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To the Point, November 26 2009

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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 November 26, 2009 Cecilia Hermansson Chief Economist Economic Research Department +46-8-5859 1588 cecilia.hermansson@swedbank.se No. 2 2009 11 26 Beware of the bubbles In the 1930s’ financial crisis, the world’s policy makers made the mistake of not stimulating the economy sufficiently, leading to many years of low growth, no inflation and weak confidence among households and companies. This time, we may err on the other side, by overstimulating the economy, providing a flood of money through central banks and, on top of it, fiscal stimulus, leading possibly to a buildup of new asset price bubbles, and also inflation at a later stage. Investors are caught between the two risks of deflation and inflation: record-low nominal bond yields signal a fear of deflation, while hot stock markets and commodity prices suggest an appetite for inflation- protected assets. This months’ “To the Point” analyses the difficult trade-off between, on the one hand, supporting growth in many of the OECD countries especially hard hit by the financial crisis and the fall in world trade, and, on the other, possibly providing too much liquidity, with the risks of building up new bubbles on asset markets. However, there are solutions! There is still a case for keeping the stimulus The good news is that the world economy is growing again, albeit from low levels. We may have to revise up GDP growth rates upward ¼ -½ percentage point or so for 2010 and 2011 to some 3 and 3 ½ %, respectively, not least because of stronger growth in China and India, and perhaps in Japan and the US as well. We may even revise upward the negative growth figure for this year, although marginally. The bad news is that world economy is not capable of taking care of itself on its own. Stimulus is needed to make sure demand continues to grow, and to provide the necessary risk appetite for various actors to invest in the future. The polarisation between West (advanced or OECD countries) and East (China, India and other parts of developing Asia) is very clear. While China and India showed GDP growth of 8.9 % and 6.1 %, respectively, in the third quarter in annual terms, GDP in the US, Japan and Germany fell by of 2.5%, 4.5% and 4.7%, respectively. This large difference in growth rates means that developing countries and emerging economies’ share of the global economic cake will increase from about half today to around two thirds within five-six years. Or as they say, in China and India: this is not a crisis for all, it is a crisis for the West.
  • 2. To the Point (continued) November 26, 2009 2 Chart 1: Annual GDP growth in selected countries Source: Reuters EcoWin 00 01 02 03 04 05 06 07 08 Procent -12.5 -10.0 -7.5 -5.0 -2.5 0.0 2.5 5.0 7.5 10.0 12.5 15.0 Japan EMU-area Sweden China US India Germany Russia Chart 2: House prices in selected countries 99 00 01 02 03 04 05 06 07 08 75 100 125 150 175 200 225 250 S DK SP USA UK N SF IRL The need to keep the stimulus is more accentuated in the US, Europe and Japan than in the emerging economies. However, it is worth remembering that vulnerability is still great in all countries. There are a number of reasons why continued support is important: 1. The banking sector has not yet recovered. In the US, the key problems are in mortgage- and consumer-related assets, whereas in the euro area banks, the main complications deal with Central and Eastern European loans and securities. Asian banks, on the contrary, are quite sound. A period of recapitalisation and strong earnings is still needed before banks will be in general good health. According to the IMF’s October Global Financial Stability Report, additional write- downs of US$1.5 trillion are expected on top of the US$1.3 trillion already carried out. 2. The housing sector in the US (and in some countries in Europe – mainly the UK, Ireland, Spain and the Baltics) has not yet stabilised. Commercial real estate deterioration is in full swing. There are some green shoots, but without the stimulus, prospects would look much paler indeed. 3. The private consumption outlook in the US, Japan, and Europe looks very weak. Unemployment is still on the rise, wage developments have been dampened, and many are being discouraged from searching for jobs, thus making us believe that the unemployment situation is a lot worse than we can tell from official statistics. Corners will be cut, which means that consumers will change their spending habits. Smaller houses, cheaper state universities, and cheaper food and durables will have to be preferred. More cautiousness is expected with regard to purchases of capital goods, such as cars and home appliances. In the US, households used to make up more than 70% of GDP, so surely a weaker consumption outlook will hurt overall growth prospects. 4. Output gaps (the difference between the actual level of production and the “potential output level”) are still between some 5-8% for advanced or OECD economies. Stimulus is needed to narrow this gap, and it will take several years before the gap is closed. For the advanced economies, growth rates will most likely stay below potential growth, even as potential growth itself will slow when labour and capital are used differently going forward. Merely, looking at output gaps, unemployment, credit conditions and other subdued demand factors discussed above, could have prompted central banks to set negative policy rates. Since that would have been difficult, they have opted for almost zero interest rate policies, tried quantitative easing, and signalled that interest rates will stay low for an extended period of time. Fiscal policy has been focused on infrastructure projects, labour and housing markets, and consumption to boost demand and confidence.
  • 3. To the Point (continued) November 26, 2009 3 Chart 3: Stock marets in Russia, China, India, Japan and the US Source: Reuters EcoWin jan 06 maj sep jan 07 maj sep jan 08 maj sep jan 09 maj sep Index 50 100 150 200 250 300 350 400 Russia Japan China (Shanghai) India (Mumbai) USA (S & P 500) Where will all this money go? The buildup of the central banks’ balance sheets in the US, Japan, and the Euro area has not increased the money supply. Bank lending is subdued, and instead, banks’ balance sheets are contracting. But investors are looking for some return on their savings/capital. They are buying stocks, bonds, commodity futures, emerging markets equities and gold. They are borrowing in dollars or yen where interest rates are low and looking for more lucrative markets where yield is higher. They are ending up in the emerging markets, where stocks and real estate prices are increasing more than the fundamentals would indicate. The money provided has been intended for the real side of the economy, but so far it has mainly ended up in asset markets. The monetary transmission mechanism is thus not working in the way it was intended. Monetary policy needs to be expansionary, but the side-effects could be cumbersome in the medium term. Is a property bubble building up in Asia? An eye-catching deal was recently transacted in Hong Kong where an apartment was sold for US$439 million, or US$88 000 per square foot. Thus, it replaced an apartment in London as the most expensive real estate in the world. Hong Kong’s previous record was only US$23 000 per square foot. And property prices are soaring elsewhere in Asia. In Shanghai, there is now a view that property prices are higher than Tokyo’s. China’s approach to keeping stimulus – providing liquidity through state-owned banks and maintaining the peg to the dollar – is thus also increasing the money supply, and having an impact beyond its borders. This is because many of the economies in Asia are more China-dependent than before. Also, the possibility of a new stock market bubble in Shanghai cannot be excluded. Stocks listed in Shanghai show p/e ratios of 35 on average, and since the beginning of the year, the stock exchange has gained 80%. Stock and property markets are very vulnerable to the economic policy measures, and without these measures, market prices and demand would look very different. Most central banks are not taking steps to burst these incipent bubbles because they feel that it is better to create bubbles than to create a new depression. It is perhaps easier to struggle with the problem of higher asset values than of negative equity. No need to be passive The need to avoid asset bubbles may be less acute in advanced countries, although Sweden could present a case for potential problems as household lending is a bit too brisk, and house prices are rising from already high levels.
  • 4. To the Point (continued) November 26, 2009 4 Chart 4: Central banks’ policy rates Source: Reuters EcoWin 00 01 02 03 04 05 06 07 08 09 Percent 0 1 2 3 4 5 6 7 Sweden USA Euroland UK Japan Economic Research Department SE-105 34 Stockholm, Sweden Telephone +46-8-5859 1000 ek.sekr@swedbank.com www.swedbank.com Legally responsible publishers Cecilia Hermansson +46-8-5859 1588 Even if monetary policy needs to be expansionary, there are other measures that could be taken to cool asset markets. What can be learnt from Asian countries in this respect? Three governments – in Hong Kong, Singapore and China – have warned that they might be forced to implement measures to deter speculation on the property markets. The Hong Kong Monetary Authority (central bank) has instructed banks that loans for homes selling for US$2.6 million or more must be capped at 60% (down from 70%). The Hong Kong Mortgage Corp. is cutting its maximum loan size and will not issue second mortgages. Singapore has scrapped interest-only loans, and is providing more land for development. Meanwhile, China is expected to raise mortgage rates and introduce administrative measures to combat prices increases. China could also place caps on the share of bank lending for real estate and portfolio investments. Also, in advanced countries, regulators should implement tools that decrease the risk of building up of asset price bubbles. Even if transmission mechanisms do not work properly, interest rates may have to stay low for some time. Meanwhile, there is no need to be passive. To wait for bubbles to burst and then to clean up afterwards is not the way to go. Didn’t this crisis teach us that lesson? Cecilia Hermansson To the Point is published as a service to our customers. We believe that we have used reliable sources and methods in the preparation of the analyses reported in this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or its use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in To the Point.