Economic prospects: the
challenges & opportunities
July 2008
Trevor Williams, Chief Economist
Lloyds TSB Corporate Markets
BUSINESS UNIT IN HERE

Setting the scene
There are two overriding global economic themes at
present in my view, one is the credit crisis, the second
is the return of price inflation. The key risk is the latter.
• The first stems from a bursting of the first asset price bubble of the
new century. It was caused by too low interest rates from 2001
onwards, high liquidity and hence a ‘search for yield’, aided by
complacency about risk
• The second stems from fast growth in the world economy, that is
now pushing up demand for commodities to fuel that faster pace of
growth and, as a result of rising living standards, greater demand
for better food and more goods. This is showing up in higher oil
prices and in rising prices for manufactured goods exports.
• The solution is tighter policy in the developed & developing
economies and more open markets, like in agricultural goods. But will
this be the outcome?
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Assessing the impact of the credit crunch so far
Page | 3

Liquidity has drained out of financial markets…
Source: Bank of England
Page | 4

Credit risk has fallen but remains volatile and…
Bps Index
650 35
600
550 Vix, rhs, stock market volatility 30
500
450 25
400 Itraxx, lhs, credit market riskiness
350 20
300
250 15
200
150 10
09/06/06
09/08/06
09/10/06
09/12/06
09/02/07
09/04/07
09/06/07
09/08/07
09/10/07
09/12/07
09/02/08
09/04/08
09/06/08
Source: Bloomberg
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….concern about liquidity has widened borrowing spreads…
UK corporate spreads over benchmark bond yields
Spread, Bps AAA AA A BBB
2000
BB B C
1800
1600
1400
1200
1000
800
600
400
200
0
01/01/07
01/02/07
01/03/07
01/04/07
01/05/07
01/06/07
01/07/07
01/08/07
01/09/07
01/10/07
01/11/07
01/12/07
01/01/08
01/02/08
01/03/08
01/04/08
01/05/08
01/06/08
Source: Bloomberg
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…raising the cost of funds
bps spread, 3mth libor - base rates So mortgage spreads have risen for most borrowers
120
% 2yr - 95% LTV Tracker
8.0 2yr - 75% LTV
100
£
7.5
80 €
7.0
60
6.5
40 6.0
20 5.5
$ 5.0
0
4.5
-20
4.0
-40 3.5
J a n -9 9
J a n -0 0
J a n -0 1
J a n -0 2
J a n -0 3
J a n -0 4
J a n -0 5
J a n -0 6
J a n -0 7
J a n -0 8
-60
J F M A M J J A S O N D J F M A MJ
2007 2008
Source: DataStream & LTSB Corporate Markets
Page | 7

Financial markets remain volatile – the dollar continues to slide
and equity markets are uncertain…
105 Index Jan 07 = 100 115 Index Jan 07 = 100
Yen
Euro 110
Dow Jones
100 105
100
95 UK £
95
90
DJ Stoxx
90
Australian $ 85 FTSE 100
85
80
75 Nikkei
80
Canadian $
70
Brazilian real
75 65
J F M A M J J A S O N D J F M A MJ J F M A M J J A S O N D J F M A MJ
2007 2008 2007 2008
Source: DataStream & LTSB Corporate Markets
Page | 8

…fixed term rates are rising, short term interbank rates are up
%, 3mth interbank rate %, 3mth interbank rate
%, 10yr gov't bond yields %, 10yr gov't bond yields 7.0 1.1
6.0 2.0
6.5
Japan, rhs UK, lhs 1.0
1.9
5.5 6.0
UK, lhs 1.8 5.5
0.9
5.0
1.7 5.0
4.5 0.8
4.5 1.6
4.0 EU, lhs
1.5 0.7
4.0 EU, lhs 3.5 US, lhs
1.4 Japan, rhs
3.0
3.5 0.6
US, lhs 1.3 2.5
3.0 1.2 2.0 0.5
J F M A M J J A S O N D J F M A M J J F M A M J J A S O N D J F M A MJ
2007 2008 2007 2008
Source: DataStream & LTSB Corporate Markets
Page | 9

What are some of the medium term implications of the
crisis – for regulation?
Page | 10

Lessons from the recent financial turmoil
Area of weakness Specific issues raised
Liquidity management • Underinsurance against closures of key funding markets.
• Inadequate recognition of contingent liquidity obligations to off balance sheet entities.
• Scenarios used in the stress testing of funding insufficiently severe.
Valuation of complex • High dependency on models in valuation.
structured products
• Extent of investors’ reliance on a narrow ratings metric.
• Insufficient clarity in the composition and construction of instruments.
Opacity of structured • Inadequate disclosure of exposures and losses.
credit exposures
• Lack of transparency in off balance sheet exposures.
Crisis management • Insolvency arrangements for banks.
arrangements
• Deposit insurance regime.
• Improvements in tripartite arrangements.
• Underdeveloped practical arrangements for managing stress at an international institution.
Page | 11

What are the likely results?
Change in legislation as regulators try and catch up with the markets.
Greater transparency, for issuers, insurers, ratings, credit scoring methodologies,
disclosure of who has debt, implications for balance sheets of exposure (confidential to
regulator).
Understanding and reporting of total leverage and so exposure of whole of firm risk is
required in future, not just on balance sheet, but all products. Only then can proper analysis
be taken of risk of defaults.
Models have only be taking account of risk on balance sheet (i.e. regulated capital), totally
missing overall risk. This is gross failure on an epic scale.
Scenarios / stress testing must be more varied and ‘blue sky’.
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What are the implications?
Global economic growth is likely to slow to around 4.3%, but should still
remain relatively robust, led by continuing solid economic performance
from emerging markets.
Financial strains are likely to remain until the fundamental questions of
valuation and exposure are addressed – how much liabilities have to be
brought on to balance sheets?
Corporate and individual insolvencies forecast to rise, reflecting weaker
economic growth, tighter credit conditions and high leverage.
Risk of recession (receding fast) in those countries most affected by the
ongoing turmoil in credit markets, notably the US.
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What are some of the medium term implications of the
crisis – for the financial players in the market place?
Page | 14

What are the implications for financial firms?
Those reliant on wholesale markets will see a sharp rise in the cost of
capital, lowering profits and leverage
The higher the credit rating, the lower the cost of finance so higher rated
will gain relative to lower rated companies
There will be a return to relationship banking and deposit taking
institutions will gain relative to wholesale borrowers. That may make retail
banks more competitive versus investment banks.
Private equity to gain too, as those seeking higher returns turn from credit
instruments to old fashioned value investments.
Sovereign wealth funds to remain a key feature of the future financial
landscape
Developing markets gain at expense of the developed markets, as crisis
was in developed markets and made their assets cheaper
Mortgage banks to lose out compared to older retail institutions, as they
have moved into these new markets with weaker balance sheets and less
experience
Firms with global presence in emerging markets to gain relative to others
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So what’s in store for the world economy?
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Despite the credit crisis, growth to
remain positive – no recession
Global growth 2008; fast in emerging markets, slow in developed markets
Real GDP
North America 2007 2008 2009 2010 2011 2012
United States 2.2 1.7 2.6 3.4 3.2 3.0
Canada 2.6 1.4 2.4 3.1 2.8 3.0
Europe
Eurozone 2.6 1.7 2.0 2.0 1.9 1.9
Germany 2.6 1.8 2.0 1.5 1.5 1.5
France 1.9 1.7 2.0 2.1 2.0 2.0
Italy 1.7 0.7 1.5 1.4 1.3 1.3
UK 3.1 1.8 2.0 2.9 2.6 2.8
EU27 2.9 1.7 2.2 2.3 2.3 2.3
Asia
Japan 2.1 1.5 1.9 2.1 2.1 2.1
Emerging Asia 9.2 8.6 7.5 7.3 7.2 7.2
China 11.4 10.8 9.1 8.7 9.2 9.2
India 8.9 7.9 7.6 7.6 7.6 7.6
World 2000 PPPs 4.8 4.2 4.1 4.3 4.3 4.3
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Emerging markets continue to outperform…
% increase in year
9 F'cast
8
7
Emerging and developing
6
5 World
4
3
2
1
Advanced
0
-1
-2
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
Page | 18

…but inflation poses a serious risk to global economy…
Annual average, %
18
Developing economies F'cast
16
14
12
10
8
6
4
2 Advanced economies
0
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
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…especially in the emerging markets
% increase in year, inflation
14 % increase in year, inflation 20
18
12 16
Russia Indonesia
14
10
12
Argentina
8 10
India
8
6
6
Philippines
4 Brazil 4
2 Singapore
2
China 0
0 -2
2005 2006 2007 2008 2005 2006 2007 2008
Page | 20

So what does this all mean for the $, £,
euro and their interest rates?
We project a weaker £, rate rise in the UK (2009), higher
EU (2008) & hikes in US rates (2009)
End quarter exchange rates v UK £ Short term interest rates, %
2.1 Forecasts 6.0 Forecasts
2.0 UK
5.0
1.9
1.8 4.0 Euro
£ buys US$
1.7
3.0
1.6
£ buys euro
1.5 2.0
US
1.4
1.0
1.3
1.2 0.0
12.03 6.04 12.04 6.05 12.05 6.06 12.06 6.07 12.07 6.08 12.08 6.09 12.09 12.03 6.04 12.04 6.05 12.05 6.06 12.06 6.07 12.07 6.08 12.08 6.09 12.09
Page | 21

Possible triggers for a global economic crisis
• Asian/World inflation builds up unexpectedly
• Diversification away from US assets/fall in USD, due to housing market
collapse, fiscal and external deficits
• A further leg to the credit crisis could exacerbate economic slowdown, i.e.
another credit crisis
• Oil prices – have been rising to record highs recently. Iran a wildcard?
• EU risk from over tightening and strong currency?
• UK fiscal policy too loose, currency at risk of even sharper fall?
• Commodity prices are rising, oil, metals, food, does this pose a bigger threat?
• China slows sharply, derailing global economy
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