Global Economics Morgan Stanley 16 Marco 2012

8/2/2019 Global Economics Morgan Stanley 16 Marco 2012

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In fact, in the US the share of energy in total household expenditure has actually declined lately,courtesy of a mild winter (which reduced the volume of demand) and lower gas price quotes(which reduced the price of energy for some households).

Further, the barrel bill concept can help us to gauge the impact of oil on the global economy.

Scenario analysis: Using assumptions about oil prices for the rest of the year and theresponsiveness of demand to prices (price elasticity of demand'), we can construct differentscenarios for the 2012 barrel bill - and its change over the 2011 barrel bill.

At current oil prices (around US$125 for Brent), our scenarios indicate an increase in the barrel billof about 0.2-0.4pp of oil importers' combined GDP compared to last year. This is roughly in linewith the average increase in the barrel bill over the last ten years (0.3% of GDP). That, in general,has not been recessionary in the past. In addition, we take heart from the fact that despite asizeable increase in the barrel bill between 2010 and 2011 (of 0.9% of GDP), 2011 was not arecession year for the global economy (although it did weaken the US economy in the first half).This despite: i) general DM sluggishness induced by deleveraging; ii) the global shock from theJapanese catastrophe; and iii) the European sovereign and banking crisis.

An oil price at US$150 per barrel would, depending on the demand responsiveness, add at least0.7% of GDP to the barrel bill of oil importers. It is likely - although not certain - that this would tipsome of the more fragile parts of the global economy into recession, particularly in DM. It wouldalso bring the share of GDP importers' spend on oil to well above 4%, levels we haven't seensince the early 1980s (the barrel bill declined from 5.9% of oil importers' GDP in 1980 to 3.5% in1982). In short:

Oil prices at current levels are a drag, but should not be too much of a problem for oil importersand the global economy as a whole.

A meaningful further rise in oil prices from current levels, say to US$150, could tip the morefragile parts of the global economy into recession, particularly in DM.

A final worry: It is always worth bearing in mind that it is difficult to draw conclusions about thefuture path of the economy from correlations; all else' is rarely equal'. One of the ways in whichthis oil price surge could impact the economy is indirect: by rendering global monetary policy lessaccommodative. This may already be happening:

The Fed seems to be favouring sterilised asset purchases (Operation Twist 2) to another roundof unsterilised purchases (QE3) - not least because we think it would not want to be seen to befanning inflation expectations when energy quotes are likely to climb.

Our ECB watcher, Elga Bartsch, is flagging upside risks to her call for another 25bp cut in 2Q asthe oil price surge exerts upward pressure on the inflation outlook. And of course, last year theECB hiked in response to the oil price rally then.

Our Asia ex-Japan economist, Chetan Ahya, thinks that the rally in oil prices will delay repo ratecuts by the Reserve Bank of India, initially expected to commence in March; an April move woulddepend on the trajectory of oil and commodity prices, in his view.

Our Bank of Korea watcher, Sharon Lam, sees risks to her call for a cut if inflation rises in thecoming months.

Conclusions: We estimate the global wealth transfer from oil importers to oil exporters at currentoil prices at around US$2.5 trillion for 2012 - 4.2% of oil importers' GDP or 3.6% of global GDP.This will likely be a drag on global growth, but would on its own not be sufficient to derail the


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recovery. Oil prices at US$150 could well tip the more fragile parts of the global economy intorecession, however. We also worry that higher oil prices will act as a constraint on central bankeasing, thereby resulting in less monetary support for the economy.

Box 1: The Global Effect of Oil Price Shocks

Higher oil prices first and foremost constitute a redistribution of wealth - and therefore demand -from net importers to net exporters (demand redistribution effect). This income transfer occursbecause, in the short run, there is no escape for net importers: the responsiveness of energydemand to price (the price elasticity') is low, since much of energy-consuming economic activity isessential' (people have to drive to work, factories need to run, and so on). As a consequence,consumer spending on other items gets squeezed, as do corporate profits and therefore spendingby firms.

Net exporters, the recipients of the income transfer from the net importers, are likely to save asubstantial part of the income transfer. How much is saved and how much is spent dependscrucially on whether the oil price increase is (perceived to be) permanent or transitory - the moretransitory, the more is saved. In any case, the fact that at least some of the transfer is saved

means that higher oil prices also, on net, take out demand from the global economy (demanddestruction effect).

What happens to those savings? Part of it will be invested domestically. The other part will beinvested abroad - oil producers' persistent current account surpluses are evidence of this. Some ofthese funds will be invested in other oil-exporting countries. But a substantial part of them will beinvested in net oil-importing countries. In short, some of the initial income transfer is recycled intothe purchase of assets of net importing economies - naturally, oil exporters obtain claims on net oilimporters. So, the oil shock results in a reshuffling of the global ownership of assets - the assetmarket counterpart of the global wealth redistribution (asset recycling effect).

What happens to the part of the income transfer that is consumed? Again, a part of it will beconsumed on domestic goods, and a part on imported goods. And once more, some of thesegoods will be imported from other oil producers, but most will be imported from net oil-importingcountries. That is, part of the initial income transfer is reversed through goods imports from net oilimporters (goods recycling effect).

So, from a high-level perspective, the oil bill is not a net negative for the global economy. Theresources spent on purchasing more expensive energy do not disappear into outer space. Rather,a redistribution takes place - and as with every redistribution, it creates winners and losers. Andeven within the group of the losers, some will be relatively better off and some will be relativelyworse off.

Box 2: The Barrel Bill and GDP Growth

How do oil prices and the barrel bill relate to GDP growth?

Level versus change: We think that it is usually more helpful to look at the change in the barrelbill rather than the level. Why? The level of the oil import bill most of the time matters for the levelof income available to an economy, not real GDP growth. Think of an economy that transfers aconstant share of its income abroad every year. The consumption and investment decisions thatdetermine GDP growth are then made on the basis of the post-transfer income. It is only when theshare of income that goes abroad changes that spending plans have to be changed. If the shareof the income transfer changes meaningfully, the resulting adjustment in spending can bedisruptive to the economy. In particular, since spending on energy is essential', other spendingusually has to be reduced when energy becomes more expensive. (Of course, the level matters in


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the sense that, for a given change, the level determines the percentage - i.e., the relative - changein the bill.)

Large versus small; permanent versus transitory: This is why large, permanent increases inthe barrel bill matter more. Small increases only generate minor changes in level and pattern ofspending; temporary increases can be absorbed by reducing saving.

Supply versus demand: Last but not least, the driver of the (change in the) barrel bill matters. Astrong world economy will boost oil demand, prices and hence the barrel bill; and vice versa whenthe global economy is weak. At the same time, an oil price and barrel bill driven by demand will actas an automatic stabiliser: they will slow the economy when it's strong and boost it when it's weak.On the other hand, a supply shock will increase the price of oil, decrease demand and increasethe value of oil importers' imports, the barrel bill. (The latter increases because the response ofdemand to higher prices is muted - the price elasticity of demand' for energy is low - hence thepercentage price increase in the price outweighs the percentage decrease in demand.) The higherbarrel bill has an impact on spending and hence reduces growth.

In short, it follows that while demand shocks increase prices and the barrel bill, the impact on GDP

growth will be to slow it down gradually. Metaphorically speaking, in this case the price of oil actslike an elastic leash on the dog that is the global economy. If the dog surges ahead too quickly, theconstricting effect of the leash will make sure it slows down - but it will not stop. Between 2003 and2007, the real price of oil roughly doubled, with little evident harm to the global economy. A supply-induced increase in the price of oil (and barrel bill) would tend to have more serious effects. In thedog metaphor, an oil supply shock could act as a jerk on the leash, which could bring the dog to ahalt.

The upshot: the most dangerous oil shocks are - you guessed it - large, permanent supply shocks.How large is large' and how long-lasting is permanent'? Here's an indirect answer. The currentsupply change is certainly large' (Brent is up 17.5% year to date). And December 2013 oil futures

trade at around US$113 (implying an average price of US$120 between April 2012 and December2013) - long lasting but not permanent'.

Box 3: Measuring the Oil Bill

The metric one uses depends on the purposes of the investigation. Here, we focus on the wealthredistribution that takes place in the global economy due to oil shipments from exporters toimporters. Hence, we look at oil imports (equivalently: trade), rather than total oil consumption. It isonly imports (exports) that imply a transfer (receipt) of resources abroad (from abroad).Correspondingly, to scale the global income transfer, we divide by the aggregate GDP of the oil-importing economies only.

The difference between imports and consumption is meaningful, both on a global and individualcountry level. Globally, consumption of oil for 2010 was around 87 mbd; imports on the other handwere around 54 mbd. This implies that out of the total consumption of oil, only around 59%crosses borders. The remaining 41% is nearly equally split between what oil exporters consumedomestically (19% of global consumption) and what oil importers produce - and consume -domestically (22% of global consumption).

In terms of individual countries, some net exporters are important consumers, and some netimporters are important producers. Russia and Saudi Arabia, the two biggest producers, togetheraccount for almost 7% of global consumption. Similarly, the US and China - both in the top three ofglobal oil consumers - produce a substantial part of their total consumption domestically (in 2010,the US produced 39% or 7.5 mbd of its total 19.1 mbd consumption while China covered 45% ofits 9.1 mbd crude oil needs from its domestic production of 4.1 mbd).


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For full details and accompanying exhibits, see Global Economics: Barrel Bill (2012 Edition),March 14, 2012.

Latin AmericaOil Risk to AbundanceMarch 16, 2012

ByGray Newman & team | New York

No sooner have the tail risks in Europe begun to subside, than a new threat has appearedon the horizon - the rising price of oil threatening the global recovery. After arguing in recentyears that there were three risks to abundance in Latin America - the pace of the US recovery, thesovereign debt crisis in Europe and the magnitude and effectiveness of China's policy response - itlooks like we have to add a fourth.

But it is not clear that an oil shock belongs in our risks to abundance in Latin America. Theregion is, after all, a net exporter of oil. While the latest data from Argentina and Brazil show that

the two countries are beginning to trade places - Brazil is becoming a net exporter even asArgentina is becoming a net importer - the differences are presently modest. (There are somediscrepancies between the widely used oil balance as measured by BP and the US EnergyInformation Administration, which define the oil balance as the difference between production andconsumption, and some of the national statistical measures, which compare imports and exports.For the sake of consistency across the region we are using the BP and EIA series.) Indeed, onlyChile is a significant oil importer in the region.

Indeed, a simple exercise that tries to measure the impact of an oil shock concludes thatLatin America is one of the three regions in the world that actually gain from higher oilprices. The World Bank exercise suggests that even with a large shock to oil prices - defined here

as a US$50 per barrel increase (roughly twice the magnitude of the average oil shock over thepast 40 years), Latin America would see a boost to GDP of 0.7% in the calendar year following amid-year price jump. The other winners would be sub-Saharan Africa and the Middle East, evenas global GDP and emerging market GDP would suffer a hit to growth.

Gaining, Before Losing

I am a bit sceptical of such exercises. Most of the episodes of stronger oil prices during the past40 years (the experience of developed economies during the 1970s being the most importantexception) have found that higher oil prices are associated with rising demand and stronger globalGDP. I am concerned that the positive relationship between higher oil prices and stronger growth

has it limits; the risk is that the relationship is non-linear.

Up to some threshold, higher oil prices should benefit Latin America. But if prices climb farenough and fast enough to send the global economy into a downturn, the benefits to the regionbegin to diminish and may be overwhelmed by the global downturn. The difficulty is that moststudies have had a hard time measuring the damage on overall growth, and those that do find it tobe modest. Indeed, the IMF study cited above suggests that an increase in oil prices of 25%(close to the average for shocks in the past 40 years) led to a loss in real GDP in oil-importingcountries of less than half of one percent, spread out over two to three years. Meanwhile, ourcommodity analyst Hussein Allidina argues that even with a supply disruption from a conflict withIran, he still sees limited upside to oil prices (see Crude Oil: Pricing for a Disruption, February 10,2012). Confused? You can understand why we leave the oil call to our global and commodityteams.
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That doesn't mean we cannot say anything about the region. This note looks at three metricsto determine sensitivity of economic activity in each country in the region to an oil shock. And weprovide an update on our thinking of how oil could impact both inflation as well as the fiscaldynamic in the region's largest economies.

But keep in mind that while the greatest near-term risk to the region is one of the three (orpossibly four) risks to abundance, we still think that the greatest medium-term challengefor the region is the risk of abundance - a period of strong inflows pressuring currencies everstronger (see "Latin America in 2012: The Risks to Abundance Return", This Week in LatinAmerica, November, 28, 2011). What happens to the cycle in 2012 matters a great deal to us, butwe suspect that the risks in the near term are the exact opposite of the region's medium-termrisks.

Oil: The New Grease?

We've looked at three metrics to determine sensitivity of economic activity in each countryin the region to an oil shock. The first and seemingly most straightforward is to measure the oilbalance: what is the magnitude of an economy's status as a net importer or exporter of oil. The

second metric - an oil reliance measure - looks at what percentage of energy requirements in acountry is met by oil. The third is an oil efficiency or intensity measure, comparing how manybarrels of oil are necessary to produce a unit of GDP and then comparing each country in theregion to the global average.

First, from an oil balance perspective, Chile seems most exposed to a sudden spike in oilprices as the region's largest net importer of oil - running near 4% as measured by BP and EIAdata. In contrast, Venezuela and Colombia are the largest net exporters. While there aresignificant differences on the precise magnitude of Venezuela's oil surplus, recent estimates placeit anywhere from 18-26% of GDP, with Colombia's oil balance running from 6-8% of GDP. Ofcourse, this metric fails to take into account the sizeable stabilisation funds that Chile has built to

withstand such a shock. Chile's vulnerability is likely to be much more limited than its exposure.

Second, it is worth noting that not only is Chile the region's largest net importer of oil, but italso has the greatest reliance on oil for its total energy needs of any of the majoreconomies. One might think that, given Chile's net oil importer status, it may have had greatersuccess in weaning itself off its overreliance on oil, but no economy in the region relies moreheavily on oil than Chile as a share of total energy needs. In contrast, Colombia and Argentinahave the lowest reliance on oil relative to other sources of energy in the region.

Third and finally, Venezuela and Mexico appear to be the least efficient in their use ofoil: They have the highest oil consumption requirement to produce US$1 million of output. Once

again, Colombia is by far the most energy-efficient, requiring the least oil per unit of output - asurprising feat, given that Colombia is an important net exporter of oil.

Country Details: Inflation and Fiscal Impact

We see a limited inflation impact in the region from the current increase in oil prices. It isworth remembering that the prices that consumers see at the pump do not necessarily move one-to-one with global oil prices, and that the potential inflation impact is complicated by fiscalsubsidies.

Even in Brazil, where Arthur Carvalho has repeatedly warned that there is very littlemanoeuvering room on the inflation front and that any shock in prices of foodstuffs couldpush inflation well above 6%, he sees little room for an oil price shock to feed through toinflation in 2012 in a significant way. While it normally takes on average about six months beforehigher oil prices feed through to the consumer in Brazil, this scenario seems unlikely in 2012. A


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move upward in consumer fuel prices would coincide with municipal elections and with thebeginning of headline inflation's year-on-year rise, according to our forecasts.

One possible outcome in Brazil would be to raise gasoline and lower taxes in order to have alimited impact on the final consumer price. Unfortunately, Arthur believes that there is not muchmore room to reduce this tax (CIDE). Currently, if the administration raises gasoline prices by10%, which is only half of what would be compatible with the current oil prices, it would be able tooffset 5% by cutting taxes. In turn, a 5% price increase for consumers would add roughly 20bp toheadline inflation.

In Mexico, direct subsidies on gasoline - which are unlikely to be lifted ahead of the Julypresidential elections - limit the fiscal gains from higher oil prices, but also likely limit theinflation impact in 2012. With the government deriving nearly a third of total revenues from oil,rising crude quotes translate into greater tax receipts which, given a fiscal regime that de-emphasises saving, are for the most part spent. If the Mexican oil basket were to remain at theearly March level of around US$115 per barrel - well above the budget projection of US$84.9 perbarrel - Luis Arcentales estimates that the oil-revenue windfall could reach near 1.2% of GDP in2012 (In 2011, above-budget oil receipts reached M$95.1 billion or 0.6% of GDP). The problem of

course is that, by controlling gasoline prices, a heavy fiscal burden emerges when crude pricesrise. By end-February, domestic regular gasoline was some 30% lower than US retail prices.

Among the largest economies in the region, the greatest risk to inflation (and growth)appears to be in Chile. As the experience of 2007 and 1H08 showed, the country is stillvulnerable to pressure from oil prices via rising costs, expectations and inflation.

On the inflation front, Luis Arcentales notes, gasoline prices are adjusted on a weekly basis toreflect swings in international benchmarks, and thus the impact on consumer pockets is almostimmediate, even without considering potential second-round effects from higher input costs.Today's backdrop, moreover, bears some resemblance to 2007, because dry weather conditions

have the potential to disrupt hydroelectric generation, which would force companies to switch tomore expensive thermal sources at a time of high crude prices. While electricity tariffs plunged inJanuary, the risk of higher tariffs is something we are monitoring closely. After all, Chile watcherslikely remember the one-two punch of soaring fuels and electricity prices in the last cycle: by thetime annual inflation peaked in October of 2008 at 9.9%, higher fuels and electricity were addingnearly two full percentage points to headline inflation.

In addition, Luis suspects that persistent pressure from fuel prices could make Chile'scentral bank more cautious - particularly given today's backdrop of tight labour markets - andthus reduce its incentive to ease policy in coming months (see "Chile: Dj vu 2007?", This Weekin Latin America, February 27, 2012). On the fiscal front, higher oil hurts the government coffers

via several ways, including from the drag on economic activity as well as from weaker tax receiptsfrom miners whose margins are squeezed by steeper energy costs, unless metal pricescompensate for this. Last, in the recent past when faced with soaring energy prices, thegovernment has resorted to cutting gasoline taxes or adding resources to the fuel stabilisationfund. Given Chile's strong fiscal position, with some 8pp of GDP in its main stabilisation funds, wesuspect that the fiscal drag won't become a major issue for Chile watchers.

After decades of being a net energy exporter, Argentina appears to have become an energyimporter in 2011 as measured by the INDEC: The energy trade balance slipped to a deficit ofUS$3.2 billion in 2011 from a surplusof US$2.0 billion in 2010. To put this in perspective, theoverall trade surplus in Argentina in 2011 was US$10.3 billion, suggesting that if last year's paceof deterioration in oil trade continues, Argentina's trade balance would be wiped out within twoyears. Higher oil prices would only shorten that timeline, heightening concerns regarding theviability of the current managed floating exchange rate regime.


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Further, Daniel Volberg is concerned about the negative impact on Argentina's fiscalaccounts. With regulated prices of energy largely frozen over the past decade, the impact ofrising energy prices has had a serious impact on the fiscal accounts, as last year energy subsidieshit 2% of GDP and rising. Indeed, with the domestic oil price in Argentina at just under US$75 perbarrel in December 2011, upside to international prices would likely force either a more rapidincrease in domestic prices or a larger fiscal effort to maintain subsidies in place. Given lack ofdirect access to international capital markets, a higher burden of energy subsidies may not befiscally sustainable.

If there is a positive story in the oil shock scenario, Colombia may be the region's biggestbeneficiary, up to a point. With a positive oil balance estimated at 6-8% of GDP in 2011 and oilproduction expected to continue rising over the next few years, higher prices - absent a globaldownturn - would likely boost Colombia's GDP, trade and current account.

Finally, while Venezuela is normally seen as the biggest beneficiary of higher oil prices,Daniel argues that there are two issues that likely limit the benefits. First, we suspect thatofficial oil production and export numbers are overstated. Officially, Venezuela's oil trade surplusin 2011 reached 26% of GDP, boosting the overall trade surplus to nearly 15% of GDP. However,

data on production and consumption by other sources suggest that Venezuela's oil balance maybe widely overstated. Second, a decade of policy heterodoxy has impaired domestic production ofgoods and services, so export proceeds are increasingly used to pay for imports. Therefore, wesuspect that upside in oil prices is likely to have a positive but limited impact on Venezuela's tradebalance and GDP growth.

Bottom Line

As an oil exporter, Latin America likely gains from rising oil prices...up to a point. But wesuspect that the rise in oil prices has a limit: crossing that threshold could damage global activity,and it is not difficult to see that Latin America's oil gains could be tempered or offset. While Chile's

exposure is well known, we would argue that Mexico is also at risk. Although Mexico is a modestexporter, if an abrupt rise in oil prices called into question the recovery of the US - and presumablythe threshold that could cause the US to stumble is lower today - the link with the US would likelyoverwhelm the gains associated from higher oil revenues. An oil shock per se might not beenough to make it to our trio of the risks to abundance, but nor would Latin America be immune tooil's impact on the rest of the globe.

United StatesFed Thoughts: QE or Not QE?March 06, 2012

ByVincent Reinhart | New York

For some time, our call has been that the Federal Reserve will undertake additional balance-sheetaction in 1H12. This view has been in and out of consensus thus far this year, even though theFed appears to have been adhering to a consistent storyline throughout. Three observationssupport our assessment that there is a three-in-four chance of unconventional action by June.

First, the political calendar makes it likely that the Fed will want to keep a low profile in thesecond half of the year's campaign season. If the window for a policy move closes by June, thehurdle for action is lower before then.

Second, economic slack persists and inflation is running below the Fed goalin its medium-term projection. The dual shortfall from its mandate provides both justification and political coverfor action.
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Third, the decision-makers at the core of the FOMC have consistently pointed to reasons why theperformance of the economy will be subpar and at significant risk in the near term. Here,too, at Morgan Stanley, we share the view that the fillip to economic growth associated with arestocking of inventories is fading and that real GDP growth will slow notably in the currentquarter. Anxiety-inducing headlines that the economy is losing steam would be conducive to Fedaction.

The most likely form of that action is open market purchases of Treasury and mortgage-backed securities funded through the creation of reserves - Quantitative Easing 3 (QE3) - atthe April or June meetings. We expect it to total around $500 billion to $700 billion. Such aprogram would dovetail with the expiration of the ongoing Operation Twist at the end of June.

An attractive alternative to the Fed would be to expand the scale and scope of that existingprogram - that is, announce Operation Twist 2 (OT2). It could stretch purchases out until theend of the year, implying total new purchases of about $400 billion, and include MBS as well asTreasuries. Moreover, the Fed would use the tools of monetary policy to sterilize the effects onthe balance sheet. Those tools include continuing to sell shorter-term Treasuries and arrangingtemporary reserve-draining operations. OT2 would allow the Fed to act sooner, say at the March

or April meeting, and frame the initiative as support for the ongoing economic expansion. It wouldalso buy some insurance from criticism by keeping the overall size of the balance sheetunchanged.

We made this Fed call late last year (see Fed Thoughts for 2012: Into the Heart ofDarkness, December 27, 2011), and the first order of business is to mark it to market in light ofwhat we've since learned. In the event, data, particularly those describing labor markets, havecome in stronger than we expected. The Fed's core policy-makers, however, have soundeddovish in almost every public utterance. On balance, the logic for additional Fed action still seemscompelling.

Why, then, has the expectation of action fallen out of the consensus? The answer hinges on anassessment of the economy's momentum, a careful reading of the latest FOMC minutes, and anunderstanding of the Fed's conduct in anticipation of an adverse turn of events. Of course, thereis the possibility that we could be wrong, which is why we end with some discussion of the one-in-four chance that the Fed stays on hold in 2012.

What Have We Learned?

The Morgan Stanley outlook is that the US economy will expand this year and next at around a 2%rate, about that of potential output growth. Unfinished business from the financial crisis leaves themortgage market impaired and households needing to improve their balance sheets. This

balance-sheet improvement is likely to come the hard way - by increased saving - rather thanthrough significant capital gains on equity and real estate holdings. This is because the forwardcalendar is chock-full of events in the US and Europe that may set back global financial marketsand the economy. As a consequence, we think investors will not retain a durable-enoughconviction about fundamentals to support an extended market rally. Without a continuing boostfrom wealth creation, the economy grows at trend. If so, resource slack and inflation would movesideways.

This was our outlook in December and is still so in March. The data have been better, of course.Readings on the labor market, including initial claims for unemployment insurance, have beendecidedly more upbeat. We know now that real GDP expanded at a 3% annual rate in 4Q11.However, about 2 percentage points of that growth owed to inventory stock-building. This is notthe basis for sustained robust expansion, and as inventory levels settle down, we expect real GDPto slow appreciably. Indeed, our tracking estimate of growth this quarter clocks in at only 1%.


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The Federal Reserve has seen these data and seems to share a similarly cautious assessment ofthe outlook, at least judging by the summary of the economic projections of FOMC participantsthat accompanied the January meeting. Thus, it has a medium-term forecast in which it falls shortof both parts of its dual mandate of maximum employment and stable prices, a ready justificationfor additional policy action.

In other aspects of its communications, the Fed has been transparent in its intent. It apparentlydoes not want market participants to get too enthusiastic about the outlook. Three specificaspects of its message deserve more attention.

Stronger incoming data have mostly been ignored by the Fed. There was almost no mentionof favorable readings on activity and the labor market in the Fed's public statements earlier thisyear. Only late in the game, with the semiannual testimony to Congress, did Chairman Bernankedevote much attention to employment gains. No doubt, it would have been awkward otherwise toreview economic developments over the past year without noting that the unemployment rate hasfallen by 0.75 percentage points. Even so, the Chairman's reminder that "the job market remainsfar from normal" seemed to be the main takeaway. The Fed either does not accept that the pick-up in growth will be sustained or does not want market participants to get carried away in

connecting the last few data points.

The emphasis is on the dark clouds, not the silver lining. Every Fed statement frets that"strains in global financial markets posed significant downside risk to the economic outlook".Deep down to their free-market bones, Fed officials are mostly euroskeptics who have troubleconvincing themselves that a flawed currency union will survive. A general piece of advice fromFed economists working on the policy challenges posed by the zero bound to the nominal fundsrate is that it is best to front-load policy accommodation if there is a significant risk of an adverseevent. That way, the economy is on a stronger footing if the blow does strike. The politicalcalendar makes this insurance motive more important: Since the Fed likely wants to keep a lowprofile during the height of the campaign season, it should be quicker to act in the first half in

anticipation of adverse shocks.

Follow the Fed and do not worry about inflation. The Fed has signaled in multiple ways that itdoubts that a pick-up in inflation is a material risk to the outlook. It excised the sentence referringto monitoring inflation and inflation expectations from the January FOMC statement. In thesummary of economic projections for that meeting, it forecasts inflation to run below its goal in themedium term. This is not surprising, because the basic determinant of inflation in Fed-stylemodels is resource slack, which it asserts is considerable. After all, policy-makers have not raisedtheir assessment of the natural rate of unemployment or lowered their estimate of the rate ofgrowth of potential output. For good measure, the Fed's inflation goal was raised a touch, to 2%,just to be sure that there was white space between desired and actual inflation.

Reasons We Are Not Wrong

Our three-in-four expectation of Fed action has moved out of consensus in the past few weeks.Some of the objections are easy to understand. After all, we also see a one-in-four chance thatnothing happens. If the economy surges or equity investors continue to embrace risk, the Fedwould cheerfully keep its plans on the shelf. Therefore, if we are undercounting the resilience ofthe US economy, we are also overestimating the likelihood of Fed action.

Some of the objections, though, seem off kilter. In particular, we push back against three leadingquestions whenever we are asked them.

Doesn't the Fed Need to See a Fall in Economic Activity before it Acts?


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No. That notion is based on a misreading of the minutes of the January meeting. In thediscussion of the views of all FOMC participants about whether additional balance-sheet changeswere appropriate, we learned that a few preferred to act in 2012 and a number remained open tothat possibility "if the economic outlook deteriorated". This phrase just means that their forecast ofeconomic growth has to soften, not that the level of activity has to drop. Even more to the point,this characterization was in the back of the book, which discussed the views of all those who aresurveyed - the five governors and the 12 bank presidents. What matters is the explanation earlierin the minutes that is limited to the ten voters. There we learned that a few members thoughtcurrent and prospective economic conditions could warrant action "before long". Other memberswould support this if "the economy lost momentum or if inflation seemed likely to remain below itsmandate-consistent rate". In minutes math, a "few" plus "others" is likely a majority. Note that thefirst trigger only requires a slowing in economic expansion and that the second is already met intheir published forecast.

Doesn't the Recent Run-Up in Oil Prices Take Fed Action Off the Table?

The Fed does have a problem because oil prices are 35% above their local bottom of October2011. Such a run-up creates an uncomfortable tension for a central bank, in that headline inflation

rises but spending gets hit because the US is a net importer of energy. However, ChairmanBernanke's academic work on the strong post-WWII association between energy price spikes andsubsequent recessions puts part of the blame on the Fed's historical response. As long asinflation expectations are well anchored, the strong conclusion is that the central bank should easepolicy to counter the blow to aggregate demand. Thus, the recent rise in oil prices and the riskthat they go higher likely inclines the Fed to do more, not less.

How Can Fed Officials Believe That Further Balance-Sheet Manipulation Would Work?

It is their job. Fed officials do not have outsized expectations for the efficacy of their policyinstrument. Rather, they feel a responsibility to use an instrument that most likely works in

furthering their mission, even if those benefits may be small. Moreover, while the basis pointconsequences of asset purchases might be modest, the Fed wants to be seen by the private andpublic sectors as willing to act when there is a need. For households and firms, QE3 or OT2 mightboost confidence. For the rest of officialdom, the Fed would show that at least one institution inWashington DC retained a sense of purpose.

Reasons We May Be Wrong

We see a three-out-of-four chance that the Fed acts as the data on growth soften and the rally inthe equity market fades. If the Fed is in a hurry or feels no need to push up inflation expectations,the action likely takes the form of sterilized asset purchases, i.e., the one-in-four chance of

Operation Twist 2. Recent public comments by Fed officials, along with press comments, make itmore likely we are underestimating, not overestimating, their willingness to execute OT2. If theFed needs to see some slowing in the economic expansion either to get internal agreement orexternal insurance, the policy initiative waits until the April or May meeting and more likely entailsasset purchases that are funded with reserve creation. This policy, Quantitative Easing 3, whichwe peg at a one-in-two chance, would also be favored if the Fed desired more significant currencydepreciation.

The remaining one-in-four probability of no action hinges mostly on a happy outcome for the Fed.It would not ease if it sees no reason to do so as payrolls expand robustly and equity marketsextend their rally. This requires, of course, that politics at home and the ongoing sovereign andbanking crisis abroad do not intrude.


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ImportantDisclosure Informationat the end of this Forum

ChinaDownside Risks to Growth Capped; More Policy Easing to ComeMarch 06, 2012

ByHelen Qiao, Ernest Ho, Yuande Zhu | Hong Kong

Silver lining starts to shine... On a recent field trip to China, we noticed evidence of rising exportgrowth momentum as well as a substantial increase in property transactions in major cities in thelast few weeks, which we believe will help to cap the downside risks to growth in the near term. Inaddition, policy-makers indicated that existing projects of government-driven infrastructureinvestment have been prioritised, most likely lifting infrastructure investment growth in the nearterm from the low level seen in 4Q11.

...but a bigger push from monetary policy easing is needed. We highlighted an early start inpolicy loosening since the end of 2011, but we believe that monetary easing will have to step up to

provide sufficient credit to the growth recovery. In particular, we noted that liquidity in the interbankmarket does not seem to have translated into notably looser financial conditions for the corporatesector, not least because of binding constraints such as the loan-to-deposit ratio and the directcontrol on loan drawdown.

More tolerance for property policy easing by stealth to come. The central governmenthesitates to withdraw property tightening policies, but we maintain our view that local governmentswill likely loosen the implementation of such measures after the NPC and CPPPCC towards theend of 1Q and early 2Q. Initial relaxation will likely benefit first-time property buyers, while leavingleveraged purchase for upgrade demand still constrained.

1. Downside Risks to Growth Capped...

We believe that some positive evidence has started to emerge of trends that could cap thedownside risks to growth we have highlighted since 4Q11 (namely soft external demand, propertymarket weakness and infrastructure investment deceleration caused by funding difficulties withlocal government investment vehicles). If we see further support from official data in these areas inthe next one or two months as well as effective delivery of policy easing in implementation, therisks would likely be biased towards the upside with regard to our baseline forecast of real GDP at8.4%Y this year.

I. Exports

Although January export growth seemed weak due to the Lunar New Year effect, we witnessedsome positive developments in support of a small rebound in export recovery. These included: (i)better sentiment from exporters, as seen in the manufacturing PMI sub-index on new exportorders; (ii) improvement in Korean exports, which tend to lead Chinese exports, especially theprocessing trade component; and (iii) improvement in US consumer demand in certain markets,e.g., furniture.

II. Property

In the last three weeks, both developers and property agents reported a strong pick-up inresidential housing transaction volume in first-tier cities, despite the lack of policy change or pricecuts by developers. It is possible that the better availability and lower costs of mortgage loans forfirst-time buyers compared to 4Q11 have stimulated some release of pent-up demand.
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However, we admit that it may be too early to call for a property market recovery at this stage. Wecite three factors: (i) the Lunar New Year effect prevents us from gauging such growth momentumwith precision; (ii) the significant acceleration in sequential growth was amplified by a particularlylow base at the end of 2011; and (iii) second-tier cities have yet to see a similar recovery intransaction volume.

Nonetheless, we believe that this is worth watching closely - a broad-based increase in both first-hand and second-hand housing transaction volumes in top-tier cities has often been a prelude tochanges elsewhere in the past.

III. Infrastructure

There is likely to be an uplift to infrastructure investment growth in the near term from the recentlow levels of 4Q11. The official release on government-driven project approvals confirms ourearlier prediction that infrastructure investment has shifted more towards utilities (especially underthe umbrella of CDM - clean development mechanism) and rural development (e.g., irrigation andwater conservation and rural infrastructure construction). In addition, funding support to keyprojects and existing projects has also been extended and verified by banks.

2. ...but a Bigger Push from Monetary Policy Easing Is Needed

Liquidity in the interbank market does not seem to have translated into notably looserfinancial conditions for the corporate sector. We highlighted that policy loosening has beenunder way since the end of 2011 (see China Economics: Policy Easing Limits the Downside Risksto Growth, January 17, 2012). The market has also been expecting a strong rebound in bank loanextension after the Chinese New Year. Still, domestic media reported a possible disappointment ofless than Rmb700 billion of loans made in February. If bank loans in February indeed turn out tobe less than Rmb750 billion, as we forecast in our preview, it would confirm our suspicion that theliquidity released by the recent RRR cut has yet to be channeled to the real economy.

Supply-side constraints on loans, rather than demand-side weakness, should take theblame. On our field trip, we observed firm demand for bank loans and informal lending, but banks'responses were lackluster because of binding loan-to-deposit ratios (especially outside of the BigFive banks). In addition, the macro-prudential measures introduced in 2010 (such as the directcontrol on loan drawdown) have also hurt banks' capability in deposit creation and thus loanextension.

We believe that monetary easing will have to step up to provide sufficient credit to growthstabilization. As CPI inflation continues to trend downwards, policy-makers will likely see fewerobstacles in promoting a more effective relaxation through multiple policy tools. The central

government's Rainy Day Fund' (Budget Adjustment Fund) could provide some cushion to a fewexisting government-driven investment projects, but further monetary easing is indispensable to acash-strapped economy in the near term. We expect top decision-makers to promote the usage ofmultiple tools to ensure easing in financial conditions by the PBoC and CBRC, including windowguidance and fine-tuning of the existing macro-prudential measures.

3. More Tolerance for Property Policy Easing by Stealth to Come

We maintain our view that local governments will likely loosen the implementation of policy-tightening measures after the NPC and CPPCC towards the end of 1Q and early 2Q (see ChinaEconomics: Policy Easing Limits the Downside Risks to Growth, January 17, 2012). The centralgovernment has overruled local governments' recent attempts to relax the purchase restrictions;we don't think it will take long before some forms of policy loosening take place.


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1) Local governments need to revive their fiscal revenue resources from property-related sectors(especially land sales) to support ambitious plans for social housing as well as new investmentprojects under the 12th Five Year Plan.

2) With notable declines in new residential housing prices (especially in city suburbs), the centralgovernment may not think it is too far from reaching the implicit targets set in April 2010.

In our view, initial relaxation will likely benefit first-time property buyers, while leaving demand stillconstrained for leveraged purchases of upgrade properties. We expect positive catalysts to comefrom follow-up measures of the Hukou system reform and the requirement by MOHURD to lowerthe requirement for non-local resident purchases. However, relaxation in top-tier cities and onmortgages for purchases of third (and above) housing would be more difficult to realize in theimmediate term.


ChinaNPC Preview: Domestic Demand Promotion with Focus on 'Stability' and 'Livelihood'March 06, 2012

ByHelen Qiao, Yuande Zhu, Ernest Ho | Hong Kong

China will hold the Fifth Session of the 11th National People's Congress (NPC) on March5: The Chinese People's Political Consultative Conference (CPPCC) began on March 3. We

expect stability, structural adjustment and people's livelihood to be keystones of the agenda. Thepolicy stance should adhere to the combination of "proactive fiscal policy and prudent monetarypolicy" set at the central economic working conference in December.

We expect the following key issues to be featured prominently during the two sessions (Liang Hui)this year.

Fiscal Policy Outlook

The proactive fiscal policy stance remains unchanged. We expect the 2012 fiscal budgetdeficit target to be set at around Rmb800 billion or about 1.5% of GDP, lower than the budgeted

Rmb900 billion (2% of GDP) in 2011. On a cash basis, the actual fiscal deficit was Rmb519 billionin 2011, equivalent to 1.1% of GDP.

Therefore, if compared to the pre-2008 deficit of below 1% of GDP or the cash-basis deficit of1.1% in 2011, a budget deficit of 1.5% is consistent with the proactive fiscal policy stance.Meanwhile, we expect that overall fiscal revenue and expenditure growth rates will grow at around15% in 2012, in line with a modest expansionary stance.

In addition to the deficit figure, we think it is of more interest to see how proactive fiscal policy willbe deployed to support economic growth in the context of anemic global recovery.

Structural tax adjustment is a policy focus. The potential tax reform topics may involve VAT forbusiness tax, preferential tax treatments for SMEs, personal tax cut, resource tax, property tax,etc. The tax burden for some categories will be lowered, but will be increased for others.
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Government spending will be more targeted. We expect budget priorities will be placed onsocial housing, agriculture infrastructure (e.g., water projects), urban transportation (e.g.,subways), industrial upgrading, R&D, education and initiatives to boost consumption - pension andhealth, etc.

Social housing remains as a policy priority. The central government will likely increase itsfinancial support for social housing projects, since more units are scheduled to be completed thisyear than last year. By our estimate, social housing under construction will increase to 13 millionunits, with 5 million units expected to be completed in 2012.

Local government financing: After the clean-up of local government financing platforms in 2010-11, the central government will likely loosen platform financing modestly this year. Possibleoptions may include loan restructuring and rollover, issuing local bonds to replace bank loans, etc.In this light, local government bond issuance may be slightly expanded from Rmb200 billion tounder Rmb300 billion.

Monetary and Financial Issues

Monetary policy stance remains prudent. In particular, the PBoC has set the target for M2growth at 14.0% in 2012, lower than the 16% target in 2011, but slightly higher than the actualgrowth of 13.6% at end-2011. Provided that RMB position for foreign exchange purchase willregister lower growth in 2012, we estimate that the implicit new loans target should be at leastRmb8 trillion (versus Rmb7.5 trillion in 2011), so the overall liquidity conditions will be moreaccommodative in 2012 than 2011. In particular, new credit will be more targeted, with emphasison SME financing, social housing, selective infrastructure projects, etc., in our view.

People's Livelihood

We expect people's livelihood' to remain a buzzword. Some old questions will be put on the

table again, such as how to keep household income growth at the same pace as economicgrowth, and how to boost households' consumption. This would entail improvement of the incomedistribution by raising the minimum wages continuously, more policy measures to tackle housingaffordability, and improving social safety net coverage. On this front, more fiscal budget funds maybe allocated to support education, healthcare and pension system, especially in rural areas.

Other Topics

We think the discussions/debates during the two sessions will also touch the following issues:openness for private sector, relaxation of property market tightening, urbanization and farmers'land, and utility pricing mechanism.

France2012 Elections Series - Addressing Structural IssuesMarch 06, 2012

ByOlivier Bizimana | London

Addressing Structural Issues

Investors seem to be concerned about the upcoming elections in France. This report outlines themain structural weaknesses of the French economy, evaluates the candidates' economicprogrammes proposed, and assesses possible market implications.
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France's economic performance has declined over the recent decade and, moreimportantly, the competitiveness gap with its main trading partners has widened. Given thesteepness of the trend, we believe that bold reforms would be necessary to address the underlyingstructural problems. This stresses the importance of the upcoming elections, as the economicprogrammes presented by the candidates are expected to outline the reforms that are needed tofoster competitiveness and potential growth in the longer term. The question is whether theeconomic proposals are proportionate to adequately address French economic imbalances.

Yet, this early in the presidential race, the outcome of the elections is still open. The latestpolls indicate that Franois Hollande and Nicolas Sarkozy are the frontrunners for the secondround of the presidential election, with a victory implied for the former. In addition, the platforms ofthe candidates are still evolving, so it is too early to establish with certainty what economic policymay be implemented post-elections. What is certain, however, is that the winning candidate willhave to undertake bold reforms to tackle the structural issues of the French economy, under atight budget constraint.

The Reform Strategy

The key challenge for France's new government is to implement reforms that wouldaddress the main structural problems of the economy, while pursuing the adjustment in thepublic sector at the same time. In the longer term, these supply-side reforms would contribute torestoring the soundness of public finances as well. Indeed, fiscal consolidation in the medium termwould require stronger potential growth, which would necessitate a larger contribution fromexternal demand. Hence, reducing labour market rigidities and fostering productivity should boostcompetitiveness, reduce external imbalances and help to restore public finance soundness.

In the near term, the persistence of the eurozone sovereign debt crisis is a hurdle. Marketparticipants seem to have some concerns over public finances in general, and France's fiscalposition in particular. At the moment, the interest rates on French government debt remain at

relatively low levels. A spike in the costs of borrowing cannot be ruled out though, especially if oneor more other rating agencies lower France's credit rating (S&P has already cut France's long-termcredit rating to AA+, from AAA, with a negative outlook, while Fitch and Moody's have affirmed the

AAA rating but revised the outlook to negative'). This, in turn, might further increase the financialconstraint, making it more difficult to push through reforms.

Overall, we believe that a successful reform strategy would need to focus on the labourmarket, by increasing the flexibility of the labour force, easing the high employment protection andenhancing the efficiency of job placements. In addition, the priority should be on promotingreforms aimed at creating a favourable environment for businesses, notably SMEs, by facilitatingthe expansion of their capacity of financing, and their size and investment in R&D, as well as

innovation. The fiscal consolidation strategy would need to focus on further control ofspending in all the sub-sectors of the general government. Moreover, given the challengesposed by population ageing in the medium term, pension and healthcare reforms would need to bepushed further. On the revenue side, fiscal reform should focus on reducing ineffective taxloopholes and a more pro-growth tax system for corporates, and additional progressivity forhouseholds. Finally, in the longer term, the adoption of a binding fiscal rule would enhance thesustainability of public finances.

Why French Elections Matter for Financial Markets

French elections seem to be a source of concern for financial markets this time round,mainly because of the context of the eurozone sovereign debt crisis. Indeed, politicaluncertainty in the eurozone's second-largest economy is clearly unwelcome, given that confidencein financial markets remains fragile.


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When it comes to risks, we think one should make a distinction between perception andimplementation risks. In the near term, during the electoral campaign, market participants arelikely to worry more about the main candidates' positions than what they may do once elected. Theimplementation risks, on the other hand, may arise after the elections. These are related topolicies that are likely to be undertaken once the new government is sworn in.

Based on the main candidates' current economic programmes, we see four factors that may besources of concerns for market participants in the near term:

1. The orientation of fiscal policy post-elections: Some policy proposals may give theimpression of increasing risks to the sustainability of public finances in the medium term. Forexample, the expenditure side of the main candidates' budgetary plans is not yet completelydetailed, which could raise some doubts over fiscal consolidation going forward. Challenging therecent pension reform may also raise some concerns about a future increase in healthcarespending, especially given the future challenges posed by population ageing. As the Frenchsovereign rating is under scrutiny by the credit rating agencies, further concern over thesoundness of public finances could trigger a downgrade, which would have significantrepercussions on other sovereigns, notably the EFSF credit rating, which could conceivably put

the overall eurozone crisis management framework at risk.

2. Uncertainty about the resolution of the eurozone crisis: The upcoming elections present anadditional source of uncertainty for the resolution of the sovereign debt crisis. For example, Franceis unlikely to be able to implement the intergovernmental treaty before the next parliament is swornin. Moreover, major new initiatives from the French government to address the sovereign debtcrisis also seem unlikely to be considered during the electoral campaign. Finally, candidates' newproposals to address the sovereign debt crisis (or amend or complement existing proposals) mayincrease uncertainty about the implementation of the decisions that have already been agreedupon by the current government.

3. Near-term growth risks: The political debate over how to achieve the deleveraging of thepublic sector could generate uncertainty about future economic policies. This policy uncertaintymay, in turn, lead households and corporates to be more cautious in their spending decisions. Thismay ultimately aggravate the economic downturn and weigh on fiscal revenue. Given that Francehas committed to achieve a numerical budget deficit target, weaker growth would require furtherfiscal tightening to achieve the same target, which would lower further growth and ultimately leadto a fiscal austerity trap' (seeEurope Economics: Breaking the Spell of the Euro Crisis, January 9,2012).

4. Effectiveness of the reform agenda: The effectiveness of the economic reforms may raisesome concerns. The question that may arise is whether the proposals will be able to adequately

address the underlying structural problems of the French economy. This may especially be asource of concern for rating agencies questioning France's long-term growth outlook.

A Glimpse of the Main Economic Imbalances

France's economic performance has weakened over the past decade and reflects largelystructural factors.External sector imbalances have gradually worsened since the late 1990s, and,though remaining modest at present, the trend seems persistent. Part of the downturn trend in theexternal sector reflects structural labour market rigidities, which are viewed as one of the mostimportant hurdles to higher employment growth. What's more, public finances have deterioratedcontinuously, with a structural budget deficit in place since the 1970s and a very high debt-to-GDPratio.

1. Gradual Deterioration of the External Sector


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French export growth has declined since the start of the last decade. Export underperformance isalso noticeable relative to most of its euro area peers. In addition, export market share hasdeclined significantly over the same period.The downward trend in export market share partlyreflects the rising share of large emerging economies in world markets. Still, French exportperformance lagged over the last decade compared with other developed competitors as well,which suggests that this phenomenon may be attributable to other factors. As a result, the currentaccount balance has declined, essentially as a result of deterioration in the trade balance ofgoods. The trade balance of services is still in surplus, but it has retreated gradually over therecent period. Given the cumulative current account deficits, France's net foreign assets havedeclined, from a surplus of 1% of GDP in 1999 to a deficit of 11% in 2010.

Several complementary factors may explain the worsening external sector performance:

Declining price and cost competitiveness may be one among other reasons whyFrench export growth was sluggish, especially compared to main trading partners. The eurohas appreciated and was above its historical average during the first years of the decade,suggesting some overvaluation of the real effective exchange rate. However, that appreciationaffected all euro area countries, and hence does not explain in itself the underperformance

compared to eurozone peers. In addition, unit labour costs have increased in France since thebeginning of 2000 from faster growth in wages, which has been only partially offset by productivitygains. However, the divergence in the development of unit labour costs in France is especiallyvisible relative to Germany, while the upward trend is similar to the average euro area.

Hence, non-price factors are likely to explain most exports' underperformance andthe loss in competiveness. Structural features, including the following, are important factors thatmay explain the underperformance of French exports: inadequate industrial specialisation (focuson low and medium-high-technology, limited degree of product differentiation), which limits theflexibility to respond to changing global demand, and supply constraints (small size and number ofSMEs limiting their export capacity; insuff icient R&D leading to weak innovation). In addition,

French exports are more oriented towards slow-growth regions (64% of exports are to EUcountries) and less to the more dynamic regions (less than 20% of exports are to developing andemerging economies). This could also explain their moderate pace of growth.

Finally, the weak performance of exports partly explains the erosion of non-financialcompanies' profit margins over recent years. Indeed, exporting companies have reduced theirprofit margins to compensate for the deterioration in cost competitiveness in order to limit losses inmarket share.

Our view: The strengthening of the supply side should help to reduce external imbalances. Thepriority should be on promoting reforms that aim at creating a favourable environment for

businesses, notably SMEs, by facilitating the expansion of their capacity for financing, their size,investment in R&D and innovation, but also taxation and other fiscal incentives.

2. Persistent Structural Rigidities in the Labour Market

The weaknesses of the French labour market are structural. The unemployment rate remainselevated, at just a touch below 10% in 2011. The unemployment rate of young workers (between15-24) is particularly elevated, at an average of more than 20% since 1980. Most importantly, thestructural unemployment rate in France is above the euro area average since the 1990s, at around9%. In addition, it is likely to continue to rise, as long-term unemployment has worsened over therecent period. As a result, France has one of the lowest employment rates among developedcountries, especially for seniors (19.1% versus 51.5% in OECD countries in 2010) and youngworkers (33.9% versus 42.5% in OECD countries in 2010).


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The structural weaknesses of the labour market in France include: High labour tax wedgesthat push up labour costs (relative to productivity), which limits demand for labour; a high andincreasing minimum wage that reduces employment opportunities, especially for the young andlow-skilled workers; heavy legal restrictions in employment contracts (hiring, firing and workinghours) that generate segmentation between employment contracts; poor quality of labour dialoguebetween trade unions and employers' organisations; and the inefficiency of public job placement.Despite governmental efforts to address some of these shortcomings over recent years, we thinkthat policies to enhance the situation of the labour market must be stepped up in order to continueto ease structural rigidities.

Our view: Labour market reforms should focus on raising the labour force participation of youngpeople and older workers, by increasing the flexibility of the labour force (hours worked), easingthe high employment protection, and enhancing the efficiency of job placement. More specifically,we believe that promoting a system of flexicurity', which combines contractual flexibility (hiring anddismissal) with enhanced income security for workers between jobs and active labour marketpolicies, could improve employment conditions. In addition, policies aimed at supporting trainingprogrammes for unemployed people and low-skilled workers should enhance their reintegrationinto the labour market, in our view. Moreover, lowering labour tax wedges should reduce labour

costs, which would boost employment and competitiveness. As labour taxes help to finance socialsecurity, their reduction would require, on the revenue side, alternative sources of financing (taxon capital or tax on consumption), and more importantly, on the expenditure side, a reform ofsocial benefit.

3. Trend Deterioration in Public Finances

France has run a fiscal deficit almost continuously since the beginning of the 1970s. Thisdeterioration of public finances reflects largely structural factors. The cyclically adjusted fiscalbalance has remained in deficit over the entire period. Despite tentative improvements in the mid-1990s, ahead of entering the EMU, the fiscal consolidation plans have not been sustained long

enough to be able to bring the budget balance back into surplus. Even during periods of stronggrowth, the structural budget balance remained in deficit, which reveals the weakness of theinstitutional framework of budgetary policy.

In terms of sectors, the main source of the budget deficit is the central government, thoughthe balances of local government and social security have somewhat turned to deficits over therecent period as well. As a result of the cumulative budget deficits over the last three decades, thedebt-to-GDP ratio rose to almost 90% in 2011, which is considered a level harmful to growth. Inparticular, the debt-to-GDP ratio has trended upwards from 20.7% in 1980 to 85.1% in 2011.

The deterioration in public finances in France over the last 40 years is due to a sharp rise in

spending.General government spending as a share of GDP has considerably increased over thelast three decades, to 56.6% in 2010 from 46% in 1980.

The continued rise in expenditure is mainly due to a sharp expansion in social spending - inparticular, healthcare and pensions. The other components of government spending have risenover the recent decades as well, albeit at a slower pace. The interest payment rose sharply duringthe 1990s, on the back of higher government debt, but debt service eased afterwards, with thereduction in the costs of borrowing. The ratio of operating expenditures to GDP increased as well.By contrast, public investment as a share of GDP fell until the beginning of the 2000s.

General government revenue has increased over the last three decades as well, at 49% ofGDP in 2010, compared to 46% at the beginning of 1980. More specifically, the tax burden (taxrevenue as a share of GDP) increased by around three percentage points over the period to42.5% in 2010. However, it has been trending down since the beginning of the lastdecade. Despite the recent decline, the general government tax burden in France remains


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one of the highest among developed countries. The average tax burden for OECD countrieswas at 33.8% of GDP in 2009, almost 10 percentage points lower than in France.

The split of the tax burden by government sub-sectors shows divergent dynamics. While the shareof the central government in the tax burden has tended to decline, the share of social security andlocal government has increased. The increase in the tax burden of social security reflects theupwards trend in social expenditures.

Overall, the high level of tax burden, especially relative to other developed countries,suggests little scope to increase revenue in France. Nevertheless, there seems to be someroom to manoeuvre, as tax expenditures (tax loopholes) are elevated. Hence, they may constitutea potential source for increasing fiscal revenue. According to the 2012 budget bill, there are 491tax expenditures (versus 504 in 2011), including 449 that would cost public finances 65.9 billionin 2012 (around 3.3% of GDP).

Our view: A successful fiscal consolidation strategy would need to focus on further control ofspending in all the sub sectors of the general government. Moreover, given the challenges posedby an ageing population in the medium term, pension and health care reforms would need to be

pushed further, by notably increasing the legal retirement age further in line with life expectancy.On the revenue side, we believe that fiscal reform should include a reduction in ineffective taxloopholes and a more pro-growth tax system for corporates, and additional progressivity forhousehold taxation. Finally, longer term, the adoption of a binding fiscal rule would enhance theinstitutional framework of budgetary policy, and hence sustainability of public finances.

To sum up, the French economy faces persistent structural challenges, including aworsening of the external sector, persistent labour market rigidities and deterioratingpublic finances. Hence, the main candidates at the upcoming elections would face the sameproblems and will have to tackle them once elected, under the same budgetary constraint.

A Closer Look at Main Candidates' Platform on the Economy

The presidential candidates who are leading in the polls - in particular Mr. Bayrou, Mr. Hollandeand Mr. Sarkozy - seem to share a similar analysis of the source of structural challenges within theFrench economy. Their economic programmes presented so far intend to tackle the supply-sideweaknesses of the economy, mainly by supporting SMEs and strengthening the labour marketconditions, while pursuing fiscal consolidation. The economic programme of Ms. Le Pendistinguishes itself by envisioning an exit of the euro area and establishing protectionist measures.

Our first assessment of the candidates' proposed programmes:

Labour market reforms may prove insufficient and do not address the main structuralrigidities: All the candidates envisage measures to stimulate employment for young people andolder workers, by providing incentives, especially for SMEs. This would increase the participationrate of these categories of workers. Some measures are also designed to reduce the labour taxwedges. However, in our view, the envisaged reduction in payroll contributions remains toomodest and wouldn't significantly increase employment. In addition, the proposals do not addresssome of the important constraints of the French labour market, notably the high employmentprotection and the low labour market flexibility.

Candidates' proposed measures to strengthen the external sector underperformancepoint in the right direction: The measures proposed to reduce the underlying structuralproblems of the external sector are focused on strengthening the supply side, and morespecifically on improving financing conditions for SMEs, promoting their research anddevelopment capacity, and hence innovation. These measures should improve firms'competitiveness in the medium term. Still, in order to address the deterioration in cost


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competitiveness, these measures would need to be complemented by reforms of the labourmarket, healthcare and pensions.

The candidates are aware of the need for fiscal consolidation, but the spending sideremains unaddressed: Broadly, all the proposed economic programmes project to continue fiscalconsolidation in the medium term, with a balanced budget by 2016 or 2017. We view this as a stepin the right direction in order to stabilise the debt-to-GDP ratio in the medium term. The way toachieve fiscal consolidation differs only slightly among candidates, as all would rely on a reductionin tax loopholes. Also, they would implement tax reforms, which would result notably in a rise intaxes on the wealthiest households and large corporates. However, while the fiscal consolidationplans are relatively detailed on the revenue side, the spending side remains relatively vague. Thiscould present a challenge, as a main source of the structural deterioration in public finances stemsfrom expenditures, and more specifically social spending.

How Do the Platforms Differ?

Nicolas Sarkozy: Fiscal Consolidation and Enhancing Competitiveness

President Sarkozy has officially announced his candidacy, but he has not yet unveiled a detailedeconomic programme. Still, on the fiscal side, he is likely to stick to the consolidation planannounced by the current government, which expects to balance the budget by 2016. In addition,he unveiled the latest economic reforms of his mandate at the end of January, most of which islikely to be implemented after the elections, even though parliament is expected to pass thembefore. Moreover, the 2012 Project' unveiled by his political party (UMP) provides the outlines ofwhat his presidential platform would be. In particular, the project presents reforms on the supplyside aimed at supporting SMEs and their expansion. The new measures announced at the end ofJanuary were designed to stimulate job creation and improve businesses' competitiveness. One ofthe key measures announced was a so-called Social VAT', in which a reduction in employer socialcontributions will be financed by a VAT, but also complemented by an increase in social welfare

tax on investment income (see France Economics: 2012 Elections Series -Social VAT'- SoWhat?February 1, 2012). In addition, businesses and labour unions would be encouraged toconclude the competitiveness-employment pact' aimed at saving jobs, by allowing for bothworking hours and compensation to vary in connection with demand. Finally, President Sarkozyannounced that France would unilaterally impose a tax on financial transactions.

Franois Hollande: Strengthening the Supply Side and Social Justice

The Socialist Party candidate's economic programme is centered on measures to support SMEsand other supply-side reforms focused notably on the labour market, in particular, by lifting theparticipation rate of seniors and young people, in addition to support for research and innovation.

Fiscal consolidation is also a priority, with a deficit target of 3% of GDP in 2013 and a balancedbudget by 2017. This fiscal effort would be financed by cuts in tax loopholes and an increase intaxes for the wealthiest households and big corporates. A broad fiscal reform would complementthe adjustment of public finances. Financial institutions would be subject to several regulatorymeasures and taxes. In addition, the socialist programme intends to repeal some of the policiesthat have been implemented by the current government. For example, the pension reform is to bepartially reviewed according to the proposal. The intergovernmental treaty agreed at theDecember 9 Summit would be renegotiated by adding measures aimed at strengthening growthand governance. In addition, Mr. Hollande would propose the creation of euro bonds to theEuropean partners and would call for more involvement of the European Parliament into thesedecisions.

Franois Bayrou: Public Sector Deleveraging and Boosting the Supply of Output


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The economic programme of MODEM's president outlines two key priorities: fiscal consolidationand restoring France's supply of output. More specifically, fiscal consolidation would beaccelerated in 2013, with a budget deficit of 2.8% in 2013 and a balanced budget in 2016. Toachieve these objectives, government spending would be frozen in the medium term. In addition,cuts in tax loopholes, as well as a rise in VAT, would contribute to increase government revenue.The tax system, especially on the wealthiest households, would be reformed. Finally, theeconomic plan calls for a fiscal rule (Golden Rule') enshrined in the constitution in order tomaintain fiscal discipline in the medium term. Hence, Mr. Bayrou will support the implementation ofthe fiscal compact. In addition, to boost the production potential, his plan proposes measures tosupport SMEs by stimulating their capacity of financing and research and innovation. Finally, theemployment proposals also focus on small businesses, by reducing tax wedges on new jobs foryoung people.

Marine Le Pen: Exit from the Euro and Favouring National Production

Ms. Le Pen's economic programme calls for a progressive and coordinated exit of France from theeuro area, accompanied by capital control and a partial nationalisation of commercial banks. Thesupply side of the economy would be supported by protectionist measures favouring domestic

products and SMEs. In addition, the central government would intervene directly in almost allsectors of the economy. On the fiscal side, Ms. Le Pen projects a balanced budget by 2017. Thefiscal adjustment would be achieved essentially through an increase in government revenue (cut intax loopholes, increase and creation of various taxes). The previous pension system would bealmost restored and financed by new taxes. Moreover, the principle of debt sustainability would beset in framework laws. Finally, labour market conditions are expected to be improved byintroducing binding laws on hiring policies, as well as reductions in tax wedges.

What Are the Most Recent Polls Saying?

Latest polls (as of February 29, 2012) indicate that Mr. Hollande is leading in the first round of the

presidential election, followed by Mr. Sarkozy, Ms. Le Pen and Mr. Bayrou. In addition, Mr.Hollande is projected to win the second round over Mr. Sarkozy by 56% to 44%. Finally, the gapbetween the two front-runners in the second-round run-off has held fairly steady since thebeginning of the year. However, at this stage of the campaign, it is difficult to assess whichcandidate is likely to emerge victorious out of the elections, as polls are only indicative.

The Electoral Process at a Glance

The fact that the electoral process in France involves two consecutive elections with two rounds islikely to generate a relatively long period of uncertainty. Indeed, the presidential elections will befollowed by the legislative elections, and hence the electoral campaign will in fact end in mid-June.

So, how will the electoral process work?

Presidential Elections

The presidential term is five years (since a referendum of September 24, 2000), renewable(versus a seven-year term previously). In addition, a president cannot serve more than twoconsecutive terms (since the constitutional law of July 23, 2008).

Under the Fifth Republic and since the constitutional revision of November 6, 1962 (approved by areferendum of October 28, 1962), the President of the Republic has been elected by directuniversal suffrage through a two-round majority system:

To be elected in the first round of voting, a candidate must obtain an absolute majority of thetotal votes;


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If no candidate receives a majority of votes in the first round, a second round takes placetwo weeks later. As the elected candidate needs the majority of the votes in the second round,only two candidates may go forward to this second round (the two highest-scoring candidates inthe first round).

Only potential candidates who receive signed presentations from 500 elected officials areofficially allowed to run for the presidential election. These officials must include differentelected representatives from at least 30 dpartements or overseas collectivities and no more than10% of them should be from the same dpartements or overseas collectivities. The ConstitutionalCouncil publishes the names and offices of the signatories.

In addition, the candidates must submit to the Constitutional Council a declaration of their wealthand an undertaking to file a new declaration at the end of their term of office. After the election, theConstitutional Council publishes only the elected candidate's declaration. After checking all theadmissibility requirements, the Constitutional Council draws up the list of candidates.

Legislative Elections

Members (deputies) of the National Assembly (the lower house of the bicameral parliament) areelected during the legislative elections. There are 577 deputies, who are elected by directuniversal suffrage with a two-round system by constituency, for a five-year renewable term, unlessthe National Assembly is dissolved.

To be elected in the first round of voting, a candidate must obtain the absolute majority ofvotes cast and a number of votes equal at least 25% of the registered voters;

If no candidate is elected in the first round, those who obtained a number of votes equal toat least 12.5% of the registered voters enter the second round. In this round, the highest-scoringcandidate is elected and, in the case of a tie, the older of the candidates is elected.

How Markets Reacted to Elections in the Past?

Given that French presidential elections take place in two rounds, and they are immediatelyfollowed by the legislatives elections, we think that uncertainty may persist throughout this period.A peak in uncertainty may occur between the first and the second round of the presidentialelections, depending on the posture of the candidates. Moreover, the legislative election campaignis likely to generate some uncertainty, too, as it determines whether the newly elected presidentwould have a majority in the lower house of parliament to govern. In particular, even though onewould expect the parties supporting the newly elected president to benefit from the momentumfrom the victory at the presidential elections, there is still some uncertainty over the final results.

The legislative campaign is on national and local issues, and the reaction of the electorate can bedifficult to predict. Therefore, for this year, uncertainty could last until mid-June.

Looking back at the most recent presidential elections (2002 and 2007), volatility infinancial markets appears to have increased a few days before the first round and remainedelevated before the second round. However, for the 2002 presidential election, volatility infinancial markets spiked before the second round, presumably because of the unexpectedelimination of the former Prime Minister, Lionel Jospin, from the presidential race at the first round,while Jean-Marie Le Pen, the FN candidate, had qualified. We do caution against reading toomuch into implications of past French elections for financial markets, as the overall economic andfinancial environment, as well as the candidates themselves and their positions at the time, mayalso have played a role. In addition, other elements outside of the elections may have contributedsomewhat to the past increase in volatility.


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However, given the context of the sovereign debt crisis, we would expect more volatility in thefinancial markets this time round than in the previous elections.

For full details, see France Economics: 2012 Elections Series - Addressing Structural Issues,March 2, 2012.


BrazilThe Rate Cut Debate ContinuesMarch 06, 2012

ByArthur Carvalho | Sao Paulo

While there continues to be a debate regarding how far Brazil's central bank will go inreducing interest rates, until recently there was little disagreement about the pace of thecuts (see "Brazil: How Much Lower Can Rates Go?" This Week in Latin America, January 31,2012). In recent days, however, local rates markets have begun to price in the possibility of anacceleration in the pace of the easing cycle, from the 50bp pace we have seen so far to 75bp oreven 100bp. While we expect the central bank to continue with its 50bp pace at the upcomingmeeting that concludes on Wednesday, March 7, there is a risk that the authorities may increasethe pace of the easing cycle. We believe that such a move would risk damaging inflationexpectations even further and could shorten the planned easing cycle.

Accelerating the Pace?

The argument in favor of accelerating the pace of rate cuts centers on the exchange rate.When the central bank began cutting interest rates by 50bp last August, it was f

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