Swedbank's Global Economic Outlook, 2010 August

Global Economic Outlook
by Cecilia Hermansson 17 August 2010
Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46-8-5859 7740
E-post: ek.sekr@swedbank.se Internet: www.swedbank.com Responsible publishers: Cecilia Hermansson, +46-8-5859 7720.
Magnus Alvesson, +46-8-5859 3341, Jörgen Kennemar, +46-8-5859 7730, ISSN 1103-4897
The global economy muddles along
We have revised upward our current year GDP forecast for the global
economy mainly due to a stronger-than-expected rebound in the euro zone
and emerging economies. GDP is growing 4.3% (+0.3 percentage points
compared to our spring forecast). Next year we expect global GDP growth to
slow to 3.6% and in 2012 we see the pace rising slightly to 3.8%. This is 0.1
percentage point lower per year than in our spring forecast and is mainly due
to more modest growth in Europe and Asia. Our forecast of sluggish US
growth remains unchanged.
Beyond the rebound, growth in the Western World (West) continues to trend
weakly. Fiscal austerity, debt reconstruction and weak labour, housing and
credit markets are softening growth prospects. The optimism in Europe that
followed in the wake of positive growth data, the bank stress tests and strong
corporate earnings will soon be replaced by pessimism, similar to the situation
the US now faces. Emerging economies are expected to see a soft landing.
Economic policy is being tightened to avoid an overheating in consumption
and asset markets. Emerging economies will continue to drive the global
economy, and the convergence between them and the West is accelerating.
Despite the slowdown in the US, we consider the risk of a new recession
(double dip) to be relatively small (10%). Our main scenario, with weak
growth, low inflation and low interest rates in the West, has a probability of
50%. On the other hand, the risk of deflation and weaker growth has
increased, i.e., a Japan scenario does not appear to be as far-fetched as
before. A zero interest rate policy could also contribute to a deflation scenario.
We give this a 25% probability. Faster normalisation driven by high investment
growth has a 15% probability.
Although our forecast points to a continued recovery in the Nordic and Baltic
countries, the region is vulnerable to a deterioration in Europe and emerging
economies. Countries that combine cutbacks/stimulus with structural reforms
have a better opportunity to handle new downturns and strengthen their
position in the slightly longer term at a time when globalisation is leading to
greater competition.
Cecilia Hermansson
Contents:
1. After the rebound, many challenges remain 2
2. The biggest threats to the global economy – 5
and to our forecast
3. A Japan scenario no longer far-fetched 9
4. Economic policy 11
5. Our outlook for the financial and commodity markets 15
6. Regions/countries: Western World, please hold! 20
7. Conclusions for our home markets 40

2 Swedbank’s Global Economic Outlook • 17 August 2010
1. After the rebound, many challenges
remain
Emerging countries, the US, Japan and most recently Europe,
in that order, have seen their economies rebound following the
severe recession of 2008-2009. Economic stimulus programs,
rescue packages for the financial sector and stronger future
confidence have helped exports to accelerate once again, and
inventories have been built up, giving a big, though temporary,
lift to growth.
GDP growth on an annual basis (%) in a number of major countries/regions
S o u rc e : R e u te rs E c o W in
0 0 0 1 0 2 0 3 0 4 0 5 0 6 0 7 0 8 0 9
Percent
-1 0 .0
-7 .5
-5 .0
-2 .5
0 .0
2 .5
5 .0
7 .5
1 0 .0
1 2 .5
1 5 .0
J a p a n
E u ro z o n e
In d ia
U S
C h in a
B ra z il
It is positive that the recovery has continued, but worrisome that
the US is again weakening following the rebound. Pessimism
has returned. Gigantic problems in the labour, housing, and
credit markets still remain. It takes time to correct balance
sheets. The political situation is also becoming more
challenging. Our outlook has not changed significantly since the
spring: After 2.8 per cent growth this year, GDP will increase by
2.2% in 2011 and 2.5% in 2012.
Global GDP forecast
August forecast April forecast
GDP-growth (%) 2009 2010 2011 2012 2010 2011 2011
US -2.6 2.8 2.2 2.5 2.8 2.2 2.5
EMU-countries -4.1 1.2 1.1 1.6 0.9 1.3 1.9
of which: Germany -4.9 2.2 1.3 1.7 1.3 1.5 2.0
France -2.6 1.5 1.5 1.7 1.5 1.8 2.2
Italy -5.0 0.8 0.9 1.3 0.6 1.0 1.5
Spain -3.6 -0.7 0.5 1.6 -0.5 0.7 1.7
United Kingdom -4.9 1.0 1.6 1.9 1.1 1.6 2.2
Japan -5.2 2.8 1.4 1.5 2.0 1.4 1.5
China 9.1 9.8 8.5 8.1 9.5 8.8 8.0
India 5.6 8.0 7.5 7.8 7.5 7.8 8.0
Brazil -0.2 6.5 5.0 5.0 4.7 4.5 5.7
Russia -7.9 4.3 4.3 4.5 4.3 4.5 5.0
Global GDP in PPP -0.7 4.3 3.6 3.8 4.0 3.7 3.9
Global GDP in US dollars -1.9 3.4 2.8 3.0 3.1 2.9 3.2
Source: National statistics and Swedbank’s forecasts with World Bank 2009
weights. Note: These countries represent 75% of the global economy.
The recovery
continues …
… but a weaker US is
a concern

Swedbank’s Global Economic Outlook • 17 August 2010 3
Japan’s rebound is closely tied to the high growth rate in China.
Exports have risen at the same time that domestic demand is
low and deflation remains a problem. In the second quarter,
growth faded. Even so, GDP growth has been revised
significantly upward to 2.8 % this year, while thereafter the cool
off in China and strong yen point to more modest 1.4-1.5%.
The spring crisis in the Eurozone has passed its most acute
stage. After the banks underwent stress tests and transparency
improved, concerns eased somewhat. Strong GDP figures for
the second quarter – particularly in Germany, which has
benefitted from demand from emerging countries – have also
increased optimism. We expect that like in the US this will turn
to pessimism later this fall and that our revised GDP growth
estimate for this year (to 1.2%) will be lower for 2011 and 2012.
Due to fiscal austerity and continued weak credit and labour
markets, activity is not growing as quickly in many export-
intensive European countries as the rest of the world develops
more slowly.
The West's more U-shaped recovery is clearly more
problematic than the emerging economies’ V-shaped rebound.
China and India, for example, do not face the same balance
sheet problems, public debt crises and subsequent need for
austerity. Instead, they have the leeway for a further stimulus.
Overheating problems have grown, however, and China, India,
Southeast Asia and Brazil, among others, must now tighten
their financial and monetary policy in order to fight off the signs
of inflation. We feel that a soft landing is possible given the
strong fundamentals in emerging countries and the continuing
recovery in the West.
The G20 economies’ austerity measures correspond to about
1.25% of GDP in 2011. Central banks are expected to wait
before raising interest rates until the end of 2011 (US, UK) and
until 2012 (ECB). Additional quantitative easing cannot be ruled
out. Short- and long-term market interest rates will remain low in
the West during the entire forecast period. Commodity prices
are rising weakly. We see the dollar strengthening against the
euro at a time of fluctuating economic data and big problems for
the Eurozone. After appreciating against the dollar, the
Japanese yen is expected to depreciate slightly during the
period. The Chinese yuan is rising against the dollar, but very
cautiously.
The biggest threat to the global economy is that the wrong
economic policies are adopted and concerns about the financial
market again send the global economy into a tailspin. We have
counted up to thirteen threats, each of which individually or
together could change our relatively positive, growth-oriented
outlook: a new recession in the West, deflation, instability in the
financial markets, government finances, savings imbalances,
labour markets, middle class stagnation, protectionism and a
lack of global leadership, a political stalemate, ineffective
economic policy, inflation, jittery commodity markets, and
natural disasters and other major shocks.
In Japan, the lift from
China is fading
Big risk that the
optimism in Europe
won't last
Emerging economies
have managed better,
but now need to
temper demand
We assume that
interest rates will
remain low with slightly
rising commodity
prices and a stronger
dollar during the period
The forecast risks are
both short- and long-
term – and complex

Since developments remain complex following the financial
crisis, we offer four scenarios. We give our main scenario –
“muddling through” – a 50% chance. The risk of a new
recession, a scenario with a double dip, has dropped to 10%.
We see that the risk of a Japan scenario, i.e., with slow growth
and deflation, as higher and give it a probability of 25%. A
scenario with faster normalisation driven by a stronger
investment climate has been assigned a 15% probability.
Based on a muddling-through scenario, economic policies are
pretty much on the mark. Countries facing major fiscal problems
have no choice but immediate austerity, as is the case in
Southern Europe, the UK and Ireland. Larger economies, on
the other hand, can wait until 2012 to ensure that the recovery
has legs and better coordinate economic policy within the G20.
This means that Germany and Japan are in too much of a rush.
The argument that their growth will be stronger if they tighten
their belts does not make sense when all countries are doing
the same thing and long-term interest rates are already low.
It would be reasonable to delay interest rate hikes, but there are
risks. In the report, we show, based on a study by the Federal
Reserve Bank of St. Louis, that a zero interest rate policy could
steer a country into a Japan-like scenario where deflation
becomes entrenched and monetary policy has no effect.
Despite quantitative easing and fiscal stimulus, Japan is stuck
in just such a stage. That interest rates are not as close to zero
in Europe is positive, whereas the risk is greater in the US,
where core inflation has now dropped to historically low levels.
The debate among economists, especially in the US and the
UK, over austerity versus stimulus (see, e.g., the Financial
Times) misses the point that in the longer term it is even more
important to consider demographic factors and runaway welfare
spending, which are tightening fiscal constraints. As a result,
implementing structural reforms that raise growth potential
could improve government finances in the medium term and are
more important than the next year's policy mix. The quality of
financial policy must be a higher priority, in addition to which
both stimulus and austerity must be linked to structural reforms.
In the report we discuss the reforms that are needed.
The crisis has peaked. Soon the rebound will also be over.
There is a risk of a new recession, and even more so that
growth will be weaker with an element of deflation. The export-
dependent Nordic and Baltic region can learn from crises that it
is important to have public and private buffers to reduce the
region's vulnerability to global slowdowns. Furthermore, labour
and product markets have to function better, and compete-
tiveness must be strengthened. The key is also to avoid internal
imbalances that can create big problems. The huge debt build-
up we are now seeing in the Norwegian and Swedish
household sector is a concern from this perspective. On the
other hand, the majority of the countries in the region have
decided to maintain strict discipline in their public finances,
which in any case will soften the blow of any new shocks that
occur.
We have therefore
devised four scenarios
While some countries
are in need of
austerity, this does not
apply to Japan and
Germany, which can
wait until 2012
While it seems
sensible to keep
interest rates low,
there is a risk that
the zero interest rate
policy in the US is
contributing to
deflation
Structural reforms
have to become a
higher priority and be
linked to both a new
stimulus and austerity
measures
The Nordic and Baltic
region can learn from
the crisis – reducing
their vulnerability is a
key, but it is also
important now to see
competitiveness from a
broader, longer-term
perspective

2. Threats to the global economy – and to
our forecast
The threats to the global economy outlined below (in no
particular order) should be viewed from a more long-term
perspective than a forecast period of two to three years. They
should also be looked at as individual threats or linked to and
mutually dependent on each other.
New recession in the US, Europe and Japan
Although the risk of a new recession has diminished as the
financial sector has improved, it still remains and can pop up
later during or after the forecast period. A couple of quarters of
negative growth does not necessarily have to be a major
problem. Only if a new downturn creates instability in the
financial market, deflation and bigger political concerns would
the effects be serious as policy tools are less effective.
Triggers: A hard landing in emerging economies, sovereign debt
defaults, another shock to the financial market, economic
austerity and growing pessimism that chokes off consumption,
investment and trade.
Deflation
Deflation driven by weaker demand and balance sheet
corrections upsets the recovery and debt reconstruction, as
consumers stop spending in expectation of lower prices,
companies find it hard to raise prices, and real debts rise in
value. It is usually hard to extricate from a deflationary spiral.
Triggers: A weak labour market and extended period of debt
reconstruction in the private and public sectors that causes
deflation similar to Japan in the 1990’s and 2000’s. Compare
Irving Fisher’s (1933) theories on debt and deflation. A zero
interest rate policy can also raise the risk of deflation if negative
shocks occur (see more below under monetary policy).
Inflation
A huge stimulus in the form of a zero interest rate policy,
expanded balance sheets and fiscal programs create the risk of
high inflation when growth proves sustainable. At this point the
monetary base has increased substantially, but not the money
supply.
Triggers: If lending were to increase significantly and central
banks don't have the chance to react. The need to fund public
budget deficits and higher bank reserves could cause long-term
interest rates to rise, which would contribute to higher inflation.
New instability in the financial sector and financial markets
There seems to be a general consensus that systemically
important financial institutions will be rescued if problems arise,
but if this isn't the case there is a risk that new concerns will
arise which could spread through counterparty risks and
psychological effects. If the concerns are great, global trade, the
balance sheets of many players and growth could be at risk.

Triggers: Governments decide not to rescue institutions in crisis
or lack the means to do so, new “skeletons in the closet” are
found despite the stress tests, important connections are
neglected in the stress tests, which means that conditions were
not as bright as reported, the public debt crisis in Southern
Europe flares up again and spreads to more countries at the
same time that rescue packages prove insufficient. In addition,
tougher financial regulations could push some banks into
bankruptcy. For the financial markets, this could mean new
shocks occur at the same time and that assurances normalcy
will be restored do not come in time.
Financial crisis for Western governments
To date the sovereign debt crisis has been limited to the PIIGS
(Portugal, Ireland, Italy, Greece and Spain). The financial
market’s confidence in the fiscal policies of the US, the UK,
Japan and Northern Europe appears to be intact. This could
change, with the risk of major tension in global fixed income,
currency and stock markets.
Triggers: The public finances in a number of major economies
are considered unsustainable at the same time that signs of
budget consolidation are not seen as ambitious enough by the
financial market. Foreign players (mainly China and Japan) are
no longer willing to finance the US budget deficit. Difficulties in
financing Japan's deficit will arise if the Japanese instead invest
more abroad or if interest rates rise.
Savings imbalances grow again
The US current account deficit again increases at the same time
that China’s surplus becomes bigger and its currency reserves
swell. Previously this contributed to bubbles in the financial
market, which could be the case again in a few years.
Triggers: China is overly cautious in adopting a more flexible
currency policy, i.e., the yuan appreciates slowly against the
dollar and is offset by its depreciation against other currencies.
The dollar becomes stronger, which weakens the trade balance.
US current account balance (US$ billion) and China's currency reserves
(US$ trillion)
9 0 9 2 9 4 9 6 9 8 0 0 0 2 0 4 0 6 0 8 1 0
USD(billions)
-9 0 0
-8 0 0
-7 0 0
-6 0 0
-5 0 0
-4 0 0
-3 0 0
-2 0 0
-1 0 0
0
1 0 0
USD(thousandbillions)
0 .0 0
0 .2 5
0 .5 0
0 .7 5
1 .0 0
1 .2 5
1 .5 0
1 .7 5
2 .0 0
2 .2 5
2 .5 0
K in a s a c k m le ra d e
U S A C u rre n t
A c c o u n t
C h in a 's c u rre n c y re s e rv e s

Labour markets in the West experience jobless growth
After a recession it can take time to reduce unemployment.
Instead productivity usually improves and new hiring is put on
hold. Structural unemployment tends to increase when the ranks
of the long-term unemployed grow and competence is lost.
Concerns about unemployment reduce turnover and market
dynamism. A focus on job security keeps wages in check.
Growth and public finances suffer.
Triggers: If orders remain weak, companies will face greater
pressure to cut costs, partly by further raising productivity and
partly by outsourcing more to countries with lower wages.
Pessimism and weak confidence make companies reluctant to
hire new workers.
Difficulties for middle class in raising their standard of living
Until the financial crisis many US – and European – middle-
class families were able to raise their standard of living by
borrowing against their homes. Annual incomes for the 90% of
the US population with the lowest incomes have remained
unchanged since 1973. The 1% of the highest wage earners
have seen their incomes triple during the same period. Fewer
poor people are managing to climb the income ladder than
before. In Europe, social welfare systems are under threat. The
great stagnation increases the risk of political instability,
populism and protectionism.
Triggers: The middle class has been shrinking for some time.
The situation could get worse now that many people are being
forced from their homes and the job market is weak.
Protectionism and lack of global leadership
After the financial crisis broke out a number of protectionist
measures were adopted around the world. “Buy American” in
the US, French cars shouldn't be manufactured in Eastern
Europe, etc. While some of this was rhetoric, it has had an
impact: bilateral trade negotiations instead of multilateral and
reduced trade and investments. The US, for example, has
restricted Chinese direct investment at the same time that China
hasn't done anything to help foreign companies. Integration is
being slowed both regionally (EU) and globally. Immigration is
also being held back.
Triggers: Weak labour market, political demands to focus more
nationally and help the domestic population. Weak growth
prospects for households can lead to increased protectionism.
National needs take precedence over the need to coordinate
global policy.
Political deadlock – political instability
The midterm elections in the US could result in the Democrats
losing their majority, which would put the administration’s ability
to govern to the test. In Japan, the majority in the upper house
is lost. In Germany, Chancellor Angela Merkel has lost her
majority in the Bundesrat upper house. Political deadlock can
arise more easily, which would delay important reforms.
Triggers: Displeasure with the parties that are trying to lift

countries out of the crisis has grown, and politicians are
regarded as ineffective. In the US, there is a fear that the
country is being Europeanised and socialised.
Ineffective economic policy
Economic policy can be ineffective for several reasons. One is
that resources/reforms are targeted incorrectly and at the wrong
time. To reach compromises, for example, ineffective measures
may end up being adopted that benefit a limited few. Another is
resources are not available to drive economic policy in the
Eurozone, for example, where austerity is being introduced
despite that the recovery hasn't proved sustainable. A third is
that it has no effect, e.g., a monetary policy where interest rates
are around zero but where the willingness to lend or finance is
too low for interest rates to have an effect. The fourth reason is
policy mistakes, such as the delay in agreeing on a rescue
package for Greece.
Triggers: We already see examples of ineffective economic
policy. The second case – insufficient resources – will increase
due to austerity needs and higher funding costs for some high-
debt countries. Complexity alone could raise the risk of policy
mistakes.
Rapidly rising commodity prices
Commodity prices have rebounded in the same way as the
economy in general. However, substantially higher commodity
prices could affect growth prospects for commodity-exporting
and -importing countries with positive and negative effects,
respectively. Major fluctuations can also create tension in the
financial markets, e.g., lower stock prices due to poorer
earnings prospects for manufacturers. Central banks may have
to raise their benchmark rates if the price increases aren't seen
as temporary. A stagflation scenario with low growth and high
inflation can (with a small probability) be painted.
Triggers: Supply problems in particular can disrupt price trends,
but stronger demand from emerging economies could also put
upward pressure on certain commodity prices.
Natural disasters and other major shocks
Floods, fires and terrorist attacks are examples of shocks that
can affect financial markets and commodity prices. Apart from
human suffering (see Pakistan, China, Russia and Bangladesh),
they can also cause economic disruptions.
The biggest negative forecast risks in 2010-2012 are the effects
on the economy of financial markets and financial institutions,
psychology and public sentiment, economic policy and debt
reconstruction in the private and public sectors. Political
developments could also have an impact.
The biggest positive forecast risks are that the labour market
improves faster than expected, which increases confidence in
the future as well as domestic demand. Stronger investment in
light of high corporate earnings and solid demand for computers
and other equipment could also raise growth.

3. Japan scenario no longer far-fetched
The uncertainty in analysing the current global economy is
unusually great. For one thing it is hard to decipher economic
trends after a major recession, then a rebound. Secondly, it is
unclear what economic policy will be – whether countries will
choose austerity or stimulus and which structural reforms they
implement. Importantly, this recession has been different, with a
structural crisis that resulted in major changes in relative prices,
balance sheets and business models, as a result of which the
old equations no longer work. Our econometric models are
becoming obsolete and have to be replaced.
Reinhart & Rogoff (2009) have studied the financial crises of the
last century. With regard to banking crises, they have found that
on average they result in the following:
A 35.5 per cent rise in housing prices lasting six years;
A 55.9 per cent upswing in stock prices lasting 3.4 years;
A 7 per cent increase in unemployment lasting for 20 years;
A 9.3 per cent decline in GDP lasting 1.9 years (normal
recessions last about a year);
An 86 per cent rise in government debt three years after the
banking crisis began.
Thus far this recession has generally followed the earlier
pattern, including Japan’s. Compared to a normal cyclical
recession, this recovery is taking longer in the West. Even
though a Japan scenario no longer seems as far-fetched as
before, we see it as a less likely scenario. In our main scenario,
deflation is avoided because the financial crisis is addressed
faster than in Japan, asset prices have not fallen as much and
there is less need for debt reconstruction in non-financial
companies in the US and Europe than there was in Japan.
Since the global economy has become more complex,
economic policy more active and financial crises no longer just
national or regional but global in scope, we have to include
other scenarios. Below we review the assumptions behind our
four scenarios for the global economy as a whole and the
probability we assign each of them:
Scenario 1: “Muddling through” – our main scenario
The recovery continues, but erratically and with slow growth
and low inflation
Assumptions: After the downturn and rebound the global
economy continues to strengthen, but with major swings in
activity owing to shifting sentiment between optimism and
pessimism. Some stimulus measures are reversed and
austerity is adopted in countries with no other alternative,
although a further stimulus is possible as well. Domestic
demand in the West is held back, which limits inflation. Deflation
It is hard to decipher
trends beyond
rebounds
A Japan scenario no
longer seems far-
fetched, but deflation
can still be avoided
Probability: 50%

is avoided (see above). Interest rates remain low when risk-
averse investors choose safer investments in government
securities rather than real investments and due to lower growth
and inflation expectations.
Scenario 2: Japan scenario
The recovery continues with slower growth than our main
scenario and with deflation
Assumptions: Japan is already struggling with deflation. The US
and Europe see weaker price growth (core inflation) due to
sluggish demand and labour market. A zero interest rate policy
helps to keep inflation expectations low. Negative shocks
reduce them further. Pessimism increases. Debt reconstruction
becomes difficult and growth is held in check. To avoid a
recession, the US in particular tries to stimulate its economy
with the help of fiscal policy and quantitative easing as it can no
longer resort to interest rate cuts, but in the Japan scenario this
does not help to raise inflation expectations and normalise
monetary policy.
Scenario 3: Double Dip
A new recession arises
Assumptions: New concerns arise in the financial markets
which cannot be managed with the help of economic policy.
Weak economic indicators cause concern. Confidence falls in
pace with asset prices and currency concerns grow. A recovery
takes longer after opportunities for a new stimulus have been
exhausted. The recession could give rise to deflation, especially
if it is long lasting.
Scenario 4: Faster normalisation
The recovery gets stronger with higher growth and a risk of
inflation
Assumptions: Strong earnings from large corporations and
banks as well as low capital costs pave the way for real
investments and innovation. This generates stronger household
confidence as the labour and housing markets also improve in
the light of more expansive investment conditions. The credit
multiplier rises, which means that banks have more money to
lend in relation to their reserves and the money supply
increases, which leads, in combination with stronger demand
and greater opportunities to raise prices, to higher inflation
expectations. Another contributing factor is that fiscal conditions
and banking regulations push long-term interest rates higher as
demand for safe investments declines at the same time that the
supply of bonds increases substantially.
Probability: 25%
Probability: 10%
Probability: 15%

4. Economic policy
To avoid a depression and deflation, countries around the world
have resorted to every possible economic tool at their disposal.
Aside from those we see in the simplified figure below,
guarantees have been given to financial institutions, for
example, to stabilise financial markets.
The strategies appear to be working. A depression has been
avoided and a recovery is on the way. Under these
circumstances this would seem to be the right time to begin
normalising economic policy. There are several reasons why:
Public debt/GDP is projected at 115% in 2015, nearly 40
percentage points higher than before the financial crisis
(IMF)
The Greek crisis has shown that the financial market is not
willing to finance certain countries’ large budget deficits
without very high risk premiums.
Even if the US, the UK, Japan and Germany have the
confidence of the financial market at this point, this could
quickly change and drive up long-term bond rates.
The zero interest rate policy could lead to an incorrect
allocation of capital and create new asset bubbles. In the
event of another downturn, there will be no room to
manoeuvre. See, e.g., Hoenig (2010).
The balance sheet policies of central banks – quantitative
easing – could lead to a dependency on government
support (e.g., in the US housing sector) if they are kept in
place too long.
Based on our main scenario where the recovery continues but
remains slow, we recommend the following:
1) Countries that have no alternative or whose national debt is
rising too quickly should tighten their fiscal policies
immediately and set medium-term budget targets that
generate confidence (PIIGS, UK). Within the G20 austerity
measures are estimated at 1.25% of GDP next year.
2) Countries that can afford to wait should set medium-term
budget targets and make sure that their fiscal policies are
not restrictive in 2011, when other countries are tightening
Economic policy
has prevented a
depression
If the recovery
continues, economic
policy should
normalise

theirs, possibly providing targeted fiscal support to the
labour market, for example (Germany, US, Japan).
3) Monetary policy provides support for the budget
consolidation by delaying interest rate hikes at the same
time that central bank balance sheets stabilise and shrink
automatically.
4) G20 countries coordinate their economic policy in terms of
size, timing, mix and reforms.
This probably agrees largely with the strategies that are now in
the cards, except that Germany and Japan have decided to turn
to austerity earlier. Waiting another year or so would have been
preferable. A new quantitative easing is also possible.
Moreover, the G20 should not try to overly coordinate policy.
If it turns out in the months ahead that the recovery gets
sidetracked and consumer prices and inflation expectations
drop, it might be worth considering other measures.
In a 2010 study, James B. Bullard, president of the Federal
Reserve Bank of St. Louis, states that a zero interest rate policy
in actuality increases the risk of deflation. He claims that the US
could find itself closer to a Japanese-style outcome in the years
ahead.
His thesis is that with the Taylor Rule that central banks
currently use when nominal interest rates rise more than one-
for-one when inflation deviates from a given target, there are
two stages of steady state1
: 1) a conventional steady state
where monetary policy is effective/active and where the nominal
interest rate is adjusted so that inflation reaches the target, and
2) an unintended steady stage where monetary policy has no
effect/is passive since interest rates cannot be reduced when
inflation is falling.
In the diagram below we see that the US to date has operated
in steady state 1 and Japan in steady state 2. The zero interest
rate policy, in combination with fresh inflation data, indicates
that the US is shifting westward in the diagram. In the event of a
negative shock inflation will not return to the target. Instead both
actual and anticipated inflation would be negative, a stage that
is difficult to extricate from. This situation is similar to the
liquidity trap Japan has been in for years.
Japan has received a lot of advice on how to fight deflation, but
has not managed to climb out of this stage despite quantitative
easing and fiscal stimulus. Richard Koo (2008) has stated that
1
The Taylor Rule is not linear. If it were the benchmark interest rate would be
negative when inflation was extremely low, which is not possible. The other
curve in the diagram is a Fisher Relation, i.e., it says that the nominal interest
rate has a real interest rate component and an anticipated inflation
component. Where the Fisher Relation and the Taylor Rule cross is where the
optimal interest rate and inflation point can be found. They cross in two places
and therefore there are two stages.
Austerity is
unavoidable in certain
countries, but Japan
and Germany could
have waited
A zero interest rate
policy can contribute
to deflation
Despite quantitative
easing and fiscal
stimulus, Japan has
been unable to avoid
deflation

in balance sheet recessions the focus is on deleveraging, so
there is little desire to borrow. Monetary policy becomes less
active, while the importance of fiscal policy increases. Koo also
claims that the advice to “drop money from helicopters” wouldn't
work either, since there would be complete loss of confidence in
money.
Nominal short-term interest rates and core inflation in Japan (circles) and the US
(squares) 2002-2010 – Fisher Relationship (broken line), Taylor Rule (solid line)
Source: J.B.Bullard (2010)
Benhabib, et al (2002), who in 2001 were the first to show that it
was possible to go from steady state 1 to 2, view that printing
money is an alternative, but not if there are guarantees that
government finances will be managed sustainably and people
expect tax cuts later on. This would only worsen the deflationary
spiral. The suggestion that governments will be perceived as
irresponsible and face insolvency problems does not seem
relevant in the reality we live in today. Still, Japan has not been
able to avoid the deflation stage either, with a debt ratio of
200% of GDP.
The Bank of England (BOE), on the other hand, seems to be
better at manoeuvring the situation. Its benchmark rate has not
been cut below 2% in 314 years, and the BOE chose to set a
floor of 0.5% (ECB at 1%). Quantitative easing entails
purchases of government bonds, which more than purchases of
mortgage bonds drives up inflation expectations. On the other
hand, the monetary base can be adjusted quickly both upward
and downward, which actually should not affect inflation
expectations. Quantitative easing has not helped to prevent
deflation in Japan either.
The advice being given
is unreasonable given
today's reality
It is important not to
cut to zero – maybe
the US should raise
rates earlier?

Efforts to correct balance sheets in the private and public sector
will take time. There is no room for a massive fiscal stimulus
given the state of the financial markets and that demographic
trends are already contributing to rising debt ratios. The
measures that are being taken must be correctly targeted in
areas where they are needed, such as the labour market.
Furthermore, expansive monetary policy must be combined with
structural reforms that raise growth expectations over time. In
the West, especially the US, the time horizon appears to be
short and the direction based too much on boosting household
consumption as a growth engine despite all signs otherwise.
New growth models must focus on investments in the future in
order to compete with China, which is busy developing its
infrastructure and human capital – though still from low levels.
Structural reforms should therefore focus on:
Measures that speed up the replacement of growth models
if needed and reduce global savings imbalances;
Strengthen financial regulations through global coordination
and with a reasonable time horizon given the current
economy (an analysis of the financial regulations and a
postponed Basel III is forthcoming);
Measures that increase regional and global integration –
totally new frameworks for collaboration are needed within
the Eurozone (will be dealt with in a fortcoming analysis);
Pension reforms where the retirement age is raised, since
we live longer;
The functioning of the labour market – to increase
employment;
Efficiency improvements in the public sector – to handle
social and welfare needs;
New budget targets and spending and tax reforms;
More flexible currency regimes – needed mainly in China;
Liberalisation of trade and investments;
Deregulation of product and service markets – the service
sector needs to be more dynamic and integrated, especially
in the EU;
Educational reforms – to handle globalisation and growing
competition;
Infrastructure investments – that help to expand local
labour markets and strengthen productivity and growth.
Too much focus on
fiscal and monetary
policy and too little
on structural policy

5. Our outlook for the financial and
commodity markets
The forecast in our main scenario is based on assumptions
regarding interest rates, currencies, stocks, housing prices and
commodity prices. There are considerable forecast risks
involved, since it is notoriously difficult to predict individual
exchange rates and asset prices.
Interest rates
Fiscal austerity and weak domestic demand will soften price
pressure in the West during the forecast period. Compared to
last year consumer prices are rising, but in many cases inflation
is below its target. Emerging economies are cooling down to
reduce overheating problems, which is keeping inflation in
check.
Inflation outlook based on the consumer price index (%)
2009 2010 2011 2012
US -0.3 1.5 1.3 1.5
EMU-countries 0.3 1.3 1.0 1.2
UK 2.2 3.0 1.9 1.8
Japan -0.7 -1.0 -0.3 0.5
China -0.7 3.2 3.0 3.0
India 2.2 8.5 6.5 5.5
Brazil 4.3 5.2 4.8 4.3
Russia 11.7 6.6 8.9 10.0
Global CPI 0.9 2.6 2.4 2.5
These conditions, along with the fact that the growth rate is
slowing and the recovery is taking more time, mean that central
banks are not expected to raise their benchmark rates as early
as we predicted in our spring forecast, where we assumed that
rate hikes would begin in Europe and the US during the second
half year. Now we do not see the first hikes for another year.
The zero interest rate policy will continue.
Note: These assumptions are based on our main scenario that
deflation can be avoided. If, however, a Japan scenario occurs,
interest rate hikes will come later, probably not at all during the
forecast period. Then quantitative easing will also intensify,
which means that the balance sheets of central banks will
expand.
Consumer prices are
rising, but core inflation
remains low
Interest rate hikes
have been delayed
for a year

Short-term interest rate assumptions 2010-2012
Poliy interest rates 2010 2010 2011 2011 2012
16 aug 31 dec 30 jun 31 dec Average
Federal Reserve, US 0.25 0.25 0.25 1.00 2.00
ECB, Euro zone 1.00 1.00 1.00 1.00 1.50
BOE, Great Britain 0.50 0.50 0.50 1.25 1.75
BOJ, Japan 0.10 0.10 0.10 0.10 0.10
Thanks to the continued recovery and weak inflation, long-term
bond rates are staying relatively unchanged or trending slightly
higher. In a Japan scenario, they would fall further, and in a
scenario where normalisation happens faster, with the risk of
inflation in the slightly longer term, they could rise much faster.
It should be noted that in the diagram below it took a fairly long
time before Japanese bond rates had dropped before levelling
off at below 2%, despite that deflation was already a fact.
At the same time it should be kept in mind that when confidence
in a country's finances is undermined in the financial markets,
bond rates will quickly rise, as we have now seen in Southern
Europe, for example.
Long-term market interest rates , 10 yr government bonds (%), US, UK, Japan and
Germany
8 6 8 8 9 0 9 2 9 4 9 6 9 8 0 0 0 2 0 4 0 6 0 8 1 0
Percent
0 .0
2 .5
5 .0
7 .5
1 0 .0
1 2 .5
1 5 .0
U K
U S A
J a p a n
G e rm a n y
Currencies
Since the beginning of the year the euro has fallen by just over
11% against the US dollar and by 3.5% against the British
pound, while the Japanese yen has appreciated by 8.4% and
the Chinese yuan by less than 1%. Through June the US dollar
had risen by slightly over 4% based on a broad, trade-weighted
index after last year's depreciation.
The more positive trend in Europe this summer since the worst
of the debt and banking crisis had passed has strengthened the
euro and pound against the dollar. The yen has also continued
to rise, but at the same time that China appreciated the yuan
slightly against the dollar, it has weakened against the euro.
Low bond rates can
quickly turn higher – if
confidence sinks

Exchange rates of various currencies against the dollar and the dollar's trade-
weighted trend (Index August 2007 = 100) – a rising curve indicates weakening
S ource: R euters E coW in
98 99 00 01 02 03 04 05 06 07 08 09 10
70
80
90
100
110
120
130
140
150
160
170
Y en against the U S dollar
E uro against the U S dollar
Y uan against the U S
dollar
S terling
against the
U S dollar
We expect the dollar to rise against the euro during the forecast
period driven by slightly faster growth and a continued appetite
for US treasuries, which are still regarded as safe bets. The
Eurozone’s continued problems are also a contributing factor.
The Chinese yuan will continue to appreciate assuming that the
global recovery lasts, but the pace will remain slow at about 4-
5% per year. If a new global recession occurs, we think it is
likely that China will again stop the yuan’s appreciation.
While the yen isn’t likely to lose ground in the year ahead, it
probably won't go much higher from today's levels either. A
relatively strong yen is partly due to the need among central
banks to diversify their currency portfolios away from the dollar.
As the dollar appreciates, this need subsides. Slower growth in
2011 and 2012 will also weaken the yen slightly.
Exchange rate assumptions 2010-2012
2010 2010 2011 2011 2012
16 aug 31 dec 30 jun 31 dec Average
EUR/USD 1.32 1.30 1.25 1.22 1.20
RMB/USD 6.77 6.60 6.50 6.30 6.15
USD/JPY 86 87 90 95 98
Commodity markets
In line with a stronger global economy this year, we are raising
our oil price forecast upward to 78.5 dollars a barrel (75 dollars
in our spring forecast). The growth rate will then slow and be
weaker in 2011 and 2012 compared to our previous forecast.
Oil is now expected to rise to 82 dollars in 2011 and 90 dollars
in 2012.
The price of oil will remain considerably above the average for
1970-2010 of 27 dollars, and even above the average for 2005-
2010 of 72 dollars.
The dollar is expected
to rise during the
forecast period
China remains
cautious
Diversification away
from the dollar is
helping the yen
After rebounding
oil prices will rise
more slowly

Nominal price of oil, US dollars/barrel 1970-2010
Source: Reuters EcoWin
70 73 76 79 82 85 88 91 94 97 00 03 06 09
USdollar/barrel
0
25
50
75
100
125
150
First Oil Crisis
Second Oil Crisis
Kuwait
Asian Crisis
9 eleven
Irak
High demand, also some supply problems
Financial
bubble
IT bubble
2012
2011
2010
We expect metal and food prices to continue to trend upward,
although the growth rate will slow in 2011 and 2012 compared
to the rebound after the crisis. The risk of higher grain prices
has increased due to the fires in Russia and the export
stoppage there and in Ukraine, although the inventory situation
still seems better than during the supply shock in 2008.
Commodity price trend in dollars (Index 2000 = 100)
Source: R euters EcoW in
00 01 02 03 04 05 06 07 08 09 10
Index
50
100
150
200
250
300
350
400
450
Food price index
C om m odity price index - total
C om m odity price index - excluding energy
Asset markets
Housing prices have not yet hit bottom in Spain and Ireland, for
example, and even though the slowdown has eased in the US
and Denmark there are as yet no signs of a clear recovery. In
the US, the phase-out of tax subsidies has created uncertainty,
The fires in Russia
have increased the risk
of higher grain prices

in combination with the Federal Reserve’s decision to stop
buying mortgage bonds from Fannie Mae and Freddie Mac. A
new stimulus for debt-burdened homeowners and mortgage
institutions cannot be ruled out and could give housing prices a
boost, but a self-generating, robust recovery is still in the future.
There is still considerable overcapacity. A recovery has been
noted in the UK, where supply is limited and demand has risen
in pace with low interest rates, but prices have now been falling
for two months. In Norway and Sweden, the rise in housing
prices has gotten ammunition from a rapid credit expansion.
Provided that low interest rates stick around for a while longer,
housing prices will remain stable or rise in a number of
countries, except where there is overcapacity and too many
homes were built before the crisis.
Housing price trend in selected countries (Index 2000 = 100)
9 9 0 0 0 1 0 2 0 3 0 4 0 5 0 6 0 7 0 8 0 9
7 5
1 0 0
1 2 5
1 5 0
1 7 5
2 0 0
2 2 5
2 5 0
S
S P
U S A
U K
N
S F
IR L
D K
Market jitters returned in 2010 due to the Greek crisis and the
Eurozone’s inability to handle it. To date stock markets have
benefitted from corporations’ lower costs. Order bookings,
especially from the West, are lower than normal, however.
Going forward they will have to increase in pace with the
recovery – a reasonable scenario – but since the impact of cost
savings is ebbing, stock prices are rising slower than in 2009.
Stock price trends in the US, Japan, India, China, Russia and Europe
(Index January 2009 = 100)
0 6 0 7 0 8 0 9 1 0
Index
5 0
1 0 0
1 5 0
2 0 0
2 5 0
3 0 0
3 5 0
4 0 0
R u s s ia
J a p a n
C h in a
(S h a n g h a i)
In d ia (M u m b a i)
U S A (S & P 5 0 0 )
Strong equity prices
will require an increase
in order bookings

6. Regions: Western World, please hold!
Although the global recovery is continuing, there are signs of
slower growth in the second half year as the effects of stimulus
measures fade and the rebound after the great recession
comes to an end. In particular, growth is no longer getting the
same lift from inventory investment.
In the years ahead the recovery will also slow due to tighter
economic policy, mainly fiscal policy, though also gradually less
expansive monetary policy as well as stricter rules on the
financial sector.
Emerging economies, especially in Asia, have had a strong
impact on the recovery. Growth has been high not only in China
and India. The economies of Singapore, Taiwan, Thailand,
Malaysia, the Philippines and Indonesia are also growing
strongly, at between 6% and 20% on an annual basis. The
West is getting a boost, especially export-oriented countries
such as Germany, Japan and Sweden.
Annual GDP growth in a number of Asian countries (%)
Q 1 Q 3 Q 1 Q 3 Q 1 Q 3 Q 1 Q 3 Q 1
0 6 0 7 0 8 0 9 1 0
Percent
-1 0
-5
0
5
1 0
1 5
2 0
S in g a p o re
T a iw a n T h a ila n d
In d o n e s ia
M a la y s ia
P h ilip p in e s
Activity in many emerging countries has risen a little too quickly,
however, and there is a risk of overheating. One sign is high
inflation. Others are rising asset prices and a rapid increase in
consumer spending.
Attempts are being made to reduce imbalances and cool off
these economies. The key is to avoid too fast of a slowdown,
especially if stricter economic policies are coupled with lower
capital inflows and a downturn in more developed countries.
Our main scenario includes a soft landing in emerging countries
such as China, India and Brazil. The risk of a recession there is
limited, and if one does occur, it could be countered by new
stimulus measures more easily than in the West. (Russia will be
dealt with in a forthcoming analysis).
In more developed countries, i.e., the West, there is greater
concern for a new recession after several quarters of growth.
The risk has eased, however, thanks to greater transparency in
Thanks to a V-shaped
recovery in emerging
economies, the global
economy is getting a
lift
The key is to avoid
a hard landing in
emerging economies

the European banking system following the stress tests and
after Greece implemented the reforms and cutbacks that had
been expected, which calmed the financial market. The West
still faces a massive debt restructuring in the private and public
sectors, at the same time that the financial sector has to shrink
in the wake of the financial crisis and new regulations.
Note: The focus should not only be on the size of austerity
packages but also on the difference between previous stimulus
measures and austerity – a major “swing” that at the same time
is slowing activity in several sectors in several countries.
The US has led the recovery. The rebound has also been
stronger than expected in Japan. The fourth quarter of 2009
and first quarter this year were the strongest measured in terms
of annual and quarterly growth. Now we expect a slower second
half at the same time that Europe, which usually trails by about
a half year, sees its growth peak in the second and third
quarters. The positive trend in the US about six months ago has
crossed over to Europe, and with it optimism has followed.
It is important, however, to look beyond rebounds and instead
focus on the underlying trend. Western countries are struggling
with relatively similar problems: weak labour, housing and
financial markets and growing political instability. The US is
expected to stabilise with GDP growth of 2.5% in 2012, while
the Eurozone and Japan are more likely to reach 1.5%.
The US and Eurozone are both growing about one percentage
point lower than before the financial crisis. The US is back at its
GDP level before the crisis late last year, while Japan and the
Eurozone will have to wait until 2012. The difference between
the US and Europe isn't that great, however, about 5
percentage points, compared to China and India, which instead
are expected to grow 35-40% during the period (2008-2012).
Actual and estimated real GDP growth 2007-2012
(Index second quarter 2008 = 100)
75
80
85
90
95
100
105
110
115
120
125
130
135
140
145
150
Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2007 2008 2009 2010 2011 2012
US
Japan
Eurozone
China
India
While the West is obviously starting from a higher income level,
the financial crisis and recession are accelerating a
Optimism has turned
to pessimism in the US
– Europe is likely to
follow
It is important to look
at the trend beyond
a single economic
rebound

convergence. Given growth of 8% and 2.5%, respectively,
China will pass the US as the world's largest economy in 9-10
years with GDP in PPP terms. If GDP is calculated in dollar
terms, it will instead take slightly over 20 years.2
2009 2019 2030
PPP US-dollar PPP US-dollar PPP US-dollar
US 1 14.256 1 14.256 China 1 19.189 2 10.598 China 1 44.740 1 24.711
China 2 8.888 3 4.909 US 2 18.249 1 18.249 US 2 23.944 2 23.944
Japan 3 4.138 2 5.068 India 3 8.100 9 2.159 India 3 18.887 4 6.524
India 4 3.752 11 1.296 Japan 4 4.802 3 5.880 Russia 4 7.488 8 3.430
Germany 5 2.984 4 3.347 Russia 5 4.377 10 2.005 Japan 5 5.657 3 6.927
Russia 6 2.687 12 1.231 Germany 6 3.463 4 3.884 Brazil 6 5.628 6 4.380
UK 7 2.256 6 2.175 Brazil 7 3.290 7 2.561 Mexico 7 4.290 10 2.437
France 8 2.172 5 2.649 UK 8 2.888 6 2.784 Germany 8 4.079 5 4.576
Brazil 9 2.020 8 1.572 France 9 2.520 5 3.074 UK 9 3.791 7 3.653
Italy 10 1.922 7 2.113 Mexico 10 2.508 13 1.425 Korea 10 3.689 11 2.289
Our conclusion is that the West is continuing to grow below its
potential, at the same time that emerging economies are
cooling off but still expanding greatly in comparison. Even
without the financial crisis and recession, the convergence
would have continued, but now it is accelerating due to slower
anticipated growth in the West.
In other words, the countries around the world are operating at
different speeds. China and India are driving in the fast lane,
Brazil and Russia are in the centre lane, and the US, Europe
and Japan are in the slow lane. On the shoulder are the
economies that continue to shrink such as Iceland and Greece.
Note: For the West to grow faster will require structural reforms
that lead to higher productivity and compensate for the negative
effects of austerity measures.
US – Weak growth and price pressure
• Weak labour, housing and credit markets are holding back
the recovery
• Continued low interest rates, more quantitative easing and
fiscal stimulus
• Many challenges: public finances, the middle class,
demographics, politics
Despite that the US central bank, the Federal Reserve, cut its
benchmark interest rate to zero two years ago and expanded its
balance sheet by US$1.2 trillion – and the administration
pushed through a fiscal stimulus package worth nearly US$800
billion in February of 2009 – the American economy has not
shown signs of a lasting recovery.
2
Other assumptions include an annual growth rate of 5% in other emerging
economies, 2.5% in the UK, Canada and Australia, and 1.5% in the Eurozone
och Japan. The PPP assumptions here are constant, but in reality will change
over time.
The financial crisis
has accelerated the
convergence between
East and West
An unconvincing
recovery despite
the stimulus

During the fourth quarter of 2009 and first quarter this year the
economy grew strongly by 4.9% and 3.7% on an annualised
basis. Domestic demand remained weak during the second
quarter, however, while net exports contributed negatively to
GDP growth, which measured a more modest 2.4% - a
preliminary result which most likely will be revised downward.
Note: If we exclude the inventory build-up and public spending,
growth was a meagre 0.5% on an annualised basis.
The Bureau of Economic Analysis, which releases GDP data,
has also revised its previous data. In fact the recession was
worse than previously reported and the huge job losses are
more in line with the new GDP statistics.
The fact remains that the US has not experienced such a
severe recession since World War II, and with such a big impact
on employment. Since January 2008, 7.5 million jobs have
been lost, including a temporary blip due to the national census.
In the last quarter only 51 000 new jobs were added in the
private sector.
During previous recoveries the US labour market benefitted
from its mobility, but because this recession was nationwide in
scope and people aren’t moving to the same extent, along with
the fact that the housing market continues to stagnate, there is
a lack of vitality in the economy. Long-term unemployment has
risen. Unemployment compensation has been extended to
avoid a further slowdown in spending. The risk of higher
structural unemployment is high.
There is a lack of consensus among US economists on the
recipe for a robust recovery. So it is not strange that American
politicians can't figure out what to do, either. Democrats, who
feel that the stimulus package was too small, have had an
interest in seeing the economy weaken so that an additional
stimulus can be approved. Republicans also have an interest in
a weaker economy, in their case to bolster their position going
into congressional elections this fall. In general there are
concerns about the impact the stimulus is actually having and
that the US is becoming more like Europe, where the state’s
role is bigger (i.e., a fear of socialism).
Confidence in politicians is low. This includes President Obama,
who is fighting for support leading up to the elections in the
Senate and House of Representatives on 2 November. If the
Republicans can gain 10 seats, they would secure a majority in
the Senate (51-49 vs. 41-59 now). That would lead to a political
impasse with difficulty passing any reforms, which could impede
the recovery and affect the growth prospects in the longer term.
In our previous economic forecast we predicted that the
economy would weaken during the second half year when
stimulus measures were phased out and the impact of the
inventory build-up had passed. The signals we are now seeing
– continued weakness in employment, housing sales, lending,
The national recession
and weak housing
market are reducing
mobility in the labour
market
A political impasse is
expected following the
election, which would
make it difficult to pass
any real reforms

and especially among small and medium-sized businesses –
seem to indicate that this recovery will take longer. We are
retaining our forecast from last spring with estimated GDP
growth of 2.8% this year, 2.2% in 2011 and eventually up to a
modest 2.5% for the US in 2012.
The following factors support our forecast:
Private consumption (about 70% of GDP) remains weaker than
normal due to high unemployment and small income gains, a weak
credit market, high credit card debt and diminished wealth, which
increases the need for debt reconstruction and saving, as well as a
slow recovery in the single family home market as tax rebates are
phased out. With households’ real and financial net wealth as a
percentage of disposable income having returned to the 1990
level, the saving ratio will continue to rise for a few more years.
Saving and outstanding debt in relation to disposable income
6 0 6 5 7 0 7 5 8 0 8 5 9 0 9 5 0 0 0 5 1 0
Debtasashareofdisposableincome
0 .5
0 .6
0 .7
0 .8
0 .9
1 .0
1 .1
1 .2
1 .3
Savingsasapercentageofdisposableincome
-2 .5
0 .0
2 .5
5 .0
7 .5
1 0 .0
1 2 .5
1 5 .0
1 7 .5
< ---- S a v in g s ra tio
D e b t ra tio ---->
The manufacturing sector has held its own so far, especially in IT
equipment, but weaker global growth and slowing investment
demand for replacement products will impede the recovery. Small
and medium-sized businesses are in a historically weak situation
due to the slow demand. Companies are still facing overcapacity
and have little need for new investment or hiring. The problems
with commercial real estate continue to affect investment
conditions and could lead to financial instability among regional
banks.
The stronger dollar and slightly slower global growth are expected
to impede exports. Instead there will be a shift to imports of foreign
products in manufacturing, which makes it harder for domestic
players and does nothing to alleviate surplus capacity.
Stricter regulations on the US financial sector are expected to
contribute to slightly slower growth, partly because of lower lending
volumes and partly because of less innovation in the sector.
The effects of the fiscal and monetary stimulus are fading at the
same time that the administration has been unable to garner
support for a new stimulus. If the so-called Bush tax cuts from
2001 and 2003 are not extended when they expire in 2011, it could

pose a risk to growth. The medium term fiscal issues are now
being shifted to 2012 or 2013.
Optimism among small businesses (index 1986 = 100) and the
percentage that intend to hire new workers
8 5 9 0 9 5 0 0 0 5 1 0
Index
8 2 .5
8 5 .0
8 7 .5
9 0 .0
9 2 .5
9 5 .0
9 7 .5
1 0 0 .0
1 0 2 .5
1 0 5 .0
1 0 7 .5
Percent
-1 5
-1 0
-5
0
5
1 0
1 5
2 0
2 5
3 0
3 5
O p tim is m in d e x
1 9 8 6 = 1 0 0 --->
< --- S h a re o f c o m p a n ie s
p la n n in g to re c ru it
Weak demand and excess supply are keeping pressure on
consumer prices and limiting opportunities for companies to raise
their prices.
Political uncertainty is also creating less confidence among
households and businesses. The difficulty in reaching a consensus
on immigration policy and uncertainty about health care reform
despite its having passed are two examples. High unemployment
could lead to more protectionism, especially vis-à-vis China. The
negative sentiment that has arisen since growth numbers brought
on a disappointed reaction in the media and the financial markets
raises the risk of a vicious cycle of pessimism, political bickering
and a sluggish recovery in the private sector.
One positive forecast risk is that business investment (which
accounts for about 6.5% of GDP) rises more than expected
thanks to low capital costs and higher profits. At a growth rate of
15%, this would contribute 1% to growth.
At this point the risk of a double-dip or a new recession has
diminished since late last spring as Europe's situation has
improved. The most likely scenario is weak GDP growth in line
with our forecast, with little in the way of consumer price
increases. The risk of deflation in the US has risen, however.
Core inflation (consumer price index less energy and food) was
less than 1% in April, May and June, the first time this has
happened since the 1960s. US 10-year treasury notes have fallen
from 4% in April to 2.8% at the time of writing. The US imports
deflation due to a weaker euro/stronger dollar. In Japan, deflation
is already a fact, and parts of Europe also risk deflation.
As more and more jittery households and businesses decide to “sit
on their money” and invest in treasuries, the demand for money
increases. Lending isn't working as it normally should, and even
banks are investing in government securities.
IT investments are
surprising on the
upside and can
raise growth
Deflation problems
are getting closer

The Federal Reserve has cut its benchmark rate to zero, where it
is expected to remain for some time to come. With such a
monetary policy the US could find itself in a Japan-like scenario
with low nominal interest rates and deflation for an extended
period, since new negative chocks are reducing inflation
expectations and monetary policy has become passive. New
quantitative easing is likely to alleviate at least some of the
deflation threat, but the positive effects will probably be modest at
best. Also, the credit multiplier (the money supply in relation to the
monetary base) is lower since banks are lending less and
increasing their reserves.
And so the signs of a Japanese scenario don't seem all that
farfetched for the US: A period of weak to modest growth,
deflation or low inflation, a liquidity trap, debt restructuring and
growing hopes that fiscal policy is the recipe.
The medium- and long-term fiscal situation in the US is a
concern and does not allow for another large stimulus package.
As a result quality must become a greater focus in reform
efforts: middle-class stagnation, gradually declining education
levels, demographic factors in healthcare spending, growing
structural problems in the labour market and the financial
difficulties facing many states (e.g., about US$ 1 trillion more is
needed to pay public pensions). These are only a few of the
challenges the US faces in the years ahead.
Japan – Boost from China is fading
• Deflation and weak domestic demand are slowing growth as
the export rebound ebbs
• Tighter economic policy through fiscal policy and the
appreciation of the yen, passive monetary policy
• Growing concerns how Japan’s government debt will be
financed in the future
Like the US, Japan saw its GDP rebound after the deep
recession in 2008 and 2009. In the first quarter of this year GDP
grew by 4.4% on an annualised basis, mainly due to a recovery
in auto exports. A strong boost from China and other parts of
Asia has benefitted Japanese exporters and is reflected in the
optimism in the Tankan business sentiment index. The second
quarter saw a more modest growth of 0.4% in annualised terms.
After the strong first quarter Japan’s GDP in real terms is back
to the 2005 level. Nominal GDP, on the other hand, is only back
to the same level as 1993. This is an indication of the
deflationary problems Japan has faced in the last two decades.
Except for 1997/98 and 2008, consumer prices have fallen.
We expect the economic recovery to continue, but not as
quickly as earlier in the year. In 2010 GDP growth is expected
to reach 2.8%, an unusually high number mainly the result of
stimulus measures, the inventory cycle and strong demand from
The risk of a Japan-
like scenario in the US
is no longer negligible
Japan’s nominal GDP
is back to the 1993
level!

China and the rest of Asia. Next year and in 2012 we expect
Japan to return to GDP growth of around 1.4-1.5% per year.
Real and nominal GDP growth and CPI 1980-2010
8 0 8 2 8 4 8 6 8 8 9 0 9 2 9 4 9 6 9 8 0 0 0 2 0 4 0 6 0 8 1 0
Percent
-3
-2
-1
0
1
2
3
4
5
6
7
8
9
JPY(thousandbillions)
1 0 0
1 5 0
2 0 0
2 5 0
3 0 0
3 5 0
4 0 0
4 5 0
5 0 0
5 5 0
6 0 0
6 5 0
7 0 0
C o n s u m e r p ric e s
< -----N o m in a l G D P -le v e l
< ---- R e a l G D P -le v e l
The slowdown is partly due to slowing GDP growth in Asia and
partly to the stumbling recovery in Europe and the US. The
stronger Japanese yen will also affect export opportunities.
Debt reconstruction in Japan’s public sector and elsewhere
around the world as well as in the private sector could hurt
growth. To date export gains have not led to more jobs and will
weaken consumption once rebound is over.
In our March forecast we assumed that the yen would weaken
significantly when it again became popular as a funding
currency for the carry trade. Instead foreign investors (central
banks and sovereign funds) have purchased Japanese
securities, despite the marginal return, to diversify their
portfolios away from the dollar and euro. The yen – now about
JPY 85 per US dollar – is stronger than businesses would like
(the pain threshold is around 90). However, the real effective
exchange rate has not appreciated as much due to deflation.
Since unit labour costs have fallen greatly in the wake of
increased productivity, industry’s profit margins have held up so
far. If the yen rises further, which authorities are trying to offset
by giving commercial banks greater incentive to lend to certain
sectors, and later possibly interventions as well, there is a risk
of a new recession.
In addition to hurting exports, a stronger yen could intensify
deflationary pressures. Weak domestic demand also makes it
difficult to raise prices. We expect consumer prices to fall by
about one percent this year and marginally in 2011. This means
that the central bank, the Bank of Japan, will not raise its
benchmark rate during the forecast period.
With a public debt ratio of around 190% of GDP and an acute
crisis of confidence in European government finances, Naoto
Kan, the Democratic Party of Japan’s second Prime Minister
since Yukio Hatoyama stepped down in June of last year and
Japan's fifth PM in four years, launched a fight to improve the
If the yen becomes
even stronger,
interventions may
be needed
A political impasse is
close at hand in Japan
as well

country's fiscal situation. His goal was to cut the budget deficit
in half by 2015 (from the current 7.5% of GDP) and reach a
surplus in 2020. With an unpopular proposal to raise the VAT
from 5% to 10%, the DPJ lost its majority in the upper house on
11 July (but still has a majority in the lower house). At the same
time domestic policy has been paralysed, making it difficult for
the current government to pass reforms. There is a strong
likelihood Kan will be replaced during the DPJ’s convention this
fall.
Japan's biggest challenges are to fight deflation and at the
same time avoid driving bond rates so high that it becomes hard
to manage the huge government debt (which is 95% financed
by the Japanese). An aging population will also make it harder
to improve the government's finances. Lighting a fire under
domestic demand, the labour market and satisfying younger
generations are therefore important priorities.
China – Trying to avoid an overheating
• The economy is cooling off to a more sustainable growth rate
– a soft landing is likely
• Slower lending growth, but it is still rising – the yuan is slowly
appreciating
• Focus on transition from export- and investment-led to
consumption-led growth
The Chinese recovery slowed during the second quarter of the
year, which was welcome. Annual GDP growth fell from 11.9%
in the first quarter to 10.3%. On an annualised basis the
slowdown was even more evident, from about 11% to about
8%, according to unofficial figures. The question now being
asked is whether China can manage a soft landing or whether
the slowdown will be drastic in the quarters ahead, which would
impact the global recovery.
The reason why has China been forced to step on the brakes is
that the tremendous credit growth through the banking system,
which has been permitted to offset the effects of the recession,
has created a risk of inflation and overheating in several
sectors: real estate, the stock market, retail, auto sales, etc.
This year banks are committed to add only US$ 1.1 trillion in
new lending, 22% less than last year. It hasn't hindered growth,
however.
Note: Chinese banks’ bad loans are likely to increase
dramatically in the years ahead. Although the state finally
realises the problem, the banking system is likely to grow more
unstable. Furthermore, the government’s finances will be seen
in a slightly less positive light.
Although credit growth
has now slowed, it is
still too expansive

By also raising mortgage rates and requiring larger down
payments on housing purchases, activity has abated somewhat.
Since the statistics aren’t of high enough quality, there is
considerable uncertainty about the real estate sector. We
believe that housing prices have now begun to decline in areas
where they had previously risen significantly, such as Beijing
and Shanghai. Growth in auto sales has declined as well, from
over 100% to about 25% on an annual basis. The Shanghai
Stock Exchange has fallen by nearly 20% since the beginning
of the year. The purchasing managers index (PMI) indicates
that production and order bookings in the manufacturing sector
have faltered and only now begun to stabilise.
Credit growth and consumer price trend, annual percentage change
S o u r c e : R e u t e r s E c o W in
9 8 9 9 0 0 0 1 0 2 0 3 0 4 0 5 0 6 0 7 0 8 0 9 1 0
Percent
- 3
- 2
- 1
0
1
2
3
4
5
6
7
8
9
Percent
7 .5
1 0 .0
1 2 .5
1 5 .0
1 7 .5
2 0 .0
2 2 .5
2 5 .0
2 7 .5
3 0 .0
3 2 .5
3 5 .0
3 7 .5
C o n s u m e r p r ic e s - - - >
< - - - K r e d it e x p a n s io n
The economy is still posting strong growth, however. For
example, retail sales are climbing 15-20% on an annual basis
and exports are rising significantly. But if government measures
to slow growth are combined with weaker global growth and
lower capital inflows, there is a risk that the economy will face a
hard landing. Since we do not foresee a new global recession
as the most likely scenario, China has the opportunity to avoid a
hard landing. If one occurs nonetheless, China can again
quickly increase lending and institute another fiscal stimulus.
China’s currency – the yuan – in relation to the US dollar and euro as well as
nominal trade weighted index from BIS (inverted here and forecast for July)
0 5 0 6 0 7 0 8 0 9 1 0
0 .0 0 8 0 0
0 .0 0 8 2 5
0 .0 0 8 5 0
0 .0 0 8 7 5
0 .0 0 9 0 0
0 .0 0 9 2 5
0 .0 0 9 5 0
0 .0 0 9 7 5
0 .0 1 0 0 0
0 .0 1 0 2 5
0 .0 1 0 5 0
6 .5
7 .0
7 .5
8 .0
8 .5
9 .0
9 .5
1 0 .0
1 0 .5
1 1 .0
1 1 .5
< --- E U R /C N Y
< ----U S D /C N Y
N o m in a l tra d e w e ig h te d in d e x -->
Several indicators
point to the Chinese
economy having
downshifted to a
lower gear

Another question is whether China has begun a transition to
stable growth driven more by private consumption and less by
exports and investments. China’s increased flexibility in terms of
the yuan has created hopes, but to date the currency has
depreciated due to the stronger euro. The trade surplus has
continued to grow. Exports are breaking new records, rising
nearly 50% in June on an annualised basis. Relations with the
West, though also with other emerging countries, may sour
unless China shows greater resolve in achieving a transition.
At the same time there has to be a realisation that this transition
will take time. Strengthening the social insurance system so that
greater security encourages more consumption and less saving
won’t be a quick fix. It is worth noting that wage growth has
risen among foreign companies along the coast after strikes. A
new law from January 2008 strengthening workers’ rights has
produced results and been applauded by the administration (at
least in the case of foreign companies). Better educated
workers in a new, younger generation are more assertive about
their rights.
Wage growth has been relatively high in recent years, at about
9% per year in dollar terms. Labourers in urban areas demand
compensation on par with Thai or Filipino cities. Minimum
wages have increased. In addition, the Chinese population is
aging and the number of young people who possibly could
move is shrinking. Although there are still workers inland
(around 70 million) who could potentially move, the hukou
system of residency permits may be holding back younger
workers who won’t as easily give up their rights. According to
hukou, immigrants and their children are treated differently than
urban residents when it comes to healthcare and education, for
example.
Although wage growth has intensified, productivity has
increased even faster, which means that Chinese
manufacturing has become more competitive, not less. The key,
however, is to be able to repeat this, which is unlikely. All
indications are that foreign companies will look for opportunities
in inland China or other countries in Asia, such as Vietnam,
where wages are lower than along the Chinese coast.
If costs increase, there is a risk of inflation that may affect China
and the rest of the world. At the same time this isn't the West’s
headache, where concerns about deflation should be a higher
priority. China, on the other hand, is sensitive to inflation, and it
is likely that it will only narrowly stay below the central bank's
comfort range of around 3-4%.
Our expectation is that China will grow by nearly 10% this year
(9.9%). During the second half of the year economic growth will
cool to an annualised rate of 8.5% by year-end. Since stimulus
measures are not having the same impact on growth and the
West is growing somewhat slower, we expect China to dip
down to 8-8.5% in 2011-2012. In other words, there will be a
soft landing in our main scenario.
After the adoption of a
more flexible currency
policy the yuan has
depreciated because
of the euro
The saving ratio
cannot be reduced
with a quick fix
Competitiveness has
risen thanks to high
productivity growth –
higher wages on the
coast are pushing
production inland

India – Struggling with supply problems
• Rapid growth in service and goods production – urban
population benefits
• Further interest rate hikes and possibly a stronger rupee –
lower subsidies reduce the budget deficit
• Structural reforms should take greater precedence – a long
time until the next election
India’s economy grew relatively strongly at slightly over 8.5%
during the third quarter of 2009 and first quarter of this year.
Growth was supported by stimulus measures and domestic
demand sparked by strong activity in the manufacturing and
service sectors. Agriculture, which accounts for 15% of GDP,
has started to recover after the unpredictable monsoon rains
last year.
Despite that growth only slightly exceeds India's potential
(around 7.5%), there have been growing problems with
overheating. High commodity prices, rapidly rising wages and
the strong domestic demand, which provides companies with
opportunities to raise prices, coupled with a shortage of certain
foods, have contributed to rising inflation. In addition, the
government is reforming its program of fuel subsidies, which is
also raising consumer prices and having one-time effects.
Inflation, measured in wholesale prices, is rising by around 9-
10%, but inflation will slow along with consumer prices for
industrial workers and farmers now that the monsoon rains
have stabilised.
In reaction to the risk of overheating, the government has
tightened fiscal and monetary policy. The question, though, is
whether they shouldn't have done so earlier. At the same time
the effects of economic policy shouldn't be exaggerated. For the
70% of the population that lives in rural areas, supply problems
are of greater importance, and it is hard to alleviate a shortage
of lentils, for example, by raising interest rates.
Real GDP growth and inflation in India June 2005 - June 2010 (%)
0 5 0 6 0 7 0 8 0 9 1 0
Percent
-2 .5
0 .0
2 .5
5 .0
7 .5
1 0 .0
1 2 .5
1 5 .0
1 7 .5
2 0 .0
C P I a g ric u ltu ra l w o rk e rs
W h o le s a le p ric e s
G D P -g ro w th
C P I in d u s tria l w o rk e rs
Stronger domestic
demand and supply
problems have both
driven inflation higher

Signs of overheating have been negated, however, by tighter
economic policy and weaker domestic demand resulting from
global developments and domestic bottlenecks. Capital good
production growth is slowing down. Even so, we are forecasting
GDP growth of 8% this year, slightly stronger than our spring
forecast (7.5%). However, we have revised our forecasts for
2011 and 2012 downward to 7.5% and 7.8%, respectively. It will
take longer to return to the growth rate of around 10% India had
before the global financial crisis broke out.
The fact remains that the urban population has benefitted from
rapid growth in many service-oriented sectors: outsourcing, IT,
telecom, real estate and finance. Wage growth is in the double
digits. Moreover, taxes have been cut. The urban population
has had plenty of opportunity to increase consumption, and car
sales in particular have climbed substantially. In spite of a slight
slowdown, we expect domestic demand to remain strong,
driven by large capital inflows, foreign and domestic investment,
and latent demand following the financial crisis, during which
many people saw their net wealth shrink.
At the same time these capital inflows, which are driven by a
combination of attractive investment opportunities and higher
interest rates, represent a problem for financial stability. The
central bank may want to try to regulate inflows, which in turn
could hurt the investment climate. The benchmark interest rate
can only go higher. We expect the Reserve Bank of India (RBI)
to continue to gradually raise it from the current level of 5.75%
up to 8% in 2012. To reduce inflation it would also help if the
rupee further appreciated. Given the volatile capital flows,
however, exchange rate trends are uncertain at best.
Since India does not have an upcoming congressional election
scheduled, the sitting government has the opportunity to
consolidate the budget and introduce unpopular structural
reforms. By further reducing subsidies and broadening the tax
base, it could boost revenue. Combined with the recovery, this
would enable it to slash the budget deficit from nearly 7% last
year to just below 5% this year. The national debt, at around
80% of GDP, is still trending higher, and that has to change.
Structural reforms include the need to strengthen the supply
side of the economy to avoid bottlenecks. Investments in
infrastructure and human capital would help. Making the labour
market more flexible so that more people shift from agriculture
to services and manufacturing is desirable, but targeting
productivity improvements in the agricultural sector is important
as well. Social areas such as health, education and sanitation
therefore must be strengthened in both qualitative and
quantitative terms.
The urban population’s
standard of living has
improved in recent
years
With no elections in
the near future, will the
government take this
opportunity to institute
reforms?

Brazil – Prepping for presidential election
• Major upward revision of growth forecast for 2010 – but now
growth is slowing
• Certain inflation risks will cause the benchmark rate to
further rise to a high 12%
• Regardless of who wins the 3 October election,
macroeconomic stability is critical
Brazil has handled the global financial crisis and recession well.
Last year GDP fell by a marginal 0.2%. International confidence
in the country seems fairly strong, and access to foreign capital
has been good. The future challenges facing the country are to
ensure a soft landing after signs of overheating and to
successfully hold the presidential and congressional elections in
October.
With growth of nearly 9% on an annual basis (11.4% measured
on a seasonally adjusted basis) for the first quarter, we have
had to significantly revise our spring forecast upward from 4.7%
to 6.5%. Domestic demand – investment growth – has been
especially surprising and has received support from foreign
direct investment, strong commodity demand and higher future
confidence among businesses and households. Retail sales
have been helped by relatively strong income growth for the
population as a whole as the labour market improves in pace
with the higher growth. Since imports have also risen
substantially, net exports are not contributing positively to GDP
growth.
GDP and various components of the national accounts,
annual percentage change
Q 1 Q 3 Q 1 Q 3 Q 1 Q 3 Q 1 Q 3 Q 1 Q 3
0 5 0 6 0 7 0 8 0 9
Percent
-2 0
-1 0
0
1 0
2 0
3 0
4 0
Im p o rt
P riv a te
C o n s u m p tio n
G D P
E x p o rt
In v e s tm e n ts
After strong growth of around 6.5% this year we anticipate a
soft landing when fiscal and monetary policy are tightened,
global growth slows slightly and domestic demand falls. In 2011
and 2012 GDP growth will reach a more cautious 5%, but this is
still stronger than the 3.5% average for the last 10 years.
We have significantly
revised our GDP
forecast for 2010
upward – investment
is surprising on the
positive side

There is a big risk that inflation will exceed the central bank's
target of 4.5% and in fact close in on 6% this year. A tighter
labour market is increasing wage pressure, which could lead to
higher inflation given the current strong demand. More
restrictive economic policy will gradually ease price pressures.
The central bank is expected to raise the SELIC rate from
10.75% to slightly over 12%. Uncertainties include the country’s
exchange rate. The real has appreciated 25% against the dollar
and nearly 30% against the euro since January 2009.
Commodity prices are also affecting domestic inflation, and
based on our assumptions we see a slightly positive trend.
Fiscal policy will be a more important focus after the 3 October
election. Regardless of who wins – the Workers’ Party (PT) or
Social Democrats (PSDB) – macroeconomic policy isn’t
expected to change, i.e., budget discipline will stay in place.
The budget deficit as a share of GDP is estimated at 2% this
year and the national debt could continue to decline during the
forecast period to 60% of GDP (40% of GDP net).
The two most popular presidential candidates are Dilma
Rousseff, President Lula da Silva’s chief of staff (Rousseff who
has been ill this year and hasn’t been seen much in public until
now) and José Serra, the former governor of Sao Pãulo.
Rousseff recently passed Serra in opinion polls. Since the
Green Party has a candidate (Marina Silva) with some support,
a second round of voting is expected when the two of principal
candidates can face off.
From a longer-term perspective Brazil’s democratisation has
progressed well. Both candidates will continue Lula da Silva’s
fairly successful economic policy. At the same time elections
are being held for the entire lower house and two thirds of the
senate. It is worth noting that 147 of 513 lower house members,
as well as 21 of 81 senators, are being investigated on
corruption charges. With Brazil's new “Ficha Limpa” (Clean
Record) legislation, corrupt politicians who have been convicted
are not able to remain in Congress to the same extent as
before. If the law is followed, it will be another step toward
democracy.
Eurozone – Temporarily positive sentiment
• After some optimism, reality returns in the form of weak
growth and the risk of deflation
• Budget consolidation in large parts of the Eurozone – the
benchmark rate will be held unchanged in 2010-2011
• Many challenges: A single framework for Euro zone
cooperation, the banking system, divergence between
countries in the north and south
Developments in the Eurozone have been anything but
homogenous in recent years. While Germany and other
Higher inflation and
interest rates are a
concern, but the real’s
appreciation could
ease the situation
Economic policy is not
expected to change
significantly after the
election

Northern European countries have improved their
competitiveness, the Southern European countries have fared
worse and face huge current account deficits. Imbalances have
been accumulated over time driven by negative real interest
rates, a public and private debt build-up, high wage growth,
weak productivity, overinvestment in sectors such as finance,
real estate and retail, and a rapid expansion of the public
sector, as in Greece.
When the financial market no longer wanted to finance the
burgeoning budget deficit, which was due to both the financial
crisis/recession and earlier domestic structural problems, there
was no alternative to austerity and reforms. Currencies can not
be devalued. Rising long-term interest rate differentials mean
higher costs to finance the deficits in debt-heavy countries,
Greece being the most extreme example.
Differences between various countries 10-year government bond rates, and
Germany’s ditto, percentage points
ja n
0 7
m a j s e p ja n
0 8
m a j s e p ja n
0 9
m a j s e p ja n
1 0
m a j
PercentagePoints
-1
0
1
2
3
4
5
6
7
8
9
1 0
G re e c e
Ita ly
B e lg iu m
F ra n c e
S p a in
P o rtu g a l
S w e d e n
The €110 billion rescue package for Greece took too long for
Germany and the other euro countries to agree upon. As a
consequence, a massive €750 billion rescue package had to be
passed in early May to avoid having the Greek crisis spread to
Spain, Portugal and potentially other euro members with high
levels of public debt such as Italy. Despite uncertainty about the
specifics of the package, it has had a calming effect on the
financial market.
The stress tests of European banks have also created calm, as
have their strong results in the last two quarters. A number of
outstanding questions remain, such as whether the
requirements in the tests were tough enough. In any case, the
increased transparency into the European banking system has
been positive. While US banks have written off “toxic” assets,
shrunk their balance sheets and secured US$700 billion in new
capital in the last 18 months, European banks have largely sat
on their hands. They are therefore less capitalised and carry
about twice as much debt as their American competitors. The
stress tests showed that 7 of 91 European banks had to
The imbalances in
Southern Europe in
particular were
unsustainable
Despite uncertainty
about the specifics,
both the rescue
package and …
… stress tests have
helped to calm
financial markets

strengthen their capital base, and if that isn't possible, to merge
with other banks.
Concern about public debt in the Eurozone is simply concern
about the region's banking system. Of the US$2533 billion debt
Greece, Ireland, Portugal and Spain have issued, and which is
being held abroad, Eurozone banks account for 75%. Despite
the rescue package, Greece’s national debt will reach 150% of
GDP within a couple of years, so the risk of a suspension of
payments has merely been put off a little longer.
Still, the countries of Southern Europe now enjoy a respite to
resolve their problems with the help of reforms and cutbacks. In
the meantime Germany, France and other countries, where
banks are sitting on the claims, can find new ways to
renegotiate. We can expect this to happen within a two-year
period.
The Eurozone faces a murky situation due to declining
confidence in politicians to handle crises. Between November of
2009 and June of this year the euro depreciated by slightly over
20% against the dollar, though it has since begun to rise again.
Expectations that the euro will collapse are mostly outside
Europe. Although this fear subsided during the summer after
the results of the stress tests were announced and Greece was
praised by the IMF’s oversight board, the region still faces a
number of issues going forward.
Political leadership is needed within and outside the Eurozone.
The difficulties Germany and France have had reaching an
agreement are a problem. Germany is disappointed that
countries that haven't acted responsibly have to be given
support and that the ECB has been forced to buy government
bonds in the secondary market to help banks. There is
anecdotal evidence that not only Greek and Spanish banks but
also German citizens are moving their money from euro
accounts to Switzerland, for example.
Germany’s four-year, €80 billion austerity package should be
seen as a way to restore budget discipline throughout the
region and the so-called stability and growth pact. But there is
still a need for appropriate regulations to penalise countries that
fail to abide. The rescue packages that have been introduced
could send a signal that gives rise to moral hazard problems.
As second quarter GDP figures were released in Europe,
optimism rose. The weaker euro is giving a boost to exports.
Emerging countries are contributing with strong demand for
European products. Germany in particular is reporting strong
growth after record high export numbers, which have now
nearly returned to the pre-crisis levels of 2008. Industrial
production is back at the 2006 level. On the other hand
Southern Europe still lags behind, and its underlying problems
remain.
Concern about public
debt = concern about
the banking system
Concern about a
euro collapse feels
overblown – political
commitments are
being forgotten
Optimism is now
returning to Europe,
but it is likely to be
short lived

Industrial production in several euro countries (Index January 2007 = 100)
S o u rce : R e u te rs E co W in
0 6 0 7 0 8 0 9 1 0
Index
7 5
8 0
8 5
9 0
9 5
1 0 0
1 0 5
1 1 0
1 1 5
G e rm a n y
F ra n c e
F in la n d
E u ro zo n e
Ita ly
We forecast GDP growth in the Eurozone of 1.2% this year, but
with big differences between countries. Germany’s GDP growth
will reach more than 2%, while the economies of Spain and
Greece are shrinking. Stronger growth in the second and third
quarters mirrors the US in the fourth quarter of 2009 and first
quarter this year. Growth will then fall and at the start of 2011
will again be weaker. Next year GDP will grow 1.1% before
rising a little more in 2012 to 1.6%. The modest numbers are
due to debt reconstruction, tighter economic policy and jitters
about the future.
The labour market has deteriorated but with regional
differences. Unemployment has risen to nearly 20% in Spain,
upwards of 10% in France – the Eurozone average – and 8.6%
in Italy. In Germany, on the other hand, unemployment has
fallen after a brief upturn partly thanks to a shortened work
week (kurzarbeit) and partly because the labour market has
become more flexible in general. This differs significantly from
the US, where productivity has improved considerably without
any real job gains.
Unemployment in the Eurozone, Germany and the US (%)
S o u r c e : R e u te r s E c o W in
9 4 9 5 9 6 9 7 9 8 9 9 0 0 0 1 0 2 0 3 0 4 0 5 0 6 0 7 0 8 0 9
Percent
3
4
5
6
7
8
9
1 0
1 1
1 2
1 3
G e rm a n y
E u r o la n d
U S
Germany’s labour
market has gone
against the stream

Compared to the 2000’s, when inflation varied between
Eurozone countries, they are now more harmonised. Inflation is
below the ECB’s target of less than 2%, but the trend is upward.
In light of weaker growth and economic austerity, we expect
inflation to reach 1.5% on an annual basis this year and rise
slightly in 2011.
Since the Eurozone does not face a major inflation threat and
deflation is probably a greater risk in light of upcoming fiscal
constraints, it would be reasonable for the ECB to wait before
launching a period of interest rate hikes until 2012 at the
earliest. What could change this picture are if the central bank
governor is replaced (by the more inflation-focused Axel
Weber), commodity prices rise or growth surprises by being
consistently stronger than expected.
Like ourselves, we expect many forecasters to revise their GDP
growth projections upward for the Eurozone after a strong
second quarter. It is important, however, not to draw hasty
conclusions since the rebound, like in the US, may not be
sustainable. The Eurozone – like the US – is struggling with a
number of underlying problems: a weak labour market, a huge
need for debt reconstruction, a shrinking and more regulated
financial sector, cutbacks in the public sector, pensions and
wages. That is why developments weaken in 2011 and 2012
compared to 2010, and why we revise our forecast downward.
As long as the Eurozone does not address its structural
problems – partly at a regional level and partly at a national
level – the cutbacks will lead to weaker growth. The important
thing is to combine austerity policies with reforms that
strengthen growth in the medium term. For the Eurozone and its
member states, it is important to make the labour market more
flexible, reform the pension system, develop the service sector
within and across national borders and be able to attract
investments and ideas.
UK – Shrinking public sector
• Domestic demand is under pressure from weak balance
sheets and labour market
• Fiscal austerity, the public sector must be shrunk,
temporarily high inflation, but the benchmark rate will not be
raised until the end of 2011
• Uncertainty about the staying power of the coalition
government due to the cost cuts it must enact
The British monarchy is struggling with a number of problems.
Households are holding tightly onto their wallets now that the
job market is weak, it is hard to obtain credit and debts have to
be paid off. Furthermore, a stronger pound and higher costs will
hurt exports going forward. In the political world, the new
coalition government's biggest challenge is to trim the largest
The ECB isn't
expected to raise
its benchmark rate
when fiscal policy
is tightened
The key is not to draw
hasty conclusions
based on the second
quarter’s positive data

budget deficit of any G7 member this year and shrink the public
sector.
One example of an overblown expansion is that the number of
public employees has increased by 877 000 in the last decade,
while the private sector hired 870 000. Wages have risen by
3.3% in the public sector, but by 2.7% in the private sector.
The goal of the new government, consisting of the Conservative
Party led by Prime Minister David Cameron and the Liberal
Democrats headed by Deputy Prime Minister and Minister for
Constitutional and Political Reform Nick Clegg, is to reduce the
budget deficit from around 10% to 2% in 2014. This will require
tax hikes and spending cuts. In addition to trimming the public
payroll, the VAT is expected to be raised from 17.5% to 20% in
January of next year.
The UK’s growth model, like the model in the US – consumption
driven by a large share of investments targeting finance and
real estate – has to be replaced. The purchasing managers’
index indicates that export orders are beginning to stabilise
rather than continuing to rise. If the global economy slows and
the pound remains fairly strong, it will be hard to create higher
growth through the export sector. Relatively high inflation of
around 3% is also contributing to higher costs compared to
competitors.
The British central bank (the Bank of England) seems to have a
tougher equation to solve than its counterparts – at least in the
short term. The problem is that inflation remains above its
comfort zone. Waiting too long to raise the benchmark interest
rate from the current 0.5% is risky. There hasn’t been a new
quantitative easing since February of last year. British banks
have strengthened their results, but if the economic recovery
grinds to a standstill due to budget consolidation and weak
domestic demand, the banking system again faces a risk. A
new quantitative easing cannot be ruled out.
At the same time the medium-term risk of deflation is lower in
the UK than in the US and the Eurozone. It is also positive that
the central bank hasn’t adopted a zero interest rate policy and
instead focused more on quantitative easing in the form of
government bond purchases that, if anything, raise inflation
expectations.
Our new GDP growth forecast is intact at 1.1% and 1.6% for
2010 and 2011 compared to our spring forecast, but slightly
weaker for 2012 due to the growing impact of the budget
consolidation and slightly weaker global demand.
The challenges facing the UK are to maintain political stability,
i.e., keep the coalition together until the next election, and at the
same time drastically slash public spending. Furthermore,
political leadership is needed to change the previous growth
model, in no small part by creating confidence in the future and
implementing reforms that create incentives to change.
The public sector has
expanded quicker than
the private sector in
the last decade
The British have to
change their growth
model
The BOE may have
to raise interest rates
earlier – a more
difficult equation to
solve ...
... although the risk
of deflation is lower!

Swedbank's Global Economic Outlook, 2010 August

Swedbank's Global Economic Outlook, 2010 August

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Swedbank's Global Economic Outlook, 2010 August