18feb14 Global Macro Outlook 14 15

GLOBAL RISK PERSPECTIVES

Table of Contents:

EXECUTIVE SUMMARY 1 FORECASTS FOR 2014-15: GROWING PAINS 2 FINANCIAL VOLATILITY IN SOME EMERGING ECONOMIES 4 SOMEWHAT STRONGER OUTLOOK FOR ADVANCED ECONOMIES 4 DEFLATION AND DEBT DYNAMICS 7 RENEWED FINANCIAL TURMOIL IN SOME EMERGING MARKETS 9 DOWNSIDE RISKS REMAIN RELATIVELY SUBDUED 12 MOODY’S RELATED RESEARCH 14

Analyst Contacts:

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Colin Ellis +44.20.7772.1609 Associate Managing Director [email protected]

Ruosha Li +44.20.7772.8638 Analyst [email protected]

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NEW YORK +1.212.553.1653

Elena Duggar +1.212.553.1911 Group Credit Officer - Sovereign Risk [email protected]

Richard Cantor +1.212.553.3628

Chief Risk Officer [email protected]

Bart Oosterveld +1.212.553.7914

Managing Director - Sovereign Risk [email protected]

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Global Macro Outlook 2014-15: Growing Pains

Executive Summary

After the global financial crisis and subsequent recessions in advanced economies, the pace of recovery in global activity was weak, compared with recoveries from past downturns. In part, this reflected the fact that financial crises often leave deep and lasting scars on national income. Emerging market economies picked up the baton of growth following the initial stabilization of banking sectors during 2009, but more recently this impetus waned in the face of nascent headwinds to growth such as the prospective removal of monetary stimulus measures. However, advanced economies now appear to have reached a genuine turning point, with several set for robust growth over the coming years. Over the medium term, that should support a gradual strengthening in emerging markets; but in the shorter term, the ongoing adjustment in capital flows as investors rebalance portfolios continues to pose challenges for several emerging economies. As such, stronger growth in advanced economies is likely to be associated with further painful adjustments in some emerging markets. Downside risks to the outlook for global growth remain, but are relatively small compared with some recent adverse scenarios.

In the G-20 advanced economies, data revisions have indicated a somewhat stronger growth trajectory in the US and the UK, while the euro area still looks set for a more gradual economic recovery. With Japan exiting deflation, and other advanced economies such as Australia and Canada continuing to expand, the overall outlook remains one of a gradual acceleration in economic activity over the coming two years. Overall, we expect real GDP growth in the advanced G-20 economies to be around 2.3% this year, and around 2.5% in 2015. This is a little stronger than in our November 2013 forecasts.

After the deterioration in near-term growth prospects associated with private capital outflows during 2013, emerging market economies appear to have diverged somewhat more recently. Some larger economies, such as China and India, have reported reasonably robust growth. But other economies, such as Turkey and Argentina, have seen renewed financial turmoil. Overall, the broad outlook for emerging economies is little changed from our November 2013 forecasts, notwithstanding further weakness in some emerging markets. We expect real GDP growth in the emerging G-20 economies to be around 5% this year, before rising towards 5.5% during 2015.

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GLOBAL RISK PERSPECTIVES: GLOBAL MACRO OUTLOOK 2014-15: GROWING PAINS

Compared with the past five years, Moody’s believes that the overall magnitude of risks around its central economic scenario remains relatively low. Particular concerns relate to the timing and impact of the gradual and necessary normalization of US monetary policy, and potential spillover effects on other countries such as emerging market economies with large current account deficits. At the same time, while market conditions have also stabilized in the euro area over the past 18 months, the debt crisis remains far from resolved. At this juncture, an immediate renewed flare-up in the euro area crisis seems unlikely, but the region faces deflationary risks as banks in many countries remain unable to fund a stronger pace of economic recovery. Concerns also remain about China’s ability to induce a managed slowdown in its property and credit markets, and the potential impact of the April 2014 hike in Japan’s consumption tax rate. Geopolitical risks also remain elevated in several regions.

Moody’s Global Macro Outlook underpins our universe of ratings, providing a consistent benchmark for analysts and investors. This report is an update to our November 2013 Global Macro report.1 It reviews key recent developments, provides an update on our central forecasts for 2014-15, and discusses the key risks around our forecasts.

Forecasts for 2014-15: Growing pains

Global synthesis

The financial crisis and subsequent recessions in advanced economies cast a long shadow over the global economy. Policymakers’ initial focus was to step in to support the banking sector and put a floor under economic activity, by recapitalizing banks, running fiscal deficits and resorting to less conventional monetary stimulus measures. But the capacity for fiscal support, in particular, was limited in many instances, and several advanced economies subsequently instigated austerity measures that weighed on economic growth. At the same time, emerging market economies initially rebounded well from the global slowdown, but growth then faltered in the face of relatively weak external demand. However, after several years of slow and bumpy progress, it now appears as if advanced economies have reached a genuine turning point. The outlook for the US and UK in particular is brighter than previously thought, with recent revisions to past data painting a stronger picture than was originally reported. Over the medium term, stronger external demand from advanced economies will also bolster emerging market growth. But in the short term, investors are still reallocating capital in the face of the prospective (yet eventual) normalization of US monetary policy. As such, some emerging markets have continued to see declines in exchange rates and rises in market yields, with several central banks hiking policy rates in an effort to contain inflationary pressures. This suggests that stronger growth in advanced economies will probably also engender further monetary tightening in some emerging markets, weighing on near-term growth prospects.

Given the somewhat stronger outlook for advanced economies, our current growth forecasts are a little higher than those presented in the previous Global Outlook published in November 2013. Real GDP growth in the G-20 economies (weighted by nominal GDP at market exchange rates) is expected to be around 3¼% in 2014, followed by around 3.5% in 2015.

Overall, Moody’s judges that the uncertainties around the growth outlook remain relatively subdued, compared with the substantial risks seen in recent years. In particular, some of the large global risks – such as the euro area debt crisis, and US fiscal deadlock – have significantly receded. Many of the risks around the macroeconomic outlook now relate to country-specific factors such as the impact of the increase in consumption taxes in Japan, or the potential for disruption arising from strong credit growth and property price rises in China. Even the prospective normalization of US monetary policy is now having more of a differentiated impact on emerging markets. It seems unlikely that the crystallization of any single country-specific risk, by itself, could derail the global economy over the

1 See ‘Global Macro Outlook 2013-15: Navigating towards calmer waters’ (159743), 12 November 2013.

http://www.moodys.com/viewresearchdoc.aspx?docid=PBC_159743

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coming two years. Instead, it would probably take a combination of different shocks to blow the recovery off course.

EXHIBIT 1

Moody’s Central Forecast Scenarios for 2014-15

Notes: Green shading denotes improvement from the November 2013 update, orange denotes deterioration. Blue shading denotes considerable forecast uncertainty relative to historical GDP volatility. GDP growth figures are reported on a market price basis, and data for 2013 are Moody’s estimates where official statistics have not yet been published. [1] G-20 All includes the 19 individual countries that comprise the G-20, weighted by nominal USD GDP shares. G-20 Advanced includes Australia, Canada, France, Germany, Italy, Japan, South Korea, the UK, and the US. [2] The percentage point difference between the highest and lowest forecasts of sources such as the International Monetary Fund (IMF), World Bank, Organization for Economic Co-operation and Development (OECD), European Commission, J.P. Morgan, Barclays, and Moody’s Analytics. [3] The standard deviation of real GDP growth over the 15 years to 2012. [4] In February 2012, the IMF approved a decision calling on Argentina to implement specific measures to address the quality of reported GDP and Consumer Price Index data; on 1 February 2013, the IMF’s Executive Board found that progress had not been sufficient and issued a declaration of censure against Argentina under its Articles of Agreement. On 9 December 2013, the Executive Board adopted a decision calling on Argentina to implement specified actions to improve official data, including an initial set of actions by end-March 2014.

We present our central scenario in Exhibit 1 and highlight the following factors:

» We express our forecasts for annual GDP growth and unemployment as a range of one percentage point (ppt) to avoid spurious precision and to focus on significant changes that could potentially influence rating decisions.

» We indicate the level of uncertainty for our central forecasts, presenting ranges from the forecasts that we survey and comparing them to the historical standard deviation of real GDP growth. The blue shading in Exhibit 1 denotes countries with greater forecast uncertainty relative to historical GDP volatility.

2012 2013 [E]Growth central range

Unemp't central range

Growth central range

Unemp't central range

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range [2]

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[3]

Argentina [4] 1.9 3.5 2.5/3.5 -- 2.5/3.5 -- 2.6 5.5 6.3

Austra l ia 3.7 2.3 2.0/3.0 5.0/6.0 2.5/3.5 5.0/6.0 0.6 1.1 1.0

Brazi l 0.9 2.5 2.0/3.0 -- 2.5/3.5 -- 0.7 2.4 2.4

Canada 1.7 1.7 2.0/3.0 6.5/7.5 2.0/3.0 6.5/7.5 0.4 0.5 1.9

China 7.7 7.7 7.0/8.0 -- 7.0/8.0 -- 0.4 1.0 1.9

Euro area -0.6 -0.4 0.5/1.5 -- 1.0/2.0 -- 0.5 0.4 2.0

France 0.0 0.3 0.5/1.5 10.5/11.5 1.0/2.0 10.5/11.5 0.6 0.5 1.7

Germany 0.9 0.4 1.0/2.0 5.0/6.0 1.0/2.0 5.0/6.0 0.3 0.6 2.3

India 3.2 3.8 4.5/5.5 -- 5.5/6.5 -- 2.9 1.5 2.4

Indones ia 6.2 5.3 5.0/6.0 -- 5.5/6.5 -- 1.4 1.6 4.9

Ita ly -2.4 -1.9 0.0/1.0 12.0/13.0 0.0/1.0 12.0/13.0 0.5 0.9 2.2

Japan 2.0 1.6 1.0/2.0 3.5/4.5 1.0/2.0 3.5/4.5 0.6 0.9 2.4

Mexico 3.6 1.2 2.5/3.5 -- 3.0/4.0 -- 2.4 1.1 2.6

Russ ia 3.4 1.5 1.5/2.5 -- 2.0/3.0 -- 0.8 1.3 4.9

Saudi Arabia 5.1 3.6 3.5/4.5 -- 3.5/4.5 -- 0.9 0.4 3.1

South Africa 2.5 2.0 2.5/3.5 -- 2.5/3.5 -- 0.5 0.5 1.9

South Korea 2.0 2.8 3.0/4.0 -- 3.0/4.0 -- 0.6 0.6 3.8

Turkey 2.2 4.1 2.0/3.0 -- 3.0/4.0 -- 0.9 1.6 5.1

UK 0.3 1.9 2.0/3.0 6.5/7.5 2.0/3.0 6.0/7.0 0.9 1.5 2.4

US 2.8 1.9 2.5/3.5 6.0/7.0 2.5/3.5 5.5/6.5 0.4 0.8 2.0

G-20 All 2.9 2.6 3.0/4.0 -- 3.0/4.0 -- -- -- --

G-20 Advanced 1.8 1.4 2.0/3.0 -- 2.0/3.0 -- -- -- --

G-20 Emerging 5.1 5.0 4.5/5.5 -- 5.0/6.0 -- -- -- --

Countries [1]

Past growth 2014F 2015F Forecast uncertainty measures

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Financial volatility in some emerging economies

Financial markets have been decidedly mixed in recent months. The US Federal Reserve started tapering its asset purchases in January 2014, but long-term government bond yields in advanced economies took this in their stride, with a much more muted reaction than was seen in the wake of initial discussions around tapering last May (Exhibit 2). Over the longer term, these yields should rise further as economic recoveries strengthen and central banks start to normalize monetary conditions. However, there is considerable uncertainty around the precise timing of these necessary increases in yields.

EXHIBIT 2

Ten-year government bond yields Jan 2013-Feb 2014

Source: Haver Analytics.

EXHIBIT 3

Bilateral exchange rates versus the US dollar Jan 2013-Feb 2014; 1 November 2013 = 100


The relative stability of advanced economy yields has been broadly mirrored in commodities, with prices of many global benchmarks exhibiting little significant trend in recent months. Oil prices have picked up slightly since November 2013, but over the medium term Moody’s still expects prices to decline gently.

In contrast, financial markets in some emerging economies have seen considerable volatility recently. While some countries have seen less pronounced fluctuations in exchange rates than those seen last year (Exhibit 3), individual countries such as Argentina and Turkey have still experienced significant currency declines. In many instances, monetary policy makers in emerging markets have raised interest rates to counter the inflationary risks associated with falls in exchange rates.

Somewhat stronger outlook for advanced economies

The outlook for advanced economies as a whole is similar to our previous assessment, with a gradual strengthening in growth likely over the coming years. However, recent data revisions have indicated a somewhat stronger pace of recovery in the US and the UK in particular, which should provide some further impetus to the global recovery. Overall, we expect the G-20 economies to grow by around 2.3% in 2014, followed by 2.5% in 2015. This is a little stronger than in our November 2013 forecasts.

In the United States, economic growth eased at the end of last year, with GDP increasing at an annualized rate of 3.2% in the fourth quarter according to the preliminary estimate. However, the pace of growth earlier in the year was also revised up significantly, such that US GDP expanded by

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1.9% during 2013 as a whole, somewhat stronger than previously expected. Although non-residential investment decelerated during the year, it still increased by 2.6% during 2013 as a whole, while residential investment rose 12%. The housing market has played an important role in the broader US recovery, with building starts and prices both accelerating during 2013 (Exhibit 4).

EXHIBIT 4

US housing market indicators Jan 2003-Dec 2013


EXHIBIT 5

US labor market metrics Jan 1996-Jan 2014


At the same time, there has also been further positive news from the labor market. Non-farm payrolls increased at an average pace of 154K a month over the three months to January, while the headline unemployment rate fell to 6.6%, the lowest since October 2008. However, while the decline in joblessness partly reflects further hiring by firms, consistent with stronger economic growth, it is also due to workers becoming discouraged and leaving the labor force (Exhibit 5). Long-term unemployment also remains high. Both of these factors will impede potential supply over the medium term, as a prolonged period of non-employment leads to workers’ skills eroding over time. However, as the recovery gathers momentum more workers may rejoin the labor market, limiting this erosion and helping to contain any nascent inflationary pressures.

The recent performance of the US economy is more remarkable given the considerable fiscal squeeze that hit economic growth last year. The sequestration cuts and other fiscal measures are likely to have shaved around 1.5 percentage points (ppts) off calendar-year growth during 2013. This suggests that the private sector saw a robust underlying recovery last year, and that activity should accelerate over the forecast horizon as fiscal drag subsides. Policymakers agreed the outline of a two-year federal budget in December 2013, and recently suspended the debt limit until March 2015. With the Federal Reserve now also tapering its purchases of financial securities, the broad picture for the US economy is one of a gradual normalization of fiscal and monetary policy over several years, against a backdrop of robust growth.

In contrast, any normalization of monetary policy in the euro area still looks quite distant. Euro area GDP expanded by 0.3% on the quarter during Q4 2013, after near-stagnation across the single currency area during the third quarter of last year. Although considerable progress has been made to reduce fiscal deficits in many countries, several peripheral member states are still struggling to reduce high government borrowing and unemployment. Spain managed to register weak positive GDP growth during the second half of 2013, but the unemployment rate remains above 25% and both it and Italy still face slow and bumpy paths towards sustainable fiscal positions and lower rates of joblessness. In addition, the French and German economies both decelerated following robust growth in the second quarter of 2013 (Exhibit 6). This has raised concerns about the ability of the region’s

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larger countries to support growth throughout the single currency area as a whole, as softer growth prospects in core countries will resonate throughout the rest of Europe.

EXHIBIT 6

GDP growth in euro area countries Q2 2013-Q4 2013

Source: Eurostat.

EXHIBIT 7

Euro area CPI inflation rates Jan 2006-Dec 2013


Deflationary concerns have also resurfaced in recent months. Faced with unsustainable current account deficits, many peripheral euro area countries have cut nominal prices and wages in order to regain export competitiveness within the confines of the single currency. Ideally, this process of so-called internal devaluation should now be coming to an end, with many countries likely to run balanced current accounts during 2014. However, it is possible that the recent weakness of wages and prices has affected near-term inflation dynamics in the euro area. Headline CPI inflation fell to just 0.7% in January 2014, and core inflation – which excludes volatile items such as energy and food – was just 0.8%. With inflation now closer to zero than the European Central Bank (ECB) target of below (but close to) 2%, there is a risk that nascent deflationary tendencies in some peripheral countries could become entrenched across the euro area as a whole. Countries such as Ireland and Greece have already experienced some degree of deflation (Exhibit 7), which in turn has increased the real burden of debt for households and businesses, as discussed in Box 1. Left unchecked, deflation could significantly increase financial fragmentation in the single currency region and bring the risk of breakup back to the fore, as individual countries become unable to control real debt dynamics.

In light of this, the ECB may decide to take further steps to support the economy and prevent the euro area from slipping into outright deflation. The ECB’s balance sheet has been shrinking as a result of some banks’ reduced reliance on central bank funding, and the recent rise in short-term market interest rates relative to policy rates was indicative of a modest tightening in monetary conditions. With the main refinancing rate already at 0.25%, and several long-term refinancing operations still outstanding, members of the ECB Governing Council have recently discussed potential further measures to support activity and offset deflationary risks, including facilitating small and medium-sized enterprises’ access to capital markets.

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Box 1: Deflation and debt dynamics

At the start of the financial crisis, a key concern for policymakers in advanced economies was to avoid the onset of deflation – outright and sustained declines in the general price level. The risk of deflation was exacerbated by the significant falls in domestic demand as recessions took hold, which left excess spare capacity in many economies. In turn, the prospect of falls in the general price level can lead to consumers and businesses delaying purchases in expectation of cheaper prices, further weighing on domestic demand.

Apart from the normal effects arising from weak aggregate demand, such as rising unemployment and credit defaults, deflation can also lead to other consequences. For instance, deflationary risks may force a central bank to use less conventional forms of monetary stimulus if the short-term policy rate approaches zero; such responses have been seen both in the US and the euro area, and in other advanced economies, since 2008.

A more troubling aspect of deflation is the role it can play in exacerbating debt burdens and financial stress. Deflation increases the real value of debt, thereby putting more strain on debtors as it makes it more expensive to service and repay past borrowings. For loans and bonds that are denominated in nominal terms, as is usually the case, a general fall in the price level will redistribute wealth from debtors to creditors. In turn, this will likely lead to a further fall in aggregate demand, given the lower marginal propensity to consume among creditors than debtors.

Such an increase in the real burden of debt would also likely engender increased financial stress among households and businesses, which in turn would further impede economic growth. The increase in real debt burdens, coupled with the probable deterioration in activity, would hit corporate and household balance sheets, leading to an increase in non-performing loans and a deterioration in banks’ balance sheets. As such, deflation can swiftly result in a negative feedback loop between households, businesses and banks, making it difficult to reflate the economy. Japan’s experience with persistent mild deflation since the late 1990s is often cited in this context.

Current concerns about deflation seem more pressing in the euro area than in the US. While inflation rates are currently close to zero in both economies, the deflationary impetus in the euro area is more prevalent given the internal devaluation processes seen in many peripheral member states. In addition, while US bank balance sheets have largely recovered from the financial crisis, the health of many euro area banks remains highly uncertain; these concerns are unlikely to be addressed before the conclusion of the ECB’s comprehensive assessment of the banking system. Furthermore, outright deflation would significantly increase pressure from financial markets on governments that are still wrestling with unsustainable fiscal positions, potentially raising the likelihood of a country leaving the single currency.

One option that the ECB has resisted thus far is the purchase of government bonds through its Outright Monetary Transactions (OMT) program. The question of the legal standing of the program was recently referred to the European Court of Justice by the German constitutional court.2 This is in contrast to the likes of the US Federal Reserve, the Bank of England, and in particular the Bank of Japan (BoJ), where Governor Kuroda has been pursuing a more aggressive monetary policy stance since he took office in March 2013. The BoJ has continued in its pledge to expand the monetary base by between ¥60 and ¥70 trillion a year, purchasing Japanese Government Bonds (JGBs) in an effort to raise inflation expectations. Progress has been encouraging, with CPI inflation rising to 1.6% in

2 See ‘German Court Casts Doubt on ECB Bond-Buying Program, a Credit Negative for Euro Area Sovereigns’ (165076), 17 February 2014.


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December 2013 and core inflation also turning positive, as the weaker exchange rate has fed through to consumer prices. In the short term, inflation should jump higher in April 2014 when the planned increase in the sales tax is implemented, echoing a similar tax hike in 1997 (Exhibit 8). However, this effect should prove temporary, as the increase in the sales tax represents a relative price shift rather than persistent underlying inflationary pressure. The broader risk is that growth stutters once the tax rate is raised, with consumers having brought forward spending prior to its implementation; Japan’s GDP expanded by 0.3% in Q4 2013, a weaker pace of growth than seen during the rest of the year. Meanwhile, the government’s efforts to enact structural reforms have borne little fruit thus far, raising concerns about Japan’s ability to sustain GDP growth above 1% a year over the medium term.

EXHIBIT 8

Japanese CPI inflation measures Jan 1995-Dec 2013

(a) Excluding food and energy. Source: Haver Analytics and Moody’s Investors Service.

EXHIBIT 9

UK public sector net borrowing (a) Financial Year 2009/10-Financial Year 2018/19

(a) Excluding Royal Mail and Asset Purchase Facility transfers. Source: OBR.

In the United Kingdom, recent data revisions have also painted a more robust picture of recovery than was previously the case. According to the preliminary estimate, UK GDP expanded by 0.7% during Q4 2013. Together with the recent revisions, this implies that the economy expanded by 1.9% during 2013 as a whole. That represents the UK’s fastest pace of growth since 2007, albeit still weaker than its long-run average growth rate. Due in part to timing effects, whereby the stronger pace of growth during 2013 lifts the calendar-year growth rate in 2014, UK GDP is likely to expand at a robust pace over the coming two years. However, following the sharp slowdown in deficit reduction over the past two years (Exhibit 9), fiscal drag will intensify again during the coming financial year, weighing on economic activity. Concerns also remain about the unbalanced nature of the UK’s recovery, with business investment still almost 25% below its pre-recession peak. Alongside the recent sharp decline in unemployment, this is consistent with most of the recent weakness in productivity being permanent, rather than cyclical.

Other advanced economies have seen steady expansion in recent quarters, with Canada, Australia and South Korea all set to report positive growth throughout 2013. With many other countries likely to see some acceleration in activity over the coming two years, these smaller and relatively open advanced economies should benefit from the stronger tailwinds that ensue.

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Renewed financial turmoil in some emerging markets

After the widespread deterioration in near-term growth prospects associated with private capital outflows during the summer of 2013, prospects for emerging market economies have diverged somewhat more recently. Some countries, such as Turkey and Argentina, have seen renewed turmoil in financial markets as investors continue to reassess their portfolios in the wake of tapering by the Federal Reserve. However, the impact on other countries has been less pronounced, consistent with greater differentiation by market participants, which in turn is likely to reflect different underlying economic conditions and policy choices.3 As such, our overall outlook for emerging markets is little changed from November 2013, and we expect real GDP growth in the emerging G-20 economies to be around 5% this year, before rising to 5.5% during 2015.

In China, the official estimate of GDP indicated that the economy grew by 7.7% during 2013 as a whole, unchanged from growth in 2012. While this is somewhat slower than in 2010 and 2011, it still represents robust growth. In the short term, the Chinese authorities are likely to continue to support activity. The People’s Bank of China acted to ease credit concerns in December by increasing its funding provision to the banking system, and the authorities are likely to respond in a similar fashion if credit risks crystallize. For now, near-term indicators of growth such as investment spending suggest that economic momentum is likely to be sustained in 2014, with wholesale and retail sales accelerating during 2013. Over the longer term, however, China’s sustainable growth rate is likely to decline as the marginal return on capital declines and the population ages. This could support a rebalancing of the economy away from investment and saving towards consumption, reversing the trend of the past decade (Exhibit 10).

One recent uncertainty surrounding the Chinese economy has been the extent of local government borrowing. While central government borrowing remains relatively low, it was unclear how much local governments had been relying on debt to support regional development and investment. This uncertainty has been tempered following an updated assessment of local government debt and contingent liabilities by the National Audit Office (NAO) in December 2013. Total local government debt and liabilities were much higher than in 2011, suggesting that the central government may need to provide additional fiscal support to local governments. However, even with this extra funding requirement China’s general government financing needs remain relatively moderate, particularly set against the continuing rapid rise in nominal GDP.4

3 See ‘Credit Implication of Emerging Market Volatility Depends on the Credibility of Policy Choices’ (163779), 3 February 2013. 4 See ‘New Report Shows Sizeable Debt Accumulation by China’s Local Governments, a Credit Negative’ (162145), 3 January 2014.



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EXHIBIT 10

Composition of Chinese GDP 1994-2012


EXHIBIT 11

Effective interest rate relative to nominal GDP (a) 2004-2013

(a) Effective rate paid on government debt minus nominal GDP growth. Source: IMF and Moody’s Investors Service.

After a period of relatively weak growth during 2013 H1, the Indian economy accelerated during the third quarter, bolstering expectations that the recent downturn will prove short-lived. At the same time, recent increases in policy interest rates – including the further 25 basis point (bp) tightening in January – and the substantial rise in long-term yields over the past nine months will weigh on domestic growth prospects. However, despite the slowdown in growth, and the rise in long-term yields, financing conditions for government debt remain more favorable than in many other emerging markets. In particular, India’s relatively long maturity profile means that the effective interest rate on government debt has not risen with long-term yields, thus supporting the government’s ability to fund itself.5 Furthermore, the effective interest rate remains low, relative to nominal GDP growth (Exhibit 11). As such, Indian policymakers have somewhat more leeway than their peers to support the economy in the face of further movements in the exchange rate and long-term yields. However, progress on necessary structural reforms remains slow, which will impede any acceleration in economic activity.

Turkey has seen a sharp tightening in financial conditions over the past eight months, with ten-year government bond yields exceeding 10% in January – a rise of almost 400 basis points (bps) in less than a year, more pronounced than in other major emerging markets (Exhibit 12) – and a sharp depreciation in the lira. In response, the Central Bank of Turkey significantly raised policy rates in late January to contain inflationary pressures. While this should help limit currency volatility and the risk of a balance-of-payments crisis, it has also significantly weakened prospects for Turkish economic growth over the near term.6

5 See ‘India’s Government Debt Structure Mitigates Credit Impact of Macro-Economic Imbalances’ (160589), 8 January 2014. 6 See ‘Turkey: Central Bank’s Monetary Tightening Will Alleviate Foreign-Exchange Pressures, But Downside Risks Persist’ (163639), 30 January 2014

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EXHIBIT 12

Emerging market long-term bond yields April 2013-February 2014

(a) Domestic currency terms. Source: Haver Analytics.

EXHIBIT 13

Indonesian exports and world trade Q1 2003-Q3 2013; Q1 2003 = 100

Source: Haver Analytics and CPB Netherlands Bureau for Economic Policy Analysis.

Indonesia is the third largest developing economy in Asia, representing a market of 250 million people. During the past two years, the country has run modest current account deficits as capital investment from abroad has sought to develop and market the country’s sizeable natural resources. While this meant that policymakers were forced to spend foreign-exchange reserves to limit the decline in the rupiah in the wake of market concerns about US tapering, its subsequent stabilization should support growth in the coming years, by boosting exports. While risks remain, Indonesia looks set for a somewhat swifter bounceback in growth than some other Asian economies, given the strong linkage between exports and world trade (Exhibit 13) and the more robust outlook for global growth.

Near-term prospects for the Brazilian economy remain subdued. As the largest economy in Latin America, accounting for just under 40% of regional GDP, Brazil is a critical engine of regional growth. During 2013, economic activity was weaker than first expected, reflecting businesses’ reluctance to invest and persistently high inflation eroding households’ spending power. The central bank’s recent efforts to contain inflationary pressure, which have seen it raise the Selic target rate by over 300bps in the past year, will also weigh on domestic demand. While final construction work ahead of the FIFA 2014 World Cup and the tournament itself may provide some modest spur to activity this year, there are increasing signs that growth may struggle to return to its pre-crisis pace. Indeed, concerns remain about the long-term sustainable growth rate of the Brazilian economy, with recent falls in productivity growth probably reflecting poor infrastructure and skills. The private sector’s limited appetite for risk is also likely to persist, constraining the ratio of investment to GDP and thereby weighing on potential supply. As such, Brazil looks likely to see relatively lackluster economic growth over the coming two years.

Argentina is currently experiencing a pronounced repricing of its economy. The peso depreciated by a third against the US dollar during 2013, and subsequently plunged by 17% in one week last month as the government eased currency controls and the central bank limited its market interventions in order to preserve exchange reserves. Haphazard policymaking is likely to perpetuate uncertainty and exacerbate anxiety, while the poor state of official statistics in Argentina, despite the continued pressure from the IMF, is likely to have amplified investor caution. Until investor confidence improves, economic prospects are likely to remain negative.

Elsewhere, near-term growth prospects in Russia remain weak, with policymakers still striving to boost competition and provide support to smaller businesses in an effort to diversify activity. The Winter

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Olympics in Sochi are unlikely to provide any significant macroeconomic boost.7 Economic prospects in Central and Eastern Europe are broadly unchanged from November, with the likes of Poland and the Czech Republic having come through the recent downturn in relatively good shape. Developing Asian economies remain tied to developments among their larger peers, and as such are also likely to see some pickup in growth over the next two years. Smaller Latin American nations, meanwhile, should benefit from stronger US growth, although any softness in commodity prices will weigh on exporters such as Peru. Sub-Saharan Africa still looks set for a robust pace of expansion, notwithstanding the recent slowdown in South Africa, where the central bank has also raised interest rates in an effort to limit the inflationary consequences associated with the decline in the rand.

Downside Risks Remain Relatively Subdued

The forecasts presented above represent Moody’s central outlook for the global economy. However, there are numerous risks around that central view, which could impact on activity, unemployment and credit quality. Overall, Moody’s judges that the uncertainties around the economic outlook remain subdued, compared with the substantial risks seen in recent years. But there are several scenarios that would result in weaker activity and creditworthiness.

A key risk for the US economy relates to the US Federal Reserve’s efforts to normalize monetary policy. This process will be slow and gradual, with the Fed’s balance sheet likely to expand for much of 2014, and the target Fed Funds rate only likely to increase by late 2015 at the earliest. However, the forward-looking nature of financial markets makes it likely that increases in US Treasury (UST) yields may materialize more quickly. Given the importance of long-term rates for the nascent US housing recovery, in particular, the Fed will need to strike a careful balance between nurturing recovery and gradually unwinding its monetary stimulus. At the same time, if the Fed proves too cautious in tightening policy, it could unwittingly engender new bubbles in asset prices. This would represent an upside risk to growth and inflation over the short to medium term; but a downside risk to activity over the longer term when these bubbles eventually burst.

Fed tapering could also hit emerging market economies more severely than currently envisaged. Long-term bond yields in many countries have risen over the past year, tracking UST yields higher, and spreads over US yields have widened in many emerging markets. Those countries that are most exposed to rises in rates are also vulnerable to capital flight, often reflecting a high dependence on capital inflows to fund existing current account deficits. Recent events in Turkey and Argentina, in particular, have re-illustrated the potential for disorderly financial corrections. While other countries may face less stark adjustments, further currency declines and associated rises in both long-term yields and policy rates are likely in several economies. Over the longer term, falls in exchange rates should help curb current account deficits and rebalance economic activity. But in the short term, the likely use of measures to stabilize financial conditions will weigh on GDP growth.8 As capital inflows diminish, there is also a risk that it becomes apparent that these economies are more dependent on foreign funding to drive growth than expected; as a result, potential growth could turn out to be weaker than previously thought.

While financial conditions in the euro area have stabilized over the past 18 months, there are remaining risks to growth and macroeconomic stability arising from the euro area debt crisis. The implications of the ongoing comprehensive assessment of European banks for the credibility of the ECB, and by extension the wider European Banking Union project, remain to be proven.

7 See ‘Sochi 2014 Winter Olympics: Uncertainty over Long-term Legacy Overshadows Benefits’ (163533), 5 February 2014. 8 See ‘Credit Consequences of US Monetary Tightening’ (158462), 30 September 2013.



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Furthermore, in the absence of an agreement on how to provide communal support to institutions with legacy assets, governments may need to provide further financial support to their banking sectors. Without improvements in the ability of banks to fuel the economic recovery with credit, the euro area remains vulnerable to a renewed flare-up in the sovereign debt crisis. However, at present it is difficult to see this risk materializing over the next 12 months, as it would probably take some combination of shocks to result in conditions deteriorating substantially.

At the same time, there is a risk that deflation takes hold in the euro area. With prices already falling in Greece, and only negligible inflation in Spain, Ireland and Portugal, it would only take a modest downside shock to prices to push the aggregate euro area inflation rate below zero. If deflation became entrenched, it would significantly damage borrowers’ ability to repay their debts, potentially leading to further financial distress in the region. In the absence of full-blown quantitative easing, the ECB’s ability to mitigate these deflationary risks could prove limited.

In Asia, the key risks relate to the two largest economies. In China, concerns remain about the pace of property price increases and credit provision. With official estimates suggesting that almost a third of aggregate financing is now provided by the shadow banking sector, a potential dislocation in financial and credit markets could have serious consequences. Thus far, the Chinese authorities have been able to respond to these risks as they threaten to crystallize; China’s key advantage, relative to some other economies, is its ability to mobilize resources when it needs to. With the world’s largest stock of currency reserves, and a still-robust growth trajectory, the country looks well placed to cope with these risks. However, any substantial liquidation of assets, perhaps in response to unexpected bank losses or local government funding problems, could also have implications for the exchange rate, thereby complicating policymakers’ options.

Meanwhile, the upcoming April 2014 increase in the Japanese consumption tax rate could hit economic activity. While the impact would likely be short-lived, it could also threaten the popular consensus for the various reforms that policymakers hope to implement. With many of these structural changes still yet to materialize, political stagnation in the face of households choosing to tighten their purse strings could soon be reflected in weaker longer-term economic prospects. In addition, the continuing dispute between China and Japan over the Senkaku-Diaoyu islands could escalate, with potentially dramatic consequences for regional trade.

North Korea also poses a singular geopolitical risk, as the recent lowering in tensions has not yet led to a normalization in relations on the peninsula. Ongoing conflict in the Middle East could also have a global impact, if the war in Syria or domestic turbulence in Egypt were to spillover to neighboring countries and threaten oil supply from the region. Similarly, ongoing discussions to limit Iran’s nuclear capabilities could suffer a setback. While relations between Iran and the six countries leading the negotiations about its nuclear ambitions and associated sanctions have recently improved, the situation remains combustible, particularly in the face of Israeli unease.

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Moody’s Related Research

Recent Global Macro Risk Scenarios:

» Global Macro Outlook 2013-15: Navigating towards calmer waters, November 2013 (159743)

» Update to Global Macro Outlook 2013-14: Rising yields dampen recovery, August 2013 (156821)

» Update to Global Macro Outlook 2013-14: Loss of Momentum, May 2013 (153268)

» Global Macro Outlook 2013-14: Downside Risks Have Diminished, February 2013 (149555)

» Update to the Global Macro Risk Outlook 2012-14: Slow Adjustment to Weigh on Growth, November 2012 (146944)

Selected Sovereign Research:

» German Court Casts Doubt on ECB Bond-Buying Program, a Credit Negative for Euro Area Sovereigns (165076)

» Sochi 2014 Winter Olympics: Uncertainty over Long-term Legacy Overshadows Benefits (163533)

» Credit Implication of Emerging Market Volatility Depends on the Credibility of Policy Choices (163779)

» Turkey: Central Bank’s Monetary Tightening Will Alleviate Foreign-Exchange Pressures, But Downside Risks Persist (163639)

» Argentina Devaluation Is Credit Negative for Banks, Corporates, Insurers and Securitizations and No Sovereign Panacea, January 2014 (163343)

» Below-Trend Growth in Brazil Presents Limited Credit Risks to Rest of Latin America, January 2014 (163059)

» Egypt’s Constitutional Referendum Is a Credit Positive Step Towards Political Stabilization, January 2014 (162905)

» India’s Government Debt Structure Mitigates Credit Impact of Macro-Economic Imbalances, January 2014 (160589)

» Credit Analysis: Brazil, Government of, January 2014 (162135)

» New Report Shows Sizeable Debt Accumulation by China’s Local Governments, a Credit Negative, January 2014 (162145)

» Credit Analysis: France, Government of, December 2013 (161827)

» Sovereign Monitor: Focus on Bilateral and Multilateral Support and Sovereign Creditworthiness, December 2013 (161418)

» QE Tapering & Turkey: Impact on Various Sectors of Turkish Economy Will Likely be Limited and Short-Lived Given Existing Buffers, December 2013 (161004)

» Islamic Finance: Global Sukuk Market: Positive Long-Term Growth Trends Set to Continue, November 2013 (159706)

» 2014 Outlook – Global Sovereigns, November 2013 (160671)



































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Selected Financial Institution and Corporate Sector Research:

» Europe’s Open Access Rule Will Not Affect Exchange Credit Quality, January 2014 (163355)

» Systemically Important Designation for Asset Managers and Funds Is Credit Positive, January 2014 (162823)

» Declines in Reinsurance Prices Are Credit Negative, January 2014 (162299)

» Basel Committee’s Final Standard on Equity Investments in Funds Is Credit Positive for Banks, December 2013 (161948)

» Credit Implications of the German Coalition Agreement: Energy, Infrastructure at Top of Agenda, December 2013 (161540)

» Early Introduction of European Union Bail-In Regime Is Credit Negative for Banks’ Unsecured Bondholders, December 2013 (161802)

» European Business Services: Recovery Is Fragile, But Prospects Are Improving, November 2013 (160089)

» European Banks: ECB’s Comprehensive Assessment Is Credit Positive, But Crucial Questions Left Unanswered, November 2013 (159844)

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients.















http://www.surveygizmo.com/s3/1133212/Rate-this-research?pubid=163544

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Report Number: 163544

Author Colin Ellis

Production Associate Srinivasan Raghavan

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