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January 2010

Global Macro-Risk Scenarios 2010-2011 On the Hook

Table of Contents
Executive Summary Introduction: A Few Steps Away from the Precipice Our Central Scenario for 2010-2011: Still Hook-Shaped The Rationale Behind The Hook: Output Losses and Diminished Growth Trends What Are the Main Downside Risks Downside Risk # 1 Downside Risk # 2 Downside Risk # 3 1

for Some Time Yet

Executive Summary
Moodys continues to believe that a sluggish recovery is the most likely global macro-economic scenario. In other words, we believe that the global economy is not going to rebound strongly in 2010 and 2011, but rather return to trend growth rates, with persistent unemployment and budget deficits. This is in line with the hook-shaped recovery scenario which Moodys introduced in May 2009 1 and which stipulated that the crisis will leave lasting scars, with many economies not returning to their previous output paths. In our view, the sluggish recovery will be characterized by the following factors: There will continue to be no homogeneity in the economic rebound across different regions. In most advanced economies, the recovery will be fragile because of numerous headwinds especially those related to expected challenges in sovereign risk. Our global economic outlook is therefore intertwined with our global sovereign risk outlook for 2010. 2 The combination of lower levels of activity given the significant output losses and diminished trend growth in many regions will have an important impact on credit. The world has more or less tacitly opted for financial stability at the expense of economic vitality and this will in turn make the absorption of large public debts more challenging. We have also identified at least three downside risks albeit of varying probability to our hook-shaped rebound scenario. Governments disorderly exit from high-stimulus policies, leading to an abrupt increase in long-term interest rates and/or sharp currency realignments.3 Financial institutions not rebuilding capital buffers at a sufficient speed to withstand the remaining economic and financial threats. An unexpected decline in Chinas growth dynamic.

3 5 5 7 8

Contact Us
Email and Web page globalriskanalysis@moodys.com www.moodys.com/gra Pierre Cailleteau +44.20.7772.8735 Chief International Economist MIS pierre.cailleteau@moodys.com Aurelien Mali +44.20.7772.5567 Analyst Global Financial Risk Unit aurelien.mali@moodys.com Jean-Franois Tremblay +1.212.553.2997 Vice President Senior Analyst Financial Institution Group jean-francois.tremblay@moodys.com Elena Duggar +1.212.553.1911 Vice President Senior Analyst Credit Policy elena.duggar@moodys.com Client Services +44.20.7772.5454 clientservices@moodys.com Media Relations: +44 20 7772 5456

Please refer to Moodys report entitled On the Hook - Update on Moody's Global Macroeconomic Risk Scenarios 2009-2010, published in May 2009. Please refer to Moodys Special Comment entitled Sovereign Risk: Review 2009 & Outlook 2010, published in December 2009.

Introduction: A Few Steps Away from the Precipice?

The graph below offers a stylized illustration of global macro-economic and credit conditions over recent years, as well as our forecast of credit conditions in 2010.

Our Central Scenario for 2010-2011: Still Hook-Shaped

Given the past two years of turbulence, we present our central scenario as follows: We provide a range (of 1%) to avoid spurious precision in such agitated times. Also, our rating decisions across asset classes are influenced by meaningful economic shifts rather than decimal changes. Our central assumptions are based on a sample of forecasts, including Moodys own economic forecasts.

We indicate the level of uncertainty [1] surrounding the central forecast. It is measured by comparing the range of forecasts we poll and the historical standard deviation of the countries real growth. For instance, if the dispersion in the growth forecast for a given country in 2010 is 3% when the standard deviation was 0.5%, we indicate that the forecast is highly uncertain. Lastly, we indicate whether the bias [2] is positive or negative i.e. whether, for example, a forecast of uncertainty is more likely to surprise us positively or negatively.

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Forecasts for 2010 and 2011

Countries
Growth central range

2010
Uncertainty [1] Bias [2] Unemployment central range Growth central range

2011
Uncertainty [1] Bias [2] Unemployment central range

Argentina Australia Brazil Canada China France Germany India Indonesia Italy Japan Mexico Russia South Africa South Korea Turkey UK USA

2.5/3.5 2.0/3.0 4.5/5.5 2.0/3.0 8.5/9.5 1.0/2.0 1.2/2.2 7.0/8.0 4.5/5.5 0.5/1.5 1.0/2.0 3.0/4.0 2.0/3.0 2.0/3.0 3.0/4.0 3.0/4.0 1.0/2.0 2.0/3.0

I II III II I III III II III III II II I II II II II III

positive neutral positive neutral neutral positive positive neutral neutral positive positive positive positive positive positive positive positive positive

-5.5/6.5 -8.0/9.0 -9.5/10.5 9.0/10.0 --8.0/9.0 5.0/6.0 -----8.0/9.0 9.5/10.5

2.5/3.5 3.0/4.0 3.5/4.5 2.5/3.5 8.5/9.5 1.5/2.5 1.5/2.5 7.5/8.5 6.0/7.0 1.0/2.0 1.0/2.0 3.5/4.5 4.0/5.0 3.5/4.5 4.0/5.0 3.5/4.5 2.0/3.0 2.5/3.5

I I I II I II II II II I II II I I I II II III

positive neutral neutral neutral neutral neutral positive neutral neutral neutral neutral neutral neutral neutral neutral positive neutral neutral

-5.0/6.0 -7.5/8.5 -9.5/10.5 9.0/10.0 --8.0/9.0 4.5/5.5 -----8.0/9.0 8.5/9.5

[1] Uncertainty levels (I, II III in increasing order) are measured by comparing the difference between the highest and lowest forecasts of sources such as the IMF, WB, OECD, Eurostat, JPMorgan, Barclays and Moodys divided the standard deviation of real GDP growth over the last 20 years: 0<I<0.5 standard deviation, 0.5<II<1.0 and III>1. [2] If the balance of risks is positive, it means that there is an upward bias (the risk of being too conservative is higher than the risk of being too optimistic), etc.

The Rationale Behind the Hook: Output Losses and Diminished Growth Trends
Levels and Trends: Back to Basics
There are two main features to take into account in the central scenario. First, many countries have recorded output losses. For instance, from Q1 to Q3 2009, cumulated output losses reached 7.7% in Japan, 5.9% in Italy, 5.6% in Germany, 4.8% in the UK and 3.2% in the US. This means that production has declined and, in some cases, that production capacity has also shrunk i.e. the companies that defaulted and the workers that were laid off cannot resume producing goods as and when demand picks up. So a key issue is the extent to which the crisis has led to a loss of economic muscle or simply to a period of inaction.

Second, the question arises of how rapidly an economy can grow when the banking sector has to operate at a higher capital-asset level, and when companies, households and also governments must repair their own balance-sheet and save more (or spend less). With a less abundant and less cheap supply of finance on the one hand, and more restrained demand for finance on the other, growth potential is reduced i.e. the economy cannot grow as rapidly as previously thought without generating inflation. The charts below describe the interplay between two factors: output levels and output trends. We can broadly group countries into three categories although it is too early to determine with any degree of certainty to which group advanced countries belong:

Crisis, what crisis? This category represents the countries that will weather the crisis with little damage. Such countries will have ex-

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perienced a slowdown or even contraction in growth; but output growth will subsequently rise above potential for a time until there is no further slack; whereupon the countries will reposition themselves on their previous track. The level of output for such countries in, say, 2012 will be roughly where it was three years ago. Good examples are China or Korea. While Koreas growth plummeted in the first half of 2009, the countrys rebound was sharp and it will probably return to its medium-term path, having recouped the output loss of early 2009.

same speed but at a lower path in terms of output levels. The output trajectory will not be the same as before in other words, the countries will not become as wealthy as previously expected. This lost output growth, as compared to expectations, is probably the situation of countries like the US, France and Germany.

Broken destinies. Countries in this category have suffered sharp output contractions and damage to their economic engine to the extent that their growth potential is impaired. Not only is the level of activity lower, but the trend is lower as well. Such countries will be growing from a lower level and a lower pace i.e. their growth trends are diverging from their previous paths. This is the situation of Ireland for instance or, to a much worse extent, Iceland or Latvia.

The future is not what it used to be.

This category comprises the countries that have suffered output losses and are unlikely to grow sufficiently (above potential) to recoup the output loss that the previous trend had promised. However, their trend growth is the same as before. In effect, these countries will be growing at the

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Why does this matter?

The level of output and its trend do matter a lot. After all, debt in an economy is predicated on or made sustainable by some assumptions in terms of future income. If the level of output/income and its growth are lower, part of the leverage in the economy is based on fragile assumptions. This applies to public sector debt as much as to private sector debt. From a government perspective, there is less output to back debt levels in other words, debt/GDP increases and structural deficits open up as public spending remains broadly the same while public revenues, indexed on activity, plummet.

What Are the Main Downside Risks?

The following downside risks are not likely enough to be a main feature of our central scenario although they do influence it somewhat. However, they are plausible enough to merit consideration by analysts. We have ranked them below in descending order of probability.

So wheres the hook

The hook in our hook-shaped scenario is a stylized description of a world economy where some major countries have undergone an output contraction and are experiencing only a mild rebound. Not all economies in the world will face sluggish growth and many emerging market economies have sharply rebounded but the economies that face strong headwinds are large enough to influence the global outcome. One reason why we expect the rebound of most advanced economies to be subdued is the need for fiscal consolidation on which many of our Aaa ratings are predicated. In countries where both fiscal deficits and unemployment are high, policy dilemmas abound: should fiscal consolidation take precedence over economic growth and the fight against unemployment? Or should the need to stimulate growth as much as possible to reduce unemployment before it becomes structural prevail over fiscal austerity?

Downside Risk 1: A disorderly exit from high-stimulus policies, leading to an abrupt increase in long-term interest rates and/or sharp currency realignments
The world economy is slowly emerging from a very perilous situation with outright output contractions in most large countries and plenty of excess capacity. At the same time, government bonds in large Aaa countries - especially the most liquid among them - have benefited from a massive flight to safety after the collapse of Lehman Brothers. This has helped to mitigate the immediate cost to public finances of an unprecedented move towards risk socialization. Moreover, central banks have added to the demand for government debt by offering (zero) interest rate policies with active balance-sheet policies also known as quantitative easing (QE). As a result, in 2009 global long-term interest rates recorded the largest fall from an already low level in 50 years, or in the post-Bretton Woods period. However, the current equilibrium seems fragile. While it is possible that the most apt reference is Japan of

Another "Misery" Index

Fiscal Deficit (2010F) 0 Unemployment Rate (2010F) 5 10 15 20 25 30

the last decade - where deflationary pressures compensated for abundant monetization and uncomfortable public debt levels to keep long term interest rates close to zero the balance of risks points, in our view, to higher global interest rates. First, although subdued in large advanced economies, the economic rebound is clearly in evidence. Also, as stated earlier, it is plausible that the crisis has eroded growth potential in the economies worst hit by the crisis, which means that inflationary pressures may appear sooner than expected. Secondly, as the world economy rebounds and banking systems return to profitability and restore equity buffers, the reason for investors to shun private sector debt and find refuge in government debt seems less compelling.

Spain Latvia Lithuania Ireland Greece United Kingdom Iceland United States Jamaica France Estonia Portugal Hungary Germany Italy Czech Republic
Sample of countries, sources: Moodys and national authorities

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This is also partly true for banks that have acquired massive amounts of public debt - although the risk of a sudden investment shift is mitigated by mounting regulatory requirements. Fourthly, the reason why long-term interest rates were Thirdly, sooner or later, central banks will have to reverse QE. It is not obvious that the massive increase in bank reserves prefigures an inflation shock - indeed, this is the wrong call that the Fed made in 1937. In fact, as was shown in Japan, the explosion of the monetary base does not necessarily herald an explosion in broad money, followed eventually if one adopts an even vaguely monetarist stance by a rise in inflation. The money multiplier effect, whereby increased cash reserves that are pumped into the banking system have a disproportionate impact on banks' balance sheets, has been muted. But the key impact of QE is to deliberately and effectively spur asset price reflation. Beyond the fact that asset price increases could ultimately lead to an increase in demand for goods and services (the wealth effect), fueling asset price inflation (and occasionally bubbles) creates a dilemma for central bankers. Another way to present the policy challenge low before the crisis despite the booming world economy (the famous Greenspan "conundrum") was often attributed to the savings glut in emerging market economies with rapidly rising incomes. If these economies (starting with China) succeed in rebalancing their growth model, following the exhortations of western policy-makers, the need to intervene to support the dollar will be lower and the equilibrium between supply and demand of US government bonds will be altered. Of course, one could argue that such a macro-economic shift will help sustain economic growth in the US, which will improve government revenues and in turn reduce the supply of government paper. But it is unclear whether such an adjustment will be seamless for government yields - especially as a further depreciation of the dollar would increase inflationary pressures and raise the risk premium on dollardenominated assets for foreigners. is that the fear of inflation matters almost as much as inflation itself.

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among banks and a mediocre contribution to economic Overall, it seems likely that upward pressure on government yields will build up in 2010. The question seems to be more whether this will be an orderly or a disorderly adjustment. As we explained in our Aaa Sovereign Monitor, 3 an abrupt increase in government funding cost would materially change the debt adjustment equation. In this report, we also tried to quantify the impact of a jump in long-term interest rates on debt-to-GDP ratios and debt affordability (the interest-payment-to-revenue ratio). The severe scenario we chose in order to measure interest rate sensitivity includes a 1% increase in 2010 and 2% increase from 2011 onwards. Although the period is longer, this interest rate shock is slightly more hard-hitting than the 1994 shock. That said, long-term interest rates would still remain below the last 50-year average. The table below shows the impact on these ratios two years after the interest rate shock compared with the baseline scenario. Overall, the deterioration of public finances would be significant especially in terms of affordability as debt levels are very high. Additionally, the macroeconomic impact of such a scenario would certainly be severe unless the hike in long-term interest rates is solely predicated on a much more vigorous growth outlook. The unusual combination of a material increase in long-term interest rates and a sluggish recovery would be damaging to economic and credit prospects.
2012 Debt/GDP US FG US Germany France UK Baseline IR Shock Baseline IR Shock Baseline IR Shock Baseline IR shock Baseline IR shock 69.8 70.8 101.2 102.5 80.3 81.2 91.8 93.1 91.8 92.6 IP/Rev 13 17 9.4 11.7 7.2 8.8 7.2 9.1 8.5 10 2013 Debt/GDP 70.8 72.8 101.4 103.9 80.3 82.3 94.9 97.6 95.5 97.3 IP/Rev 14.5 20.4 10.4 14.1 7.5 9.9 7.7 10.8 9.1 11.3

growth. There is a risk though that from being moderately helpful to the hook-shaped recovery, banks could turn out to be a drag once again. One concern is that the banking sector must complete the unfinished clean-up of their balance sheets against the background of a challenging operating environment characterized by the imminent withdrawal of government support, the introduction of more stringent regulation and difficult refinancing conditions. During 2009, investors provided significant amounts of capital and other funds to banks, but this should not be confused with a return to a normal operating environment. The extensive support that governments have provided over the past two years has undeniably affected investors risk perception and contributed to keeping the rates that banks pay to raise funds artificially low. Government interventions have led to some degree of decoupling between risk pricing and financial fundamentals. Furthermore, the substantial profits that large banks have reported in the second half of 2009 were largely driven by the rebound of financial markets and banks related investment activities, which are unlikely to be repeated to the same degree in 2010. There will be a sea change in 2010 and 2011 for banks. Governments and central banks will unwind their expansive support, government bond yields which banks have purchased en masse will probably rise and the economy is not likely to be vigorous enough to stem the continued accumulation of non-performing loans. Therefore, there is a risk that the exit strategy may lead to a disorderly re-pricing of risk within the banking system, thereby leaving the weakest banks to fend for themselves on a stand-alone basis and forcing them to shrink their balance sheets further to remain viable or be perceived as such.

Downside Risk 2: The realization that financial institutions have not reconstituted capital and liquidity buffers at sufficient speed, given the remaining economic and financial threats
The recovery of the economy is closely intertwined with that of the banking sector. Our central scenario is based on a challenging but progressive return to profitability
Please refer to Moodys quarterly Special Comment called Aaa Sovereign Monitor published in December 2009.
3

This risk is compounded by the fact that, in addition to keeping borrowing rates low, government programs have also contributed to shortening banks wholesale debt maturity profiles, resulting in large amounts of debt maturing in the coming years. 3 No less than US$7 trillion of wholesale debt is set to mature by the end of 2012 globally. A debt profile skewed towards short-term maturities makes a bank vulnerable to market volatility, including any in-

3 Please refer to our Special Comment Banks Wholesale Debt Maturity Profiles Shorten, Exposing Many Banks to Refinancing Risks, published in November 2009 (120846).

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crease in benchmark government rates and/or swings in investor confidence. The downside risk therefore is that a disorderly exit from the highly supportive conditions of the past two years may combine with the lagged realization of the losses associated with the economic casualties of early 2009. This would place many banks in a precarious situation to face the looming wall of refinancing and create the conditions for a double-dip scenario.

example, Oxford Economics estimates that the impact of trade and investment with China on the US economy amounts to an increase in US GDP of 0.4-0.7% per year over 2005-2010, in addition to a reduction in US consumer prices of 0.5-0.8% per year over the same period. Taken together, these benefits equate to an average increase in real income of 1.5% per year by 2010. However, some Asian economies are going to be much more affected by a slowdown in China than countries like the US. Although important for China, US and EU exports to China represent only about 5-6% of total US and EU exports and only about 0.5-0.8% of their GDP. On the other hand, exports to China represent more than 100% of GDP and about 50% of total exports for Hong Kong and over 20% of GDP and over 30% of total exports for Taiwan. Additionally, exports to China represent 6-10% of the respective GDPs (and 10-20% of total exports) of Singapore, South Korea and Thailand; and 1-5% of the respective dia. GDPs (8-26% of total exports) of Malaysia, Australia, the Philippines, Japan, Indonesia, and In-

Downside Risk 3: An unexpected fall in Chinas growth dynamic

In our view, this risk has a low probability - indeed, we recently placed a positive outlook on China's A1 rating based on our expectation that the country would be able to manage the economic and financial consequences of highly expansionary policies. However, the risk of an unexpected decline in China's growth should be considered not only because the vigorous response of the economy poses macro-economic policy challenges, but also because widespread economic and financial expectations increasingly seem to incorporate a strong and steady performance of the Chinese economy as if it was impervious to cyclical tensions. The confirmation that growth proved resistant in China at the end of Q1 2009, along with the comforting stress-tests of US banks, have helped create a more constructive mood in world financial markets. In fact, an abrupt slowdown would have many global implications for commodity prices and trade flows more generally and, in turn, for many emerging markets growth prospects but it would also complicate the re-absorption of global imbalances.

What could trigger such a slowdown?

There are at least three possibilities. First, a commercial war with the US or EU would be (mutually) disruptive. Second, market perceptions that the exchange rate is undervalued could induce large capital inflows, and greater capital account liberalization would add to such pressures. This would add to asset price pressures, thereby complicating monetary and demand management policies. Third, retaining expansionary policies for too long is bound to generate macro-economic turbulence. Excessively high credit growth, asset price inflation, rapid income growth and nominal effective exchange rate depreciation may overwhelm the policy capabilities of the authorities. In conclusion, the expectation of a linear and robust growth trajectory in China is an assumption that could be tested - and could upset the pace of world recovery if the rebound of large advanced economies has not yet become entrenched.

Why it does matter?

Although China represents only about 11% of global GDP on a PPP basis (compared to about 21% for the US), it will add a full percentage point per year to global output growth in 2008-2010 according to the IMF, and thus account for about 50% of global growth. China's trade with the rest of the world has been growing three times as fast as the global average since it joined the World Trade Organization in 2001. Moreover, Chinese imports have recently been growing faster than Chinese exports. Thus, an abrupt slowdown in economic growth in China can have significant consequences for its main trading partners. Empirical evidence can throw some light on which countries are most likely to be affected and by how much. For

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All our publications can be found at www.moodys.com/gra. Alternatively, you can also click on the links below.

Global Imbalances: A Positive-Sum Game from a Global Credit Perspective, April 2007. French Presidential Elections: A Slow Entry into the 21st Century, April 2007. The European Union at 50: Are its Best Years Behind it?, March 2007. Current Account Deficits In Emerging Europe More Inflammability But No Repeat Of Asian Crisis, March 2007. Why Is Credit Risk Priced so Low? A Perspective on Global Liquidity, February 2007.

Global Financial Risk Perspectives -- Report On the hook, May 2009 From Global integration to Global disintegration, December 2008. Navigating the Fog, July 2008 Mapping
the Near Future: Macro Stress Scenarios for 2008-2009, January 2008

The Archaeology of the Crisis, January 2008. Stress-Testing the Modern Financial System: Feds rate
cut, key pressure points, risk scenarios, September 2007.

Related Global Banking Series Banking consolidation in Europe:

Agency Perspective, June 2007.

Rating

Stress-Testing
ber 2007.

the Modern Financial System, Septem-

Banking

From Illiquidity to Liquidity: The Path Towards Credit Market Normalization, September 2007. The Asian Crisis Ten Years Later: What We Know, What We Think We Know and What We Do Not Know, May 2007.

Systemic Fears are Exaggerated Vanishing Liquidity in an Abundantly Liquid World, August 2007.

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