Global Economic Outlook 20 August 2009

Global Economic Outlook By Cecilia Hermansson 20 August 2009

Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46 (0)8-5859 1028 e-mail: [email protected] Internet: www.swedbank.se Responsible publishers: Cecilia Hermansson +46 (0)8-5859 1588

Magnus Alvesson +46 (0)8-5859 3341, Jörgen Kennemar +46 (0)8-5859 1478 ISSN 1103-4897

Brighter outlook for the global economy – but the stimulus measures need more time

In recent months conditions in the financial sector have improved, several economies have reported growth, and confidence among households, businesses and the financial market has risen. We believe the global economy has reached bottom and that a recovery will begin in the second half of the year.

In the short term, the recovery could be fairly decent, but in the medium term there is an increasing risk of a setback. The reasons for a slow, bumpy recovery are still there: growth is being supported by stimulus measures, many consumers and businesses are trimming their balance sheets, and there is little incentive to add capacity. When this stimulus is unwound, there will be a risk of weaker growth. Global GDP will fall by 1 ¼% this year, but rise by 2 ½% in 2010 and 3% in 2011. Consequently, growth will remain below its potential.

The stimulus has to be kept in place until the recovery is robust in the private sector. Phasing it out too quickly increases the risk of a new recession and deflation. Central bankers will begin to raise their key interest rates in 2010/2011. The risk of inflation is not imminent considering the huge production gaps and rising unemployment. On the other hand, we expect new bubbles in asset and emerging markets during the forecast period.

We give our primary scenario with a slow recovery a 40% probability and our two stronger growth scenarios (with and without inflation problems) a probability of 15% and 20%. A stagflation scenario gets 10% and a deflation scenario 15%. The report also discusses risks globally and by country.

Following the financial and economic crisis, potential growth has probably shrunk. This is why reforms are needed in the financial sector, international trade and various countries’ product and labour markets. The old growth engines and models don’t work anymore. Finding new ones may take time. Countries with relatively good underlying economic conditions, such as Sweden, can more aggressively reform and give themselves an advantage when globalisation revs up.

Cecilia Hermansson

Contents . Recovery in the short to medium term 2 2. After the fire: Extinguishing the ashes and rebuilding 4 3. Pay attention to risks! 9 4. Five scenarios for the global economy 11 5. Primary scenario: A slow recovery 12 6. Forecast assumptions: Politics and the financial, commodity and real estate markets 13 7. Regions/countries – Asia is leading the recovery 22 8. Consequences for Sweden 35

2 Swedbank’s Global Economic Outlook • 20 August 2009

Global GDP forecast

Source: National statistical authorities and Swedbank. Note: Countries representing around 70% of the global economy. The World Bank’s weights from 2007 (purchasing power parity, PPP) have been used.

1. Recovery in the short to medium term The global economy has reached bottom and a recovery could begin during the second half of the year. China, India and other emerging economies are already growing rapidly. Growth in Japan, Germany and France has also turned positive.

During the last half year conditions in the financial sector have improved. Stimulus programs by central banks and governments have had a positive impact. Confidence has increased and a risk appetite has returned. Equity and commodity prices have risen, while interest rate spreads have shrunk. Real estate markets are finding a bottom in countries where bubbles have burst.

It’s certainly possible that growth could be fairly good initially, rebounding after a historical downturn. The stimulus is also contributing to the recovery. The more interesting question is what will happen in the medium term.

In our primary scenario the recovery will be anything but smooth, with a rebound followed by a setback, followed by a rebound, etc., although the underlying trend is slowly upward. Correcting balance sheets takes time. We also offer four alternative scenarios: two with stronger growth and two with weaker growth, with different inflation expectations for each scenario. As in previous forecasts, we stress that many risks are interwoven.

We can reasonably assume that potential global growth has returned to a historical level of around 3 ½% after an exaggerated rate of around 5% through 2007. Slower globalisation, a chastened financial sector, a weaker labour supply and a calmer investment tempo are all reducing growth.

The global economy has hit bottom …

… but after a rebound expect a setback

The crisis has reduced growth potential – and the global economy is still growing below trend

GDP-growth (%) 2007 2008 2009 2010 2011 2009 2010USA 2.1 0.4 -2.3 1.3 1.8 -2.7 1.2

EMU-countries 2.7 0.7 -4.1 0.6 1.3 -4.5 0.1of which: Germany 2.6 1.3 -5.5 0.8 1.3 -6.0 0.2

France 2.1 0.3 -2.7 1.1 1.4 -3.5 0.3Italy 1.4 -1 -4.0 0.3 1.0 -4.2 0.2Spain 3.7 1.2 -3.3 -0.1 1.3 -3.5 -0.3

United Kingdom 3.0 0.7 -4.0 0.5 1.3 -4.0 0.2

Japan 2.4 -0.7 -6.0 1.0 1.4 -6.5 0.4China 13.0 9.0 7.5 8.0 7.5 6.5 7.5India 9.3 7.5 4.8 6.0 6.5 5.0 6.0

Brazil 5.4 5.1 -1.0 2.5 4.0 -1.0 2.0Russia 8.1 5.6 -7.0 1.5 3.0 -6.0 1.0

Global GDP 4.9 2.7 -1.3 2.5 3.0 -1.6 2.2

August Forecast June Forecast

Swedbank’s Global Economic Outlook • 20 August 2009 3

In our primary scenario GDP growth will not recover its potential until 2012, i.e., after the forecast period. Following a global decline of 1 ¼% this year, GDP will rise by 2 ½% in 2010 and 3% in 2011.

The production gaps that have developed in recent years as growth failed to meet its potential will not be bridged until the forecast period is over. In our primary scenario we therefore see no imminent risk of rising inflation. At the same time we feel that the stimulus has ensured that deflation – which now is the result of previously high commodity prices and interest rates – won't take hold. Japan could be an exception, with more prolonged deflation.

We also feel that the stimulus should remain in place in the global economy, through low interest rates and fiscal stimulus measures, until the recovery is certain. The risk of winding it up too soon is greater, we feel, than the risk that they will contribute to new bubbles and inflation. Not until late 2010 will the Federal Reserve begin to raise interest rates, with the ECB and the Japanese central bank following in 2011. A consolidation of government budgets will not begin until 2011.

It is important – not least for the confidence of the public and financial market – that central bankers and governments explicitly commit to winding up their stimulus programs in time and efficiently. It is also important that the stimulus is combined with regulatory and oversight reform in the financial system. Global harmonisation and multilateral regulations are especially needed.

In emerging economies such as China and India, where there isn’t the same great need to trim balance sheets as in the US, UK, Ireland and Spain, for example, growth will remain at significantly higher levels than in the US, Japan and Europe. The wealth gap between East and West is shrinking.

One way to prevent the loss of growth potential is to promote new growth engines/models and implement structural reforms. Economic development in emerging economies could help global growth prospects. New trade agreements will be needed. Another way is to stimulate the labour supply, especially those over age 55, women and young adults. Expanded child care and social services in countries where they are lacking could also add growth potential. More investment in the educational sector would boost productivity. Research and development can produce technological advances. And we need new energy solutions and investments in green technology.

The financial and economic crisis, the environmental crisis and prospects of weaker potential global growth could accelerate the pace of reform in many different areas. In countries where the economic outlook is fairly good, more aggressive thinking should offer an advantage. Though it may have slowed due to reduced trade and a shrunken financial sector, globalisation continues and will require more reforms that favour competition and innovation.

In our primary scenario neither deflation nor inflation is a problem

The stimulus is needed until the recovery feels robust …

… but strategies to wind it up should be spelled out

The wealth gap between East and West is shrinking

Finding new growth engines and models takes time …

… and the need for reform has increased following the crisis


2. After the fire: Extinguishing the ashes and rebuilding

The lead-up to – and development of – the financial and economic crisis, along with crisis management and recovery, can be compared to a building fire. First there are warning signs. Then the fire breaks out and it is extinguished, but the house burns down. An investigation is conducted to determine the cause of the fire. Then the house has to be rebuilt. Last but not least a commission is appointed to create tools and rules to minimise the risk of future fires.

In our case, the fire alerts have sounded, the fire has broken out and the worst of the panic is behind us. Right now we are probably about finished extinguishing the ashes and preparing to rebuild. In the following sections we sum up what has worked well and what hasn't and what is needed to manage the current crisis and future crises better.

1. The signs were there Economists have taken a lot of the blame for not predicting the financial and economic crisis. We have plenty of reason for soul-searching. Many economists, prognosticators and multilateral institutions (IMF and BIS) had warned about macroeconomic risks, like the unsustainably low household savings in the US, escalating housing prices and excessive credit growth in a number of countries, as well as savings imbalances, especially between China and the US. But it was harder to predict the impact of new financial instruments on the crisis and the consequences for the real economy. Weak oversight of regulatory and incentive systems and the financial sector’s decision-making, including the use of models – various types of micro factors – was not analysed properly from a macro perspective. The crisis has forced us to understand the connection between the financial and real economy and to take a more holistic approach to macro- and microeconomic development.

It’s too much to ask forecasters to figure out exactly when asset prices collapse. Prices of financial assets reflect available information. If there were a model that predicted prices a week in advance, that information would cause prices to fall a week earlier.1 Nor can anyone foresee exactly what decision-makers will do (read to rescue or not to rescue Lehman Brothers). We always have to look ahead to the future using different scenarios. It is up to those who read forecasts to analyse the risks and draw their own conclusions.

Of course, there were economists and others who warned us of a financial and economic crisis (e.g., Shiller, Roubini and BIS economists). What the financial market and politicians decided is another thing. Trying to put a stop to successful, though 1 cf. Robert Lucas’ defence in the Economist on 8 August, “In defence of the dismal science”, who commented on the Economist on 18 July, “Modern Economic Theory – where it went wrong and how the crisis is changing it”.

Fire alerts, the fire itself and fire fighting are all behind us

Economists were more worried about imbalances than a financial crisis


short-sighted, habits isn’t usually popular, especially since forecasts are no more than that, just forecasts.

2. The fire has been successfully put out Central banks in Europe and the US were relatively quick to try to put out the fires and rescue the financial system. This is especially true of the US when the crisis broke out in 2007, and both the US and in Europe when it escalated in the fall of 2008. Interest rate cuts were combined with other measures to increase liquidity and calm the credit markets.

The actions by central bankers were a key reason why the financial crisis didn’t become worse than it did, and why confidence was restored and a total collapse avoided. It is common to criticise current economic policies for being too expansive and contributing to new crises, but in this case such criticism shows a lack of understanding of the seriousness of the situation faced by the financial sector and the macroeconomic consequences of the financial panic of 2008. The IMF has estimated that USD 4 trillion in value, equivalent to a third of the US GDP, will have been lost by the financial sector by the time crisis is over. A stimulus was needed, but it is equally important to unwind it in time.

Governments also succeeded in having a positive impact. In Europe, we saw some of the co-operation across borders that was needed due to the global nature of financial markets. State guarantees for investors and lending from financial institutions were a key to creating confidence. There were also problems doing the right things at the right times. In the US, the election campaign was under way and it was hard to build a national consensus what to do with the financial sector. Especially since other industries, such as automakers, were being brought to their knees for more structural reasons.

When the economic crisis worsened during the second half of 2008 and first quarter of 2009, new economic policies were crucial. The emphasis shifted from monetary to fiscal policy. The biggest risk was that the major drop in demand and balance sheet adjustments that were needed following the financial crisis would create deflation and depression. With the help of infrastructure investments, tax cuts labour market measures, etc., this risk was reduced.

The fire fighting work has largely been successful. Decades of economic theory have been applied pragmatically (e.g., Keynes and Friedman). The financial crisis has eased, even if balance sheets still need trimming and will for some time to come. Economies are no longer in a free fall, though we can expect a weak job market even while the economy recovers. A few months ago we had no idea that conditions would improve so quickly. Although timing was a factor, it is reasonable to assume that the measures that were taken were the most important reason why we prevented an even more severe crisis.

Central bankers handled the crisis resolutely

Among governments the results were more mixed

The focus shifted from monetary to fiscal policy

The fire fighting has largely been successful


3. Extinguishing the ashes While fighting fires, neither central bankers nor governments were able to correctly decide which institutions were worth rescuing with financial support and which should have been allowed to fail. With the exception of Lehman Brothers – where a more orderly bankruptcy would have been preferable – many institutions presumably received access to capital to survive at the same time that they had solvency problems that required new contributions of private or, in the worst case, public capital under special conditions. Japan’s experience shows that it is easy to give too much support and ask for too little in return from financial institutions, which leads to slower growth (zombie banks) and the risk of future bubbles (moral hazard). There is plenty of room for improvement.

Experience from the 1930s and the Japanese real estate crisis shows that a stimulus shouldn’t be phased out too quickly or it will increase the risk of a new, even worse recession. That's why we have to be sure to extinguish the ashes. Fiscal stimulus will still be needed for a while, as will unconventional measures from central banks and low interest rates. Since much of the rebound is the product of the stimulus, growing confidence and a bigger risk appetite, phasing it out too quickly could sidetrack the recovery. Starting over with a new stimulus would be much more difficult under those conditions, since confidence wouldn’t rebound as quickly. It can also be costly, as evidenced by Japan’s VAT hike in 1997/98, which hurt the country’s growth and budgets.

We are at a stage now when lots of people are trying to figure out the reasons for the crisis. No one is going to be helped by simplistic conclusions. We have to realise that several factors were working together in a complex fashion. The fact that they are interwoven means we must analyse them together, not individually. This is also something we learned from the crisis. Overly expansive monetary policy following the IT crash contributed to excessive lending and inflated asset prices. A narrow-minded focus on official or unofficial inflation targets based on consumer prices facilitated expansive monetary policy. Financial oversight and effective regulation that could adapt to changes in the marketplace were practically nonexistent. China’s and India’s entry into the global market and their economic policies contributed as well. Psychology and values were also factors that have to be listed among the causes (which we don’t claim to have covered in full).

Hopefully, economic theory will now be reassessed and we will learn from crises related to inflated balance sheets. Economic policies don’t work the same way when companies are focused on maximising profit (the normal state of affairs) as opposed to when they are interested in cutting debt. Credit demand has remained low in Japan for years since the real estate crash. Monetary policy isn’t as effective, but fiscal policy is needed if the intention is to stimulate demand.2 Low interest rates and 2 cf. Richard Koo (2009) for a more detailed discussion.

More focus on liquidity than solvency problems

Unwinding the stimulus too quickly could be costly

No simple explanations for the crisis

Economic theory has to focus more on balance sheets


quantitative easing have mainly helped the banking system and credit market, but will not have enough impact on demand in countries where balance sheets are being drastically trimmed.

One conclusion we can draw from similar crises is that it takes time to extinguish the ashes. And we should give it time. The residual risk of deflation and depression is a good reason why the state should compensate for the private sector’s increased savings. When the recovery is robust again based on higher private sector demand, the emphasis should shift back to increasing state savings.

4. The recovery raises questions It is not surprising that after 18 months of recession the US is poised for recovery. Growth is now returning to several countries, driven by public investment and consumption as well as a stimulus for households and businesses. After a substantial decline, growth could rebound and be higher than expected. This turnaround could be at risk, however, particularly if the stimulus is wound up too quickly and is followed by a period of economic tightening.

The question isn’t whether we will see a recovery in the short term, but what the next 3-5 years will look like. Rebuilding the house requires a stable foundation, skilled workers and good material.

Three questions are especially pertinent following the crisis:

1. Will global growth potential decrease after the crisis? A country achieves its growth potential when its GDP increases at a rate that produces an inflation-neutral balance between labour and capital. Growth potential improves, for example, through investments in human capital and machinery, a growing labour supply and/or technological advances.

Growth potential has gradually increased in recent decades thanks to the financial sector’s innovations, globalisation, new technology, new organizational structures, etc. Even still, the global economy probably exceeded its growth potential in recent years when it expanded by 5% (against 3 ½% over the last 20 years). This was unsustainable.

Among the factors that could now reduce growth potential are a shrinking labour supply, slower globalisation, less investment in new technology and a chastened financial sector.

It will take time to extinguish the ashes

Focus on the recovery in the medium term

Several factors could impact growth potential


2. Where will new growth engines come from when the old ones lose steam?

One way to prevent the loss of growth potential is to promote new growth engines. Economic development in emerging economies such as China and other countries in Asia could improve global growth prospects – perhaps even in the poorest countries as a result of increased agricultural trade. New trade agreements will be needed. Another way is to stimulate the labour supply, especially those over age 55, women and young adults. Expanded child care and social services in countries where they are lacking could also add growth potential. More investment in the educational sector would boost productivity. Research and development can produce technological advances. And we need new energy solutions and investments in green technology, for example. Nanotechnology, robotics and medical technology are also important growth areas.

3. Will we really need new growth models or could we use the same old ones?

The growth models we have been using in recent years have been based on the assumption that US households will borrow to maintain their standard of living (which has been under pressure from weak wage growth) and therefore artificially increase their consumption. A mountain of debt and rising asset prices has been the driver of the US economy, and many European economies as well. It’s a growth model that won’t work any longer – economically or environmentally – as painful as that may be for major exporters such as Japan, China, Germany and Sweden to realise.

New growth models will be based on a better savings balance between countries. Boosting domestic spending in China will require policies that reduce household savings, including with the help of safety nets and an appreciating currency. Globalisation, expanded industrial supply chains and a rejuvenated financial sector are also important puzzle pieces to improve the standard of living in every type of country.

New growth models will also factor in the state’s role and the welfare state differently than in recent decades. Deregulation and liberalisation of markets have been and will remain important to growth. In Europe this means liberalisation of service markets. Demographic trends and environmental threats will also increase the government’s importance. Add to that the market interventions by governments during the financial crisis. The question is what role states want to play when the economy starts growing again?

5. How do we reduce the risk of future fires? Naturally this is the area where the most work still remains. Politicians have shown great interest in regulating bonus

We have to find new growth engines when the old ones lose steam

Economic and environmental crises require new growth models

The role of governments has grown since the crisis

The risk of future fires hasn’t changed …


packages and hedge funds. In the US the focus has been on which government agencies will oversee various financial institutions. Europe could use more cross-border oversight, but is taking only small steps forward to avoid infringing on national sovereignty.

There is a risk that once the economy rebounds, a large part of the necessary reforms will get sidetracked. Interest in more global co-ordination to relieve global imbalances – with multilateral institutions given a greater say – could wane. Even without the Lehman Brothers collapse, the financial system was in need of an “extreme makeover,” especially of oversight and supervision, though certainly also in terms of regulation. There is a risk, however, that regulations will be changed ad hoc simply because of the financial crisis without actually improving efficiencies, and thus create an incentive to build new structures (new shadow banking systems). More needs to be done to develop macro prudential rules for the financial market.

There are already a number of proposals to reduce the risk of new financial fires in future, which can be summed up as follows:

• Better, more modern supervision of financial institutions

• Better risk management and smarter use of models

• Higher capital adequacy requirements – but not procyclical

• Greater transparency requirements, especially in stock markets where needed (e.g., certain types of securitisation)

• Greater focus on liquidity risks

• More effective accounting rules

• Limits on the interdependence of financial institutions in part by excluding payment streams from balance sheets and by introducing safer ways to clear OTC trades

• Introduce a safer way to liquidate banks (too big to fail)

• Cross-border banking must be regulated at a regional or international level.

Tightening oversight and regulation is important. Then there is monetary policy, which must combine the goals of price stability with financial stability. Psychology, values and how decisions are made at the board level are also important. On the other hand, it is difficult to see how higher ethical standards and better values would suffice. They are needed, but are not enough to reduce the risk of new financial crises in future.

3. Pay attention to risks! In following chapters we review a number of risks that could be realised during the forecast period or possibly the slightly longer term.

Though discussed individually, we know from the financial crisis that in many cases it is the interplay between risks that has a considerably greater, more damaging impact.

… and some of the work could get sidetracked

High ethical standards are important – but the right regulations and incentives systems are needed as well


The most important individual risks:

Global forecast risks

Time horizon (short-med-long)

Factors that impact/mitigate

1. Strength of the recovery and possible setbacks

Short-medium Don't unwind stimulus plans too early, any new measures

2. Prolonged deflation Short-medium Further stimulus measures

3. Financial health – credit crunch

Short-medium Free up problem loans, add new capital to the banking system

4. Less spending among indebted consumers

Short-medium Debt restructuring takes time; the stimulus is helping

5. Labour market (economic and structural risks)

Short-medium-long

Fiscal stimulus for municipalities/infrastructure, education, retraining, sustainable growth policies

6. Housing markets – bubbles

Short-medium-long

Productive regulation in financial sector, appropriate taxes and interest rates, construction

7. Rapid rise in commodity prices

Short-medium-long

Financial regulation, financial market developments (dollar), China’s inventory cycle, psychology/sentiment

8. Stock markets Short-medium Health of the financial sector Normalisation of interest rates Psychology/sentiment

9. High inflation Medium-long Central banks’ confidence/exit strategy for adding liquidity

10. Financial health – new imbalances

Medium-long Design of financial regulations Global co-ordination/harmonisation

11. Public sector debt/fiscal policy

Medium-long Announce exit strategy, framework that instils confidence

12. Central bankers’ confidence/monetary policy

Short-medium Announce exit strategy Imbalances China-the US

13. China – risk of new bubbles and social tension

Short-medium-long

Balance growth, currency policies, reforms, increased focus on households

14. Insufficient domestic demand in EU/EMU countries

Short-medium-long

Reforms for labour market, pensions, service market, taxes, etc.

15. New Japanese government with new policies

Short-medium Democratic Party’s attitude toward the US and financing of the US deficit, protectionism, growth model to strengthen households

16. Dollar collapse and lower capital inflows to the US

Short-medium US relations with China, Japan-yuan, Fed policy, psychology

17. Global long-term interest rate shock

Medium-long Inflation, dollar, savings imbalances

18. Insufficient action to tackle environmental threats

Short-medium-long

Focus on economic crisis over environment Political leadership and co-ordination

19. Protectionism Short-medium-long

Political leadership for future trade negotiations

20. Pandemics Short-medium-long

Global co-ordination/expertise/monitoring

21. Terrorism and war Short-medium-long

Global co-operation, political leadership

22. The unknown factor Short-medium-long

Open to the unknown, humility


4. Five scenarios for the global economy Global economic uncertainty remains great. On the one hand, households, businesses and financial players must considerably slim their balance sheets. On the other are the stimulus programs from central banks and governments, whose effect on growth is hard to measure in terms of time and scope. Uncertainty about price stability and the risk of new bubbles have also increased. Following are five scenarios we have sketched for the global economy:

Scenario 1 (primary scenario): Probability 40% Slow, bumpy recovery – neither inflation nor deflation

Global economy grows below its potential in 2009-2011 – balance sheet adjustments.

Stimulus measures counter deflation and are phased out in time to avoid inflation.

Recurring bubbles in asset markets and emerging markets.

Gradual reconstruction of the financial sector – regulatory reform.

Scenario 2 (strong secondary scenario): Probability 20% More rapid recovery– without inflation

The global economy reaches its potential (3 ½%) in 2011.

Deflation risks mainly due to base effects, economic policies maintain confidence and stimulus measures are phased out in time to avoid inflation.

Longer, more extensive bubbles form in asset and emerging markets.

Reconstruction of financial sector becomes sidetracked – reforms are put on the back burner.

Scenario 3 (very strong secondary scenario): Probability 15% More rapid recovery – with growing inflation problems

The global economy reaches its potential as early as 2010, begins to close the production gap in 2011.

Stimulus plans are not wound up in time, asset and consumer prices rise too quickly.

Lack of confidence in the Fed creates the risk of a dollar collapse, rising inflation and long-term interest rates.

Scenario 4 (weak secondary scenario): Probability 10% Further declines after a rebound – stagflation risk increases

Recession continues in 2010 – a recovery begins in 2011.

Further stimulus, confidence in central banks falls, inflation rises.

Period of high inflation and low growth, weak labour markets, but with pricing pressure from commodity markets and financial sector.

Scenario 5 (very weak secondary scenario): Probability 15% Further declines after a rebound – deflation risk increases

Recession continues in 2010 and 2011, not until 2012 does a prolonged recovery begin.

Weak demand and sluggish labour markets with growing deflation that isn't relieved by new, larger stimulus packages.


5. Primary scenario: A slow recovery What is driving the recovery in the primary scenario? The primary factor is the monetary and fiscal stimulus in a number of countries. Public spending is growing due to infrastructure investments. Low interest rates and taxes are gradually encouraging households to consume more and are partly offsetting the slowdown caused by higher unemployment and debt restructurings. In addition, there will be a rebound in industrial production after inventories are slashed and have to be built up again. Slightly lower demand from Asia is generating increased order bookings in industry and on commodity markets. Another factor driving the recovery is improved confidence, which has led to a bigger risk appetite and could also mean new investment.

Why should we expect a slow recovery? Many companies had built up tremendous capacity over a period of several years prior to the financial and economic crisis. Capacity utilisation has dropped substantially and demand, while increasing, will remain relatively weak. In the US few interest rate-sensitive sectors are reacting to the more expansive monetary policy. Moreover, the financial sector is struggling with huge problems, and the demand for and supply of credit is restricting lending. We therefore see no clear driver for private investment. Households in the US, the UK, Ireland and Spain will limit their spending and instead save more and reduce their debt. Eventually the public sector will have to begin a period of budget consolidation, which could also have a negative effect on growth.

Why do you anticipate a bumpy road to recovery? Once the rebound is over, there is as risk of a backlash. Also, the stimulus plans will eventually have to be phased out to avoid inflation and new bubbles. So it is likely that the upswing we will initially see after reaching bottom will not last. Experience from similar recessions, shows that economies often fluctuate up and down before normalising and reaching their full potential.

Why isn't deflation or inflation included in your primary scenario? We believe that the stimulus has helped to avoid the bad or ugly type of deflation. On the other hand, base effects, i.e., a sharp decline in interest rates and commodity prices, are having an impact, which is why inflation is currently negative. Since our primary scenario includes gradually rising demand and a more positive sentiment, we expect businesses to find gradually improving opportunities to raise prices. Only in Japan – which has long faced deflation problems – do we foresee deflation in 2010, and possibly in 2011 as well.

With regard to inflation risks, we feel that since the global economy will grow below its potential and not close the production gap until late in or after the forecast period, the risk of high inflation is relatively small. Though they will initially rise, commodity prices may fall if the recovery struggles. It will take time before higher interest rates have a major impact on the

No stimulus, no recovery

Balance sheet adjustments limit growth

When the stimulus is phased out, growth risks will increase

Stimulus plans are lowering the risk of deflation – large production gaps reduce the risk of inflation


CPI. By announcing their exit strategies, we expect that central bankers are laying the foundation for a phase-out of their stimulus packages. Confidence that the banks will act resolutely to prevent high inflation will remain strong. Inflation targets and the independence of central banks will also help to raise confidence.

Since there is still a risk that the expansive fiscal policy, quantitative easing and uncertainty about central banks’ balance sheets, could result in a loss of confidence in the financial market, we have included loss of confidence/high inflation in two of our alternative scenarios.

6. Our forecast assumptions for 2009-2011: Politics and the financial, commodity and real estate markets

Politics New governments with new economic policies will impact their countries’ growth prospects, though it is difficult to determine by how much. An often neglected factor is consumer confidence, which can be affected by a change of the political power. Below we have listed the dates of major elections and made certain attempts to assess their effects. The election in Ukraine is included because of the risk of increased tension with Russia.

Year Type of election/country Growth effect (+,-,0,?)

Aug 09 General election in Japan Light+

Sep 09 Federal election in Germany Light+

Jan 17 Parliamentary election in Ukraine Turbulence

Jun 10 Latest date for UK parliamentary election Light+

Dec 11 Parliamentary election in Russia 0

Mar 12 Presidential election in Russia ?

Jun 12 Presidential election in France 0

Nov 12 Presidential election in the US ?

Sentiment Surveys on future confidence and expectations among households, businesses, and financial and purchasing managers have taken on greater importance in the media’s depiction of the state of the economy. George Katona from the University of Chicago created an Index of Consumer Sentiment (ICS) back in the late 1940s. A number of imitators have since been developed in many countries.

These indexes don’t really provide a gauge of optimism or pessimism, but rather which way sentiment is pointing. If pessimism increases, household savings usually do, too. On the other hand, when optimism grows, so does spending. These

Our alternative scenarios contain bigger problems with deflation and inflation

Elections in Japan and Germany will certainly impact growth, but are difficult to measure


indexes are especially important when trying to find turning points in the economy, which of course is difficult to do.

The purchasing managers index isn’t really a sentiment indicator at all. The purchasing managers are only asked about their past month’s performance. As a result, it is really an early economic indicator for industry and the economy as a whole. When the index falls to 32-33 and then rises above 50, which is usually described as the dividing line between a manufacturing decline and growth, it is considered a major rebound after a severe downturn. Since we have little experience from such major recessions, these rebounds must be interpreted cautiously. This also applies to confidence among households and businesses. We can still use these indicators as evidence of a turnaround, but they can’t tell us about its strength.

Fiscal policy We do not expect any more discretionary stimulus packages in G20 countries beyond those that have already been approved. To date they represent about 2% of GDP in 2009 and 1.6% in 2010. In our primary scenario we will then see a continued recovery closer to our growth potential. Fiscal policies will be largely neutral in 2011 before tightening the reins on the economy.

The budget deficit in G20 countries will grow by 5.5 percentage points of GDP in 2009 and 2010, according to the IMF. Besides the discretionary stimulus, automatic stabilisers will help to flatten out economic swings, though they are add to budget deficits.

About a quarter of the fiscal stimulus took the form of tax cuts and was paid out relatively quickly. It is taking longer to increase spending (infrastructure, etc.). In the US about 40% of the stimulus has been utilised, although that number is now growing. Multiplicator effects, i.e., the impact of the stimulus on growth, vary between 0.7 and 2.7%. We can therefore expect a positive impact on growth in 2009, 2010 and to some extent 2011 as well.

Since many of the major G20 countries already had relatively large budget deficits before the crisis, they are now reaching uncomfortable levels. The increase in public debt is the biggest since World War II. The IMF expects it to be 40 percentage points between 2007 and 2014. We don’t see an intense budget consolidation until after the forecast period, i.e., in 2012. Based on what we learned from Japan, cutting back too soon could threaten the recovery. During the period, unemployment will continue to rise, which could make tax hikes and/or spending cuts simply too painful.

Having a plan in place to phase out the stimulus (the much-discussed exit strategy) is important to the financial market’s and public’s confidence in price stability. In Japan, long-term interest rates did not rise after the crisis in the 1990s, but

It's not strange that sentiment is improving when it had been so low

We do not expect any major new stimulus packages

The IMF expects public debt to increase by 40 percentage points in G20 countries!


demand there for new loans was low and the economy eventually entered a deflationary stage. Japan also had huge domestic savings, which financed the growing public debt.

Germany, Japan and the UK have formulated strategies for a medium-term budget consolidation. In some cases stabilisation is expected in 2010/2011. Although the US has 10-year plans in place, they are based on overly optimistic growth assumptions. France has played down the issue.

We believe that every country – after being pressured by the OECD and IMF – will begin to announce plans that include the measures that will be required. On the other hand, we are more sceptical how the plans will be implemented. This is an issue that won’t arise until after the forecast period, however. Until then announcements, if well-designed, will calm the financial market.

Budget deficit and public debt as % of GDP 2010

Monetary policy

- Unconventional measures

We assume that central banks will maintain their special arrangements to help credit markets for some time, while stressing that they are ready to phase out the stimulus when needed.

The Bank of England has announced that it is increasing the volume of private and government bonds it will buy (quantitative easing) to reduce friction in the credit market and at the same time – though this is more difficult to assess – to strengthen growth and reduce the risk of deflation. The IMF estimates that UK government bond rates have fallen by 0.4-1.0 percentage points due to the quantitative easing. The Federal Reserve’s

Developing strategies is one thing, implementing them is another

Unconventional monetary policies will be retained for a while

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actions, which greatly expand its balance sheet, have mainly been designed to help the credit market (credit easing).

While the Fed announced it would purchase assets valued at 14.7% of GDP, to date that figure has yet to exceed 6%. The corresponding numbers in the UK are 8.6% and 7% of GDP. The Bank of Japan has also increased and extended its programme to buy private and public assets (bonds, equities, etc.). Thus far these measures have reached 3% of GDP. The European Central Bank has decided to buy covered bonds to help the mortgage market.

Some of the measures by central bankers to increase liquidity in the market will be phased out automatically when financial institutions no longer want help. Other measures, such as expanding its balance sheet with assets from mortgage giants Fannie Mae and Freddie Mac and the insurance company AIG, will be more difficult for the Fed to phase out and will remain a risk on its balance sheet.

- Key interest rates

Since the start of the year central banks in Europe have continued to cut their key interest rates (the ECB from 2.50% to 1.00%, the Bank of England from 2.00% to 0.50% and the Swedish Riksbank from 2.00% to 0.25%). Even before the start of the year the Bank of Japan had reached a low of 0.10% and the Fed was in a range between 0% and 0.25%.

Key interest rates from central banks

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The most recent statement of the Federal Reserve’s FOMC (Federal Open Market Committee) from 12 August: “The Committee will maintain the target range for the federal funds rate at 0 to ¼ percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

The UK has the highest share of quantitative easing in terms of GDP

A portion of the easing will be phased out automatically, but other aspects will increase risks


Based on current economic conditions and demand pressures, we expect central banks to maintain their low interest rates during the forecast period without jeopardizing price stability. Inflation is projected to be negative in Japan, the US and China this year before gradually rising but not exceeding official or unofficial inflation targets (Japan is expected to see deflation again in 2010). On the other hand, low interest rates are likely to mean that capital allocations won’t work as well and that the risk of new bubbles in asset markets will grow. Central banks may want to see interest rates gradually normalise during the forecast period. We expect the Fed and the Bank of England to take the lead and raise their rates for the first time during the second half of 2010 (this also applies to the Swedish Riksbank).

Consumer price trend

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Aug 19 Dec 31 Jun 30 Dec 31 Avg. 2009 2009 2010 2010 2011

US Federal Reserve 0.25 0.25 0.25 1.00 1.5

Bank of Japan 0.10 0.10 0.10 0.10 0.5

ECB 1.00 1.00 1.00 1.00 1.7

Bank of England 0.50 0.50 0.50 1.00 1.7

Long-term interest rates Despite central banks’ attempts to tame interest rates, particularly long-term rates, the latter (10-year treasuries) have risen in 2009. The biggest gain has been in the US. There are several reasons for the higher market rates. A growing risk appetite is pushing rates back to more normal levels. Prospects for higher inflation and growth are also likely reasons why long-term rates are rising.

Based on current demand, low interest rates are little threat to price stability, although new bubbles could arise

Higher growth, the inflation outlook and a growing risk appetite will push long-term rates higher


Long-term interest rates in the US, the UK, Germany and Japan

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Our assumption is that 10-year treasuries will rise from their current level of around 3 ½% to 4 ½% on average in 2011. The German equivalent won’t trend as high, mainly due to a weaker growth outlook, while the Japanese rate will scarcely rise above 2%.

Credit markets Interest rate spreads between interbank rates and treasury bills have dropped to levels we haven't seen since before the Lehman Brothers collapse. We assume that risk aversion will continue to decline this fall as optimism about the economy and stock market grows. Credit spreads will therefore shrink in a number of areas as long as investors’ risk appetite remains at a relatively high level. We can expect setbacks during the forecast period, however. We have already seen that even the slightest indication of slower growth or earnings can easily trip up markets.

Since central bankers and governments are sticking with the measures they have introduced to help the credit market, our forecast assumptions do not include any new trouble spots. Instead, these measures will be phased out automatically as financial institutions stop asking for them.

Whether the credit crunch is and will remain a problem is decisive to growth prospects. In certain countries credit demand is low, since businesses and households are paring their debts or have been hard hit by the recession and aren’t looking to increase capacity (demand problems). In other countries credit demand may be relatively high, but financial institutions are repairing their balance sheets and therefore are cutting back on their lending (supply problems). Usually it is a combination of the two, which makes it hard to figure out where to look. We have assumed that there are supply problems in the US and parts of Europe (partly because of developments in Eastern and Central Europe), while Japan’s banks are managing fairly well. Demand problems are affecting every country, but as the economy improves those countries where companies have

Interest rate spreads may shrink a little more

Credit tightening should be viewed from both a supply and demand side


relatively manageable problems with their balance sheets will be in a better position to jumpstart lending, which will eventually help their growth prospects.

Interest rate spread between 3 -month interbank rate and treasury bill

Source: Reuters EcoWin

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Currencies The US dollar rose against the euro between January and March of this year before trending lower to its current level of around 1.41. The dollar has become a funding currency in carry trades, where investors borrow at low interest rates and invest the capital in countries with higher yields. US fiscal and monetary policy will contribute to a further weakening this year. A higher risk appetite will also hurt the dollar. We assume that the dollar will then gradually rise in pace with interest rate hikes and prospects for slightly higher growth in the US economy than the euro zone.

Although a dollar collapse isn’t part of our primary scenario, if confidence in monetary policy should wane there is such a risk, which we include in one of our alternative growth scenarios.

The euro, yen and yuan against the dollar (index 9 August 2007 = 100)

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The dollar has become a carry trade currency


Exchange rate assumptions 2009-2011

Aug 19 Dec 31 Jun 30 Dec 31 Avg. 2009 2009 2010 2010 2011

EUR/USD 1.41 1.47 1.40 1.32 1.25

RMB/USD 6.83 6.83 6.83 6.83 6.50

USD/JPY 95 100 110 115 110

After appreciating by nearly 20% in 2005-2008, the Chinese yuan began a period in which it was more or less pegged to the dollar. Based on negative net exports, there was probably good reason to let the yuan weaken, but instead, in no small part due to its relationships with other Asian countries and the US, China chose to stop the currency’s appreciation. To avoid an appreciation of the yuan when the dollar again rises in value, China is buying dollars and adding to its currency reserves.

We expect that US pressure on China to allow its currency to further appreciate has eased, since there is a stronger need to attract Chinese financing for the US budget deficit. Eventually pressure to appreciate the yuan will return, and given that China’s growth is considered more robust, the currency may start appreciating again. This would certainly be in line with the need to strengthen domestic demand and reduce the country’s export dependence on the US.

The Japanese yen, which previously played the role of funding currency in carry trades, has weakened slightly in 2009, but is still considerably stronger than prior to the Lehman Brothers collapse. A growing global risk appetite is reducing demand for relatively “safe” yen investments. Japan’s weak public finances are becoming a concern in the financial market. Short-term interest rate spreads between the US and Japan will increase during the period as well. The yen is again becoming something of a funding currency. We anticipate a gradual depreciation against the dollar in 2009 and 2010.

Equity markets Stock prices tend to “overshoot” during both up- and downswings in the market. Equities have risen substantially since March, especially in emerging economies, but concerns about the sustainability of these gains have led to lower prices recently. As long as exports to the OECD remain stagnant, these stock gains will rest on an unstable foundation. The rise in commodity prices has also been of great importance, both for raw material exporters such as Russia and countries that want prices to stay low, such as India. For China, it is a question of how much expansive policy the economy can handle. Raising banks’ capital adequacy requirements is one way to reduce lending to equity and housing markets, but probably won’t be enough as long as market sentiment is strong. The risk of a bubble is great, even after the Shanghai Stock Exchange has begun to decline.

China is retaining its peg to the dollar

Japan is again taking on the role of funding currency in carry trades

Stock exchanges in the emerging markets have risen quickly since March, but now are facing doubts


Equity prices in the US, Japan, India, China and Russia

S ource : R euters E coW in

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Equity prices continue to rise in the OECD zone in pace with signs of improving economic conditions and an imminent recovery, which is raising optimism. The stimulus has been crucial, and we can expect to see a continuing improvement as long as it remains in place, though in the long term risks will increase if these economies cannot stand on their own. For equity markets in the OECD, the key will be housing, the banking sector, Eastern Europe's development, commodity prices and other factors that affect earnings and confidence.

Commodity markets Swedbank’s commodity price index fell in July for the first time since February. Commodity prices have risen significantly faster this year than the economy would suggest. Contributing factors include a weaker dollar, China’s growth and increasing inventory of raw materials, a stronger risk appetite and less severe economic conditions (or the first signs of a recovery).

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Commodity prices are trending higher, but still fluctuating


We expect oil prices to reach an average of 60 dollars a barrel this year before rising to 70 dollars in 2010 and 80 dollars in 2011. A gradually improving economy certainly suggests higher oil prices, but the trend is likely to be a bumpy one, especially since the economic recovery and consumer confidence are likely to stumble along the way. Metal prices are also rising from relatively depressed levels, and food prices continue to trend higher long-term.

Real estate markets Thus far housing prices have fallen the most in Ireland, the US and the UK, while Spain – despite problems with over-investment in housing in recent years – has not yet seen a major price decline. It could be due to data problems, but even so the trend is still downward. We expect further corrections in 2010 and 2011. The US is nearing a bottom, though the data is still clouded by a temporary stop to foreclosure sales that otherwise would have reduced prices.

Housing price trend in various countries (Index 2000 = 100)

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For countries that have largely avoided major price declines, risks will rise when interest rates return to levels that put pressure on households with small margins. Alternatively, a major increase in joblessness could push housing prices lower than they have gone so far. This is true in the Nordic countries, the Netherlands and France. Germany and Japan offer examples of housing markets with no risk of a bubble.

7. Regions/countries – Asia is leading the recovery

The recovery will initially begin in China and other parts of Asia. Japan’s growth also turned positive during the second quarter, although that seems to have been mainly because imports dropped more than exports. Germany and France reported growth in the second quarter as well, while the euro zone as a whole shrunk. In the US the slowdown has levelled off and a recovery is imminent. We anticipate that Asia will continue to

Higher interest rates and unemployment may hold housing prices in check in the long term

Emerging Asian economies are expected to grow faster than OECD zone


lead the recovery, with the US and Europe following at a slower pace.

The US – Is about to recover from the recession

Highlights from our previous forecasts in 2009: The US was expecting a severe, protracted recession driven by households and the financial and real estate sectors. In the second half of 2009 a cautious recovery was expected, driven by public and private investment. The economic stimulus presumably would ease the downturn. GDP growth for 2009 was written down from -1 ½% (Jan) to -2 ¾% (June) and would remain relatively unchanged at around 1-1 ¼% for 2010.

Highlights from our new August forecast: The US recession will end in Q3, but the recovery that begins will be sluggish. Balance sheet adjustments by households and the financial sector are likely to take several years. Nor are private investments expected to drive the economy, since capacity is already too high and financing opportunities are limited. Unemployment will continue to rise and make it difficult for consumers to slash their debt. GDP growth of -2 ¼%, 1 ¼% and 1 ¾% for 2009, 2010 and 2011 will fall below potential. Economic policies are gradually, and cautiously, becoming less stimulative.

Important forecast risks: Global growth, housing market, financial sector and credit crunch, household savings, labour market, political consensus, dollar and confidence in the Federal Reserve, oil prices.

The US recession officially began in December 2007. The real economy took a blow in the fall of 2008 when Lehman Brothers filed for bankruptcy and the financial markets fell into a state of shock. The downturn in the last year is reflected in the purchasing managers index, which fell from 49.3 in August last year to 32.9 in January this year, before recovering and reaching 48.9 in July.

The labour market was in free fall until January of this year. In that month 741,000 people lost their jobs. Since then job losses have gradually slowed, and in July the figure fell by an unexpectedly low 247,000. During last year the number of working Americans decreased by 5,740,000. At the same time unemployment has risen from 6.2% in August last year to 9.4% in July.


Purchasing managers index and change in number of working Americans

Based on leading indicators, the US appears to have hit an economic bottom, but has not yet started on the road to recovery. The recession has now lasted 18 months and will be the longest since the Great Depression of the 1930s. The purchasing managers’ index has to climb above 50 before a recovery is in place. Ensuring a robust recovery is an even greater challenge.

GDP fell during Q2 relative to the preceding quarter, but not as much as in the two previous quarters. Compared with the first quarter the slowdown in private investment has levelled off. On the other hand, consumer spending has slowed as households save a larger share of the huge stimulus (the savings ratio rose to 5.2% of disposable income, equivalent to the entire stimulus packages).

Efforts to reduce the debt ratio have just begun. The debt service ratio (interest and principal as a percentage of disposable income) has fallen thus far from 14.25% to 13.50%, but it previously had drop to 10-11% for consumers to increase their spending. We expect higher savings before the balance sheet adjustments are done.

The US has reached bottom, but we have yet to see clear signs of a recovery

Debt restructuring continues


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Growth (%) Quarter 2 Quarter 1 Quarter 4GDP -1.0 -6.4 -5.4 2.8Private investment -20.4 -50.5 -24.2 3.6Consumer spending -1.2 0.6 -3.1 3.0Inventory contribution (p.e.) -0.83 -2.36 -0.64 0.02Contribution net exports (p.e.) 1.38 2.64 0.45 -0.16

Annualised rate2009


US household savings in relation to disposable income (savings ratio) and debt in relation to disposable income (debt ratio)

Among the factors contributing to the recovery are the relatively weak dollar, a turnaround in the inventory cycle, the fiscal and monetary stimulus, slightly stronger growth in some emerging economies (mainly China), declining pessimism and a slowly improving financial sector. Still, the recovery is likely to be a bumpy one due to the balance sheet adjustments needed by households and the financial sector, which will limit consumption and lending growth. Even if the housing market soon reaches bottom, no major growth impulses can be expected from this sector. Unemployment is likely to rise until 2010. Together with more bankruptcies, this will lead to higher credit losses for a while longer.

Initially growth will mainly come from public sector spending and investment, as well as a slightly brighter global outlook. Interest-rate sensitive sectors won’t benefit from a monetary stimulus, and in contrast to our January forecast we believe it will take time for private investment to become a driving force. Capacity is extensive and, if anything, needs to be reduced. Companies have to continue to improve efficiencies, shed employees and cut costs.

We expect GDP to shrink by 2 ¼% this year. Note that US statistical authorities have revised 2008 GDP growth downward from 1.1% to 0.4%. Next year GDP will rise by 1 ¼%, partly thanks to the stimulus programs. In 2011 we are forecasting that GDP growth, at 1 ¾%, will fall below its potential (or its historical average, which we estimate at around 2-2 ½%). An important reason why the financial sector has been able to avoid a collapse and why the US economy – despite the huge financial and real economic chock – can expect a recovery is the fiscal and monetary stimulus.

President Barack Obama’s administration unveiled a stimulus package corresponding to 5% of one year’s GDP for the period 2009-2011. The budget deficit is expected to rise to 13% this year and remain high for several years to come. Public debt is likely to increase from 44% this year to 87% of GDP in 2020. A tax reform is probably needed. Criticism of President Obama is

Several factors favour the recovery, but previous growth engines have lost steam …

… and the public sector has had to take over


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growing3, particularly with regard to the country's deficit and health care reforms, which are dragging out. Demands for a budget consolidation could put the recovery at risk, however. Japan’s experience shows that unwinding emergency measures too quickly can prolong a recession. The timing of the US’s exit strategy is important.

The same is true of monetary policy. Cutting back too quickly could threaten both the real and financial economy. Unwinding the stimulus too slowly – by raising interest rates and shrinking the Federal Reserve’s balance sheet – could hurt confidence in the central bank and price stability target. Because of the vulnerability of the US economy and low rate of inflation, the Fed can take its time. The combination of large budget deficits (partly financed by the Fed) and lots of liquidity is a concern, however. To reduce the risk of losing the confidence of the rest of the world, which would cause a precipitous drop in the dollar, the Fed may want to raise interest rates during the second half of 2010.

Japan – Continued dependence on the US

Highlights of our previous forecasts in 2009: We stated in January that Japan's economy was characterised by recession and deflation due to a strong yen and weaker foreign demand. We did not expect the economic stimulus to have its intended effect and that the country’s recovery would depend entirely on the rest of the world. GDP was expected to fall by just over 2% this year, but after a major decline late in 2008 the forecast was revised downward to -6 ½% in June. A slight upturn was expected in late 2009, lasting into 2010 (GDP growth 0.4%).

Highlights from our new August forecast: The economy has reached the point of recovery, though this is still dependent on global growth. Japan’s stimulus has contributed to GDP growth, however. Eventually we can expect a period of tightening, since the savings ratio could get too high given the country’s demographic challenges and lower domestic savings. A new government faces several challenges, including a transition to higher domestic demand and a new growth model. After GDP shrinks by 6% this year, we can expect to see a weak recovery this fall, with GDP growth reaching 1% in 2010 and 1.4% in 2011.

Important forecast risks: Weak global growth, deflation, political consensus, the possibility of a new government with new policies, fiscal and monetary policies, corporate earnings, rapidly rising commodity prices and the yen.

Japan is one of the countries that in real economic terms have suffered the most from the global crisis, especially its industrial sector and exports. Unemployment, on the other hand, has not risen as quickly. Wages and bonuses have tumbled, however, 3 56% of Americans still support Barack Obama, compared with 44% for Bill Clinton at the same point during his first term.

Economic policy has become more risky


at the same time that Japan has again entered a period of deflation.

GDP growth in Japan (%)

Positive signals from around the world would seem to indicate that the worst is over, as a result of which Japan’s purchasing managers index now exceeds 50. GDP grew in the second quarter. A stronger Chinese economy has helped to stabilise exports. Japan’s fiscal stimulus, worth about 5% of GDP, has also had an impact. The risk of a setback remains great, however. There is also the risk that the recovery could be weak. Domestic demand is soft due to sceptical households and businesses, which see no reason to invest given current overcapacity. Unemployment will continue to rise, from 5 ½% at present to levels of around 6-7%.

Not until the US economy is in better health will Japan’s growth be sustainably higher. It’s true that China is growing quickly, but its growth is based on a domestic stimulus that does not generate as much Japanese exports as when the world demands Chinese products. Moreover, Japanese companies are hoping for a weaker yen now that the search for safer investments has eased.

On 30 August the Japanese will go to the voting booths. Despite that the Liberal Democratic Party (LDP) has held onto power since 1955 (with the exception of 11 months in 1993-94), the more left-leaning Democratic Party of Japan (DPJ) is expected to win the election. A power shift could lead to changes, e.g., an increased focus on households, less interest in US securities, efforts to reduce bureaucracy and fewer infrastructure investments.

Whether the LDP or DPJ wins the election, the challenges facing the Japanese economy are great. The public debt ratio is nearly 200% of GDP, demographics could complicate the financing of the deficit and a budget consolidation will have to begin eventually. Monetary policy is also in need of normalisation (with higher interest rates and an end to quantitative easing) after years of artificially low rates and deflation problems.

Japan’s GDP rose in the second quarter …

… but its dependence on China and the US still remains

A change in government is expected on 30 August


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Our forecast for Japan’s GDP was revised upward to -6% for 2009 after more positive growth figures in the second quarter. In our latest analysis of Japan (6 August), we revised GDP growth for 2010 upward to 1%. This hasn’t changed. In 2011 GDP growth will rise marginally, reaching 1.4%. Deflation is expected to remain an issue in 2010, which is longer than in many other countries.

China – The stimulus generates growth, and bubbles

Highlights of our previous forecasts in 2009: In January we saw that China's economy had entered a slowdown, but that the huge stimulus package and interest rate cuts would help somewhat. Major declines in exports and car sales were reported. Social tension in the aftermath of slower growth remained a possibility. Uncertainty about the effects of the stimulus was considered great. During the spring GDP forecasts were unchanged at around 6 ½ -7 ½% for 2009 and 2010.

Highlights from our new August forecast: Domestic demand (read lower investments) is being aided by the huge stimulus, not least increased bank lending. There is a risk that capacity is expanding too much at the same time that asset prices are skyrocketing. New bubbles could be the price the Chinese have to pay to compensate for lower global demand. A new growth model will require structural reforms (currency policy, credit market, agricultural reform, labour markets, welfare systems). We are revising GDP growth upward to 7 ½% this year and 8% next year. After that we foresee weaker growth rate (7 ½%) when investments contract and consumer spending remains in check.

Important forecast risks: Impact of the stimulus, asset bubbles, excessive capacity, bad loans, global growth, labour market, social tension, political decisions and deflation.

The Chinese economy is bifurcated. On the one hand, exports are still falling substantially (-23% in July). On the other, auto sales are growing tremendously (+63% in July). The global recession is still being felt, and demand for Chinese consumer goods remains low. Domestic demand, on the other hand, is being driven higher by expansive economic policies: lower interest rates (the People’s Bank of China cut its key interest rate to 5.31% in January and has since kept it unchanged) as well as lower reserve requirements in the banking system and a fiscal package corresponding to 5% of one year’s GDP for 2009-2010.

The stimulus has strengthened investments, though exports are still developing weakly


China’s exports in USD and passenger car sales (annual change and two-month moving median)

The fiscal stimulus is increasing investments in infrastructure, particularly in the construction sector. The investment ratio (investments as a share of GDP) in the economy has now reached a historically high 45%. In addition, households have received subsidies and tax cuts, which are fuelling spending and the real estate and stock markets. Inland regions are now growing faster than coastal regions, which are more dependent on export demand. The high growth rate raises questions, however, about the sustainability of the Chinese economy now that foreign demand is slowing:

1. Can we trust the data? A debate has arisen about the quality of China’s economic statistics, especially since China is becoming increasingly important to the global economy and is reporting substantial growth (GDP grew by nearly 8% at an annual rate in the second quarter). This debate isn’t new, though. China’s provinces are almost always growing faster than the national average. Statistics for some periods arrive practically before the periods have ended. The Chinese aren’t especially confident in their own numbers, either. In other words, the data have to be interpreted cautiously, which is nothing new!

2. Are new bubbles forming? The Shanghai Stock Exchange (Composite Index) has risen by about 60% this year (90% on 3 August). Real estate prices are skyrocketing. Chinese authorities are encouraging banks to reduce their lending and lend more money for investments in the real economy rather than equities or real estate. Yet the stimulus through the banking system will keep fuelling the economy, with the risk of an unsustainable rise in asset prices. There is also a risk that the capacity expansion is going too far and that it could require several years to clean up the banking system’s bad loans. In that case, the growth rate will drop considerably from where it is now.

China’s inland is now growing faster than coastal regions

S o u r c e : R e u t e r s E c o W in

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3. What is happening with China's currency? Since abandoning the peg to the dollar in July 2005, the yuan has appreciated by 28% in real trade-weighted terms. During the last year the yuan again seemed to be pegged to the dollar. Analysts offer various estimates of how undervalued the yuan is. The exact number is impossible to know. The current currency policy isn’t sustainable, however, if China is going to change its growth model to encourage more consumption at home. US pressure on China has diminished, since there is concern about getting enough Chinese financing for the US budget deficit. A liberalisation of currency policy will probably have to wait.

4. And what about China’s current account balance? For the first time in several years China’s current account surplus is decreasing in both nominal and real terms. Imports are rising due to higher domestic demand at the same time that exports are falling. Net exports are now contributing negatively to GDP growth. Compared with 2007-2008, when the surplus was 10% of GDP, it will drop by half next year. Of course, China still has a huge current account surplus and tremendous currency reserves (USD 2,130 billion in Q2) that must be invested.

5. What steps are being taken to create a new growth model? China’s growth has been driven to date by investment, and even though exports do not seem to be that important to GDP growth, they do have an indirect connection to the country’s investment growth. On the other hand, consumer spending accounts for only about 35% of GDP (about half that of the US). The risk is that China builds up too much capacity and that the banking system will get stuck with lots of bad loans. Households, on the other hand, have increased their savings at least partly to compensate for an inadequate public welfare system. It is unlikely that China will be able to create a new growth model without deregulating and modernising its credit markets so that companies can reduce their savings ratios. Important reforms are also needed in the agricultural sector, as well as in labour and currency markets.

Growth outlook: We are revising this year’s GDP growth upward to 7 ½% in light of a stronger stimulus and bank lending. Next year is also expected to see a faster growth rate (from 7 ½% to 8%). However, investments are likely to grow at a slower pace in 2011, and since households need more time to increase their spending, growth will decline to 7-7 ½%.

India – Weak monsoon rains are hurting growth

Highlights of our previous forecasts in 2009: In January we forecast a slightly weaker Indian economy due to the impact of lower capital inflows and declining demand for Indian products. We expected

Weaker investments could slow growth


fiscal policy to have only a slight impact on the drop in demand. Instead the country needed faster reforms. GDP was expected to grow by 5 ½% in 2009 and 6% in 2010, but in June the 2009 forecast was revised downward to 5%.

Highlights from our new August forecast: We don't expect India to be back on its previous growth track in 2009-2011. We have revised our June forecast down from 5% to 4 ¾% and estimate that GDP will grow by 6% in 2010 and 6 ½% in 2011. Below-normal monsoon rains are threatening the agricultural sector, though there are also indications of a recovery in the financial sector. An economic stimulus has had an impact, but must be phased out in time to avoid inflation and excessive deficits.

Important forecast risks:

Monsoon rains, economic policies and the impact of the stimulus, global growth, inflation, credit market, access to foreign capital, state budget, political climate.

Growth in India’s GDP, consumption and investments (%)

The slowdown in the Indian economy has levelled off. A growth rate of 5.8% was reported in the first quarter, i.e., the same as the fourth quarter last year. Exports are still developing weakly and there is no longer the same push behind domestic demand as during the expansive years of 2005-2007. Because it is not dependent on exports, India nevertheless has managed the global crisis better than many other countries. The Bombay Stock Exchange has recovered since the start of the year and risen by over 50%, although the index is still only two-thirds of the way back to its peak in early 2008.

A number of challenges remain in both the real economy and with regard to economic policies. Sub-par monsoon rains are leading to poor harvests, which will hurt growth and push consumer prices higher. A fiscal stimulus and the weaker economy are swelling the total budget deficit to slightly over 11% of GDP (around 7% of state finances). With a debt ratio of around 80% of GDP – and growth below its potential – the government is facing increasing pressure from investors to institute reforms, at the same time that the Congress appears to be sceptical to further liberalisations and privatisations.

Optimism has increased in the stock market

Sub-par monsoon rains are a new threat to growth


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Since January the central bank has cut its key interest rate in two stages, from 5 ½% to 4 ¾%, and then its top level by 4.25 percentage points. Monetary policy now has to take fiscal policy and rising commodity prices into consideration and therefore will be tightened fairly soon if inflation continues to rise. The medium-term inflation target of around 3% will not be met. Concerns about asset bubbles have grown due to the stimulus and increasing risk appetite from abroad. India has also tried to increase liquidity and help credit markets. Which means it also needs an exit strategy.

Higher capital inflows have strengthened the rupee. If it rises any more, there is a chance the authorities will again become proactive to keep the currency from appreciating too much. We are writing down our forecast to 4 ¾% for 2009 due to the weaker agricultural production we expect in the wake of the lacklustre rainfall. For 2010-2011 we are projecting GDP growth of 6-6 ½%.

What would help India to return to its previous growth rates of 8-9%? Reforms! Labour law must be modernised. Many state-owned enterprises could be privatised. Measures to attract foreign direct investment would help the economy and increase competition. More needs to be done to phase out subsidies that have proved ineffective. Last but not least, it is important that the country refrain from protectionist measures.

EU countries – Following the US out of the recession

Highlights of our previous forecasts in 2009: Export-dependent EU countries were expected to be strongly affected by weaker global growth. Falling consumption and investments would result from weaker trade. Additional economic rescue packages were expected. GDP growth in the euro zone would reach -2% this year according to our January forecast, but after a major decline in late 2008, 2009 was revised downward to -4.5% in the June forecast. A more stable GDP was expected in 2010, i.e., zero growth. The UK was felt to be facing its largest economic decline in decades, while the Nordic countries would manage better than the euro countries.

Highlights of our new August forecast: A recovery began in the euro zone in the second quarter, but will be sluggish due to a weak turnaround in the rest of the world, continued problems in the banking sector and insufficient domestic demand in many countries. Monetary policy will remain expansive for some time, but interest rates will begin to normalise no later than 2011. Fiscal policy will be even more expansive and a budget consolidation will not begin until after the forecast period. GDP growth will slightly exceed -4%, ½% and 1 ¼% for 2009-2011. In the UK the recovery is affected by efforts to adjust balance sheets, while the Nordic countries have an advantage in that a budget consolidation at a later point will have less impact on growth.

India’s inflation problems could be exacerbated by the poor rains

A faster pace of reform would put India back on its earlier growth track


Important forecast risks: Global growth, credit market and banking system, Eastern and Central Europe’s development, German federal election, labour market, the impact of stimulus measures, housing market and household debt restructurings in certain countries, commodity prices, consumer prices.

GDP growth in major EU/EMU countries (%)

Euro zone: The region has been hard hit by the global economic slowdown and financial crisis. Several countries (Spain, Ireland) have savings imbalances, while others (Germany, France) have mainly been hurt by the decline in exports. Austria, Greece and Italy have also been affected by uncertainty about their banks’ operations in Eastern and Central Europe.

When the turnaround does arrive, countries with small or no imbalances (Germany) will have relatively good growth opportunities. But Germany will still have to reassess its growth model in light of weaker demand from many highly indebted and previously important export markets. This will be a challenge for the next government that takes over after the Bundestag election on 27 September. The auto industry’s future is an important risk factor. Reforms that increase flexibility in the labour market and improve confidence among consumers could boost household spending.

After the ECB cut its key interest rate and pumped liquidity into the market – and countries to varying extents adopted fiscal stimulus packages – demand has slowed. The financial markets are working better, but it is still too early to say that the danger is over. Banks have to continue to trim their balance sheets, and there is a risk of a more serious credit crunch that squeezes companies and the labour market. Real estate prices are continuing to fall in many countries, which also could affect European banks negatively.

The region is on its way to stabilising. Demand will soon start to grow, both from abroad and within the region, driven by the stimulus. Although the purchasing managers index (46.3 in July) is nearing the growth zone, industrial production is still falling at a monthly rate. Investments will remain low, since there is sufficient capacity. Employment will continue to rise,

The new German government faces several challenges


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even after GDP starts to grow. We expect it to reach 12% in 2010 and then stabilise in 2011. We are projecting that GDP will fall by slightly over 4% this year and grow marginally in 2010. Not until 2011 will growth come close to 1 ¼%, and then we will also see a greater willingness to invest and spend.

Inflation will remain negative in the months ahead, but turn higher later in the year. Core inflation will instead fall next year as available capacity increases. The European Central Bank (ECB) is maintaining its key interest rate at 1%, not least since its interest rate weapon has lost its effectiveness due to the crisis. Instead it will maintain measures to ease the credit market.

Furthermore, fiscal policy has become more expansive. On average, budget deficits as a share of GDP will increase from 0.6% in 2007 to 7% in 2010. This shows that many countries should have increased their public savings during earlier growth years. Public debt will grow from 65% to 90% of GDP during the same period. The differences between Germany’s and France’s fiscal policies have widened. While Germany will set a ceiling for its 2016 deficit, France does not feel it is a problem to increase its deficit.

UK: The imbalances in the country’s financial and property markets are worsening an already severe recession. A recovery will soon begin, however. The purchasing managers’ index for the industrial and service sectors indicated growth, and there is good reason to assume that most of the inventory cutbacks are done. There are still growth risks, since it will take time before bank lending increases, at the same time that a phase-out of the stimulus and a transition to budget consolidation will be painful. The UK’s public debt could exceed 100% of GDP. This will be even more painful when interest rates rise.

Cutting the budget deficit from 12% of GDP will be a challenge when the new government takes over after the election (which must be held by 3 June 2010). The Bank of England has expanded its quantitative easing and sees an imminent risk that inflation will fall below its target. The main challenge, however, is that it will take time for households, businesses and the financial sector to trim their balance sheets.

Nordic countries: Despite strong government finances and no obvious economic imbalances, Sweden, Finland and Denmark have been hard hit by the global recession. Norway can still avoid recession, while Iceland’s problems mainly relate to the financial sector’s collapse after questionable investments outside the country’s borders.

Tighter fiscal policy during the good years would have helped now

Fiscal policies will be the new government’s biggest challenge next year


Though the much-discussed Nordic model makes it relatively easy to hire/fire employees and offers an extensive social welfare network for the jobless, there is still good reason for the Nordic countries to work harder with structural reforms to alleviate the crisis. On the plus side from a medium-term perspective is the fact that a Nordic budget consolidation will not affect growth prospects as much as in many larger EU countries.

8. Consequences for the Swedish economy Following is a summary of some of the areas where Sweden could be affected by global developments:

• Swedish businesses and households can expect considerably weaker development in 2009-2011 than during the growth years of 2005-2007. Unemployment continues to rise, wages are dropping and the number of bankruptcies will push higher in the years ahead. For those with work, the monetary and fiscal stimulus should make things better than in previous years.

• Sweden’s financial situation is deteriorating, but the trend – which is positive in a relative sense – still gives it a head start in the medium term. Its budget consolidation will have less impact on growth than in many other OECD countries. As a result, Sweden has an opportunity to take advantage of better economic conditions to aggressively tackle its reforms. This could mean reforms in the labour and product markets, tax and social insurance reforms, and investments in green technology and energy.

• Globalisation has slowed but continues, and the pace will again increase. It is important at this moment to make the country even more competitive by investing in education, professional training and research and development (R&D).

• No country is able to improve its citizens’ standard of living by leveraging. The financial crisis nullified this growth model. Consequently, any increase in the standard of living in the years ahead will have to be tied to wage growth, which in turn requires strong productivity improvements and increased value-added in production. Once again R&D is a key to the growth model.

• Sweden has a head start when it comes to expanded child care and measures to strengthen the labour supply among young adults. It is important therefore that it also reassess other areas that are limiting job opportunities for young people.

• Working with education, health and social care as growth sectors is one way to stay ahead of the growth curve, particularly considering that demographic trends point to an increase in demand for social services.

Though it may offer certain advantages, the Nordic region has been hurt by the global crisis and also has to increase its pace of reform


• Developments in Eastern and Central Europe remain a risk to the Swedish financial sector in the short and medium term. Promoting more cross-border regulation and oversight in the financial sector, as well as measures to bolster financial integration at a regional level, would also be in Sweden's interests in the medium and long term.

• Sweden is a small, open economy focussed on exports. The export sector is and should remain important to the economy. At the same time economic policies could give more emphasis to domestic private demand (investment and consumption). First and foremost, a higher share of investment could provide a foundation for stronger growth potential.

Cecilia Hermansson

Economic Research Department SE-105 34 Stockholm, Sweden Telephone +46 8 5859 1031 [email protected] www.swedbank.se Legally responsible publishers Cecilia Hermansson, +46 8 5859 1588 Magnus Alvesson, +46-8-5859 3341 Jörgen Kennemar, +46 8 5859 1478 ISSN 1103-4897

The Swedbank Global Economic Outlook is published as a service to our customers. We believe that we have used reliable sources and methods in the preparation of the analyses reported in this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or its use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, directly or indirectly, owing to any errors or omissions in Swedbank’s Global Economic Outlook.

Global Economic Outlook 20 August 2009

Economy & Finance

Transcript of Global Economic Outlook 20 August 2009