A Deloitte Research publication | 2nd Quarter 2011 Navigating a world of turmoil · 2011-05-20 ·...

A Deloitte Research publication | 2nd Quarter 2011

Navigating a world of turmoil

The global food fight

Japan: Disaster strikes the rising sun USA: The upside risk of black swan events

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Since our last quarterly outlook, the world has been awash with unexpected events. In recent years such events have come to be known as black swans, in reference to the eponymous book. These incidents suddenly and surprisingly change the economic landscape and compel us to shift the outlook accordingly. In this case, political events in the Middle East and the ruinous earthquake and tsunami in Japan have cast a shadow over the global economy. In this issue of our outlook, we explore the implications of both events. In addition, we examine the continuing evolution of the global recovery, including challenges to growth in the affluent markets and the fight against overheating in the emerging world.

We begin with a look at the causes and implications of rising food prices. Siddharth Ramalingam and Pralhad Burli analyze the perfect storm of multiple factors contributing to the unusually large increases in food prices. They offer their view on the impact this will likely have on overall inflation, consumer behavior, government policy and political stability.

Next, Ian Stewart examines the global trend to more skewed income distribution. He looks at factors such as globalization and investment in information technology as contrib-uting to this trend. He also considers the impact on the distribution of wealth, the role of government policy and the impact on economic structures. He concludes that one possible solution to the widening gap could include more investment in education.

Carl Steidtmann then looks at the global implications of the Japanese earthquake and tsunami. Among other things, he focuses on the impact of electricity shortages on the global supply chain for technology products. Then I examine the impact of the crisis on Japan’s economic outlook. This entails both the short-term costs as well as the potential benefits of rebuilding.

Carl returns to look at the outlook for the U.S. economy. He discusses the various “black swans” that are having a significant impact on the economic situation in the United States. These include negative factors like the rise in oil prices following instability in the Middle East. He also looks at positive black swans such as the impact of rising inflation expectations on the end of cash hoarding. This could help to lift credit market activity. Carl concludes that most of the potential surprises in the near term could have a positive effect on growth.

In my analysis of China, I look at the impact of external events on China’s economic fortunes. I also look at factors within the control of the authorities such as monetary and

Global Economic Outlook Q2 2011

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Global Economic Outlook Published quarterly by Deloitte Research

Editor-in-chiefIra Kalish

Managing editorChandra Gajjar

Contributors Pralhad Burli Elisabeth Denison Siddharth Ramalingam Carl Steidtmann Ian Stewart

Editorial address350 South Grand StreetLos Angeles, CA 90013Tel: +1 213 688 [email protected]

currency policy. I conclude with a discussion of longer term dynamics such as demographics and what this means for growth and potential policy decisions.

Elisabeth Denison follows with her quarterly outlook on the Eurozone economy. She notes that, although overall growth in the region is picking up, it remains highly unbal-anced with success in Germany and substantial troubles in the peripheral countries. This creates a conundrum for policymakers, especially regarding monetary policy. She also considers unresolved issues regarding the economic structure of the region and causes for the continuing imbalances.

Ian Stewart then examines the outlook for the United Kingdom. He discusses the unenviable task facing Britain’s central bank. It must navigate an environment of unpleas-antly high inflation combined with declining growth. Yet the bigger and longer term challenge for the UK is to shift from debt and consumption to investment and exports. This transition is likely to be quite bumpy.

Siddharth Ramalingam provides his view on the outlook for India. He discusses how rising food and energy prices create a challenge for policymakers attempting to suppress inflation while maintaining reasonable growth. Despite this, he predicts that growth this year will likely continue to be strong.

I return to focus on the outlook for Russia. Unlike many other major economies, Russia stands to benefit from the rise in energy prices. Not only will this boost export revenue, it will also improve the government’s fiscal stance. On the other hand, high inflation stands to create problems. I also look at the recent proposals from Russia’s president regarding greater transparency and market orientation.

Brazil is my next focus. I look at the impact of inflation and monetary tightening on growth and currency values. This includes a discussion of Brazil’s efforts to stem the inflow of foreign capital. I also consider the potential impact of a changed fiscal policy on interest rates and exchange rates. Finally, I examine the effect of rising energy production on Brazil’s economic outlook.

Lastly, Pralhad Burli examines the diverse economies of the Middle East. Specifically, he considers the outlooks for Saudi Arabia, Egypt and two small Gulf countries – the UAE and Bahrain. Pralhad looks the impact of the current political unrest and the outlook for growth in a world of volatile energy prices.

Dr. Ira KalishDirector of Global EconomicsDeloitte Research

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Topics

The global food fight A rise in bio-fuel production, extreme weather and a wealthier middle class are some reasons behind the increased appetite for food. As the basket of goods gets costlier, governments around the world are battling with high inflation and enforcing export bans to manage supplies. With the global population nearing 7 billion, will current agricultural methods keep pace or are farming techniques nearing their natural limit of productivity?

Weighing in on household wealth The huge rise in wealth inequality has been attributed, in part, to globalization and industrial change. The world’s wealthiest continue to live in the developed world but the sources of wealth are changing. A decreasing fraction of the rich have inherited their money; instead they are either entrepreneurs, part of a dual high-income household or a beneficiary of the house price boom of the last three decades.

Disaster strikes the rising sun: Japan’s impact on the world The brief economic pause caused by the Tohoku earthquake will likely be replaced by a pick-up in economic growth. Financing the rebuilding process will have a global impact; companies worldwide will boost buffer stocks of strategic parts, overseas capital brought home will put upward pressure on global interest rates, the yen will likely appreciate and Japanese imports for construction-related commodities will increase.

Geographies

Japan: Weathering the storm The recent disaster in Japan will have a worldwide impact. In the short run, expect a big negative impact on goods-producing industries worldwide, as Japan produces many inputs used in the electronics, automotive and shipbuilding sectors. Longer term, rebuilding efforts will boost economic growth and could even kindle much-needed inflation.

United States: The upside risk of black swan events In fall 2008, the U.S. economy fell into a liquidity trap. A liquidity trap dissolves when the fear of insolvency is replaced by the fear that cash is becoming a depreciating asset. With commodity prices on the rise, cash is indeed losing favor. As U.S. households and businesses sit on a pile of liquidity, the tinder for a much hotter economy just awaits a match to set it afire.

China: Applying the brakes Authorities have been engineering a slowdown in economic growth for some time now and this appears to be happening. Rising oil prices and a growing older population will help the economy expand at a more sustainable pace. On the downside, excessive investment in the property sector could spell trouble ahead.

Global Economic Outlook 2nd Quarter 2011

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Geographies (continued)

Eurozone: Mind the icebergs The Eurozone recovery has built momentum over the past few months but a few risks still linger. Fringe nations continue to struggle with high unemployment and huge external debt, while core nations show signs of overheating with inflation rearing its ugly head. The emphasis of economic policy will remain on strengthening the regulatory environment and reducing imbalances between member states.

United Kingdom: Growth rebalances The United Kingdom remains on course for an erratic but probably continued recovery. The consumer and government segments will likely shrink as a share of the UK economy, with the hope that a revitalized private sector can take up the slack. Forecasts are thus predicated on a shift toward exports and capital spending.

India: Present murky, future murkier India’s biggest worry over the last year, inflation, ceases to abate. While food inflation trended down, rising crude prices and demand-side pressures threaten to derail growth targets. With the efficacy of simply raising interest rates in question, it seems likely that a combination of both monetary and fiscal policy will have to be exercised in order to combat rising prices.

Russia: Reengineering the path to recovery Bucking the trend, higher oil prices in Russia will likely have a positive economic impact by boosting export and government revenues. But for how long? Sustainable growth depends on how well Russia can move toward a market-driven economy. Recent proposals that include investments in energy production, scaling back payroll taxes and greater transparency are steps in this direction.

Brazil: Inflation and currency concerns Increased commodity costs and the influx of short-term capital have caused higher than desirable inflation but the outlook remains healthy. Robust global demand for commodities, improved manufacturing exports and strong consumer demand will likely emerge as positive drivers. Furthermore, the fiscal conservatism of the new government has led to increased market confidence and could augur well for business spending.

Middle East and North Africa: Balance of power The global economy is at risk of stagnating due to the rapid spike in oil prices. At the heart of the issue is political turmoil in the Middle East. Demands for political reforms, media reforms and constitutional reforms are expected to increase alongside government expenditures as subsidies are doled out to help combat high food prices and unemployment. A drop in tourism and capital flight will likely deepen the unfavorable effect on the region’s balance of payments.

Appendix

Charts and tables GDP growth rates; inflation rates; major currencies vs. the U.S. dollar; yield curves; composite median GDP forecasts; composite median currency forecasts; OECD composite leading indicators.

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Over the past few years, food prices have exhibited a concerning pattern. Prices spiked in 2007-2008, setting off protests in several countries such as Haiti, Bangladesh and Egypt. After reaching a high in June 2008, prices of agricultural commodities fell and seemed to have stabi-lized. However, in the second half of 2010, food prices began to rise sharply again, surpassing previous records by year-end. Countries like China and India are challenged by the impacts of soaring food prices, and there is a real threat that rising food costs may stifle growth and the global recovery. Consumer confidence is already beginning to drop in several countries due to rising food prices.

The soaring cost of food is due to a combination of factors. One reason that has gained much credence is that the demand for food increased alongside the demand for bio-fuels. Volatile energy costs, fears of imported inflation and increased awareness of climate change are likely some of the reasons behind the rapid growth in bio-fuels during the last decade (figure 1).

As a result, more land was cultivated for crops used in the production of bio-fuels. Corn, a major feedstock for bio-fuel, became one of the hottest farming commodities in the United States during 2007. This was done at the expense of soybean cultivation, which declined signifi-cantly (figure 2). In other parts of the world, food crops have been replaced by oilseed and sugarcane. The rise of bio-fuels not only reduced the production of food crops like wheat, it also increased the price of sugarcane, oilseed and maize as competing demands between bio-fuel producers and consumers pushed prices up.

The global food fight by Siddharth Ramalingam and Pralhad Burli

Source: U.S. Energy Information Administration

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Pralhad Burli is a Senior Analyst atDeloitte Research, India

Siddharth Ramalingam is a Senior Analyst atDeloitte Research, India

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TopicsThe global food fight

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These trends are understandable given the policy stance taken by several governments across the globe. In an attempt to mitigate the inflationary impact of rising petroleum prices, and to reduce the dependence on petroleum imports, several countries have set aggressive targets for the use of bio-fuels in transportation. Indonesia, Japan, Brazil and the EU have stated that bio-fuels must supply 10 percent of the energy used in transportation by 2020, while China has set a target of 5 percent. The United States has set an aggressive target of 30 percent by 2030. In order to achieve their objectives, governments have provided support for the bio-fuel sector through a mix of subsidies, tax breaks, tariffs and use mandates. These policy measures have helped alter the equilibrium of the sustainable bio-economy. In the absence of direct policy actions, bio-fuel production would have been lower and the associated rise in certain food prices would likely also have been smaller. Furthermore, while advanced technologies for bio-fuel generation and alternative raw materials (like algae) are being looked into, these develop-ments will have to be commercialized fairly quickly in order to meet country targets.

While the emergence of bio-fuels can explain the rising prices of some agricultural commodities, it cannot explain the spike in prices across a basket of food items. Another possible reason for the rise in food prices has to do with the effect of quantitative easing in some developed countries, especially the United States. Expansionary monetary policy in the United States has been blamed for increased speculation in commodity futures markets as investors chase after real assets and higher returns. However, it is unclear how the rise in the price of futures contracts spills over into the spot market. With no signifi-cant rise in inventories, it is fairly clear that speculation is not leading to a rise in prices in the spot market. That being said, it is likely that rising prices are making price discovery difficult in the spot market and therefore contrib-uting, in some part, to food inflation.

Rising income levels and an associated rise in demand, especially in the developing world, also played a part in the increased prices of food grains. Several countries in Asia have witnessed robust economic growth in recent times and, as incomes have risen, people have begun to consume more of what was previously considered expensive. Between 2000-2002 and 2005-2007, the share of meat,

pulses, fruits, eggs, and milk in the diets of those living in China, India, Indonesia and the Philippines rose 10 percent. This jump in consumption led to the rise in the prices of these products and influenced the bump in overall food prices. The rising demand for sugar and oil has also placed upward pressure on food prices (figure 3). Furthermore, higher demand for oilseeds and soybean for livestock feed in the poultry industry has led to a spike in prices for these food grains. As income levels rise further and the proportion of meat consumption

Figure 3: Dietary changes are pushing food prices higher

Source: FAO

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increases, the demand for cattle and poultry feed will likely keep rising.

Another significant contributor to the current rise in food prices has been extreme weather conditions. Australia experienced droughts in 2006 and 2007 that adversely affected its food grain exports. The recent floods in December 2010 caused massive destruction to the wheat-producing northeastern region. Droughts in Russia and China, and unseasonal rains in India, also resulted in extensive crop damage during 2010. It has been estimated

that about half of the total decline in grain production was due to extreme weather conditions in Russia. Over the past four years, global grain production fell by about 3 percent and wheat production declined by about 6 percent. Since the price elasticity for food grains is quite low, there is much headroom for a rise in prices before consumption habits change. As a result, grain prices have risen sharply.

Governments across the globe have taken strong measures to check food inflation. In late 2010, the Indian govern-ment released 5 million tons of wheat and rice for sale in

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order to rein in food prices. Similar steps have been taken by governments across the globe and these actions have helped to contain inflation to some extent. However, some measures, while helpful for the domestic economy, tend to export inflation. In response to the loss of about 20 percent of its wheat crop, Russia banned the export of wheat in August 2010. While the ban did help stabilize domestic prices, wheat prices in Europe rose sharply. As soon as the ban was announced, the price of a bushel of wheat rose 60 cents – the maximum daily limit allowed by the Chicago Board of Trade. Although the price of wheat fell in the following months, it rose sharply towards the end of 2010 on the back of Russia extending its ban of exports until the next harvest. One unanticipated fallout of the ban of exports has been a decrease in the land area under wheat cultivation. The ban has reduced the incomes of farmers and it is anticipated that the area under wheat production will fall by about 2.3 percent.

A notable trend that has emerged over the last year is the adverse impact food prices have had on overall inflation, especially in Asian, African and South American countries. Coupled with rising petroleum prices, food prices have pushed both consumer and wholesale prices upward. In order to control inflation, some governments have (and several are willing to) raised interest rates. India, for instance, raised its interest rate eight times in the last 12 months. This is not only increasing the cost of capital for industries, but there is also a real fear that producers will pass on rising costs to consumers.

High inflation is also influencing consumers’ saving behavior. Low real interest rates are driving away savings from bank deposits and into other competing asset classes. There is a real fear that deposit growth will slow down, and thereby impact credit availability and growth in the economy. The flow of money into other asset classes

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may also be fuelling imbalances in countries like China and India. Economic losses apart, high food prices have the potential to cause social and political unrest as well. The spike in food prices during 2008 triggered protests in countries like Haiti, Bangladesh and Egypt.

In the broader sense, the biggest question is whether we will be able to feed the world’s population going forward and how much it is going to cost us. Falling yields over the last few decades are raising concerns that current agricul-tural techniques are nearing their natural limit for produc-tivity. The lack of adequate property rights for farmers and the existence of small holdings that preclude efficiencies of scale also reduce the incentives required to stimulate investment in efficient farming. Furthermore, some of the food that is produced, mainly in developing countries, does not reach the plate. Supply-side bottlenecks like poor storage and transport burdens lead to significant losses. For example, much of the food inflation in India is said to have been caused by supply-side bottlenecks. Government investment and the use of cheaper technologies are however anticipated to improve the situation over time.

The recent food price rise also begs the question of how much it will cost to feed 6.7 billion people. Will food prices drop like they did in 2008, or are the days of cheap food over? The answer is both yes and no. The current rise in food prices has largely been due to supply-side factors; extreme weather conditions, the rise of bio-fuels, changes in diets, and government reactions to shortages have all played a part. The relative price of food vis-à-vis other commodities has increased in so much as food inflation is greater than headline inflation. The rise in food prices could well be a temporary phenomenon. However, food retailers who are currently burdened with high costs will likely raise the cost of products on the shelves and not drop prices even if food costs decline. The result is that several food products are likely to be permanently costlier.

Extreme weather conditions, the rise of bio-fuels, changes in diets, and government reactions to shortages have led to the rise of food prices. The relative price of food vis-à-vis other commodities has surely increased in so much as food inflation is greater than headline inflation.

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Weighing in on household wealth by Ian Stewart

Ian Stewart is Chief Economist at Deloitte Research in the United Kingdom

The last hundred years have witnessed two major shifts in the distribution of wealth in the industrialized world. In the early twentieth century through the 1970s, the growth of the state, better schooling, and higher and more progres-sive taxes led to relatively balanced creation and distribu-tion of wealth. Then, since the early eighties, the trend has been dramatically uneven.

In the United Kingdom, the wealthiest 1 percent of the population saw their share of total wealth shrink from 70 percent in 1913 to 20 percent in 1980. But since the 1980s, the trend has gone into reverse.

In the United States too, different parts of the income distribution expanded at roughly similar rates from the end of World War II to 1970. In the early 1980s, however, the U.S. wage structure began a period of widening that has lasted to this day.

Economic and social changes have probably played the most important role in contributing to this trend. Globalization and industrial change have reduced the returns to unskilled labor. Knowledge-based industries such as finance and technology have emerged as the major employers and value creators in the economy. The demand for highly-skilled workers has increased the payoff to employees with a university education, making cognitive skills especially valuable in a knowledge economy. At the same time, lower tax rates have resulted in less progressive tax systems.

Greater income equality between men and women – coupled with the tendency of people to pair up with a partner from a similar background – has boosted the balance sheets of higher income households. So-called

“assortative mating” implies that people usually choose life partners with similar educational and financial back-grounds. The result has been rapid growth in the number of dual high-income households.

Credit Suisse estimates that there are 24.5 million dollar millionaires, or adults with net assets (including housing) of more than $1 million, in the world today. This group, which accounts for 0.5 percent of the world's adult popu-lation (figure 1), owns 36 percent of the world's private wealth. By contrast, the bottom 50 percent of the world's adult population owns less than 2 percent of world's private wealth.

Source: Credit Suisse Global Wealth Databook, October 2010

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Figure 1: Global wealth distribution% of world population at different wealth levels

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TopicsWeighing in on household wealth

0.5 percent of the world's percent of the world's private bottom 50 percent of the less than 2 percent of the

adult population owns 36 wealth. By contrast, the world's adult population owns world's private wealth.

As for the source of wealth, a decreasing fraction of the rich have inherited their money. Most of them are either entrepreneurs or have earned their money through paid work.

Most millionaires are located in the industrialized world – North America and Europe have nearly 80 percent of the world's total (figure 2). About 4 percent of U.S. adults are dollar millionaires; so are 1.3 percent of Europeans. Lately, emerging economies have seen a significant rise in wealth but these countries still rank on the lower rungs in terms of wealthy households. Over the past decade, wealth per adult has tripled in China and more than doubled in India. Nevertheless, only 0.08 percent of Chinese and 0.02 percent of Indian adults are dollar millionaires.

The composition of wealth also varies widely across countries. In developed economies, a large share of wealth is stored in financial assets. In many developing economies on the other hand, a less sophisticated financial services market implies that wealth is mostly stored in non-financial assets. In the United States, financial assets constitute two-thirds of household wealth while, in India, non-financial assets account for 83 percent of household wealth.

The house price boom of the last three decades has significantly boosted the wealth of older households. UK house prices, for instance, increased fourfold in the 20 years to 2007. This has turned some people with modest incomes, including pensioners, into millionaires. Wealth is not always synonymous with high incomes. Around 2.6

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percent of UK adults are dollar millionaires – but only 0.6 percent of adults earn more than £150,000 a year.

Upper-income individuals contribute disproportionately to economic activity and tax revenues. In the United Kingdom and the United States, the top 20 percent of income earners account for roughly 40 percent of consumer spending. The top 4 percent of taxpayers in the United Kingdom account for roughly 40 percent of government's income tax revenues.

The growing concentration of wealth among older house-holds has raised concerns about prospects for younger people. One contributor to the debate is David Willetts, a British MP and minister of state for Universities and Science. In his book titled: "The Pinch: How the Baby Boomers Took Their Children's Future – And Why They Should Give it Back", Willetts argues that subsequent generations will have to confront a future burdened by debt, greater competition for jobs and the burden of

financing the welfare and health benefits of baby boomers.

Yet the divide between the different socioeconomic groups is more fluid than it seems because high and low earners are not static groups. A U.S. study of income mobility found that about a third of taxpayers in the bottom 20 percent of the income distribution ranking in 1996 had made it to the top 40 percent of income earners by 2005. More than half of the richest 1 percent of income earners in 1996 had dropped to a lower income group by 2005.

While many older house-holds are asset-rich, the value of their assets is not

guaranteed to appreciate. Japan's experience over the last 20 years shows that the value of housing and equities can decline sharply and over long periods. America's Great Depression is another example where vast amounts of household wealth were destroyed.

Moreover, the costs facing the older generation are likely to rise. Recently, an adviser to the UK government, Lord Warner, said that the baby boomer generation would have to use its wealth to finance care in old age. Crucially, younger people may have the most resilient asset of all – university education. According to the latest OECD statis-tics, incomes in the United Kingdom for those who have attended universities are 50 percent higher than those with just a secondary education.

The premium paid by employers for those with a higher education has also risen significantly over time. In 2005, a U.S. college degree graduate earned around 70 percent

Figure 2: Distribution of dollar millionaires by geographic region% of the world's dollar millionaires in different geographic regions

Source: Credit Suisse Global Wealth Databook, October 2010

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TopicsWeighing in on household wealth

more than those without one, up from 30 percent in 1980. In the United Kingdom, the return on investment for an individual obtaining university education is around 10 percent, which is higher than the return on UK equities or housing in the last 20 years.

The distribution of wealth and income changes over time. But one durable finding – and a consolation to the

younger generation – is that the returns on education are high. On a 30 year view, higher education probably offers a better return than housing or equities.

References and Research Sources:Income mobility in the U.S.: Evidence from income tax returns for 1987 and 1996, U.S. Department of Treasury, OTA Paper 99, November 2007Lisa Barrow and Cecilia Elena Rouse, “Does College Still Pay?”, The Economists’ Voice, Volume 2, Issue 4, 2005

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Dr. Carl Steidtmann is Chief Economist at Deloitte Research

Disaster strikes the rising sun: Japan's impact on the world by Dr. Carl Steidtmann

In the first of two articles, Carl Steidtmann looks at the impact of the Japanese crisis on the global economy. This is followed by Ira Kalish examining the impact on Japan itself.

The effects of the Japanese earthquake and tsunami will be felt for many years to come in Japan and around the world.

In the short run, the disaster in Japan is a deflationary event. It significantly reduces global demand for a wide range of products and services. It will likely result in slower growth and lower prices worldwide. Japan accounts for 6.2 percent of all U.S. imports and 4.5 percent of exports. Many automobile, semiconductor, medical equipment, telecommunications and machine tool supply chains run through Japan, and they will have to scramble to obtain parts and products. Most of these industries have spare capacity, creating an opportunity for non-Japanese suppliers to step in, and thus, most of these disruptions will likely be short-lived.

Just-in-time inventory management will get more scrutiny from businesses that now find their supply chains unable to adapt to an abrupt interruption. The result could add to global growth as buffer stocks of strategic parts and supplies accumulate. A desire for multiple suppliers could also give a boost to business investment in order to create added capacity.

Financing the rebuilding process will have a global impact. The Japanese yen has already seen a sharp jump in its value, hitting an all-time high against the dollar. The yen is rising as the Japanese repatriate capital to fund the rebuilding process. The G-7 intervention shortly after the

crisis to stem the rise in the yen is, at best, a temporary reversal. The yen is likely to continue to rise, further hurting the position of Japanese exporters and benefitting their global competitors.

With low interest rates at home, Japanese investors aggressively diversified their portfolios globally by becoming buyers of foreign debt. They will likely very quickly become net sellers, bringing capital home to finance rebuilding and putting upward pressure on interest rates around the world. Additional capital repatriation will come from the insurance industry. Faced with at least $25 billion in insured losses, major insurance companies face a significant capital hit. Insurance rates are set to rise, particularly in earthquake-prone areas of the world.

Electricity production in Japan is going to be a challenge for some time to come. There is considerable back-up elec-tricity capacity in Japan but it was used primarily for peak load capacity. When those periods of peak load demand do occur in the future, that capacity might not be there to meet it, resulting in blackouts. These blackouts will make Japanese production somewhat less reliable, creating more opportunities for Japanese competitors and increasing demand for larger inventories of buffer stock.

Once the debris is cleared away, the process of recon-struction will likely begin in earnest, giving a boost to global growth. Japanese imports are expected to recover faster than exports, particularly for construction-related commodities. Commodity prices should rebound quickly. Insurance companies should see a turnaround in their profitability, driven by higher rates. It is likely that the brief economic pause caused by the disaster will be replaced by a pick-up in economic growth.

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Topics Disaster strikes the rising sun: Japan's impact on the world

Finally, the problems with the Fukushima reactors are expected to slow the global push toward nuclear power as more countries take a second look at the risks associ-ated with generating electricity. While it will not be the end of nuclear energy, it will most likely delay the building of many of the projects that are now under consideration. As a stopgap measure, the recent growth in natural gas reserves, coupled with the decline in prices, will likely accelerate the use of natural gas.

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Japan: Weathering the storm by Dr. Ira Kalish

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GeographiesJapan

The earthquake and tsunami that hit Japan in March 2011 caused a human toll that is beyond comprehension. The number of deaths is likely to exceed 25,000, and the number of displaced will likely tally in the hundreds of thousands. However, the economic toll is something that, while uncertain, can be assessed. As of this writing, the value of the physical damage is estimated to be in excess of US$ 300 billion. That is the amount of money that is projected to be spent on rebuilding in the coming few years. As the money is spent, it will have a mildly positive impact on economic growth. Yet, before that positive effect is felt, Japan is likely to suffer a serious decline in income in the next one or two quarters as the disruption from the tragedy stymies economic activity.

Short-term declineConsider the short-term consequences. Japan lost some of its capacity to generate electricity when several nuclear reactors were damaged and shut down. In addition, some parts of the electric grid have been damaged. Therefore, although excess generating capacity is sufficient to make up for the loss of nuclear power, it will take time to get the electricity to customers. Hence, power outages and rolling blackouts are the order of the day. The prefectures affected by the blackouts account for about 42 percent of Japan’s GDP. This has a big negative impact on the ability of goods-producing industries to function. That, in turn, decreases overall economic output as well as export volume. In addition, even if goods can be transported to the coast, ports accounting for roughly 7 percent of Japan’s industrial output were damaged by the earth-quake. They could be out of commission for months.

Notably, Japan remains a very important exporter – despite all the focus in recent years on China’s manufacturing prowess. Japan produces many inputs used in the elec-

tronics, automotive and shipbuilding industries. For example, Japan accounts for roughly one-fifth of global high-technology production. It makes about 40 percent of the world’s DRAM chips that are used in smartphones and other electronic products. It makes much of the steel that Korea’s shipbuilding industry uses. Japan also makes many components used by automotive manufacturers around the world. Factories have shut down due to earthquake damage and unreliable supplies of electricity. A loss of power half way through the process of making semiconductors results in the complete loss of product. Prices of many Japanese electronic products have already risen precipitously. Hence, the prices of some of the final products will rise as well – at least temporarily. This episode demonstrates the surprising fragility of modern, just-in-time supply chains.

While the crisis in Japan initially led to a drop in the price of oil (due to the expected decline in Japanese economic activity), the longer term impact could be quite the opposite. As Japan’s economy recovers, demand will rise, putting upward pressure on the price of oil. Moreover, as some of Japan’s electricity generation switches from nuclear power to liquid natural gas (LNG) and coal, the prices of these inputs will rise as well.

Longer term issuesSometime in 2011, the electricity will be restored, ports will be fixed and many of the bottlenecks will disappear. Of course, the most damaged part of Japan, the north-eastern coast, will take many years to rebuild. Yet, the areas affected by the tsunami were not highly populated and did not account for a sizable share of GDP, so the loss of economic capacity, while notable, will be modest compared to the rebuilding expenditures that will take place.

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History shows that natural disasters often lead to a boost in economic growth because of the large expenditures that take place. In the case of Japan, which is a relatively rich country, there is no doubt concerning the ability to raise the necessary funds. As a result, the rebuilding will indeed take place and will likely boost GDP growth for two to three years.

The Japanese government will probably finance most of the rebuilding while the insurance industry covers the rest. Some observers have raised concerns about the ability to finance this, given Japan’s already large government debt (gross debt of 200 percent of GDP, net debt of 120 percent). Yet Japan has been funding its budget deficit entirely from domestic lenders – unlike many other rich countries such as the United States. In addition, private sector wealth in Japan still vastly exceeds public sector debt. Indeed, the annual surplus of the private sector (net savings of households and businesses) is large enough not only to fund the public deficit but to export capital as well. Thus, financing will not be a problem and will likely not cause bond rates to rise precipitously.

The path that bond rates take depends on how much of the increased debt is funded by the Bank of Japan (BOJ) as opposed to the private sector. One encouraging sign is the fact that the BOJ quickly injected $150 billion in liquidity into the system on the first business day following the earthquake. This showed a willingness to act unconven-tionally in an unusual situation.

An optimal policy for dealing with reconstruction would be for the BOJ to fund the rebuilding process by purchasing the new government debt. This would create a bit of inflation at a time when Japan is suffering from deflation. The problem with deflation is that it discourages consumer and business spending and increases the real value of debt. A bit of inflation would probably rouse consumer spending, boost asset prices, keep real interest rates low and provide support to the economy. On the other hand,

20

a recovery financed by the private sector would also have a stimulatory effect. However, the increase in privately held government debt could partially spook financial markets and therefore lead to higher bond rates.

Regardless of how the rebuilding is financed, it is worth noting that the amount of incremental government spending required is not terribly significant compared to the overall stock of public debt. However, it will be sufficient to significantly, yet temporarily, boost economic growth.

What about the yen?In the immediate aftermath of the crisis, the value of the Japanese yen rose rapidly. This resulted from expectations that some of Japan’s overseas assets would be repatri-ated in order to fund the reconstruction effort. Certainly, this will be true for insurance companies and private sector businesses. In response, the central banks of the G7 countries engaged in a coordinated intervention in the currency markets aimed at suppressing the value of the yen. This was a success and will likely be repeated whenever the yen rises too quickly or too far again. The reason is that an overvalued yen would hurt the competi-tiveness of Japan’s exports. In addition, it would create deflationary pressures at a time when Japan hardly needs such a thing.

Risks to the Japanese outlookPerhaps the biggest risk facing Japan is the uncertainty over potential radiation poisoning. While the public health factor is of utmost importance, the psychological impact on the business environment could be critical as well. Already, many global companies have sent staff home, flights to Japan have been cancelled and products arriving from Japan are increasingly facing scrutiny about their level of radiation. In addition, the food supply chain in Japan has been restricted. What happens next cannot be known, but the possibility of very negative economic consequences cannot be dismissed.

21

GeographiesJapan

Finally, the Japanese experience will probably have a chilling effect on global support for nuclear power in general. If the result is fewer nuclear power plants built in the near future, then global demand for coal, LNG, and oil

will likely increase even more than otherwise. That would lead to increased prices of these commodities, which in turn, would have a negative impact on Japan’s net exports as well as economic growth.

22


USA

A black swan is an event with low probability and high impact. Wars, oil shocks, plagues, revolutions, earthquakes and market reversals are all downside black swan events. Since the first of the year, a flock of black swan events – from the earthquake and tsunami in Japan to the uprisings in the Middle East – have swarmed the headlines. Black swans tend to get pigeonholed as things that can go wrong, but not all black swans are negative.

New technologies and energy discoveries can both be unexpected and positive for their developers and the economy at large. Even negative black swan events like the Japanese earthquake can have a positive silver lining. While much has been written about downside black swans, little attention is paid to the upside black swans that might produce a much better outlook than many are currently expecting.

Positive black swans: Draining the liquidity trapOne potential positive black swan that could take wing is the draining of the liquidity trap that formed during the great recession starting in 2008. A liquidity trap is a rare credit event that makes it difficult for central banks to stimulate the economy through traditional monetary policy. It is characterized by a parabolic spike in the demand for money, driven by a fear of insolvency.

For businesses, the increase in the demand for money is offset on the balance sheet by a reduction in debt, inventories and capital investment. For the consumer, a liquidity trap induces a reduction in debt and an increase in savings. Shifting balance sheets result in reduced consumer spending. These changes in consumer and

United States: The upside risk of black swan events by Dr. Carl Steidtmann

business balance sheets deepen the recession. Prior to the 2008 downturn, the last liquidity trap in the United States formed in the early 1930s. When it broke in 1933, the U.S. economy experienced a sharp, V-shaped recovery. Real growth soared for the next four years, averaging just under 10 percent a year.

In the fall of 2008, the U.S. economy fell into a liquidity trap. Demand for liquidity soared, resulting in significant shifts in the balance sheets of banks, non-financial busi-nesses and households. The collective balance sheet adjustment resulted in an increase of roughly $3 trillion in liquidity and a corresponding drop in business spending, inventories and consumer spending. A liquidity trap is a little bit like a game of musical chairs, with everyone rushing to build up a limited supply of cash reserves for fear of insolvency. As that fear passes, businesses and households can be slow to relinquish their newly created cash hoards, but they eventually do.

Breaking a liquidity trap requires a banking system that is willing to lend and businesses or consumers that are willing to take risks. As the bunker mentality that served everyone so well during the recession begins to pass, the demand for cash declines. The tipping point comes when the fear of insolvency falls and is replaced by the fear that cash is becoming a depreciating asset. With commodity prices on the rise and inflation picking up both in the United States and the developing world, cash is becoming a depreciating asset.

U.S. inflation rates fell sharply during the recession, led by falling prices for energy, food and housing. While housing

23

GeographiesUSA

24


prices are still falling, food and energy prices are expe-riencing a sharp turnaround. At some point, rising infla-tionary expectations will reverse the demand for liquidity. Falling demand for liquidity will produce a significant shift in corporate and household balance sheets.

From cash to inventoriesOver the past thirty years, non-financial corporations have steadily shifted their asset mix from inventories into cash. With the pace of inflation slowing over that period of time, the shift in asset mix made sound financial sense. As the liquidity trap deepened in 2008, the move into cash accel-erated as inventories and capital investment were slashed. That asset mix will change in an environment where inflation is rising. Even a small shift in money preference will have a large impact on business spending for capital investment and inventories.

Non-financial corporate businesses currently hold just under $1.9 trillion in cash and other liquid assets, up from $1.4 trillion as recent as the first quarter of 2009. Total business investment for all of 2010 was $1.4 trillion. Simply maintaining current levels of liquidity would give a boost to business spending on both inventories and capital investment. Returning cash to prerecession levels would more than double the current growth rate of business investment.

Just-in-time inventory management has been viewed as a more efficient use of capital since the early 1980s. In periods of disinflation, this makes good sense for financial management. In a period of rising inflation, the benefit of lean inventories diminishes. The lean manufacturing philosophy will take another hit from the supply chain disruptions coming out of the Japanese earthquake and tsunami.

Finally, business spending is likely to get a second boost from the tax compromise bill, passed by Congress and signed by President Obama just before the end of 2010. In addition to extending both the previously passed Bush and Obama tax cuts, the bill offers businesses two years of accelerated depreciation on capital investment. A reversal of the inventory reduction that took place during the recession would be another significant source of growth for the economy.

Acceleration in consumer spendingRecoveries become sustainable as part of a virtuous cycle. Early growth leads to rising profits, rising profits lead to employment growth, employment growth generates consumer spending, which starts the cycle over again. So far, the breakdown has been at the employment growth segment of the cycle. That may be changing.

24

Source: Bureau of Labor Statistics

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

2001 2003 2005 2007 2009 2011

Consumer prices Producer prices

Figure 1: Consumer and producer inflation ratesYoY%

Source: Federal Reserve Board

Inventories Liquidity

0%

2%

4%

6%

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10%

12%

14%

1960 1970 1980 1990 2000 2010

Figure 2: Non-financial corporations’ changing asset mix Liquidity and inventories as a share of total assets

25

GeographiesUSA

Job growth will be critical to getting households spending again. While job growth in this recovery has been disap-pointing to date, the job market has recently shown some signs of improvement. Initial jobless claims have broken decisively below the 400,000 per week level after stagnating for more than a year between 425,000 and 475,000. In the last two business recoveries, when claims broke down below 400,000, job growth accelerated.

Job creation reduces the demand for liquidity. As job holders feel more secure in their position, they no longer feel the need to accumulate savings against the risk of

a possible layoff. As the recession deepened in 2008, consumers dramatically increased their level of savings. And like businesses, they have continued to hold on to that cash in the recovery. From a low of $127 billion in late 2005, household savings soared to just under $700 billion at an annualized rate in early 2011. In the fourth quarter of 2010 when consumers stopped increasing their rate of savings, real consumer spending rose by 4.0 percent, its fastest pace since 2006. Reducing the rate of savings would translate into a significant acceleration in consumer spending and overall GDP growth.

Recoveries become sustainable as a part of a virtuous cycle. Early growth leads to rising profits, rising profits lead to employment growth, employment growth generates consumer spending, which starts the cycle over again.

26


Technology-driven black swan: Falling natural gas pricesWhile virtually all commodity prices have steadily risen since the start of the recovery, natural gas prices have been falling. This anomaly is due to the application of new drilling technologies that have unlocked sizable new reserves of natural gas in Pennsylvania, New York, Louisiana, Arkansas, Colorado, Utah and the Dakotas. As a result of this expansion in reserves, the price of oil relative to natural gas has soared. It takes roughly 6,000 cubic feet of natural gas to generate the same amount of energy as a barrel of oil. At roughly $6 per 1,000 cubic feet, natural gas is trading at an equivalent of $36 a barrel.

With ample supply of reserves guaranteeing a relatively low price for natural gas, businesses and consumers will likely begin to substitute natural gas for oil. This process, however, will take time and considerable investment to build out the natural gas infrastructure needed to offset this sizable price difference. One of the biggest opportuni-ties is expected to come from electrical utilities building out capacity using natural gas instead of coal. The nuclear accident in Japan will probably further accelerate the move toward natural gas. The other opportunity may likely come from businesses and governments that have large fleets of cars and trucks shifting from gasoline to natural gas. The conversion time and cost here is less than that of electrical generation and the transition would likely have a signifi-

cant impact on reducing the demand for and the price of gasoline.

The economic impact of this black swan shift to natural gas will likely include a reduction in the cost of doing business, giving a small boost to corporate profits; a reduction in the cost of government, producing some budgetary benefit; and an increase in business investment, giving a boost to GDP.

Source: U.S. Department of Labor

Jobless claims Job growth

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Figure 3: Jobless claims and employment growthClaims in 000’s, Job growth YoY%

Source: Bureau of Economic Analysis

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Figure 4: Consumer savings Twelve month moving average, in billions of dollars

Source: Energy Information Administration

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1985 1990 1995 2000 2005 2010

Relative price of oil 1985–2005 average

Figure 5: Relative price of oil to natural gas Adjusted for price per British thermal unit

27

GeographiesUSA

Conclusions and observationsIt was Thomas Carlyle who dubbed economics “the dismal science” after reading the works of Thomas Malthus who predicted that no amount of charity or economic growth could lift the lower classes out of poverty. Since Carlyle’s day, many in the profession still are able find the dark cloud behind every silver lining.

Dark clouds abound on the current economic horizon. Sovereign debt, rising energy prices and unrest in the Middle East are but the more obvious. However, it should never be forgotten that recoveries end in excessive euphoria and over-lending. With the Treasury yield curve steep and Federal Reserve monetary policy still very accom-

modating, the recovery will likely be sustained on rising bank margins and a sea of liquidity.

The surprises, if there are any in this expansion, are more likely to be on the upside than the down. With both households and businesses sitting on a pile of liquidity, the tinder for a much hotter economy awaits a match to set it afire.

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ChINA

China: Applying the brakesby Dr. Ira Kalish

For some time now, events in China have been important drivers for the rest of the world, but lately, events in the rest of the world are driving the economic path for China.

External eventsRecent events in the Middle East have driven up global prices for oil. For China, a net importer of oil, this implies higher import bills and a reduction in the trade surplus. This has two consequences. It means slower economic growth as the contribution of net exports diminishes. This might not be a bad thing at a time when the authorities are attempting to slow the growth of the economy in order to stifle inflation. On the other hand, higher-priced energy could itself be inflationary. Of course, that will depend on how the monetary authorities respond to any inflationary pressures. If they tighten monetary policy further, inflation will be held in check, but possibly at the cost of much slower growth.

In addition, a rise in the price of oil has implications for the exchange rate. One of the reasons behind the upward pressure on China’s currency is that China runs a very large external surplus. Thus, there is excess demand for the currency. China prevents the currency from rising in value by accommodating the excess demand. That is, the authorities sell renminbi by purchasing dollars. This has the effect of preventing a sizable increase in the value of the currency. Clearly, they do this in order to maintain the competitiveness of the country’s exports. Yet, by issuing renminbi, they increase the money supply, thereby adding to inflationary pressures. With a declining trade surplus, there might be less upward pressure on the currency. Hence, China may be able to hold the currency down without creating substantial inflationary pressure.

On the other hand, China appears to be willing to allow some increase in the value of its currency. This is due to concern over the inflationary effects of currency interven-tion. In addition, a rising currency reduces import prices and is, therefore, disinflationary as well. In the past few months, the authorities have allowed the currency to rise at an annualized rate of about 6 percent. Add the fact that China has higher inflation than its principal trading partners, and the real value of the currency is rising faster, at about 10 percent annually. If this continues – and it seems likely that it will – then there will probably be some negative impact on the growth of exports. This, too, will reduce the trade surplus and slow the growth of the economy.

Factors that the authorities can controlChina’s authorities have been raising interest rates and tightening credit conditions for several months, the goal of which is to suppress inflation. Despite rising interest rates, inflation has risen as well. However, inflation appears to be stabilizing at around 5 percent. In February, consumer prices were up 4.9 percent year-over-year, but producer prices were up 7.2 percent. This suggests higher consumer price inflation and/or lower retail margins in the months ahead.

Given the level of inflation, real interest rates (nominal rates minus inflationary expectations) are either negative or close to zero. Hence, there remains a substantial incentive for businesses to continue borrowing. Indeed, in the first two months of 2011, investment in fixed assets was up 25 percent over the previous year. This is a breakneck pace that cannot be sustained indefinitely without creating large imbalances in the economy. Much of this investment is

Geographies

29

China

30


in property and the result is a vast supply of empty resi-dential units and shopping malls. Moreover, investment has accounted for the lion’s share of economic growth recently. However, unless interest rates are raised further or inflation comes down, investment is likely to continue growing at a blistering pace. Thus, for 2011, it seems likely that investment will account for much of the economy’s growth.

One problem with excessive investment in the property sector is that it potentially sets the stage for a correction. A vast supply of property that fails to provide a financial return to its owners implies possible losses for banks. The end result could be a decrease in property prices, a loss of wealth for consumers and businesses, and a contraction in credit creation. This is clearly one of the serious risks facing the Chinese economy.

As for consumer spending, there are competing forces at work. On the one hand, rising wages should be helpful

30

to the growth of consumer spending, but the pace of growth in retail sales has decelerated recently. Specifically, in the first two months of 2011, retail sales increased 15.8 percent over the previous year, but this was down from growth in the neighborhood of 18 percent for most of 2010. Why? Several factors are having a negative impact on the consumer. High property prices have discour-aged middle-income households from purchasing homes. Transactions in the housing market tend to stimulate consumer spending.

Longer term issuesChina is on the precipice of experiencing demographic changes that will likely put a damper on consumer spending. This year, for the first time in decades, the labor force is projected to expand more slowly than the popu-lation. The lagged effect of the one-child policy is now creating an older population and a smaller young popula-tion. Going forward, this implies slower growth in the largest spending cohort, slower economic growth overall,

31

GeographiesChina

and a rising dependency ratio (that is, the ratio of depen-dents such as children and the elderly to workers). The latter could have an upward impact on taxes and pension contributions.

Interestingly, the Chinese government recently issued its latest five year plan, which on the surface, did not appear very different from the last plan. However, the government is anticipating slower growth, and this time they might really mean it. One likely reason is the rapid demographic change taking place in China.

There are other important reasons to expect slower growth in the years ahead. For example, China is becoming a more mature, middle-income country. It is unusual for such countries to grow at 10 to 12 percent. Middle-income countries like Brazil or those in Southeast Asia tend to grow in the neighborhood of 6 to 7 percent. This is because middle-income countries have less low-hanging fruit to pick. For example, when workers move from farms

to factories, there is a huge productivity gain that contrib-utes to strong economic growth. Once that process slows down, economic growth slows as well.

Finally, the authorities’ prediction of slower growth may reflect their concern about the process of transitioning away from an export-oriented economy. Past experi-ence of other countries suggests that the transition to more consumer-oriented growth is often difficult. Thus, although China’s future has many bright elements, it may entail slower overall expansion.

China is on the precipice of experiencing demographic changes that will put a damper on consumer spending. This year, for the first time in decades, the labor force will expand more slowly than the population. The lagged effect of the one-child policy is now creating an older population and a smaller young population.

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EUROZONE

Eurozone: Mind the icebergs

by Dr. Elisabeth Denison

32

Dr. Elisabeth Denison is Senior Economist and Director of Corporate Development & Strategy, Deloitte Germany

Geographies

33

Eurozone

The Eurozone economy has left the recession behind and the recovery has built momentum over the past few months. Germany could reach the pre-crisis level of GDP as early as summer this year – a full year earlier than many had expected. However, as the European steamship ploughs on, icebergs are lurking: Fringe nations continue to struggle with high unemployment in comparatively uncompetitive workforces and huge external debt, while core nations show signs of overheating with inflation rearing its ugly head. The banking sector crisis is not over yet, and the EU was recently forced to tie still more government rescue packages under its newly designed bailout fund in order to keep the euro safe. Meanwhile, adverse external developments are affecting business and consumer confidence, but their long-term economic impact on the Eurozone is likely to be relatively modest.

Recovery and rising inflationary pressureThe Eurozone purchasing managers index (PMI), which reflects manufacturing activity across the major Euro area economies, dipped slightly to 57.5 in March from

February's near 11-year high of 59.0. Overall, the index remains at very robust levels; March marked the 18th month in a row with the index holding above the 50 level that divides growth from contraction (figure 1). The indicator suggests that the Eurozone recovery will continue in the near term and may even gain some momentum in the manufacturing and services sectors.

Source: Bloomberg

Eurozone PMI manufacturing Eurozone PMI services

30

35

40

45

50

55

60

65

2006 2007 2008 2009 2010 2011

Figure 1: Eurozone PMI

34


However, because the recovery remains highly uneven with a stark contrast between core and fringe nations, several risks remain. One of them relates to inflation and interest rate policy. In the PMI survey, the output price index in March rose to its highest level since tracking began in November 2002. Overall, reported Eurozone inflation has risen to 2.4 percent, with core inflation (excluding food and energy) standing at 1.1 percent (figure 2).

In an environment of fast growth and falling unem-ployment, as seen in the core nations, there is a great danger that global food and energy price inflation starts feeding through to higher core prices and wage demands rise. Already there are signs of more union activity in Germany, with rail and service unions exerting pressure on tariff talks. The rapid pace of expansion in core countries and the related inflationary danger will influence decision-making at the ECB in coming months. Indeed, Commerzbank analysts calculate that, following the guidance of the old Bundesbank approach to policy, interest rates in Germany would have been approaching 5 percent in March in contrast to the 1.1 percent prevailing.

Unfortunately for the ECB, the Eurozone is not uniformly experiencing growth and inflationary pressures. Fringe nations continue to struggle with high unemployment

and wage tendencies that are diametrically opposite to the core. This is partly rooted in history. In the past 10 years, wages in countries like Spain, Italy and Portugal rose faster than output, thereby eroding competitiveness through rising unit labor costs. On the other hand, core nations stuck to a strict reform process holding labor costs in check (figure 3).

Now the process is reversing; core nations are starting to face wage pressure as their economies rebound, while fringe nations are forced to adjust wages downward in a bid to regain competitiveness. In the private sector, there will likely be some resistance to these endeavors in nations like Italy or Spain where union penetration is very high. In the public sector, wage reforms have already been implemented in many nations as part of austerity packages over the past year. The average government indebtedness in the Eurozone has risen by over 20 percentage points in the past three years, from around 65 percent in 2007 to 85 percent in 2010 (figure 4). Now that the worst of the crisis is over, Brussels is exerting pressure on Eurozone members to get back into compli-ance with Maastricht rules.

The average Eurozone government deficit is forecast to fall from 6.2 percent of GDP in 2010 to 4.6 percent in 2011 and 3.7 percent in 2012. One could in fact argue

Figure 2: Eurozone inflationYoY%

Source: Eurostat

Headline inflation Core inflation (ex energy and unprocessed food)

-1%

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97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

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Germany Belguim Portugal Ireland Spain Italy Greece

Unit Labor Costs Avg. 2000-2010 (in %)

Figure 3: Unit labor costs in select Eurozone countries

35

GeographiesEurozone

that, against global inflationary pressure, there will be a deflationary impact from shrinking public sectors in Europe, with massive stimulus falling away. Eurozone GDP growth is forecast to slow moderately in the second half of this year and into next year, averaging 1.7 percent in 2011 and 1.5 percent in 2012. The worst case scenario for Europe would be to fall into a prolonged period of stagflation, with little to no growth in the real economy, while at the same time rising food and energy costs are pushing up overall inflation. However, mainstream forecasts do not rate the probability of such a scenario very high currently.

The industrial core of the Eurozone is likely to remain a growth driver in the coming years, thereby satisfying strong demand from emerging nations, particularly in Asia. External events – such as unrest in the Middle East and the calamity in Japan – might temporarily affect business and consumer confidence, but should be of only limited importance in light of the longer-term economic prospects for the Eurozone. Meanwhile, the emphasis of economic policy in the EU will probably remain heavily focused on strengthening the regulatory environment and reducing imbalances between member states of the Eurozone.

References and Research Sources:European Commission Interim Forecast, March 2011Euro-Peripherie vor der Lohnrevolution, Commerzbank Research, March 2011Eurozone: Recovery Amid Huge Internal Disparities In 2011, BMI January 2011Business Europe, EIU March 2011

Figure 4: Government debt % GDP

Source: IMF

20

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160

Eurozone Germany France Ireland Greece Portugal Spain

2000 2002 2004 2006 2008 2010 2012

36

United Kingdom: Growth rebalances by Ian Stewart

UK

37

GeographiesUK

• Momentum of the recovery has slowed

• Inflation is well above the Bank of England’s target

• UK interest rates seem likely to rise by the middle of this year

The UK recovery unexpectedly went into reverse during the fourth quarter of 2010, with the economy contracting by 0.5 percent. While severe winter weather was partly to blame, even underlying growth was estimated to have been flat in the fourth quarter, with these trends raising concerns about the pace of the UK recovery. This weakness pre-dates the onset of major fiscal tightening in April and also the sharp rise in the price of oil, which has further squeezed consumer incomes. Consequently, consensus or market forecasts for UK growth have drifted down in recent months (figure 1).

Consumer confidence waned in the last year and is running at levels normally associated with recessions. After inflation, changes in taxation and national insurance,

Figure 1: UK growth consensus forecasts 2011 & 2012YoY%

Source: Consensus forecasts from The Economist

1.5

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2012 growth forecast

2011 growth forecast

Mar 10 May 10 Jul 10 Sep 10 Nov 10 Jan 11 Mar 11

38


shrink the UK’s budget deficit and to bolster the private sector by raising the rates of return on capital.

The corporate sector is in a very different position to consumers and government. Corporates shed bank debt aggressively during the downturn, relying on internally generated funds, equity raising and corporate bond markets to keep them going. As a result, UK corporates have reduced bank debt by 18 percent over the last three years. In fact, profits have rebounded strongly in the last year; on average, profits for FTSE 350 companies rose by 37 percent. Over the next three years, the OBR expects corporate profits to grow far faster than wages. This would spell a rise in the company segment of GDP and a decline in the consumer share.

A profitable, reviving corporate sector is likely to invest more and borrow more from banks. Recent surveys conducted by the Bank of England show that banks are seeing growing demand from corporates for borrowing. The Deloitte CFO Survey* reports that UK CFOs no longer think that the corporate sector is overleveraged and suggests that CFOs are planning to increase borrowing. Some are already doing so. Last year saw a surge in corporate borrowing through the bond market. Investment-grade corporates were able to borrow at spreads of just 1 percentage point over government bonds, suggesting that both the investor and corporate appetite for credit is alive.

If the recovery is to be maintained, corporates will have to start spending this capital – on hiring, capital spending and M&A. There is some evidence that this is starting to happen. In the last year, the private sector created more than 428,000 jobs, far more than the 132,000 job losses seen in the public sector. Business investment rose by 13 percent over the last year, while manufacturing output increased by 5.5 percent, the fastest rate in 16 years.

Certainly the OBR’s forecasts for a continuing recovery in the UK economy are predicated on a marked shift

the income of an average UK employee has fallen by 3.7 percent in the last year. With more tax hikes coming in April, the squeeze on incomes is likely to increase. The governor of the Bank of England, Mervyn King, recently warned that UK consumers face the severest squeeze on real wages since the 1920s. Weakness in consumer incomes spells a prolonged period of slower growth in consumer spending.

In March, the independent Office of Budget Responsibility (OBR) forecast that household spending would rise by an average of 1.2 percent over each of the next three years. This is less than half the rate of growth seen in the decade before the credit crunch.

Over the coming years, the consumer and government segments will likely shrink as a share of the UK economy. Slower growth in consumer spending and an outright contraction in government expenditures are symptoms of the rebalancing of UK growth (figure 2). The government's hope is that much of the slack will be taken up by a revital-ized private sector. The Chancellor's principal aims are to

Figure 2: Composition of UK growth: Before and after the recession YoY%

Source: Office for Budget Responsibility forecasts & ONS

-2%

0%

2%

4%

6%

8%

10%

2011–2015 (OBR forecasts) 1998–2007

Business investment

Exports GDP Consumerspending

Governmentspending

*Deloitte UK CFO Survey, 1st Quarter 2011

The Deloitte CFO Survey was conducted by Deloitte LLP, the UK member firm of DTTL

39

Geographies

in activity toward exports and capital spending. Over the next three years the OBR expects exports and business investment to rise by an average of 8 percent a year – almost twice the pre-recessionary trend rate.

The Bank of England faces an unenviable task as it confronts a slow recovery and unexpectedly persistent inflation. In 2010, the United Kingdom had the highest inflation rate in any major industrialized economy, a perfor-mance it seems likely to repeat in 2011. In the 12 months to February, UK CPI inflation rose by 4.4 percent, more than twice the Bank of England’s 2 percent target rate. The central bank and most economists believe that rising UK inflation reflects transient factors like higher commodity prices, sterling weakness and a rise in VAT, and that inflation is likely to fall sharply next year.

Financial markets now assume that the Bank of England will likely raise interest rates by the middle of 2011. But while interest rate expectations have risen over recent months, the big bet being made by markets continues to be that interest rates will remain at historically low levels for a long time to come (figure 3). In the United Kingdom, for instance, base rates are expected to rise to 3.6 percent by early 2013 – but that would leave them well-below the average rate of 5.0 percent seen in the 10 years to 2007.

The United Kingdom remains on course for an erratic but probably continued recovery. Rebalancing growth away from debt and consumption toward investment and exports is likely to create more sustainable growth. But the politics of such a recovery, in which the government and consumer take a back seat and the corporate sector thrives, may not be easy.

UK

Figure 3: Interest rates expectations YoY%

Source: Datastream

0%

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Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11

Bank of England’s base rate

Market expectations:

Dec 2011

Market expectations:

Dec 2015

The governor of the Bank of England, Mervyn King, recently warned that UK consumers face the severest squeeze on real wages since the 1920s.

40


India: Present murky, future murkierby Siddharth Ramalingam

INDIA

The positive news and healthy outlook announced in the Union Budget of India (“union budget”) have brought cheer to both Indian markets and the economy at large. However, India’s biggest challenge over the last year, inflation, ceases to abate. While food inflation trended down from last year’s highs, rising crude prices and a more generalized inflation threaten to derail the government’s plan of achieving about 9 percent growth in the next fiscal. If current inflation levels transform into inflation expecta-tions as the new normal, the government and its agencies may face a challenge trying to rein in inflation without severely affecting growth.

Inflation – a “new normal”?Headline inflation remained above the 8 percent mark in the first two months of 2011. The main driver of inflation thus far – food prices – cooled to 9.5 percent in the week ending March 19. This is a significant fall from nearly 20 percent a year ago. While the harvest of winter crops like wheat, mustard and pulses are expected to exert downward pressure on food prices, a seasonal increase in the price of fruits, vegetables, meat and dairy products is expected to keep food inflation around the 8 percent level in the short term. Looking farther out, expectations regarding the monsoons in the second half of the year will play a strong role in how prices move.

Food price inflation apart, India could well experience the effects of an oil-price shock if oil prices continue to rise. Political instability in the Middle East and a payments crisis with Iran are causes for concern. While petrol has been fully deregulated and prices have been trending upward in the last few months, diesel prices remain artificially low as the price is decided on by an empowered group of ministers. Diesel is estimated to be selling at about 10 rupees below the actual market price. How long the

exchequer will be able to continue subsidizing diesel remains to be seen. The trade-off is a challenging one: a high fiscal deficit versus higher inflation.

Although headline inflation hovered around the 8 percent mark, the food price increase was not the only culprit for the climb in overall inflation. Non-food manufactured product inflation, an indicator of demand-side pressures, is rising as well suggesting that other forces could drive inflation going forward. Non-food manufactured product inflation rose from 4.8 percent in January to 6.1 percent in February. This new trend is causing some consternation for central bank authorities. There is increasing fear that both consumers and producers will accept the current rate of inflation as the new normal. If this does happen, the central bank fears that inflation will only rise further as inflation expectations will probably not fall below the new normal that easily.

Industrial growth, credit growth and interest ratesAfter slowing to a 20-month low in December 2010, industrial production grew 3.7 percent in January 2011. The production of capital goods weighed heavily on the sluggish performance as the sector logged an 18.6 percent decline during the month. Interestingly, consumer durables and consumer non-durables recorded growth rates of 23.3 percent and 6.9 percent respectively, indicating that domestic demand is still quite robust and that the fiscal stimulus program has indeed succeeded in encouraging spending. The purchasing managers index (PMI) for March came in at 57.9 signifying steady growth in manufacturing for the past 24 months. On the face of it, the positive movement in industries bodes well for economic growth. However, growth despite aggressive interest rate hikes by monetary authorities suggests that consumer demand is still very strong and could very well fuel demand-side inflation.

41

GeographiesIndia

In 2010, increasing demand for loans from public and private sector banks was viewed upon favorably. However, credit offtake and deposit mobilization figures for the year ended December 2010 are a little concerning in more ways than one. Credit offtake grew by 23 percent, while deposit growth was only about 16 percent. This mismatch between deposit growth and credit growth could poten-tially affect liquidity in the economy going forward. The central bank is also worried that despite increasing deposit

rates, high inflation is keeping the real rate of interest low, thereby drawing money away from deposits and into other asset classes. This, coupled with the increases in non-food credit is also likely fuelling the rise in asset prices across the country.

The central bank continues to re-iterate its commitment to controlling inflation, and has gone so far as to say that it is better to trade some growth for lower inflation now

42


rather than foregoing growth completely sometime in the future. With food prices yet to be tamed, oil-price based inflation looming large and demand-side inflation threatening to spike, it is likely that the central bank will increase interest rates in the coming months. The bank has already increased interest rates eight times since March 2010. However, the efficacy of simply raising interest rates remains to be seen; monetary policy has to be exercised in tandem with fiscal policy.

FDI and the external frontIndia's merchandise exports surged 50 percent in February from a year earlier, largely on the back of improving global demand. Exports in February came in at US $23.5 billion. For the period from April 2010 till February 2011, exports were $208.2 billion. Since this is well above the govern-ment’s target of $200 billion, estimates for the year have been revised upward to $225 billion.

It is likely that India will carry the buoyancy in exports into the new financial year. India signed a comprehensive market-opening pact with Japan in February. Over the next ten years, India and Japan will eliminate tariffs on 90 and 95 percent of goods, respectively. Recent develop-ments in Japan notwithstanding, bilateral trade between the two countries could rise to US $25 billion by 2014. The India-EU free trade agreement (FTA) and the trade agreement with Thailand are also close to being finalized.

Foreign direct investment (FDI) during the last fiscal year was disappointing. During the 11 month period from April 2010 through February 2011, FDI fell 25 percent to $18.3 billion. The trailing off of FDI in the last year led the finance minister to proclaim during his budget speech that changes in India’s FDI policy were imminent. In the first week of April, the government scrapped a controversial rule that had prohibited foreign companies from setting

43

GeographiesIndia

up wholly-owned subsidiaries in a field of business where they were already jointly operating with a local partner without prior permission of the local partner. This change in FDI policy is expected to bring substantial amounts of investment into the country. It is likely that the government will announce further updates to the FDI policy as the year rolls on.

Long-term concernsThe finance minister once again announced that India is set to grow over 9 percent in the new fiscal year. However, the cheer is not shared by everyone. Analysts have tempered India’s growth forecast for the new fiscal year from around 8.5 percent to 8.3 percent. Given India’s monetary and fiscal concerns, uncertainty about the rate of global recovery, political instability in the Middle East, and rising commodity and food prices, it seems difficult to assert with any certainty that India will grow faster than

it did in the last fiscal. India, for now, is progressing along fairly well.

44


Russia: Reengineering the path to recovery by Dr. Ira Kalish

RUSSIA

Current economic situationEvents in the Middle East that have resulted in higher oil prices are leading many analysts to make downward revisions to their forecasts of economic growth around the world. However, this is not the case in Russia. Higher oil prices are likely to have a positive impact on Russia’s economic performance in 2011. Unless oil prices climb high enough to create a global recession and significantly reduce demand, Russia’s export revenue is expected to expand while government revenue increases. This will have the effect of reducing the budget deficit, which in turn, could have a beneficial impact on interest rates. The result could be a boost to business investment. On the other hand, higher oil prices could have an inflationary impact. This would not be helpful at a time when inflation is already uncomfortably high.

Acceleration in growth will certainly be welcome given the recent performance. After a very deep recession in 2009, growth in 2010 was somewhat disappointing. The summer drought dampened third quarter growth. By the fourth quarter, analysts expected a significant increase. Instead, growth came in at 4.5 percent for the quarter and 4.0 percent for the year. The fourth quarter figure was lower than many observers expected. Part of the problem was that rising inflation dampened real wage growth, thereby having a negative impact on consumer spending.

In the first few months of 2011, the economic perfor-mance appeared to be deteriorating. In the first two months of the year, real disposable income declined and the unemployment rate rose. The drop in income was probably exacerbated by the increase in the payroll

tax that took effect in January (more about this later). In addition, fixed asset investment declined. Lastly, industrial production also dropped as businesses evidently prepared for a deceleration in demand.

Aside from the effect of rising oil prices, the prospects for a better economic performance are not terribly good. One factor is that much of the growth in 2010 was related to inventory replenishment. Clearly, that cannot continue indefinitely. Therefore, maintaining a decent performance will require a boost to final demand. Higher oil prices will help by holding the lid on taxes and increasing export volumes. In addition, if prices are perceived as permanently higher, it could stimulate increased investment in energy production capacity. On the other hand, high inflation will hurt real wage gains. In addition, higher payroll taxes will hurt, unless they are repealed as proposed by the President (see below).

Medvedev’s proposalsThe speed at which Russia can grow in the longer term will depend on the economic structure. President Medvedev would like Russia to achieve the very high rates of growth that are more typical of other BRIC economies. Volatile energy prices aside, Russia will have to reform its economy to stimulate greater and more efficient investment. As such, proposals were recently vetted.

Specifically, President Medvedev gave an important speech at the end of March in which he called for a number of economic reforms aimed at boosting the market economy. First, he called for the removal of government ministers from the boards of directors of state-owned or partially state-owned companies. His reasoning was that the

45

GeographiesRussia

46


presence of government officials on such boards creates a conflict of interest and injects politics into business decisions. This represents a reversal from the policies intro-duced by Vladimir Putin.

Second, Medvedev called for incentives for foreign invest-ment; specifically, he called for more foreign investment in the energy sector. This would represent a significant change from the past decade’s precedent of discouraging foreign investment in energy. Given that energy production has been stagnant due to inadequate investment, this new policy offers the potential for increased investment and output.

Third, Medvedev suggested scaling back the payroll taxes that had recently been increased to help pay for rising retirement and health care costs. He said that the higher taxes were burdensome for businesses. Prime Minister Putin replied that the payroll taxes should not be cut if it means higher excise taxes on vodka.

Finally, Medvedev called for greater transparency concerning financial information about publicly-traded companies. Specifically, he wanted minority shareholders of government-controlled enterprises to have access to information about company performances. This is clearly aimed at creating a more efficient market for capital. Presumably, the goal would be to ensure that financial intermediation leads to the most efficient use of capital, thereby leading to faster economic growth.

The importance of these proposals is that they suggest an interest in creating a more market-driven economy rather than one led by state diktat. It is clear that there is a differ-ence of opinion about these issues at the highest levels of Russian government. How this debate is ultimately resolved could have important implications about the future growth and the structure of Russia’s economy.

The speed at which Russia can grow in the longer term will depend on the economic structure. President Medvedev has said that he would like Russia to achieve the very high rates of growth that are more typical of other BRIC economies.

47

GeographiesRussia

48


Brazilian inflation is registering higher than the 4.5 percent that the central bank had targeted. Instead, inflation is running in the neighborhood of 5.5 percent. The Brazilian Central Bank (BCB) now expects to hit its inflation target in 2012 rather than 2011. This suggests that commodity prices have played a role in boosting inflation temporarily. Yet it does not seem likely that the tightening of monetary policy, underway for the past year, will continue for much longer. Instead, the BCB will have to wait for the lagged effect of tighter policy to take effect. As is often the case, this is one of the hazards of monetary policy: It is difficult to know when to stop tightening before the impact is actually felt.

On the positive side, the likely tightening of fiscal policy by the new government will play a role in the decision by the BCB to slightly relax policy. Fiscal tightening (spending reductions and/or tax increases) will have the effect of constraining overall demand, thereby reducing the economic overheating that tight monetary policy was designed to offset. In addition, tighter fiscal policy may have the effect of pushing interest rates downward by reducing government borrowing requirements. This would do two positive things. First, it would reduce capital costs and stimulate interest-sensitive economic activities, espe-cially business investment. Second, lower interest rates will remove some of the upward pressure on the currency. This is critical as Brazil has suffered from an overvalued currency at a time when the country’s exports are otherwise becoming more competitive.

Preemptive action on inflowsBrazil’s government is not waiting for lower interest rates to discourage the inflow of portfolio funds. Instead, it has increased the tax on inflows of short-term portfolio capital from abroad. The tax was originally imposed over one year ago in order to stem the massive inflow but that move was evidently not as successful as intended. Indeed, the government reports that inflows in the first quarter of 2011 were actually 42 percent higher than inflows for

Brazil: Inflation and currency concernsby Dr. Ira Kalish

BRAZIL

all of 2010. Thus, inflows are accelerating. It is not yet clear whether increasing the tax from 5.38 percent to 6.0 percent will necessarily have the desired effect.

The inflow of short-term capital has created many problems. It has encouraged credit growth and, conse-quently, contributed to money supply growth and inflation. Yet tighter monetary policy – by boosting interest rates – has had the perverse effect of also boosting the inflow of short-term capital. It is, in a sense, a vicious cycle. The tightening of fiscal policy, however, is most likely to have a beneficial effect as it could lead to lower interest rates.

Do they speak Dutch in Brazil?One problem for Brazil is the euphoric attitude of investors about prospects for energy exports. Rising energy prices are making Brazil more attractive given its vast untapped energy production potential. This is a preemptive Dutch disease. That is, when a country becomes dependent on the exporting of a commodity whose price is rising, there is often an increase in the value of the country’s currency. This causes non-commodity exports to lose their competitive advantage and makes the economy even more dependent on commodity exports – and vulnerable to the volatility of commodity prices. The current rise in the Brazilian real portends a future Dutch disease for the South American giant.

OutlookDespite the currency and monetary policy travails, Brazil’s overall outlook remains good. While growth in 2011 will be considerably less than the China-like growth of 2010, it is expected to remain relatively good. Brazil continues to have many positive drivers. These include rising global demand for the many commodities that Brazil exports, improved manufacturing exports and strong consumer demand. In addition, the markets have been surprised by the fiscal conservatism of the new government. This has led to increased market confidence and could portend improved business spending as well.

Geographies

49

Brazil

50


Middle East and North Africa:Balance of powerby Pralhad Burli

MIDDLE EAST AND NORTh AFRICA

It is an historic period for several countries in the Middle East and North Africa. Local protests and political turmoil have the potential for very negative effects on economic prospects both within the region and globally. The magnitude of the current protests and the fear of a contagion could translate into a large spike in oil prices that could derail the global economy. At this point, the likelihood of a double-dip global recession is remote. However, if oil prices increase significantly, the possibility of several economies stagnating or even contracting cannot be ruled out.

Historically, a large spike in oil prices preceded at least three of the last five global downturns. Ever since the protests in Egypt gathered momentum, oil prices have been volatile. The prolonged turmoil in Libya exacerbated matters further by constraining two-thirds of the country’s output. The reasons behind rising oil prices range from higher stock-piling, to supply-side constraints, to the development of a higher risk premium. By and large, an unstable political environment in this region does not augur well for the recovery of the global economy.

Saudi ArabiaAmidst regional turmoil, Saudi Arabia also experienced some small-scale protests in its Shia-dominated eastern province. The government, however, responded quickly and managed to dampen the fervor of angry protestors.

A lavish spending program and unemployment benefits totaling US $36 billion – nearly 8 percent of GDP – was announced in the hope of appeasing demonstrators, at least temporarily. While the fear of a resurgence has abated, much depends on how neighboring economies such as Bahrain and Yemen emerge from the wave of public dissent.

The increased stimulus will likely support GDP growth in 2011. Domestic consumption seems bound to pick up and could emerge as a key driver for growth. Increasing levels of urbanization, higher disposable incomes and a large number of Muslim tourists visiting the country to take part in the Hajj and Umrah pilgrimages augurs well for the retail sector. Saudi Arabia’s young population will also likely provide a boost to the consumer electronics and automobile sectors in 2011. Increased oil output to help offset the shortfall from Libya’s supply will bolster revenues in the petroleum sector. Furthermore, employment in non-oil private industries has picked up in recent months. Both output and new order growth have been strong. Saudi Arabia’s economy is likely to grow between 4 and 4.3 percent in 2011.

With over US $440 billion in foreign reserves, the govern-ment has substantial financial resources. Moreover, the recent spurt in oil prices allows Saudi Arabia to easily absorb higher fiscal expenses. The public sector will likely

Geographies

51

Middle East and North Africa

52


drive consumption and investment during 2011. However, private sector activity may gather pace in early 2012.

On the other hand, high levels of unemployment are a real concern in Saudi Arabia. Estimates suggest unemploy-ment levels as high as 10 percent whereas the jobless rate among youth is even higher at 27 percent. Furthermore, high levels of inflation will likely exacerbate conditions – estimates range between 5.1 and 5.4 percent in 2011. Rising food prices, higher rental costs and loose fiscal policies stimulating domestic demand are likely to fuel inflation in the next year.

Overall, Saudi Arabia is probably better placed than some of its neighbors to deal with the changing political climate. However, demand for labor market reforms, improvements in education and growth in the private sector are gaining prominence. If the political turmoil in Bahrain escalates and spills over into the oil-rich eastern province, Saudi Arabia’s economic growth could face headwinds.

EgyptFollowing the resignation of President Hosni Mubarak, Egypt will likely face several challenges during the transi-tion to a new form of government. The lack of strong government institutions and political parties could destabi-lize the country. Consequently, several downside risks loom large.

The economy appears to have stagnated. Consumption and private investments have declined. Consumer and business confidence has dwindled. Disruptions and strikes at factories are common. As a result, industrial produc-tion has fallen. GDP growth will take a hard hit, at least during the first half of 2011. If the political situation fails to stabilize, the slowdown in growth may extend up to the end of the year. In 2010, Egypt achieved a relatively strong growth rate of 5.7 percent. Consensus estimates for GDP growth in 2011 range between 1.5 and 2.5 percent, a sharp decline from pre-crisis forecasts.

53

GeographiesMiddle East and North Africa

Given the uncertainty, large portfolio outflows are likely in the near term. Furthermore, foreign direct investment (FDI) may be postponed until the political environment becomes more stable. Capital flight coupled with a decline in FDI is likely to have an unfavorable effect on Egypt’s balance of payments. Meanwhile, a significant drop in tourist inflows will likely widen the current account deficit. Employment will also be adversely affected by a slowdown in the tourism sector. On the positive side, an increase in global demand for natural gas may provide a fillip to the hydro-carbons industry and boost revenues.

In 2011, tax revenues are likely to decline. A drop in retail trade will probably result in lower sales tax revenues. Customs and excise duties are also expected to decline. In addition, higher government expenditure on subsidies, unemployment benefits and wage hikes will likely push the budget deficit beyond 10 percent of GDP. Furthermore, excessive government spending would probably crowd out private investments by increasing interest rates.

Supply chain disruptions and shortages of essential commodities have pushed inflation further up. Owing to rising food and fuel prices, inflation is likely to range between 13 and 14 percent in 2011, up from 11.9 percent in 2010.

Much depends on how Egypt manages the transition. If the political environment stabilizes, consumer and business confidence may return and Egypt would then return to normalcy. However, if the unrest is prolonged and the transition to a new political regime is not smooth, the turmoil may exacerbate problems and stall economic activity further.

United Arab EmiratesThe UAE achieved higher GDP growth in 2010 compared to 2009. The upward trend in GDP growth will likely continue into 2011, albeit at a slower pace. While re-export trade will largely depend on the recovery in Europe and the United States, trade in petroleum products

54


has been rising steadily. The worst days of the debt crisis may be behind Dubai; however, the UAE is likely to undertake several restructuring measures as the risk of a credit crunch looms large.

The UAE’s fiscal policy is likely to remain expansionary in 2011. Investments in infrastructure and the services industry will probably be the focus for development. The government will also offer subsidies on rice and bread to the poorer parts of the country beginning in April 2011. While Dubai will likely continue to repay its debt and focus on sectors such as tourism and trade, a majority of govern-ment spending will be funded by Abu Dhabi.

Real estate prices fell 1.7 percent in February 2011 and estimates suggest a further decline over the next few months. The excess supply has resulted in a correction in the housing market, with prices contracting over 55 percent since mid-2008. The supply of new real estate is likely to fall as projects are being held back. However, the recovery of the real estate sector is crucial for a revival of growth in the region. The government has also proposed

setting up an Emirates Mortgage Guarantee Corporation (EMGC) to support the recovery of the region’s mortgage markets.

Legislative reforms will likely boost FDI inflows to the UAE. Higher oil prices can also boost investment and increase liquidity. Growth is likely to be gradual and will depend largely on the pace of the global recovery.

BahrainBahrain produces very little oil. Instead, the country has one of the most diversified economies in the region with the financial sector and hydrocarbons industry raking in most of the government’s revenues. After achieving 6 percent GDP growth in 2010, a sharp deceleration is likely ahead for 2011. Retail trade and tourism have slowed and are unlikely to pick up soon. The repercussions of a decline in retail trade and industrial production are likely to extend to the all-important banking sector as well. Bahrain will probably achieve GDP growth between 3 and 3.5 percent in 2011. However, numerous downside risks remain. Violent protests, the declaration of a state of emergency,

55

GeographiesMiddle East and North Africa

and the entry of Saudi Arabian troops into Bahrain may worsen the already volatile political situation and cause growth to decline further.

The government, with the help of more affluent Gulf nations, has increased fiscal expenditures on social spending programs. The cost of pursuing such programs is likely to be high. However, it may not weaken the country’s fiscal position drastically as higher oil prices will probably bolster government revenues as well. Yet, compared to its peers, Bahrain’s high level of public debt coupled with prolonged protests prompted rating agencies to lower the country’s sovereign rating.

Bahrain is the financial hub in the region and current events may cause capital flight as investor confidence is dented. Following the financial crisis, Bahrain’s banking sector had just begun its road to recovery in 2010. The economy’s credit crunch was expected to ease in 2011; however the recent turn of events has cast a shadow of doubt.

ConclusionIn the short run, the political environment is likely to remain fragile. The government and protestors will not likely reach a satisfactory conclusion immediately. Demands for political reforms, media reforms and consti-tutional reforms are expected to increase. Government expenditures will likely also increase as subsidies are doled out to help combat high food prices and unemployment. At the same time, however, higher private consumption will also place upward pressure on inflation. Meanwhile, oil prices may continue on a volatile path until the political climate stabilizes. Given the influence of the region on the global economic recovery, developments in the Middle East and North Africa will be monitored closely by the rest of the world.

56


GDP Growth Rates (YoY %)*

Major Currencies vs. the US Dollar*

GDP Growth Rates (YoY %) *†

Appendix

Source: *Bloomberg †India's fiscal year is April-March ‡Inflation data for India is based on the WPI

Source: Bloomberg

U.S. Eurozone JapanU.K.

-12

-8

-4

-2

-6

-10

0

4

6

2

8

Q1 07

Q2 07

Q3 07

Q4 07

Q1 08

Q2 08

Q3 08

Q4 08

Q1 09

Q2 09

Q3 09

Q4 09

Q1 10

Q2 10

Q3 10

Q4 10

Inflation Rates (YoY %)*

Source: Bloomberg

U.S. JapanU.K. Eurozone

-4

-2

0

2

4

Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 Apr 10 Ju1 10 Oct 10 Jan 11

Source: Bloomberg

GBP-USD Euro-USD USD-Yen (RHS)

80

82

84

86

88

90

92

94

96

98

100

1.0

1.1

1.2

1.3

1.4

1.5

1.6

1.7

1.8

Jan 09 May 09 Aug 09 Nov 09 Feb 10 May 10 Aug 10 Nov 10 Feb 11

Source: Bloomberg

Brazil RussiaChina India

-15

-10

-5

0

5

10

15

Q1 07

Q2 07

Q3 07

Q4 07

Q1 08

Q2 08

Q3 08

Q4 08

Q1 09

Q2 09

Q3 09

Q4 09

Q1 10

Q2 10

Q3 10

Q4 10

Inflation Rates (YoY %)*‡

Source: Bloomberg

Brazil RussiaChina India

-4

0

4

8

12

16

Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 Apr 10 Ju1 10 Oct 10 Jan 11

57

Appendix

U.S. Treasury Bonds & Notes UK Gilts

Eurozone Govt. Benchmark

Japan Sovereign

Brazil Govt. Benchmark

China Sovereign

India Govt. Actives Russia‡

3 Months 0.04 0.62 0.88 0.11 12.00 2.63 7.10 3.57

1 Year 0.25 0.89 1.46 0.16 12.48 2.86 7.52 4.41

5 Years 2.31 2.55 2.81 0.56 12.954 (4 year) 3.52 7.94 7.25

10 Years 3.58 3.81 3.48 1.33 12.82 3.92 7.94 8.07

Yield curves (as on April 11, 2011)*

Q2 11 Q3 11 Q4 11 Q1 12 2011 2012 2013

GBP-USD 1.61 1.62 1.62 1.65 1.62 1.63 1.72

Euro-USD 1.38 1.37 1.36 1.34 1.36 1.3 1.36

USD-Yen 85 86 88 88 88 93.5 95

USD-Brazilian Real 1.67 1.65 1.66 1.69 1.66 1.68 1.76

USD-Chinese Yuan 6.45 6.4 6.3 6.27 6.3 6 6.11

USD-Indian Rupee 45.1 45.17 45 44 45 43.99 44

USD-Russian Ruble 28.5 28.39 28.9 28.76 28.9 28.97 32.5

Composite median currency forecasts (as on April 11, 2011)*

U.S. UK Eurozone Japan Brazil China India† Russia

2011 2.92 1.7 1.7 1.4 4.05 9.5 8 4.35

2012 3.1 2.1 1.7 1.85 4.5 4.4

2013 3.1 2.3 2.1 2.36 4.6

Composite median GDP forecasts (as on April 11, 2011)*†

Source: *Bloomberg ‡MICEX rates †JP Morgan

U.S. UK Eurozone Japan Brazil China India Russia

Apr 09 89.6 94.2 92.2 90.8 89.8 98 97.3 87.2

May 09 90.7 95.3 93.6 91.5 91.9 99.3 98.1 88.6

Jun 09 92.1 96.6 95 92.4 94 100.6 98.8 90.3

Jul 09 93.5 98 96.5 93.4 95.8 101.7 99.3 92.2

Aug 09 94.8 99.5 97.9 94.5 97.2 102.5 99.7 93.9

Sep 09 96 100.8 99.1 95.5 98.4 103 100 95.2

Oct 09 97.1 101.9 100.1 96.6 99.2 103.3 100.4 96.3

Nov 09 98.1 102.8 101 97.7 99.9 103.4 100.8 97

Dec 09 99 103.3 101.6 98.7 100.3 103.4 101.1 97.6

Jan 10 99.9 103.7 102.1 99.5 100.6 103.1 101.3 98

Feb 10 100.5 103.8 102.4 100.2 100.8 102.8 101.4 98.5

Mar 10 101 103.8 102.7 100.6 100.9 102.4 101.2 99

Apr 10 101.2 103.6 102.8 100.8 100.8 102 101.1 99.6

May 10 101.2 103.2 102.8 100.9 100.5 101.5 100.9 100.2

Jun 10 101.1 102.8 102.8 100.9 100.1 101.2 100.7 100.9

Jul 10 101 102.4 102.8 101 99.8 100.9 100.5 101.6

Aug 10 101 102.2 102.8 101.2 99.5 100.9 100.4 102.3

Sep 10 101.2 102 102.8 101.5 99.5 101.1 100.3 103

Oct 10 101.5 101.9 102.9 102 99.7 101.4 100.2 103.7

Nov 10 102 101.9 103 102.7 99.8 101.6 100.1 104.2

Dec 10 102.5 101.9 103.2 103.6 99.9 101.7 100.1 104.7

Jan 11 102.9 101.8 103.4 104.5 99.8 101.8 100 105

Feb 11 103.2 101.8 103.5 105.4 99.6 101.9 99.9 105.3

OECD Composite leading indicators (Amplitude adjusted)

Note: A rising CLI reading points to an economic expansion if the index is above 100 and a recovery if it is below 100. A CLI which is declining points to an economic downturn if it is above 100 and a slowdown if it is below 100. Source: OECD

58


Deloitte Research Thought Leadership

Additional resources

Cell me the money: Unlocking the value in the mobile payment ecosystem

Insurance industry outlook: high hurdles loom in 2011 and beyond

Asia Pacific Economic Outlook: China, Japan, the Philippines and South Korea

Global powers of the consumer products industry 2011: Getting back to growth

Please visit www.deloitte.com/research for the latest Deloitte Research thought leadership or contact Deloitte Services LP at: [email protected].

For more information about Deloitte Research, please contact Dan Latimore, Global Director, Deloitte Research, part of Deloitte Services LP, at +1.617.437.3410 or via e-mail at [email protected].

59

Global Economics TeamPralhad BurliSenior AnalystDeloitte ResearchDeloitte Services LPIndiaTel : +91.40.6670.1886e-mail: [email protected]

Dr. Elisabeth DenisonSenior Economist/DirectorCorporate Dev. & StrategyDeloitte & Touche GmbHGermanyTel: +49.89.29036.8533e-mail: [email protected]

Dr. Ira KalishDirector, Global EconomicsDeloitte ResearchDeloitte Services LPUSATel: +1.213.688.4765e-mail: [email protected]

Siddharth RamalingamSenior AnalystDeloitte ResearchDeloitte Services LPIndiaTel : +91.40.6670.7584e-mail: [email protected]

Dr. Carl SteidtmannDirector, Chief EconomistDeloitte ResearchDeloitte Services LPUSATel : +1.303.298.6725e-mail: [email protected]

Ian StewartChief EconomistDeloitte ResearchDeloitte & Touche LLPUKTel: +44.20.7007.9386e-mail: [email protected]

U.S. Industry LeadersBanking & Securities and Financial ServicesJim ReichbachDeloitte LLPTel: +1.212.436.5730e-mail: [email protected]

Consumer & Industrial ProductsCraig GiffiDeloitte LLPTel: +1.216.830.6604e-mail: [email protected]

Health Plans and Health Sciences & GovernmentJohn BigalkeDeloitte LLPTel: +1.407.246.8235e-mail: [email protected]

Power & Utilities and Energy & ResourcesGreg AliffDeloitte LLPTel: +1.703.251.4380e-mail: [email protected]

Public Sector (Federal)Robin LinebergerDeloitte Consulting LLPTel: +1.517.882.7100e-mail: [email protected]

Public Sector (State)Bob CampbellDeloitte Consulting LLPTel: +1.512.226.4210e-mail: [email protected]

Telecommunications, Media & TechnologyPhil AsmundsonDeloitte LLPTel: +1.203.708.4860e-mail: [email protected]

Global Industry LeadersConsumer BusinessLawrence HutterDeloitte LLPUKTel: +44.20.7303.8648e-mail: [email protected]

Energy & ResourcesPeter BommelDeloitte NetherlandsNetherlandsTel: +31.6.2127.2138e-mail: [email protected]

Financial ServicesChris HarveyDeloitte LLPUK Tel: +44.20.7007.1829E-mail: [email protected]

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A Deloitte Research publication | 2nd Quarter 2011 Navigating a world of turmoil · 2011-05-20 ·...

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