Prospects for individual economies.

Holland, Dawn ; Delannoy, Aurelie ; Fic, Tatiana 等

United States

Many of the recent economic indicators emanating from the US have been surprisingly favourable when set against the bleak developments in Europe. According to the advance estimate, GDP increased at an annualised rate of 2.8 per cent (or 0.7 per cent in quarterly terms) in the final quarter of 2011, the fastest rate of growth since early 2010. The unemployment rate dropped to 8.5 per cent in December, after remaining broadly fiat at about 9 per cent over most of the preceding year. Share prices have increased by more than 10 per cent from their trough in September/October of last year. The volume of imports of goods and services increased by 4.4 per cent in the final quarter of 2011, suggesting that estimates indicating that global trade contracted in the final quarter of the year may overstate the slowdown. Inflation as measured by the consumer expenditure deflator remains relatively moderate, at 2.6 per cent in the final quarter of 2011, but above the new target of 2 per cent specified by the Federal Reserve at the last meeting of the Federal Open Market Committee. Nonetheless, the US financial system is closely tied to that in Europe, and this, combined with expected fiscal tightening measures, is expected to keep GDP growth this year below 2 per cent. In 2013 we forecast an acceleration in growth to 2.7 per cent. Contrary to the situation in Europe, we see significant upside risks to the outlook for the US this year. A more rapid recovery in labour and housing markets has the potential to push growth above trend in 2012.

The budget for 2012 includes fiscal tightening measures worth 1 1/2 per cent of GDP. Just prior to the downgrade of US sovereign debt in August of last year, a bipartisan 'Super Committee' was set up with a mandate to agree a fiscal programme that would save at least $1.2 trillion over the next ten years. The committee failed to come to an agreement by the specified date last November, which triggers automatic spending cuts in 2013. The automatic cuts are intended to be binding regardless of the outcome of the presidential election in November 2012. Our forecast is based on the assumption that the temporary payroll tax cuts that were extended for two months in December 2012 will eventually be extended through the end of the financial year, with other policy in line with the Congressional Budget Office's Budget Outlook of August 2011. We assume that the automatic spending cuts will be eased in as gradually as possible, with $20 billion (about 1/2 per cent of GDP) in spending cuts per annum over the next ten years.

At its latest meeting on 25 January, the Federal Open Market Committee announced its intention to maintain a highly accommodative stance for monetary policy, with the intention of maintaining exceptionally low interest rates until at least late 2014, whereas in previous statements they had suggested mid-2013 as the turning point for interest rates. The Committee also, for the first time, announced a more specific set of medium-term targets for monetary policy, specifically an inflation rate of 2 per cent per annum and the longer-term 'normal' unemployment rate, which it currently sets at 5.2-6 per cent. While the Federal Reserve stands poised to introduce a further round of quantitative easing this year should economic conditions deteriorate, under our current forecast we do not think such an action will be required. The experience of quantitative easing in the US since 2009 is discussed in the World Overview. In general the evidence suggests that the US policy of investing in mortgage backed securities, rather than government debt, has been more effective in lowering private sector borrowing costs. This may be one factor behind the 13 1/2 per cent rise in private sector investment in the US since the trough reached in 2009, compared to a rise of just 5 3/4 per cent in the UK and 4 1/2 per cent in the Euro Area.

The improvement in the unemployment rate in the final quarter of last year is a welcome development in the labour market, which showed no improvement in 2010 despite the strong rebound in growth that year. Given the moderate projection for GDP growth this year in our central forecast, further improvements are likely to materialise only gradually, and we expect the unemployment rate to remain stable at about 8 1/2 per cent in 2012, declining towards 8 per cent in 2013.

The weak housing market has been closely linked to the unemployment rate, as it acts as a significant impediment to labour mobility. According to the quarterly report of CoreLogic, about 1/4 of all residential properties in the US with a mortgage were in negative equity in mid-2011. There are some signs that the housing market has reached a trough--housing investment showed some growth in the second half of 2011 and house prices according to the Federal Housing Finance Agency showed a rise in the third quarter of 2011--but clear signs of revival remain some way off. The high rate of mortgage delinquencies and repossessions in the US has forced a relatively abrupt adjustment to household balance sheets, and household financial obligations have adjusted more rapidly than in the UK for example.

Canada

The Canadian economy, supported by strong exports and consumption, is estimated to have expanded by 2.4 per cent in 2011. While the banking sector is relatively well insulated against the sovereign crisis in the Euro Area, the Canadian economy is very sensitive to developments in the US. Fiscal consolidation measures will act as a restraint on growth this year, as in most of the other advanced economies, and we are unlikely to see any further loosening of the monetary stance. Hence, we expect growth to remain below the strong performance of 2000-7, and forecast an economic expansion of 1.9 per cent and 2.5 per cent in 2012 and 2013, respectively.

At the height of the financial crisis in 2009, the Bank of Canada considered quantitative easing, but in practice it temporarily implemented a form of credit easing and engaged in measures to shape interest rate expectations. To support recovery, the Bank of Canada lowered its key policy interest rate to 0.25 per cent. The policy rate was raised to 1 per cent between April and September 2010, as economic conditions improved. The Bank of Canada is concerned about inflationary pressures and it considers monetary conditions to be sufficiently lax. Inflation has indeed risen from very low levels in 2009 and 2010 to an annual average of 2 per cent in 2011, in line with the inflation target. We predict that inflation will fall below target this year and moderate further to about 1 1/2 per cent in 2013. The high oil price can be expected to strengthen the exchange rate, and also acts as a support to public finances.

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Brazil

According to the IMF World Economic Outlook database, Brazil has now overtaken the UK as the world's seventh largest economy in purchasing power parity terms. This marks a further shift in economic power from the advanced economies to the emerging markets, in particular the populous and resource rich BRIC states (Brazil, Russia, India and China), which currently account for a combined 25 per cent of world production and 42 per cent of the global population. Brazil's economic ascent is closely linked to the rise of China and China's growing need for commodities. Already rich in natural resources, Brazil has recently discovered large oil reserves located at its Atlantic coast and is expected to become one of the top five oil producing countries in the near future.

Unlike China, where exports account for about 40 per cent of its GDP, Brazil's economic performance does not rely as heavily on its export sector, which was equal to just 14 per cent of its GDP in the second quarter of 2011. Instead, Brazilian growth is largely supported by strong consumption, generated by a quickly growing middle class. According to a recent study by the consultancy Datafolha, six out of ten Brazilians are now considered to be middle class. Furthermore, the government's programme to battle extreme poverty has lifted an estimated 17 million people out of poverty. According to the World Development Indicators of the World Bank, from 1990 to 2009, Brazil managed to lower its enormous income inequality as measured by the Gini index from 60.6 to 53.9.

Brazil is less exposed to external economic turbulences than other smaller and more open emerging economies. We estimate that Brazil's economy expanded by 3 per cent in 2011 and predict growth to be 3 3/4 and 4 per cent in 2012 and 2013, respectively. Brazil's intensified efforts to foster sustainable growth is mirrored in our forecast as we predict stable rates of about 3 1/2 per cent per annum over our medium-term horizon.

Following a tightening of its fiscal policy until June 2011, the Central Bank of Brazil has lowered its Selic interest rate in four consecutive rounds, from 12.5 per cent to 10.5 per cent, to provide a stimulus to the economy. In 2011, the annual inflation rate of an estimated 6.6 per cent only narrowly exceeded the target band of between 2.5 and 6.5 per cent. The looser monetary stance has allowed the exchange rate to decline from the recent peaks reached in mid-2011. However, further interest rate cuts could pose an upward risk to our central inflation forecast of about 4 1/2 per cent for 2012.

Japan

The Japanese economy has started to recover from the March 2011 Great East Japan Earthquake and tsunami, but the speed of recovery has moderated after an initial strong rebound. Some confidence indicators have lost ground, pointing to the anxiety about the state of the world economy and the appreciation of the yen, which has risen by about a further 6 per cent against the US dollar since the beginning of 2011.

We forecast GDP growth in Japan of about 1 3/4 per cent this year and 1 1/2 per cent in 2013. Public and private reconstruction will be driving forces behind the recovery this year and to a lesser extent next year. Deflation is expected to last until 2014, given the magnitude of the output gap. There are both domestic and external risks to the economic growth projections. Existing shortages of electricity supply and the extended closure of nuclear power plants and lack of alternative energy sources that can act as a substitute may become unsustainable and hinder output growth. A sharp deterioration in the world economy is another risk factor that could lead to a collapse in external demand (see for example the 'downside' scenarios in Euroframe, 2012 and OECD, 2011).

The experience of Japan in conducting monetary policy at extremely low interest rates is of relevance both to the economic outlook for Japan itself and for evaluating the policy options facing the US, UK and Euro Area. Japan first introduced quantitative easing in March 2001, at a time when the economy was in a deflationary spiral (recording the 12th consecutive quarter of deflation). Under this policy, the Bank of Japan (BoJ) acquired Japanese Government Bonds in order to achieve a certain operating target of current account balances held by financial institutions at the BoJ. The BoJ ended its bond purchasing programme in March 2006. Most empirical studies find a limited impact of the 2001-6 quantitative easing on economic activity and inflation, although downward pressure on bond yields was found in the majority of cases (see World Overview for more discussion).

Following the onset of the global financial crisis, the BoJ embarked on a new round of monetary easing measures, with the aim of achieving sustainable growth and price stability. Since 2009 these measures have included purchases of corporate bonds and commercial papers, as well as quantitative easing in terms of increased purchases of government securities. But the major novelty was an introduction of a Comprehensive Monetary Easing (CME) policy in October 2010 aimed at the reduction of long-term interest rates and risk premia. This programme foresaw the purchase of corporate bonds, commercial paper and financial assets from exchange-traded funds (ETFs) and real estate investment trusts (REITs) in addition to government securities. Table 3 illustrates the target level for each item in the asset purchase programme according to the BoJ (as of October 2011). Actual purchases under the programme were initially lower than the targets reported in the table, but following the earthquake in March 2011 additional easing measures were undertaken through this programme.

There are several channels through which the CME programme may affect the real economy and help stem deflation. The commitment to the virtually zero interest rate policy could help shape expectations and thus reduce long-term interest rates and affect inflation expectations. Portfolio rebalancing effects could lead to a reduction in long-term interest rates and a fall in private sector borrowing risk premia, given that corporate as well as government debt is being purchased. The asset purchase programme could increase the risk appetite of investors, pushing up the demand and price of risky assets, which in turn could have a positive wealth effect through higher asset prices.

It is still early to assess fully the impact of CME, but the results so far suggest the policy has been successful in stimulating economic activity, which may be linked to the credit easing approach that included the purchase of private as well as public sector assets. But while analysing benefits to the real economy, the possible negative effects stemming from the risks associated with undermining the independence of the BoJ and possible crowding out of private transactions in the financial markets should not be forgotten.

China and India

The fourth quarter of 2011 saw a continuing moderation in economic activity in China, with annual GDP growing by 9.3 per cent, down from 10.4 per cent a year earlier. During 2011, private sector investment in housing slowed, as house prices cooled and the trade balance weakened, but there was an improvement in household consumption. We expect this rebalancing of the Chinese economy to continue in 2012, with weak foreign demand restricting export performance and domestic policies aimed at an increase in domestic demand bearing fruit. We expect GDP will grow by about 8 1/2 per cent in 2012 and 8 per cent in 2013.

Economic growth in India moderated in 2011 to an estimated 7.3 per cent, after a strong expansion of 9.9 per cent in 2010. GDP growth is forecast to remain below capacity this year, at about 7 1/4 per cent, as weakening external and domestic demand will both weigh on the economic performance.

Inflation in China, measured by the change in the consumer price index (CPI), fell in the second half of 2011, reaching 4.1 per cent in December from a peak of 6.5 per cent last July. Earlier monetary tightening measures, a moderation in output growth and the recent weakening in commodity prices contributed to the decline in the rate of inflation. Looking forward, weaker economic activity should support a further easing in inflationary pressures, with annual inflation staying below 4 per cent this year. Such a reduction in inflation should facilitate an introduction of monetary policies (such as a cut in bank reserve requirements) aimed at easing credit flows in the economy. We do not expect changes in the central bank policy rate this year unless economic activity slows significantly owing to a significant worsening in net trade and/or a slump in private investment and surge in non-performing loans as a result of a hard landing in the domestic housing market.

The Reserve Bank of India has tightened monetary policy significantly in response to high inflation, which we estimate averaged 9 per cent last year. A sharp depreciation of the exchange rate, which has dropped by about 9 per cent since mid-2011, will keep inflation high this year, forecast to average 8.3 per cent.

There has been a slow but steady appreciation of the yuan/dollar exchange rate throughout the last year. The real effective exchange rate has appreciated by about 5 per cent since the beginning of 2011. If the yuan were to appreciate significantly in future, monetary authorities would be able to put less emphasis on domestic interest rates to effect monetary tightening. Appreciation of the yuan will also help to rebalance the economy, contributing towards a reduced current account surplus as well as reducing growth in foreign exchange reserves, which were valued at US$3.2 trillion (about 38 per cent of nominal GDP) in the third quarter of 2011.

For the past several years the world has been witnessing a gradual internationalisation of the Chinese Renminbi (RMB). Internationalisation means that non-residents as well as residents can use the currency to invest, borrow and invoice outside the home country. The process has accelerated significantly since the subprime credit crunch in 2007, when the shortage of dollars had a huge negative effect on China, as the vast majority of its trade was conducted in dollars. Since 2009 there has been liberalisation of invoicing of trade in RMB and there have been an increasing number of bilateral currency swap agreements allowing Chinese trading partners to settle trade in RMB directly.

Some lessons can be drawn from the liberalisation of the foreign exchange market in Japan in early/mid-1980s, which led to a jump in offshore operations from the mid-1980s onwards (Hoshi and Kashyap, 2001). A significant increase in offshore bond issuance put pressure on the domestic bond market and led to its liberalisation, with domestic banks losing many of the most creditworthy and larger corporate borrowers. Japanese banks instead started to lend to small and medium-sized firms with real estate collateral, and this ultimately led to a banking crisis. This illustrates a possible vulnerability that a rationed domestic bond and bank loan market could face from the development of an offshore renminbi market with easy cross-border flows of Chinese currency. In India, full current account liberalisation was achieved in 1994. However, India remains one of the most closed economies on the capital account, on a similar scale to China.

So far the internationalisation of the Chinese currency has been conducted step-by-step and capital controls in both India and China have been retained. But, it would appear (McCauley 2011) that the Chinese authorities are reducing capital controls gradually and India can be expected to follow a similar path. Relatively undeveloped domestic financial markets are far from ready to cope with foreign inflows and competition. However, over the longer term, removing barriers to foreign capital may help promote competitiveness and improve growth prospects. There are already some loopholes in capital controls and prices in the offshore market are beginning to matter. This raises the issue of how much control the authorities can continue to exert over the process.

Australia and New Zealand

Compared with most other advanced economies, Australia is in a strong economic position, mainly due to its commodity exports to China and South East Asia. This strength is also its biggest weakness since it would be vulnerable to a rapid slowing of the Chinese economy. Although there are some signs of such a slowing, we predict only a moderate deceleration of Chinese growth and, thus, we forecast a favourable outlook for the Australian economy. We predict GDP growth of 2.6 and 3.3 per cent in 2012 and 2013, respectively.

Compared to other advanced economies, Australia has a low government debt ratio of about 30 per cent of GDP and also has not suffered protracted economic weakness. In contrast to the UK, the US, the Euro Area and Japan, interest rates in Australia and New Zealand are not close to the zero lower bound, and monetary policy has remained focused on interest rate policy. Since October, the Reserve Bank of Australia has cut interest rates by 50 basis points in line with monetary stimulus measures in other major economies, and the cash rate currently stands at 4.25 per cent. In Australia, as in other commodity exporters and emerging markets, there has been some use of 'quantitative tightening' measures as opposed to the quantitative easing policies in other advanced economies, in an effort to ease pressure on the exchange rate from high interest rates.

Throughout the 1970s and 1980s, New Zealand's economy suffered from high and volatile inflation of up to 18 1/2 per cent annually. As a consequence, New Zealand was the first country to adopt inflation targeting in 1990. The target band currently stands at 1-3 per cent, with a central target of 2 per cent per annum. Recently there have been concerns about inflationary pressures, as the inflation rate climbed to 3.1 per cent in 2011, just above the maximum threshold set by the Reserve Bank. However, the consumer price index surprisingly declined in the last quarter of 2011 by 0.3 per cent and we forecast a moderation in inflation in 2012 to about 1 1/2 per cent per annum, which makes it unlikely that the Reserve Bank will increase its current cash rate of 2.5 per cent.

We expect a rebound in GDP growth in New Zealand this year, as the economy recovers from the Canterbury earthquake in February 2011, which depressed growth to an estimated 1.6 per cent last year. We forecast growth of 2.8 and 3.4 per cent in 2012 and 2013, respectively, mainly owing to increased domestic demand due to the reconstruction of Christchurch in 2012 as well as strong exports in 2013. New Zealand's newly elected government announced it will make considerable efforts to consolidate the budget deficit, which has climbed to a record high of 8 per cent of GDP, and halt the accumulation of debt which stands at about 45 per cent of GDP.

Russia

Russia's economy has so far proved resilient against the Euro Area debt crisis, as it benefits from high oil prices. In 2011, the Russian economy expanded by an estimated 4 per cent, supported by buoyant domestic demand, which we estimate expanded by more than 8 per cent last year. We project annual growth of 4 and 5 1/4 per cent in 2012 and 2013, respectively. If the EU imposes oil import sanctions against Dan, it is likely that these will be substituted by Russian oil and gas exports, adding a further boost to the country's GDP growth next year. Russia has attempted to move away from using the US dollar as its primary exchange currency. Trade between Russia and China is already conducted using their domestic currencies and Russia has made a similar move towards trade with Iran after the US imposed additional sanctions on the country.

Inflation averaged 8.7 per cent in 2011 which is high for a middle income country. However, year-on-year inflation moderated to 6.1 per cent in December 2011, from 9.6 per cent in January. The dissipation of the food price shock and a good harvest in 2011 will contribute to a further reduction of inflationary pressures. We forecast a significant slowdown in inflation this year, but over the medium term deep-rooted inflation expectations and a depreciating currency will maintain a significant positive inflation differential in Russia over most of the rest of Europe.

South Africa

The speed of economic recovery in South Africa during 2010 gradually slowed over the course of 2011, with output in the third quarter of last year recording a year-on-year rise of just 3.5 per cent, the slowest rate since the first quarter of 2010. Frail external demand, as well as domestic labour unrest, were the main reasons behind slowing economic growth. With global consumer and investment confidence expected to be subdued this year we forecast external demand to remain weak and GDP growth in South Africa to remain below its potential at about 3 1/4 per cent.

In 2011 inflation edged up towards the top of the 3-6 per cent inflation target of the South Africa Reserve Bank (SARB) on the back of high food and energy prices. With inflation base effects expected to improve this year and without a further increase in commodity prices, inflation is expected to ease in 2012. Despite the rise in headline inflation, the SARB kept its repurchase rate unchanged at 5.5 percent, given the weakening of economic activity. Modest fiscal tightening is planned for the next three years so that the national debt-GDP ratio will stabilise, but rapid improvement in the deficit will be held back by weak growth in tax receipts.

European Union

Prospects for all Euro Area members have worsened. We expect that GDP in the Euro Area will decline by 0.2 per cent this year, reflecting a sharp tightening of bank lending conditions across Europe, uncertainty regarding the future of EMU, and fiscal austerity measures introduced in most economies. We forecast that this year output will decline in five members of the Euro Area: Greece, Portugal, Spain, Italy and France. Northern European countries should see somewhat stronger growth, with Sweden and Finland expanding by close to 2 per cent.

Underlying the deterioration of growth prospects in Europe are several factors: the sovereign crisis, the weakness of the banking sector, reduced competitiveness and frail institutions. The sovereign debt crisis has severely affected bank funding and triggered a deleveraging process. In a bid to restore stability of the banking system the European Banking Authority (EBA) has recommended a plan to raise capital buffers of major European banks. By summer 2012 they are required to build up an exceptional and temporary capital buffer against sovereign debt exposures and ensure that the Core Tier 1 capital ratio reaches 9 per cent. Figure 5 shows capital shortfalls in selected Euro Area countries. The overall capital shortfall in the Euro Area amounts to 114.7 [euro] billion (of which 30 billion [euro] reflect shortfalls in Greek banks).

The adjustment will require banks to reduce lending, and the assumption underlying our forecast is that this tightening of credit conditions persists throughout the first half of 2012. The sovereign debt crisis and its interplay with the banking sector have contributed to a significant plunge in confidence. Should this negatively affect the process of debt rollover in Europe, the EFSF funds would need to be used to a larger extent and we expect to see the ECB take on a more direct role before the end of the year. Figure 6 shows the likely borrowing requirement in the Euro Area in 2012.

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Weak growth prospects and the loss of confidence constitutes a major challenge for monetary and fiscal policies. Last quarter the ECB lowered interest rates twice (by 25 basis points in both November and December), to 1 per cent. As in 2009, the monetary authority has also recommenced unconventional measures to restore confidence and support financing conditions. In October 2011 the ECB launched a second covered bonds programme. (5) The purchase of covered bonds, of an intended amount of 40 billion [euro], will be carried out by means of direct purchases under specific conditions: the bonds must be eligible for use as collateral in Eurosystem credit operations; have an issue volume of a minimum of 300 million [euro]; have a minimum BBB- rating from at least one of the major rating agencies; have a maximum residual maturity of 10.5 years; and have underlying assets exposed to private and/or public entities. The ECB continues to conduct refinancing operations. These encompass two longer-term refinancing operations (LTROs), with maturity of 12 and 13 months, allotted in October and December 2011, and six three-month LTROs to be allotted in January, February, March, April, May and June 2012. Furthermore, additional credit measures to support lending and liquidity in the Euro Area money market involve conducting two longer-term refinancing operations falling in December 2011 and February 2012 with an extended maturity of 36 months; reducing the reserve ratio from 2 per cent to 1 per cent; and increasing collateral availability. (6) The ECB, governed since November by Mario Draghi, has provided an important contribution to improving the funding situation of the banks, by injecting liquidity into the single block's economy.

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The sovereign crisis has prompted fiscal policy actions both at the EU and national levels. In December the EU Council proposed a new fiscal compact to strengthen fiscal discipline and impose more automatic sanctions and stricter surveillance. The pact is a move towards a stronger economic union and builds on previous EU initiatives encompassing the enhanced Stability and Growth Pact (SGP), the implementation of the European Semester (a cycle of European policy coordination), (7) the new macroeconomic imbalances procedure, and the Euro Plus Pact aimed at improving fiscal strength and competitiveness of individual members. The new fiscal rule envisages that general government budgets should be balanced or in surplus, with the annual structural deficit not exceeding 0.5 per cent of nominal GDP. Countries will have to introduce a 'debt brake' in their constitution and adhere to the 3 per cent SGP ceiling or face automatic consequences set at the EU level.

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At present, a number of countries are in the Excessive Deficit Procedure (the only exceptions in the EU15 are Finland and Sweden). Our forecast suggests that Denmark, Germany and Italy will comply with the target dates set by the European Commission (2012-13) to reduce their deficits below 3 per cent of GDP. France, Portugal, Netherlands, Austria and Belgium may need to make an increased effort if their deficit targets are to be met on time.

The consolidation of public finances, which will necessarily have a negative impact on growth, could result in an increase in the ratio of debt to GDP over the near term. The structure of fiscal consolidation is thus important. Several countries in continental Europe need to conduct a series of structural reforms (such as for example increasing the retirement age) that would improve their fiscal position and growth in the long run. The plans for consolidation, structural reforms and reforms of the banking sector coincide with a number of forthcoming elections across Europe, and indeed globally. Figure 7 shows dates of elections planned for 2012-13. The elections remain a factor that increases economic and political uncertainty, and makes it more difficult to establish long-term credibility of any major policy changes.

Germany

The final quarter of 2011 saw a contraction in output in Germany of an estimated 1/4 per cent quarter-on-quarter. We forecast a further decline in the first quarter of this year and, after annual growth of 3 per cent recorded in 2011, the German economy is expected to expand by a mere 0.6 per cent in 2012. Underlying the bleak prospects for the German economy are two external factors. The uncertain evolution of the sovereign debt crisis has placed a restraint on spending by both firms and households in Germany and the broader global slowdown is expected to take a toll on exports from Germany, which is the largest and one of the most export-oriented economies of the EU.

The high degree of openness and financial integration of the German economy with other economies in Europe and the world make it very vulnerable to negative external developments. However, a resolution of the Euro Area crisis that restores confidence and brings relief to uncertainty in the banking sector will allow the economy to return to a path of stronger growth, as domestic conditions remain relatively favourable, with the labour market resilient and the banking sector relatively healthy. We expect a slight revival of economic activity in Germany in late 2012 and GDP growth of 1.9 per cent in 2013.

Although the outlook has taken a turn for the worse, the situation in the labour market remains unprecedentedly resilient. The jobless rate fell again in December, hitting its lowest level since unification in 1991. Despite the poor current outlook, German enterprises so far have generally avoided shedding staff. Labour market conditions in Germany remain markedly healthier than in other countries of the Euro Area. Should this year see increased migration from Spain or Greece to Germany, the German labour market is well placed to absorb the shock, and this could constitute one of the factors stabilising the situation in Europe.

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The resilience of German banks has increased over the past two years with the quality and quantity of capital at major German banks improving and the leverage ratio decreasing. (8) However, despite the relatively positive overall assessment of the banking system, German banks face contagion risks arising from the European sovereign crisis and poor general prospects for a number of economies in Europe, and Southern European countries in particular. While the risks emanating from exposures to Greece, Portugal and Ireland are manageable (Bundesbank, 2012), the volume of exposures to Italy and Spain is much greater. (9)

According to the European Banking Authority guidelines (see above) European banks need to increase their core tier capital ratio to 9 per cent by 30 June 2012. Results of a Bundesbank and BaFin (Bundesanstalt fuer Finanzdienstleistungsaufsicht) survey on bank recapitalisation show that German credit institutions have a capital shortfall of 913.1 billion [euro] in total, with six of thirteen institutions reporting a shortfall. Figure 8 shows core tier 1 capital ratios for major German banks. The total capital shortfall of 13.1 billion [euro] includes the sovereign capital buffer for sovereign exposures--see figure 9.

Despite the fact that the liquidity provided by the ECB alleviates some pressure on German banks, risks arising from the sovereign debt crisis are a drag on German banks, which may affect the real economy this year.

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France

France is facing a year of great instability and uncertainty, amid the deepening Euro Area debt crisis and the presidential elections in May. The economic outlook worsened in the final months of 2011 and is expected to remain bleak in 2012. We estimate that French production contracted in the fourth quarter of 2011, and we expect a mild recession, with output declining by 0.2 per cent for 2012 as a whole. Tighter financing conditions caused by banks' recapitalisation needs and rising unemployment weigh heavily on domestic demand. We forecast stagnant consumption and a decline in housing investment of 2.3 per cent this year, with the saving ratio remaining high. Business investment is also expected to decline. Furthermore, the global downturn will cause a slowdown in French exports in 2012, as demand from European partners weakens.

Much will depend on the outcome of the presidential elections. Nicolas Sarkozy aims at greater labour competitiveness and further fiscal tightening, notably through the introduction of a 'social VAT' and a financial transaction tax, even without a European consensus. His main opponent, the Socialist party candidate Francois Hollande, is also in favour of the financial transaction tax, but only at a European level, whilst Marine Le Pen, leader of the populist National Front, advocates more drastic solutions, such as quitting the euro, limiting immigration and setting up protectionist barriers. Standard & Poor's recent downgrade of French sovereign debt from AAA to AA+ prompted little response from the financial market, perhaps because it was widely expected, and thus already accounted for by forward-looking investors. Yet, it has reactivated the political debate, as candidates blame Nicolas Sarkozy for the large budget deficit.

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Italy

The Italian economy fell into recession in the second half of 2011, with a contraction of 0.2 per cent in the third quarter. Government bond yields came under increasing pressure towards the end of the year, and Italian sovereign debt was downgraded by Standard and Poor's in January 2012, along with eight other Euro Area sovereigns. The Italian rating fell from A to BBB+, two steps above junk status, despite a government announcement that the budget deficit is on track with the budget plan for 2011. The new government also introduced new austerity measures to meet its budget targets in 2012-14. The combined measures that were introduced amount to a fiscal tightening of around 980 billion [euro] over three years, or 4.8 per cent of GDP. The Italian government has also started a series of structural reforms to boost competition and spur economic growth.

Recent increases in government bond yields shown in figure 12 pose a risk for the Italian economy. Government interest payments as a share of GDP in Italy are second only to those in Greece (figure 11). While yields eased slightly in January, the Italian government has so far raised around 16.7 billion [euro], compared to a target of 159 billion [euro] to be raised by April. There is a risk that borrowing costs for Italy will increase further if uncertainties persist in the sovereign debt market. The implications of this would be severe.

Prospects for growth in Italy over the forecast horizon are not favourable to the new government, with GDP growth expected to contract by 1.3 per cent in 2012 and 0.2 per cent in 2013. Fiscal tightening and a high cost of credit as well as low growth elsewhere are likely to overwhelm the positive effects of structural reform.

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Box B. Social VAT in France

French incumbent candidate Nicolas Sarkozy has put labour
competitiveness at the centre of his agenda for the presidential
elections. To curb unemployment and restore competitiveness, the
so-called 'social VAT' was at the centre of the debate during the
recent Social Summit between the government, business
representatives and trade unions. This instrument involves a change
in the way social welfare is financed, transferring part of the
burden of social contributions onto the VAT. It aims to raise
competitiveness by reducing direct taxes on labour, compensated by
a rise in VAT in order to maintain the effects on the government
budget neutral. A similar measure was introduced in 1987 in Denmark
and in 2007 in Germany, and has been widely discussed in France in
recent years. (1) Opponents claim the social VAT is regressive, as
it impacts more on low-income households. Our model simulations
below consider only the macro-level impacts of the policy, and
cannot contribute to the debate on distributional effects.

The magnitude of the proposed measures remains under debate. MEDEF,
the largest union of employers in France, suggests that the basic
rate of VAT should rise by 2.4-3.4 percentage points. Sarkozy
recently indicated that he would implement a slightly smaller
policy, and raised the VAT rate by 1.6 percentge points from
October 2012. In order to assess the impact of such a policy, we
run a series of scenarios using NiGEM. The scenario that we
consider is based on the lower bound of the policies proposed by
MEDEF. We raise the rate of VAT by 240 basis points permanently.
This raises revenue by roughly 5.4 billion euro in the first
quarter of the simulation. We apply an equivalent cut to employer
social contributions, so that the ex-ante impact on the budget is
neutral. (2)

The figure illustrates the impact of the simulated policy on key
economic indicators in the first year. We show the effects of the
two policies separately as well as the combined effects. The impact
on GDP growth of the combined policy would be essentially neutral.
However, we would expect a significant impact on the unemployment
rate as a result of the decline in labour costs, as firms can
afford to take on additional labour. Our estimates suggest the
unemployment rate could fall by approximately 3/4 percentage point
in the first year. Inflation would be expected to rise by about 1
1/4 percentage points, with roughly half of the VAT rise passed on
to consumers. The fiscal position would be expected to improve
slightly in the first year (by 0.2 per cent of GDP), as the rise in
employment brings in additional income tax revenue.

Over time, we would expect the decline in real labour costs to be
eroded, as the lower rate of unemployment and rise in consumer
prices pushes up wages and eventually fully offsets the cost
savings from the decline in social contributions. This is
consistent with the model described by Nickell and Layard (1999)
and is also consistent with empirical studies such as Bell et al.
(2002) for the UK. According to our estimates, the stimulus to
employment in the short term would have fully dissipated by 2016.
The rate of inflation would remain slightly elevated for up to
three years, due to the rise in nominal wages, but after the sharp
rise in the first year we would expect the impact on inflation to
be not more than 0.2 percentage points, unless inflation
expectations are allowed to drift.

[FIGURE B1 OMITTED]

A key assumption underlying the analysis that we present is that
when real labour costs fall firms respond by taking on additional
labour, rather than raising profit margins or cutting prices. If
instead firms put all of the savings into profit margins, we would
expect little change in employment and a small negative impact on
GDP growth in the first year. If half of the savings were instead
passed on to consumer prices, this would offset about 20 per cent
of the inflationary impact of the VAT rise. The long-run effects
would be the same in all scenarios, as we would expect real labour
cost to revert to base over time.

NOTES

(1) See Al-Eyd et al. in the April 2006 National Institute Economic
Review for a similar analysis of the German policy and Besson
(2007) for an earlier study on France.

(2) The actual policy under discussion would allocate a small
fraction of the cuts to employee contributions, but here we
allocate the full amount to employer contributions for simplicity.

Spain

Output growth in Spain stagnated in the third quarter of 2011, reflecting weak domestic demand. There is a huge overhang of debt and unsold property from the real estate boom, while uncertainty related to the Euro Area sovereign debt problem has put even further pressure on the economy. As a result we expect the Spanish economy to enter recession this year. This will put further pressure on unemployment, which already stands at the highest level in Europe.

As in Italy, Standard & Poor's decided to downgrade Spanish sovereign debt in January 2012. In addition, the newly elected government made an upward revision for the 2011 budget deficit, which is expected to be 8 per cent of GDP, compared to the 6 per cent targeted by the previous government. However, despite the downgrade and worsening public finance situation, the government has managed to issue bonds with lower yields than at the end of 2011 (figure 12). Since the beginning of this year Spain had raised 18.2 billion [euro] in new debt, of a total of 86 billion [euro] to be raised in 2012 as a whole.

Banks may not be willing to continue heavy purchases of government bonds despite the new 3-year loan facility introduced by the ECB, as they remain undercapitalised and vulnerable to a further rise in bond yields. The banking system in Spain is also highly exposed to the housing market, and house prices have continued to decline. The Bank of Spain's latest Financial Stability Report estimated that about half of the total real estate asset base in the banking system is troubled.

[FIGURE 12 OMITTED]

EU8+2 (10)

Economic activity in Central and Eastern Europe has weakened and become more uneven. Growth in the EU8+2 block as a whole will slow from about 3.2 per cent in 2011 to 1.9 per cent in 2012, with the sharpest slowdowns expected to materialise in the small and open Baltic economies. The slowdown is largely due to significantly weaker import demand from EU15 (11) economies. Exposure to Euro Area banking systems also hampers growth prospects. Banks in Central and Eastern Europe are generally dependent on their parent banks in Western Europe. Figure 13 shows the share of bank assets owned by foreign owned banks in the EU8+2 economies.

Despite the slowdown in growth, most countries are expected to expand this year, with the exception of Hungary. The government of Victor Orban has undermined public confidence by transferring private pension assets to the state, which in Argentina in 2001 was a prelude to their massive devaluation. The government has also adopted a law allowing the early repayment of foreign exchange mortgages at a discount on the prevailing exchange rate. This has led to financial market volatility and an increase in Hungary's risk premium. Regional currencies are susceptible to contagion from a depreciation of the Hungarian forint.

Interest rates in inflation targeting countries remain at relatively high levels compared to the major global central banks: 4.5-7 per cent in Poland, Hungary and Romania, far from the zero bound. As inflationary pressures remain a concern, we do not expect any unconventional monetary policy measures to be applied in the EU-8+2.

[FIGURE 13 OMITTED]

doi: 10.1177/0027950112219001014

ACKNOWLEDGEMENTS

We would like to thank Angus Armstrong, E. Philip Davis, Simon Kirby and Jonathan Portes for helpful comments.

This forecast was completed on 25 January, 2012.

Exchange rate, interest rates and equity price assumptions are based on information available to 23 January 2012. Unless otherwise specified, the source of all data reported in tables and figures is the NiGEM database and NIESR forecast baseline.

REFERENCES

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Barrell, R. and Holland, D. (2010), 'Fiscal and financial responses to the economic downturn', National Institute Economic Review, 211, pp. R51-R62.

Bell, B., Jones, J. and Thomas, J. (2002), 'Estimating the impact of changes in employers' National Insurance Contributions on wages, prices and employment', Bank of England Quarterly Bulletin, 42, 4, pp. 384-90.

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Bundesbank (2011), Financial Stability Review, November 2011

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NOTES

(1) Unlike most central banks it cannot act as a lender of last resort to the government.

(2) Article 104 of the Treaty on European Union expressly forbids the ECB from lending to governments and prohibits the Community from becoming liable for the debts of member states.

(3) Measured as the spread of 10-year government bond yields over those in Germany.

(4) Agency debt includes the direct obligations of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks and MBS guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae.

(5) The first one was launched in June 2009.

(6) By reducing the rating threshold or allowing national central banks to accept additional performing credit claims.

(7) 6-month period every year during which member states' budgetary and structural policies will be reviewed to detect any inconsistencies.

(8) Between spring 2008 and summer 2011 the tier 1 ratio (average for thirteen major banks) increased from 8. 1 per cent to 13.1 per cent (according to Basel II rules), and the leverage measured as total assets to tier I capital dropped from 43 to 33.

(9) The exposure of German banks to sovereign debt is the following: Greece 17.5 bn [euro], Portugal 6.2 bn [euro], Spain 22.6 [euro] and Italy 42.2 bn [euro].

(10) The EU-8+2 block refers to countries that joined the EU in 2003 and 2007, with the exceptions of Malta and Cyprus, for which we do not provide a separate forecast.

(11) The EU-15 block refers to countries that were members of the EU prior to 2003.

Table 3. Asset purchase programme (as of Oct 2011)

 Target level (in trillion
 of yen)

Japanese government bonds with coupons 9
Treasury discount bills 4.5
Commercial paper 2.1
Corporate bonds 2.9
Exchange traded funds 1.4
Real estate investment trusts 0.11
Collateralised loans to financial
 institutions 35

Source: Bank of Japan.