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To the Point, 2010 March

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Swedbank was founded in 1820, as Sweden’s first savings bank was established. Today, our heritage is visible in that we truly are a bank for each and every one and in that we still strive to......

Swedbank was founded in 1820, as Sweden’s first savings bank was established. Today, our heritage is visible in that we truly are a bank for each and every one and in that we still strive to contribute to a sustainable development of society and our environment. We are strongly committed to society as a whole and keen to help bring about a sustainable form of societal development. Our Swedish operations hold an ISO 14001 environmental certification, and environmental work is an integral part of our business activities.

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  • 1. To the Point Discussion on the economy, by the Chief Economist March 30, 2010 The art of doing it right Our global forecast from March 18th envisaged a slow recovery for the world economy with diverging developments between industrial countries and emerging markets. The outlook for China and India is clearly positive with GDP growth rates of 8-9%, while growth in the US, Europe and Japan more or less stays between 1 and 2.5%. The somewhat faster upturn in the Cecilia Hermansson US this year is mainly a result of inventory adjustments and stimulus Chief Economist measures, while underlying demand in most mature economies will remain Economic Research Department weak. +46-8-5859 1588 cecilia.hermansson@swedbank.com A slow and bumpy recovery may not be problematic as long as a double dip can be avoided. More important are the many policy challenges facing the world economy in general, and industrial countries in particular. Deleveraging in the private sector, consolidating public finances to deal with sovereign debt, withdrawing monetary policy stimulus, and rebalancing growth in Europe as well as globally are just a few. In addition, structural adjustments to counter increasing competition from emerging markets, climate change, energy renewal, the development of welfare systems and demographics are issues that must be addressed by policymakers. This version of To the Point discusses the art of doing it right over the next few years. We limit the discussion to the following areas: 1. Realistic policy-making 2. Monetary policy and financial regulation 3. Fiscal policy 4. Rebalancing growth 5. Growth policies and structural reforms Realistic policy-making With so many challenges facing policymakers at the same time, policies have to be coordinated at many different levels, such as: 1) between fiscal and monetary economic policies, 2) between countries and regions, 3) between national political parties, and 4) over time. Policymakers have been successful in managing the crisis, but will they also be successful in preventing new ones? The dilemma they face is that as long as there is a risk that the recovery will come to a halt, financial regulation should not be altered nor should austerity measures be put in place, but when the growth outlook has substantially improved the window of opportunity may have closed. Therefore, the lessons learnt from the crisis must be kept alive and policies must be coordinated from a long-term perspective. There are challenges for politicians in developing policies that may come into practice No. 3 many years after they have left the political scene. In addition, most practices are local or national, even though they are affected by other countries’ policies. Creating 2010 03 30 policies on a regional or global level – and with a longer horizon – is much more demanding for policymakers than usual.
  • 2. To the Point (continued) March 30, 2010 Most economic policies announced, for example, in the EU or the US have incorporated optimistic growth assumptions over the next few years. This may prove counterproductive if there is no Plan B. Why not be more cautious on growth assumptions as the crisis in itself may have lowered potential growth and altered economic models used to calculate growth? This would leave room for more realistic policies going forward. At a minimum, worst case scenarios should be created with a Plan B attached. Monetary policy and financial regulation Central banks face challenges on many fronts. Balance sheet policies must be scaled back as the crisis abates, but when government bonds or the housing market are involved it will be much more difficult to phase out the stimulus. Keeping the repo rate low for an extended period of time may be good for the real economy, but the transmission mechanism is not as strong as usual, and instead of supporting companies there is a risk that household credits grow too fast in countries where housing markets have been robust during the crisis. There are tests ahead for central bankers in combining financial stability with price stability. We could see a situation with lingering problems in the financial sector and increasing inflation in consumer prices. Most likely, the goal of price stability will be set aside if financial stability is threatened. There is also a need for more research on how to combine these goals. So far, dealing with asset prices seems to have been asymmetric in the sense that interest rates have been lowered (in Chart 1: Inflation in the OECD countries particular in the US) when asset prices have fallen, but have not increased when 1972-2010 asset prices have risen too fast. Leaning against the wind is one way of taking asset 17.5 prices into consideration, but more research is needed, not least to understand the 15.0 impact of often volatile asset prices on monetary policy. 12.5 Instead of discussing these challenges, there has been unreasonably large focus on the acceptable level of inflation. IMF Chief Economist Olivier Blanchard may have 10.0 an academic interest when he suggested it would be worthwhile to analyse the pros Percent 7.5 of raising the level from 2% to 4% so that monetary policy could respond more 5.0 aggressively to economic shocks. For practitioners it must have seemed like a joke. 2.5 At a time of growing uncertainty regarding central banks’ and governments’ commitment to keeping inflation low, it is important to stick to the anchor created. 0.0 It has taken years to develop inflation expectations around 2%, and by altering them -2.5 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 the confidence in central banks and governments may be lost. Besides, while the Source: Reuters EcoWin level may be raised in theory, in practice it is not possible to increase inflation “just a bit”. If raised to 4%, why not 6% or 8%? And higher and more volatile real interest rates would clearly be more of a disadvantage to the economy than an advantage. Monetary policy will have to be reformed in the years to come. Inflation targeting focused solely on consumer prices will have to be complemented with a larger focus on asset prices, credit growth and financial stability in the longer term. In the meantime it is important to stick to the inflation targets that have been set up as policy makers’ commitment to keeping inflation low is being questioned. While overregulating the financial sector must be avoided, there is still a need for smarter regulation and supervision. The most important thing is to make the financial sector less procyclical and more macro prudential. Creating incentives to reduce the risk of moral hazard is also important, as is creating a financial sector that can be an intermediary for the capital needed to facilitate growth and structural transformation. As the financial sector will always be fragile, the right level for capital requirements is hard to find. Too high of a requirement will raise capital costs for companies and households, and too low of a requirement could increase instability in the longer term. 2
  • 3. To the Point (continued) March 30, 2010 Fiscal policy As central banks unwind their balance sheet policies and keep repo rates low, Chart 2: Fiscal position in selected OECD- governments must deal with rising sovereign debt causing turbulence on financial countries markets and negatively affecting growth. In countries like Ireland, Greece, Portugal Public debt, % av GDP 250 and the Baltics, budget consolidation has already begun. In the Baltics especially, Japan there is an awareness of the need for austerity, but in many other EU countries this 200 awareness is still lacking. For the US, UK, France and other large economies, there is also a need to create 150 Greece awareness. It will no longer be possible for them to live beyond the means, as it Italy 100 Portugal Belgium most likely will become harder to find financing in the future. Because banks may USA Ireland UK France Eurozone Germany also have to raise more capital, the combination of high sovereign debt and tighter 50 Spain financial regulation may increase interest rates going forward. Finland Sweden Budget consolidation will most likely start during the next year in most larger 0 economies. Still, there is lack of detail in the austerity plans, and most growth -16 -14 -12 -10 -8 -6 -4 -2 0 Budget balance,% av GDP assumptions are too optimistic. How to raise taxes and lower expenditures when voters are not ready can certainly be a challenge. In the EU, there is still a vision of expanding the welfare state, lowering working hours, and further reducing taxes. Add the demographic challenge, and the equation will be hard to solve. After the high inflation of the 1970’s and 80’s, new institutions were set up in many countries, such as inflation targeting, an independent central bank, etc. Efforts to create lower inflation expectations were successful, and inflation targeting served its purpose for many years (but became too narrow-minded when asset bubbles started to blow up more frequently). Now it is time to strengthen institutions that create budget discipline in both good times and bad. Sweden is a case in point. After the financial and property crisis in the early 1990’s, expenditure ceilings and budget goals were established, improving fiscal discipline since then. The fact that most EU countries allowed budget deficits during the good times points to the need for such institutions, including independent fiscal councils and fixed targets. Rebalancing growth Germany should not become less competitive, as has been suggested as a solution to rebalancing growth within the Euro zone. Of course, countries like Greece, Portugal and Spain must become more competitive. The agenda for 2020 rightly points to reforms to increase competitiveness in Europe as a whole. As these countries must improve their external balances, however, there must be increasing demand from outside of Europe to absorb the larger European export volumes. Where is this demand going to come from? Countries with high surpluses today (e.g., China, Japan, Germany, Arab countries, Singapore, Norway and Sweden) will be the ones best able to absorb most of the rebalancing of growth. They have more leeway to increase demand among companies and households. The problem is that it takes time. In China, for example, the social security system must be developed in order to lower the need for savings, and that is a slow and complicated process. The US congress is pressing the Obama administration to declare China a currency manipulator on April 15th, when a report is due to be presented by the Treasury. If this happens, the US may take the issue to the World Trade Organisation (WTO) or start raising tariffs on Chinese products. As China will not succumb to foreign pressure, there is a risk that declaring China a manipulator will develop into a trade war. If anything, this would be devastating to global economic growth going forward. 3
  • 4. To the Point (continued) March 30, 2010 China has increased imports during the crisis and become a growth engine in the world economy, although perhaps not sufficiently so. The rebalancing must Chart 3: GDP Growth according to continue, as the US and the UK can no longer be consumers of last resort; other Swedbank’s forecast countries must slowly take over. For Europe to take greater responsibility, the key 12 is to continue with growth-oriented policies and structural reforms that increase 10 2009 2010 domestic demand, for example, by integrating service markets. 8 2011 6 4 2012 Growth policies and structural reforms 2 The best way to reduce sovereign debt in industrial countries is not by increasing 0 inflation. A recent IMF study by Carlo Cottarelli shows that with 6% inflation -2 (instead of 2%), public debt as a share of GDP would be 8 percentage points lower -4 in 2014 in the OECD countries. Therefore, inflation would have to be much higher -6 for several years to have a substantial impact on debt ratios, and then there would -8 be significant disadvantages for the real economy. Raising taxes and cutting USA EMU Japan China India Global expenditures considerably could cause anaemic growth for years. So despite the GDP need, there also have to be structural reforms and growth-oriented policies that at the same time enhance growth. Notwithstanding the stimulus measures used to boost demand, the recovery in the industrial economies has been less than convincing. Supply side measures must be added, such as improvements to education and research systems, better rules for entrepreneurship, and micro-oriented reforms that improve efficiencies in labour markets, housing markets and product markets. The EU in particular has much to gain by increasing competition and better integrating the service sector. Further, climate change could create incentives for investments in green infrastructure, including energy. Without bold measures, there is going to be a long period of slow growth in many industrial countries. This will make it much more difficult to face growing competition from emerging markets, where there is no need for austerity measures and credit markets are functioning better. With so many challenges facing our policy makers, a lot of credit must go to those who make the hard decisions. Who said the art of doing the right thing was easy? Cecilia Hermansson Economic Research Department To the Point is published as a service to our customers. We believe that we have used reliable SE-105 34 Stockholm, Sweden sources and methods in the preparation of the analyses reported in this publication. However, we Telephone +46-8-5859 1000 cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any ek.sekr@swedbank.com error or omission in the underlying material or its use. Readers are encouraged to base any www.swedbank.com (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in To the Legally responsible publishers Point. Cecilia Hermansson +46-8-5859 1588 4