Deloitte Economic Outlook Q2 09

Global Economic Outlook 2nd Quarter 2009

A Deloitte Research Study

About Deloitte Research Deloitte Research, a part of Deloitte Services LP, identifies, analyzes, and explains the major issues driving today’s business dynamics and shaping tomorrow’s global marketplace. From provocative points of view about strategy and organizational change to straight talk about economics, regulation and technology, Deloitte Research delivers innovative, practical insights companies can use to improve their bottom-line performance. Operating through a network of dedicated research professionals, senior consulting practitioners of the various member firms of Deloitte Touche Tohmatsu, academics and technology specialists, Deloitte Research exhibits deep industry knowledge, functional understanding, and commitment to thought leadership. In boardrooms and business journals, Deloitte Research is known for bringing new perspective to real-world concerns.

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EXECUTIVE SUMMARY

Global Economic Outlook April 2009 Since our last Outlook in January, the financial crisis has deepened and become a truly global recession. Economic activity in the United States, Europe, and Japan has declined at an alarming rate. Emerging countries in East Asia and Central Europe have experienced sharp drops in economic activity with the latter at risk of further financial turmoil. Even the BRIC economies that at one time seemed relatively immune to the global financial situation, have experienced serious problems. Global trade has plummeted, causing concern that the increasingly global nature of the economy leads to more rapid transmission of trouble than in the past. And yet, there are starting to be indications of light at the end of the tunnel. Global shipping rates have stabilized and modestly increased. Risk spreads are far below their level of a few months ago. And governments have been pumping money into the system at an unprecedented rate. Still, risks remain. Deflation appears to be rearing its ugly head. The degree to which government action regarding banks will be effective is far from certain. And the specter of protectionism is not far below the surface.

Dr. Ira Kalish is Director of Global Economics at Deloitte Research

In this issue of our quarterly Outlook, our economists offer their perspective on the global situation. Carl Steidtmann provides an analysis of the Obama economic plan and a moderately optimistic view of the U.S. outlook. Elisabeth Denison examines the Eurozone economic outlook as well as the limitations on economic policy action within the context of the European Union. Elisabeth also writes about the more long-term issue of demographics and the likely constraints it will impose on policymakers the world over. Ian Stewart looks at the outlook for the U.K. economy, while Sunil Rongala provides outlooks for Japan, China, India, and Russia. In addition, Sunil considers the impact of China’s economic troubles on S.E. Asia. Finally, I provide our outlook for Brazil, as well as an analysis of the troubles in Central and Eastern Europe and their potential impact on the West. As always, we hope that this Outlook provides useful information for business planning. Moreover, all of our authors welcome feedback.

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“In a global economy where the most valuable skill you can sell is your knowledge, a good  education is no longer just a pathway to opportunity – it is a pre-requisite.” Barack Obama Address to Joint Session of Congress, Feb. 24, 2009

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United States Eurozone China and South East Asia United Kingdom India Japan Brazil Russia Central and Eastern Europe

Preparing for the Next Battle: Demographic Threats Have Not Gone Away





Developed Countries: United States, United Kingdom, Eurozone, Japan Emerging Countries: Brazil, Russia, India, China

- Big Four Yield Curves - BRICs Yield Curves - Composite Currency Forecasts - GDP Forecasts - OECD Composite Leading Indicators

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United States: An Unprecedented Policy Response Resets the Playing Field Dr. Carl Steidtmann

“You never want a serious crisis to go to waste. What I mean by that is it’s an opportunity to do things that you think you could not do before.” Rahm Emmanuel Presidential Advisor

Dr. Carl Steidtmann is Chief Economist of Deloitte Research

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Every business cycle leaves its mark on both the nature of business and the role of government in the economy. Not since the 1930s have we seen the government policy response to a recession as transformative as the response by the Obama administration to the current recession. In the U.S. we are witnessing a fundamental realignment of the relationship between government and the private sector. With government as the growth sector in the U.S. economy, both taxes and regulation are set to expand.

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These changes are expected to create a financial services sector that is less leveraged, with business models that are much less prone to wide swings in earnings and losses. Increased government oversight of U.S. business will not be limited to financial services. Both health care and energy can expect significant changes. In these industries we are likely to see new innovations and business models that will sustain growth for the broader economy.

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Credit spreads on a roller coaster

Figure 1: 3-month Libor less 3-month T-Bill spread (in basis points)

The immediate problem for the economy still lies in the banking system. The sharp down draft that hit the U.S. and the global economies in the fall of 2008 came blowing out of the banking sector. The collapse of Lehman Brothers, the government rescue of AIG, the passage of the Treasury’s Trouble Assets Relief Program sent credit spreads through the roof and set up the economy for a significant contraction in both credit and the real growth that is now unfolding. The Libor-T-Bill spread is a good measure of bank fear of lending to other banks. In normal times it will fluctuate between 25 and 50 basis points. The failure of Lehman Brothers sent that spread up from an elevated level of 110 to 150 overnight on its way to 300. The passage of the TARP pushed the rate to its peak of 456 basis points.

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The government’s efforts did not end with the TARP. The Federal Reserve set up a wide variety of different lending facilities to keep the financial system liquid. They created a wide array of different facilities to buy everything from commercial paper to mortgage backed securities. The good news here is that the Treasury and Federal Reserve’s efforts have slowly brought down the Libor-T-Bill spread and other measures of risk from their mid-October peaks.

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Fixing the banks The difference between the U.S. economic performance and that of Japan in the 1990s was the United States dealt with its banking system problems in an expeditious manner and Japan did not. The Resolution Trust Corporation was highly effective in dealing with the problem of failed savings and loan banks. While the banking problems of today are both bigger and more global than in the early 1990s, the RTC is one model that could be followed in addressing bank failure today. Whether the United States experiences a lost decade like Japan in the 1990s will depend on how quickly the current banking system problems are addressed. Without private sector lending, any government stimulus program eventually runs out of cash before the recovery becomes self-reinforcing. The Japanese in the 1990s went through stimulus program after stimulus program and yet could not jump start their economy. 2nd Q ua r t er 20 09

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The Geithner plan The centerpiece of the Geithner bank plan is the creation of a series of P-PIPs or Public-Private Investment Partnerships that will buy up what are now euphemistically referred to as “legacy assets”. The plan extends low interest nonrecourse loans from the FDIC and Treasury to the P-PIPs to buy up legacy assets, allowing them to pay a higher price for them than other non-P-PIP participants. While the gains from any of these purchases will be shared, the downside risk falls mainly to the U.S. taxpayer.

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The plan’s viability and likelihood of success has been vigorously debated among economists. Liberal economist and Nobel prize winner Paul Krugman emerged as a vocal critic. His case against the plan is that even after you give huge windfalls (“gold plated toasters” in Krugmanese) to hedge fund speculators and bail out the bank’s equity holders, you still have zombie banks. These legacy assets are not mispriced as the Geithner plan assumes. To be solvent the banks need to get at least 80 cents on the dollar for their legacy assets. The market is offering them 30 cents and the P-PIPs might get them 50 cents due to generous government subsidies, but that still leaves the banks short and insolvent The counter argument to Professor Krugman is that the purpose of the Geithner plan is not to rescue the banks outright, but to buy them time. The Treasury may not have the resources or the political support to save the banks but if they can give the banks some time, they might be able to save themselves. The banks still have strong business models. With bank spreads as wide as they are, it’s a great time to be a banker. Several large money center banks recently announced that since the first of the year they have been

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“What do you get when you cross a Godfather with a deconstructionist? Someone who makes you an offer you can’t understand.” Paul Krugman on the Geithner plan making money. Even in the worst of times the banks can earn billions each quarter in free cash flow. With enough time, they can earn their way out of their balance sheet problems. While the banks can probably save themselves if given enough time, there are two other reasons why the current plan may faces challenges in the long run. In rescuing the banks, the U.S. Treasury is replacing the Greenspan Put with an even larger Geithner Put. This plan potentially takes moral hazard to a whole new level. Its longer-term success will depend on new financial system regulation aimed at limiting the future risk that the rescued banks will be allowed to assume. Secondly, the Geithner plan assumes that banks are not lending because they are holding too many bad assets on their balance sheets and if we just remove these legacy assets, all will be well. Even if we make the banks whole, they need to have qualified borrowers to get lending going again. A second factor that contributed to the current crisis was giving out loans to unqualified borrowers. With total economy-wide debt at 350 percent of GDP, we have a limited pool of qualified borrowers.

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The heart of the problem: Private sector deleveraging

The deleveraging antidote

As the credit crunch unfolds, it forces the banking system to deleverage. As the banks reduce their leverage, they are forced to cut back on lending. That, in turn, creates a cascading process of deleveraging on the rest of the economy, particularly the household sector. In addition to pulling back on the issuance of mortgage debt, the banks have become much more aggressive in the approach to consumer credit card debt. In that arena, rates are rising, terms of credit becoming more restrictive, and credit balances being reduced. To offset this credit contraction, both the Federal Reserve and the Treasury have responded aggressively.

Since the beginning of the current credit crisis in August 2007, the Fed has taken an aggressive stance towards easing policy. The goal was to keep the banking system liquid and to reduce the risk of deflation. The magnitude of the Fed’s efforts can be seen in the exploding size of their balance sheet. As the private sector reduced its leverage, the Federal Reserve has increased theirs. The Federal Reserve has done this by greatly expanding its own balance sheet, effectively becoming one of the largest hedge funds in the world. The Federal Reserve’s most aggressive move into the world of structured finance will begin full operation in late-March. The TALF (Term Asset Backed Securities Loan Facility) is an attempt to get the shadow banking system’s debt securitization process functioning again. The Federal Reserve’s plans include the purchase of up to $1 trillion in securitized debt. TALF will purchase AAA rated asset backed securities backed by newly and recently originated auto loans, credit card loans, student loans, and SBAguaranteed small business loans. By taking on another $1 trillion in assets with the TALF, the Fed will have effective tripled the size of its balance sheet, an unprecedented move that substantially increases the future risk of inflation.

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Figure 2: Non-financial, private sector debt growth (in Trillions $ annualized) 2.5

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Spending to soar The Obama administration has been very aggressive in pushing through its spending proposals. Last year’s $188 billion stimulus package seems like a quaint notion in comparison to the massive $787 billion stimulus package passed in February. That package had a little something for everyone.

Figure 3: American recovery and reinvestment act of 2009 (Billions $ of spending by category) 250 200 150 100 50

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The stimulus package contained a mix of spending on jobless benefits ($83 billion), health care ($148 billion), tax cuts for both individuals ($237 billion) and businesses ($51 billion), as well as spending on what is typically thought of as stimulus like building roads ($45 billion) and energy infrastructure ($45 billion). At $787 billion, the total stimulus package is slightly more than 5 percent of total GDP.

Source: Office of Management and Budget

In addition to the stimulus package, the U.S. Congress has also passed an 8 percent increase in spending for the balance of fiscal year 2009. The budget plan envisions a massive increase in U.S. government indebtedness. While the U.S. government has no problem selling its debt in the current market, there is a growing level of concern about its ability to sell that debt in the future. No one less than the United States’ largest creditor, Chinese Premier Wen Jiabao has openly worried about the state of U.S. credit and for good reason: U.S. debt will rise from 40 percent to 60 percent share of GDP, its highest levels since the end of World War II.

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A case for cautious optimism

Conclusions and observations

With an aggressive fiscal and monetary policy in place in the United States, a case can be made for cautious optimism. The recession in the United States turned severe this past fall when credit markets contracted and consumer spending went into a cliff dive. The combination of credit contraction, wealth destruction, and lost employment was simply too much for the world economy’s consumer of last resort. Not since President Carter placed credit controls on the American consumer in the spring of 1980 have we seen consumer spending in such a free fall.

The business cycle is a little like a rubber band. The more it gets pushed down, the sharper the recovery. The conventional wisdom for the coming recovery is that it will be tepid at best. It is argued that the consumer is hopelessly in debt and unable to spend while business investment is constrained by excess capacity. By the time it is all over, the current recession will have been the worst downturn of the post-World War II era. As such, the economy is creating an unprecedented level of pent up demand, particularly for durable goods.

Credit markets have slowly healed. Measures of credit distress have ebbed. The U.S. Treasury yield curve, a measure which has the single best track record of any financial leading indicator, has steepened — a positive sign for future growth. In the household sector, cash flow is currently being hurt by the sharp contraction in employment. Offsetting those job declines has been a sharp rise in real hourly earnings. Falling prices for energy and other consumer staples have given a sharp boost to consumer purchasing power. Real disposable income has been up five months in a row through January for an annualized gain of 11 percent. Additional gains in cash flow are coming in the form of tax reduction for middle and low income consumers. Consumers have the means to spend more; they simply have been lacking the will. The result has been one of the sharpest increases in consumer savings in the past 50 years.

With home prices falling, housing has become more affordable than at any time in recent memory. Weak auto sales have produced a sizable increase in fleet age. Both should produce sizable increases in consumer demand once the banking system is stabilized. The same is true for business investment. Stronger demand coupled with delayed investment will create a very favorable environment for stronger business investment. Couple this pent up demand with unprecedented levels of fiscal and monetary stimulus and this should make the recovery anything but conventional.

Stabilization in consumer spending will halt the severe inventory reduction that has accelerated the economy’s downward slide. With inventories lean, any small pickup in spending will produce an increase in industrial production, making the recovery more self-reinforcing. Business investment will follow and eventually more businesses will start to hire.

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Figure 4: Real consumer spending (% change, year-to-year) 10.0 8.0 6.0 4.0 2.0 0.0 -2.0 -4.0 1968

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Eurozone Economic Outlook Dr. Elisabeth Denison

Dr. Elisabeth Denison is Senior Economist at Deloitte Research, contributing Eurozone perspectives from Germany

The recession is tightening its grip on Europe. As the downturn deepens, structural and ideological differences are coming to the fore. Nonetheless, concerted efforts are being made to combat the crisis, because the fates of individual nations have become strongly intertwined. More than half of all trade in the Eurozone is within the region, and banks have formed close cross-border ties over the past decade. A show of multilateral action might help shore up confidence and stimulate a recovery from within.

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Growth prospects Eurozone growth deteriorated markedly in recent months as the world economy and domestic demand slowed simultaneously. Euro area real GDP is estimated to have contracted at an annual pace of 5.8 percent in the final quarter of 2008, after more moderate declines in Q2 and Q3 (see figure 1). With average growth of 0.8 percent in 2008, the expansion was at its slowest since the early 1990s. Unfortunately, the negative momentum seems to have carried over into 2009. Preliminary data point to another decline in GDP in the first quarter.

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Figure 1: GDP growth in the Euro area takes a dive 6.0%

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Exports Weakening external demand is part of the reason for declining GDP. Euro area exports slumped in the final quarter of 2008, falling by 7.3 percent quarter-on-quarter. Historically low levels of export orders as well as pessimistic business surveys point to another decline in exports in Q1. Long-term prospects depend crucially on the development of the Euro area’s most important trading partners, including Eastern Europe, Asia, and America. In the near term, exports may gain some support from the depreciation of the euro in recent months — if it is sustained. With the Federal Reserve Bank now also resorting to Quantitative Easing, pressure is mounting on the European Central Bank (ECB) to close the interest-rate gap with the United States to remove reasons for renewed euro strength.

Figure 2: Easing inflation pressures 4.5%

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The ECB certainly has room for further maneuver. Annual inflation in the Eurozone dropped from a peak of close to 4 percent in June 2008 to under 2 percent by the end of the year and is expected to fall further in the months ahead. The moderation in overall price gains is not limited to food and energy prices, but is translating into slowing core inflation as well (see figure 2).

Consumer spending The decline in consumer price inflation is providing some support for real incomes in the Eurozone. Unfortunately, this effect is offset by deteriorating labor-market conditions. Unemployment increased sharply over the past year, rising from 7.2 percent in January 2008 to 8.2 percent in January 2009. The worst affected nations include Spain, with an increase of almost 6 percentage points, and Ireland, with a rise of 4 percentage points. These countries — just like the United States — are suffering from an unraveling housing and construction boom. France has fared slightly better, with a more modest 0.7 percentage point rise in unemployment over the past year, while Germany still boasted a decline in unemployment from 7.7 percent in January 2008 to 7.3 percent in January 2009 (see figure 3).

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Figure 3: Diverging fortunes I: Labor markets in the Eurozone 20 18 16 14 12 10 8 6 4 2 0

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Consumer spending is almost a mirror image of these trends. While German and French consumers each spent roughly equal amounts in the last six months of 2008 compared to the same period in pre-crisis 2007, Spanish and Irish retail sales were 9 percent lower (see figure 4).

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Germany’s labor market has fared well so far, thanks to extensive help from the government. Instead of laying off workers, companies are able to put them on reduced hours (“Kurzarbeit”). While the wages are correspondingly reduced, workers receive up to two-thirds of the lost compensation from the government. The program runs up to 18 months. In December 2008, 270,000 workers (approximately 0.7 percent of the country’s workforce) were enrolled. In January and February 2009 alone, the German employment agency received 900,000 new applications. How many of the planned reductions will be realized in the coming months is still uncertain, and depends on how the economy evolves. It is possible that despite their best intentions to hold on to their most valuable assets, firms might be forced to resort to layoffs in the end. But, for as long as it lasts, keeping employees on the payroll provides support for domestic demand. Further aided by easing inflation and augmented by programs such as the government’s “environmental bonus” for new cars (€2500 of taxpayers’ money for scrapping one’s old car in favor of any new model), it is certainly lifting the consumer mood in Germany. Figure 4: Diverging fortunes II: Retail Spending in the Eurozone 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10%

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Nonetheless, in the long term, household spending decisions are determined by expectations regarding lifetime income from both asset wealth and labor compensation. With severe losses in financial assets and falling house prices in many regions, the outlook for returns on financial and non-financial wealth is poor. Expectations about labor market developments going forward have also deteriorated. So, despite short-term stimulus, the longer-term picture for consumer spending remains worrying.

Business spending Investment spending by companies is not likely to pick up pace anytime soon, either. Businesses in Europe are faced with a sharp deterioration in their profit picture — not only due to falling volume but also due to deteriorating unit profits. The latter is being caused by weakening pricing power (declining inflation) and rising unit labor costs. It might seem odd that unit labor costs are rising in the face of the worst economic downturn in decades. The reasons lie in the long lags with which adjustments take place in the labor market. Unions now seem to be trying to make up for lost participation during the upswing. In the last quarter of 2008, Euro area annual negotiated wage growth increased to 3.5 percent, up from 3.4 percent a quarter earlier. There were also second-round effects in some Euro area countries, stemming from indexation to temporarily high inflation outcomes in the past. As a result, annual growth in unit labor costs in the third quarter of 2008 remained at its most elevated level in over a decade even as output declined. This, of course, is a two-edged sword: while providing stimulus to real incomes, it endangers the long-term viability of businesses and jobs. Declining profitability, combined with waning capacity utilization and tighter lending standards, is leading to a decline in business investment spending. Construction spending — which accounts for about half of total investment and therefore has a significant influence on GDP — is expected to contract further in 2009, judging by the dwindling number of building permits granted in 2008.

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Government stimulus To offset weakness in private demand, fiscal expansion has taken hold across Europe. According to IMF tabulations, stimulus packages range from 0.2 percent of GDP in Italy to 1.3 percent in France and 3.4 percent in Germany. However, the effectiveness of countries’ stimulus packages also depends on their composition. Not all measures are clearly linked to the root of the current economic problems nor can they be implemented quickly. Some reflect political compromises rather than economic considerations. Government intervention also carries the risk of distorting the efficient allocation of resources. Rising deficits and debt risk undermining confidence in fiscal sustainability. Indeed, fiscal deterioration is widespread among Euro area countries. According to the European Commission’s forecast, Ireland, Greece, Spain, and France, as well as Italy, Portugal, and Slovenia are projected to breach the 3 percent of GDP reference value this year and (with the exception of Slovenia) to remain above it in 2010; Belgium, Germany, Austria, and Slovakia are expected to join them in 2010. This implies that, by 2010, the government deficit in 10 out of the Euro area’s 16-member countries is likely to be above the reference value. In essence, rescue packages have resulted in a transfer of credit risk from the private to the public sector. In January and February 2009, rating agencies lowered long-term sovereign credit ratings or their rating outlook for Ireland, Greece, Spain, and Portugal. Financial markets are watching this evolution carefully. At the same time, the financial crisis has so far convincingly demonstrated the advantages of a common currency. Without it, some members of the Eurozone might have found themselves in difficulties akin to those of some Eastern

European neighbors. As George Soros notes in a recent article on the Web site of the European Council on Foreign Relations, “The euro may be under stress but it is here to stay.” If there is any danger, he warns, it comes from its strongest member, Germany, which is understandably reluctant to become the deep pocket of the Monetary Union. Soros pleads for an integrated Eurozone bond and bill market, which would complement but not replace the existing government bond markets of individual states. The proceeds would be under the control of Eurozone finance ministers, providing the means for coordinated fiscal action, bank rescues, or even for assistance of new EU member countries that do not yet belong to the EMU.

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Outlook The Eurozone is in recession. There is a general consensus that GDP growth will decline further in 2009, with some stabilization in 2010. ECB staff sees a drop of -2 percent to -3 percent in 2009, noting that the economic outlook continues to be surrounded by uncertainty. On the positive side are the extensive monetary and fiscal stimuli, which might help to shore up confidence. On the negative side are concerns about the emergence and intensification of protectionist measures, and possible adverse developments stemming from a disorderly correction of global imbalances.

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For Europe, the cards have certainly been reshuffled. The sharp widening in spreads between member states’ sovereign debt indicates unprecedented strains in the Eurozone. However, rather than leading to a breakup, these strains could, in fact, provoke just the opposite — taking the union to the next level of integration.

References and Research Sources: International Monetary Fund (IMF), “The Size of the Fiscal Expansion: An Analysis for the Largest Countries,” February 2009. European Central Bank (ECB), “Monthly Bulletin,” February and March 2009. European Commission, Directorate-General for Economic and Financial Affairs, “Interim Forecast,” January 2009. European Economic Advisory Group, “The EEAG Report on the European Economy 2009,” February 25, 2009. George Soros, “The Eurozone Needs a Government Bond Market,” European Council on Foreign Relations, February 18, 2009. 2nd Q ua r t er 20 09

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China and South East Asia: Can the Dragon Protect the Tigers? Dr. Sunil Rongala

Dr. Sunil Rongala is the Asia Pacific economist at Deloitte Research

Economies in South East Asia have been hit badly in the current recession because of falling exports and the related spillover effects into manufacturing. There are many who posit that China will partially shield the S.E. Asian economies from the full impact of the recession. Their expectation is partially based on the still relatively buoyant domestic consumption numbers in China. Therefore, the question arises as to whether the dragon can protect the tigers from being fully mauled in the global downturn?

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A complex but integral relationship Up until the financial crisis in 1997, the ASEAN51 economies, or the “tiger economies,” were extolled as the right models of economic development. The 1997 crisis, however, exposed major fault lines and most of the tiger economies have never quite been able to match their performance of the 1990s. China was then considered to be an up-and-coming power — a second-tier economic power — and not the economic phenomenon, and a clear first-tier economic power, it has now become.

For a while, S.E. Asian economies considered China to be a threat especially when it came to attracting foreign money. In the early 1990s, of the money coming into Asia, three-fifths went to ASEAN countries and only one-fifth went to China. Toward the end of the 1990s, two-thirds went to China (including Hong Kong) and only one-fifth went to ASEAN countries. However, it wasn’t a loss as first thought. There were positive spillover effects from China’s growth: the ASEAN-5 countries received substantial amounts of foreign capital where factories were set up establishing production sharing networks.

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ASEAN stands for Association of South East Asian Nations and it has 10 members. ASEAN-5 refers to the five largest members namely Indonesia, Malaysia, Philippines, Singapore, and Thailand.

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Figure 1: Exports to China as a percentage of total exports 60% 50% 40% 30% 20%

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If an electronic item says “Made in China,” there is a good chance that the item was probably not fully made in China but rather assembled in China; the parts, components, and accessories (PCA) are likely to have come from all across Asia, particularly the ASEAN-5 countries. The process where PCAs are made in many places and then assembled in one place is called “production sharing” or “product fragmentation”; it is defined as “the decoupling of previously integrated goods into their constituent PCAs, which in turn are distributed across countries on a comparative advantage.”2 As a result, China has become one of ASEAN’s top export markets; exports rose from $14.1 billion in 2000 to $117 billion in 2008. Apart from increasing their exports, it has also contributed to job creation. According to the Asian Development Bank (ADB), “International production sharing has been associated with a high and rising degree of intraregional trade in parts and components that are produced and assembled into final goods within Asia, particularly in East and Southeast Asia.”3

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Note: Singapore’s numerator and denominator include only non-oil exports. Source: Bloomberg

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Can China protect the tigers? The short answer is no. The IMF has forecast 2009 ASEAN-5 growth at 2.7 percent and the member countries are essentially taking the full brunt of the slowdown. There are two major reasons why China cannot protect the ASEAN-5 countries. First, their top three customers are the United States, Europe, and Japan respectively and their fourth biggest customer is China. Figure 1 shows ASEAN-5’s exports to China as a percentage of total exports in recent months aren’t spectacularly large except in the case of the Philippines. With the economies of the United States, Europe, and Japan slowing sharply, their imports have also slowed. This means exports from S.E. Asia have suffered and the predictable result is that their manufacturing sector is suffering, too. Exports to China are also slowing down, but the cause isn’t straightforward and that is the second reason why China cannot protect S.E. Asia.

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R.S. Rajan and S. Rongala, “Asia in the Global Economy: Finance, Trade and Investment,” p. 140. Asian Development Bank, “Asian Development Outlook 2006,” p. 272.

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The outlook on China

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The reality is that, while the S.E. Asian countries would like to increase their exports to China, Chinese consumers will not soon be able to compete with the purchasing power of consumers in the United States, Europe, or Japan. In essence, they have struck a Faustian bargain: we don’t mind suffering for a couple of years, if we can reap large benefits for many years.

Figure 2: GDP growth (% YoY)

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A recent paper from the Hong Kong Monetary Authority4 suggests that over 50 percent of exports to China from Malaysia, Philippines, Singapore, and Thailand (significantly less from Indonesia) are used as intermediate inputs in goods that China re-exports. In other words, more than 50 percent of their exports to China are PCAs. This actually means that ASEAN-5 exports are even further exposed to the West. Therefore, as China’s exports to the West have suffered, so too have the imports of these intermediate goods. If the intermediate goods are discounted, actual Chinese demand for goods from S.E. Asia accounts for well less than 10 percent of their total exports — and even these exports have been hit.

In a speech delivered in early March at the second session of the Eleventh National People’s Congress, Prime Minister Wen Jiabao said: “GDP will grow by about 8 percent… It needs to be stressed that in projecting the GDP growth target at about 8 percent, we have taken into consideration both our need and ability to sustain development.”5 The target may be an optimistic one, though. The World Bank cut its 2009 forecast for China to 6.5 percent largely because it expects exports to contract in 2009. GDP growth in the fourth-quarter of 2008 increased by 6.8 percent compared to 9 percent in the third (see figure 2). Exports fell by 25.7 percent in February, and this contraction was the fourth straight month of negative growth. However, there are some early signs that the economy may be strengthening. Yet it should be noted that these signs are still fragile and not necessarily a predictor of sustained economic growth.

Mar 06

The World Bank cut its 2009 forecast for China to 6.5 percent largely because it expects exports to contract in 2009.

Source: Bloomberg

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Zhiwei Zhang, “Can Demand from China Slow East Asian Economies from Global Slowdown,” December 30, 2008. English translation of the original speech made in Mandarin.

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Industrial production grew at 11 percent in February compared to 5.7 percent in January. Many attribute this to the stimulus plan working, but that may be overstating the case. It has been reported that the $585 billion plan unveiled in November 2008 is facing hiccups. The Wall Street Journal reports that of the $15 billion allotted to be spent in the last quarter of 2008, less than a third had actually been spent. Another sign of recovery is the manufacturing purchasing managers index (PMI); it rose from 45.3 in January to 49 in February, though it is still below the 50 threshold (numbers below 50 indicate contraction). The fragility of the recovery can be seen in the contradictory signal coming from the non-manufacturing PMI which fell nearly 10 points to 41.9 in February from 51 in January. The non-manufacturing sector includes airlines, transportation, construction, retailing, etc. Urban fixed asset investment for the first two months of 2009 was up 26.5 percent. The increase in spending is to counteract the effects of falling exports and was only possible because banks, with a little nudge from the government, went on a lending spree; the government is looking to increased bank lending as part of their stimulus effort. Bank lending was about $380 billion in the first two months of 2009. It is still too early to gauge the multiplier effects of increased lending, but not all of the money is finding its way into the economy. A Wall Street Journal article suggests that companies are hoarding the cash received from loans rather than spending it: 42 percent of January’s loans were short-term and the interest rate was lower than the deposit rate. Another concern is that troubled loans are increasing and that is why the authorities have asked banks to increase their provisions to 130 percent on loans that they think will likely go into default. In contrast, foreign banks lent less in January and February because of perceptions of elevated risk.

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Retail spending remains fairly healthy and could get a boost if the revised stimulus plan goes ahead as planned. Chinese consumers tend to have fairly high savings rates because of the lack of a safety net. The government increased the planned spending on healthcare and education from 40 billion yuan to 150 billion yuan. The hope is that consumers may feel safer and spend more. Also, to sustain consumer spending as well as boost the weakened economy, it is likely that the central bank will cut their benchmark interest rate, the 1-year lending rate, currently at 5.31 percent; it has indicated that it is ready to do so. The central bank will likely decrease rates to head off deflation. The CPI in February fell by 1.6 percent compared to a rise of 1 percent in January. The World Bank predicts that inflation for 2009 will be 0.5 percent. However, there is still a possibility of deflation. 30 percent of all manufactured goods are exported, and if exports still remain weak, there is a chance that the strengthening industrial sector may create a glut of goods, putting downward pressure on prices. The yuan has, on average, varied very little since July 2008, though it strengthened slightly between December 2008 and March 2009 on account of the general weakness of the U.S. dollar. The central bank has been managing the currency very closely and the yuan will likely remain stable in the medium term. Given the fragility in the economy, if there is any upward pressure on the currency, the PBC will ensure that any appreciation is very slight.

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The United Kingdom: The Printing Presses Roll Ian Stewart

The U.K. recession that started in the second half of 2008 has deepened. Consensus growth forecasts for the U.K. economy have fallen sharply in the last four months. The average forecast currently shows a 3.2 percent contraction in GDP growth in 2009 followed by a weak recovery with growth of 0.5 percent in 2010. But with leading indicators heading down and very limited signs of stabilization in the financial system, the risks are that the outcome will be weaker than is currently expected. Ian Stewart is a Director of Deloitte Research

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• The U.K. recession is deepening and the economy may continue to contract in 2010 • The authorities have responded with aggressive fiscal and monetary ease • With the Bank of England printing money, policy is now highly stimulative • But a return to trend growth is unlikely until 2011 at the earliest Indeed, the IMF’s latest forecasts, released on March 18, show the U.K. economy shrinking by 3.8 percent in 2009 and a further 0.2 percent in 2010. The U.K. economy contracted by 2.1 percent in the second half of 2008 alone. As is typical in downturns, investment spending and “big ticket” spending by consumers have borne the brunt of the fall in growth as the private sector seeks to strengthen its balance sheet. Household spending, g lobal eco n omic outloo k

which accounts for about 70 percent of GDP, is likely to contract for several quarters as consumers repay debts and increase savings. Unemployment has risen rapidly, reaching a 12-year high of 6.5 percent in February. With firms focused on cutting costs, the pace of job losses is likely to accelerate. The only significant part of the U.K. economy to post growth in the last three quarters has been government. Asset prices are continuing to decline. House prices are down almost 20 percent from their peak and broad equity markets have fallen over 50 percent. Lower asset prices erode corporate and consumer wealth and confidence. A further dampening influence on growth is the re-emergence of macroeconomic volatility or uncertainty. As the failure of Lehman, the rise, then fall of inflation, and the collapse in the oil price attest, the unexpected keeps happening. With growth contracting and risk at elevated levels, the natural reaction of consumers and corporates is to cut costs, eliminate debt, and raise cash.

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U.K. policy makers have acted with increasing vigor in trying to offset the effects of financial weakness on the economy. The Bank of England has reduced its main base rate from 5.25 percent to 0.5 percent, its lowest level since the bank came into existence in 1694. A further, substantial stimulus has come from the sharp fall in the pound, down by over 25 percent on a trade weighted basis since 2007. The U.K. authorities have also taken a series of measures to provide liquidity and capital to the banking system and to ease credit conditions. Fiscal policy has switched to ease, with the government unveiling tax cuts and spending increases worth roughly 2 percent of GDP. In recent years, U.K. monetary policy has operated through the bank rate in order to affect the price of credit. With base rates at just 0.5 percent this sort of conventional policy is running out of steam. This is a worrying prospect against a backdrop of a recession and with the economy on the verge of deflation. The RPI inflation rate has dropped from a peak of 4.9 percent last year to just 0.1 percent by February. In the second half of 2009, RPI inflation is likely to move into negative territory in what is generally expected to be a temporary bout of deflation. In response to these risks, the Bank of England deployed a new weapon in early March with the launch of a £75 billion program to buy back government debt from the private sector financed by borrowing from the commercial banks. Quantitative Easing (QE), popularly known as printing money, will lead to an expansion in the Bank of England’s balance sheet and an equal increase in commercial banks’ assets or reserves with the Bank of England. The exact effect of this policy is uncertain but it has the potential to support demand through three main channels: first, by swapping government bonds for cash, private institutional balance sheets become more liquid; second, purchases of government bonds drive down government bond yields and, potentially, market rates too; and third, increasing banks’ reserves with the Bank of England may encourage banks to lend to the private sector. Yet QE is no magic bullet. QE in Japan in the 1990s failed to live up to expectations. And a Fed study in 2000 concluded that “there is considerable uncertainty regarding the likely effectiveness of unconventional monetary policy.” This is experimental policy in which the authorities will make adjustments as time progresses.

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Taken together, the measures by the authorities to bolster the economy represent a major easing of policy and one which is far more substantial than was seen at a comparable stage in the recessions of the 1980s and 1990s. These measures are likely, in time, to help drive a recovery. But, given the scale of the deleveraging and asset price reductions now underway, that recovery is unlikely to come soon. Moreover, history shows that the real economy effects of financial crises are severe and protracted. As the U.S. academics Michael Bordo and Barry Eichengreen observe in their seminal study of financial crises, “Over the last 120 years financial crises have been followed by a downturn lasting two to three years and costing 5 to 10 percent of GDP” (2002). There are, so far, only very limited signs of any improvement in capital and credit market conditions. Interest rates on new bank lending to corporates and households have fallen and equity and bond issuance surged in the opening months of the year. But such improvements are the exception, not the rule. The overwhelming picture is of continued high levels of financial stress. In particular, credit default swaps for banks, a key measure of concerns about the risk of insolvency, have picked up to their highest level since just before the collapse of Lehman. Huge uncertainties remain about the scale and location of losses in the financial system. A process of deleveraging and derisking in the financial system has much farther to run, and suggests that credit conditions will remain tight through 2009.

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The economy faces formidable headwinds and looser fiscal and monetary policy will take time to work through the system. Since central banks can create money without limit, they can create inflation and buy any or every asset in the land. However, the practice of unconventional monetary policy is uncertain and experimental. It is not clear which levers need to be moved, and how much, to save the economy. Recovery will come, as it always does, but a return to anything approaching normal levels of growth looks at least two years away. The best news that 2009 can realistically hope to deliver is gathering evidence that the financial system is on the mend.

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India: The Sheen is Peeling Off Dr. Sunil Rongala

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logistical exercise of mammoth proportions is set to take place in India. Elections are scheduled to be held for about a month between April and May, and voters will be electing the federal government as well as governments in several states; the voting had to be staggered in several phases since there will likely be over half-a-billion voters. Campaigning is in full swing and one way to connect with voters is to send text messages. A text message recently sent in a state where elections for the state government is scheduled is from someone called “Jobless.” The message says that many jobs will be

on it. The manufacturing sector, like much of Asia, has contracted; it fell 0.8 percent in January in the first back-to-back fall in 16 years (the sector contracted by 1 percent in December). One of the major reasons for manufacturing falling is the automobile sector, which contracted sharply in the past few months on account of tight credit. The good news, though, is that February automobile production numbers are up and this could influence the as-yet-unreleased manufacturing number. However, the contraction in the manufacturing sector is nothing compared to what is happening in South East and East Asia.

lost if voters reelect the incumbent government. After several years of optimism — some argue irrational exuberance — there is a definite feel of pessimism in the air. The opposition has latched on to this pessimism and blames the government for the current state of the economy. It hasn’t helped that there is no one heading the finance ministry full-time at this crucial juncture, giving the impression of a rudderless ship. Unfortunately for the current government, whose tenure includes four years of India’s best ever economic growth, what counts is the now in any election and a sharp economic slowdown is happening now.

Not surprisingly, exports have fallen; they fell by 16 percent in January. The trade balance has been getting smaller and can be almost completely attributed to the fall in oil imports (in currency terms). A picture of how devastated global trade

GDP growth in the third-quarter of FY09 (Oct–Dec 2008) slowed down to 5.3 percent compared to 7.6 percent in the previous quarter. The slowdown can be directly attributed to negative growth in the manufacturing and agriculture sectors, the latter contracting by 2.2 percent. What is scary about a shrinking agricultural sector is that, though it contributes to less than 20 percent of GDP, over 70 percent of the population depends

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Figure 1: India exports ($ billions) 18 17 16 15 14 12 11 Jan 09

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is can be seen through the lens of Indian exports. Traditional economic theory teaches us that if a currency depreciates, the exports of that country typically go up because goods become cheaper. The Indian rupee has lost close to 25 percent of its value in less than a year, yet its exports have been falling consistently month-on-month since August 2008. The rupee has been sliding largely because of outflows from foreign institutional investors and not because of capital flight. Inflation in India has reached near deflation levels when the inflation rate came in at 0.44 percent for the week ending March 7 (India’s inflation is released weekly). On February 9, the government forecast that GDP growth for FY09 (April 2008–March 2009) would be 7.1 percent. It was a baffling forecast because nearly everyone had predicted that growth would be closer to 6 percent. The forecast was given despite data showing that industrial production, exports, and domestic demand were under pressure. With the third-quarter number coming in at 5.3 percent, growth in the fourth-quarter will necessarily have to be no less than 7.6 percent — a feat that would be nothing short of miraculous. The IMF expects GDP to grow at 6.3 percent in FY09 and worsen to 5.3 percent in FY10. Consensus forecasts for FY09 are close to the IMF number. The slowdown is intensifying in FY09 because of the slowing services sector, India’s powerhouse in recent years, with demand for software outsourcing falling and sales contracting in the financial industry. The government has thus far deployed two plans in the form of new spending and indirect tax cuts, but the amounts are small and are not likely to counter the recession. The present government (and even the next one) will face fiscal constraints given the subsidies provided for fuel and other products. A consequence is that the fiscal deficit of the federal government is likely to be 7 percent in FY09 compared to 3.4 percent the year before. A likely casualty of the deficit is India’s credit rating, currently at BBB- (according to Standard & Poor’s), the last investment-grade level. At the end of February, Standard & Poor’s (S&P) changed its outlook on India from stable to negative because of the unsustainable fiscal deficit level. Typically, an outlook change almost always precedes a ratings downgrade and, in India’s case, it is almost a certainty because it is unlikely to reduce the deficit in the near term.

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The fiscal constraint of the government means that only the Reserve Bank of India (RBI) has some ammunition left, but it is also rapidly reaching its floor. The RBI has been cutting interest rates fairly aggressively; they have cut rates by 400 basis points between October 2008 and March 2009, and the repo rate now stands at 5 percent. In theory, central banks can cut rates to 0 percent but, in reality, the floor is well above that level. The RBI is likely to cut rates by another 50–100 basis points this year but that is likely to be it. However, it typically takes almost 12–18 months for interest rate cuts to impact an economy and the slowdown will likely be nearing its end. Despite the RBI cutting rates, the TED spread (three-month Mumbai Interbank offer rate less three-month government T-bill yields) remains at elevated levels and commercial lending rates have fallen less than the RBI’s cuts. The RBI will likely cut the Cash Reserve Ratio (currently 5 percent of deposits) that banks have to keep, but that too is near its floor. There is always the possibility of cutting the Statutory Liquidity Ratio (currently 24 percent of deposits), but the SLR is used to fund the government’s deficit and with the deficit likely to grow, there is no chance of that being cut.

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The RBI has some legroom to cut rates because inflation is likely to remain low in the mediumterm. However, inflation remains low because the RBI prefers to use the Wholesale Price Index (WPI) and not the Consumer Price Index (CPI) to measure inflation, because the data for the latter is lagged. CPI data for January (the latest available) suggests inflation was over 11 percent, though the WPI averaged about 5.1 percent for the month. The WPI components reveal that the dip in inflation is being caused by manufacturing and fuel but prices of primary articles (including grains, fruits, and vegetables) are on the rise. Even when the WPI increased by 0.44 percent, primary articles increased by 4.38 percent. If anything, this could give the RBI second thoughts when it is deciding to cut rates the next time. The threemonth and one-year non-deliverable forwards for the rupee show that it is likely to depreciate by about 3–5 percent from current levels (51.9 to the U.S. dollar) but Bloomberg’s composite median and mean forecasts indicate that the rupee will appreciate by 3–5 percent. It is likely to appreciate from the current levels only because there is an expectation that the Fed’s plan to buy U.S. treasuries will drive yields down and possibly increase demand for higher-yield assets, i.e. the Indian rupee.

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Japan Dr. Sunil Rongala

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hen the United States started going into a slowdown, it was commonly remarked that it “deserved” to go into a recession because Americans were “profligate” and spent well beyond their means. Of course, they were referring to the massive U.S. current account deficit. By that standard, it is odd that Asia, where most countries ran current account surpluses, has been hit so hard. However, one must not forget that Asia was the primary enabler of the Americans’ profligacy by buying their bonds in order to suppress their currencies. It also helped that a good share of the American profligacy

This fall in vehicle exports obviously means that vehicle production was down; it fell by 41 percent in January and 25.2 percent in December. This drop in exports and vehicle production led to the industrial sector falling by an astounding 31 percent in January compared to a fall of 20.8 percent in December. In the last quarter of 2008, corporate profits shrank by 64.1 percent.

was directed toward goods produced in Asia, thus allowing Asian countries to achieve stellar rates of growth. Now, with the slowdown in the United States comes the blowback, though some countries in Asia have been hit harder than others. China has seen its exports fall, but the fact is that they are the low-cost manufacturing hub of the world and this makes demand for their goods relatively inelastic.

happened only because workers pulled out of the labor pool. Bloomberg News estimates that over 150,000 jobs at large companies were cut between October 2008 and March 2009. The Wall Street Journal reports that the Japan Production Skill Labor Association expects 40 percent of the 1– 1.3 million temporary workers in the manufacturing sector to be employed in April. As if that wasn’t enough, wages fell by 1.3 percent in January. This has predictably had a dampening effect on consumer confidence, which languishes at levels not seen in many years. Domestic vehicles sales have taken big tumbles and retail sales have also fallen, though not by much: total retail sales fell by 2.4 percent in January. However, department store sales fell by 9.1 percent in January. Like almost every country, real estate has taken a huge hit with the orders of the top 50 construction firms falling by 38.3 percent in January. The fall in demand has meant a return to deflation in Japan, but only mildly.

This fall in manufacturing and profits has led to companies letting go of workers. The unemployment rate fell to 4.1 percent in January from 4.3 percent the month before, but this

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Japan, on the other hand, makes and exports relatively expensive things that are often discretionary. This has meant that the impact of the global downturn has been hard on them: exhibit A is the GDP growth number in the fourthquarter of 2008 (Japan’s fiscal year is from April to March), which indicates that the economy shrank by 3.6 percent, the worst performance since World War II. Exports collapsed in January, falling by a record-setting 45.7 percent. In fact, Japan’s current account went negative in January (just $1.8 billion though), the first time since 1996. One of the big components of exports, vehicles, was down 59.1 percent in January. This was on top of the 33.6 percent fall recorded in December.

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Japanese companies are suffering from a severe funds crunch as foreign sources of money have dried up and with Japanese banks unwilling to lend money. Bloomberg News reports that state lender Japan Bank for International Cooperation received requests for $40 billion — four times its annual budget — between the end of 2008 and early March 2009. It hasn’t helped that local swap market spreads have reached record levels, leaving domestic companies to pay high premiums on their borrowings. In a bid to ease credit conditions, the BOJ voted in February to spend 1 trillion yen ($10 billion) to buy corporate bonds held by banks as well as increase their buying of commercial paper. In March, the BOJ announced that they would provide 1 trillion yen in subordinated debt from banks. However, it is not clear if a modest sum will unclog the credit market and it is likely that the BOJ will have to provide more funds going forward.

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Figure 1: Industrial production (% YoY) 10 5 0 -5 -10 -15 -20 -25 -30 -35

1/1 /08 2/1 /08 3/1 /08 4/1 /08 5/1 /08 6/1 /08 7/1 /08 8/1 /08 9/1 /08 10/ 1/0 8 11/ 1/0 8 12/ 1/0 8 1/1 /09

Looking forward, the Japanese economy is likely to shrink in 2009. In January, the IMF forecast that the Japanese economy would contract by 2.6 percent; in March, they downgraded this number to 5 percent. This is close to Bloomberg’s consensus forecast of a 5.6 percent contraction with the large part of the contraction coming from the first-quarter. When compared to the U.S. forecast (2.6 percent contraction), Japan looks especially weak. All the indications point to 2009 being as bad as the forecasts suggest. First, Japan’s two largest customers, China and the United States, are going through bad times; the World Bank forecast that China would grow at 6.5 percent in 2009 contrary to the government’s claims of 8 percent. Second, the Bank of Japan’s (BOJ) Tankan survey indicates that companies of all sizes are expecting the economy to worsen going forward. Among the large companies, manufacturing companies expect to be worse hit than non-manufacturing companies. Companies expect their profits to fall by 19 percent in FY08 (April 08–March 2009) while large manufacturing companies expect profits to drop by 24.2 percent. That companies are bracing for a slowdown is evident in the orders for machinery: orders fell by 39.5 percent in January compared to 26.8 percent in December. Machinery orders usually indicate capital spending for the next three to six months. A related statistic, machine tool orders, fell by a whopping 83.9 percent in February. Employment is almost certainly going to worsen and this is going to takes its toll on the retail sector.

Source: Bloomberg

It is likely that 2009 is going to be deflationary given the pessimism at home and globally. The Tankan survey indicates that supply will likely far exceed demand and that inventories are “excessive.” The BOJ is unlikely to make any changes to the interest rate, which is currently at 0.1 percent. Three-month and one-year nondeliverable forwards for the yen show that the yen will be around 97 to the dollar, though there are indications that the yen may depreciate more than what the NDFs indicate. The BOJ has announced that it will buy government debt to the tune of $18.3 billion a month to keep yields low. This is ostensibly to help the government pay a lower yield on the debt it would need to sell in order to finance the stimulus plans, but low yields could keep investors away from the yen.

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The government announced two large stimulus packages in 2008 totaling some 50 trillion yen ($500 billion). However, there have been significant delays in implementing fiscal measures and the opposition has rejected parts of the package. The government is planning to introduce another 30 trillion yen package but it is almost certain to run into significant headwind in the Diet given looming elections later this year.

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Brazil: Innocent Bystander Dr. Ira Kalish

When the global credit crunch took a turn for the worse in late 2008, the conventional wisdom was that, while Brazil would experience a slowdown, it would not suffer as much as other big emerging markets. After all, Brazil is less integrated into the global economy than many other emerging markets. Indeed, this benign view was echoed by our own Outlook last quarter. Yet we may have been wrong. In fairness, everyone is now surprised to learn that things are deteriorating rather quickly. In the fourth quarter of 2008, GDP actually declined, setting off alarm bells.

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Interestingly, economic deterioration was completely due to a drop in domestic demand rather than export weakness. The latter was expected to be the primary issue for Brazil, given the troubles in the global economy. Instead, global credit problems and their impact on domestic conditions, including capital flight, led to weaker domestic demand. Business investment and consumer spending both fell. In addition, net exports actually made a positive contribution to economic growth. From an output perspective, services and agriculture both witnessed a drop in production. Yet industrial production declined the most.

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In early March, the central bank responded to the situation by slashing the benchmark interest rates by 150 basis points and offering direct loans to financial institutions that have been hurt by the credit crunch. This was done despite the fact that the rate of inflation remained uncomfortably high at 5.9 percent in February (although it was lower than in previous months). It was done, however, because the outlook for Brazil’s economy is becoming worrisome. Leading economists have dramatically revised downward their forecasts for economic growth in 2009. As of this writing,

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Brazil’s equity markets actually responded positively to the Obama plan to resolve toxic assets. the consensus is that the economy will barely grow. Some economists anticipate negative GDP growth. Moreover, the central bank is now widely expected to cut rates even further, perhaps a lot further. On the other hand, there are some positive signs for Brazil. Retail sales grew in January, indicating that domestic demand is not in a free fall. The consumer evidently has some confidence. In addition, the relaxation of monetary policy should ultimately have a positive impact on investment later in 2009, especially if global credit markets start to loosen up. Brazil’s equity markets actually responded positively to the Obama plan to resolve toxic assets. Also, the relatively benign position of Brazil’s fiscal policy should help to keep market interest rates lower than would otherwise be the case. There is currently no serious concern about government crowding out private investment or creating new inflationary pressures. As for inflation, the weakness in domestic demand and the strength of the currency mean that monetary easing is not likely to lead to a new bout of excessive inflation. As for the currency, its recent stability is a sign that financial markets are confident in the overall stance of policy and the probability of a positive impact.

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In the longer term, Brazil is likely to benefit significantly when the global economy recovers, especially when global credit conditions improve. Already, the stabilization of commodity prices augurs well for Brazil’s agricultural and potential energy exports. In addition, the continuing strength of China’s domestic demand is a positive sign for Brazil’s industrial exports. Brazil is also likely to receive considerable foreign direct investment in the future, as was the case in recent years. Hence, although 2009 looks troubling, the longer-term outlook is not.

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Russia Dr. Sunil Rongala

The basic and traditional explanation of the “Dutch Disease” is that the overreliance of an economy on natural resources (mostly one resource) leads to the appreciation of the local currency, causing exports to become uncompetitive and leading to the shrinkage of the domestic manufacturing sector. Of course it’s slightly more complicated than that and a fuller explanation can be found at http://www.imf.org/external/pubs/ft/fandd/2003/03/ebra. htm. The contemporary version of the Dutch Disease occurs when countries dependent on a source of funds such as aid, remittances, or commodities become vulnerable when the inflow is reduced. Oil is in a class by itself when it comes to nurturing a dependency; Venezuela is an example and so is Russia.

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After several years of an oil-fueled boom, Russia is feeling the ill-effects of the sharp fall in the price of crude oil, its largest export. GDP slowed sharply in the fourth-quarter of 2008 and is estimated to have grown at 1.1 percent compared to 6.2 percent in the third. Despite the slowdown, inflation rates continue to remain at elevated levels and the Central Bank of the Russian Federation (CBR) has kept the interest rate constant (the last action was a hike in December 2008). The cause for the elevated inflation rates and high interest rates has been the falling currency. Between August 2008 and March 2009, the ruble fell by over 45 percent and its decline can be tracked to the fall in oil prices. Capital flight in the aftermath of the Georgian war hastened the ruble’s decline. Inflation has been high because the weak currency caused an increase in the price of food (Russia imports 40 percent of its food and the number rises to 70 percent in the cities). February’s inflation rate was 13.9 percent compared to 13.4 percent in January, though it is a notch below the 15 percent recorded in September. The CBR raised its interest rate, the refinancing rate, by 100

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basis points in both November (to 12 percent) and December (to 13 percent where it currently stands) in a bid to control the currency depreciation as well as capital flight. The capital flight and the money spent by the CBR to keep the ruble from depreciating have led to plummeting foreign currency reserves; they fell from a high of $462 billion in July 2008 t0 $341 billion in February 2009. Falling oil prices have led to a slowdown in foreign exchange inflows. Oil exports in January 2009 were $5.5 billion compared to an average of $12.6 billion per month in 2008, though the numbers are skewed towards the first three-quarters. Its second-largest export, oil products, accounted for $2.7 billion in January compared to a monthly average of $6.5 billion in 2008. It hasn’t helped that exports from other sectors have suffered badly, too. The negative wealth effect from falling oil prices and the global slowdown has meant a double-whammy for the industrial sector; it fell 13.2 percent in February compared to a fall of 15.9 percent in January, while the manufacturing sector

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Figure 1: Oil exports (USD billions) 18 16 14 12 10 8 6 Jan 09

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4

Source: Bloomberg

contracted by 18.3 percent in February and 24.1 percent in January. The data indicates that, among others, a fall in the demand for cars, buses, and cement led to the contraction. Retail sales grew at an anemic 2.4 percent in January compared to a monthly average of 13.4 percent in 2008. This is not surprising given half a million people lost their jobs in December because of the contraction in the industrial sector: the unemployment rate stands at 7.7 percent. Construction has suffered, too, with contracts falling by 16.8 percent in January. Not surprisingly, real estate prices have also been falling; Moscow real estate prices fell from a high of $6114 per square meter in October 2008 to $4909 in February. Like almost every major government, Russia has introduced a host of measures to combat the slowdown. Prime Minister Putin has indicated that the stimulus package could reach 12 percent of GDP in 2009 with the government already pledging some $200 billion since September. The package includes a cut in the corporate tax rate as well as $11 billion in aid to banks to increase lending to companies and consumers. The package, however, is unlikely to prevent a contraction in the economy in 2009. While the IMF estimates that the Russian economy will contract by 0.7 percent in 2009, the Russian Economic Development Ministry expects the economy to contract by 2.2 percent. The Bloomberg consensus forecast indicates that the economy will shrink by 0.8 percent in 2009. While most of the spending is being sourced from their reserve fund, the budget deficit is expected to increase to 8 percent of GDP in 2009. What is crucial for the stimulus plan to succeed is whether banks will be able to fully perform their roles as intermediators of credit. The CBR is predicting that the bad debt levels of banks may be 10 percent in 2009. This would imply an extra $40 billion in provisions. Added to that, in 2009, Russian

2nd Q ua r t er 20 09

banks have to make payments of $52.1 billion to service their external debt. Given the times and the general state of the Russian banking system, it is going to be very difficult for them to roll over their debts. The government may not step in to help with their debts because, if they do, it could worsen their sovereign debt rating; Standard and Poor’s and Fitch Ratings cut their rating in December on concerns related to their external debt portfolio as well as the ruble depreciation. The Russian government had forecast that the industrial sector will shrink by 5.7 percent in 2009, but the shrinkage will likely be more, given dismal numbers in January and February. The current account, from a record high achieved in 2008, will likely worsen and possibly be in a deficit in 2009. Data shows the level of imports reducing but it is unlikely to prevent a worsening of the current account. External debt service of $117 billion is also due in 2009 (including the banks’ $52.1 billion) and this will also put pressure on the current account. The ruble forward markets indicate only a mild depreciation from the current number and a Bloomberg consensus median forecast indicates the ruble may be around 36–37 against the U.S. dollar for the remainder of 2009. However, if the economy does shrink closer to the government’s estimates, there is going to be significant downward pressure on the ruble and the CBR may be forced to let the ruble depreciate. Also, if the economy does worsen, the CBR may also be forced to soften its tight money policy and reduce interest rates. This could put further pressure on the ruble. That apart, the CBR may still reduce its rates to provide a boost to the economy and it may calculate that the costs of a depreciating ruble may be less than the economy shrinking. That said, an investment bank is expecting that the foreign reserves will be halved in 2009 because it expects the CBR to defend a depreciating ruble. That logic still ties in with a looser monetary policy. Because of the weak ruble, it is likely that inflation will remain at elevated levels because of high food imports.

Russia

24

In the end, though, it will continue to be oil that will determine Russia’s future fortunes. The government has reconciled to the fact that oil prices will remain low in 2009, but will not remain low forever. However, when the price does eventually go up, the boom cycle will start all over again and it will be as if Russia’s problems never existed.

g lobal eco n omic outloo k

GEOGRAPHIES

Eastern Europe and the Financial Crisis Dr. Ira Kalish

In the late 1990s, a financial crisis in South East Asia spread like a contagious disease to other emerging markets around the world such as Brazil and Russia. What all of these countries had in common was a large foreign currency debt, excessive dependence on foreign investment rather than domestic saving, overvalued currencies, lax banking standards, and inadequate foreign currency reserves. In the countries infected by the contagion, the result was a steep drop in economic activity, substantial currency devaluation, and a need for assistance from the IMF. The latter required these countries to enact austerity policies that caused considerable suffering in the short term.

central & eastern europe

25

History, evidently, repeats itself. Today, a financial crisis that began in the United States and spread to Western Europe is now infecting several countries in Central and Eastern Europe (CEE). The countries of particular concern are Hungary and the three Baltic nations. What they have in common is not surprising: • In recent years, they borrowed heavily in foreign currencies to take advantage of low interest rates in Europe. In addition, they did this on the expectation that they would eventually join the Eurozone, thus eliminating any currency risk. In the case of Latvia, for example, foreign currency debt accounts for roughly 85 percent of total loans. Foreign currency lending turned out to be risky once the global economy decelerated, exports dropped, and currency values became untenable. • Their banking systems relied heavily on borrowing as opposed to deposits. In the Baltic nations, the ratio of loans to deposits ranged from 150 to 200 percent. Thus, when global g lobal eco n omic outloo k

credit conditions became onerous, they were not in a good position to fund their loans. • In the case of the Baltic nations, their currencies were fixed in value relative to the euro. Hence, when a drop in global demand hurt export growth, they faced a difficult choice. They could devalue the currency to improve export competitiveness, which would increase the value of foreign debts. Alternatively, they could maintain a fixed exchange rate at the cost of drawing down foreign currency reserves and tightening monetary policy. They chose the latter, and it came at a cost. They accepted assistance from the IMF, which forced them to implement austerity programs. Not all countries in the region have been infected, but all will suffer as a consequence of this situation. Poland and Czech Republic, with floating exchange rates, have done relatively well during this crisis. Slovenia and Slovakia, already members of the Eurozone, are not at risk.

2nd Q ua r t er 20 09

GEOGRAPHIES Yet there are factors other than the exchange rate regime that have influenced the situation in which countries find themselves. For example, countries that relied heavily on foreign direct investment (FDI) as opposed to portfolio investment have been better prepared for the deluge. FDI is hard to liquidate and tends to be more stable. Loans, on the other hand, are problematic during a credit crunch. Countries like Hungary that depend on foreign currency loans have faced foreign banks that are unwilling to roll them over. The result is that several CEE countries now face substantial financing needs in 2009 that are not likely to be easily met. Although the European Bank for Reconstruction and Development (EBRD) and World Bank have provided roughly $40 billion in assistance, estimates of the total financing needs (interest payments and rollovers) are between $200 billion and $400 billion.

debts might be compromised. In other words, there is no easy solution. Moreover, this is not likely to happen, given the current outlook of the member governments.

What went wrong? The problem was a combination of excessive borrowing in foreign currencies, a sizable downturn in demand for the region’s exports, and a seizing up of global credit markets. This toxic combination caused these countries to experience downward pressure on their currencies, difficulty in servicing external debts, and declining economic activity. Moreover, these countries found themselves in need of assistance from international agencies. Yet the European Union, which has a considerable stake in the success of Central and Eastern Europe, has decided against a general bailout of the region. Nor has there been support for accelerating the accession of these countries into the Eurozone — something that would instantly alleviate the currency risk that is ultimately at the heart of the crisis. The result is that the region remains on thin ice as of this writing. In addition, the Western European banks that financed the region face the prospect of sizable losses on their Eastern operations.

The outlook in this situation depends on several factors that are difficult to forecast. First, the degree to which the global financial system becomes repaired will make a big difference. When credit conditions improve, it will be easier for CEE economies to refinance their debts. Second, the degree to which global demand recovers will make a huge difference. When CEE economies can increase their exports, the situation will improve dramatically. Yet even if all goes well, it is clear that the economic model of the past decade is no longer sustainable. These countries will not so easily take on external debts, especially when currency risk exists, nor will they be able to rely on foreign capital for such a large share of their investment. While entrance into the Eurozone would certainly change such dynamics, the crisis at hand has probably reduced the likelihood of rapid integration into the West.

Ordinarily, a solution to this kind of situation would entail the European Central Bank providing assistance to the banks that are heavily exposed to this problem. In addition, if there were a central fiscal authority in Europe, it might allocate funds to this problem. Given the fragmentation between monetary policy, fiscal policy, and bank supervision, it is not a simple matter to develop a pan-European solution. Instead, each national government will act in its own interest. Hence, the most likely solution is that individual governments in Western Europe will, depending upon how much their nation’s banks are exposed to the East, provide assistance to those banks. Austrian banks, for example, are heavily exposed. central & eastern europe

26

So what happens next? At the very least, it is highly likely that the entire Central and East European region will experience a deep recession in 2009, especially Hungary and the Baltics. Uncertainty exists, however, about the degree to which the region’s troubles will infect Western Europe. It depends, in part, on what actions are taken by policymakers in Western Europe. If they quickly bring the Baltics and Hungary into the Eurozone, the issue of currency risk will quickly disappear. On the other hand, if the exchange rate at which they enter is too high, the competitiveness of their exports could be damaged. If the rate is too low, payment of

2nd Q ua r t er 20 09

g lobal eco n omic outloo k

topics

Preparing for the Next Battle: Demographic Threats Have Not Gone Away Dr. Elisabeth Denison

With the recession spreading at an alarming speed, it is understandable that governments and companies across the globe are in crisis management mode with a focus on short-term stimulus. But in the rush to contain the fallout of the crisis, it is important not to forget about a much bigger threat that transcends the current economic cycle: demographic change. Not only was it partly responsible for fueling the boom that led to the crisis, it also has major consequences for the trajectory of growth to which economies will return after the recession. Now is the time for companies and governments to think about the right steps to take in order to get ahead in the demographic game once the economy recovers.

The role of demographics going into the crisis Even if there seem to be more pressing issues currently, some underlying long-term developments should not be ignored. Demographic change is one of them. In January 2009, the Washington Post ran an article entitled “The World Won’t Be Aging Gracefully. Just the Opposite.” It argued that the current crisis would be dealt with eventually, but things would get worse over the next decade as the “demographic ebb tide” plays havoc with the structures of the twentieth century.

27

In fact, to begin with, demographics were not completely unrelated to the crisis. Over a span of 10 years from 1995 to 2005, the homeownership rate in the United States rose from 64 percent to 69 percent. Research by the Federal Reserve Bank of Atlanta suggests that mortgage innovation (securitization and smaller down payment programs) accounted for about 56–70 percent of the increase in the homeownership rate during that period, while demographic factors accounted for 16–31 percent with middle-aged baby boomers boosting demand. From 2005 onward, the first baby boomers started to trade out of their big houses contributing to the decline in the homeownership rate; the rate currently stands at 67.5 percent. Builders might have underestimated the impact of this demographic shift, which was partly masked by speculative buying as the bubble inflated, adding to excess supply, which is now holding back the recovery of the building sector. It is also clear that the demographic shift has important effects on saving and investment behavior in different countries. The “global savings glut” has been partly blamed for contributing to the financial crisis by providing the liquidity for high-risk investments. However,

g lobal eco n omic outloo k

the demographic factors that were part of the phenomenon are now reversing. In Japan, private saving was boosted in recent years by the working-age population moving through their high saving years, but is starting to decline with the elderly using their savings to supplement falling employment income. In the United States, the problems are reversed. The International Monetary Fund (IMF) estimates that the savings-to-GDP ratio in 2005 was 3 percentage points lower due to demographic changes, but will rise to 5 percentage points higher by 2040 as an increasing number of the population move into their high saving years. While the change in the U.S. savings pattern might aid its current account deficit, it will fundamentally change the country’s role as the consumption engine of the world.

The shifting pyramid Rich countries have been aging for decades, due to falling birth rates and rising life spans. In Japan, those over 65 equaled approximately 30 percent of the working-age population (15 to 64 years) in 2005. By 2050, they will have reached almost 70 percent; the working-age population is projected to drop by 30 million, from 82 million in 2010 to 52 million in 2050 (see figure 1). In practical terms, this means that while currently there are 3.4 people at work in Japan for every person over 65, by 2050 this will have diminished to less than 1.5. In Western Europe, the current level of close to four working people for every person over 65 will be approximately halved by 2050. Germany is one of the worst affected countries in the region, expected to lose about 13 million workers between 2010 and 2050. The United States is also aging, but thanks to a higher birth rate and

2nd Q ua r t er 20 09

topics

more immigration, the working-age population is expected to continue to expand, adding approximately 45 million workers over the next 40 years. Nonetheless, the ratio of working to non-working population will drop to 3.2 in 2050 from 5.4 currently.

It is not only industrial nations that are facing a shift in age distribution. In China, due to drastic family planning measures in the form of a one-child policy, the working-age population is expected to shrink by a staggering 108 million over the next 40 years, and the number of those working for every person over 65 years will plummet to 2.7 in 2050, down from 9 currently.

Figure 1: Working-age populations (15–64 years) in selected countries and regions Japan

94

60

Germany

88 82

55

76 70

50

64 58

45

52

Projections

Projections

46 1980

1990

2000

2010

2020

2030

2040

2050

40 1980

Working-age population (15 to 64 years), Mio

2000

2010

2020

2030

2040

2050

28

Working-age population (15 to 64 years), Mio

USA

250

1990

China

1,100 1,000

230

900 210 800 190

700

170

600

Projections 150

Projections

500 1980

1990

2000

2010

2020

2030

2040

2050

1980

Working-age population (15 to 64 years), Mio

900 800 700 600 500 Projections

300 1980

1990

2000

2010

2020

2030

2040

Working-age population (15 to 64 years), Mio

2010

2020

2030

2040

2050

Middle East & Africa

1,600 1,500 1,400 1,300 1,200 1,100 1,000 900 800 700 600 500 400 300 200

1,000

400

2000

Working-age population (15 to 64 years), Mio

India

1,100

1990

2050

Projections 1980

1990

2000

2010

2020

2030

2040

2050

Working-age population (15 to 64 years), Mio

Source: The World Bank

2nd Q ua r t er 20 09

g lobal eco n omic outloo k

topics

India has somewhat better demographic cards. Thanks to a higher birth rate, the population is expected to increase by a third over the next 40 years, with the dependency ratio still at 4.5 in 2050. Nonetheless, this is a noticeable shift from a ratio of over 12 currently. The country remains in a development race to be able to claim its demographic dividend in time; only an educated and productive young generation will be able to support the pyramid. For other fast growing nations — most of them located in the Middle East and Africa — the challenge will be to create enough jobs to cope with a surging young population. Over the next 40 years, almost 800 million people will be looking to join the workforce in this region — not a bright prospect with unemployment running at over 50 percent in many countries.

Hard choices Demographic shifts will have an important impact on productivity and the distribution of growth around the globe. While the increase in the labor force in developing countries will raise their marginal product of capital and stimulate higher investment, industrialized nations will be hardpressed to compensate for their aging workforce. The IMF estimates, for example, that the level of Japanese GDP in 2050 will be 30 percent lower than would have been the case without the impact of the demographic transition, because the decline in the labor force is only partly offset by a higher capital stock.

29

The challenges associated with the demographic shift are big and varied. For the developing world, the race is on to achieve the standard of education and innovation needed to turn its young workers into a globally productive force. Unfortunately, the financial crisis has stripped many of them of the necessary capital to invest in this future. In a background paper prepared for the G20 summit in April 2009, the World Bank estimates that $270–$700 billion is missing from the coffers of developing nations due to the crisis. Nonetheless, all existing fiscal expansion programs should be directed to these long-term aims.

g lobal eco n omic outloo k

For shrinking industrial nations, policies need to focus both on solving the financing dilemma of demographic change and counteracting the impact of a shrinking labor force. In terms of finances, the prospects look grim. Aging populations have serious consequences for nations’ health care and welfare spending. With fewer taxpayers supporting government finances, funding this expenditure will be a real problem. Encouraging private retirement plans is certainly a solution, but considering the loss many retirees or near-retirees with such plans have had to put up with over the past year, it will be a hard sell. Persuading more people to enter the workforce could help to alleviate some of the problems of coming years. However, according to research by IMF, this cannot be the sole solution: For countries like Germany, Spain, South Korea, or Italy, participation rates would have to increase between 15–20 percent to help offset aging — a highly unlikely feat given historical experience. In Japan, even an increase in participation to 100 percent (it stood at 78.8 percent in 2000) could not halt the decline in the relative size of the labor force. Other common policies include raising retirement ages and encouraging more women to enter the workforce, but these, too, are only partial remedies — just like immigration. The latter is a particularly sensitive topic in times of economic uncertainty, which tend to bring nationalistic tendencies to the fore. Governments are hard-pressed currently to keep these issues in mind while being challenged by rising unemployment and the biggest financial upheaval in recent memory. While demandfostering policies such as subsidies and workers’ protection might alleviate some of the shortterm pain in the crisis, flexibility is needed for the great adjustment that lies ahead. As the Economist points out in its March issue article “The Jobs Crisis. And What to do About It,” how governments react to the current crisis will shape labor markets for years to come.

2nd Q ua r t er 20 09

topics

War for talent or war on talent?

Keeping things in perspective

Against the background of dire monthly job reports and media stories about the Great Depression, it is easy to see why some are asking whether the “war for talent” has turned into the “war on talent.” However, companies seem well aware of what is awaiting them in the long term. Despite the crisis, the supply of skilled workers continues to be an issue in industries such as mining, government, information technology, engineering, education, and health.

Governments and companies are left to deal with the fallout of the crisis. However, demographic challenges have not gone away and will likely make it harder to return to a sustainable growth path in the long term. Steps have to be taken now to be ahead in the game as the recovery unfolds. Companies can upgrade the talent within their firm and try to attract the best and brightest in preparation for the rebound. Governments can use fiscal expansion as an opportunity to fund the innovation needed to keep their shrinking workforce productive and support an aging population in the decades to come. It will not be easy, but forgetting about these long-term issues in the race to deliver the biggest short-term impact could have disastrous consequences.

A survey by Korn/Ferry International in January 2009 showed that despite rising unemployment, global executives believe that the war for talent is still being waged. More than three-quarters of respondents felt that the demand for talent will increase more over the next five years than it did during the previous five years. Forty-five percent said the demand will increase “significantly.” While more pressing short-term issues no doubt dominate boardroom discussions across the globe currently, surveys suggest that companies also see the crisis as an opportunity to implement strategic long-term approaches to talent management. A survey by the Chartered Institute of Personnel and Development (CIPD) in the United Kingdom in November 2008 showed that companies appear to be adopting some positive talent management practices. “Now is not the time to postpone or scale back talent management strategies,” the CIPD noted.

30

References and Research Sources: Matthew Chambers, Carlos Garriga, and Don E. Schlagenhauf, Federal Reserve Bank of Atlanta, “Accounting for Changes in the Homeownership Rate,” September 2007. World Bank, “Swimming Against the Tide: How Developing Countries are Coping with the Global Crisis,” Background Paper prepared for the G20 Meeting Horsham, U.K. on March 13–14, 2009. International Monetary Fund (IMF), World Economic Outlook 2004/02, Chapter III, “How will Demographic Change Affect the Global Economy?” September 2004. Natalia T. Tamirisa and Hamid Faruqee, International Monetary Fund (IMF), “Macroeconomic Effects and Policy Challenges of Population Aging,” IMF Working Paper No. 06/95, April 2006. Nicoletta Batini, Tim Callen, and Warwick McKibbin, International Monetary Fund (IMF), “The Global Impact of Demographic Change,” WP/06/9, January 2006. Neil Howe and Richard Jackson, the Washington Post, “The World Won’t Be Aging Gracefully. Just the Opposite,” January 4, 2009. The Economist, “The Jobs Crisis. And What to do About It,” March 14, 2009, p. 11. 2nd Q ua r t er 20 09

g lobal eco n omic outloo k

APPENDIX

GDP Growth Rates (YoY%)

GDP Growth Rates (YoY%) 4

14

3

12

2

10

1

8

0

6

-1

4

-2

2

-3

0

-4 -5

Q1 07 Q2 07 Q3 07 Q4 07 Q1 08 Q2 08 Q3 08 Q4 08 Q1 07 Q2 07 Q3 07 Q4 07 Q1 08 Q2 08 Q3 08 Q4 08 U.S.

Eurozone

UK

Brazil

Japan

India

China

Russia

Source: Bloomberg

Source: Bloomberg

Inflation Rates (YoY%)

Inflation Rates (YoY%) 20

6 5

15

4 3

10

2

31

1

5

0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb 08 08 08 08 08 08 08 08 08 08 08 08 09 09 U.S.

Eurozone

UK

0

Japan

-5 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb 08 08 08 08 08 08 08 08 08 08 08 08 09 09

Source: Bloomberg

Brazil

India

China

Russia

Source: Bloomberg

Major Currencies vs. the U.S. Dollar 2.2

115

2

110 105

1.8

100 1.6 95 1.4

90 85

1

80

Ja n 0 Fe 8 b 0 M 8 ar 0 Ap 8 r0 M 8 ay 0 Ju 8 n 0 Ju 8 l0 Au 8 g 0 Se 8 p 0 Oc 8 t0 No 8 v De 08 c0 Ja 8 n 0 Fe 9 b 09

1.2

GBP-USD

Euro-USD

USD-Yen (RHS)

Note: As of March 25, 2009 Source: Bloomberg

g lobal eco n omic outloo k

2nd Q ua r t er 20 09

APPENDIX

Yield Curves (as of March 25, 2009) U.S. Treasury Bonds & Notes

U.K. Gifts

Eurozone Sovereign Benchmark

Japan Sovereign

3 Months

0.25

0.37

0.58

0.27

1 Year

0.65

0.66

0.99

0.29

5 Years

1.78

2.49

2.64

0.75

10 Years

2.74

3.40

3.44

1.29

Brazil Govt. Benchmark

China Sovereign

India Govt. Actives

Russia Sovereign

3 Months

10.62

0.85

4.82

7.06

1 Year

10.02

1.05

5.15

8.22

5 Years

12.30

2.36

6.68

12.25

10 Years

12.49 (8 years)

3.19

6.80

11.15

Source: Bloomberg

Yield Curves (as of March 25, 2009)

32

Source: Bloomberg

Composite Currency Forecasts (as of March 25, 2009) Q2 09

Q3 09

Q4 09

Q1 10

2010

2011

2012

2013

GBP-USD

1.41

1.44

1.5

1.54

1.57

1.73

1.59

1.62

Euro-USD

1.25

1.27

1.3

1.29

1.27

1.27

1.25

1.26

USD-Yen

97

98

99

102

100

115

113

119

USD-Brazilian Real

2.4

2.35

2.28

2.29

2.35

1.94

NA

NA

USD-Chinese Yuan

6.85

6.83

6.8

6.7

6.53

6.45

6.2

NA

USD-Indian Rupee

51

49.75

48

48.92

45

43

NA

NA

USD-Russian Ruble

46.92

46.97

49.91

NA

52.88

NA

NA

NA

Source: Bloomberg

2nd Q ua r t er 20 09

g lobal eco n omic outloo k

APPENDIX

GDP Forecasts (as of March 25, 2009) U.S.

U.K.

Eurozone

Japan

Brazil

China

India

Russia

2009

-2.5

-3.3

-2.8

-5.9

0.8

6.5

6.3

-0.8

2010

1.8

0.4

0.55

0.55

3.4

8

5.3

3.15

Source: Bloomberg, IMF, World Bank

OECD Composite Leading Indicators U.S. 33

U.K.

Euro Area

Japan

Brazil

China

India

Russian Federation

January ‘08

100.61

100.68

103.02

100.61

104.65

102.26

102.03

105.23

February ‘08

100.31

100.30

103.25

100.79

104.49

102.25

101.78

105.47

March ‘08

99.99

99.85

103.26

100.88

104.48

102.20

101.38

105.71

April ‘08

99.68

99.24

103.01

100.93

104.75

101.99

100.87

105.83

May ‘08

99.46

98.52

102.44

100.82

105.19

101.54

100.26

105.67

June ‘08

99.10

97.71

101.52

100.51

105.53

100.79

99.58

105.06

July ‘08

98.68

96.87

100.16

99.91

105.54

99.62

98.80

103.82

August ‘08

98.19

96.04

98.27

98.99

105.05

98.02

97.88

101.86

September ‘08

97.64

95.24

95.91

97.75

103.92

96.04

96.81

99.14

October ‘08

97.15

94.50

93.33

96.20

102.14

93.82

95.61

95.89

November ‘08

96.75

93.82

91.03

94.42

99.83

91.60

94.43

92.46

December ‘08

96.48

93.16

89.66

92.55

97.20

89.52

93.38

89.16

January ‘09

96.32

92.49

89.05

91.01

94.51

87.45

92.42

85.87

Source: OECD Note: A rising CLI reading points to an economic expansion if the index is above 100, and a recovery if it is below 100. A CLI which is declining points to an economic downturn if it is above 100, and a slowdown if it is below 100.

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2nd Q ua r t er 20 09

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