>WORLD DEBT GUIDE / WORLD DEBT GRAPH

• Overall
• Government
• Household
• Financial 
• Non financial 

To see presentation:  WORLD DEBT GUIDE

>GLOBAL MARKETS: Risky assets retain their appeal

■ Despite a temporary blip, economic data has again begun to surprise consistently to the upside, and risky asset returns are trumping uncertainty for investors in 2010.

■ The current point in the cycle is a swwet spot, with output gaps that can accomodate above trend growth, yet inflation that keeps central banks on the sidelines.

■ Whereas global central bank rates fell roughly in unison as the financial crisi struck, there is an obvious divergence on the way back up, with the emerging markets and commodity players moving before the major advanced economies.

■ The publication also includes quarterly interest rate and exchange rate forecasts for the U.S., Canada, Australia, and New Zealand and also offers additional exchange rate forecasts for the Japenese yen, the euro, the U.K. pound and the Swiss franc.

To read the full report: GLOBAL MARKETS

>Eurozone sovereign risk: a hierarchy of countries to watch (ECONOMIC RESEARCH)

■ Financial markets are highly concerned about the risks surrounding the public finance imbalances present in a number of eurozone countries. This has been represented by the sharp increase in the government bond spreads between the countries seen as risky (Greece, Portugal, Italy, Ireland and Spain) and those of Germany, considered as the reference country.

■ However, not all the countries should be put on the same level. The situation of public finances has developed differently from one country to another. In Ireland and Spain, the deterioration in budget balances and the build-up of public debt are fairly recent phenomena. In the remaining southern European countries (Greece, Italy and Portugal), public finance difficulties go back a long way.

■ This article sets out a hierarchy of short-term and longer-term sovereign risks (related to the ageing problem). The results show that: 1) in the short term, and, more importantly, in the longer term, Greece is by far the riskiest country; 2) Ireland and Spain are also risky countries regardless of the timeframe; 3) Portugal presents large-scale short-term risks; 4) Italy is considered to be the least risky among these countries.

The eurozone’s public finances have deteriorated severely. This is especially the case in countries that in the past have shown relatively poor budget management, namely Greece and Portugal, and, to a lesser degree, Italy. It is also the case in economies that are currently experiencing very severe cyclical corrections, following a housing boom that played out against a backdrop of galloping prices and credit, notably Spain and Ireland. All of these countries will see a sharp rise in sovereign risk if they do not implement credible public finance consolidation plans in the near term.

These countries, however, should not all be viewed in the same manner. This article attempts to establish a hierarchy of sovereign risk in countries with poor public finances (Portugal, Italy, Ireland, Greece and Spain). After highlighting the source of these imbalances in the country’s public finances, we have attempted to set out a hierarchy of shortterm sovereign risks using a range of indicators: the primary budget balance ratio, the ratio of public debt to GDP, the government revenue-to-GDP ratio and the ratio of public spending to GDP. Finally, we evaluate the longer-term risks linked to an increase in age related expenditure, based on demographic projections from the European Commission. Of course the crisis is to blame, but it’s structural problems, too

The budgetary situation in eurozone countries has deteriorated sharply due to the financial crisis and the recession. A look back at how these imbalances developed helps to gauge how difficult it will be to resolve them.

In Ireland and Spain, the deterioration in government finances and the build-up of public debt are fairly recent phenomena. In 2000-2007, the budget situation in these countries was fairly healthy, with an average GDP surplus of 0.25% and 1.49%, respectively, compared with an average eurozone deficit of 1.85%.

In the other countries, notably in southern Europe, there is a long history of struggles with public finances. Italy and Greece have always been highly indebted countries whose public deficits are mainly structural in nature, due to the lack of public spending effectiveness and poor budgetary management. Greece and Portugal, and to a lesser extent Italy, have had considerably higher structural deficits than the eurozone average (see graph in report).

To read the full report: EUROZONE SOVEREIGN RISK

>GLOBAL MARKETS: THE GREAT TRANSITION (ECONOMIC RESEARCH)

• Country-specific risk is now returning to the forefront as systemic risks wane.

• 2010Q1 marks the return of headline inflation as the 2008/09 oil price declines fall out of the data.

• Central banks will look through this to stable and low core price inflation but the divergence ensures that the inflation risk premium in financial assets persists.

• A sticky inflation risk premium has some potential to cause measures of inflation expectations to drift higher, with the U.K. most at risk.

• Fiscal strains are building with ratings agencies focused on European sovereigns for now.

• The fabric of the Euro is strained by divergent economic trends within the Euro area and the ECB will struggle to manage sixteen imperfectly integrated economies with just one interest rate.

• The publication also includes quarterly interest rate and exchange rate forecasts for the U.S., Canada, Australia, and New Zealand, and also offers additional exchange rate forecasts for the Japanese yen, the euro, the U.K. pound, and the Swiss franc.

To read the full report: GLOBAL MARKETS

>The source of financial imbalances: Global excess production capacity (NATIXIS)

Globalisation has led to excess global production capacity: emerging countries have high savings rates, invest a lot and have large available labour reserves; OECD countries have not reduced their production capacity despite the opening of trade with emerging countries. The first effect of this situation is of course the enduring absence of inflation.

Since there is excess global production capacity, various countries are clashing as they want to use their domestic production capacity, and therefore to grab a larger share of the demand:

■ in OECD countries, the technique used is an increase in indebtedness, private-sector until the crisis, and now public;

■ in emerging countries, the technique used is an undervaluation of their currencies.

The result of this conflict about capacity utilisation is excess private-sector and public indebtedness, financial crises, excess liquidity and anomalies in the exchange-rate system. The imbalances will disappear only when the excess production capacity has been corrected, which is not the case currently.

To read the full report: FINANCIAL IMBALANCES

>Top 10 Questions for 2010 (ECONOMIC RESEARCH)

1. Will the recovery become self-sustaining? Viewed from the depths of despair earlier this year, even the mild turnaround in the global economy in recent months is nothing short of remarkable. But while the economies of the U.S. and Canada may have stopped falling around the middle of 2009, the recovery has been tepid so far, and that’s even with a heavy assist from government spending. Conditions are gradually falling into place for a firmer and self-sustaining recovery next year, especially with employment finally stabilizing and business confidence perking up. Even so, the conventional wisdom that the upturn will remain subdued by past standards looks quite compelling. The main reason: the U.S. consumer simply is not going to ride to the rescue for global growth as it has so often in the past. Accordingly, we look for GDP growth of around 2½% in both countries next year (Chart 1); that’s not bad under normal circumstances, but it’s disappointing in the wake of the worst single year for U.S. growth since the 1940s.

2. Has the jobless rate peaked? The unemployment rates in both Canada and the U.S. ticked down last month, and recent hiring intention surveys have picked up, sending a tantalizing hint that the worst may be over on the job market front. However, it may be a tad premature to sound the all-clear note just yet, especially in the U.S., where the recovery will still be too modest to generate solid job gains for some time yet (Chart 2). The employment outlook is generally more positive in Canada, due to the relative strength in job-rich domestic spending areas such as housing and consumer spending. However, in both countries, we look for the unemployment rate to be lower a year from now.

3. Will China’s growth remain strong enough to drive commodities higher? To paraphrase our Global Commodity Strategist, Bart Melek, “Commodity markets have performed much better than anyone would have dared to predict at the beginning of 2009, when global depression chatter was rife and massive deleveraging and panic selling were the order of the day. Depression was averted thanks to massive government spending in China, the U.S., Europe and elsewhere totalling some $2.2 trillion, zero interest rates and various central bank liquidity measures.

4. After a powerful rebound, are stocks due for a correction? We have long maintained that the real distortion in equity markets this year was not the massive 65% bounce from the March lows, but the depth of those March lows. Much of the rebound in stocks occurred in the first two months after the lows were hit, driven by the realization that the global economy and credit markets were stabilizing, with a helping hand from extremely accommodative monetary policies globally. While the annual gains in many major equity markets in 2009 are certainly impressive—the TSX is currently just shy of a 28% rise this year, vying for the best performance in 30 years—they are by no means highly unusual, especially in a recovery phase.

5. Is the Canadian housing market set to pop? It seems many are falling over themselves to pronounce that the Canadian housing market is in a bubble, partly because it has been able to fully recoup all of its (fleeting) recession losses in a matter of months (Chart 4). If anything, we believe the risk is that the market will get even hotter in the first half of 2010, ahead of impending interest rate hikes and the Harmonized Sales Tax in B.C. and Ontario at mid-year. There is bound to be at least some modest correction in the second half of next year, almost certainly in sales, and possibly in prices.

To read the full report: TOP 10 QUESTIONS

>The dollar/euro exchange rate: Potentially, very significant instability

Since the start of 2009, the dollar has depreciated against the euro as a trend. This depreciation is no longer due to the same causes as before the crisis: the US external deficit has shrunk drastically, but the changeover to virtually zero dollar interest rates has led to massive capital outflows from the United States, and this is currently the cause of the dollar’s weakness.

However, the dollar/euro exchange rate may prove to be very unstable:

■ for the dollar to depreciate against the euro, the sum of the US external deficit and the capital outflows from the United States must outweigh the purchases of dollars by central banks in emerging and oil-exporting countries, which want to stabilise their exchange rates against the dollar;

■ a faster rise in interest rates in the United States than in the euro zone, a rise in risk aversion after an unfavourable shock or a fall in the oil price due to sluggish growth would lead to a reduction in the borrowing positions in dollars or long positions in euros that would stop the depreciation of the dollar against the euro.

We might therefore see (in 2011?) a drastic changeover to an equilibrium where the dollar appreciates markedly against the euro once again, something that would obviously be a serious problem for the US administration.

To read the full report: DOLLAR/EURO

>Households consumption: an economic heavyweight but the weakest link in US recovery (ECONOMIC RESEARCH)

■ The strength of the recovery taking shape in the United States depends on resilient household
consumption.

■ A review of the main determinants of this vital component of GDP, such as confidence, incomes, inflation, wealth and credit, nevertheless does not tell us with any certainty which forces will prevail in the play-off between cyclical support and structural curbs.

■ Our baseline scenario assumes that there is sufficient monetary and fiscal stimulus, along with pentup demand, to ensure that the nascent “technical” recovery is transformed into a lasting one. However, the recovery seems likely to be sluggish by US standards, as growth in consumption is hobbled by high unemployment, tight credit and households deleveraging.

According to the retail sales figures of the past three months, the recovery in household demand is less and less a mirage and more and more a real trend taking shape. The improvement follows a sharp, prolonged contraction in real consumption spending in the second half of 2008 followed by a stabilisation phase in the first half of 2009 made possible by the fiscal stimulus injected at that time, with lower taxes and higher transfer incomes. In Q3 of this year, the rebound in consumption (up an annualised 2.9% according to second estimates) is mainly due to the success of the “cash for clunkers” car scrappage scheme, but not entirely so. If we factor out cars and
gasoline, retail sales are also up, which is a sign that vehicles sales have not cannibalised other spending items and that the Q4 payback due to the expiry of the scrappage scheme should be softened.

What is there to drive a recovery in household consumption at a time when the US economy continues to destroy large numbers of jobs? While there is no doubt that the environment is scarcely favourable, what counts is the fact that the main determinants of consumption are gradually becoming less and less unfavourable, with rising consumer confidence levels, less job destruction, less and less stringent lending conditions, the dissipation of negative wealth effects, and low inflation(absent a new oil shock).

The conditions still exist, however, for an upward trend in the saving rate which, for a given income level, will hamper the recovery in consumption as households build up their precautionary savings in light of high unemployment (and the high budget deficit, assuming that some US households are Ricardians and thus increase today their saving to pay for higher taxes tomorrow), and with the lagged impact on wages of rising unemployment, the lagged impact of the collapse in personal wealth, plus the indirect impact of the elimination of leverage from Mortgage Equity Withdrawals and Home Equity Lines Of Credit, not to mention less abundant, less cheap credit and the process of shedding debt.

The confidence effect
As a leading indicator, confidence plays a key role in cyclical reversals, up or down. Confidence is also a capital that appreciates, runs out and reconstitutes itself. An upturn in confidence is a sign that the timeframe of economic agents (households and firms alike) is lengthening, and is favourable to more active spending behaviour. That said, it is an indicator of willingness, rather than capacity: if households do not have the means to fund their spending, their increased confidence will have a limited impact on their purchases. Currently, consumer confidence is no
longer at its lowest ebb due to the recovery in the equity markets and the fall in oil prices since their July 2008 peak. But recovery is still fairly tough going and the uptrend remains hesitant (the increase is not (yet) generating increases in a cumulative, self-sustaining process) due to the continued difficult conditions on the labour and credit markets.

Constraints on recovery
Our baseline scenario assumes that there is enough monetary and fiscal stimulus, along with pent-up demand, to ensure that the “technical” recovery we are seeing right now transforms into a lasting and selfsustaining recovery – in other words, to trigger a virtuous circle of supply and demand. However, this is likely to remain sluggish by American standards, as growth in consumption is being held back by high unemployment, tight credit and the necessary households deleveraging.

The income constraint
The deterioration in the labour market has put severe pressure on wage and salary disbursements (53% of the personal income), while the sharp rise in unemployment is prompting agents to build up their precautionary savings. And even if employment picks up in 2010, the lagged adjustment of wages to the unemployment rate means that wages will continue to be dragged down: the risk of wage deflation is not zero.

The wealth constraint
Between Q3 2007 and Q1 2009, just over 10 trillion dollars’ worth of financial wealth evaporated and between Q1 2007 and Q4 2009 around 4 trillion dollars’ worth of housing wealth followed suit. The negative effects of this severe, huge destruction of wealth will have a long-term adverse impact on household consumption, even if they are likely to dissipate gradually

In addition, the rebound in the equity markets since the trough of March this year (since when the S&P 500 has risen 42%) has put the dramatic erosion of their household wealth on hold. And since financial assets comprise 60% of total wealth, compared with 40% for housing assets, what is happening to the former is decisive, at least at the aggregate level. The big inequalities in the distribution of financial wealth mitigate the impact of stock prices fluctuations on consumption: the richest are not those with the highest propensity to consume. The estimates of the wealth effect are consistent with this observation: a 100-dollar drop in financial wealth results in a more moderate fall in consumption (of 3-5 dollars) than a similar drop in housing wealth (4- 9 dollars).

The credit restriction
We believe that the crisis is likely to make US households more conservative, frugal and risk averse. Their shedding of debt, partly forced and partly voluntary, looks set to be a long process so important do the past excesses to be purged appear. Yet it is quite difficult to measure the extent of those excesses, as they have to be measured against a yardstick that is very difficult to define: what is sustainable? A first criterion is debt service. This is falling but is still a long way from the previous peak of 12% reached in the mideighties. Low interest rates are undoubtedly contributing to keeping monthly payments under control. But if the fall is to continue, the stock of debt must be further reduced.

To read the full report: HOUSEHOLDS CONSUMPTION

>What were the initial causes of the crisis? (ECONOMIC RESEARCH)

The crisis is often blamed on the "excesses" in finance and banks. However it is important to understand that the crisis has far deeper causes. If we go from the most recent events to the earliest events, we can identify:

- the excesses of finance and banks;
- the rise in debt ratios and the excess liquidity;
- income inequalities and the need to boost demand via credit;
- deindustrialisation and the dichotomy of labour markets;
- globalisation and the gaps between real exchange rates.

It is sad that governments and the G20 only look at the most recent causes of the crisis (finance and banks); "intellectuals" go as far as income inequalities, but rarely link them to deindustrialisation and globalisation. This hierarchy of causes of the crisis must be identified (from the most recent to the earliest) to conduct efficient policies: in the near term, redistributive policies, in the long term, policies of reindustrialisation and maybe coordinated management of exchange rates.

To respond to the crisis, the chronicle of causes behind the crisis must therefore be clearly identified, from the most upstream causes to the most downstream causes.

We believe that the hierarchy of the causes of the crisis, from the earliest to the most recent, is as follows:

1. globalisation, and reinforcement of the competition from emerging countries by distortions in real exchange rates;
2. deindustrialisation, deskilling and dichotomy of labour markets;
3. income inequalities, low level of wages, and need to boost demand via credit;
4. rise in debt ratios and excess liquidity;
5. financial engineering, and excesses in finance and banks.

To read the full report: CAUSES OF CRISIS

>Have the central banks saved us from the crisis, or caused it?

The behaviour of the central banks of major OECD countries since the start of the crisis has led to opposing comments: for some, thanks to them the global economy has avoided a deflationary collapse; for others, they have put in place the conditions for the next financial crisis through the adoption of incredibly expansionary monetary policies, exacerbated by the reaction of emerging countries to the dollar weakness this has caused.

So, have the central banks saved the planet, or have they condemned it to another crisis? We believe that both theories are true, on different time horizons, and that, as in the past, central banks are unable to exit quickly enough from the excessively stimulating policies justified by the crisis.

To read the full report: BEHAVIOUR OF CENTRAL BANKS

>The cause of the dollar’s weakness is different, and less durable than before the crisis

Before the crisis, the dollar’s weakness was mainly caused by the US external deficit due to the shortfall in savings. It resulted in a continuous rise in the US external debt, and therefore a long-term trend depreciation of the dollar.

Since the second quarter of 2009, the dollar’s weakness has mainly been due to capital outflows from the United States, due to the very low level of interest rates. The potential for dollar weakening is greater than before the crisis, due to the magnitude of the capital outflows. However, if the US household savings rate remains higher, investment lower and the US trade deficit accordingly becomes smaller, this dollar weakness will be temporary and not permanent, as it will disappear when dollar interest rates rise again due to the future improvement in the economy. This will, nevertheless, take time: interest rates must rise again in the United States up to the point where capital stays in the United States.

1 - Dollar weakness until the Lehman bankruptcy
Until the summer of 2008, the dollar’s weakness (Chart 1) was mainly due to the widening of the US external deficit (Chart 2) due to the decline in household savings (Chart 3); or in an equivalent manner, the rise in their indebtedness (Charts 3 and 4).

2 - The dollar’s weakness since the beginning of the second quarter of 2009
The crisis caused an upturn in the US household savings rate (Chart 3 above) and a fall in investment (Chart 7), and hence a marked reduction in the US external deficit (Chart 2 above).

3 - A major difference impacting the duration of dollar weakness
When the dollar’s weakness was due to the US external deficit and the accumulation of external debt before the crisis, it had a structural, durable cause: the shortfall in savings. One could therefore anticipate a lasting depreciation of the dollar in the long term.

Since the second quarter of 2009, the dollar’s weakness has been accounted for by a different cause: the capital outflows due to the low dollar interest rates. The upturn in Americans’ savings and the fall in investment (productive and housing) have eliminated the US trade deficit as the main cause behind the dollar’s weakening. The difference from the pre-crisis situation is that there are cyclical reasons for the dollar’s weakness: the Federal Reserve’s low interest rates due to the weak US economy (Charts 11A, B and C), which explains the high unemployment and the very low inflation.

To read the charts and report: SPECIAL REPORT

>Monetarism of financial assets (ECONOMIC RESEARCH)

We can draw a distinction between two types of inflationary episodes in the past, analysed by “conventional monetarism”:

• episodes of moderate inflation, due to excessively expansionary monetary policies would lead to major strains on production capacity or the job market (1970s, early 1980s, late 1980s, India currently);

• episodes of hyperinflation (Germany in the 1920s for instance), due to a flight (because of mistrust) from money, as holders of money try to get rid of it by buying goods and services, leading to a very rapid rise in the prices of these goods and services.

The first kind of inflation has now disappeared, owing to the significant flexibility in the supply of goods and services (globalisation, deregulations) which implies that the rise in the demand for goods and services no longer results in a rise in their prices. It has been replaced by inflation in asset prices, because of the stickiness of the supply of assets (real estate, equities, bonds, commodities, etc.).

The second kind of inflation (hyperinflation in prices of goods) could, for the same reasons, be replaced by hyperinflation in asset prices: if economic agents want to get rid of money because the money supply is growing too fast, they buy real assets (commodities, gold) and not goods, as is perhaps already beginning to happen.

We are referring to the conventional monetarist explanation of:
1. inflation;
2. hyperinflation.

1. Inflation
Inflation, in the conventional monetarist explanation, is due to the excess demand for goods and services in comparison with the supply stimulated by the excess monetary (and credit) creation, in a situation where the output of goods and services can no longer rise (where the supply of goods and services becomes sticky).

In a nutshell, we have:

This occurred, for instance in the late 1970s and early 1980s in the United States and Europe, with, after the oil shocks that led to a contraction in supply, monetary policies that were at initially expansionary and led to the appearance of a situation of excess demand for goods and, therefore, inflation.

To read the full report: MONETARISM OF FINANCIAL ASSETS

>Is the crisis over? (ECONOMIC RESEARCH)

As the economies are improving and the financial markets are rising, this question is often asked: is the crisis over? Our answer is clearly negative, with arguments depending on the horizons:
■ in the near term (2010), we cannot see how OECD countries could avoid a significant slump in consumption - which will no longer be bolstered by any of the factors that have accounted for its resilience in 2009;

■ in the longer term, several serious threats appear:

• the irreversible job losses linked to the crisis can no longer be offset by stimulation of demand via credit, and we cannot see how an equivalent number of jobs can be created;

• "de-globalisation" seems to be emerging, due to the substitution of domestic output for imports in emerging countries, which means that growth in emerging countries will no longer drive growth in OECD countries. De-globalisation is, moreover, likely to lead to increased transfer of capital and production capacity to emerging countries;

• it will not be easy to eliminate the huge fiscal deficits run up during the crisis, and they may monopolise savings in OECD countries, especially as prudential rules make it difficult to use savings to provide companies with long term funding; they may also lead to a sharp rise in interest rates if they are no longer financed by central banks in emerging countries;

• the monetary and foreign exchange policies implemented in emerging and OECD countries are leading to massive growth in global liquidity and circulation of global savings that are paving the way for bubbles. These bubbles are already appearing, heralding future crises, due to the inability to control global money supply.

In a medium term prospect, our analysis would be mistaken if:
• new sectors massively created new jobs in OECD countries;
• global trade stopped contracting;
• governments implemented policies of reduction in government expenditure to have any hope of reducing deficits without a significant cost in terms of growth, thanks to Ricardian neutrality;central banks disciplined themselves and stopped the limitless growth in the size of their balance sheet.

However, over the next few quarters, the consumers will be faced with:
• a stabilisation of fiscal deficits (see charts in report ), which will therefore no longer underpin growth in consumption. We can in particular mention the end of the car purchase incentives;

• a rise in inflation (Chart 3) due to the rise in commodity prices (Chart 4);

• continued job losses (Chart 5A), as productivity has still not returned to its normal level (Chart 5B), especially in Europe, and therefore an ongoing rise in unemployment (Chart 5C);

• a slowdown or even a decline in wages in the United States (Chart 6A), due to the high unemployment and companies’ determination to restore their profitability (Charts 6B and C).

To read the full report: IS THE CRISIS OVER?

>MARKET MUSINGS & DATA DECIPHERING

A "V" SHAPED RECOVERY
In this particular case, "V" stands for Valuation, because every basis point of this 60% rally in the U.S. equity market from the lows has been due to an unprecedented expansion in P/E ratios. In fact, by some measures, the S&P 500 is already trading at valuation levels that would ordinarily be consistent with an economic expansion that is five-years old as opposed to a recovery that, at best, is in its infancy stages.

ONE OVERVALUED MARKET
There has been plenty of debate over whether equities are overvalued or not, and certainly we would assume that many investors know where we stand on the topic. Lets look at the facts now that the September data are in.

On an operating ("scrubbed") basis, the trailing P/E multiple on the S&P 500 has expanded a massive 10 points from the March lows, to stand at 27.6x. Historically, when the economy is taking the turn away from contraction towards expansion, which indeed was the case in Q3, the trailing P/E multiple is 15x or half what it is today.

To see full report: MARKET MUSINGS & DATA DECIPHERING

>RUBBER BAND SYNDROME (ECONOMIC RESEARCH)

The recovery is here, within reach… But we are nevertheless going to have to differentiate between the technical factors that will temporarily boost activity data, giving the illusion of new-found growth, and the underlying trend, which is extremely fragile.

It’s like the elastic band that has been stretched too far and which sprang back when economic activity stopped hit the buffers at year-end. Just the simple upturn in production and the ratchet effects transmitted through global trade, with its internationalised chain of value-added, seems likely to generate a marked rebound in growth in the second part of the year. Not forgetting that the inventory cycle (less downsizing followed by rebuilding) could also bolster the trend by adding a supplementary spurt to output.

Our projection takes these technical factors into account, with an upwardly revised second-half growth figure, also synonymous of emergence from recession, for most industrialised countries, as early as Q3.

But if the elastic is to be stretched even further and lead to strong, self-sustained growth, we will need other traction factors on the demand side which, in our view, are likely to be missing. In other words, the underlying trends will end up by taking over to guide the global economy along a sluggish postbubble growth path, the time it takes to clean up global finance. The global reduction in indebtedness is a lengthy process that will doubly constrain private consumption, especially in countries where the credit boom erred on the side of excess. The scars of
the crisis will still be discernible in 2010, with growth rates on either side of the Atlantic far lower than those traditionally observed during a recovery phase after such a deep recession. However, given the scale of the stimulus injected into the economy, the transition to this less leveraged growth regime is very likely to be gentle and the risk of a relapse is, in our view, low, in the short-term at least.

Sooner or later, however, the fiscal and monetary drips that are artificially keeping growth going will have to be removed. The question of timetable is critical since the idea is to remove the stimulus neither too early to avoid stopping the emerging recovery in its tracks, nor too late, to avoid committing new excesses, with their potentially inflationary (real and financial) cocktail. At all events, this question of an exit strategy will preoccupy the markets over the coming months. From the monetary policy angle, central banks have two strengths to help them successfully
see this arduous task through. First, they have considerable credibility in view of the success
of their nominal anchoring policy. Second, they can talk up to guide market expectations. On the fiscal front, the field of communication currently lies fallow and the authorities’ credibility is at quite a low ebb – two vacuums which it will be necessary to try and fill, even though it is well known that it will be extremely difficult to remove the stimulus lifesupport system in a sluggish growth environment.

To see full report: PERSPECTIVES

>FLASH ECONOMICS (ECONOMIC RESEARCH)

Shift of global capital flows (towards Asia) and public debts in OECD countries: Towards an inevitable crisis?

Asia’s attractiveness for capital will pick up very significantly after the crisis: vigorous growth - whereas growth has decelerated in OECD countries; development of domestic demand, infrastructure construction programmes; growth in the size of financial markets and banks; improvement in the perception of emerging risk and deterioration in the perception of risk related to OECD countries.

This means that Asia will become more and more attractive for private capital, and that Asian savings will increasingly be encouraged to remain invested locally. At the same time, public debt in OECD countries will rise considerably. We can therefore see the risk of an imbalance between the sharply increased supply of public debt and fading demand for OECD
countries’ public debt, to the benefit of financing of investments in Asia.

To see full report: FLASH ECONOMICS

>GLOBAL ECONOMIC MONITOR )ECONOMIC RESEARCH)

LIFT-OFF?

■ Strength of rebound to surprise…
Second quarter data continue to suggest that the pace of contraction in activity has slowed markedly since the precipitous pace of decline in the first quarter. This sets the stage for a return to positive growth rates in Q2. US economic evidence for example continues to surprise on the upside, with demand for housing and autos in particular rising above expectations. Consensus expectations for the US in H2 are shifting higher towards to 2-2.5% range. We see potential for even stronger growth as the inventory cycle alone could add 1.5% in GDP in H2. It’s a similar story in the euro area, where the success of car incentives is coming on top of the cyclical rebound in inventories. We continue to think that the strength of the recovery in manufacturing H2 will come as a surprise to the markets and will strength expectations that central banks will be heading for the exit early next year.

■ …but rate hike speculation premature
In contrast both the ECB and the Bank of England struck a more cautious tone last week largely on concerns about what happens after the inventory-led bounce in manufacturing. These are concerns that to a certain extend we share. So far the consumer has been supported by falling inflation leading to a resilient consumer outturn in H1. However these trends are about to turn around which will put pressure on consumer spending power in H2. Without a self sustaining recovery in consumption, activity risks falling back next year. As such, expectations of early interest rate rises by the Fed and the ECB look set to be dashed next year even if the market is increasingly moving in that direction in the short term.

To see full report: GLOBAL ECONOMIC MONITOR

>FLASH MARKETS (ECONOMIC RESEARCH)

Continuously excessive exchange rate fluctuations

In this Flash, we will look at the currencies of major OECD countries (dollar, euro, yen, pound sterling, Swiss franc, Australian dollar) and emerging currencies taken as a whole. At different periods, new mechanisms appear that lead to excessive fluctuations in exchange rates, for different reasons:

• before the crisis (2005-2006, first half of 2007), carry trades financed with low interest-rate currencies (yen, Swiss franc) and invested in higher-interest rate currencies (pound sterling, Australian dollar, emerging currencies, euro);

• in a first phase of the crisis (second half of 2007, first half of 2008), firstly a flight from the dollar as the crisis broke out in the United States, and a switch into emerging currencies (due to the decoupling theory) and into the euro; appreciation of the yen and the Swiss franc, depreciation of the pound sterling and the Australian dollar due to the end of carry trading;

• in a second phase of the crisis (second half of 2008, first quarter of 2009), safe haven role of the dollar, significant aversion for emerging risk, fall in commodity prices: the dollar appreciated; emerging currencies and the Australian dollar depreciated; the pound remained weak and the yen and the Swiss franc strong;

• since April 2009, rise in confidence again and prospect of an improvement in the economy; renewed investment in the currencies of countries where the markets believe growth will return faster: emerging countries, Australia, United Kingdom.

The "stories" told in the markets to justify the currency fluctuations are sometimes far-fetched: there was no reason to doubt that growth would return in most emerging countries, the United Kingdom remains in a tricky situation. However, we can see the huge exchange-rate fluctuations fuelled by the masses of capital shifted around, according to the markets perception. These fluctuations are unacceptable for the countries’ real economies, and are threatening global economic and trade integration.

To see full report: FLASH MARKETS

>THE NASCENT RECOVERY

THE NASCENT RECOVERY:
IS THE END NEAR FOR THE U.S. GREAT RECESSION?

• Real GDP fell by 1.0% (annualized) in the second quarter, the smallest contraction since the Great Recession began.

• Recent developments in the U.S. housing market, fiscal stimulus, and the emergence of
Chrysler and GM from bankruptcy suggest that Q3 may well show positive economic growth, a good signal that the U.S. economy has emerged from the Great Recession.

• While the recession may be coming to a close the road to recovery will not be swift. A pummelled labor market and shrunken household net-worth imply a slow-go recovery in 2010.

To see full report: THE NASCENT RECOVERY

>FLASH ECONOMICS (ECONOMIC RESEARCH)

Which emerging countries have the greatest risk of exposure to triple crisis?

The impact of the international crisis on emerging economies initially entailed considerable pressure on foreign exchange, in similar fashion to a crisis, but this also entailed a banking crisis.

We intend to evaluate the risk of a sovereign debt crisis for a group of emerging economies, and to this end we have come up with a composite sovereign vulnerability indicator produced from weightings on six variables in relation to solvency, liquidity, currency and governance.

Our results show considerable exposure to the risk of a sovereign debt crisis in Iceland, Latvia, Hungary, Estonia, Lithuania and Ukraine, whereas there is little risk of a sovereign debt crisis in Latin America (Brazil, Colombia, Mexico, Chile, Peru and Venezuela), Asia (Indonesia and Malaysia) and South Africa. In all other cases only average risk is perceived (Croatia, Bulgaria, Poland, the Philippines, Romania, Argentina, Czech Republic, India and South Korea).

To see full report: FLASH ECONOMICS