7.5 5.0 2.5 0.0

retain its own AAA rating. Because of France’s large budget deficit, we believe that it must craft further budget-cutting measures and speed up its reform efforts, which have proceeded very slowly so far. 2011, per cent of GDP

Key ratios, selected countries
Debt 81.1 85.6 120.9 68.6 158.1 103.9 108.7 87.5 NIIP 41.6 -10.6 -24.6 -86.9 -82.2 -111.7 -73.1 -13.4 CAB 5.4 -2.4 -3.6 -3.7 -8.9 -7.5 1.3 -0.3

Balance Germany -1.9 France -5.9 Italy -3.9 Spain -6.5 Greece -8.3 Portugal -5.9 Ireland -10.5 Euro zone -4.4

Note: Balance refers to public sector budget balance, debt refers to central government debt, NIIP means net international investment position (year-end 2010) and CAB means current account balance. Source: European Commission, IMF, SEB

Country risk
1.25
SE FI GE NL AT DK BE NO

Normalised comparative figures
1.25 1.00 1.00 0.75 0.50 0.25 0.00 -0.25 -0.50 -0.75 -1.00
Source: SEB

France Greece

Ireland Italy

Portugal Spain

Source: Reuters EcoWin

0.75 0.50 0.25 0.00 -0.25 -0.50 -0.75 -1.00
GR UK PT IR JP US IT FR SP

Markets are now focusing on developments in Italy and Spain. The yield spread on these countries’ 10-year sovereign bonds against their German equivalents widened to 4 percentage points in early August and then narrowed again after ECB interventions. Yields on their bonds are thus still well below the levels that Greece, Ireland and Portugal had to grapple with before being rescued by bail-out loans. Italy’s budget deficit is not alarmingly big and its banks are comparatively well-capitalised. The stumbling block is Italy’s large central government debt, 120 per cent of GDP, which risks growing further if growth stalls and bond yields remain high. As a reaction to such market scepticism, in mid-August the Italian government approved further budget cutbacks of EUR 45 billion (about 2.5 per cent of GDP) during 2012-2013. Italy’s ambition is to push down its budget deficit to 1.6 per cent of GDP as early as next year, which we believe is unrealistic. Spain, too, is implementing sizeable reforms and austerity measures, but its sky-high unemployment and shaky banking sector represent major risks if the economy should turn downward again. By accelerating the Spanish parliamentary election to November, Prime Minister José Luis Rodríguez Zapatero hopes to help improve political and economic stability this autumn and winter. Pressure on France has also recently increased. The longterm sovereign bond yield spread between France and Germany widened in early August, but as with Italy and Spain it has narrowed again more recently. Market worries are strongly associated with the large exposure of French banks to southern European countries. Standard & Poor’s downgrade of the US government’s credit rating further increases the pressure, since it shows that not even AAA-rated countries are safe. Continued confidence in France is essential if the EFSF is to

If we summarise various measures of macroeconomic stability such as budget balance, government debt, current account balance etc., it is still clear that the situation in France and Italy is substantially better than in the GIPS countries. This is one of the reasons why we expect these countries to take steps that will ensure that no rescue actions from the EFSF will be needed. However, we foresee a high probability that Spain will need some form of aid from the EFSF. On August 16, German Chancellor Angela Merkel and French President Nicolas Sarkozy reached agreement on three measures to deal with the euro zone debt crisis. Their ambition is to have the finance ministers of Germany and France present a joint proposal to the EU institutions as early as September. According to this proposal, 1) EU institutions would introduce a tax on financial transactions; 2) an “economic government” would be formed; and 3) the euro zone countries would adopt balanced budget laws by mid-2012. However, Sarkozy and Merkel do not want to introduce euro bonds or strengthen the finances and powers of the EFSF. Their proposals may potentially improve stability in a somewhat longer perspective, but the market would have preferred steps to address acute crisis situations and, not unexpectedly, is critical of the proposed tax on financial transactions.
Nordic Outlook – August 2011 | 27

The United Kingdom

Growth will remain weak for some time
ƒ ƒ ƒ Higher unemployment Temporary inflation peak this year Bank of England will not touch its key rate
equity indices have fallen by more than 10 per cent since July, making it likely − via wealth effects − that consumption growth will be weak. Household consumption will fall by 0.8 per cent this year and rise by an average of 1.2 per cent in 2012-13. One downside risk in the forecast is that the household savings ratio has fallen sharply and is lower than the historical average. A weak currency is propping up exports nicely. In effective terms, the pound has lost 25 per cent of its value since its 2007 peak. Although a large percentage of exports goes to the slowgrowing euro zone and US, we expect decent contributions from foreign trade during our forecast period. Partly due to a combination of rising oil prices and the VAT hike of last January, inflation will peak at around 5 per cent later this year but then slow greatly as base effects vanish from the statistics. In 2012, annual average inflation will be 2.1 per cent. Weak growth in pay, GDP and money supply as well as subdued inflation expectations indicate that a bit further ahead, inflation risks will be on the downside. In light of the weak economy and the likelihood of lower inflation to come, the BoE has indicated its openness to new quantitative easing (QE), even though long-term bond yields are already at their lowest level since the Second World War. We predict bond purchases equivalent to GDP 50 billion within six months (compared to GBP 200 billion in 2009/10), which may put the pound under further pressure. In addition, we expect the key interest rate to remain at its current record-low level throughout our forecast period. Meanwhile long-term equilibrium associations point in the opposite direction. The EUR/GBP exchange rate will be 0.86 at the end of 2012 and 0.84 at the end of 2013, a marginal strengthening of the pound compared to its current level. Gloomy growth prospects imply that the actual trend of budget deficits, sovereign debt and borrowing requirements will probably be worse than in the government’s forecasts. The budget deficit, which was equivalent to 10 per cent of GDP last year, will fall to 8 per cent in 2012 and 6.5 per cent in 2013. So far, the government has signalled that it intends to continue pursuing its current budget austerity path, but if the economy seizes up, it will probably soften these policies. In such a scenario, it is doubtful whether the United Kingdom will be able to keep its AAA credit-worthiness.

The British economy is facing headwinds due to lowered global economic prospects and the government’s tough fiscal austerity programme. A weighted average of purchasing managers’ indices for the service, manufacturing and construction sectors hardly provides reason for optimism. Our own indicator model foresees even weaker growth figures in the next few quarters. GDP growth will be only 1.1 per cent this year. In 2012, GDP will grow by 1.6 per cent (below consensus), then climb somewhat further in 2013. Temporary factors have driven inflation well above target, but we foresee a sharp slowdown in 2012-13. The key interest rate will be kept at a record-low 0.5 per cent throughout our forecast period, while the door to quantitative easing is opening ever wider. The probability of further Bank of England (BoE) bond purchases within six months is 70 per cent, in our assessment. GDP is still 4 per cent below its peak three years ago, while employment has recovered most of its recession loss. But now the labour market recovery is under threat, and in July the upturn in joblessness was the largest since 2009. Employment is still rising, but the rate of increase has decelerated greatly and leading indicators are pointing downward. The jobless rate, which has been around 8 per cent since 2009, will rise according to our forecasts. Measured as annual averages, unemployment will be 8.4 per cent both in 2012 and 2013.
Unemployment rising again
Monthly change, thousands persons
150 125 100 75 50 25 0 -25 -50 00 01 02 03 04 05 06 07 08 09 10 11 150 125 100 75 50 25 0 -25 -50

Source: ONS, SEB

The upturns of last spring in household confidence indicators, from deeply depressed levels, have reversed. Meanwhile pay growth is weak, lagging far behind inflation. Since they peaked in 2008, wages and salaries have fallen by more than 8 per cent in real terms. Both retail sales and home prices are treading water; year-on-year rates of increase are close to zero. Broad

28 | Nordic Outlook – August 2011

Eastern Europe

Good resilience but a slowdown in exports
ƒ ƒ ƒ Moderate public debt creates stability Domestic demand will continue to recover Currencies will depreciate further in autumn
increases the debt and interest burden of borrowers. Aside from this minor problem, we are sticking to our earlier forecast that domestic demand will gradually continue to recover in Eastern Europe. Households will benefit from continued labour market and real wage improvements as higher inflation (mainly energy and food) culminates late this year. Corporate capital spending will also grow, after being depressed for years. Poland and Ukraine will also enjoy extra stimulus from hosting the 2012 European football championships. The Russian economy will continue to benefit from high commodity prices and we expect Russia’s government to launch extra stimulus measures this autumn, partly to bolster its own popularity before the December 2011 parliamentary election and March 2012 presidential election. Russian GDP will increase by 4.3 per cent this year and by 4.5 per cent in 2012 and 5.0 percent in 2013. We expect Polish growth to reach around 4 per cent yearly. Ukraine is plagued by political risks, and growth will continue to be hampered by the budget tightening that the IMF requires as a condition for its loans.
The Russian and Polish currencies
USD/RUB and EUR/PLN exchange rates
5.00 4.75 4.50 4.25 4.00 3.75 3.50 3.25 3.00 Jan May 08 Sep Jan May 09 Sep Jan May 10 Sep Jan May 11 Sep 40.0 37.5 35.0 32.5 30.0 27.5 25.0 22.5 20.0

Eastern Europe is showing good resilience in the current global slump, though export growth is slowing and currencies are suffering setbacks. Relatively low public debt and little exposure to economic trouble spots are key reasons. Unlike most Western countries, Eastern (including Central) Europe generally emerged from the 2008-2009 recession with moderate or low public sector debt. In 2010, Poland’s debt was 55.7 per cent of GDP, with Ukraine, Slovakia and the Czech Republic at around 40 per cent and Russia 8 per cent. Hungary was the exception, with debts totalling 80 per cent of GDP. Meanwhile many countries showed relatively high budget deficits. All countries except Russia thus launched austerity programmes. In our view, these measures will be enough to stabilise debt during the next couple of years. Further cutbacks that might severely hamper GDP growth are not needed. Direct trade with the US and crisis-plagued southern Europe is small. The US buys less than 5 per cent of Eastern European export value. Exposure to the hardest-hit euro zone country, Greece, is also small. This applies both to the banking system and foreign trade. It is primarily Bulgaria and to some extent Romania and Serbia that risk being affected by the Greek crisis. But due to poorer export prospects, we are making downward revisions in our previous relatively optimistic Eastern European growth forecasts, mainly for 2012. One major reason is the slowdown in Germany, which weighs heavily in the exports and GDP of Central Europe (especially the Czech Republic and Hungary). Germany is also a relatively important market for the Baltic countries, but less significant for Russia and Ukraine. In Russia, unexpectedly weak domestic demand this year is also contributing to the downward adjustment in our forecast. Higher inflation has undermined purchasing power. This is one reason why GDP growth slowed from a year-on-year rate of 4.1 per cent in the first quarter to 3.4 per cent in the second. The purchasing managers’ index in manufacturing also slid lower this summer, to just below the expansion threshold. As elsewhere in Eastern Europe, since last spring industrial production in Russia has also entered a calmer growth phase. The sharp appreciation of the Swiss franc (CHF) is also indirectly helping slow private consumption in certain Eastern European countries. Many Hungarian and Polish home mortgages are CHF-denominated, and the rising value of the CHF

EUR/PLN (LHS)

USD/RUB (RHS)

Source: Reuters EcoWin

In the past year, higher growth and public budget-cutting have strengthened financial market confidence in Eastern Europe. CDS prices there have fallen, whereas major worries have surrounded Western countries. Minor increases have been noted recently. The earlier upward trend in Eastern European currencies clearly ended this summer. We believe these setbacks are mainly tied to global risk aversion. For example, the Polish zloty also depreciated greatly during the Lehman Brothers shock three years ago. This autumn will be financially shaky at the global level and this is expected to lead to further downward pressure on the Eastern European currencies. Over time, however, we expect most of these currencies to appreciate on the basis of relative growth advantages and higher capital inflows. In 2013 we also expect the zloty and Russian rouble to climb as the central banks resume cautious key interest rate hikes.
Nordic Outlook – August 2011 | 29

Baltics

Fading export boom will lead to slower growth
ƒ ƒ ƒ Domestic demand slowly rising High CPI – low core inflation Fiscal loosening in Estonia and Lithuania
the pay-cutting process ended. This year Estonia and Lithuania are pursuing neutral fiscal policies, while Latvia has noticeably eased its fiscal tightening.
Real effective exchange rate
Index 100=2005
135 130 125 120 115 110 105 100 95 90 85 00 01 02 03 04 05 06 07 08 09 10 11
Source: BIS

The gradual recovery of the Baltic economies after their deep 2008-2009 recession is continuing. First half 2011 growth was stronger than expected, especially in Estonia and Lithuania. We are thus revising our above-consensus GDP forecasts for 2011 compared to Nordic Outlook in May; the Lithuanian forecast was raised as far back as early July. We expect GDP increases of 6.5 per cent in both Estonia and Lithuania this year. Meanwhile Latvia will still lag somewhat behind in growth, with a GDP increase of 4.0 per cent. But prospects for 2012 have become gloomier. The export boom that has so far been instrumental in driving the economic upturn will fade during the next 6-12 months. The reason is weaker global demand, which will be especially apparent in strongly export-dependent Estonia. As a result, GDP growth rates next year will end up somewhat below potential, which we estimate at 4-5 per cent. We have lowered our forecasts for 2012 to 3.5 per cent in Estonia and Latvia and 4 per cent in Lithuania. In 2013 growth will rebound.
EU household sentiment indicator
Net figures
20 10 0 -10 -20 -30 -40 -50 -60 00 01 02 03 04 05 06 07 08 09 10 11 20 10 0 -10 -20 -30 -40 -50 -60

135 130 125 120 115 110 105 100 95 90 85

Estonia

Latvia

Lithuania

Exports will continue to increase relatively strongly during the next couple of years, although export growth will slow significantly after the exceptional growth figures of the first half of 2011. Demand in nearby countries is cooling slightly, but the Baltic countries remain competitive following their earlier cost adjustments. Over the past six months their real effective exchange rates have admittedly appreciated again, but this is largely due to the relatively large impact of inflation from energy and food. Wages and salaries have risen at a moderate pace. This trend will continue, due to persistent low resource utilisation in the Baltic economies.
Unemployment
Per cent
22.5 20.0 17.5 15.0 12.5 10.0 7.5 5.0 2.5 02 03 04 05 06 07 08 09 10 11 22.5 20.0 17.5 15.0 12.5 10.0 7.5 5.0 2.5

Estonia

Latvia

Lithuania

Euro zone
Source: Local statistical offices

Leading indicators do not show that the region is facing an abrupt economic deceleration. In Estonia, manufacturing sector confidence has admittedly dropped this summer, in line with the general euro zone pattern. But in Latvia and Lithuania, no slowdown is visible according to manufacturing sector surveys; Lithuania instead reported a sharp upturn. Also notable is that international turbulence has not had any negative impact on household sentiment indicators in the three countries. One important reason why indicators have been resilient so far is that the domestic economic sectors are slowly rising up after a depression-like downturn. Households and businesses are no longer being squeezed by harsh crisis policies. During 2010

Estonia

Latvia

Lithuania
Source: Local statistical offices

Domestic demand is continuing to recover gradually, after bottoming out in the second half of 2010, although sizeable base effects are exaggerating year-on-year growth figures. Private consumption is being sustained by progressively higher employment and rising pay levels. High unemployment is slowly falling. Inflation pressure is relatively high, mainly due to energy and food (in Latvia, core inflation is still zero, while the broad CPI is above 4 per cent) and will ease early next year.

30 | Nordic Outlook – August 2011

Baltics

Capital spending activity is climbing slowly as a consequence of higher capacity utilisation, recuperating residential markets and the use of EU structural funds.

Estonia: Far from overheating

In the second quarter, Estonia’s year-on-year growth amounted to 8.4 per cent. This was the highest GDP increase in the EU. The first half increase was also 8.4 per cent, the strongest growth since the second half of 2006, but no new period of overheating is likely. During the upturn phase, Estonia has benefited from its large export sector, with good demand from Sweden and Finland, which buy about one third of exports. Estonia’s exports are equivalent to some 75 per cent of GDP. The corresponding figure for Lithuania is 55 per cent and for Latvia about 45 per cent. Now that the global economy is decelerating, this Estonian advantage is instead becoming a disadvantage. Inflation, too, has risen faster than in other EU countries, from a year-on-year rate of just below 3 per cent one year ago to 5.3 per cent in July 2011. Global energy and food effects are a major explanation. Core inflation has risen modestly, however, from less than 1 per cent to 2.1 per cent. This is because of leisurely pay increases and weak domestic demand. The broad inflation measure has also levelled out this year. We continue to foresee a slowdown ahead, since base effects and earlier price hikes via fiscal tightening measures will vanish. Inflation expectations have also fallen appreciably in recent months. HICP will increase by an average of 5 per cent this year, 3.5 per cent in 2012 and 4.5 per cent in 2013.
Estonia: Inflation and core inflation
Year-on-year percentage change
12.5 10.0 7.5 5.0 2.5 0.0 -2.5 00 01 02 03 04 05 06 07 08 09 10 11 12.5 10.0 7.5 5.0 2.5 0.0 -2.5

is also backed by the EU and the IMF in their international loan programme, which expires this year and was initiated during the financial crisis late in 2008. We predict that the deficit will shrink from 7.7 per cent of GDP last year to below 5 per cent this year and that the government, despite a more uncertain growth picture, will manage to implement enough cost-cutting measures to meet the 3 per cent Maastricht criterion next year. The government of Valdis Dombrovskis has consistently fulfilled EU/IMF budget consolidation requirements. Despite the impact of his tough belt-tightening policy on households, the government strengthened its position in the October 2010 parliamentary election. More recently, however, parliamentary uncertainty has increased. Former President Valdis Zatlers pushed through a new election on September 17 via a referendum in July. A full 94 per cent voted to dissolve Parliament. After losing the presidential election, Zatlers’ newly-created Reform Party is challenging the governing two-party coalition (Unity and the Union of Greens & Farmers). After the referendum, opinion polls indicated an upswing for the Reform Party and the leftist Harmony Centre, while Unity lost support. Our assessment is that a change of government is likely, but that if this happens, the new government will be a broad coalition that will continue to prioritise budget-tightening and qualifying for the euro zone. Reform Party candidates have actually not issued such signals in their initial programme declaration, but they may consider such issues too sensitive to discuss before the election.

Lithuania: Surprising domestic upturn

Lithuania’s GDP rose by 6.6 per cent year-on-year in the first half. The increase was surprisingly strong and was largely due to a thaw in retail sales, which grew faster than in the other Baltic countries. Domestic demand will continue to recover, gaining an extra injection when Lithuania hosts the EuroBasket 2011 tournament this autumn. The inflation upturn slowed this summer, and in July the inflation rate was 4.2 per cent. Underlying inflation has been stable and measured 0.6 per cent in July. This autumn, continued energy price hikes will undermine household purchasing power. Heating costs may climb 20 per cent, and gas price increases are already planned. During 2012-2013, inflation will decline to 3.5 per cent a year, with some downside risks due to the coming slowdown in growth. Public support for the government is weak, and there is rising uncertainty as the autumn 2012 election approaches. Our assessment is that fiscal stimulus measures will be initiated next year, though the 2011 deficit looks set to be a relatively high 4-5 per cent of GDP, down from 7.1 per cent in 2010.

HICP

HICP excl energy, food, alcohol, tobacco
Source: Eurostat

In our judgement, the decelerating economy and slow price increases will open the way for certain fiscal stimulus measures in the next couple of years; income and real estate tax cuts are already on the table. There is room. Estonia has the strongest public sector finances in the EU, with debt of 6.6 per cent of GDP last year and a balanced budget.

Latvia: Continued austerity after election

Latvia’s growth rate was 4.4 per cent during the first six months of 2011, after the economy accelerated in the second quarter. The country will continue to muddle through with 3-4 per cent growth. The upturn will be slowed by poorer international demand and continued fiscal austerity. The government is determined to squeeze its budget deficit below 3 per cent in 2012 in order to qualify for the euro zone by 2014. This goal

Nordic Outlook – August 2011 | 31

Sweden

Below-trend growth in 2012
ƒ ƒ ƒ ƒ ƒ ƒ Cyclically sensitive export industry Home prices will gradually fall 10 per cent Consumption growth will slow Unemployment will stay above equilibrium Riksbank will not hike key rate in 2012 Parliamentary deadlock = tighter policy
pay increases of about 3.5 per cent next year, or about half a percentage point lower than we believed in May. Higher pay increases will contribute to decent income growth in 2012-13, with purchasing power rising 2-2½ per cent annually. CPI inflation will fall quickly as the contribution from oil prices and increased residential mortgage interest expenses declines sharply. Core inflation, which has been stable at around one per cent during 2011, will rise during 2012 because of faster pay increases and less downward pressure from Swedish krona appreciation than in 2010. The upturn will be slow, however, and core inflation will be lower than 2 per cent during the next couple of years. The Riksbank will hike its key interest rate once more during 2011 as unemployment shrinks. Because of decelerating growth, however, resource restrictions will disappear as a justification for further rate hikes. The risks associated with the credit and housing markets have changed too. We thus expect the Riksbank to keep its repo rate unchanged at 2.25 per cent throughout 2012. The risks in our rate forecast are on the downside. Fiscal policy is likely to be less expansionary than we had previously expected. During the financial market turbulence of recent weeks, the government announced that it is withdrawing proposed measures, in particular a further stage in the earned income deduction reform. In all likelihood, this is mainly a consequence of parliamentary difficulties and internal divisions within the governing minority coalition. We thus still expect various stabilisation policy proposals to be unveiled in next month’s autumn budget, making the government’s fiscal policy weakly expansionary in 2012.
Continued good orders but companies prepare for slowdown
Net balance
50 40 30 20 10 0 -10 -20 -30 -40 -50 94 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 75 70 65 60 55 50 45 40 35 30 25

The international slowdown is having a clear impact on the Swedish economy. Given the country’s cyclically sensitive export structure, GDP growth appears likely to end up only marginally above the EU average, despite good domestic fundamentals. After the past two years of strong recovery, growth will slow next year to 1.4 per cent (1.8 corrected for working days), or lower than the long-term trend. In 2013 there will be a modest recovery, with GDP growing by 2.6 per cent.
GDP growth will slow in 2012
2.5 2.0 1.5 1.0 0.5 0.0 Q1 8 7 6 5

SEB forecast

4 3 2 1 0

Quarter-on-quarter percentage change (LHS) Year-on-year percentage change (RHS)

Q3 10

Q1

Q3 11

Q1

Q3 12

Q1

Q3 13

Source: Statistics Sweden, SEB

The consumption propensity of households will determine how deep the slowdown will be. Historically high savings at the outset and a degree of fiscal stimulus will help keep the deceleration moderate, but the risks are on the downside and are mainly connected to housing market trends. Our forecast assumes a gradual home price downturn totalling about 10 per cent, but such a soft landing is historically rather unusual. A sharper drop in home prices would most likely be accompanied by falling consumption, especially since the recent stock market downturn is amplifying the decline in wealth. Given below-trend growth, the labour market situation will gradually cool. Unemployment will continue to fall during the coming six months, but then level out at around 7 per cent. This autumn’s wage round will face a weaker economic situation than we anticipated in May, but employee demands to be compensated for earlier low pay increases imply that we still face a sizeable acceleration in wages and salaries. We expect

NIER survey (LHS)

PMI (RHS)
Source: Swedbank, NIER

Slowdown in manufacturing

Swedish exports have now recovered their entire 2008-2009 decline. Companies’ expectations remain relatively robust, according to the National Institute of Economic Research

32 | Nordic Outlook – August 2011

Sweden

(NIER) Business Tendency Survey. Manufacturers are counting on a continued climb in orders and production, though at a lower pace than before, but large downturns in the purchasing managers’ index and SEB’s CFO index hint that companies are already beginning to prepare for a deceleration. Since many large Swedish manufacturers specialise in cyclical investment or intermediate goods, a relatively sharp slowdown is a distinct possibility. Nor is it likely that exports will enjoy the same help from the krona exchange rate as during the 2001 and 2008 recessions. We nevertheless believe that exports may avoid a pronounced decline, instead levelling out during a few quarters. Measured as annual averages, exports will increase by 4 per cent in 2012 and 7 per cent in 2013.
Export growth is decelerating
Year-on-year percentage change
25 20 15 10 5 0 -5 -10 -15 -20 -25 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 25 20 15 10 5 0 -5 -10 -15 -20 -25

cause a partial reversal of the upturn that has occurred during the past two years, but here too, the low investment level makes a moderate downturn likely. For example, residential investments as a percentage of GDP are on a par with Spain and the US, despite very large declines in these countries in the past few years. In addition, because of a rapid population increase in recent years, Sweden has a structural housing shortage. Overall, we expect the downturn in residential investments in 2012 to be limited to 15 per cent.

Gross fixed investments
Percentage change

2010 4.5 20.1 4.6 7.1

2011 8.0 15.0 7.7 10.0

2012 3.0 -15.0 3.3 0.0

2013 3.0 4.0 3.9 4.0

Government sector Housing Business sector Total

Source: Statistics Sweden, SEB

As a rule, inventory investments amplify cyclical fluctuations. Their impact has been exceptionally large in recent years. Next year we expect a stabilisation of inventories after the stock build-up of the past few years. This means that inventories will have a negative effect of 0.7 percentage points on GDP.

Sweden

Germany

US
Source: Local statistical offices

Sizeable slowdown in consumption growth

Capital spending will stabilise at low level

The recovery in capital spending has mainly been driven by rising residential investments and higher public-sector investments. Only during the past two quarters has capital spending by the business sector begun to increase. Statistics Sweden’s capital spending survey shows that industrial companies plan to increase such spending by more than 10 per cent this year. Once demand slows, it is likely that some of these plans will be postponed, but given the historically low level at the outset, capital spending in the business sector will probably not fall again.
Fixed investments will stabilise at a low level
Per cent of GDP
21 20 19 18 17 16 15 14 13 98 99 00 01 02 03 04 05 06 07 08 09 10 11 21 20 19 18 17 16 15 14 13

Private consumption rose by 3.4 per cent during 2010, on a par with the highest growth figures of the past 20 years. Rising residential mortgage rates have contributed to a slowdown in growth during the past six months. The rate of increase is now consistent with the long-term trend. Looking ahead, the signals are mixed. Household optimism has fallen but remains significantly higher than the historical average. Meanwhile expectations in the retail sector are lukewarm, with a downward tendency. Growth in lending to households continues to decelerate. The annual rate of increase remains above 6 per cent but is beginning to approach a sustainable level (4-5 per cent).

Household income and consumption
Year-on-year percentage growth

2010 Consumption Income Savings ratio, % of dispsable income 3.4 1.3 10.7

2011 2.0 2.1 10.7

2012 1.5 2.6 11.7

2013 2.5 2.6 11.8

Source: Statistics Sweden, SEB

Total

Ex residential construction
Source: Statistics Sweden

Residential investments quickly recovered from their 2009 decline, driven by very low interest rates and a temporary tax deduction for home renovations and repairs. Reports from construction companies indicate lower demand for homes, but not a steep deceleration. The number of housing starts still climbed sharply early this year. We expect a weaker housing market to

We expect income to continue rising, but at a slower pace than we had previously anticipated. Fiscal policy will be less expansionary than expected. We foresee tax cuts equivalent to about SEK 5 billion, only one fourth of the amount signalled in the spring budget bill. In addition, employment and wage forecasts have been adjusted downward. Lower mortgage rates and lower inflation will partly offset the downward adjustment in real income. Compared to most Western European countries, income nevertheless remains fairly stable, mainly due to a comparatively expansionary fiscal policy. At present, the houseNordic Outlook – August 2011 | 33

Sweden

Falling home prices often lead to lower GDP
An international comparison shows that periods of falling home prices almost always coincide with low or falling GDP and consumption growth. The driving forces behind the downturn are wealth effects, meaning that households tend to increase their savings ratio when home prices are falling, and the fact that falling home prices often lead to declining residential construction. This is a downward spiral, leading to falling employment and further caution in consumer behaviour. In a number of countries, the decline in residential construction has been dramatic in recent years. In the US and Denmark, it has been equivalent to 4 per cent of GDP, in Spain 5 per cent and in Ireland no less than 10 per cent. Because residential construction in Sweden is low (accounting for about 3½ per cent of GDP), the downturn risks via this channel are limited. Wealth effects are more difficult to assess. One encouraging sign is that households have not been as inclined as in some other countries to take out new home loans in order to boost

their consumption. The Riksbank has made a rough estimate of this, indicating that the share of new home loans used for non-residential-related expenditures totalled about 3 per cent of disposable income during 2011. The above factors indicate that the Swedish economy may be less sensitive to housing market downturns than the economies of many other countries.
Relatively low residential investments in Sweden
Per cent of GDP
10 9 8 7 6 5 4 3 2 1 0 98 99 00 01 02 03 04 05 06 07 08 09 10 11 10 9 8 7 6 5 4 3 2 1 0

Sweden

US

Spain
Source: Local statistical offices

hold savings ratio is historically very high. The upturn during the financial crisis has only been partially reversed, and this decreases the risk of a sharp decline in consumption.
Historically low household savings ratio
Per cent of disposable income
15.0 12.5 10.0 7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5 94 96 98 00 02 04 06 08 10 12
SEB forecast

15.0 12.5 10.0 7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5

significantly and the percentage of households that believe prices will fall is now somewhat larger than the percentage of those that believe they will rise. We foresee a gradually downturn in residential prices totalling 10 per cent during the next couple of years, but there is considerable uncertainty. The main risk is that the decline will be larger following an almost 200 per cent price upturn during the past 15 years.

Unemployment will level out

Total Excl collective retirement saving Financial savings, excl collective retierment saving
Source: Statistics Sweden, SEB

Unemployment has steadily fallen during the past year, and it stood at 7.5 per cent in June. Employment has improved even faster and is now already higher than before the crisis. A rising labour supply, due among other things to reduced levels of sick leave and high immigration, has dampened the downturn in unemployment.
Unemployment will level out
Three-month moving average
9.0 8.5 8.0 7.5 7.0 6.5 6.0 5.5 05 06 07 08 09 10 11 12 13 SEB forecast 4750 4700 4650 4600 4550 4500 4450 4400 4350 4300

Our assessment is nevertheless that downside risks predominate. The threat comes primarily from the housing market, where signs of weakening are becoming ever more apparent. Over the past year, home prices have been unchanged, but both households and estate agents have become more pessimistic. The SEB home price indicator, for instance, has fallen Slowdown in residential prices
Year-on-year percentage change and net figures
15.0 12.5 10.0 7.5 5.0 2.5 0.0 -2.5 -5.0 04 05 06 07 08 09 10 11 100 75 50 25 0 -25 -50 -75 -100

Unemployment, per cent (LHS) Employment, thousands (RHS)

Source: Statistics Sweden, SEB

Home prices (LHS) SEB home price indicator (RHS)

Source: Statistics Sweden, SEB

Judging from short-term indicators, Sweden’s labour market improvement will continue in the near future. Hiring plans according to the NIER’s Economic Tendency Survey, as well as the number of newly listed job openings, remain at very high levels. We are thus sticking to our forecast that unemployment will fall to 7 per cent by the end of 2011. After that, slower

34 | Nordic Outlook – August 2011

Sweden

growth will contribute to a significant slowing in job creation, and the jobless rate will level out at around 7 per cent. During the next couple of years, unemployment will thus be well above its long-term equilibrium. The discussion of equilibrium unemployment that was so central to last spring’s public debate on monetary policy is thus becoming less topical.

The 2012 wage round will take place in a weaker economic situation than was expected only a few months ago. But even if the labour market levels out, the wage round will be dominated by union demands for compensation following the very low pay agreements they signed in 2010. We expect an acceleration in wage and salary hikes to 3.5 per cent in 2012. This is about 0.5 percentage points below what we forecasted in May.

Labour market
Percentage change Employment Labour supply Unemployment, % Productivity (GDP) 2010 1.0 1.1 8.4 3.5 2011 2.2 1.1 7.4 -0.2 2.6 2012 0.7 0.3 7.1 0.2 0.9 2013 0.4 0.3 7.1 0.2 1.6

Core inflation will remain low

Average hours worked 0.9

Source Statistics Sweden, SEB

Despite rising energy and food prices, CPIF inflation (CPI with constant mortgage rates) has remained low. The reason is that core inflation − defined as CPIF excluding energy − has remained unchanged at around 1 per cent during 2011. Core inflation will soon bottom out, but the upturn will occur very gradually. Unit labour costs will rise as pay increases accelerate from today’s very low level, while productivity growth slows. Downward price pressure due to the krona appreciation that occurred during 2010 will also weaken.
Core inflation will rise only gradually
Year-on-year percentage change
5 4 3 2 1 0 -1 -2 SEB forecast 5 4 3 2 1 0 -1 -2 08 09 10 11 12 13

Productivity has recovered strongly during 2010 and 2011, but we expect productivity growth to decelerate again. This will decrease the impact on employment of weaker economic growth. One uncertainty factor, however, is that in recent years job creation has been very strong, compared to GDP growth. As a result, the level of productivity growth today is already below its long-term trend. Given a new slowdown phase in productivity growth, the gap will widen further and GDP productivity will be as much as 4-5 per cent below its long-term trend by the end of 2013.

Wage round, 2011 and 2012
Expiration 2011 Sep 30 2012 Jan 31 Feb 28 Mar 31 Apr 30 staffing May 31 Sep 30 Employees 174,000 350,000 82,000 454,000 1,180,000 138,000 160,000 Categories included White-collar (industry) Mainly industrial Auto sales and service et al Retail, IT and telecom Local gov’t, temporary Hotel, restaurant et al Central gov’t et al

CPIF

CPIF excl energy and food

CPI
Source: Statistics Sweden, SEB

Source: National Mediation Office

Higher pay increases in 2012

During 2011, about 70 collective agreements for some 400,000 employees will expire. Agreements for white-collar employees in industry run out this September, but the parties have postponed the start of their next contract negotiations until early January 2012 to allow co-ordination with blue-collar agreements in industry. With a new framework Industrial Agreement in place since mid-2011, manufacturing will resume its traditional role as the first sector to negotiate. We expect industrial wage talks to enter their most intensive phase around the turn of the year. Other negotiations will be concentrated in March and April, when retail and local government sector agreements are among those that expire. Expiration dates are less concentrated in 2012 than they were in 2012.

So far this year, food prices have risen significantly less than expected; in July the rate of increase was below 2 per cent. Rising producer prices nevertheless indicate that food prices will keep climbing somewhat during the autumn. The international price upturn has culminated, which is already reflected in price expectations within the food processing industry. These indicate downside risks from our forecast that prices will increase by 2.5-3 per cent in the course of 2011. The contribution of oil prices to inflation also seems to have culminated, which will help reduce inflation ahead. Electricity prices have climbed steeply during the winter in recent years, due to unusually cold weather and low water levels in reservoirs. Because of intensive rain during late summer 2011, reservoir levels have normalised and the risk of new electricity price spikes this winter is small. As a result, electricity prices are expected to contribute about -0.5 per cent to inflation late in 2011. The decision to phase out nuclear power in Germany has not led to any upturn in forward contract prices for electricity during 2012 and 2013, and we foresee stable prices later during our forecast period. Overall, we expect annual CPIF inflation to remain below 2 per cent during the next couple of years. We expect indirect taxes to have a neutral effect on inflation during 2012. The lowering of value-added tax (VAT) on restaurant services will theoretically lower CPI by 0.4 per cent during 2012, but in the short term the entire tax cut will not be passed on to consumers. The announced tax increases on alcoholic

Nordic Outlook – August 2011 | 35

Sweden

beverages and tobacco products will boost CPI by 0.2 per cent, while indexing of energy taxes will add another tenth. Rising mortgage interest expenses are currently contributing more than 2 percentage points to CPI. Once the Riksbank stops hiking its key interest rate, these contributions will rapidly fade and CPI inflation will fall towards 2 per cent.

Riksbank will not hike key rate in 2012

The deceleration in economic growth will significantly change the monetary policy outlook in Sweden. Our forecast of a levelling-out in unemployment and persistent low resource utilisation implies that the most important justifications for key interest rate hikes will vanish. A slower rate of increase in household borrowing and signs of weakness in the housing market are other factors that at least indirectly point towards a weaker consumption trend. Leading central banks have also signalled a gentler monetary policy ahead, which in practice also limits the Riksbank’s room for rate hikes.
More central banks will leave key interest rates unchanged 2012
Per cent
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Jan May Sep 10 Jan May Sep 11 Jan May Sep 12 Jan May Sep 13 SEB forecast 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

buy government securities, although the average equity/assets ratio among insurance companies is still high. The above factors have also contributed to major downward pressure on yields internationally. German government bonds are nevertheless being traded with a certain risk premium. Yields on Swedish 10-year bonds are thus below German yields right now, even though Sweden’s key interest rate is 50 basis points higher. Uncertainty about the euro zone is very likely to persist over the next six months, and this is likely to result in continued downward pressure on Swedish bond yields. Swedish long-term yields will thus probably remain lower than German ones in the near future, despite Riksbank rate hikes.
Lower risk premium for Sweden than Germany
CDS, 10-year dollar bonds
175 150 125 100 75 50 25 0 Dec 07 175 150 125 100 75 50 25 0 Oct Jan Apr

Germany

Jul 09

Oct

Jan Apr

Sweden

Jul 10

Oct

Jan Apr Jul 11
Source: Reuters EcoWin

Euro zone Sweden

US United Kingdom

Norway

Source: Central banks

If the situation normalises somewhat and if the gloomiest scenarios for the euro zone become less probable, the yield spread against Germany will again become positive. Bond yields will nevertheless remain low in a historical perspective. We expect a 10-year yield of 2.65 per cent at the end of 2012 and 3.10 per cent at the end of 2013.

When the current acute financial turbulence eases somewhat this autumn, the Riksbank is likely to hike the repo rate to 2.25 per cent. In a situation characterised in the short term by a continued decline in unemployment, an increase in lending to households and economic indicators that are above historical averages, it is most likely that the Riksbank’s change of direction will occur gradually. Such action is also consistent with the Riksbank’s historical behaviour pattern of preferring to wait for clear confirmations of cyclical changes before shifting its monetary policy. However, a more acute financial crisis − one that requires bank bail-outs or triggers a dramatic downturn in home prices − would persuade the Riksbank to keep its repo rate unchanged at the 2 per cent level that it reached in July and later lower the repo rate.

Krona resumes rising trend

This summer’s market turmoil and increasing signs of economic downturn have not weakened the Swedish krona to the extent that normally occurs. This confirms our view that Sweden’s strong balance sheet is transforming the krona from an extremely pro-cyclical currency to a somewhat more stable one, which represents an important global investment alternative. Sweden’s cyclical export structure nevertheless contributes to a squeeze on the SEK during periods of greater global economic weakness. Liquidity shortages will also help make it hard for the krona to fully hold its own in times of instability. We thus expect the EUR/SEK exchange rate to rise to 9.35 during the coming month. However, the krona is one of the few currencies with relatively strong fundamentals that is not overvalued. Our model indicates an equilibrium rate for EUR/ SEK at 8.50. Looking further ahead, we are thus sticking to our forecast that the krona will strengthen to 8.70 per euro. This forecast implies that USD/SEK will move below 6.00 next year but then move back to 6.20 when USD regains some lost ground internationally.

Bond yields at record lows

Yields on 10-year Swedish government bonds have now been pushed down to their lowest level since the 1930s. This downturn is being driven by international developments and by sharply lowered expectations of the Riksbank. Strong central government finances limit supply, while demand for Swedish government bonds is being stimulated by new market players that are seeking safe investments, such as other central banks. Also driving demand is the fact that banks must increase their bond holdings due to the introduction of the Basel 3 rules. The major downturn in long-term bond yields may also force certain insurance companies with excessively low equity/asset ratios to

Less stimulus as the economy slows

In recent years, Swedish public sector finances have improved at a rapid pace. The budget deficit bottomed out at less than 1 per cent of GDP in 2009. In 2011 and 2012 we expect a

36 | Nordic Outlook – August 2011

Sweden

surplus equivalent to 0.6 and 0.5 per cent of GDP, respectively. The changes for this year compared to our earlier forecasts are small but they are larger for next year; the adverse impact of worsening economic conditions will be partly offset by tighter fiscal policy. Last year, Swedish central government finances showed a marginal surplus of SEK 1 billion. The surplus will shrink next year but then grow again. Due to financial instability and turbulence in the stock market, we are not expecting any further revenue from divestments of state-owned companies during 2012 either, which explains a large proportion of our revision. Overall, the central government surplus (negative borrowing requirement) will end up at SEK 55 billion in 2011, SEK 11 billion in 2012 and SEK 49 billion in 2013.

most important reason for this shift is probably the parliamentary situation. The opposition parties, both to the left and right of the minority Alliance coalition, have announced that they are prepared to join forces to defeat a proposed fifth stage in the earned income deduction reform. Now that representatives of the smaller government parties have made critical statements about the deduction reform, saying they would instead prefer to prioritise other areas, the political cost to the dominant Moderate Party has probably become too great. The short-term costs of retreating away from this central element of the Moderate Party’s 2010 election promises are not especially large. Finance Minister Anders Borg can now burnish his image as a responsible steward of the national finances who chooses a cautious strategy in turbulent times, but looking ahead, it is difficult to avoid the impression that discussions of additional stabilisation policies will move higher on the agenda. The sum of the reforms that have already been approved and those that were unveiled in the spring budget bill represent a contractive fiscal policy equivalent to 0.3 per cent of GDP. Yet considering that Sweden’s public finances are increasingly strong, the current economic situation undoubtedly justifies more expansionary fiscal policy, especially if unemployment gets stuck at a high level in the next couple of years. After all, the government recently stated its view that medium-term equilibrium unemployment is around 5 per cent. We thus believe that the September budget bill will include further stimulus measures, equivalent to about SEK 10 billion, which would result in a weakly expansionary overall fiscal policy. The withdrawal of the proposed fifth stage in the earned income deduction reform may also be a hint of the difficulties that the minority government will face in the months ahead. Based on the fiscal policy it unveils in September, the government risks being accused of passivity as the economy weakens and unemployment remains stuck at 7 per cent. If all four opposition parties are relatively agreed in arguing that expenditure increases should generally take priority over tax cuts, the government’s more long-term economic policies risk being blocked as well. It may be forced to pursue such watered-down economic policies that internal tensions both among the four Alliance parties and within the Moderate Party may become unmanageably large. In this situation, agreements across the dividing line between the Alliance and the leftist opposition, especially with the Green Party, would appear to be one way of breaking the deadlock − thereby avoiding a new election before the government’s term of office runs out in the autumn of 2014. The Greens have announced certain areas in which they are willing to have talks with the government, but so far the government has reacted coolly. The question is also whether the Greens might imagine cooperating with the government by supporting its entire budget, and what they would demand in return. When they cooperated with the earlier Social Democratic minority government, they acceded to tax cuts on labour in exchange for tax hikes on environmentally hazardous activities. The Greens’ new focus on infrastructure and school-related investments might also very well attract support from Alliance parties.

Public finances
Per cent of GDP

Revenue Expenditures Net lending Gen. gov’t gross debt Central gov’t debt Borrowing req., SEK bn
Source: Statistics Sweden, SEB

2010 50.9 51.0 -0.2 39.0 33.5 1

2011 2012 2013 50.0 49.3 49.4 49.4 49.1 49.0 0.6 0.2 0.4 34.6 32.7 30.0 29.8 28.4 25.9 -55 -11 -49

Central government debt will continue to fall, though at a somewhat slower pace than forecasted in the May issue of Nordic Outlook. This debt (consolidated) will fall to 25.9 per cent of GDP in 2013, a very low debt in a historical and international comparison. There are arguments both for and against such low indebtedness, but our assessment is that a debt level below 30 per cent of GDP is generally too low (see the box in Nordic Outlook, February 2011). The National Debt Office is currently analysing the disadvantages of excessively low (and high) central government debt from a debt management perspective and will report on this topic in the autumn. Government debt keeps falling
Per cent of GDP
80 70 60 50 40 30 20 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
SEB forecast

80 70 60 50 40 30 20

General government debt

Source: Eurostat, Swedish National Debt Office, SEB

Central government debt

In recent weeks, the government’s fiscal policy strategy has become more difficult to interpret. The autumn budget drafting process is currently under way, and despite the less favourable economic outlook, the latest signals indicate that fiscal policy in 2012 will be far less expansionary that announced in the government’s spring budget bill in April. The

Nordic Outlook – August 2011 | 37

Denmark

Denmark to outpace euro zone in 2012 after slow 2011
ƒ ƒ ƒ ƒ 2011 will see little domestic demand growth Hiring and capital spending delayed to 2012 Fiscal stimulus measures likely in 2012 New bank initiatives introduced
higher taxes, rising inflation and falling wage growth. Companies have yet to start hiring, while the public sector has begun to cut jobs. Finally, households are burdened with the accumulated debt from the housing bubble, although low interest rates are making this less troublesome.
Consumer confidence and consumption
Index and year-on-year percentage change
20 15 10 5 0 -5 -10 -15 -20 92 94 96 98 00 02 04 06 08 10 10.0 7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5 -10.0

The Danish economy is set to slow in 2011. Consumers continue to face headwinds and are signalling low confidence. So far, companies have ignored rising capacity utilisation. They are likely to postpone capital spending as well as hiring. Meanwhile fiscal austerity has caused a contraction in public consumption. During the past year the only major growth driver has thus been exports. With the global economy entering a soft patch and uncertainties rising, we foresee no significant increase in hiring or capital spending this year. In 2012 we expect Danish growth to pick up, with momentum improving as the year progresses. Public sector stimulus is likely regardless of the outcome of the imminent national election. Meanwhile, pent-up demand among both households and companies will provide further support for growth. As a result, growth in Denmark will be faster than in the euro zone next year. Tracking global momentum, we expect further normalisation in 2013, but household debt overhang will continue to weigh on growth prospects. Our overall assessment is that GDP grows 1.4 per cent this year, 1.7 per cent in 2012 and 2.3 per cent in 2013, respectively. With Denmark’s heavy reliance on exports, the risks are skewed to the downside in line with the global forecast.
GDP and employment
Year-on-year percentage change
7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5 92 94 96 98 00 02 04 06 08 10 5 4 3 2 1 0 -1 -2 -3 -4 -5

Consumer confidence (LHS)

Consumption (RHS)
Source: Statistics Denmark

Companies postpone hiring and capital spending

The near-term outlook for employment is not encouraging. The growth seen last year would typically lead to a pickup in hiring after a time lag. However, the global slowdown has filtered through and the marked slowdown in manufacturing has caused hiring intentions to start being revised downward. Given increased uncertainty about the macro outlook, it seems likely that companies will adopt a wait-and-see stance and postpone hiring into 2012. As the dust settles and global growth troughs early next year, hiring should pick up and provide some support to consumers. Lower inflation and low interest rates should also help lift disposable income and pave the way for higher consumption in 2012.
Manufacturing employment plans dampened
Year-on-year percentage change, index
15 10 5 0 -5 -10 -15 30 20 10 0 -10 -20 -30 -40 -50 00 01 02 03 04 05 06 07 08 09 10 11

GDP (LHS)

Employment (RHS)

Source: Statistics Denmark

-20 -25

Continued pessimism among consumers

Consumption shrank in the first quarter of 2011 and retail sales point to no significant pickup in the second quarter. While consumer confidence is off recession lows, the level is still not consistent with any increase in spending. Consumers face a number of headwinds: Disposable income is being hit by

Manufacturing (LHS) Manufacturing hiring intentions (RHS)
Source: DG ECFIN, Statistics Denmark

Corporate capital spending started the year on a very weak note. The recent rise in capacity utilisation suggests that invest-

38 | Nordic Outlook – August 2011

Denmark

ments should be in the pipeline, but with the melt-down of 2008 in fresh memory, it also seems likely that investments to some extend will be postponed until companies are more certain of the future.
Companies postpone investments
Year-on-year percentage change
30 20 10 0 -10 -20 -30 92 94 96 98 00 02 04 06 08 10 15 10 5 0 -5 -10 -15

count surplus, such expansionary policy should not be a cause for concern in financial markets.
Fiscal policy less contractionary ahead
Year-on-year percentage change
4 3 2 1 0 -1 -2 97 99 00 01 02 03 04 05 06 07 08 09 10 11 4 3 2 1 0 -1 -2

Public employment

Public consumption
Source: Statistics Denmark

Non-residential investments (LHS) Manufacturing capacity utilisation (RHS)
Source: DG ECFIN, Statistics Denmark

New banking bill in the pipeline

The past three years have seen a long post-bubble construction slump. A record number of houses and flats are for sale putting pressure on prices, and construction order books show little improvement. However, housing investments have reached a level where the downside is limited. We thus expect housing investments to stop being a drag on growth moving forward.
Year-on-year percentage change
20 15 10 5 0 -5 -10 -15 92 94 96 98 00 02 04 06 08 10 10.0 7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5

Exports slow down

Denmark’s private borrowing exploded during the housing bubble of the last expansion and the fragile state of some parts of the Danish banking sector is a reflection of the subsequent bust. Recent bank failures have attracted international attention due to authorities’ tough stance versus creditors. As a consequence, the sector has had trouble securing funding ahead of the termination of government guarantees in 2013. This is one factor behind some banks’ reduction in loan activities and tightening of loan standards. The head of the Financial Services Authority recently signaled that further write-downs are necessary. Meanwhile, the FSA has stated that a more pro-active approach forcing bank writedowns is warranted. In parallel, the parties behind the bank bills have agreed on the guidelines for a “Bank Bill 4”. The plan will encourage healthy banks to take over less healthy ones by extending government guarantees beyond 2013, providing upfront compensation for projected losses and introducing an option to spin off bad loans before declaring bankruptcy. In a separate step the Danish central bank has announced that it will accept a wider range of less liquid collateral to address liquidity issues. The result is likely to be quicker consolidation in the Danish banking sector. Although details are lacking we regard the new initiatives as positive steps as they create incentives for banks to consolidate before damaging failures materialise. At the same time the initiatives could ease the current reluctance among investors to fund the Danish banking sector as losses to creditors are less likely. In combination with the measures from the Central Bank, liquidity problems should be less severe going forward. However, the initiatives also highlight the Achilles heel of the Danish economy: the aftermath of consumers’ debt accumulation.

Danish exports (LHS) Sweden GDP (RHS)

Germany GDP (RHS)
Source: Local statistical offices

Rapid economic expansion by some of Denmark’s main trading partners (notably Germany and Sweden) has made exports the major positive driver of growth for the Danish economy over the past year. With the ongoing global economic slowdown expected to continue until early next year, it is evident that this crucial pull will moderate. After export growth bottoms out early next year, its 2012 level will be well below that of 2011, passing the growth baton on to the domestic economy. With global uncertainties rising, the risk that the pass will be fumbled is relatively high.

Fiscal austerity set to end

Fiscal austerity has pushed public sector consumption into reverse, while reducing public employment. National elections are due September 15 and will influence public policy in 2012. However, regardless of outcome, we expect current austerity to be reversed in 2012, providing a growth impetus to the economy. With low public debt ratios and a large current ac-

Nordic Outlook – August 2011 | 39

Norway

Slower growth ahead, but still rather solid
ƒ ƒ ƒ Domestic demand-driven recovery intact While growth will be slower, Norway should fare better than peers Norges Bank will move more cautiously, but still hike key rates during the coming year

Consumption to remain healthy

The outlook for lacklustre global growth will impact the Norwegian economy as well, but the effect should not be as severe as in countries more closely tied to the global cycle. Continued healthy domestic fundamentals should put a floor under growth. Prospects for strong capital spending expansion in the oil sector, which at least in the near term will be less affected by the global cycle, will lend important demand impulses to the rest of the economy.
Recovery led by domestic demand
Year-on-year percentage change
8 7 6 5 4 3 2 1 0 -1 -2 -3 03 04 05 06 07 08 09 10 11 8 7 6 5 4 3 2 1 0 -1 -2 -3

Due to rising electricity prices private consumption started 2011 on a soft note, as spending on goods declined, but it accelerated by rising 0.7 per cent from the first to the second quarter. A revival was expected, since higher inflation in late 2010 due to surging electricity prices squeezed households’ spending power, but it was not as strong as previously expected due to weaker auto sales. Consumption will continue to be supported by solid income growth: we are sticking to our previous forecasts that wage growth will accelerate from 3.7 per cent last year to 4.2 per cent in 2011 and 4.6 per cent in 2012. In addition, interest rates will be less of a drag going forward, since Norges Bank should move more slowly on its monetary policy normalisation. Nonetheless, due to a slightly weaker trajectory and assuming a more moderate pace in the near term, the forecast for growth in private consumption in 2011 has been revised somewhat downward to 2.6 per cent, but growth should pick up to 3.1 per cent in 2012.

Labour market improvement slowing

Mainland GDP

Non-oil final domestic demand
Source: Statistics Norway

The recovery in the Norwegian economy has been driven by non-oil domestic demand, which was up a solid 3.3 per cent year-on-year in the second quarter of 2011. In addition to accelerating private consumption, business investment revived and residential investment remained very strong. The quarterly growth rate in mainland GDP – excluding oil/gas and shipping – rose to an above-trend 1.0 per cent in the second quarter and to 2.7 per cent year-on-year. A further lift was provided by a very strong (although clearly exaggerated) gain in exports of non-oil goods from the previous quarter. Growth in overall GDP was once again restrained by declining exports of oil and gas. Growth in domestic demand is likely to settle at a moderate pace, while last spring’s revival in non-oil exports should prove short-lived amid the downshift abroad. While growth in mainland GDP should pick up from 2.1 per cent in 2010, we are cutting our forecasts for 2011 and 2012 to 2.6 per cent and 3.1 per cent, respectively. Meanwhile overall GDP growth should be 1.4 per cent and 2.6 per cent this year and next. In 2013, overall and mainland GDP should be up 2.7 per cent and 3.1 per cent, respectively.

At the same time, prospects for a further labour market improvement have changed somewhat in recent months. Unemployment started to decline markedly in late 2010, with a drop in registered unemployment during the first quarter of 2011 that was the biggest in four years. The improvement has slowed since spring, however, with registered unemployment holding at 2.6 per cent in the four months to July and the Labour Force Survey (LFS) unemployment rate stabilising at 3.3 per cent, which nonetheless is very low by any measure.
Labour market is stabilising
3-month moving average
5 4 3 2 1 0 -1 -2 98 99 00 01 02 03 04 05 06 07 08 09 10 11 7.00 6.00 5.00 4.00 3.00 2.00 1.00

Employment, year-on-year percentage change (LHS) Unemployment, per cent (RHS)

Source: Statistics Norway

In part, this stabilisation reflects stalling job creation: while showing strong growth in spring, May-July employment was unchanged from the previous 3-month period, though 1.0 per cent higher than a year earlier. Moreover, the job vacancy trend has stabilised in recent months (at a high level, though) and the

40 | Nordic Outlook – August 2011

Norway

inflow of new vacancies has stagnated as well. While employment has fully recovered from its previous decline, which was a comparatively limited 1.5 per cent of the labour force from peak to trough, prospects for slower growth in activity will dent any further improvement. Hence, we expect the LFS unemployment rate to be broadly stable going forward, averaging 3¼ per cent in 2011 and 2012.

Slow global growth to weigh on exports

Investment – the second leg of the recovery

Looking at non-oil private capital spending, residential investment should continue to be positive. While housing starts showed signs of taking a breather this summer, the level in the second quarter was up a whopping 50 per cent year-on-year. However, it was still trailing behind what demographics suggest (with an added effect from continued labour immigration). The latest order data for residential buildings thus point to further growth, as do orders for other buildings.
Housing starts rising strongly
120 110 100 90 80 70 60 50 40 30 20 99 00 01 02 03 04 05 06 07 08 09 10 11 800 700 600 500 1200 1100 1000 900

Profound weakness in exports of non-oil goods has been a puzzling feature of the recovery thus far: following an initial sharp upturn in autumn 2009, such exports fell 3.0 per cent in the year to the first quarter of 2011. This subdued performance despite healthy growth in export markets might be seen as reflecting continued loss of competitiveness, since Norwegian unit labour costs have constantly increased faster than those of foreign competitors. Although this seems to be the case to a certain extent, sharp swings in exports of electricity have had an added effect on the weakness over this period. Exports of non-oil goods surged 7.5 per cent between the first and the second quarter. Again, a few special factors (first and foremost exports of electricity) exaggerated the revival, which is likely to prove short-lived amid the slowdown in Norway’s main export markets. Although growth in manufacturing export orders in the second quarter was still very solid year-on-year, admittedly affected by commodity prices since orders are measures in nominal terms, the latest Business Tendency Survey showed weakness in actual export orders. The downshift in global growth will be a negative factor ahead.
Soft momentum in manufacturing
10.0 7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5 -10.0 98 99 00 01 02 03 04 05 06 07 08 09 10 11 25 20 15 10 5 0 -5 -10 -15 -20 -25

New residential building orders, 2 quarters earlier (LHS) Housing starts in 1,000s of sq m (RHS)

Source: Statistics Norway

However, the outlook for non-oil business investment is mixed. The level of capital spending in heavily dominant service sector is rather high relative to GDP (somewhat above its long-term average), suggesting that any shortfall in overall growth will put a lid on capital spending as well. The investment ratio in manufacturing and other goods-producing sectors is below-average, though. Recent surveys suggest unchanged to only slightly higher capital spending in the manufacturing sector, while investment in the electricity supply sector is expected to be up markedly in 2011 and somewhat higher next year. In addition, capital spending in the oil sector has rebounded: while it tends to be volatile on a quarter-to-quarter basis, the 6.4 per cent increase in the second quarter built on previous gains. The spring investment survey among oil companies operating on the Norwegian continental shelf was upbeat, and a number of projects that were not included in the survey have since been approved by authorities. In all, we expect oil sector investment to be up some 12 per cent in 2011 and a further 10 per cent in 2012 (measured in volume terms). Such strong growth will lend important demand impulses to the rest of the economy. Of course, any renewed and sharp drop in oil prices will tend to lower oil sector investment, but it should come with a time lag. For example, such capital spending increased solidly in 2009 in both nominal and volume terms despite the “crash” in oil prices from mid-2008 to early 2009, but then tanked in 2010.

Manufacturing prod, y/y % change, 3 m average (LHS) Manufacturing sentiment, % of labour force, 2Q earlier (RHS)

Source: Statistics Norway

Subdued exports should thus put a lid on the manufacturing sector in the near term. Looking through the monthly variations, manufacturing production (i.e. excluding energy) has been broadly unchanged since the third quarter of 2010, despite rather positive survey-based indicators. The purchasing managers’ index (PMI) has thus held up surprisingly well, indicating stronger momentum in production. In addition, manufacturing sentiment remained well above its long-term average in the second quarter, according to the Business Tendency Survey, which on the face of it should be consistent with above-trend growth in manufacturing output. In the near-term, at least, the dichotomy is likely to be solved by weakness in survey-based indicators. However, solid domestic demand should continue to underpin production of consumer goods. The outlook for producers of investment goods is supported by rising capital spending in the oil sector, while production of intermediate goods will be most heavily affected by sluggish global growth.

Nordic Outlook – August 2011 | 41

Norway

Norway likely to fare better

The Norwegian economy should perform better than its peers in the event of a renewed global downturn, since domestic fundamentals are relatively solid. Households’ gross debt, which is at record high levels relative to income, is a concern. However, the debt-service burden is much smaller (some 5 per cent of disposable income) than in 2008 (8.5-9 per cent), since interest rates are much lower. Households have also enjoyed solid income growth in recent years, with real disposable income rising a healthy 4.5 per cent year-on-year in the first half of 2011, while the household savings ratio of 8.3 per cent as of the second quarter is well above the long-term average. That said, while the domestic demand-driven recovery has gained a firm footing, heightened uncertainty might take its toll on sentiment, lowering private consumption and business investment. Solid household fundamentals
10 8 6 4 2 0 -2 99 00 01 02 03 04 05 06 07 08 09 10 11 15 12 9 6 3 0 -3 Real disp. income ex share dividends, y/y % change, 2Q mov. av. (LHS) Household savings ratio, 2Q moving average (RHS)
Source: Norges Bank, Statistics Norway

Home-grown inflation upturn

Inflation has remained choppy so far in 2011, with no clear trend in the CPI index − due in part to volatile electricity prices. As of July, the year-on-year increase in overall consumer prices was 1.6 per cent, well below last year’s 2.5 per cent average, while the annual rate excluding electricity was also 1.6 per cent, or in line with the average rate in 2010. In addition, core consumer prices on the CPI-ATE measure – excluding taxes and energy – has been heavily affected by very volatile air fares, a small category but with occasionally very large movements and changing seasonal pattern. For example, two thirds of the drop in core inflation from 1.0 per cent to 0.7 per cent in June was due to air fares, which subsequently accounted for one fifth of the rise to 1.2 per cent in July.
Core inflation shows signs of upturn
Year-on-year percentage change
6 5 4 3 2 1 0 -1 -2 99 00 01 02 03 04 05 06 07 08 09 10 11 6 5 4 3 2 1 0 -1 -2

CPI

CPI-ATE
Source: Statistics Norway

Obviously, non-oil exports will take a hit in the event of a global downturn. Exports of oil and gas are more constrained by production on the Norwegian continental shelf, and gas exports are tied to long-term contracts. However, the blow to the economy should not be as severe as in countries more closely tied to the global cycle. Although overall exports equal 42-43 per cent of GDP, exports of non-oil goods account for a comparatively limited 16 per cent of mainland GDP. Two thirds go to other European countries and 12-14 per cent to Asia excluding Japan (1.5 times the export share to the US). As during the deep global recession in 2008 and early 2009, Norwegian authorities have the means to sustain the economy in case of a downturn. Norway is in a unique fiscal position, with a large budget surplus thanks to oil income. According to the revised National Budget unveiled in May, the overall public sector budget surplus should equal 12 per cent of GDP in 2011. Norway’s “fiscal policy rule” should not be a constraint on countercyclical measures. While the rule implies that the nonoil structural budget deficit over an economic cycle shall equal the assumed 4 per cent real return on the Government Pension Fund Global (with NOK 3 trillion in assets), it lets automatic stabilisers work by targeting the cyclically adjusted deficit. During the last downturn, the structural non-oil budget deficit thus swelled from 3.5 per cent of mainland GDP in 2008 to 5.5 per cent in 2009, or from 3.0 per cent to 4.5 per cent of the GPFG (then estimated at 5.7 per cent of the fund). Such strong fiscal stimulus is likely again in the event of a new recession.

Looking past such volatility, it seems that core CPI bottomed out last spring: in seasonally adjusted terms, the short-term rate has thus accelerated. The upturn has been most visible for Norwegian-produced consumer goods, due in part to accelerating food inflation. This should be seen as a lagging effect of the previous rise in global food and commodity prices. Meanwhile, however, there are no signs of any upturn in import prices, which on the CPI metric are still running negative, while previous NOK appreciation suggests that import goods will continue to lower consumer prices well into next year. In all, core inflation is likely to increase only slightly during the next few months, but accelerating wage growth and higher producer prices suggest that the slow uptrend will continue. The forecast for core inflation has been cut slightly to 1.1 per cent for 2011 before rising to 1.9 per cent in 2012 and 2.2 per cent in 2013, which will be close to Norges Bank’s medium-term target.

Norges Bank adjusting its rate outlook

Norges Bank has long argued that domestic factors call for higher key interest rates. Its June Monetary Policy Report thus advocated a slightly more hawkish rate path, citing risks “that a low interest rate may result in imbalances in the real economy”, in particular that tight labour markets would fuel excessive wage growth. It thus concluded “that the key policy rate should be raised further”. While perceived as one of the more hawkish central banks, Norges Bank left its deposit rate on hold for a year before lifting it to 2.25 per cent last May. It kept the rate unchanged at the August monetary policy meeting, even though domestic factors

42 | Nordic Outlook – August 2011

Norway

warranted a higher rate. While the bank thus deviated from its optimal rate path, Governor Øystein Olsen has argued that the outlook still suggests continued monetary policy normalisation and gradually higher key rates from current “low levels”. Yet Norges Bank has so far shown that global factors have gained in importance for interest rate setting. The June MPR said the rate path would depend, among other things, on whether “the debt problems facing Greece will be resolved without significant spill-over effects on other euro area countries”. This assumption clearly no longer applies, and evidence of slower global growth will affect the outlook for the Norwegian economy as well.
Norges Bank to hike cautiously
7 6 5 4 3 2 1 02 03 04 05 06 07 08 09 10 11 12 13 7 6 5 4 3 2 1

Norges Bank expects markedly wider interest rate diffentials
75 80 85 90 95 100 105 03 04 05 06 07 08 09 10 11 12 13 14 Norges Bank, MPR 2/11 forecast 350 300 250 200 150 100 50 0 -50 -100

Trade-weighted NOK (LHS) 3 m interest rate differential, Norway vs trading partners (RHS)

Source: Reuters EcoWin, Norges Bank, SEB

In a worst case-scenario, with financial markets revisiting 2008, Norges Bank is likely to cut its key rate. Obviously, any rate cuts will get less “bang for the buck”, since the deposit rate at 2.25 per cent is only 1 percentage point above its low during the previous cycle, when Norges Bank slashed its key rate by 450 bps between October 2008 and June 2009. However, any rate cuts would have some positive effects, since more than 90 per cent of mortgages in Norway are on floating rate terms.

High demand for Norwegian assets

Norges Bank deposit rate Optimal rate path, MPR 2/11

Low scenario, MPR 2/11 SEB forecast

Source: Norges Bank, SEB

We think the low scenario in the June MPR is now Norges Bank’s new baseline. This scenario implies a 25 basis point rate hike before year-end and a deposit rate at 3.50 per cent by end-2012, instead of 4.00 per cent according to the optimal rate path. The market does not believe in this alternative either, discounting rather stable rates in the coming year.

In the current market environment, the krone is viewed as a good alternative to debt-burdened safe haven currencies. This has resulted in the krone being unusual resilient amid general risk aversion and the recent slump on the Oslo Stock Exchange. Our expectations of continued slow NOK appreciation are still on track, as higher key interest rates and continued diversification flows from global foreign exchange reserve managers into high quality currencies will support the krone. We believe that the EUR/NOK exchange rate will remain in the 7.70-8.00 range until mid-2012, before a more marked strengthening takes place. By end-2012 we expect the krone to trade at 7.50 vs. the EUR and 5.00 to the USD. Norwegian government bond yields have fallen markedly lately on back of general risk aversion and increased demand from foreign investors. The very limited supply of Norwegian government bonds has resulted in yields dropping below the deposit rate. Bonds are expensive at current levels, given our deposit rate forecast. Investors seeking higher yields by switching from government bonds to triple-A rated supranational and covered bonds will likely ease the downward pressure on government bonds going forward. However, the rise in yields is likely to be modest. We expect the 10-year yield to be 2.70 per cent and 3.15 per cent by the end of 2011 and 2012, respectively. This means that the 10-year yield spread against Germany will climb to 65 basis points at year-end 2012.

Keeping an eye on market developments

So far, weaker growth abroad and wider interest rate differentials have not resulted in a stronger krone. However, renewed turbulence in financial markets has led to unusually high money market premiums, which feeds into Norges Bank’s model, due to stronger demand for USD cash. Looking ahead, the bank will remain concerned that flight to quality and wider interest rate differentials will lead to a marked appreciation of the trade weighted krone, dampening imported inflation. We expect major central banks and the Riksbank to keep their interest rates on hold through 2012, limiting the scope and pace of Norwegian rate hikes. However, Norges Bank factored in markedly wider interest rate differentials in the June MPR. Market pricing both globally and in Norway is already at depressed levels, suggesting that the bank has some room to manoeuvre. Based on our expectation of weak but positive global growth going forward, and assuming that the turbulence in financial markets will recede in the near term, we believe that Norges Bank will hike the deposit rate 25 bps to 2.50 per cent in the fourth quarter rate and cautiously raise the rate to 3.25 per cent by end-2012.

Nordic Outlook – August 2011 | 43

Finland

Economic growth will slow
ƒ ƒ ƒ Decelerating export growth Decent domestic demand will lead to declining unemployment Public sector deficit under control, but austerity programme may be needed later
and Russia (8.8 per cent), exports regained only a small portion of their recession downturn. The situation looks brighter today, despite weak performance in such important sectors as IT. Looking ahead, the outlook will be less favourable due to the international slowdown, though continued good growth in countries like Russia will provide support. Overall, exports will grow by 7.2 per cent in 2011, 5.3 per cent in 2012 and 6.1 per cent in 2013, but their level at the end of our forecast period will be lower than earlier peaks.
Leading indicators have slowed down
40 30 20 10 0 -10 -20 -30 -40 -50 -60 -70 04 05 06 07 08 09 10 11 40 30 20 10 0 -10 -20 -30 -40 -50 -60 -70

Finland showed good growth in 2010, yet its recovery has not been convincing. GDP has still not regained its levels before the 2008-2009 downturn, when the economy fell more deeply than all other euro zone countries. The future outlook has also darkened in recent months. The global economic slowdown is hurting export-dependent Finland. An unexpectedly weak first half of 2011 is another reason why we are revising our GDP forecast downward compared to Nordic Outlook in May. In the first half of 2011 growth was still above trend. This will help full-year GDP growth reach 2.9 per cent. Growth will then slow to 2.2 per cent in 2012 and 2.8 per cent in 2013. Household consumption and capital spending will be the biggest contributors to growth, while budget austerity will curb public sector consumption. Exports will not really gain momentum, and net exports will contribute little to growth.
Major swings in the Finnish economy
Quarter-on-quarter GDP percentage change
7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5 -10.0 00 01 02 03 04 05 06 07 08 09 10 11 7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5 -10.0

Manufacturing industry Service sector

Construction sector
Source: DG ECFIN

Residential investments have been an important element of the capital spending upturn. As capacity utilisation − now equal to its average for the past 20 years − has risen there has also been a degree of recovery in industrial investments, but falling optimism during the past six months has delayed the upturn. Capital spending will grow by 4.0 per cent this year, 5.3 per cent in 2012 and above 6.1 per cent in 2013.
Capacity utilisation and capital spending
87.5 85.0 82.5 80.0 77.5 75.0 72.5 70.0 67.5 65.0 62.5 00 01 02 03 04 05 06 07 08 09 10 11 -20 -30 -40 -50 20 10 0 -10

EU

Finland

Germany
Source: Eurostat, Statistics Finland, Deutsche Bundesbank

Indicators have recently weakened. The service sector indicator has levelled out and the manufacturing indicator has dropped below zero, while the construction sector has slowly crept above zero. Finland’s economy is highly exposed to other countries and its structure is cyclical (machinery, electronics and forest products are large components). International developments thus have a major impact. Exports have been equivalent to approximately 40-45 per cent of GDP in the past decade, peaking at just above that interval at 47 per cent in 2008 but falling to 37 per cent in 2009. Since then, exports have recovered somewhat but were still a bit disappointing in 2010. Despite good demand in such key export markets as Sweden (11.3 per cent of 2010 exports), Germany (9.4 per cent)

Capacity utilisation in manufacturing (LHS) Capital spending, annual % change, constant prices (RHS)

Source: Statistics Finland, OECD.

Consumer confidence has fallen in recent months, but retail sales (measured in volume terms) have continued to grow at the same pace as in the preceding quarter. Household income is benefiting from falling joblessness but has been undermined this year by high inflation. Looking ahead, real household in-

44 | Nordic Outlook – August 2011

Finland

come will improve due to job growth, inflation will fall and pay hikes will accelerate. Household consumption will climb by 2.3 per cent in 2011 and 2 per cent annually in 2012-2013. Finland’s sharp GDP decline in 2009 helped drive unemployment nearly 3 percentage points higher. Government crisis policies, including measures to prevent lay-offs, helped limit the upturn. This explains why the unemployment surge was less than the GDP decline justified. On the other hand, the phase-out of these crisis policies has slowed the downturn in the jobless rate since the beginning of 2010. The upturn in unemployment that was noted early in 2011 proved temporary, however, and the number of job vacancies indicates that the labour market situation will continue to improve.
Rising number of job vacancies - continued decline in unemployment
Per cent, thousands
9.5 9.0 8.5 8.0 7.5 7.0 6.5 6.0 03 04 05 06 07 08 09 10 11 20.0 22.5 25.0 27.5 30.0 32.5 35.0 37.5 40.0 42.5

HICP inflation has been around 3.5 per cent since early 2011. Food and energy each contribute about 1 percentage point, but due to low resource utilisation in the economy it is difficult to see any major underlying inflation pressure. Inflation will remain high this summer but gradually decline as the impact of higher food and energy prices gradually fades from the 12-month figures. Annual average HICP inflation will be 3.6 per cent in 2011 and then fall to 2.2 per cent per year 2012 and 2013. Low central government debt at the beginning of the economic crisis has been a source of strength, helping Finland avoid the need for austerity programmes. Aside from Luxembourg, Finland was the only euro zone country to show a general government deficit below the Maastricht ceiling (3 per cent of GDP) in 2010. The deficit amounted to 2.5 per cent of GDP and government debt was 50 per cent of GDP. The deficit will fall to 2 per cent of GDP this year and then continue to fall gradually to 0.6 per cent of GDP in 2013. Government debt will then stand at 46 per cent of GDP.
Public sector deficit and debt
Per cent of GDP
7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 57.5 55.0 52.5 50.0 47.5 45.0 42.5 40.0 37.5 35.0 32.5

Unemployment (LHS) Vacancies, 12-month moving average (RHS)

Source: Statistics Finland, Ministry of Employment and the Economy

Since economic growth will be around trend despite the 2012 slowdown, the number of jobs is also likely to continue climbing, albeit more slowly. In addition, the slowdown will mainly affect exports while more labour-intensive domestic demand will show more stable growth. By the end of 2011, unemployment will be a bit above 7 per cent, resulting in an annual average of 7.6 per cent. Unemployment will fall only slightly next year but faster in 2013. Annual averages will be 6.9 per cent in 2012 and 6.3 per cent in 2013. Partly due to the economic crisis of recent years, the annual rate of pay increases has fallen from around 4 per cent in 19982007 to about 2 per cent. The improved labour market situation will probably lead to faster wage and salary hikes ahead. This year’s pay increases will average just above 2 per cent, while the annual rate of increase will end up around 3 per cent in 2012-2013.
Prices and wages
Year-on-year percentage change
7 6 5 4 3 2 1 0 -1 04 05 06 07 08 09 10 11 7 6 5 4 3 2 1 0 -1

Deficit (LHS)

Debt (RHS)
Source: Eurostat

Due to comparatively strong public finances, Finland enjoys relatively solid financial market confidence. The yield spread against Germany for 10-year government bonds has admittedly widened somewhat during the market turmoil of recent weeks but is no more than 30-40 basis points. Looking further ahead, however, a budget deficit of nearly 3 per cent of GDP combined with an ageing population will make budget-tightening necessary in order to ensure strong public finances. For a small, open economy without a national monetary policy, which also exhibits great sensitivity to international crises, stable public finances are very important. Although the euro zone crisis is not merely a crisis of public finances, developments have shown that fiscal manoeuvring room is necessary. Given the accession of a broad coalition government after the April 2011 election, we believe there is little risk that Finland will oppose further bail-out packages in the euro zone. There is popular opposition that cannot be entirely ignored, but as long as Germany provides continued support for such measures, in our assessment Finland will also accept such a policy.

Prices (HICP)

Wages
Source: Eurostat

Nordic Outlook – August 2011 | 45

Economic data
DENMARK
Yearly change in per cent Gross domestic product Private consumption Public consumption Gross fixed investment Stockbuilding (change as % of GDP) Exports Imports Unemployment (%) Consumer prices, harmonised Hourly wage increases Current account, % of GDP Public sector financial balance, % of GDP Public sector debt, % of GDP FINANCIAL FORECASTS Lending rate 10-year bond yield 10-year spread to Germany, bp USD/DKK EUR/DKK Aug 25 1.55 2.40 21 5.18 7.45 Dec-11 1.55 2.30 20 4.97 7.45 2010 level, DKK bn 1,743 853 512 292 883 791 2010 1.7 2.3 0.7 -3.2 0.9 3.8 3.9 4.1 2.2 2.3 5.1 -2.7 43.6 Jun-12 1.55 2.50 20 4.87 7.45 2011 1.4 0.5 0.0 0.0 0.2 5.5 4.0 4.0 2.5 2.1 6.2 -3.0 45.0 Dec-12 1.55 2.65 15 4.97 7.45 2012 1.7 1.5 0.5 4.0 0.2 3.0 3.5 3.8 1.5 2.0 6.0 -4.0 47.5 Jun-13 1.60 2.90 15 5.14 7.45 2013 2.3 2.0 0.0 5.0 0.2 4.5 4.5 3.5 1.7 2.5 6.0 -3.0 48.0 Dec-13 2.10 3.05 15 5.32 7.45

NORWAY
Yearly change in per cent Gross domestic product Gross domestic product (Mainland Norway) Private consumption Public consumption Gross fixed investment Stockbuilding (change as % of GDP) Exports Imports Unemployment (%) Consumer prices CPI-ATE Annual wage increases FINANCIAL FORECASTS Deposit rate 10-year bond yield 10-year spread to Germany, bp USD/NOK EUR/NOK
46 | Nordic Outlook – August 2011

2010 level, NOK bn 2,257 1,760 992 498 445 992 694

2010 0.3 2.1 3.7 2.2 -7.4 3.2 -1.7 9.0 3.6 2.5 1.4 3.7

2011 1.4 2.6 2.6 2.0 7.0 1.0 -1.9 5.7 3.3 1.5 1.1 4.2 Dec-12 3.25 3.15 65 5.00 7.50

2012 2.6 3.1 3.1 2.4 7.7 -0.6 1.3 2.6 3.2 1.8 1.9 4.6 Jun-13 3.75 3.40 65 5.17 7.50

2013 2.7 3.1 3.4 2.4 5.5 -0.1 2.1 4.2 3.2 2.3 2.2 4.4 Dec-13 4.00 3.55 65 5.36 7.50

Aug 25 2.25 2.66 48 5.43 7.81

Dec-11 2.50 2.70 60 5.20 7.80

Jun-12 2.75 2.95 65 5.00 7.65

Nordic key economic data

SWEDEN
Yearly change in per cent Gross domestic product Gross domestic product, working day adjusted Private consumption Public consumption Gross fixed investment Stockbuilding (change as % of GDP) Exports Imports Unemployment (%) Employment Industrial production Consumer prices CPIF Hourly wage increases Household savings ratio (%) Real disposable income Trade balance, % of GDP Current account, % of GDP Central government borrowing, SEK bn Public sector financial balance, % of GDP Public sector debt, % of GDP FINANCIAL FORECASTS Repo rate 3-month interest rate, STIBOR 10-year bond yield 10-year spread to Germany, bp USD/SEK EUR/SEK TCW Aug 25 2.00 2.58 2.09 -10 6.31 9.09 122.7 Dec-11 2.25 2.85 2.10 0 6.10 9.15 122.6 2010 level, SEK bn 3,301 1,601 898 587 21 1,649 1,455 2010 5.7 5.4 3.4 2.5 7.1 2.1 11.0 12.8 8.4 1.0 9.6 1.3 2.0 2.6 10.7 1.3 2.5 6.2 1 -0.2 39.0 Jun-12 2.25 2.85 2.40 10 5.85 8.95 120.1 2011 4.3 4.3 2.0 0.9 10.0 0.3 8.9 7.9 7.4 2.2 9.0 3.1 1.5 2.5 10.7 2.1 2.8 6.4 -55 0.6 34.6 Dec-12 2.25 2.85 2.65 15 5.90 8.85 119.1 2012 1.4 1.8 1.5 0.9 0.0 -0.7 4.4 2.6 7.1 0.7 1.0 2.1 1.7 3.5 11.7 2.6 2.9 6.7 -11 0.2 32.7 Jun-13 2.50 3.00 3.00 25 6.00 8.70 117.2 2013 2.6 2.6 2.5 0.9 4.0 0.0 6.8 7.0 7.1 0.4 4.0 1.9 1.7 3.7 11.8 2.6 2.9 5.5 -49 0.4 30.0 Dec-13 2.75 3.25 3.10 20 6.21 8.70 117.9

FINLAND
Yearly change in per cent Gross domestic product Private consumption Public consumption Gross fixed investment Stockbuilding (change as % of GDP) Exports Imports Unemployment (%) Consumer prices, harmonised Hourly wage increases Current account, % of GDP Public sector financial balance, % of GDP Public sector debt, % of GDP 2010 level, EUR bn 180 98 44 34 73 70 2010 3.6 2.7 0.6 2.8 0.6 8.6 7.4 8.4 1.7 2.6 2.4 -2.5 48.4 2011 2.9 2.3 0.3 4.0 0.0 7.2 6.0 7.6 3.6 2.4 3.0 -2.0 48.3 2012 2.2 2.0 0.3 5.3 0.0 5.3 6.6 6.9 2.2 2.9 2.5 -1.4 47.0 2013 2.8 2.2 0.3 6.1 0.0 6.1 6.4 6.3 2.2 3.0 2.5 -0.6 46.3

Nordic Outlook – August 2011 | 47

International key economic data

EURO ZONE
Yearly change in per cent Gross domestic product Private consumption Public consumption Gross fixed investment Stockbuilding (change as % of GDP) Exports Imports Unemployment (%) Consumer prices Household savings ratio (%) 2010 level, EUR bn 9,189 5,301 2,014 1,764 3,734 3,613 2010 1.7 0.8 0.6 -0.9 0.5 10.9 9.3 10.1 1.6 9.6 2011 1.7 1.1 0.7 3.7 0.2 6.1 6.1 9.9 2.6 9.3 2012 1.0 1.2 0.3 3.4 0.0 3.6 4.5 9.6 1.5 9.1 2013 1.5 1.3 0.3 3.9 0.0 4.7 5.0 9.6 1.6 9.2

US
Yearly change in per cent Gross domestic product Private consumption Public consumption Gross fixed investment Stockbuilding (change as % of GDP) Exports Imports Unemployment (%) Consumer prices Household savings ratio (%) 2010 level, USD bn 14,755 10,417 3,020 1,818 1,935 2,436 2010 3.0 2.0 0.7 2.6 1.6 11.3 12.5 9.6 1.7 5.3 2011 1.5 2.0 -1.9 5.4 -0.1 7.6 6.2 9.1 3.1 5.1 2012 1.8 1.4 -0.8 6.8 0.0 9.8 7.8 9.4 1.7 6.0 2013 2.7 1.8 -1.0 7.9 0.3 11.8 8.2 9.1 1.3 6.7

LARGE INDUSTRIAL COUNTRIES
Yearly change in percent 2010 GDP United Kingdom Japan Germany France Italy Inflation United Kingdom Japan Germany France Italy Unemployment (%) United Kingdom Japan Germany France Italy 1.4 4.0 3.6 1.4 1.2 3.3 -0.7 1.2 1.7 1.6 8.0 5.1 7.1 9.8 8.4 2011 1.1 -0.6 3.0 1.6 0.9 4.3 -0.3 2.4 2.1 2.9 8.0 4.8 6.1 9.7 8.0 2012 1.6 2.9 1.3 1.0 0.3 2.1 0.3 1.8 1.7 1.9 8.4 4.6 5.8 9.7 7.9 2013 2.0 2.2 1.9 1.5 0.8 1.4 0.3 2.1 1.9 2.1 8.4 4.5 5.8 9.9 8.2

48 | Nordic Outlook – August 2011

International key economic data

THE BALTICS AND EASTERN EUROPE
2010 GDP, yearly change in per cent Estonia Latvia Lithuania Poland Russia Ukraine Inflation, yearly change in per cent Estonia Latvia Lithuania Poland Russia Ukraine 3.1 -0.3 1.3 3.8 4.0 4.2 2.7 -1.2 1.2 2.7 6.9 9.4 2011 6.5 4.0 6.5 4.1 4.3 4.3 5.0 4.4 4.0 4.0 8.6 9.5 2012 3.5 3.5 4.0 3.8 4.5 4.0 3.5 2.8 3.5 2.8 7.6 9.0 2013 4.0 4.5 4.5 4.3 5.0 4.5 4.5 4.0 3.5 2.9 7.8 8.5

FINANCIAL FORECASTS
Aug 25 Official interest rates US Japan Euro zone United Kingdom Bond yields US Japan Germany United Kingdom Exchange rates USD/JPY EUR/USD EUR/JPY GBP/USD EUR/GBP Fed funds Call money rate Refi rate Repo rate 10 years 10 years 10 years 10 years 0.25 0.10 1.50 0.50 2.23 1.04 2.19 2.45 77 1.44 111 1.63 0.88 Dec-11 0.25 0.10 1.50 0.50 2.00 1.00 2.10 2.50 75 1.50 113 1.67 0.90 Jun-12 0.25 0.10 1.50 0.50 2.20 1.10 2.30 2.70 73 1.53 112 1.74 0.88 Dec-12 0.25 0.10 1.50 0.50 2.55 1.20 2.50 2.90 80 1.50 120 1.74 0.86 Jun-13 0.25 0.10 1.50 0.50 2.80 1.30 2.75 3.15 90 1.45 131 1.71 0.85 Dec-13 0.25 0.25 2.00 0.50 3.10 1.40 2.90 3.30 94 1.40 132 1.67 0.84

GLOBAL KEY INDICATORS
Yearly percentage change GDP OECD GDP world CPI OECD Export market OECD Oil price, Brent (USD/barrel) 2010 2.9 5.1 1.5 11.5 79.9 2011 1.7 4.0 2.5 5.9 110.0 2012 1.8 3.5 1.6 4.9 110.0 2013 2.1 3.9 1.7 5.7 115.0

Nordic Outlook – August 2011 | 49

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This report has been compiled by SEB Merchant Banking, a division within Skandinaviska Enskilda Banken AB (publ) (“SEB”) to provide background information only. Opinions, projections and estimates contained in this report represent the author’s present opinion and are subject to change without notice. Although information contained in this report has been compiled in good faith from sources believed to be reliable, no representation or warranty, expressed or implied, is made with respect to its correctness, completeness or accuracy of the contents, and the information is not to be relied upon as authoritative. To the extent permitted by law, SEB accepts no liability whatsoever for any direct or consequential loss arising from use of this document or its contents. The analysis and valuations, projections and forecasts contained in this report are based on a number of assumptions and estimates and are subject to contingencies and uncertainties; different assumptions could result in materially different results. The inclusion of any such valuations, projections and forecasts in this report should not be regarded as a representation or warranty by or on behalf of the SEB Group or any person or entity within the SEB Group that such valuations, projections and forecasts or their underlying assumptions and estimates will be met or realized. Past performance is not a reliable indicator of future performance. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related investment mentioned in this report. Anyone considering taking actions based upon the content of this document is urged to base investment decisions upon such investigations as they deem necessary. In the UK, this report is directed at and is for distribution only to (I) persons who have professional experience in matters relating to investments falling within Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (The ‘‘Order’’) or (II) high net worth entities falling within Article 49(2)(a) to (d) of the Order (all such persons together being referred to as ‘‘relevant persons’’. This report must not be acted on or relied upon by persons in the UK who are not relevant persons. In the US, this report is distributed solely to persons who qualify as ‘‘major U.S. institutional investors’’ as defined in Rule 15a-6 under the Securities Exchange Act. U.S. persons wishing to effect transactions in any security discussed herein should do so by contacting SEBEI. The distribution of this document may be restricted in certain jurisdictions by law, and persons into whose possession this documents comes should inform themselves about, and observe, any such restrictions. This document is confidential to the recipient, any dissemination, distribution, copying, or other use of this communication is strictly prohibited. Skandinaviska Enskilda Banken AB (publ) is incorporated in Sweden, as a Limited Liability Company. It is regulated by Finansinspektionen, and by the local financial regulators in each of the jurisdictions in which it has branches or subsidiaries, including in the UK, by the Financial Services Authority; Denmark by Finanstilsynet; Finland by Finanssivalvonta; and Germany by Bundesanstalt für Finanzdienstleistungsaufsicht. In Norway, SEB Enskilda AS (‘ESO’) is regulated by Finanstilsynet. In the US, SEB Enskilda Inc (‘SEBEI’) is a U.S. broker-dealer, registered with the Financial Industry Regulatory Authority (FINRA). SEBEI and ESO are direct subsidiaries of SEB.

50 | Nordic Outlook – August 2011

Finland Norway Sweden

St: Petersburg Moskva
Russia Estonia Latvia Lithuania

New York
Dublin

Denmark

Beijing Shanghai

London Germany Luxembourg

Poland Warsaw Ukraine Kiev

New Delhi

Hong Kong

Geneve Nice

Singapore

São Paulo

SEB is a leading Nordic financial services group. As a relationship bank, SEB in Sweden and the Baltic countries offers financial advice and a wide range of financial services. In Denmark, Finland, Norway and Germany the bank’s operations have a strong focus on corporate and investment banking based on a full-service offering to corporate and institutional clients. The international nature of SEB’s business is reflected in its presence in some 20 countries worldwide. On 30 June 2011, the Group’s total assets amounted to SEK 2,201bn while its assets under management totalled SEK 1,356bn. The Group has about 17,500 employees. Read more about SEB at www.sebgroup.com. With capital, knowledge and experience, we generate value for our customers − a task in which our research activities are highly beneficial. Macroeconomic assessments are provided by our Economic Research unit. Based on current conditions, official policies and the long-term performance of the financial market, the Bank presents its views on the economic situation − locally, regionally and globally. One of the key publications from the Economic Research unit is the quarterly Nordic Outlook, which presents analyses covering the economic situation in the world as well as Europe and Sweden. Another publication is Eastern European Outlook, which deals with the Baltics, Poland, Russia and Ukraine and appears twice a year.
SEMB0066 2011.08

www.sebgroup.com

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