Deutsche Bank Perspectives Global Economic...

20 September 2016

Global Economic Perspectives

Deutsche Bank Securities Inc.

DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 057/04/2016.

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Global EconomicPerspectives

Date20 September 2016

Deutsche BankResearch

Euro area fiscal easing: 'What if'?■ It is easier to call for euro area fiscal easing than it is to credibly deliver it.

Absent an economic shock or an acceleration of integration, we are notexpecting much easing of fiscal policy in 2017.

■ In this note we ask: What if Europe comes to the conclusion that monetarypolicy is insufficient to normalize economic conditions and a fiscal easingoutside the current rules is required? With this in mind, we do two things

■ First, we quantify the fiscal easing required to close the unemploymentgap country by country over the next three years. The objective is to raisegrowth, absorb spare capacity and boost political support for the euroarea. This should help to reduce the local hurdles to structural reforms.

■ The additional easing of the structural budget deficit required is only 0.4%of GDP on average per year for the euro area in aggregate. For threeyears this is equivalent to about EUR130bn in total. There needs to bestrong commitment from all member states and no free-riding to ensurethe spillover effects between countries are maximized.

■ The strategy should be self financing. The positive impact on GDP growthpushes the nominal fiscal deficit and public debt-to-GDP ratios belowwhat they would have been without this stimulus. It should also benefitthe ECB by pushing HICP inflation to target by 2019. That should reducepressure to ease monetary policy further and facilitate an earlier exit fromthe accommodative monetary policy stance.

■ However, there is a wide divergence in stimulus requirements acrosscountries - from no stimulus to at least 3% of GDP in some peripheraleconomies. This hints at the political challenge of such a fiscal strategy.

■ Second, we describe the necessary conditions for this euro area fiscaleasing to materialise. Some are coming in any case, if very slowly, forexample, fiscal coordination and policies to boost systemic resiliencelike the banking union. Others are more difficult, such as re-writing thefiscal rules. Some are extremely difficult to imagine, like an inversion ofGermany’s historic political belief in rules-based stability.

■ The bottom line is, we do not expect a large fiscal easing, particularly withthe very busy European political events calendar in 2017. Just like in 2016,some modest slippage relative to the fiscal rules might be as good as itgets in 2017.

Peter Hooper, Ph.D

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Michael Spencer, Ph.D

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Mark Wall

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Torsten Slok, Ph.D

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Matthew Luzzetti, Ph.D

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Distributed on: 20/09/2016 20:00:56 GMT

20 September 2016



Introduction

The argument that monetary policy is failing and that a fiscal policy or coordinatedmonetary and fiscal policy is necessary is building in markets again. With criticismof ECB policy on the rise — not least because of the counter-productive impact ofunconventional monetary policy on banks — and the euro area economic cyclestruggling to normalize, the question inevitably arises: will the euro area also easefiscal policy?

When we last reviewed the euro area fiscal stance in April, we drew threeconclusions1:

■ First, the market was under-estimating the amount of fiscal easing in2016. At the time we projected an increase in the structural primarydeficit of 0.5% of GDP in 2016, the largest easing since the coordinatedEuropean response post-Lehman and a couple of tenths larger forecastssix months earlier. Since these bottom-up estimates do not capture theJuncker Investment plan, arguably the fiscal stimulus was larger than this.Since April, this estimate has been revised up to 0.7% of GDP.

Figure 1: The fiscal stance has already eased in 2016; the concern is 2017

Source: Deutsche Bank, European Commission

■ Second, the conditions were not right for a strongly coordinatedfiscal and/or monetary policy (including helicopter money). One of twoscenarios would have to apply: (a) a sharply worse economic outlook or(b) a leap forward for euro area integration. The two are not necessarilymutually exclusive. But while the recovery is weak, it is also relativelystable. Brexit has not yet been a significant shock.

■ Third, our concern was not 2016 but 2017. On current forecasts the fiscalstance will be less easy next year. Since it is the change in the fiscal stancethat correlates with economic growth, unless current plans change thefiscal impulse threatens to become negative for growth in 2017.

Less austerity, more jobs. While the austerity pressure has eased, the pace ofimprovement in the euro area labour market has accelerated. Over the last yearthe European Commission’s forecast for the euro area unemployment rate in 2016has fallen from 10.5% to 10.3%. Even this is looking too pessimistic. If jobless

1 “Euro area: more fiscal easing than you think, less than you hope”, Deutsche Bank Focus Europe, 22 April2016.

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numbers falls at half the monthly rate in H2 as in H1, the average unemploymentrate this year will be 10.1%. Of course, this might be coincidental.

In this note we conduct a ‘what if’ analysis. What if Europe comes to theconclusion that monetary policy alone is insufficient to achieve a normalization ofeconomic conditions and a fiscal easing outside the current fiscal rules is requiredto complement it? With this hypothetical scenario in mind, this note does twothings.

■ First, to give an indication of scale, we quantify the volume of fiscal easingrequired to close the unemployment gap country by country over the nextthree years.

■ Second, we describe the necessary conditions for this euro area fiscaleasing strategy to materialise.

A change in policy stance can be justified

Optimists can construct an encouraging narrative for the current euro areapolicy stance. With a few exceptions, fiscal deficits are back below theMaastricht-compliant 3% of GDP level. Public debt as a percentage of GDP islower than what was forecast by the official sector when OMT was announced.The peripherals have swung their current account deficits into surpluses. GDPhas been expanding consistently for the last 13 quarters. Unemployment hasfallen substantially from its peak in mid 2013. If it was not for rising labour forceparticipation, unemployment would have fallen more. The unemployment gap isnow no larger than it was in the 1990s and is falling quickly.

There are counter-arguments, however. The turning point in public debt-to-GDP ratios owes a lot to the ECB compression of risk premia and funding costs.The current accounts adjustments are more cyclical than structural. The externalliabilities of the most indebted countries are no smaller than they were at thestart of the crisis and only feel more sustainable because a significant portion isnow held in official sector hands. The decline in unemployment is narrow (halfis due to Spain) and has not been enough to prevent the rise of populism. Youthunemployment remains high, with a serious risk of a ‘missing generation’ withconsequences for productivity and trend growth.

Monetary policy has been over-burdened. Monetary policy can never creategrowth. It can only reduce the price of money and accelerate activity that wasgoing to take place in the future. With negative rates and flat curves, there isa point of view, which we share, that the monetary policy stance is becomingincreasingly counter-productive in a bank-based financial system.

The most compelling case for policy failure lies with persistent negative outputgaps. The European Commission’s output gap estimates for the crisis peripheraleconomies get back to zero in 2017. Post-Brexit, there is a chance output gapremains below zero again in 2018, meaning virtually 10 years of negative outputgaps.

The corollary of persistent negative output gaps is high unemployment ratesand persistent unemployment gaps, that is, unemployment rates above the

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natural rate. This equates to a serious political failure and is the greatest risk toeuro area stability and durability, in our view.

The EU and all its institutions – including the single currency area – need betterpolitical support. Weak economic recoveries are eroding that support. Risinganti-EU and anti-euro support is leading to parliamentary fragmentation, puttingadditional hurdles in the way of structural reforms and integration. Without thereforms and integration, the durability of the single currency will be undermined.

Figure 2: The motivation for a new approach to policy isthe extent of spare capacity


Figure 3: It has declined, but the euro areaunemployment gap has persisted and remains large


Figure 4: Falling trust in EU

Source: Deutsche Bank, Eurobarometer

Figure 5: Change in trust in EU vs. Unemployment rate

Source: Deutsche Bank, Eurobarometer , Eurostat, Haver Analytics

Part 1: Estimating the fiscal stimulus needed to close theunemployment gap

Closing unemployment gaps, country by country. Given the increasingly politicalnature of the threat to long-term stability of the single currency area (and perhapsthe EU), for the purposes of this note we define the objective of fiscal easing

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to be the closure of the unemployment gap, country by country, between 2017and 2019. There are multiple benefits from closing unemployment gaps. It wouldmean:

■ Boosting demand in the weakest economies.

■ Preventing a negative spiral between incomes and private debt.

■ Leaning against the risk of political populism, particularly in the periphery.

■ Reducing the threat of hysteresis effects by reducing unemploymentmore rapidly.

■ Reinforcing political stability and sustainability. This would help minimizethe threat that the UK decision to leave the EU becomes a trend.

Our approach. We adopt the following approach for each of the eleven euro areamember states have we covered in greater detail.

■ We start with our 2017 and the IMF 2018-19 GDP growth forecasts. Wecan then infer where each country would be by 2019 in terms of outputlevel, unemployment rate, fiscal deficit and debt/GDP ratio.

■ We then specify the unemployment rate that would be needed each yearto close the unemployment gap by 2019. This allows us to define thegrowth path needed to achieve it using Okun’s law.

■ We assume that each country would commit to achieving that pace ofeconomic growth. This commitment allows us to calculate the spillovereffects that would result in each euro-area country. The growth thatcannot be achieved via spillover effects is assumed to be generated byfiscal policy.

Below we give a brief description of the methodology. See the Appendix at theend of this Special Report for full details of the exercise.

Multipliers

Fiscal multipliers measure the change in output from an exogenous change inthe fiscal deficit. A multiplier higher than 1 means that increasing governmentspending stimulates output by more than what the government spent. This isoften referred to as the Keynesian effect.

To specify fiscal multipliers in each euro-area country between 2017-19, we followthe methodology described in a recent IMF working paper dedicated to thetopic2 . The approach is relatively simple and in line with the general academicconsensus. The fiscal multipliers are meant to depend on certain structuralparameters of the economy as well as the business cycle and constraints onmonetary policy. The IMF methodology also allows us to adjust the multipliers forthe position in the business cycle and the monetary policy stance. The Germanfiscal multiplier is one of the lowest, which fits with priors. See Figures 6 and 7.

2 Batini N, Eyraud L., Weber A.,2014, “A simple method to compute fiscal multipliers”, IMF Working Paper,WP/14/93

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Figure 6: Fiscal multipliers in 2017, base case

Source: Deutsche Bank



Other parameters

We use the OECD’s potential growth estimate to infer potential growth of eachof the 11 countries. Regarding the output gap in 2016, we rely on the IMFestimates. As in previous reports, we rely on estimates from Ball et al (2013) Okuncoefficients. For Greece, as it is not available from Ball et al3 (2013) we use theresults from Karfakis et al (2014)4. For most countries we use the OECD NAIRUestimates to infer structural unemployment rates. We deviate when we feelthere is good reason to use alternate estimates. See appendix. For cross countryspillover effects, we rely on the relative fiscal spill-over estimates published in arecent ECB monthly bulletin5.

Figure 8: Main parameters behind the fiscal easing strategy

Source: Deutsche Bank, Eurostat

Results

To close unemployment gaps country by country, euro area GDP would need tobe 0.9% higher per year in 2017-2019 relative to the no-fiscal stimulus scenario.We estimate that only about half this would need to be stimulated by fiscal easing.The remainder can come from country spillover effects6.See Figure 9.

3 Ball L., Leigh D., Loungani P.,2013 “Okun’s law: fit at fifty?” NBER Working paper 186684 Karkafis C, Katrakilidis C, Tsanana E, 2014,”Does output predict unemployment? A look at Okun’s law in

Greece”, International Labour Review, 153,3,421-4335 ECB Monthly Bulletin, April 2014, “Fiscal multipliers and the timing of consolidation"6 While large at first sight, this result does not differ much from the following papers: Veld J. “Fiscal

consolidations and spillovers in the euro area periphery and core”, European Commission, 2013 ; IMF,Germany: 2013 Article IV Consultation, Country Report No 13/255

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Figure 9: Additional GDP growth required to close unemployment gaps – from (a) fiscal stimulus and (b) growthspillover effects


We estimate that the additional fiscal stimulus — defined as the rise in thestructural fiscal deficit beyond what was already assumed — required to close theunemployment gaps would be close to 0.4% of GDP a year for the euro area onaverage. This masks a considerable difference in requirement across countries.Some member states do not require stimulus. Spain would have to spend about1% of GDP a year. Portugal and Greece stand out. They would both need toincrease their structural deficit by about 3.5% a year.

Figure 10: Fiscal easing required to the close unemployment gap (negative change implies stimulus)


Because of the extra-spending associated with the fiscal stimulus the structuralfiscal deficit would increase between 2017-19. But growth rates would rise aboveforecasts and the cyclical balance of the budget deficit would improve. Puttingall these together, we can then infer what would be the difference between thedebt-to-GDP ratio without and with coordinated fiscal stimulus. In all cases, thedebt-to-GDP ratio would be lower in 2019 with the fiscal stimulus.

Figure 11: Main fiscal balances in 2019 – baseline and with fiscal easing to close unemployment gaps

Source: Deutsche Bank. Note: The table has been slightly modified from the version initially sent as a Special report. The changes do not impact the main results or conclusions

Impact on HICP inflation and ECB policy

Assuming the euro trade-weighted index follows the trajectory of our FXstrategists, euro area HICP inflation in 2017, 2018 and 2019 should be 1.4%, 1.5%and 1.5% respectively. Implementing a fiscal strategy that closes unemploymentgaps country by country would boost GDP growth enough to shift up the inflationrecovery trajectory upwards by 0.3-0.4pp by 2019.

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Figure 12: Euro area HICP inflation has been volatile andlower since the start of the crisis


Figure 13: A fiscal strategy that closes unemploymentgaps should add enough growth to push HICP to itstarget in 2019


In short, this fiscal strategy would increase the likelihood of inflation returning totarget by 2019. That should reduce pressure on the ECB to ease monetary policyfurther and facilitate an earlier exit from the ultra-accommodative policy stance(for example, tapering in 2017, first hike in 2018)7.

Sensitivity analysis

Deriving the cost of a fiscal stimulus package depends on the value of severalelasticities and unobserved variables, the values of which are uncertain andsubject to estimation errors. To capture the change in cost to movements in theseelasticities we perform the following sensitivity analysis:

■ Okun coefficient: We allow for Okun coefficients that are arbitrarily 25%smaller than our baseline assumptions to capture the risk that labourmarkets are less sensitive to economic growth.

■ Fiscal multiplier: We allow for fiscal multipliers that are arbitrarily 25%smaller than our baseline assumptions to capture the risk that economicgrowth is less sensitive to fiscal stimulus.

■ Country spillovers: We allow for cross-country spillover effects that arearbitrarily 25% smaller than our baseline assumptions to capture the riskthat indirect growth effects are small, thus requiring more fiscal stimulusto close unemployment gaps.

7 For simplicity the above calculations assume average annual funding costs remain unchanged. Given thegradual rollover of debt and the very low marginal financing rate today, the average funding cost should fall.Or to put it another way, an unchanged average annual funding cost assumes the marginal cost of fundingwill rise over the three years of the fiscal strategy. This would be broadly consistent with (a) a successfulstrategy, and (b) an earlier exit from the current accommodative policy stance.

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■ Unemployment gap: We allow for unemployment gaps that are 1pp largerthan our baseline assumptions to capture the risk that there is greaterslack in labour markets than generally assumed8.

The average annual changes in the structural budget balance required to close theunemployment gaps country by country are presented in Figure 14. The baselinestimulus for the euro area, as described above, is 0.4% of GDP per year (negativechange means stimulus). A smaller Okun coefficient would increase the requiredstimulus to 0.5% of GDP per annum. A smaller fiscal multiplier increases thecost to 0.6%. A larger unemployment gap raises the cost to 0.7%. Note, thesesensitivities are not cumulative.

Figure 14: Sensitivity analysis – how much fiscal stimulus required (negative changes imply stimulus)


Part 1, Conclusions: Technically feasible, but…

There are several points to take away from the above analysis:

■ Modest cost. It is possible to design a fiscal stimulus plan that closesunemployment gaps country by country at a relatively modest cost to theeuro area in aggregate: an additional loosening of the structural budgetbalance relative to baseline by 0.4% of GDP per year on average for threeyears. Over the three years of the easing, this would be equivalent toc.EUR130bn in cumulative terms.

■ Self-financing. Such a plan can be self-financing. The additional GDPgrowth would reduce cyclical deficits and boost the denominator in fiscalratios. Nominal budget deficits ought to be no higher in 2019 than theywould have been in the absence of this fiscal plan. Public debt-to-GDPratios ought to be lower.

■ ECB benefits. The ECB should welcome such a fiscal plan. First, net-net,fiscal imbalances would be no worse in 2019 than they would have beenwithout the stimulus. Second, the euro area output gap would be narrowenough to push inflation to target by 2019. Third, closing unemploymentgaps should reduce the political threat from the periphery to the singlemonetary policy. Fourth, it should facilitate an initial exit from the currentultra-accommodative stance by 2019, unwinding some of the concernthat monetary policy is being detrimental to banks.

8 The ECB has expressed concern that there may be labour market capacity beyond what is capturedin the simple unemployment rate. Eurostat sums a trio of indicators to get “additional potential labourforce” (APLF) — underemployed part-time workers, persons available but not seeking work and personsseeking work but not immediately available. In Q1 2016, euro area APLF was 8.9% of the active populationvs. 7.3% in 2008. To allow for the potential for larger unemployment gaps than are implied by thestandard structural unemployment estimates, we calculate how much fiscal stimulus is required to closeunemployment gaps assuming they are 1pp larger in every country at the start of the stimulus programme.

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■ Political challenge. The challenge will be building the political consensusnecessary to achieve this fiscal strategy. There is a significant gap — about1pp of GDP — between the cost of this strategy and what compliancewith the fiscal rules implies in 2017, for example. The stimulus requiredin the still indebted peripherals is extremely large. With this in mind, wenow turn to the necessary conditions for the above fiscal strategy tomaterialise.

Part 2, Necessary conditions for a fiscal easing outside thecurrent rules

In Part 1 we showed it is technically possible to construct a fiscal easing strategythat closes unemployment gaps country by country at a relatively modest cost, interms of the structural deficit, to the euro area in aggregate. It depends, of course,on a number of parameters and elasticities being estimated accurately. However,the key question is whether the implementation of this fiscal easing strategy ispolitically feasible.

In Part 2 we describe the necessary conditions for this euro area fiscal easingto materialise. The political hurdles will depend on whether the fiscal strategyto close unemployment gaps is a temporary deviation from the euro area policyframework or a permanent shift. We constructed the scenario as a temporarydeviation, albeit for three years. The political costs of a temporary deviation willbe lower than for a permanent shift, but are still likely to be substantial and largeenough to think that this temporary deviation won’t emerge soon.

#1. German belief in stability-oriented fiscal policy wouldhave to change

Monetary policy is already being counterproductive, in our view. To recommendthat fiscal policy also take risks could be seen as a double assault on stability-oriented policy. Although we can argue that the above fiscal easing scenario isself financing if all the assumptions hold, it necessarily implies a greater relaxationof fiscal policy in the already indebted peripheral economies.

Facilitating a substantial change in direction for European fiscal policy is not just amatter of re-writing the rules (discussed in the next section). The fiscal simulationexercise in Part 1 makes a lot of assumptions, making it difficult to build credibility.More than that, it requires a far more difficult change in political belief and fromGermany in particular.

Rules-based stability based on strong institutions — referred to in Germany asordoliberialism — is a deeply engrained part of German political culture. If thisfiscal strategy were to coincide with more QE, the risk is Germany will seeinstitutional borders being eroded further.

Bear in mind Germany was the main proponent of the Stability and Growth Pactand the Fiscal Compact. That is not to say that Germany itself is totally averse tofiscal easing. Germany is the country most in compliance with the fiscal rules andhence has the relatively greater room to ease policy.

According to the European Commission’s forecasts, the German cyclically-adjusted primary surplus will decline by 0.6% of GDP this year, twice as much as

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the predicted easing for the euro area. However, this may overstate the stimulus.Recent data point to a record state surplus in H1 2016 of 0.6% of GDP and we haveraised our German fiscal balance forecasts for 2016 and 2017 from zero to +0.5%of GDP. Higher tax revenues, lower interest expenditure and falling numbers ofnew refugees are each contributing9.

A recent ECB working paper presented a model whereby monetary, fiscaland structural policy could produce positive synergies between one another. Itrequires the joint implementation of pro-competition reforms in the periphery, afiscal expansion in the core and forward guidance from the ECB about the figurepath of nominal interest rates10.

However, a substantial easing of fiscal policy by Germany to reduce the burden ofreforms on other members seems unlikely, all the more so because of the GermanFederal election later in 2017. Elections elsewhere around the euro area mightcreate political pressure for fiscal easing, so at the very least the fiscal debate islikely to create some tensions. The uncertainty could erode the benefits of fiscalslippage.

We do not rule out some fiscal slippage. Berlin is not pushing for the strictestapplication of the European fiscal rules —Spain and Portugal recently avoidedfines despite agreement that they took insufficient consolidation action last year.But, in our view, German support for a substantial relaxation of European fiscalpolicy seems unlikely outside a shock scenario.

#2. Fiscal rules would need to be re-written

The intention of the fiscal rules is to put deficit correction on auto-pilot. There aredegrees of flexibility within the rules, which are being explored, but the kind offiscal easing envisaged in the above exercise to close the unemployment gap isnot compatible with the fiscal rules as they exist today.

To recap, the rules are as follows:

■ The Stability and Growth Pact (SGP) rules — which have a preventiveand corrective role — were introduced when the single currency wascreated to limit fiscal deficits to 3% of GDP and gross public debt to 60%of GDP. These targets continue to apply.

■ There is cyclical flexibility. While the 3% nominal deficit continues toapply, deviations from fiscal trajectories for cyclical reasons are permitted.However, underlying or structural fiscal adjustments must continue, withstructural balances to tighten by 0.5% of GDP per year until the country-specific Medium-Term Objectives (MTOs) are reached.

■ Required adjustments towards the MTO depend on the size of debt andthe output gap – the lower is debt and the larger is the output gap, thesmaller the required annual adjustment. High debt countries (above 60%of GDP) still face relatively tighter constraints. For example, even with

9 See “Germany’s fiscal balance has improved despite spending on refugees”, DB Focus Germany, 2September 2016.

10 O. Arce, S. Hurtago and C. Thomas, “Policy spillovers and synergies in a monetary union”, ECB Workingpaper #1942, August 2016.

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large output gaps of between 3 and 4% of GDP, high debt countries stillneed to consolidate their structural deficit by at least 0.25% per year.

■ Since the start of the crisis the rules have been supplemented in severalways, including with a debt brake rule that requires member states withdebt ratios above 60% to reduce the excess of their debt ratio with respectto the 60% limit by at least one twentieth every year.

■ An expenditure benchmark was also introduced. This requires thatmember states increase their spending by no more than medium-termpotential GDP growth unless it is matched by an adequate increase inrevenues.

■ There is now flexibility to accommodate structural reforms. However, theamount of leeway that will be granted is no more than 0.5% of GDP onthe structural balance and the MTO must be reached within four years.

■ Investment spending can be excluded from deficit calculations tofacilitate a deviation from the recommended MTO adjustment trajectory.A country qualifies for this exemption, among other things, if GDP growthis negative or if the output gap is greater than 1.5% of GDP. However,even with this exemption the deficit must not rise above 3% of GDP.

■ The tougher post-crisis regime was reinforced by the Fiscal Compact. Tomaintain sufficient fiscal buffers, the Fiscal Compact requires a structuraldeficit of no more 0.5% of GDP (1.0% of GDP for high debt countries).

Incompatible with the rules. Given the level of public debt and size of the outputgap, the rules say the euro area ought to be reducing its structural budget balanceby at least 0.5% of GDP per year. With a strong enough structural reform proposal,the requirement can be softened by 0.5pp (to zero). This still leaves a gap relativeto what is required (at least a 0.4% of GDP easing). Making the fiscal easing fitwith the current rules is more than just a benign neglect of the rules, especiallyconsidering the fiscal strategy would have to last three years.

Figure 15: Euro area fiscal rules — not compatible with a fiscal strategy to close unemployment gaps

Source: Deutsche Bank, European Commission. Note: Text in red signifies the current position of most euro area countries

A revision of Europe’s fiscal rules is not unprecedented. There was a looseningin 2003 (at the time of the Hartz IV reforms) and a broader reform triggered by thesovereign crisis. A reform of the rules is a process that could take 18-24 months tocomplete. It would not be costless from a core country perspective. The Germanelection is a non-negligible constraint.

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Figure 16: Gap between blue diamond and green triangle indicates extent to which the fiscal rules would have toweaken to accommodate the closure of unemployment gaps — 0.9pp of GDP for euro area in aggregate

Source: Deutsche Bank, European Commission, ECB. Note: Greece is not included because it is under an EU-IMF adjustment programme and therefore does not have to comply with the Stability and Growth Pact rules,Excessive Deficit Procedure, MTO, etc.

There are two other possibilities:

■ Temporary suspension of the rules. EU leaders could agree totemporarily suspend the rules rather than agree another wholesalereform of the rules. However, first, this would raise questions aboutcommitment to rules, and second, a temporary suspension could proveextremely difficult vis-à-vis rules embedded in the Treaty and, via theFiscal Compact, in national constitutions.

■ Change of methodology. The Commission could change its methodologyfor calculating potential output/output gaps/unemployment gaps tosomething that yields a less pro-cyclical fiscal policy recommendation11.Forming a political consensus around a starkly different fiscal policyconclusion on the basis of a shift in methodology would be difficult, inour view. If there is a change in methodology, we would not expect it tolead to fundamental changes of conclusions for policy.

#3. Fiscal coordination would have to improve

There are several reasons why fiscal coordination would need to improve for theaforementioned fiscal strategy to become a credible reality:

■ Country-specific recommendations. A generic agreement on fiscaleasing — for example, all member states easing by 1% of GDP —would not be appropriate given the objective. What is required is a moreprescriptive, country-specific fiscal easing. For example, our calculations

11 A recent European Commission working paper discussed the ramification for fiscal policy from shifting fromthe non-accelerating wage rate of unemployment (NAWRU) to the structural unemployment rate (SUR) asthe means of assessing spare capacity. The SUR is the portion of the NAWRU that can be explained byinstitutional factors and is therefore less cyclical. On an SUR basis, the structural fiscal position tends tobe less favourable in good times and more favourable in bad times. That is, all else unchanged, in badtimes there would be less pressure for fiscal consolidation. See “Structural unemployment vs. NAWRU:Implications for the assessment of the cyclical position and the fiscal stance”, European CommissionEconomic Papers 552, June 2015

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show that the French structural budget balance would have to loosen by0.3% of GDP on average over 2017-2019 but Spain’s by 0.9% of GDPand Portugal by 3.3% of GDP. The latter is scarcely credible. To think aneconomy can ease fiscal policy by that degree for three years and do soeffectively requires exceptional planning and coordination.

■ Avoid free-riding. There could be a temptation for free-riding. As ourbottom-up calculations show, euro area GDP would have to grow onaverage 0.9% per year more than baseline to close the unemploymentgap, with roughly half this coming from fiscal stimulus and half fromcountry spillover effects. Each country needs to commit to the fiscalstrategy for three years. Fiscal coordination would ensure everyone playstheir role. The more that some member states opt out of the strategy, thegreater the need for fiscal stimulus from the others. Otherwise, if anyonesteps out, the spillover effects weaken and the strategy fails – that is, thefiscal stimulus does not generate as much growth and fiscal ratios don’timprove as much as they could otherwise.

Fiscal coordination is difficult in the absence of fiscal union. The good news isthat Europe’s fiscal coordination capabilities are being upgraded. A new EuropeanAdvisory Fiscal Board (EAFB) was proposed in last year’s five presidents’ reportand is now in the process of becoming operational12.

The EAFB core activities include evaluating the Union’s fiscal framework andadvising the European Commission on a prospective fiscal stance for the EAand possibly also on national fiscal stances that would be consistent with theaggregate.

The EAFB should improve policy coordination, but effectiveness remainscontingent on political will. It is far too soon to judge how much fiscal coordinationbenefit might be achieved. There is a lot to prove to prudent core countries.

#4. Fiscal easing would need better systemic resilience

A large, multi-year easing of fiscal policy is not riskless. Consideration need tobe given to the possibility of the strategy failing — in the sense that it does notgenerate the desired level of growth and deficit and debt ratios end up higherthan anticipated. There are several complementary means of minimizing theramifications.

■ Completion of the banking union and capital markets union. Banksremain substantial holders of public debt. Regulations force banks tohold higher proportions of liquid securities. A failed fiscal expansionmeans increased risk of fiscal stress in the future. The ‘doom loop’between sovereigns and banks would need to be strongly neutralised.That would mean: (i) pressure to uphold the headline BRRD/bail-in rules,(ii) the need to grant a fiscal capacity to the SRF and (iii) acceleratingthe move to common deposit insurance. The planned Capital MarketsUnion (CMU) will not just facilitate alternative sources of financing in

12 The following details are from Patricia Wruuck’s “Better budgeting in Europe: What can Fiscal Councilscontribute?”, DB Focus Europe, 17 June 2016.

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the event of constraints on banks. Well-developed capital markets arealso an important means of absorbing regional shocks in more integratedeconomies. See Figure 17.

■ Structural reforms. The importance of structural reforms should notchange because of a shift to more fiscal easing. First, bear in mind,in 2019 the euro area unemployment rate is projected to be 9.2%,according to the fiscal strategy outlined above. That is still about twice theunemployment rate the CBO projects for the US in 2019 (4.8%). In otherwords, structural unemployment is too high in any case. Second, if a fiscalstrategy generates economic growth quickly, it may help governmentsto deliver structural reforms. Fiscal easing may be skewed towards theperiphery. Structural reforms are necessary to facilitate competitivenessadjustments between the periphery and the core. Moreover, structuralreforms would build better confidence in medium to long term growth,helping to reduce debt ratios after the immediate fiscal easing has ended.

Figure 17: Bolstering capital markets is a way of generating capacity to absorbregional shocks

Source: Deutsche Bank, IMF

■ Clarifying monetary and fiscal coordination. So far, QE has coincidedwith smaller euro area aggregate deficit and debt ratios than wereforecast before the start of QE. If the fiscal easing strategy to closeunemployment gaps works, the deficit and debt numbers will be lowerthan other wise, implying no threat to the EU Treaty restriction onmonetary financing. However, if the fiscal strategy is not seen as credibleat first, it could generate market pressure for a deviation from the capitalkey, the political cost of which is non-negligible.

■ Clarifying the sovereign default mechanism. What if the fiscal easingfails outright and a sovereign becomes unsustainable as a result? It wouldbe beneficial for Europe to clarify how default of a euro area sovereigndefault could work: status of euro membership, status of banks, the rolethe ESM could play, the treatment of ECB and NCB holdings of public

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debt, etc.13This is probably wishful thinking, but there are other movesthat could bring benefit.14

■ Common sovereign bond issuance. It is fanciful and highly unlikely, butany large fiscal stimulus debate is likely to circle back to common issuanceor what the Commission calls ‘stability bonds’15 . Various models havebeen discussed, from moving all member state issuance to stability bondsfrom a common euro area Treasury to the ‘blue bond/red bond’ idea wherestability bonds finance debt up to a specified sustainable limit and nationalbonds without a common guarantee are used to finance the remainder.

The improved systemic resilience above would in many ways come from thedelivery of the “Five Presidents’ Report” which lays out the path to the completionof EMU. With anti-EU sentiment and populism having increased, more rapid,genuine integration seems difficult, especially over the next year with the verybusy political calendar.

Part 2, Conclusion: Another prisoner’s dilemma

The euro area faces a complex challenge. Growth remains weak and inflation low.Monetary policy is facing limits. Fiscal balances remain far from pre-crisis norms.Lingering unemployment is boosting populist politics, fragmenting parliaments,hampering the reforms and integration that could make the euro area moreresilient.

The necessary conditions for the fiscal easing strategy described in Part 1 tomaterialize are a mixture of things that are already happening but would need tohappen more quickly and others that are far more challenging.

This leads us to the following conclusions:

■ It is difficult to see this fiscal easing strategy to close unemployment gapsbeing implemented anytime soon.

■ The gradual move to a more integrated euro area means the probabilityof this fiscal easing strategy emerging should rise slowly over time.

■ Identifying the necessary conditions also reveals the components of ahypothetical quid pro pro deal to accelerate a stronger fiscal easing. We

13 The Bundesbank recently published a report that made some proposals on how Europe could better dealwith future fiscal crisis. Key among these is reforming the ESM and converting it into an independent fiscalauthority to advise on and manage debt sustainability, thus removing the Commission and the ECB fromthe equation. Also proposed were changes to bond contracts to make extending debt maturities easierwithout triggering a credit event. See “Approaches to resolving sovereign debt crises in the euro area”,Bundesbank Monthly Report, July 2016.

14 A working paper from the German Council of Economic Experts recently proposing a two-stage mechanismto be managed by the ESM, with an immediate maturity extension followed post-crisis by a deeperdebt restructuring and debt proves unsustainable. The Experts argue the mechanism would be easy toimplement by amending ESM guidelines and introducing Creditor Participation Clauses (CPCs) in bonddocumentation to allow for “single limb” voting. This would enable a single vote across all affectedinstruments. See “A mechanism to regulate sovereign debt restructuring in the euro area”, German Councilof Economic Experts, Working Pater 04/2016, July 2016.

15 http://ec.europa.eu/europe2020/pdf/green_paper_en.pdf

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have written before about how the Macro Imbalance Procedure (MIP)could operationalise such a ‘grand bargain’16.

■ However, it is difficult to get optimistic about such a deal soon,particularly with the very busy European political events calendar over thenext year.

The absence of these conditions does not mean fiscal easing from 2017 mightnot be larger than we currently predict. However, without these conditions inplace, political tensions and uncertainties could arise from the stimulus, offsettingsome of its benefits. Moreover, without reforms, integration and measures tomake the euro area more resilient, the cost of the fiscal strategy failing — if itfailed to generate as much growth as predicted and therefore pushed deficit anddebt ratios higher, especially in the periphery — would go up.

The bottom line is, absent an economic shock (Brexit has not been a shock yet)or an acceleration of integration (rather unlikely with the elections over the nextyear), we are not expecting much easing of fiscal policy in 2017 beyond someslippage relative to the fiscal rules.

Appendix: Estimating fiscal multipliers, setting parametersand calculating fiscal stimulus

Specifying the fiscal multipliers

Brief history on fiscal multipliers estimation strategies

Fiscal multipliers measure the change in output from an exogenous change inthe fiscal deficit. A multiplier higher than 1 means that increasing governmentspending stimulates output by more than what the government spent. This isoften referred to as the Keynesian argument. A multiplier lower than 1 meansthat output increases by less than the rise in government spending. This is theRicardian argument: government spending crowds out private spending. The sizeof the multiplier is therefore crucial to the success and design of fiscal policy anddemand-side stimulus.

There exists an enormous amount of research that tries to estimate fiscalmultipliers in different countries, in different periods and at different places in thebusiness cycle. The academic literature has generally followed two approaches:

■ Theoretical and econometric analyses: since the early 1990’s the useof Dynamic Stochastic General Equilibrium (DSGE) simulations and time-series econometrics methods found that multipliers lie between 0 and 1in “normal times”. It is also generally believed that multipliers are higherfor expenditure spending than tax changes.

■ Historical events analyses: A more recent approach in the last 10 yearshas been the “narrative approach”, with Romer and Romer (2010) 17 being

16 See “Solving the euro policy quandary”, DB Focus Europe, 14 November 2014, An additional quid proquo could come from adjusting OMT eligibility to encompass MIP status. That is, countries deemed non-compliant with MIP reform recommendations could lose their OMT eligibility. This is a way of re-introducingmarket pressure as an arbiter on economic performance.

17 Romer C.D and D.H Romer, 2010, “The macroeconomics effects of tax changes: estimates based on anew measure of fiscal shocks”, American Economic Review, 100, 763-801

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the seminal work. The idea is to look at clear unexpected historicalchanges in government spending, not related to the business cycle. Thesestudies generally find higher multipliers (closer to and above 1), and nodifference between spending and tax changes.

To specify fiscal multipliers in each euro-area country between 2017-19, we followthe methodology described in a recent IMF working paper dedicated to thetopic18 . The approach is relatively simple and in line with the general academicconsensus. The fiscal multipliers are meant to depend on certain structuralparameters of the economy as well as the business cycle and constraints onmonetary policy.

Fiscal multipliers in normal times: the “structural” component

The structural component is what would prevail in “normal times” when theeconomy is growing at its potential rate and unemployment is at its natural/structural level. This structural component is between 0 and 1. It depends on aset of factors:

■ Labour market rigidities: More rigid labour markets are associated withhigher multipliers. We rely on the OECD indicators to specify country-specific labour market rigidities.

■ S ize of automatic stabilizers: This is measured as the ratio of publicspending to GDP. If the public sector is a larger part of the economy,crowding out the private sector would have a lower impact on output.

■ Fixed exchange-rate regimes: This also increases the size of multipliers.

■ Low or safe public debt level: This ensures the credibility of the fiscalpolicy.

■ Effective public expenditure and revenue administration: This ensuresthat the fiscal policy money is effectively and optimally used. We use theWorld Bank governance indicators in that case.

■ Trade openness: A relatively closed economy is less likely to see the fiscalspend escape through imports. This is measured as the ratio of importsto GDP.

All these factors are assigned a score between 0 and 1 and summed up. The finalscore puts the country in a range of estimates for the structural component ofthe fiscal multiplier. For instance the IMF paper adds up all these componentsto 4 for the US, which results in a structural component of the fiscal multiplierin the lower part of the [0.7-1] range. The authors of the paper suggest that 0.7should be used.

Adjusting fiscal multipliers for economic cycles and the monetary policy stance

The IMF paper specifies multipliers that cannot exceed 1 in normal times. Butit then provides the methodology to adjust the multipliers depending on thebusiness cycle and the constraints faced by the Central Bank. This means that

18 Batini N, Eyraud L., Weber A.,2014, “A simple method to compute fiscal multipliers”, IMF Working Paper,WP/14/93

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during large downturns and/or when monetary policy is at the zero-lower bound,fiscal multipliers are larger and could exceed 1. But when the economy is abovepotential, fiscal multipliers are below what they would be in normal times. Thisapproach allows for the Ricardian equivalence during normal times, over-heatingepisodes and mild recessions, but allows for Keynesian stimulus effects in largedownturns and episodes of constrained monetary policy.

Figure 18: Adjusting fiscal multipliers for the business cycle


More specifically, the IMF methodology suggests the following:

■ If the output gap is at its historical lowest, increase the multiplier by 0.6.If the output gap is at its historical highest, decrease the multiplier by 0.4.When the output gap is zero, no adjustment should be made. Figure 18,shows how the “structural component” is scaled up or down dependingon the business cycle for a country whose output gap historically hoveredbetween -3% and 3%.

■ If monetary policy is fully constrained at the zero lower bound, themethodology recommends increasing the multiplier by 0.3. If the CentralBank is somehow but not fully constrained, interpolate between 0 and 0.3.

We have applied the methodology conservatively to each of the 11 countries,accounting for the differing positions of each country in the business cycle assuggested by our predictions and those of the IMF past 2017. For each year,we adjust the cyclical component to account for the changes in the output gapnot only resulting from baseline forecasts but also by the previous year’s fiscalstimulation we model. Figures 19 and 20 report the fiscal multipliers for each ofthe 11 countries in 2017 and 2019 respectively.

Finally, while it follows from the above that euro area fiscal multipliers mayin many cases be above 1 currently and therefore imply a benefit from fiscalstimulus, the economic characteristics that push the multipliers higher are notnecessarily those one would associate with an efficient, sustainable economy.

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This reinforces the point that fiscal stimulus is not panacea. Structural reformsare still required.





Choice of other economic parameters

To assess the size of fiscal stimulus needed to close the unemployment gapby 2019, a list of parameters need to be specified. The macro-economicframework used by policymakers and central bankers usually depends onthe potential growth and structural unemployment rate of the economy. Theeconomy is then modeled as fluctuating around that path. The distance fromthe output level to potential output defines the output gap – the position ofthe economy in the business cycle. When output growth is faster (slower) thanpotential growth, the unemployment rate falls (rises) in proportion of the growthdifferential by an amount specified by Okun’s coefficient. For example, assumethe economy’s potential growth rate is 1%, structural unemployment is 5% andOkun’s coefficient 0.5. Furthermore, assume the economy grows at 2% whileunemployment was 7% at the end of last year. Then unemployment should fallby 0.5pp = (2%-1%)*0.5.

We use the OECD’s potential growth estimate to infer potential growth of eachof the 11 countries. Regarding the output gap in 2016, we rely on the IMFestimates. As in previous reports, we rely on estimates from Ball et al 19 (2013)Okun coefficients. For Greece, as it is not available from Ball et al (2013) we usethe results from Karfakis et al (2014) 20. Regarding the structural unemploymentrate, for Germany and Austria we use our economists’ latest assessments of thestructural unemployment there, accounting for the impact of migration and thelatest policy changes such as the implementation of minimum wages. We usethe OECD NAIRU estimates to infer structural unemployment rates in the othercountries with the exception of Spain and Portugal. For the Iberian peninsula,these estimates suggest structural unemployment rates still high by historicalstandards. In that case, we use the European Commission’s estimates of theunderlying “structural unemployment”. This is based on a recent working paperfrom the European Commission 21 . For instance in Spain, while the Non-

19 Ball L., Leigh D., Loungani P.,2013 “Okun’s law: fit at fifty?” NBER Working paper 1866820 Karkafis C, Katrakilidis C, Tsanana E, 2014,”Does output predict unemployment? A look at Okun’s law in

Greece”, International Labour Review, 153,3,421-43321 Lendvai J, Salto M, Thum-Thysen A, 2015,”Structural unemployment vs NAWRU: Implications for the

assessment of the cyclical position and the fiscal stance”, Economic Papers 552

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Accelerating Wage Rate of Unemployment (NAWRU) was estimated around 20%in 2015, the underlying structural unemployment was estimated around 15% in2015.

Finally, the close integration of the euro-area economies means that increasesin one economy’s output have spill-over effects on the neighboring economies.To account for such dynamics, we rely on the relative fiscal spill-over estimatespublished in a recent ECB monthly bulletin22.

Figure 21: Main parameters behind the fiscal easing strategy


Main results

In this section, we report the results of our fiscal policy simulation for each of the11 countries between 2017-19.

Changes in the structural fiscal deficit

If a country needs to increase its spending and generate a fiscal stimulus, thiswould lead to a temporary increase in its structural fiscal deficit. In Figure 22, wereport what the changes in the structural fiscal deficit relative to baseline wouldbe. For the Euro-area in aggregate it would be close to 0.4% of GDP a year, and ofsimilar magnitude for France, Italy and Austria. Italy and Austria would probablybenefit from front-loading the fiscal stimulus. Spain would have to spend about1% of GDP a year.

Portugal and Greece stand out. They would both need to increase their structuraldeficit by about 3.5% a year. These large numbers are due to a combination of (a)larger than average unemployment gaps in 2016, especially for Greece, (b) smallerthan average Okun coefficients and fiscal multipliers, with Portugal having lowerelasticities than Greece using the methodology and sources above.

Figure 22: Fiscal easing required to the close unemployment gap (negativechange implies stimulus)


22 ECB Monthly Bulletin, April 2014, “Fiscal multipliers and the timing of consolidation”

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GDP

In Figure 23, we report for each country the total rise in GDP that would resultfrom the 3-year coordinated fiscal stimulus. We split between spillover effectsand effects from the country-specific change in structural fiscal deficit. The Euro-area’s GDP in 2019 would be 2.9% higher than under the no-fiscal stimulusscenario. Slightly less than half of it would come from the spillover effectsbetween euro-area countries 23

■ Among the Big4, Italy would benefit most from spillover effects andincrease its overall GDP by 4.5% in 2019. Spain GDP would be about 4%higher by 2019, but the majority of that would be the result of the Spanishchange in structural fiscal deficit. France’s GDP would be slightly morethan 2.5% higher by 2019, 60% of which would be due to the changes inthe French structural deficit. Germany does not need to pursue any fiscalstimulus but would still benefit from spillovers, increasing its GDP by 1%by 2019.

■ In the smaller countries, Greece and Portugal clearly stand out. Portugal’sGDP would be 10% higher by 2019, mostly a result of changes in itsstructural fiscal deficit. Greece would also not benefit much from spillovereffects, but its GDP would be nearly 12% higher by 2019. Ireland andBelgium do not really need fiscal stimulus and enjoy spillover effects.The Netherlands would close its unemployment gap by mainly relying onspillover effects.

GDP in the medium-term. The focus of the above analysis is on estimating theadditional GDP growth and fiscal stimulus necessary to close the unemploymentgaps country by country by 2019. What happens after 2019? How sustainableare the benefits? Assuming the fiscal rules are not wholly rejected, one wouldanticipate that the wider structural fiscal deficits would have to be worked off.However, having worked off excess capacity, the fiscal multipliers ought to belower, meaning the post-2019 fiscal tightening would be less detrimental to GDP.In short, even in the medium-term post-fiscal easing one would anticipate thelevel of GDP to be higher than it would have been otherwise. Moreover, the morestructural reforms can be incentivized to take place with the fiscal strategy, thehigher medium term GDP is likely to be too.

Figure 23: Additional GDP growth required to close unemployment gaps –from (a) fiscal stimulus and (b) growth spillover effects


Cyclical changes in the budget primary balance

This increase in growth rates would be accompanied by a fall in the cyclical fiscaldeficit. As unemployment falls, the spending on automatic stabilizers such as

23 While large at first sight, this result does not differ much from the following papers: Veld J. “Fiscalconsolidations and spillovers in the euro area periphery and core”, European Commission, 2013 ; IMF,Germany: 2013 Article IV Consultation, Country Report No 13/255

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unemployment insurance falls. Figure 24 reports the fall in the cyclical balancesattributable to the coordinated fiscal stimulus. In the Euro-area as a whole the fallin the cyclical deficit would fully offset the rise in the structural deficit. This is truein most countries except Spain, Portugal and Greece.

Improvements in the debt/GDP ratio

Overall, because of the extra-spending associated with the fiscal stimulus thestructural fiscal deficit would increase between 2017-19. But growth rates wouldrise above forecasts and the cyclical balance of the budget deficit would improve.Putting all these together, we can then infer what would be the differencebetween the debt-to-GDP ratio without and with coordinated fiscal stimulus. Wedo not assume any changes in real interest rates between the two scenarios. Ascenario of coordinated fiscal stimulus to close unemployment gaps country bycountry could only come about via a consensus decision with the tacit supportof monetary policy. Hence, risk premia are likely to be suppressed.

The results are reported in Figure 24. In all countries the debt/GDP ratio wouldbe lower. In the Euro area it would fall on aggregate by about 3pp. The largestfall would be in Greece (14pp), followed by Portugal and Italy (both 7pp). Most ofthe other countries would be close to the Euro area result. Ireland and Germanywould witness marginal improvements in their debt/GDP ratio of about 1pp.

Figure 24: Main fiscal balances in 2019 – baseline and with fiscal easing to close unemployment gaps

Source: Deutsche Bank Note: The table has been slightly modified from the version initially sent as a Special report. The changes do not impact the main results or conclusions

Mark Wall

(+44) 20 754-52087

Marc de-Muizon

(+44) 20 754-77635

20 September 2016



Central Bank WatchG3

US

Figure 25: G3 policy rates



With the market odds on a Fed rate hike having dropped to 20% or less and theFed having done little or nothing to discourage that movement, the chances of arate hike this month are very slim. While a case could be made for a move nowbased on the data in hand, and we expect that case to strengthen further in thenext couple months, with the Fed raising rates in December and a couple moretimes in 2017.

JapanWe expect this week’s assessment of QQE with negative rates will conclude thatthe policy would have worked had it not been for exogenous shocks – falling oilprices and weaker Chinese growth – a stronger negative impact of the 2014 taxincrease and backward-looking inflation expectations. Such a conclusion wouldsupport an unchanged policy stance. Either at this meeting or in October whenthe Bank updates its economic projections, they may choose to adjust policy togive themselves more flexibility on asset purchases – setting a range rather thana fixed JPY80tn target and perhaps reducing purchases of very long-term bonds –but offset that with a further cut in the interest rate target. The latter’s impact onbank profitability could be softened by applying the rate cut only to the policy ratebalance or folding the macro add-on balance into the basic balance at a positiveinterest rate.

EurolandAs expected, the ECB kept policy steady in September, with Draghi expressingconfidence in the transmission mechanism but remaining cautious on theoutlook. We view further deposit rate cuts as unlikely but expect a 9-12 monthQE extension in December, accompanied by moves to ensure sufficient eligibleassets, most likely through an increase in the issue limit.

Other European countries

UK

Figure 26: Key European policy rates



The BoE eased monetary policy more aggressively and more rapidly thanexpected in August. The signal is that the 0.25% bank rate will fall again but to afloor just above zero by year end. Our view is this happens in November.

SwedenIn February, the Riksbank cut the repo rate 15bp to -0.50%. The Central Bank’srate profile suggests there is a small risk of a further cut.

SwitzerlandThe SNB left policy on hold at its last meeting with rates well below zero. We seefurther gradual depreciation of CHF vs. EUR going forward.

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Dollar bloc

Canada

Figure 27: Dollar Bloc policy rates



We continue to expect that the Bank will remain on hold till this year ends. Theupshot is that monetary policy should remain highly accommodative until wellinto H2 2017, if not longer.

AustraliaWe think that the May and August moves will likely mark the end of the RBA’sactions for this year. That said, we do retain the view from the May RBA Boardmeeting that the Bank will end up taking the cash rate lower as we expect inflationto eventually undershoot RBA’s current published forecasts. Specifically we lookfor a 1.25% cash rate come mid-2017.

New ZealandWe think the RBNZ will ease more than is currently priced in order to bring theinterest rate differential with the rest of the world down and hence take pressureoff the exchange rate. Unless, the rest of the world raises interest rates morethan expected. At this stage we think the former is more likely. We see the RBNZeasing again before the year ends and again in H1 2017. At the margin the RBNZ’shigher track for the exchange rate reduces the prospect of another rate cut thisyear somewhat.

BRICs

China

Figure 28: BRIC policy rates



Stabilized August activity data and the property boom puts upside risk to our H2GDP forecast and downside risk to our 2017 forecast. We expect policy actionsto happen in H1 2017 , including two RRR cuts and one interest rate cut.

IndiaWe expect the bank under the new Governor to cut the repo rate by at least 50bpsin this cycle. Currently markets are pricing in expectations of a little more than25bps cut; we think the RBI will readily deliver that and some more in the monthsahead.

BrazilAs the recession has allowed inflation to decelerate, the impeachment of thePresident as reduced political risk, and the BRL has recovered some ground, webelieve the next BCB move will be a reduction in interest rates, beginning with a25bp rate cut in October (although a delay in passing some key fiscal measuresin Congress might prompt the BCB to wait until November).

RussiaWe expect inflation to fall to 5.7% by end-2016 and 4.5% by end-2017, pavingthe way for the CBR to bring the policy rate to 7.5 within a corridor system thatis +/-100bps by end-2017. The CBR cut the policy rate by 50bps in September,as expected, but committed to no further cuts until end-2016. As a result we arekeeping our call for cumulative cuts of 250 by end-2017, most likely back-loaded.We will also be looking out for the CBR to switch to 25bps cuts per meeting.

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Source: Deutsche Bank, Central Banks, Haver Analytics

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Figure 30: Key Economic Forecasts

Source: See below

Figure 31: Forecasts: G7 quarterly GDP growth

Source:National authorities, Deutsche Bank Research

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Appendix 1

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Japan: Approved and/or distributed by Deutsche Securities Inc.(DSI). Registration number - Registered as a financialinstruments dealer by the Head of the Kanto Local Finance Bureau (Kinsho) No. 117. Member of associations: JSDA, Type IIFinancial Instruments Firms Association and The Financial Futures Association of Japan. Commissions and risks involvedin stock transactions - for stock transactions, we charge stock commissions and consumption tax by multiplying thetransaction amount by the commission rate agreed with each customer. Stock transactions can lead to losses as a resultof share price fluctuations and other factors. Transactions in foreign stocks can lead to additional losses stemming fromforeign exchange fluctuations. We may also charge commissions and fees for certain categories of investment advice,products and services. Recommended investment strategies, products and services carry the risk of losses to principaland other losses as a result of changes in market and/or economic trends, and/or fluctuations in market value. Beforedeciding on the purchase of financial products and/or services, customers should carefully read the relevant disclosures,prospectuses and other documentation. "Moody's", "Standard & Poor's", and "Fitch" mentioned in this report are notregistered credit rating agencies in Japan unless Japan or "Nippon" is specifically designated in the name of the entity.Reports on Japanese listed companies not written by analysts of DSI are written by Deutsche Bank Group's analysts withthe coverage companies specified by DSI. Some of the foreign securities stated on this report are not disclosed accordingto the Financial Instruments and Exchange Law of Japan.

Korea: Distributed by Deutsche Securities Korea Co.?

South Africa: Deutsche Bank AG Johannesburg is incorporated in the Federal Republic of Germany (Branch RegisterNumber in South Africa: 1998/003298/10).

?Singapore: by Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch (One RafflesQuay #18-00 South Tower Singapore 048583, +65 6423 8001), which may be contacted in respect of any matters arisingfrom, or in connection with, this report. Where this report is issued or promulgated in Singapore to a person who is not anaccredited investor, expert investor or institutional investor (as defined in the applicable Singapore laws and regulations),they accept legal responsibility to such person for its contents.

Taiwan: Information on securities/investments that trade in Taiwan is for your reference only. Readers shouldindependently evaluate investment risks and are solely responsible for their investment decisions. Deutsche Bank researchmay not be distributed to the Taiwan public media or quoted or used by the Taiwan public media without written consent.Information on securities/instruments that do not trade in Taiwan is for informational purposes only and is not to beconstrued as a recommendation to trade in such securities/instruments. Deutsche Securities Asia Limited, Taipei Branchmay not execute transactions for clients in these securities/instruments.

?Qatar: Deutsche Bank AG in the Qatar Financial Centre (registered no. 00032) is regulated by the Qatar Financial CentreRegulatory Authority. Deutsche Bank AG - QFC Branch may only undertake the financial services activities that fall withinthe scope of its existing QFCRA license. Principal place of business in the QFC: Qatar Financial Centre, Tower, WestBay, Level 5, PO Box 14928, Doha, Qatar. This information has been distributed by Deutsche Bank AG. Related financialproducts or services are only available to Business Customers, as defined by the Qatar Financial Centre RegulatoryAuthority.

Russia: This information, interpretation and opinions submitted herein are not in the context of, and do not constitute,any appraisal or evaluation activity requiring a license in the Russian Federation.

?Kingdom of Saudi Arabia: Deutsche Securities Saudi Arabia LLC Company, (registered no. 07073-37) is regulated bythe Capital Market Authority. Deutsche Securities Saudi Arabia may only undertake the financial services activities thatfall within the scope of its existing CMA license. Principal place of business in Saudi Arabia: King Fahad Road, Al OlayaDistrict, P.O. Box 301809, Faisaliah Tower - 17th Floor, 11372 Riyadh, Saudi Arabia.

?United Arab Emirates: Deutsche Bank AG in the Dubai International Financial Centre (registered no. 00045) is regulatedby the Dubai Financial Services Authority. Deutsche Bank AG - DIFC Branch may only undertake the financial servicesactivities that fall within the scope of its existing DFSA license. Principal place of business in the DIFC: Dubai InternationalFinancial Centre, The Gate Village, Building 5, PO Box 504902, Dubai, U.A.E. This information has been distributed by

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Deutsche Bank AG. Related financial products or services are only available to Professional Clients, as defined by theDubai Financial Services Authority.

Australia: Retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial productreferred to in this report and consider the PDS before making any decision about whether to acquire the product. Pleaserefer to Australian specific research disclosures and related information at https://australia.db.com/australia/content/research-information.html??Australia and New Zealand: This research, and any access to it, is intended only for "wholesale clients" within the meaningof the Australian Corporations Act and New Zealand Financial Advisors Act respectively.

Additional information relative to securities, other financial products or issuers discussed in this report is available uponrequest. This report may not be reproduced, distributed or published without Deutsche Bank's prior written consent.Copyright © 2016 Deutsche Bank AG

David Folkerts-LandauGroup Chief Economist and Global Head of Research

Raj HindochaGlobal Chief Operating Officer

Research

Michael SpencerHead of APAC Research

Global Head of Economics

Steve PollardHead of Americas Research

Global Head of Equity Research

Anthony KlarmanGlobal Head ofDebt Research

Paul ReynoldsHead of EMEA

Equity Research

Dave ClarkHead of APAC

Equity Research

Pam FinelliGlobal Head of

Equity Derivatives Research

Andreas NeubauerHead of Research - Germany

Stuart KirkHead of Thematic Research

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