The Global Economy

Monthly letter from Swedbanks Economic Research Department by Cecilia Hermansson No. 9 December 19, 2012

The global economy closes the year on a down note major challenges await in 2013
Forecasters continue to revise their global growth projections downward. On the positive side, the US recovery has become more robust and a turnaround in China is more clearly evident. But in large parts of Europe, Japan and other emerging markets conditions have deteriorated. Among the most important events in 2012 has been the strengthening of the euro zones institutional framework. Concerns about a euro collapse and so-called Grexit have eased and a muddling-through scenario is still holding. While this means that the euro zones GDP will continue to shrink, interest rate spreads could still fall if the pace of reform is maintained. In 2013 parliamentary elections are scheduled in Italy and Germany, among other countries. The focus will be on balancing credit and budget austerity with reforms that lead to stronger growth. In the US (if the fiscal cliff is avoided), UK and even Germany confidence in the financial market will make it possible to avoid austerity, but the crisis countries have no alternative due to a lack of financing. Instead, they have to continue their reform work, while fiscal policies will have to include targeted measures to stimulate growth and support societys most vulnerable groups. Without social cohesion and a focus on democracy, there is a risk that the pessimists will be proven right about a euro collapse a fight that optimists have won to date.

Industrial production is still shrinking

The global economy hasn't yet seen a turnaround, though conditions vary. We see a slightly brighter picture in the US and China, but a darker one in parts of Europe, Japan and other BRIC countries. In November the global purchasing managers index rose to 49.7, from 48.8 in October. While the US, Japan and Sweden noted declines, conditions have improved in China, the UK and India, as well as the euro zone. Only India and China (but just barely) have a PMI reading of over 50 i.e., even though the index has risen in other countries it is still signaling that industrial production is shrinking, but not by as much. Only China reported a higher index in November than in January of this year. Conditions have deteriorated most in Sweden, the US and Japan, while the euro zone, which is also weakening, already had a low reading of about 49 at the beginning of the year.

Manufacturing PMI globally and for individual countries and regions

Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46-8-5859 7740 E-mail: ek.sekr@swedbank.se Internet: www.swedbank.com Responsible publisher: Cecilia Hermansson, +46-85859 7720, Magnus Alvesson, +46-8-5859 3341, Jrgen Kennemar, +46-8-5859 7730, ISSN 1103-4897

The Global Economy Monthly newsletter from Swedbanks Economic Research Department, continued No. 9 December 19, 2012

Global economy finishes the year weaker than it started

During the second half of the year the economy has weakened, not only in terms of industrial production but also in actual GDP in large parts of Europe and Asia. Global trade has, with few exceptions, stabilized at the 2011 level, or fallen significantly as in Japan's case. The recovery has strengthened mainly in the US. Why does the end of 2012 look worse than the beginning? Here are some reasons: In 2010 and 2011 the economy seemed to be strong in the wake of the recovery after the financial crisis and recession in 20082009. These catch-up effects disappeared in the latter part of 2011 and 2012. As we approached the first half of 2011 and 2012 the central banks increased liquidity, which strengthened confidence in the financial markets and to some extent the real economy. The impact subsided during the second half of 2011 and 2012 and activity slowed. Fiscal austerity and tighter credit in Europe have led to higher unemployment and weaker confidence among businesses and households. The euro zone hasnt been able to avoid a recession. The BRIC countries have launched a new stimulus phase through monetary and fiscal policy, but not of the same scope as in 2008-2009, since inflation has stayed fairly high and/or the bad loans in the financial system make it hard to repeat expansive economic policies. It also seems that the stimulus is not having the desired effect, especially in Brazil and India. Political uncertainty is higher than normal because activity in the US is affected by the fiscal cliff at the same time that concerns about new political crises in the euro zone have reduced the willingness to invest and consume. Another factor in Japan's case is its deteriorating relationship with China, which has contributed to a boycott of Japanese products and reduced auto exports to China. See our Asia Analysis no. 15, which was recently published.

Optimists have defeated pessimists, so far

Only 43 of the 83 economists the Financial Times surveyed in January predicted that the euro would be intact at the end of the year. And that was at a point when institutions had begun to strengthen thanks to the introduction of the fiscal pact. Pessimism took over, especially among AngloSaxon analysts and journalists. Not until European Central Bank President Mario Draghi uttered the words, and believe me, it will be enough, did the financial markets confidence in the currency union grow. When the German constitutional court ratified the ESM bailout package and the ECB announced the details of the OMT, speculation about a euro collapse eased. During the early summer the focus was still on Greece, but after a new election there was optimism that the country would decide to reform. During the fall concerns returned, although fewer people are now anticipating a Grexit. Some are speculating that Greece will leave in a few years, but I find it hard to see why it would if the worst of the panic has died down and it continues to receive support from the euro zone. More debt write-offs will be needed, however, including public debts. The reason this isnt being done now is the risk it would hurt Spain and Italy's prospects of receiving support. Why would German taxpayers want to help Spain when they already know that tax money recently given to Greece has already been lost? For German Chancellor Angela Merkel it is a question of maintaining the will to reform within the euro zone and retaining power. The muddlingthrough scenario has survived, probably because of a lack of political alternatives for the 17 euro countries. The financial market is getting used to this and understands the political commitment involved in rescuing the euro zone and the EU. There are still overhanging risks of a dissolution, since you can never discount that political events could endanger the cooperation. This means that the pessimists may still be right, though the likelihood of that happening has fallen considerably. One of the most important things that have happened this year is the strengthening of institutions and confidence. Many puzzle pieces have to fall into place, however. The euro zone has to develop the Eurobond market, banking union and fiscal cooperation. Democratic aspects certainly have to be included, considering the democratic deficit in how decisions are made within the euro zone.

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The Global Economy Monthly newsletter from Swedbanks Economic Research Department, continued No. 9 December 19, 2012

Major challenges ahead in 2013

Reforms are needed in 2013 to reduce uncertainty, which in turn would strengthen the economic outlook. This applies to the US (where avoiding the fiscal cliff remains first priority), Japan and Europe, as well as emerging markets. It would require stronger institutions, the introduction of new and removal of old regulations, and smaller imbalances. Reducing protectionism is also a key. At this point the global slowdown isnt as severe as in 2008-2009, when the financial sector collapsed and affected the real economy. On the other hand, there is reason to fear that this time it could be more long-lasting in a climate of debt and banking crisis, and that the recovery could have less impact than in 2010-2011. An important reason is that last time there were opportunities for a major stimulus through fiscal and monetary policy. Economic policies dont have the same muscle this time around. On the contrary, countries are tightening fiscal policy despite current conditions. More quantitative easing is in the monetary pipeline, but it is unclear whether it will have enough impact on the real economy or last long enough.
Inflation measured by CPI in a number of countries/regions

upward. Its probably all the bad loans in the financial system that are restricting credit growth this time. Inflation is also higher in the euro zone than economic conditions warrant, but this can partly be explained by the fiscal austerity, which is leading to higher prices. Monetary policy in the more developed countries has already been expanded. Discount rates cant be cut much more, with the exception of the ECB, which could cut after the turn of the year if conditions remain weak. It had a slight opening when it made its last rate decision. In the US it is more a question of signaling that rate hikes arent in the offing and that the quantitative easing in the form of mortgage and government bond purchases will continue until unemployment has been reduced significantly, now to the Feds goal of 6.5 percent. The ECB is in position to expand its balance sheet by buying the bonds of crisis countries, but first they have to seek help from the bailout program, which they havent done yet. Although it has been said that the easing will be sterilized, there isnt always an opportunity to do so in practice. The most important economic challenges next year are to ensure a turnaround despite austerity and make sure that the recovery is strong enough to lower unemployment and increase confidence. The German and Italian elections will focus on these challenges. Reform work has to continue, partly because a stimulus isnt an option and partly because it will have a greater impact in the long term. Some countries that enjoy the financial markets confidence such as the US, Germany and UK could choose to avoid economic austerity. On the other hand, many crisis countries cannot finance their budget deficits, leaving them with few alternatives to consolidation and reform. In 2013 fiscal policy therefore has to focus more on structural reforms and targeted measures that stimulate growth and reduce the suffering of societys most vulnerable groups. Cecilia Hermansson

In BRIC countries such as India and Brazil inflation is stuck at high levels, probably due to weak competition and capacity shortages. In China inflation had declined, but has again begun to inch
Swedbank Economic Research Department
SE-105 34 Stockholm, Sweden Phone +46-8-5859 7740 ek.sekr@swedbank.se www.swedbank.se Legally responsible publisher Cecilia Hermansson, +46-88-5859 7720. Magnus Alvesson, +46-8-5859 3341 Jrgen Kennemar, +46-8-5859 7730

Swedbanks monthly The Global Economy newsletter 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 Swedbanks monthly The Global Economy newsletter.

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