global economic outlook q2 2012

7/31/2019 Global Economic Outlook Q2 2012

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A Deloitte Researc publication | 2nd Quarter 2012

A CollectiveSigh of Relief

Eurozone

Could this be the

turning point?

United States

Why the euphoria?

United KingdomThe outlook brightens

Japan

New risk actors

India

A delicate balance

Trade patterns o

te uture

Waking up and

smelling the coee


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2

Were several months into the year 2012, and things are beginning to look less dire than

the last ew months o 2011. In Europe, a second bailout o Greece has at least postponed

disaster. Plus, action by the European Central Bank may have averted a deeper downturn.

In the United States, growth continues at a modest pace, but signs o trouble have not

completely gone away. And in China, the economy appears likely to avoid a hard landing.

While there is no cause or celebration, business leaders can at least utter a collective sigh

o relie that things are not worse.

In this issue o the Global Economic Outlook, we take a close look at the actors driving

the global economy. We begin with Dr. Alexander Brschs analysis o the Eurozone.

The title o his article Could this be the turning point? draws attention to the act

that things are not as bad as some had predicted. He notes that our major decisions in

Europe in recent months have improved the outlook, reduced the risk o catastrophe, and

moderated the severity o the recession. In addition, Alexander takes a close look at what

may be required in order or Greek membership in the Eurozone to be sustainable.

Next, Carl Steidtmann maintains his relatively pessimistic stance on the U.S. economy. He

says that some o the data points that appear to herald improvement are really rather

ephemeral. For example, he notes that economic activity has been boosted by good

weather, temporary tax incentives, and inventory rebuilding hardly the stu o sustain-able recoveries. He also points out some o the unintended consequences o the Feds

monetary easing. Finally, while Carl acknowledges that modest growth can continue or

some time, he cautions that there are many at tail geopolitical risks that could pull the

United States into another downturn. Also included in Carls article is an analysis o oil

prices and their impact on economic activity.

In our third article, I take a look at Chinas economic outlook. I discuss how Chinese

government policy has been eective in partially osetting the negative external

headwinds aced by Chinas export sector. The result is likely to be a sot landing this

year. However, China continues to ace longer-term challenges, some o which are being

pushed urther down the road by the ailure to address them in the short term.

Next, Ian Stewart examines the UK and concludes that the economy is doing ar betterthan earlier thought, but its perormance in 2012 is still expected to be relatively poor.

Ian examines the Deloitte UK CFO Survey and nds that business leaders have signi-

cantly improved their perceptions and expectations. This should have a tangible eect on

economic activity. Ian also notes that a combination o easier monetary policy and the

lessening o crisis in Europe will likely help the UK to avoid recession in 2012.

Siddharth Ramalingam then provides his outlook or the Indian economy. He notes that

the central bank is caught between a rock and a hard place. That is, the central bank must

worry about uncomortably high infation as well as decelerating growth. In addition, a

large scal decit means that the government has ew policy options to deal with a dete-

Global Economic OutlookQ2 2012


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3

Global Economic Outlook

publised quarterly by

Deloitte Researc

Editor-in-cie

Ira Kalish

Managing editor

Ryan Alvanos

Contributors

Pralhad Burli

Alexander Brsch

Neha Jain

Satish Raghavendran

Siddharth Ramalingam

Carl Steidtmann

Ian Stewart

Editorial address

350 South Grand Street

Los Angeles, CA 90013

Tel: +1 213 688 4765

[email protected]

riorating situation. Siddharth concludes that an easing o

monetary policy will likely be the eventual outcome.

My outlook or Japan begins by discussing problems

related to Japans trade balance, scal policy, and currency.

Given these issues, it would seem natural to expect

economic weakness. Yet I conclude that things will likely

get better in 2012 or several reasons: a more aggressive

monetary policy, a weaker yen, higher infation, and more

government spending on reconstruction.

In the outlook or Brazil, I note that although Brazil

has experienced a deceleration, growth is expected to

rebound later this year. A loosening o monetary policy

and a boost to investment in inrastructure and energy

should help to oset the negative external headwinds. I

also discuss Brazils complaints about the impact o U.S.

and EU monetary policy on the Brazilian exchange rate

as well as global concerns about Brazils protectionist

policy initiatives.

In my outlook on the Russian economy, I note that there

are several conficting actors infuencing growth in Russia,

and that the economy in 2012 is likely to grow more slowly

than in 2011. I also discuss the uncertainty surrounding

the uture o Russian economic policy and how the choices

made by policymakers will determine uture growth.

Next, Pralhad Burli oers a view on the economy o

Indonesia, the worlds ourth most populous nation and

one that has lately attracted much attention or its strong

growth and positive prospects. Pralhad discusses the

resilience o this interesting economy and how, despite a

variety o obstacles, it is likely to see strong growth in the

coming years.

Finally, Neha Jain and Satish Raghavendran look at global

trade patterns. They note how, with rising wages and a

rising currency in China, the worlds most populous nation

may no longer be the worlds actory. Rather, global

trade patterns are changing in interesting ways. O most

interest is the rising role o Arica and the Middle East in

global trade.

Dr. Ira Kalish

Director o Global Economics

Deloitte Research

We are conducting a survey is to determine the level o reader satisaction o

Deloittes Global Economic Outlook. The survey results will help us understand yourneeds and modiy our product to better serve them. We ask that you provide your

candid eedback. Your responses will remain anonymous. The survey will take only

510 minutes to complete. You can access the survey by clicking on this link or by

pasting it in the address bar o your internet browser:

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Thank you or sharing your opinions.


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4

ContentsGlobal Economic Outlook 2nd Quarter 2012

Geograpies

6 Eurozone: Could this be the turning point?In recent months, our major decisions in Europe have improved the outlook, reduced the risk o catastrophe, and

likely moderated the severity o the recession. Ater restructuring Greeces sovereign debt, Europe will need to pursue

structural reorms to stimulate growth.

12 United States: Why the euphoria?Recent data that appears to herald economic improvement is anything but the stu o sustainable recoveries.

While modest growth may continue or some time, myriad geopolitical risks threaten to pull the United States into

another downturn.

20 China: Sot landing now, uncertainty laterRecent policy decisions have been eective in partially osetting negative external headwinds aced by Chinas export

sector. The result is likely to be a sot landing this year. However, China continues to ace longer-term challenges.

22 United Kingdom: The outlook brightensThe UK economy is exceeding previous expectations, but its perormance in 2012 is likely to be relatively poor. A

combination o easier monetary policy and the lessening o crisis in Europe will likely help the UK to avoid recession

in 2012.

26 India: A delicate balanceIndias central bank continues its eorts to strike a balance between growth and infation. Its large scal decit means

that the government has ewer policy options to deal with a deteriorating economic situation.

30Japan: New risk actors

Problems pertaining to trade balance, scal policy, and currency would suggest economic weakness in Japan, but the

countrys economic perormance is likely to improve in 2012 because o a more aggressive monetary policy, a weaker

yen, higher infation, and more government spend ing on reconstruction.

6 12 20 22


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5

32 Brazil: Worried about capital infowsBrazil experienced a deceleration, but growth is expected to rebound later this year. A loosening o monetary policy

and a boost to investment in inrastructure and energy should help to oset the negative external headwinds.

34 Russia: Conficting infuencesSeveral conficting actors in Russia may result in slower growth in 2012. The countrys growth prospects will hinge on

choices made by Russian policymakers.

36 Indonesia: Unlocking potentialIndonesias perormance has been nothing short o stellar, and despite a variety o obstacles, there are plenty o

reasons to be excited about Indonesias prospects in the coming year.

Special Topic

40 Trade patterns o the uture: Waking up and smelling the coeeWith rising wages and a rising currency in China, the worlds most populous nation may no longer be the worlds

actory. Rather, global trade patterns are changing in interesting ways.

44 AppendixCharts and tables: GDP growth rates, infation rates, major currencies vs. the U.S. dollar, yield curves, composite

median GDP orecasts, composite median currency orecasts, OECD composite leading indicators

32 34 36 40


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6

EUROZONE

Eurozone: Could this be

the turning point?by Dr. Alexander Brsc

Ater a turbulent 2011, the rst months o 2012 were

comparatively promising or the Eurozone. The downwardcycle o ragile nancial markets, vulnerable banks, a

slowing real economy, and weak sovereign debtors is

subsiding. Optimists consider this a turning point in the

Eurozones crisis, but it could prove to be little more than a

lull in ongoing economic instability.

Several recent developments are kindling cautious

optimism. The risk o a chaotic deault by Greece seems

to have aded. Bond yields o countries in the Eurozones

periphery ell substantially, while Italy and Spain the two

large countries that have experienced signicant nancial

market pressures are introducing substantial economic

reorms. On top o that, early indicators suggest

that the Euro area is experiencing only a mild

recession. This rosier outlook o the Eurozone

was supported by our decisions that

helped reassure

markets; most o these decisions are

unprecedented in European economic history,

illustrating just how desperate the crisis was.

Decision 1. Injecting liquidity into te markets

The European Central Bank (ECB) completed the secondtranche o its longer-term renancing operation in late

February. Bank borrowing in the rst and second tranches

amounted to more than 1 trillion and has been set or

an exceptionally long period (three years) at 1 percent

against a wide array o collateral. More than 800 banks

participated in the February tranche. This is, by ar, the

biggest injection o liquidity in the history o the ECB. It

helped ease pressure on the Eurozones banking sector

and sovereign debt markets as banks used part o the new

liquidity to buy sovereign bonds. The yields on Spanish and

Italian 10-year government bonds ell below 5 percent in

March rom around 7 percent in December. However, in

Dr. Alexander Brsch

is Head o Research,

Deloitte Germany


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Geographies

7

Eurozone

0.00

100,000.00

200,000.00

300,000.00

400,000.00

500,000.00

600,000.00

700,000.00

800,000.00

900,000.00

11/14/07 6/1/08 12/18/08 7/6/09 1/22/10 8/10/10 2/26/11 9/14/11 4/1/12

Deposit facility

Figure 1. Use of ECB's deposit facility(EUR millions)

Source: European Central Bank

mid-March, yields started to rise again. In mid-April, Italian

bond yields stood at 5.5 percent, and Spanish yields stood

at 5.9 percent.

While injecting massive amounts o additional liquidity

was at least temporarily successul in reassuring markets

and helping buttress asset prices, it is no panacea or the

European crisis. First, it increases medium-term infation

risks. Second, the new liquidity has not

succeeded in restoring the operability

o European interbank markets. One key

indicator or tension on interbank markets is the ECBs

deposit acility, which Eurozone banks use in normal times

to park excess cash overnight at low interest rates. Banks

dramatically increased their use o this acility during the

recent crises. In mid-March, the volume stood at 750

billion, almost 50 times more than a year ago (see gure

1). The act that banks preer the saety o an ECB deposit

over higher margins on the interbank market suggests

that the uncertainties plaguing the European banking and

nancial systems are lingering.


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8

Global Economic Outlook 2nd Quarter 2012

Decision 2. Signing te scal compact

The treaty on stability, coordination, and governance

the scal compact was signed by 25 o the 27 EU

leaders as an intergovernmental agreement; the United

Kingdom and the Czech Republic did not join. The key

point o the treaty is a balanced budget rule, which

mandates that annual structural budget decits cannot

exceed 0.5 percent o GDP. The rule must be incorporated

into national law, preerably at the constitutional level. TheEU Court o Justice will oversee the rules transposition and

will have the power to impose severe sanctions. Promoted

by Germany and other northern European governments,

the rule is supposed to prevent unsustainable uture

government debt.

The scal compact is intended to signicantly constrain

government spending in the uture. Whether or not it will

solidiy public nances will depend on its implementa-

tion and thereore on politics at both the national and

European levels.

Decision 3. Restructuring Greek private debtFinally realizing that it has taken on more debt than it can

realistically ever expect to pay back, Greece undertook the

biggest sovereign-debt restructuring in history. It is the rst

time in six decades that a developed country has deaulted

on its debt. Technically, private investors will receive new

government bonds with long maturities, which amount

to a loss o 53.5 percent. Some 86 percent o Greeces

private debtors agreed to participate in the 206 billion

bond swap. Through the use o collective action clauses,

the government will orce reluctant investors who own

bonds to participate in the swap under Greek law.

The program decreases Greek debt by 100 billion. As a

result, Greek debt currently 164 percent o GDP is

supposed to stand at 120 percent o GDP by 2020. Ater

the successul swap, the European Union agreed to a

second bailout package, which amounts to 130 billion in

credits until 2014.

While the acceptance o the bond swap by private

investors averted the threat o an uncontrolled deault,

two uncertainties remain. The rst is whether the goal o a

120 percent debt-to-GDP ratio can be achieved. Given that

the Greek economy is shrinking ar more than expected,

this is questionable. The second is that 120 percent o GDP

still amounts to an enormous mountain o debt, and there

are many doubts that the Greek economy will be able kick-

start itsel again while laboring under this burden.

Decision 4. Reorming Italy and Spain

Meanwhile, Italy and Spain two large Eurozone

economies that were endangered last year are intro-

ducing substantial economic reorms. The Italian techno-cratic government, headed by Mario Monti, redesigned

Italys pension system, increased the retirement age, and is

opening sheltered sectors. The government also plans to

liberalize employment protection.

Spains new conservative government is reorming its labor

market by introducing greater fexibility in a system that

is characterized by a two-tier structure. Older employees

with unlimited contracts enjoy a high degree o protection,

while younger employees tend to be on limited contracts.

This is one o the key actors contributing to the huge

social problem o the youth unemployment rate in Spain,

which now stands at an unprecedented 51 percent.

This act raises the question o whether or not these

austerity programs are sustainable in a political sense.

The programs introduce short-term pain or large parts o

the population while promising gains mainly in the long

term. This could lead to a circle o austerity atigue in the

population, lobby group pressure, and protests, which can

become an explosive combination. Radical parties opposed

to austerity and reorm policies might become stronger

in elections, along with an increasing appetite or change

in government.

Since the beginning o the Euro crisis, governments have

changed with remarkable requency. Examples include

Greece, Italy, Ireland, Portugal, and Spain. So ar, changes

in government have not worked against the reorm

programs. Nevertheless, the implementation o reorm

programs aces serious political risks.

Te sort-term outlook is two-tiered

In the short term, growth prospects or the Eurozone

look better than many eared in the beginning o the year

when a severe recession was widely expected. Looking

back, the Eurozone as a whole achieved a growth rate o

In the short term, growth prospects or theEurozone look better than many eared in thebeginning o the year when a severe recession

was widely expected.


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9

GeographiesEurozone

1.4 percent in 2011. In the last quarter o 2011, it expe-

rienced a negative growth o 0.3 percent. The European

Commission expects a negative growth rate o 0.3 percent

or the Eurozone in 2012, with a recovery o growth in the

second hal o the year.

Current expectations, measured by the Economic

Sentiment Indicator (ESI), are moderately optimistic.

Economic sentiment is still considerably below its

long-term average o 100, but it is recovering nonetheless

(see gure 2). The ESI rose or a second consecutive month

in February to 94.5, beore decreasing by a marginal 0.1

points in March. Beneath the surace, however, develop-

ments point to deepening growth dierentials in the

Eurozone. While Germanys ESI stands at 104, the expec-

tations or troubled Eurozone economies are still grim.

Spains ESI is 91, Italys is 89, and Greeces is 76.

Germanys situation is mirrored in the results o Deloitte

Germanys rst CFO survey. German CFOs eel that macro-

economic and nancial market uncertainty is unusually

high. They are also highly doubtul about the current and

uture stability o the Eurozone as well as the eectiveness

o the Eurozones political crisis management. However,

they show moderate optimism when it comes to their own

business outlooks.

Growth dierentials and two-tiered economic perormance

are dangerous because they reinorce the substantial

dierence in competitiveness between Eurozone nations.

While the European Monetary Union was meant to lead

to convergence in economic perormance, the reverse has

actually occurred, and economic perormance and expec-

tations continue to diverge. Neither growth patterns nor

unit labor costs, one o the main indicators or competi-

tiveness, have shown convergence in the Eurozone in the

last decade (see gures 3 and 4).

Greece: Too muc debt, not enoug growt

Until a ew years ago, Greece was one o the astest-

growing European economies. From 2001 to 2007, its GDP

grew on average by 4.1 percent per year. The Eurozone

as a whole grew by 2 percent, and Germany grew by only

1.4 percent. As it turned out, ater the nancial crisis, this

0

20

Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12

40

60

80

100

120

Euro area

Germany

Greece

Spain

France

Italy

Figure 2. Economic Sentiment Indicator

Source: European Commission


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10


growth perormance was overwhelmingly based on high

consumer and government spending, which resulted in the

current debt spiral.

Greece currently exemplies two o the Eurozones key

problems, even i it is the by ar the most extreme case:

too much debt and not enough growth. For 2012, Greece

aces the prospect o a th consecutive year o negative

growth. Last year, the Greek economy shrank by almost

7 percent.

The debt restructuring and the second EU bailout package

bought time or Greece and the Eurozone as a whole

by averting the threat o a disorderly Greek deault, at

least in the short run. However, this is not a solution

in itsel. Without addressing its economys underlying

problems and introducing structural growth policies,

Greece will continue to have a bleak long-term outlook.

Greece has a structurally weak economic base, which

spills over to its creditworthiness on the nancial markets.

Investors need to be convinced that the Greek economy

can generate resources to repay its debts in the uture.

Even achieving a debt-to-GDP ratio o 120 percent by

2020 requires substantial growth and primary budget

surpluses. Greece needs to tackle both components o its

debt-to-GDP ratio.

Restoring Greek competitiveness

Any new Greek government entering oce ater the

coming elections needs to tackle the economic structures

hindering growth and competitiveness. Ater all, economic

Euro area

Germany

Greece

Spain

France

Italy

-8

-6

-4

-2

0

2

4

6

8

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Figure 4. Annua GDP growth

(% change year on year)

Source: Eurostat

90

95

100

105

110

115

120

125

130

135

140

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Euro area

Germany

Greece

Spain

France

Italy

Figure 3. Unit labor cost index

(2000 = 100)

Source: OECD


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11

GeographiesEurozone

Reerences and

Research Sources:

European Commission, Interim

Forecast February, Directorate

General or Economic and

Financial Aairs, 2012.

Karl Brenke, Greek Economy

Needs Growth Strategy, DIW

Wochenbericht, German Institute

or Economic Research, 2012.

OECD, Going or Growth,

2012.

competitiveness is based on productivity, and economic

policy can contribute to growing productivity by ostering

the business environment.

Looking at the structures o the Greek economy and

its business environment, two characteristics areparticularly noteworthy:

Economic structure: The structure o the Greek

economy is dierent rom the average EU country. For

example, the share o agriculture is high, and the share

o manuacturing low. What manuacturing industry

exists is biased toward the production o ood and basic

goods, such as wood processing or paper production

or local markets. The average size o Greek enterprises

is exceptionally small, which implies lower produc-

tivity. Tourism is the main pillar o Greeces economic

structure; it is slightly more important or the economy

than manuacturing.

Economic openness: As a rule, smaller European

countries tend to have a high export ratio. Greece is

an exception. In act, Greece has the lowest export

ratio o all EU countries. Greeces exports o services

are ocused on tourism and transportation, especially

shipping, while comparative advantages in tradable

goods are hard to detect. It even runs a trade decit in

ood products. Manuacturing exports primarily consist

o low-technology products.

Greeces economic structure and openness imply that

Greek rms have little engagement in global competition,resulting in negative consequences or productivity. Key

indicators on how conducive the Greek business environ-

ment is or growth and productivity are not encouraging.

Regarding corruption, in Transparency Internationals

Corruption Perceptions Index, Greece ranked 80 out

o 182 countries. In the World Banks Ease o Doing

Business Ranking, which measures how business-riendly

the economic environment is, Greece ranked 100. Its

labor markets are highly regulated and so are its product

markets. In act, according to the OECD, it is among the

most highly regulated product markets in the OECD world.

Growt and structural reorms

The status quo o the Greek economy implies that

restoring competitiveness needs to include more than

cost competitiveness. A new growth model needs to

go beyond the important questions o prices, costs, and

wages. It should consider Greeces advantages as well

as the areas it should develop. There is a strong need to

substantially improve business conditions and modernize

the Greek economy, thereby boosting productivity.

Improving productivity is a long-term project that involves

structural reorm on many levels. Some policies or

example, upgrading systems or education and innovation

are crucial, but these improvements will mainly bear

ruit in the long term. Other structural reorms, like labor

market reorms, may have substantial transition costs.

However, some structural reorms have positive short- and

long-term eects.

Reorming product markets is one main example. It can

improve the unctioning o markets by removing barriers

or services and entrepreneurship. Such reorms tend to

be associated with boosting long-term productivity and

labor utilization as well as with positive employment gains

in the short run. This goes especially or labor-intensive

sectors with pent-up demand such as retail, trade, and

proessional services.

Stimulating growth by removing entry barriers and

product-market restrictions, especially in

services, is not only relevant orGreece but or the European

Union as a whole.

The internal

market

has

been

a greatsuccess

story over the

last 20 years. A

urther deepening,

especially in the area

o services, promises

substantial economic

benets. With short-term

scal stimulus becoming

extremely dicult under

Europes current scal

situation, growth needs

to come rom structural

reorms. The uture o

the Eurozone depends not

solely on the nancial markets

but at least as much on the

real economy and its uture

growth perormance.


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12

USA

United States: Why theeuphoria?by Dr. Carl Steidtmann

Dr. Carl Steidtmann is

Chie Economist at

Deloitte Research

The stock market has orecasted nine o the past

ve recessions. Paul Samuelson

The opposite is equally true; the stock market has also

orecasted nine o the past ve recoveries. The S&P 500

hit its all-time high in March 2000 at 1,527. The economy

ell into a recession a year later. Growth since then has

been less than spectacular, and total employment is no

higher today than it was in 1999. The index managed to

briefy break above its old high in mid-October 2007, only

to slip into a deep recession that started in December. Atits current level, the S&P 500 is still below its old highs set

4 and 12 years ago. The tech-heavy NASDAQs peror-

mance has been even worse.

The stock market has been partying like its 1999. We have

seen an impressive rally since the lows o October 2011.

But then we saw an impressive rally in the previous year,

which was ollowed by less-than-impressive GDP growth in

the United States and contracting growth in no less than

22 countries around the world in the ourth quarter o

2011, including Japan, Germany, and the United Kingdom

respectively the third-, ourth-, and sixth-largesteconomies in the world. So, why the euphoria?


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GeographiesUSA


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14


14

Central banks are pumping liquidity

Quantitative easing (QE) is not just or the U.S. Federal

Reserve. Around the world, we have seen unprecedented

eorts by all o the major central banks to buy assets,

expand their balance sheets, food the banking system

with liquidity, depress interest rates, and give a boost to

asset prices (see gure 1).

In the past six months, the biggest contributor to globalliquidity unquestionably has been the European Central

Bank (ECB), whose two-tranche 1.02 trillion Long-Term

Renance Operation (LTRO) program has expanded its

balance sheet by 50 percent and taken ears o potential

European bank ailures due to a lack o liquidity out o

the markets.

Since mid-December, the actions o the ECB have sent

equity prices up and the interest rates on sovereign bonds

down. They also had a positive impact on commodity

prices, with copper and oil prices up 20 percent while

wheat, soybeans, and corn have risen more than 10

percent. It was the rise in commodity prices in spring 2011that contributed to the Arab Spring protests throughout

the Middle East and did so much to undermine real growth

in the rest o the world in the summer and all o 2011.

While the ECB has been re-liqueying the European

banking sector, the U.S. Federal Reserve has been engaged

in Operation Twist, a very successul eort to drive down

long-term interest rates by shiting Fed bond purchases

rom the short end o the Treasury curve to the long end.

The eects o that policy, which went into eect last all,

can be seen in gure 2.

Interest rates and stock markets tend to move in the same

direction. A rising stock market is generally accompanied

by rising rates as money fows rom bonds into stocks.

That has not been the case over the past six months.

As the stock market has risen, longer-term interest rates

have allen. Rates on the U.S. Treasurys 10-year note are

roughly 200 basis points below the level based on their

historical relationship. While some might see this as the

best o all possible worlds, the Feds eorts to keep interest

rates depressed have unintended consequences.

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

600

S&P 500 daily closing price

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

2007-Sept 2011

Oct 2011 - March 2012

Linear (2007-Sept 2011)

Linear (Oct 2011 - March 2012)

10-yearTreasury yield

Figure 2. The S&P 500 and 10-year Treasury yie d

Daily data

Source: European Central Bank, Bank of England, Peoples Bank of China, Bank of Japan, U.S.Federal Reserve, and Swiss National Bank

0%

50%

100%

150%

200%

250%

ECB U.K China Japan U.S. Swiss

2007 - present Last 12 months

Figure 1. Growth in centra -ban ba ance sheets rom January 2007to February 2012(Percentage change)

Source: European Central Bank, Bank of England, Peoples Bank of China, Bank of Japan, U.S.Federal Reserve, and Swiss National Bank


15/48

15

GeographiesUSA

$0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

Price of gasoline

Price adjusted fordollar weakness

Price adjusted for dollar

weakness and inflation

2001 2003 2005 2007 2009 2011

Figure 3. Average price o regu ar gaso ine a ormu ations adjusted or do ar wea ness and in ation($ per gallon)

Source: Energy Information Administration, St. Louis Federal Reserve

QE works by raising equity prices, lowering interest rates,

and reducing the value o a countrys currency. Higher

equity prices create a wealth eect, inducing consumers

to spend more and businesses to increase investment.

Lower interest rates reduce the cost o borrowing, encour-

aging consumers to purchase big-ticket items like cars and

houses and businesses to take more risk. F inally, a lower

exchange rate gives a boost to exports while encouraging

consumers and businesses to buy domestic as opposed to

more expensive imported products.

Unintended consequences

The problem with QE is that it has unintended conse-

quences that oset its intended positive eects. A alling

dollar does more than just give a boost to exports. It also

gives a boost to the price o globally traded commodi-

ties in this case, oil. Oil prices rose sharply in spring

2011, ollowing QE2 in the United States. They are rising

again ollowing Operation Twist and the ECBs LTRO. In the

United States, gasoline prices are pushing $4 a gallon (see

gure 3). In Europe, where energy taxes are much higher,

gasoline prices are approaching $10 a gallon.

Oil prices when adjusted or changes in the consumer

price index and the declining value o the dollar started

rising only three months ago, and they increased only

modestly in the last decade.

Second, while low interest rates are great or both

consumer and business borrowers, they represent a s igni-

cant challenge or savers and pension unds. Businesses

with dened benet pension unds have to put more

unds aside to und these benets when interest rates

are low. Likewise, savers and retirees receive signicantly

less income rom interest payments when interest rates

all. Interest income in the United States has allen $447

billion or 31.5 percent since its peak in August 2008,

just beore the rst round o QE. Risk-averse retirees are

being orced to take on more risk in order to und their

own retirements.

The most worrisome aspect o QE is that it enables busi-

nesses, consumers, and governments to take on more debt

and risk when the problem that the economy is trying to

come to grips with is an excess o debt. Low interest rates


16/48

16


encourage leverage and put o the adjustment process

o deleveraging, distorting the economy and making the

eventual day o reckoning all the more severe.

Debt declined slightly during 2008 and 2009 (see gure

4). The decline was due largely to the sizable reduction inmortgage debt that has come about through the ore-

closure process. Banks have also been orced to reduce

debt through a tightening o the regulatory process.

Nonnancial businesses have seen their debt grow

modestly, and government debt growth has risen sharply.

Over the past year, total debt has increased by $781

billion. Nominal GDP grew by just $566 billion. Debt is still

being accumulated aster than GDP is growing.

$40.0

45.0

50.0

55.0

2006 2007 2008 2009 2010 2011

Figure 4. U.S. total debt

(In trillions of dollars)

Source: U.S. Federal Reserve

I debt cannot be reduced through the process o dele-

veraging, the only other alternative is a reduction o

the debt burden through infation. The rise o debt over

the past year greatly increases the uture risk o much

higher infation.

Curb your entusiasm: Just te acts

The disconnect between equity markets and the real

economy can be seen in myriad dierent statistics. Here

are the most troubling o them:

1. Globally, real GDP growth contracted in no less than22 countries in Q4 2011, including Japan, Germany, Italy,

Spain, the United Kingdom, Thailand, Singapore, Taiwan,

Indonesia, and Portugal. Purchasing managers indices

throughout Europe in the rst quarter o 2012 show the

decline continuing and deepening.

2. In the United States, employment growth is mainly

in lower-paying jobs and temporary employment. The

economy still has 5.3 million ewer jobs than when the

recession started in December 2007.

3. The primary target o quantitative easing in the United

States was housing. It was hoped that lower mortgage

rates would stimulate borrowing. In mid-March, the

Mortgage Bankers Associations index or new mortgage

applications had declined eight weeks in a row.

4. Despite unseasonably warm weather across the United

States in February, which should have boosted housing

activity, new home sales ell 1.6 percent, existing home

sales ell 0.8 percent, pending sales o existing homes

ell 0.5 percent, and housing starts ell 1.1 percent. It is

dicult or the economy in the United States to recover

without a recovery in housing. A robust housing market

gives a lit to new home construction, real estate, nancial

services, and retail.

5. In addition to a decline in home sales, home prices

are also alling. Despite multiple predictions that housing

has nally started to recover, home prices continue to all.

The most recent Case-Shiller Home Price Index was down

3.8 percent rom a year ago and remains at its lowest level

since the peak in home prices in March 2007.

6. Business investment in inormation technology

has been weak. New orders or computers and related

I debt cannot be reduced through the process

o deleveraging, the only other alternative is areduction o the debt burden through infation.


17/48

17

GeographiesUSA

-8

-6

-4

-2

0

2

4

6

8

10

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Figure 5. Equally weighted coincidental indicator

(Percentage change year-over-year)

Source: Bureau of Economic Analysis, Department of Labor, Bureau of Census and Federal Reserve

equipment were down three o the past our months rom

October to February, or a total decline o 14.9 percent.

Shipments ell just 12.8 percent as the backlog o unlled

orders contracted.

7. U.S. energy consumption is declining sharply. Gasoline

supplied to retail outlets is down 6.7 percent rom a year

ago in March. Oil consumption is down 4.5 percent. These

are the largest year-over-year declines in more than 20

years, exceeding the declines that occurred during the

20072009 recession.

8. Shipping is showing multiple signs o distress. Trucking

and rail indexes are both declining. The American Trucking

Associations truck tonnage index was down 4.1 percent

in February rom its reading in December. North American

railcar loadings or the month o February were down 2.9

percent compared to January and down 1.9 percent rom a

year ago. The Baltic Dry Index, a measure o global shipping

rates, collapsed rom October to February, dropping rom

2,173 to 647 beore rebounding in recent weeks to a still-

depressed 908. As recently as June 2010, the index was

above 3,800.

9. Income rom interest payments is again declining.

Operation Twist, which was designed to depress long-term

interest rates in hopes o stimulating housing, has had an

ill eect on interest income. While housing continues to

founder, interest income has been declining. Ater a very

brie recovery in 2011, in January, interest income was

down 2.8 percent rom a year ago.

10. Federal tax revenues are slumping. Over the past three

months ending in February, revenues are up just 0.6 percentrom a year ago when revenues were depressed by the

initiation o the temporary Social Security tax cut, which

was extended through this year.

11. Real income excluding government welare payments

is still down 3.9 percent rom its 2008 peak. Government

transer payments now account or 19.5 percent o all

household income. Real disposable income was up just

0.5 percent in January. Real disposable income including

transers is up just 0.5 percent rom a year ago.

Were we are: Coincidental indicators

Since the end o World War II, there have been 14 cases

where real GDP growth rom the previous year ell below

2 percent. In 11 o those cases, a recession ollowed. You

can build a coincidental indicator o the economy using

real disposable income, employment industrial produc-

tion, and real consumer spending, and you get largely the

same picture.

Over the past 50 years, when this coincidental indicator ell

below 2 percent or more than two consecutive months, a

recession ollowed (see gure 5). The indicator has correctly

anticipated all eight post-1960 recessions, including the


18/48

18


recessions o 1960, 1969, 1973, 1979, 1981, 1990, 2000,

and 2007. In 1986, the indicator ell below 2 percent or

three nonconsecutive months as the collapse in oil prices

took its toll on the oil-producing regions o the country.

In December 1995, the sharp all in real income sent

the indicator just below 2 percent. In December 1994,

Microsot issued a massive one-time dividend that sent

incomes up in 1994 and down on a percentage basis

in 1995.

The recent perormance o the indicator has not been

encouraging. Three o the our components o the

indicator (income, spending, and production) are decel-

erating. The indicator has been below 2 percent or eight

o the past nine months. There has never been a previous

time when the indicator has perormed in such a manner

and a recession has not ollowed.

Conclusions and observations: Its te dismal

science, ater all

It was Thomas Carlyle who labeled economics the dismal

science ater reading Reverend Thomas Malthus. The

business cycle remains alive and well. The current cycle has

grown long in the tooth despite its young age. The U.S.

economy has struggled over the past nine months, despite

a soaring equity market. Growth has been given a boost

by inventory building, tax incentives that shited activity

rom late 2011 to early 2012, and unseasonably warm

weather. These are not the oundations upon which to

build a recovery.

Central banks around the world have been engaged in

aggressive quantitative easing or more than three years

now. There are limits to QE that are determined by its own

set o unintended consequences. QE distorts market prices.

The most obvious o these is the price o oil. Last spring,

rising oil prices oset the positive eects o the Feds

QE2 and let the economy with weak growth and rising

infation. This spring, we once again have a rising stock

market and hopes o a stronger economy, this time as a

result o the European Central Banks rst round o QE,

only to run into the same problem o rising energy prices.

The U.S. economy very well may be able to muddle along

or another year or two with subpar growth and rising

infation. The risk, however, is rom one o the many

at-tail geopolitical risks, including a reemergence o the

European debt crisis, a harder-than-expected economic

landing in China, or a disruption o oil rom Iran or

elsewhere. With infation rising and so little margin or

error, there seems little reason or euphoria in the equity

markets or elsewhere.


19/48

19

GeograpiesUSA

Energy prices and consumer behaviorWars are ought over it. Business cycles rise and all around it. Political

elections are won or lost because o it. There are ew prices in the

world that have a bigger impact on individuals, businesses, and even

governments than the price o oil. Ater alling steadily since the spring

o 2011, the price o oil reversed course in late December and has risen

sharply. The increase has been all the more surprising given the unsea-

sonably mild winter much o the United States is experiencing. Warm

winter weather traditionally puts downward pressure on energy prices

because demand or heating alls as the temperatures rise.

The spot price o West Texas Crude rose rom $93 a barrel to $110

between mid-December and early March. Prices or Brent Crude in

Europe went rom $102 a barrel to $126 over the same period o time.

Rising oil prices have taken the price o gasoline at the pump higher by

more than 50 cents a gallon in the United States.

Oil consumption began declining in April 2011 when oil prices peaked

and has accelerated over the past year even as prices declined in the

latter hal o 2011. As o March 2012, oil consumption was down 4.5percent rom a year ago (see gure 6). Drops o this magnitude usually

have been associated with recessions. The decline in oil consumption

could be due to a number o actors. Energy productivity traditionally

rises in the ace o rising prices and continues to rise or several years

ollowing a price spike. Warmer winter temperatures are also holding

down consumption o heating oil, contributing to some o the decline.

The biggest decline, however, has come in gasoline.

Gasoline is both economically and politically important. It is a

commodity that most households purchase on a regular basis. It

directly aects consumer condence and approval o current political

leadership even though that political leadership generally has very little

to do with the actual price. It can also have a signcant impact onconsumer behavior.

Every penny increase in the price o gasoline costs U.S. consumers an

extra $3.8 million a day. An increase o 50 cents a gallon translates to

$190 million a day, $5.7 billion a month, and $68.4 billion a year. In

January, household income, ater adjustment or taxes and infation,

was up just $60 billion rom a year ago. Higher prices or gasoline are

showing up in two places: lower gasoline consumption and ewer

miles driven.

Gasoline consumption is down 6.7 percent rom a year ago on a three-

month moving average basis, an even greater drop than the demand

or oil (see gure 7). The drop is even more surprising given the severity

o last winter when compared to this years mild weather. Milder

weather should have prompted more driving.

The drop in gasoline consumption represents a combination o

improved energy eciency coupled with a signicant decline in driving.

Total miles driven on a 12-month moving average basis ell 1.2 percent

in 2011 rom a year ago (see gure 8).

Over the past 40 years, there have only been three periods o time

when the number o miles driven declined. All three were associated

with deep recessions and sharply higher gasoline prices. While high

gasoline prices limit driving, there are several others at work as well.

Internet shopping continues to climb, taking share away rom store

purchases and reducing the number o shopping trips. Telecommuting

has become a much more common practice and probably accounts or

some o the decline as well.

Rising energy prices have been a major actor in six o the past seven

recessions since the rst major oil price spike back in 19731974.

Improved energy productivity, higher gas mileage, and greater use o

the Internet or both shopping and work has reduced but not elimi-

nated the exposure o the U.S. economy to current and uture rises in

the price o oil. As was the case in the spring o 2011, the United States

and the global economy are once more at risk rom rising energy prices.

1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011

Figure 8. Total miles driven

12-month moving average, year-on-year change through December 2011

Source: U.S. Department of Transportation

8

6

4

2

0

-2

-4

1993 1996 1999 2002 2005 2008 2011

Figure 7. Gasoline supplies delivered

13-week moving average, year-on-year change through March 2012

Source: U.S. Energy Information Administration

8

64

2

0

-2

-4

-6

-8

1970 1975 1980 1985 1990 1995 2000 2005 2010

15

12

96

30

-3-6

-9

-12

Figure 6. U.S. petro eum products supp ied

Three-month moving average, year-on-year change through March 2012

Source: U.S. Energy Information Administration


20/48

20


ChINA

China: Sot landing now,uncertainty laterby Dr. Ira Kalis

The Chinese economy grew 9.2 percent in 2011, and it is

widely expected to grow signicantly slower in 2012. The

questions is how much slower. The Chinese government

recently revised its own orecast or 2012 growth rom

8 percent to 7.5 percent. Such growth would be widely

seen as a sot landing. It is the result o slower growth

overseas having a negative impact on export growth.

On the other hand, the central bank has eased monetary

policy in order to boost domestic demand to oset the

decline in exports.

Te details

As o now, the economy is gradually moving in a negative

direction. In the rst two months o 2012, there was a

decline in exports and a decline in the fow o oreign

direct investment into China. As o March, there have

been our consecutive months o declining manuacturing

activity, according to a survey o purchasing managers

conducted by the private sector. Investment in both

residential and commercial property has tailed o, and

government spending on inrastructure has slowed down.

In addition, Chinese demand or commodities has deceler-

ated, boding poorly or industrial output.

All o this was due largely to the slowing o economic

activity outside o China, principally in Europe. In response

to this slowing, Chinas central bank has twice lowered

the required reserve ratio or commercial banks with the

intention o boosting liquidity and credit market activity.

Still, the combined drop in the reserve ratio o 100 basis

points does not come close to osetting the 600 basis

point increase that took place over the past two years.

That tightening o monetary policy had taken place in

order to ght infation, a ght that has largely been a

success. That is why the central bank is now comortable

engaging in a gradual easing o monetary policy. More

is expected.

The success o the easing o monetary policy is evident

by the gradual nature o the slowdown oten called

a sot landing. Indeed, the Conerence Boards index

o leading economic indicators or China actually rose in

January, suggesting that prospects in the months ahead

are airly good.

In addition, government policymakers have signaled a

willingness to take new action to oset the negative

headwinds acing China. For example, the government is

trying to boost rst-time home ownership by providing

rst-time buyers with incentives in the orm o low interest

rates and small down payments. This is at a time when the

government continues its eorts to puncture the housing

bubble and discourage speculative activity in the housing

market. The government has also targeted the rural sector

or an easing o credit market conditions.

In addition, recent government actions have been

designed to boost consumer purchasing power as well

as alleviate income inequality. In Beijing, Shenzhen, and

Shanghai, the minimum wage has substantially increased.

In the last week o February, the minimum wage in

Shanghai rose 13 percent. This ollows an average 22

percent increase in the minimum wage in 2011 in 24

major cities. The idea is to boost consumer spending,

enable actory workers to improve their standard o

living, reduce income inequality, and reduce the risk o

social unrest.


21/48

21

GeograpiesChina

21

Longer term

Recovery overseas will eventually lead to a revival o strong

growth in China. Or will it? The problem is that, although

China seems destined to avoid a hard landing or now,

there are reasons to worry about this urther down the

road. The ability o China to maintain growth in the wake

o the crisis in 20082009 was due to massive government

support or investment. This investment now represents

48 percent o GDP, widely viewed as unsustainable as

has been discussed on these pages in the past. That iswhy there has been much discussion lately about reorm

in China.

The government recently cooperated with the World Bank

in producing a report titled China 2030, which oers ideas

on how China can sustain growth going orward. The

report says that Chinas current economic model is not

sustainable and must be changed. It calls or more priva-

tization o state-run enterprises, more reliance on market

orces, the end o restrictions on internal migration, a

boost to the social saety net in order to encourage more

consumer spending, more transparent capital markets in

order to unnel capital to the most protable investments,and better scal controls or local governments that are

currently laden with debt.

It is not likely that these or other reorms will be enacted

this year. That is because 2012 is a year o transition to

new leaders. The outgoing Premier, Wen Jiabao, has

spoken out about the urgent need or reorms. Incoming

Premier Li Keqiang said that China must deepen reorms

on taxes, the nancial sector, prices, income distribu-

tion, and seek breakthroughs in key areas to let market

orces play a bigger role in resource allocation. Yet, there

has been nothing more specic than this. Consequently,

there is some uncertainty as to nature and timing o

uture reorms. Failure to reorm could allow imbalances

to ester, leading to a crisis in the uture. Reorms, on the

other hand, could be disruptive and might challenge the

interests o those that benet rom the current system.

As such, China has no easy path. Meanwhile, the leader-

ship debates the proper role o government, the growing

problem o income inequality, and the degree to which

changes in the political system are needed to ensureeconomic reorm. Stay tuned.

Kicking te can down te road

In a year when political power will be transerred, the

government is evidently keen to avoid major disruption

to the economy. As such, it is likely that the government

will utilize scal tools to boost economic activity i the

economy aces even greater headwinds rom abroad. In

addition, the government has shown a desire to avoid, or

at least postpone, the turmoil that might come rom the

unwinding o imbalances. Specically, as discussed in this

publication recently, local governments have accumulated

about $1.7 trillion in debts that many analysts deem unsus-

tainable. Moreover, a loss o revenue rom weak land sales

has exacerbated the problem o servicing this debt. Many

analysts had recently been concerned about the possibility

o an imminent crisis i banks were orced to write down

these debts. Instead, the government has instructed banks

to roll over the local government debt, thereby postponing

the day o reckoning. Thus, there will probably not be a

crisis any time soon.


22/48

22

United Kingdom: The outlookbrightensby Ian Stewart

UK

Our last article about the United Kingdom, which was

written in late-December during a time o pessimism

about the outlook or the euro and or European growth,

concluded, What will be the signal to turn more bullish

on UK growth and risk assets? For us, it is a marked easing

o nancial and sovereign stress in the Euro area. Three

months o nancial and sovereign stress has, indeed,

eased signicantly (see gure 1), and with it, the outlook

or the UK has brightened.

Ian Stewart is Chie

Economist at Deloitte

Research in the United

Kingdom

0

50

100

150

200

250

300

2006 2007 2008 2009 2010 2011 2012

Figure 1. Deloitte financial stress index

The Deloitte Financial Stress Index is an arithmetic average of the ratio of the three-month LIBOR to base rates, the ratio of yieldon high yield bonds to yield on government bonds, the VIX index, the ratio of total market return to banking stocks return andthe ratio of yield on long-term government bonds to yield on short-term bonds.


23/48

23

GeographiesUK


24/48

24


Changes in the outlook are oten seen rst in survey

data, and a number o surveys point to a bounce in

business condence. The rst quarter Deloitte UK CFO

Survey shows that condence among Chie Financial

Ocers about their own rms nances has risen at the

astest rate since 2007, taking it close to levels last seen

in late 2010 (see gure 2). The worries about the risk

o recession and a breakup o the single currency that

dominated the air waves and newspapers at the end o

last year have eased. On average, CFOs now assign a 30

percent probability to the UK economy seeing a double

dip recession, down rom 54 percent in December. In the

Euro area, the extensive provision o liquidity to banks by

the European Central Bank and a urther debt bailout or

Greece has reduced ears o an early breaking o the single

currency. Last December, UK CFOs, on average, saw a 37

percent probability o one or more members o the single

currency leaving the euro in 2012, and this clearly weighed

on business condence. By March, this probability o

secession ell to 26 percent.

Easier policy has also helped condence and boostednancial risk appetite. The United States, UK, Japan and

Switzerland have been busy pushing money into the

system through quantitative easing. Stronger nancial

conditions, refected in rising global equity markets, seem

to be beneting larger UK companies, with CFOs reporting

an increase in credit availability in the rst quarter. This

more than unwinds the deterioration in credit availability

seen in December, which at the time, some eared could

be the start o a second credit crunch. And, as a very open

economy, the UK has also benetted rom the growing

mood o optimism about the U.S. economy over the last

ew months.

It would be a premature to suggest that the UK economy

is out o the woods. UK GDP growth in the rst hal o

2012 is likely to be anemic at best. While the Bank o

England thinks the UK should be able to avoid a recession,

the OECD reckons the UK entered a technical recession

in late 2011. And, o course, the uture remains unpre-

dictable. The deterioration in UK and European growth

prospects in the second hal o 2011 (see gure 3) derailed

what, in early 2011, seemed like a solid recovery. That

episode underscored how macroeconomic risks can

escalate. Those risks may have receded, but they have

-1.0%

-0.5%

0

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

Mar-11 Jun-11 Sep-11 Dec-11 Mar-12

US

Japan

Britain

Euro area

Figure 3. Consensus GDP growth forecasts for 2012

Source: Consensus forecasts from The Economist

2007 2008 2009 2010 2011 2012Q3 Q4 Q4Q1 Q2 Q3 Q4Q1 Q2 Q3 Q4Q1 Q2 Q3 Q4Q1 Q1Q2 Q3

-70%

-50%

-30%

-10%

10%

30%

50%

70%

Less optimistic

More optimistic

Figure 2. Financia prospects

Net % of CFOs who are more optimistic about financial prospects for their company now thanthree months ago

Source: Deloitte CFO Survey


25/48

25

GeograpiesUK

hardly been eliminated. From the high oil price to the

recent ocus on Spains debt problems, the risks to the

recovery are changeable and numerous.

In the background is the worry that rates o UK GDP

growth could remain anemic or years to come. On

average, economists expect UK growth over the next ew

years to run at signicantly lower levels than were seen in

the years beore the recession. Current near-record levels

o UK corporate cash may well be a maniestation o

caution on the part o corporates and insurance against

a volatile, slower-growth world in which the availability o

capital can shit quickly.

Yet, it is the corporate sectors hiring, exports, and

capital spending that are widely expected to drive the

UK recovery. A rebound in corporate sector activity may

be later in arriving than previously thought (see gure

4). In the last six months, the UKs ocial, independent

orecaster, the Oce o Budget Responsibility, has cut its

orecast or capital spending in 2012 rom 7.7 percent to

just 0.7 percent.

With the UK in its third year o a seven-year program

o scal austerity, government spending will make no

contribution to the recovery. Households ace a multi-year

deleveraging and rising unemployment, but, ater a double

dip recession or the consumer last year, things are looking

up. Falling infation should support real incomes. UK

consumers days o ree spending are over, but household

spending should make some modest contribution to GDP

growth in 2012.

Overall, 2012 is likely to be a year o erratic, sluggish UK

growth, which is likely to come in at well under 1.0 percent

or the year as a whole. Hopes or a more robust recovery

now reside toward the end o the year and in 2013.

Whether that recovery materializes depends as much on

nancial and economic conditions outside the UK and

especially in the Euro area as it does on the actions o

UK policymakers.

-300

-200

-100

0

100

200

300

400

Q1

2007

Q2 Q3 Q4 Q1

2008

Q2 Q3 Q4 Q1

2009

Q2 Q3 Q4 Q1

2010

Q2 Q3 Q4 Q1

2011

Q2

Private sector job growth

Public sector job growth

Figure 4. UK private and public sector job growth (thousands)

Source: ONS


26/48

26

India: A delicate balanceby Siddart Ramalingam

INDIA

Growth is slowing down, investment is alling, and

business sentiment is on the decline. The recent Union

Budget and policy announcements by the central bank

have not mollied ears o possible economic slowdown.

All quarters o the economy are hoping or more in

terms o measures to ensure long-term infation stabi-

lization, reduction o the scal decit, and a drop in

interest rates.

All is not well in te workouse

For the last several months, the Indian economy hasbeen torn between controlling infation and maintaining

robust economic growth. In order to control skyrocketing

infation, the Reserve Bank o India chose to sacrice

growth in order to rein in infation. The 20-month period,

until October 2011, o rising interest rates has slowly but

surely put the brakes on economic growth. Industry is

increasingly worried about the high cost o capital, and the

manuacturing sector is showing signs o stagnation.

GDP growth in the third quarter o the current scal year

came in at a woeul 6.1 percent, marking a sharp drop

rom 7.7 percent growth in the rst quarter, and 6.9

percent in the second quarter. Manuacturing growth

slipped to 0.4 percent rom 7.2 percent and 2.7 percent

in the rst and second quarters respectively. The seventh

successive quarterly slowdown and the slowest growth in

three years have triggered ears that the economy slowed

down urther in the last quarter o the current scal

(JanuaryMarch 2012) and that overall growth or the

scal year could all short o the downwardly revised targeto about 7.0 percent. Furthermore, despite the nance

ministers exhortation that the economy will grow at about

8.0 percent in the next scal, it is possible that growth will

stagnate at a new normal o about 6.0 percent unless

signicant eorts are made toward improving credit condi-

tions and resurrecting investments in the coming months.

Siddharth Ramalingam is

an Assistant Manager at

Deloitte Research, India


27/48

27

GeographiesIndia


28/48

28


Growth data rom Indias eight core inrastructure sectors,

although showing improvement in February ater a disap-

pointing January, provide no cause or cheer. The core

sectors expanded 6.8 percent in February, compared

to Januarys growth o just 0.5 percent. Growth in the

actory sector slowed down or the third month in a row

in March as new orders continue to all and raw material

prices headed north. The HSBC manuacturing Purchasing

Managers Index ell to 54.7 in March rom 56.6 in

February and 57.5 in January.

Indias exports grew 4.2 percent in February, the slowest

pace o growth in three months. Imports, on the other

hand, grew 20.6 percent, translating into a trade decit o

$15 billion. The commerce secretary recently expressed his

concern over the burgeoning trade decit as weak demand

rom Western markets and global political developments

are likely to exert a drag on exports in 2012.

Infation: Te artul dodger

Although infation dropped to a 26-month low in January,

it seems unlikely that it will stabilize at the current level,

casting doubts on whether the central bank can really

aord to reduce interest rates at this time. Headline

infation accelerated in February ater ve months to about

7 percent. Core infation, or infation minus the eects o

ood and uel prices, ell to 5.8 percent in February. While

this does mean that demand-driven infation is alling, it

could also imply that demand or manuactured goods

is actually on the decline, adding credence to ears that

the manuacturing sector is heading toward stagnation.

Conversely, the all in core infation also implies a rise in

ood and uel prices. Ater hitting near-zero infation in

January, ood prices rose about 6 percent in February.

Recent announcements by meteorologists predict a

below-average rainall this year, and absent any removal

o supply-side bottlenecks in the agriculture sector, ood

infation could spiral upward in 2012, taking overall

infation well above the governments target level o about

7.0 percent or the rest o the year.

The scal decit continues to be a cause or concern.

Notwithstanding last nancial years scal decit o 5.9

percent o GDP instead o the planned level o 4.6 percent,

the government has set a realistic target o 5.1 percent

or the current scal in the recently unveiled budget. Not

only may the target be unsustainably high, the credibility

o the target or the current scal year has already been

called into question by market commentators. A large

scal decit surely does not bode well or infation.

Policy ears

The government stressed that reining in scal, revenue,

and current account decits while controlling infation

were the main aims o the recently unveiled budget. The

proposed debt-to-GDP ratio is 45.5 percent, down rom


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GeographiesIndia

last years 50.1 percent. The nance minister also proposed

to reduce outlay on subsidies to below 2 percent o GDP

rom the current level o 2.5 percent. However, skeptics

believe that the targets and measures proposed are neither

spectacular nor attainable. It has been argued that the

government has neither the political desire nor support

to reduce subsidies on ood, uel, and ertilizers, apart

rom pushing through important policy reorms that are

important or ostering growth. Furthermore, the Goods

and Service Tax, the much-vaunted plan or scal consoli-

dation, is pending the resolution o key issues regarding

the division o revenues between the center and the states.

In the run up to the budget, oreign investors had looked

to the government or policies that would aid investment

in India. However, post budget, there is increasing worry

that recent government stances on oreign investment

may not be tolerated by oreign investors. The government

introduced a proposal that will allow tax authorities to

crack down on companies that may have structured deals

to avoid taxes. Firms, Indian and oreign, that have routed

their investment in India through Mauritius are potentially

under scrutiny. Another proposal to tax cross-border deals

involving the transer o Indian assets, with retrospective

eect stretching back until 1962, is worrying current and

potential investors. At a time when the government can

ill aord deterioration in its current account decit, recent

policy proposals seem, at the very least, badly timed.

Few policy options

Infation, the barb that had threatened to derail Indias

growth or several months, had been on the decline over

the last several weeks. Infation dropped to a 26-month

low o 6.5 percent in January ater remaining above 9.0

percent or much o 2011. However, infation is on the rise

again, and it is likely to stay in the 7.09.0 percent range

in the coming months. The central bank cannot aord

to conclude that the infation will stabilize in the medium

term. In act, the central bank has announced that it

would be premature or it to start reducing interest

rates without seeing any abatement o infationary threats

exerted by the high scal decit and global energy prices.

Thus ar in 2012, the central bank has already eased the

reserve requirements or banks, inusing liquidity into the

economy. It is likely that urther liquidity could be inused

into the economy in the coming months. Measures to

ease liquidity may, however, not be enough to provide

a much-needed llip to the economy. Growth is slowing

down, investment is alling, and business sentiment is

on the decline. Absent any credible government action,

the central bank may not be able to stave o calls or

reducing the interest rate or too long. In the nal analysis,

questions about whether or not the interest rate will be

reduced are giving way to when and how dramatically it

will be cut.

At a time when the government can ill aorddeterioration in its current account decit,recent policy proposals seem, at the very least,badly timed.


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30


Japan: New risk

actorsby Dr. Ira Kalis

Worrying about trade and debt

For some time, pundits have bemoaned the act that

Japans sovereign debt is roughly 200 percent o GDP,

which is widely viewed as an unsustainable number that

puts Japan at risk o a nancial crisis. However, other

observers remain unalarmed because Japan runs a current

account surplus. In other words, Japan saves so much

that the savings exceeds the unds needed to service

government debt and und domestic investment. There is

still money let over to lend to or invest in the rest o the

world. Thus, Japans massive government debt should not

be viewed as a problem because o its ormidable savings.

Yet, that is only true as long as Japan runs a current

account surplus.

That assumption is now being brought into question. In

January, Japan ran a trade decit. The current account

balance is the trade balance plus net interest payments.

Those interest payments are so large that Japan still had

a current account surplus in January. Yet, the act that

Japan ran a trade decit raised eyebrows. I continued, it

could ultimately lead to a current account decit. I that

were to happen, servicing the large sovereign debt could

be problematic. I markets perceived that to be so, they

could push up the yield on Japanese government bonds,

urther exacerbating the problem o bringing the debt to a

sustainable level.

Why did Japan run a trade decit? The main reason is that,

ollowing the earthquake, most o Japans nuclear power

plants were idled. Thus, Japan had to import massive

quantities o oil and natural gas in order to generate

electricity, so the import bill rose. At the same time, a high

valued yen conspired with weak demand in Europe to

cause exports to alter. Moreover, rising oil prices could

worsen the situation. The good news is that there was a

trade surplus in February. Still, the stage is not yet set or a

sustained improvement in the trade balance.

Aggressive monetary policy

One o the problems or exporters has been the high

valued yen. However, in recent months, the yen has

declined somewhat, thereby boosting the competitive-

ness o exports. This shit was mainly due to a change in

monetary policy. The Bank o Japan (BoJ) has implemented

two rounds o asset purchases (oten known as quanti-

tative easing), the second o which was announced in

February and involved 10 trillion yen ($130 billion). The

eect o this was to boost liquidity, boost expectations o

infation, and put downward pressure on the yen. Indeed,

the yen ell rom roughly 77 yen per dollar to 83 yen

per dollar.

Now there is talk o another round o asset purchases.There are two reasons or this. F irst, infation remains close

to zero even though the BoJ set an explicit infation target

o 1.0 percent. While the program o asset purchases

ended defation and created a bit o infation, it may not

be sucient. Second, there is concern that the yen could

bounce back as long as the Japanese currency is seen as a

sae asset in a world o risk. Further nancial market stress

in Europe or a stumbling o the U.S. economy could cause

the yen to shoot up.

Fiscal issues

Meanwhile, the Japanese government is determined

to put Japan on a sustainable scal path. Japan acesseveral problems. First, the debt is already very large

and higher bond yields would make the situation worse.

Second, Japans economy has grown very slowly, thereby

generating modest revenue gains. Third, defation meant

that incomes were declining or stagnant at best, thus

suppressing government revenue. Finally, the aging popu-

lation means that uture spending on pensions and health

is likely to increase substantially. Many observers worry

that, without a plan to create scal probity, Japan could

ace a serious crisis in the not-too-distant uture.

JAPAN


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GeographiesJapan

The solution, according to Prime Minister Noda, rests

in raising the sales tax rom the current 5 percent to 10

percent by 2015. This plan has become hugely unpopular,

and it is not clear that it will pass the Parliament. I it

doesnt pass, condence could be undermined, leading to

higher bond yields. I it does pass, however, the eect on

growth could be negative. Thus, Japan is caught between

a rock and a hard place. Moreover, ailure to pass Nodas

legislation would be indicative o a larger problem o

political gridlock. This means that passage o other reorm-

oriented legislation would be less likely.

Growt outlookGiven the scal, trade, and energy situations, one could

be orgiven or expecting poor economic perormance.

However, the reality is likely to be somewhat dierent

at least in the short run. There are a number o actors

that should boost growth in the coming year. That would

be welcome, given that Japans economy shrank by 0.9

percent in 2011. Moreover, GDP declined in the ourth

quarter at an annual rate o 2.3 percent. That was largely

due to a decline in inventories and a drop in exports.

The latter was due to the temporary eect on Japanese

supply chains emanating rom the foods in Thailand. The

good news is that the actors hurting growth in the ourth

quarter were temporary.

In 2012, growth should resume or several reasons. First,

Japans government is expected to continue to spend

massively on reconstruction, thereby boosting domestic

demand. Second, the Thai foods are over, and supply

chains have resumed. Third, the aggressive monetary

policy has suppressed the yen, which should help export

competitiveness. Fourth, the aggressive monetary policy

has also boosted expectations o infation, which have

the eect o cutting real interest rates. This should help

boost credit demand. Fith, higher infation could stimulateconsumers to spend more. Sixth, ollowing the depletion

o inventories in the ourth quarter, businesses are likely

to engage in inventory rebuilding in early 2012. Finally,

the rest o the world is not doing as badly as previously

expected. This should help to stabilize exports.

Thus, a reasonable expectation or 2012 is that the

Japanese economy will grow between 1.0 and 2.0 percent,

infation will be positive, and the yen will not resume

its appreciation.


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At a meeting o the BRICS countries in India in late March,

the Brazilian delegation sought a statement criticizing

the monetary policies o Europe and the United Sates.

The statement never happened, but the act that Brazil

sought such a statement indicates what is top-o-mind

or Brazilian policymakers. The low interest rate policies o

Europe and the United States have led investors to look

elsewhere or higher returns. Naturally, Brazil has become

a avored destination or unds in search o return. Ater

all, Brazil currently has among the highest interest rates in

a stable country. The infow o unds threatens to increase

the value o the currency enough to seriously damage

export competitiveness.

In addition, the Brazilian government says the country

is awash with cheap imports. As such, Brazil intends to

complain to the WTO that the 35 percent tari ceiling that

it authorized is too low. This could alarm China, which is

Brazils largest trading partner. It could also alarm other

members o the WTO that are concerned about Brazils

potential tilt toward protectionist policies.

One solution, o course, is or Brazil to cut interest rates,

and indeed, this has been happening. The problem is that

Brazils infation is lingering above the central banks target

o 4.5 percent. Cutting interest rates too quickly, whilebenecial to the currency, could lead to higher infation.

Moreover, higher infation would lead to higher labor

costs, thereby damaging the competitiveness o exports

even more. On the other hand, ailure to suciently cut

rates could result in an increase in the value o its currency.

This would be troublesome, given that exports are already

altering due to the economic slowdown in Europe. So, like

many other countries, Brazil is in a dicult position.

Interestingly, Brazilian policymakers complain about the

infow o capital, even as Brazil needs an infow o capital.

Since Brazil is running a current account decit, meaning

that the country is a net borrower, capital infows are

needed to nance the decit. Otherwise, Brazil would have

to borrow rom abroad. O course, the best kind o capital

infow would be oreign direct investment (FDI) rather

than the portolio fows now entering the country. That is

because FDI is more stable and less vulnerable to the mood

swings o global investors. When investors get spooked,

they can withdraw their cash more easily than a actory.

Te current situation and te outlook

Ater our 50 basis point interest rate cuts in the last our

months, the Brazilian central bank surprised markets bycutting the benchmark rate by 75 basis points in March

and another 75 in April. The benchmark rate stood at

9.0 percent as o the end o April. This ollows news that

Brazilian industrial production ell in January at its steepest

pace in three years. Not only is the central bank trying to

boost economic activity, it is also trying to reduce upward

pressure on the currency, which has risen 5 percent

this year.

In the coming year, it is likely that interest rates will

continue to be cut urther in order to stimulate a relatively

dormant economy. This expectation is based on the state-

ments o Brazils central bankers. Brazil may err on the

side o stronger growth rather than containing infation.However, it is not likely that Brazil will allow infation to get

out o hand.

Economic growth, which was strong in 2010, decelerated

considerably in 2011. Indeed, Brazils economy stalled

in the third quarter o 2011, a ar cry rom the rapid

growth o 7.5 percent experienced in 2010. All sectors o

the economy were down except or exports. Consumer

spending, which accounts or 60 percent o GDP, declined.

This may represent the end o the debt-ueled consumer-

spending boom. Business investment also dropped. Exports

Brazil: Worried about

capital infowsby Dr. Ira Kalis

ZIL


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Geographies

33

Brazil

grew, but at a slower rate than in the previous quarter.

Agricultural output increased at a good pace, but industrial

output was down. Clearly, the end o growth was not only

due to the Eurozone crisis. Rather, the lagged eects o

tight monetary policy, which subsequently reversed, may

have had an impact.

The government, keen to boost growth, will probably

increase scal spending in the coming year, nanced by

borrowing. In addition, the government is expected to

continue its auction o assets to stimulate private sector

investment in inrastructure. It has already auctioned the

right to operate several airports. The intended result is

or investment spending to contribute to growth, the

auctions to contribute to public nances, and the actual

investments to boost longer-term growth prospects by

improving productivity. Moreover, inrastructure invest-

ments will be critical to the preparation or the 2016

Olympics in Rio.

Another major area o investment is energy. Brazil sits

astride massive ocean-based reserves o oil. Petrobras, the

state-run energy company, intends to double production

by the end o the decade. To do this, it may engage in

more capital spending over the coming decade than any

other company in the world.

The bottom line is that growth in 2012 may gradually

recover, assuming that outside events dont conspire to

throw a monkey wrench in Brazils plans. Such events

could include a deeper Eurozone recession, a steeper

increase in the global price o oil, or a global nancial crisis

that could lead to capital fight.


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RUSSIA

Russias economy is perorming reasonably well, but

it aces some obstacles going orward. In 2011, the

economy grew 4.3 percent. This included consumer

spending growth o 6.4 percent and investment growth

o 6.0 percent. However, growth is likely to be somewhat

slower in 2012, given global headwinds. Slower growth

in Europe and China will have a negative impact on the

volume o exports. About two-thirds o Russias exports

are energy related, and energy demand may decline in

these markets. In China, or example, which is Russias

global economic outlook q2 2012

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