Global Economic Outlook

3rd Quarter 2012

The Summer Lull

Eurozone: Back to black United States: Five reasons for worry United Kingdom: Back into recession India: Losing its way

Global Economic Outlook Q3 2012

Ira Kalish, Deloitte Research in the United States (Deloitte Services LP)

he global economy seems to take two steps forward followed by one or two steps back, and it mostly has to do with Europe. Each time the Eurozone starts to seem more stable, the crisis rears its ugly head again. The result is downward movement of European economic activity and increased uncertainty. Both of these factors, in turn, have a negative impact on growth everywhere else. Today, we are seeing deceleration of growth in most of the worlds major economies. We are seeing new policy responses in some markets, changing direction of interest rates and currencies, and a higher degree of uncertainty than at almost any time in recent memory. Once again, we attempt to make sense of a confusing situation. In this edition of the Global Economic Outlook, we begin with Alexander Brschs take on the Eurozone crisis. Of course, this is a moving target with significant news taking place every few days. Consequently, Alexander offers an analysis of the conflicting forces at work in the search for a solution. Specifically, he highlights the conflict between the economic logic of further fiscal and financial integration and the politics and decision-making process of the full European Union. He concludes that the nature of the EU means that reforms will only take place in small steps. In other words, reforms will entail kicking the can down the road, which as Alexander points out, is not necessarily a bad thing if the can is kicked in the right direction. Next, Carl Steidtmann provides his analysis of the U.S. economy. As usual, Carl is worried about the outlook; indeed, his article is entitled Five Reasons for Worry. Among the five reasons, and probably the most worrisome, is the contagion effect from Europe. Carl notes three mechanisms by which the European problems are being transmitted to the U.S. economy. He concludes that the U.S. economy has dodged one bullet after another. Given the very slow growth now under way, and given the five reasons for worry, he suggests that the United States may be running out of luck. In the next article, I provide my view on the outlook for China. I focus on the balancing act that the Chinese government must undertake. On one hand, there is concern about the economic slowdown, the duration of which has taken policy makers by surprise. On the other hand, there is equal concern about the troubled state of bank balance sheets. There is an aversion to enabling imbalances to fester and worsen. Hence, the authorities are following a narrow path designed to minimize the downturn while avoiding a deeper financial crisis. In his article on the British economy, Ian Stewart notes that Britains economy remains 4.3 percent smaller than it was in 2007, and prices are 16 percent highera performance far worse than that of Germany or the United States. Yet, given the headwinds coming from Europe and the

Preface
continuing fiscal discipline of the British government, it is unlikely that things will improve much in the near term despite the more aggressive monetary policy now under way. Next up is my analysis of the Japanese economy. I note that Japan has been on something of a roller coaster, alternating from recession in 2011, to strong growth in the first quarter of this year, to the possibility of another downturn. I look at the factors that will determine whether Japan manages to attain steady growth. These include external demand in Europe and China, reconstruction spending, a newly aggressive monetary policy, and whether or not Japan enacts a large tax increase. In our next article, Pralhad Burli looks at the slowdown in India, which has been worse than many analysts expected. Pralhad examines the factors that are inhibiting a quick recovery for the Indian economy. Uncomfortably high inflation and a steady decline in the value of the rupee have prevented the central bank from implementing an easier monetary Global Economic Outlook policy. Furthermore, external headwinds and the governments failure to implepublished quarterly by ment market-friendly reforms are taking their toll on business sentiment in India. Deloitte Research In my analysis of Russias economy, I note that there are actually some positive factors influencing the economy. These include strong consumer demand, Editor-in-chief Ira Kalish historically low inflation, and increased government spending on infrastructure. Unfortunately, these factors are likely to be overwhelmed by negative influences Managing editor that will cause growth to decline in 2012 and 2013. The most important factors are Ryan Alvanos the recession in Europe, the slowdown in China, and the decline in the price of oil. In addition, both domestic and external uncertainty are undermining investContributors ment, thereby hurting longer-term growth prospects. Pralhad Burli Alexander Brsch Finally, in my discussion of Brazil, I note that the country is experiencCarl Steidtmann ing a considerable slowdown this year largely owing to deceleration of external Ian Stewart demand. The global situation has also led to a reversal in the direction of Brazils currency, creating problems for capital accumulation and inflation. On the other Editorial address hand, Brazil continues to experience strong consumer demand. However, high 350 South Grand Street levels of debt and default threaten to slow the consumer boom. Finally, monetary Los Angeles, CA 90013 Tel: +1 213 688 4765 policy has eased considerably, setting the stage for an economic rebound in 2013.
ikalish@deloitte.com

Dr. Ira Kalish Director of Global Economics Deloitte Research

We are conducting a survey is to determine the level of reader satisfaction of Deloittes Global Economic Outlook. The survey results will help us understand your needs and modify our product to better serve them. We ask that you provide your candid feedback. Your responses will remain anonymous. The survey will take only 510 minutes to complete. You can access the survey by clicking on this link or by pasting it in the address bar of your internet browser: https://survey.deloitte.com/wsb.dll/3333/GEOsurvey.htm Thank you for sharing your opinions.

Contents
6
Geographies
Eurozone: Back to black | 6
Economic news from the Eurozone suggests that the euro crisis is probably more severe and deeper than ever. A combination of economic and political issues is threatening the viability of the Eurozone in its current form. The nature of the European Union implies that reforms will only take place in small steps.

12

United States: Five reasons for worry

12

A wide range of structural problems pose a continuing threat to economic growth in the United States. Three fundamental mechanisms are transmitting European problems into the U.S. economy.

20

China: Balancing the long term and the short term | 20

The Chinese government is trying to strike a balance between the economic slowdown and its banks troubled balance sheets. Authorities are following a narrow path designed to minimize the downturn while avoiding a deeper financial crisis.

United Kingdom: Back into recession

24

24

The British economy remains 4.3 percent smaller than its was in 2007. Given the headwinds coming from Europe and the continuing fiscal discipline of the British government, it is unlikely that things will improve much in the near term despite a more aggressive monetary policy.

Japan: A roller coaster ride

28

28
4

The Japanese economy continues to swing dramatically between downturns and recoveries. External demand in Europe and China, reconstruction spending, changing monetary policy, and the possibility of a large tax increase may go a long way in dictating whether or not Japan can steady its growth engine.

India: Losing its way

32

The economic slowdown in India has been worse than many analysts expected. Uncomfortably high inflation and a steady depreciation of the rupee are inhibiting a quick recovery for the Indian economy. Furthermore, external headwinds and the governments failure to implement market-friendly reforms are taking their toll on business sentiment in India.

Russia: External headwinds slow growth

38

The Russian economy is currently enjoying strong consumer demand, historically low inflation, and increased government spending on infrastructure. Unfortunately, these factors are likely to be overwhelmed by the recession in Europe, the slowdown in China, and the decline in the price of oil. In addition, both domestic and external uncertainty are undermining investment, thereby hurting longer-term growth prospects.

32

Brazil: Shifting capital flows, slowing growth | 42

Brazil is experiencing a considerable slowdown this year as external demand decelerates. The global situation has also led to a reversal in the direction of Brazils currency. The country continues to experience strong consumer demand, but high levels of debt and default threaten to slow the consumer boom. But favorable monetary policy may set the stage for a rebound in 2013.

38

42

Appendix
Charts and tables | 46
GDP growth rates, inflation rates, major currencies vs. the U.S. dollar, yield curves, composite median GDP forecasts, composite median currency forecasts, OECD composite leading indicators

EUROZONE

Dr. Alexander Brsch is Head of Research, Deloitte Germany

Eurozone: Back to black

By Dr. Alexander Brsch

he glimmer of hope that the Eurozones crisis reached a positive turning point in the first quarter turned out to be all-too-faint as the regions economic woes returned with full force in Q2. In fact, the crisis is probably more severe and deeper than ever, and it is threatening the viability of the Eurozone in its current form. The reasons are political as well as economic. The rise of the radical left in Greece aroused new fears about a Greek exit from the Eurozone. The so-called Grexit, once considered unthinkable, has become a distinct possibility. However, the second round of Greek elections in June resulted in a pro-euro coalition. Meanwhile, the French presidential and parliamentary elections resulted in a socialist victory that is straining the Franco-German consensus on the handling of the euro crisis. The situation in the financial markets worsened in the second quarter. Risk premiums for Italian and Spanish bonds increased, and

concerns about the future of the Eurozone led to capital drains from periphery countries and greater insecurity about the Eurozones future. The Spanish banking sector will receive up to 100 billion euros to offset non-performing loans from the real estate bubble, making Spain the first big Eurozone country to apply for a European bailout. Whether or not the decisions taken at the European summit in late June will bring back the glimmer of hope in Q3 remains to be seen.

Eurozone outlook continues to be grim

Eurozone GDP stagnated in the first quarter of 2012 and was marginally (0.1 percent) below the level it achieved in the first quarter of 2011. The unemployment rate lingers at 11.2 percent, the highest unemployment rate in the history of the Eurozone. Looking behind the curtain of averages reveals persistently wide variation

Eurozone

Geographies

Global Economic Outlook: 3rd Quarter 2012

Figure 1: Unemployment rate between the northern and in percentage southern Eurozone mem30 bers (see figure 1). Austrias 24.3 25 3.9 percent unemploy21.7 ment rate is the lowest in 20 the Eurozone, and Spains 15 11 10.2 is the highest. In fact, the Spanish unemployment rate 10 5.4 5.2 3.9 is only very slightly below 5 the U.S. unemployment rate 0 Austria Netherlands Germany Italy Euro area Greece Spain at the height of the Great Depression in 1933 (24.9 Source: Eurostat percent). increase the month before. Interestingly, conThe Economic sumer expectations about their own financial Sentiment Indicator (ESI) for the Eurozone, situation improved in the Eurozone. which includes confidence indicators from The economic climate in Germany is still industry, services, and consumers, fell to 89.9 slightly positive, according to the ESI, but it is in June (see figure 2). The long-term averdeclining. This is confirmed by the Germanyageand the threshold between a negative specific ZEW index. From May to June, it and a positive outlookis 100. Confidence experienced the sharpest fall on a monthly in industry and services fell in May and June. basis in 14 years. While the index is a snapshot, However, as a ray of hope, the retail trade indiits fall could signal that the euro crisis is startcator rebounded in June after a sharp fall in ing to hit Germany. May. Consumer confidence fell slightly after an

Figure 2: Economic sentiment indicator [100 = Long-term average]

120 100 80 60 40 20 0 Jun 11 Jul 11 Aug 11 Sep 11 Oct 11 Nov 11 Dec 11 Jan 12 Feb 12 Mar 12 Apr 12 May 12 Jun 12 100.5 89.9 89.1 79.7 74.1
Germany Euro area Spain Italy Greece

Source: European Commission

Eurozone

Geographies

Solving the crisis: Economics meets EU politics

Lessons from EU integration

Looking back at the development of the European Union reveals two lessons. First, comprehensive moves toward integration take time. Consider the most recent step toward integration, the Lisbon Treaty. The drafting of the EUs constitutional treaty started in 2001, and it took three years to finish and sign it. It was then rejected in several national referenda, and a new treaty had to be developed. The Lisbon Treaty finally came into force at the end of 2009. Second, there are different sorts of integration, and the European Union tends to favor one over the other. European integration theorists argue that European integration is biased toward negative integration. Negative integration is about market creation and removing barriers to free trade and competition. The single market was the major milestone in this regard. Positive integrationthe harmonization and centralization of policies and regulationshas always been much harder. It often failed due to the very different public policies and governance structures of the member states as well as their diverging interests. A substantial jump in integration and the corresponding transfer of sovereignty to the European level would require consent on both

The renewed crisis has generated many ideas about how to solve it. The proposed solutions on a European level include fiscal union, the introduction of euro bonds, European deposit insurance, and a banking union. Yet, these proposals would require a much higher degree of integration than currently exists in Europe. What they have in common is that they imply substantial redistributions in terms of money and risk between northern and southern Eurozone countries to recreate the peripherys access to funding. The economic rationale is that, as a whole, the Eurozones debt-to-GDP ratio is comparatively favorable. In fact, the Eurozone ran a budget deficit of 4.1 percent of GDP in 2011, which is less than half the size of the deficits in the UK and the United States. Therefore, the fragmented nature of European debt is one of the key problems (see figure 3). While the economic logic is intuitive, any solution needs to consider the character of the European Union and its decision-making process. The European Union basically remains an association of nation-states with supra national characteristics and many veto points and actors. Realizing a true fiscal union on a European level, for instance, would Figure 3: Budget decit 2011 require completely overhaul[% of GDP] ing the EUs character. It would 0 require a harmonization of fiscal -2 policies, and by implication, such -4 harmonization would need to -4.1 span very idiosyncratic European -6 welfare states and tax systems. The -8 associated loss of national sover-8.3 -10 eignty would be unprecedented -9.6 in EU history. To be of any rel-12 evance for the current crisis, this Euro area USA UK quantum leap would need to be Source: Eurostat undertaken quickly.

-1 -3.9 -4.2

-8.5

-9.1 Italy Greece Portugal Germany

Spain

Global Economic Outlook: 3rd Quarter 2012

an intergovernmental and a national level. It is quite likely that these decisions would need to be confirmed through referenda in some countries, while in others, it would become an electoral focal point. Whether or not the electorates in the creditor and debtor nations are in favor of a deeper political union or of higher inter-European redistribution is an open question. This uncertainty would be a drag on the financial markets and the credibility of plans about deeper integration. Far-reaching plans for deeper integration and big-bang solutions will therefore face very substantial hurdles. It cannot be excluded that the depth of the current crisis could generate completely new patterns of integration. However, if history is any guide, the way out of the current crisis will likely be a stepby-step process. It will likely favor solutions that solve pressing problems over ones that require comprehensive institutional or systemic reforms.

unsustainable levels. Second, the Eurozone needs growth. While these two certainties may go hand in hand in the medium and long term, they tend to be contradictory in the short term. Reducing state expenditure and, therefore, aggregate demand during a period of high unemployment and spare capacity does not help growth. Worse, traditional economic stimulus is not viable. While the interest rate, which is currently at 0.75 percent, could be lowered, it is unlikely to have a significant effect. Liquidity is not the problem. Investors unwillingness to finance troubled Eurozone countries is at the heart of the crisis, so comprehensive deficit spending is also not a realistic option. Moreover, postponing fiscal consolidation is difficult because it would shatter the already-fragile confidence of the Eurozones investors.

Two certainties and a trade-off

There are two certainties about the Eurozones future. First, Eurozone countries need to deleverage and bring their fiscal houses in order because public debt has reached clearly

Design of fiscal consolidation is crucial

Given that there is no alternative to fiscal consolidation, two components are crucial: timing and design. In terms of timing, a gradual approach to fiscal consolidation would benefit growth in crisis countries. However, it

10

Eurozone

Geographies

Figure 4. Public spending on pensions and education, R&D expenditure 2010 [or latetst year available]

18 16 14 12 10 8 6 4 2 0 Italy Spain
Public pension spending %/GDP 2010 Source: Eurostat

15.3 13.6 10.1 5.79 4.09 0.6 Greece*

R&D spending %/GDP 2010 (or latest year available)

12.5

11.3

4.7 1.3 1.4

5.01

5.41 2

1.6

Portugal

EU 27

Public spending in education %/GDP 2009

can only work with credible plans for mediumterm consolidation. A more gradual approach requires a clear roadmap for deficit reduction. After all, investors want to be sure that they will be repaid at some point in the future. Thus, the prospects for the medium- and long-term fiscal sustainability and economic growth are crucial signals to investors and financial markets. Growth has a dual meaning. It refers to short-term growth in the business cycle as well as to the economys long-term growth potential. Bringing these two together to the largest degree possible should guide the design of fiscal consolidation. Three factors are critical in this regard: Multiplier effect: In the short term, the multiplier effect of government spending is an important way to preserve growth. For example, money flowing to low-income households is likely to have a high multiplier effect as a large percentage of this money will be spent. Composition of consolidation: The nature of fiscal adjustmentswhether they focus on cutting public spending or increasing taxes makes a difference for growth. Empirically,

spending cuts are less damaging to economic growth than tax increases. Investment versus consumption orientation: When it comes to public spending, structure is just as important as size. Public expenditure supports the economys growth potential most effectively with investments in education, infrastructure, and technology. Thus, a focus on these areas as opposed to purely consumptive spending raises growth prospects and productivity. Currently, the budget priorities in the crisis countries are geared toward consumption, for example, in the form of pensions, while investment-oriented spending lags behind the European average (see figure 4). The euro crisis is now in its third year. The combination of a public debt, a banking crisis, and an economic crisis impedes quick solutions and brings politicians and economists into unchartered territory. The institutional set-up of the European Union will favor small steps or can-kicking solutions. This is not necessarily a bad thingif the can is kicked in the right direction.

11

USA

Dr. Carl Steidtmann is Chief Economist at Deloitte Research

United States: Five reasons for worry

By Carl Steidtmann

hile Europe is grabbing a lions share of the economic headlines, it is not the only problem beguiling the U.S. economy. A wide range of structural problems pose a continuing threat to growth. In the best of times, these problems would simply limit the pace of growth. In difficult economic times, they make the economy more vulnerable to recession. These structural challenges include: 1. the contagion effects from a European meltdown 2. a deepening of the liquidity trap that makes the Federal Reserves task of managing monetary policy more difficult 3. structural problems in the labor market due to a mismatch between the job skills, location of the unemployment, and the available job openings 4. a sharp reduction in the pace of new business formation 5. private sector debt reduction that still has a long way to go.

Where Europe goes, the United States will follow

The European economy moved into a recession in the second quarter of 2012. For the Eurozone as a whole, real growth fell 0.1 percent in the first quarter of 2012 from a year ago. The decline in growth was most notable among the Club Med countries of the Eurozone: Greece, Italy, Spain, and Portugal. Growth was also negative in the Netherlands and non-euro-using Hungary and the Czech Republic. Quarter-over-quarter growth declined in the United Kingdom and Ireland. The pace of decline accelerated in the second quarter as the financial problems of the continents banks sent interest rates rising and real growth sliding. The financial crisis of 2008 started in the United States and spread to Europe. In 2012, Europe is returning the favor. Since the creation of the euro, the U.S. and the Eurozone economies have been economically joined at the hip (see figure 1). The hopes that the U.S.

12

United States

Geographies

economy can somehow decouple from Europe is not supported by the data. The correlation between U.S. and Eurozone economic growth over the past decade has been a very high 89 percent. Europes recession will be transmitted to the United States through trade, European investment in the United States, banking, and the performance of U.S. companies with material European operations.

Even as the construction industry shows some signs of life in the United States, new orders for construction equipment have fallen 8.7 percent since the first of the year. While the oil patch in the United States is in the midst of a drilling boom, businesses that supply equipment for the sector have seen orders plummet 29.6 percent. In all of these cases, the weakness in new orders for these capital goods is coming from outside of the United States.

Transmission mechanism: Trade

The recession in Europe is having a direct impact on U.S. exports (see figure 2). Europe accounts for roughly a quarter of all U.S. exports. Coming out of the deep slump in 2009, U.S. exports to Europe soared, rising more than 25 percent by early 2011 from the previous year. As the European financial crisis grew, U.S. export growth slowed. However, exports were still up 15.6 percent as recently as February of this year. In April, exports were down 2.8 percent, a dramatic 18.4 percent contraction in the pace of growth in just two months. The last time we saw a collapse of this magnitude was in the fall of 2008, making U.S. exports to Europe another recession marker for both the U.S. and the European economies. The contraction of trade is having a negative effect on a number of trade-dependent industries. Manufacturing has been particularly hard hit. This showed up in weak industrial production numbers in the United States and a June Purchasing Managers Index below 50 for the first time since 2009, a sign of contraction in the manufacturing sector. Going forward, manufacturing is facing a much more difficult road as new orders for a number of trade-dependent manufacturing sectors have been trending down since the first of the year.

13

Global Economic Outlook: 3rd Quarter 2012

Figure 1: GDP growth rates: United States and Eurozone Percentage change, year-over-year

4 3 2 1 0 -1 -2 -3 -4 -5 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: Organization for Economic Cooperation and Development Figure 2: U.S. exports to Europe Percentage change, year-over-year 40 30 20 10 0 -10 -20 -30 1998 2002 2006 2010 U.S. Euro Zone

Transmission mechanism: The banking system

As the banking system has grown more global, credit contractions in one part of the world can have negative effects elsewhere. The contraction of credit in Europe is putting pressure on European banks to raise capital. They can do this by issuing new equity or by selling assets. As selling equity dilutes existing shareholders, most European banks have taken the latter option of selling assets. As Europeans divest themselves of U.S.based assets (see figure 3), it contracts bank reserves in the United States, reducing the availability of credit. The U.S. Federal Reserve has more than offset this contraction of reserves through multiple rounds of quantitative easing. Still, as the Europeans sell their U.S. assets and go home, it puts downward pressure on prices while reducing the availability of capital for investment in the United States.

Source: U.S. Department of Commerce Figure 3: Eurozone investment in the United States In billions of dollars, 12 month moving totals

Transmission mechanism: Corporate profitability

U.S. businesses do more than just trade with Europe. Many have set up shop and conduct business in Europe. From automakers to quick service restaurants, U.S. businesses have extensive operations in Europe. And like the rest of the continent, the European operations of U.S. businesses are hurting. In the first quarter of this year, problems with European operations were a common excuse given for disappointing earnings. That excuse has continued in company guidance for soon-to-be-released second quarter results.
2012

100
50 0

-50

-100 -150 -200 2002 2004 2006 2008 2010

Source: U.S. Department of Treasury

14

United States

Geographies

The contraction in U.S. company earnings in Europe has translated into an actual decline in first quarter earnings of U.S. companies in total. While profits from domestic businesses rose by $41.7 billion, profits from overseas operations fell by $48.1 billion. For the first time since the fourth quarter of 2008, profits declined by $6.8 billion (see figure 4). As a share of GDP, profits shed 20 basis points to

12.8 percent. This declining share of GDP is a reflection of the growing pressures on margins due to increased labor and regulatory costs. As firms feel the pinch on profits, we can anticipate that they will respond with renewed emphasis on cost cutting in an effort to restore margins. As a result, weakness in job growth and business investment can be expected to follow the decline in profitability.

Figure 4: Corporate prots Quarter-over-quarter change in billions of dollars

250 200 150 100 50 0 2009

Source: Bureau of Economic Analysis

2010

2011

2012

15

Global Economic Outlook: 3rd Quarter 2012

Figure 5: Non-nancial corporation cash holdings In trillions of dollars

Commercial bank cash holdings As a percentage of total assets

1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 1988 1992 1996 2000 2004 2008 2012
Source: Federal reserve board

16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 2007 2008 2009 2010 2011 2012

The liquidity trap deepens

An increase in cash levels since the first of the year is a clear sign that the level of economic uncertainty has risen (see figure 5). While uncertainty over Europe has grown, so too has concern over the fiscal cliff faced by the U.S. government, the future status of health care reform, the future role of the federal government in regulating oil and natural gas drilling, and the pace of roll out of Dodd-Frank regulations. Banks and corporations have responded to this growing level of uncertainty by holding more cash. Since the first of the year, cash holdings by U.S. commercial banks have risen by $129.9 billion or 8 percent. Cash as a share of total assets has grown by 59 basis points to 13.4 percent. Before the recession hit in late 2007, cash holdings by commercial banks averaged less than 4 percent.

While corporate cash took a small hit during the recession, their stash of cash has risen by more than $220 billion since the end of the recession to $1.29 trillion. The problem with banks and corporations holding more cash is that it deepens the Federal Reserves liquidity trap. A liquidity trap occurs when the demand for money rises and offsets the central banks efforts at increasing money supply. Not surprisingly, the demand for money goes up during a recession as businesses, households, and banks all attempt to hold more cash out of a fear of insolvency or unemployment. The banks significantly increased their cash holdings during the 20082009 recessionary period. Cash holdings for both banks and corporations rose again last year due to banking problems in Europe, and they are rising again for much the same reason.

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United States

Geographies

Structural labor market problems dampen employment growth

The labor market remains a major drag on economic recovery. Long-term unemployment set records even as the economy has recovered. Median duration of unemployment, which has only rarely exceeded 10 weeks during the most severe recessions, jumped to 25 weeks in mid2010 and remains above 20 weeks three years into a recovery. Jobs are getting harder to find, and more job seekers have simply given up looking for work. The result has been a significant drop in the rate of labor force participation. Workers who are not looking for work are not accounted among the unemployed. Were the labor force participation rate at the same level as it was at the beginning of the recession, the unemployment rate would be a full 2 percentage points higher. Figure 6: A mismatch of skills: Job openings and the unemployment rate Historically, there has been Monthly data a close relationship between job 4.5 openings and the unemployment Dec 2000 - April 2009 rate (see figure 6). As the number May 2009 - April 2012 of job openings increased, not 4.0 Linear (Dec 2000 - April 20009) surprisingly, the unemployment rate fell. Since the beginning of this Linear (May 2009 - April 2012) 3.5 recovery, there has been a shift in this relationship. Given that the labor force participation has fallen 3.0 sharply, one might suspect that it would take fewer job openings to 2.5 drive down the unemployment rate since a declining rate of labor force participation pushes down the rate 1.5 of unemployment. In fact, the exact 3 4 5 6 7 8 9 Unemployment rate opposite has happened.
Job openings Source: U.S. Department of Labor

Since the first of the year, the rate of job openings has averaged 2.5 percent of total employment. In the last decade, that level of job openings would correspond to an unemployment rate of around 6 percent. During this recovery, there has been a shift in the relationship between job openings and the unemployment rate. It now takes a much higher rate of job openings to drive down the unemployment rate. The shift in this relationship is a reflection of an increased incidence of structural unemployment. While jobs are being created, they dont match up with either the skills or the geographical location of the unemployed. Reducing structural unemployment is a difficult task that requires some combination of retraining the unemployed and increasing labor force mobility.

10

17

Global Economic Outlook: 3rd Quarter 2012

Figure 7. New business creation and destruction As a percentage of the total number of business establishments

18.0 16.0 14.0 12.0 10.0 8.0 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010
Creation Destruction

Source: U.S. Department of Labor

A missing job creator: New business formation

A second reason for the weak performance of the economy in general and employment growth in particular has been the unprecedented low rate of new business formation. During the recession of 20072009, the pace of new business creation fell to its lowest level in more than 30 years (see figure 7). At the same time, the pace of business destruction rose although not nearly to the levels seen in the 2001 or the 19811982 recessions. Given the severity of the recession, it is surprising that the pace of business destruction was not significantly higher. The long-term decline in new business creation is due, in part, to demographics. An older population is going to be more risk averse and less likely to start new businesses than a younger population. Even though the trend in new business creation has been downward, the sharp fall in 20082009 was unprecedented and could reflect the cost of higher levels of business regulation.

This time really is different: The private sector de-levers

Over the past 80 years, deep recessions have always been followed by robust recoveries. In the first three years of recovery from the Great Depression in the 1930s, real GDP growth averaged more than 10 percent a year. After the oil shock recession of 19731974, real growth averaged 5.1 percent for the next three years. The double-dip recessions of the early 1980s were followed by three years of growth that averaged 5.3 percent. In each case, once the Federal Reserve began to ease credit policy, pent-up demand in credit-sensitive segments of the economy like housing and autos soared. One of the big differences between then and now is the role of debt. In each of those previous deep recessions, the private sector came out of the recession in a position to take on more debt. That has not been the case this time. To the degree that the increase in debt is a loan of future growth to the present, debt deleveraging is a repayment for past growth by the present. Households, businesses, and

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Geographies

financial institutions have all been aggressively reducing debt. While this is a healthy and necessary development, it creates a major headwind for current growth. Even with the unprecedented reduction in debt over the past four years, debt levels today are only back to where they were in early 2005 (see figure 8). Much of this reduction in debt has come from the write down of defaultedupon mortgages. Millions of homeowners are still underwater. With the foreclosure rate running near record levels, a lot of mortgage debt remains to be written down. As banks write down the bad debt they are carrying on their books, profits will suffer and additional capital will need to be raised either through the sale of assets or the issuing of more equity. Either way, banks will have less capital to lend in the short run, which will keep the private sector deleveraging for some time to come. As households and businesses delever, money that could have gone to current spending is used to pay down debt. In all cases, deleveraging leads to slower growth.

Figure 8: Private sector debt as a share of GDP

350% 300% 250% 200% 150% 100% 50% 0% 72 77 82 87 92 97 02 07 12

Source: Federal Reserve Board

Conclusions and observations

The U.S. economy has dodged one bullet after another over the past year in a successful and unprecedented effort to avoid recession. On a year-over-year basis, the U.S. economy has managed to grow less than 2 percent for four consecutive quarters. The previous record of less than 2 percent growth without a recession was the three-quarter stretch from Q4 2002 to Q3 2003. Every other case where less than 2 percent growth lasted more than two quarters was associated with a recession. With the recession spreading in Europe, the ability of the U.S. economy to continue growing in the face of its four structural issues seems increasingly unlikely.

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CHINA

China: Balancing the long term and the short term

By Dr. Ira Kalish

hinas policy makers continue their balancing act. On the one hand, they want to revive economic activity at a time when it is slowing far more than previously anticipated. To do this, they have eased monetary policy with the goal of boosting credit-market activity. On the other hand, they are cognizant of the volume of potentially troubled assets held by banks and are taking action to protect the integrity and liquidity of bank balance sheets. This, however, means some stifling of credit activity.

The dilemma faced by the government is partly due to the negative impact of the crisis in Europe. The European Union is Chinas largest export market and is now in a deeper recession than was expected. Chinas exports to Europe were up only 3.2 percent in May, while exports to the United States were up 23 percent. Although overall export growth was strong, it was entirely due to the United States. Export growth would have been far stronger if not for the recession in Europe. The slowdown in exports to Europe has had a negative impact

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China

Geographies

on industrial activity. For two months in a row, a purchasing managers index for manufacturing in China has declined and been below the critical 50.0 level, below which activity is declining. Another factor slowing the Chinese economy is the lagged effect of last years monetary policy tightening, which had a negative impact on the growth of credit, including consumer- and housing-related credit. For example, the automotive industry is now facing difficulties as consumers stay home and dealer

inventories pile up. The housing market has decelerated significantly as wellalthough house prices increased in May for the first time in 10 monthslikely reflecting the impact of lower interest rates. The decline in housing investment has had a direct impact on industrial activity. Finally, Chinese company profits declined in May for the second month in a row, reflecting the pricing pressures of a stagnant market. The result of all these events has been a continuing slowdown in growth, with real GDP

21

Global Economic Outlook: 3rd Quarter 2012

growth declining for five consecutive quarters. For the past year, the government has taken action to offset the slowdown. This has mostly involved a loosening of monetary policy. First, there were reductions in the required reserve ratio for banks, with the goal of boosting the volume of lending. Lately, however, the central bank has become more aggressive, with two interest rate cuts in June and July of this year. The result has been accelerated growth of the money supply and bank credit. In addition, the government has engaged in a more (but not too) aggressive fiscal policy.

Consider the fact that, in 2008, following the near collapse of global financial markets, China implemented a massive monetary and fiscal stimulus in order to offset the negative impact of weak global demand. That stimulus was successful in offsetting the collapse of export demand. However, much of that stimulus money was loaned by state-run banks to local governments, which spent the money on infrastructure and other projects. Today, local governments are having difficulty servicing that debt, and there is a general recognition that the investment was excessive. The return on much of that

The decline in housing investment has had a direct impact on industrial activity.
22

China

Geographies

investment was negative. Consequently, now that China is slowing again, the central government is reluctant to repeat such a policy, especially given the high level of local government debt. Instead, the central government is taking smaller steps to boost growth: gradual easing of credit conditions, targeted spending on some infrastructure projects, tax incentives for consumers to spend on automobiles and appliances, and more lending to small businesses. Bigger projects, however, are being avoided. Given the recent history of excessive investment in infrastructure and other fixed assets, the government is keen to avoid a further buildup of debt. Indeed, the volume of nonperforming loans held by Chinese banks increased in the most recent two quartersthe first time since 2005 that this measure had increased for two consecutive quarters. Consequently, while monetary policy has been aggressive, banking regulation has been equally aggressive in the opposite direction. Specifically, the China Banking Regulatory Commission plans to retain the maximum loan-to-deposit ratio at 75 percent and may take other actions aimed at constraining credit growth. In addition, the government has placed limits on bank lending to local governments lest their financial condition

worsens. The purpose of these actions is to reduce liquidity and default risks. The regulators are concerned that, with lower interest rates and lower reserve requirements, the already large number of bad assets held by banks could increase if lending grows too quickly. Another important action taken by the government has been to retard the appreciation of the currency. While other countries have complained, China has chosen to prevent further appreciation lest exports become less competitive at a time of weak export demand. This, of course, is only a temporary measure, and it will be in Chinas long-term interest for the currency to rise further in value. Finally, one interesting reason behind the governments reluctance to engage in more aggressive measures to boost growth is that the big coastal cities of China continue to experience shortages of labor. Even though factory output has stalled, the factories still have trouble filling their labor requirements. This is because there has been a sharp decline in the volume of migration from Chinas rural areas to the big coastal cities. This means that Chinas authorities need not worry too much about social unrest rising from urban unemployment.

23

UK

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

United Kingdom: Back into recession

By Ian Stewart

ur article on the United Kingdom in the last Global Economic Outlook noted a sharp rise in UK business confidence and a generally more positive tone for the economy. We concluded, however, that macro risks and sentiment could change swiftly, and that the United Kingdom was not out of the woods. That has proved to be something of an understatement. It has since emerged that the United Kingdom fell back into a double dip recession in the fourth quarter of 2011 and the first quarter of 2012. The economy has scarcely grown in the last 18 months. The level of UK output today is 4.3 percent lower than it was on the eve of the recession in late 2007. In the United States and Germany, output has risen over

this period. The contraction in UK GDP since 2008 has been greater than the shrinkage in the Spanish economy. Many of the factors used to explain the weakness of UK growthfrom high commodity prices, indebted consumers, and a fragile financial systemafflict other countries. So why has UK growth been so slow? Part of the explanation may lie in tighter fiscal policy. According to IMF data, the squeeze on public spending, aggravated by tax rises, has been on par with that seen in Ireland and Spain. But a possibly more significant factor is the weakness of UK consumer spending. Household spending is 5.2 percent lower today than in late 2007. In the United States, which has witnessed a housing market crash

24

United Kingdom

Geographies

25

Global Economic Outlook: 3rd Quarter 2012

and sharply higher unemployment, household spending rose 2.1 percent over this period. Indeed, no industrialized country outside the euro area periphery has suffered such a fierce contraction in consumer spending as in the United Kingdom. In part, the squeeze on UK consumers reflects the very high rates of inflation being generated in the United Kingdom in recent years. Despite suffering a deep downturn, UK consumer prices are today almost 16 percent higher than they were in late 2007, more than twice as large an increase as in the United States or Germany. But this period of inflation seems to be drawing to an end. From a peak of over 5 percent last autumn, UK inflation could drop to as low as 1 percent by the end of 2013. Further declines in inflation should offer some respite to consumers over coming quarters. But just as the pressure of high inflation on the UK economy has started to ease, a major new source of riskthe mounting crisis in the euro areahas emerged. The crisis has severely affected the outlook for growth in the United Kingdom, as well as in other northern European economies such as Sweden, Germany, and the Netherlands. The effect of economic and financial shocks in the euro area is being transmitted to the rest of Europe through trade flows, financial conditions, and business confidence. Prolonged weakness in the euro area, the United Kingdoms largest export market, poses a potent threat to hopes of export-led recovery. UK business sentiment has zigzagged over the last year, driven by events in Europe.

According to Deloittes 2012 CFO Survey, confidence among UK chief financial officers plummeted on the gathering euro crisis in the second half of 2011, rose in March 2012 as the European Central Bank injected liquidity into the banks, and in June registered its sharpest decline since the survey started in 2007. CFOs now see an average probability of 36 percent that one or more countries leave the single currency by the end of this year, up from 26 percent in March. UK policymakers responded to these challenges by announcing a further 50 billion of quantitative easing (QE) on July 5, taking the total program of money creation to 375 billion. With UK government bond yields already at historic lows, the effects of this further round of QE are likely to be limited. We do not see significant scope for a relaxation of fiscal policy. The government has been adamant on its program of fiscal consolidation, and a major change here would represent a political defeat on a core element of coalition policy. The government does, however, seem likely to use its low cost of borrowing to subsidize lending to the private sector, although the scale and effectiveness of such policies can only be guessed at. The heavy lifting of macro policy seems likely to come from further rounds of QE, coupled with attempts to improve the availability and price of credit. Such measures will not be able to fully offset the dampening effect of the euro crisis. Even outside the euro area, the outlook for UK growth over coming quarters will hinge critically on events in Europe.

26

United Kingdom

Geographies

Indeed, no industrialized country outside the euro area periphery has suffered such a fierce contraction in consumer spending as in the United Kingdom.

27

JAPAN

Japan: A roller coaster ride

By Dr. Ira Kalish

apans economy seems to be on a dizzying roller coaster ride. In 2011, the economy experienced negative growth. Then, in the first quarter of 2012, the economy grew at an annual rate of 4.1 percent, one of the best rates of growth of any developed economy. Now there is fear that the economy may actually contract again in the second quarter. What is going on? To begin, the recession of 2011 was largely the result of the March 2011 earthquake and tsunami. Recovery was always bound to come eventually. Then the very strong growth in the first quarter of 2012 was a bit deceptive. More than half the growth stemmed from strong consumer spending, especially purchases of automobiles. Yet this growth was boosted by temporary government incentives that have

since expired. Business investment actually declined in the first quarter, and exports were flat. So the strong performance did not represent a sustainable burst of activity. Heading into the second quarter, it is increasingly apparent that the strong growth of consumer spending will not be repeated. In fact, retail sales in April declined from the previous month. The automotive incentives are gone. Business investment, on the other hand, is expected to grow due to reconstruction spending. The latest Tankan survey of business sentiment reveals improved confidence on the part of Japanese business executives, especially in the nonmanufacturing sector. Exports grew at a strong pace in April, largely because of the very strong growth of exports to the United States. Exports to Europe and China, on the

28

Japan

Geographies

29

Global Economic Outlook: 3rd Quarter 2012

other hand, have faltered. As Europe continues to slide, it is likely that Japans exports to Europe will continue to decline. Meanwhile, imports of energy continue to grow due to the ongoing idling of Japans nuclear reactors. Consequently, the deteriorating trade balance could make a negative contribution to economic growth in the second quarter. As for the coming year, there are a number of factors that will influence the performance of the Japanese economy. Of course, reconstruction spending will have a strong positive impact, and the slowdown in Europe and China will have a strong negative impact. What other factors will make a difference? Monetary policy has been relatively aggressive compared to recent Japanese history. On the other hand, monetary policy has been relatively reticent compared to that of some other countries. Indeed, a debate is raging over whether the degree of quantitative easing (asset purchases by the central bank) undertaken so far is sufficient. Quantitative easing (QE) is intended to boost expectations of inflation, thereby reducing real interest rates. Recently, there have been several rounds of increased QE. One

As of writing this outlook, it is not clear whether the tax increase will actually become law. If it does, expect a negative impact on growth in 2013

measure of successful QE is whether inflation has increased. In Japan, inflation has increased only slightly, and it appears that expectations have barely moved. Another measure of QE is the impact on the exchange rate. While the yen initially depreciated at the start of each round of QE, it appreciated thereafter, but there has been no sustained effect on the yen. Consequently, it is reasonable to say that QE has not yet had its intended impact. Will the Bank of Japan do more? The answer is that we dont know. Another factor influencing the economy will be government fiscal policy. For now, the government is intent on raising the national sales tax, first from 5 to 8 percent next year, then from 8 to 10 percent in 2015. The purpose is to close the long-term budget gap that will result from the pension and health costs associated with an aging population. Fiscal consolidation is unambiguously a good ideaat least in the long run. The problem, however, is that the tax increase is intended to take place in the short runwhich could stifle growth. There has been a huge national debate about this, with one faction of the ruling party opposing the

30

Japan

Geographies

prime ministers proposed tax increase with such vehemence that it has decided to leave the party. As of writing this outlook, it is not clear whether the tax increase will actually become law. If it does, expect a negative impact on growth in 2013. Finally, an important factor that will influence growth will be the value of the yen. Of course, monetary policy will play a role, but there are other influences as well. Lately, Japan has been seen as a safe haven for investors despite the fact that Japans sovereign debt is more than 200 percent of GDP. Investors recognize that the debt is sustainable, mostly held domestically, and that Japan has a stable if dysfunctional political system. The extremely low return on Japanese sovereign debt reflects the fact that investors have great confidence in Japan. The very high value of the yen reflects this as well. At a time of great uncertainty, especially concerning the future of Europe, the safe-haven aspect of Japan has led to an uncomfortably high value of the yen. This in turn has hurt export competitiveness. Thus, the two factors that are most likely to influence the yen are events in Europe and decisions made by the Bank of Japan. Neither can be easily predicted.

31

INDIA

Pralhad Burli is Senior Analyst at Deloitte Research, India

India: Losing its way

By Pralhad Burli

hile the global macroeconomic environment is contributing to Indias decelerating growth, everyone knows that Indian GDP woes are at least partly selfinflicted. The economy has been badly hurt by a dearth of market-friendly economic policies. Moreover, bureaucratic reluctance to make key decisions amid fears of graft charges is resulting in a state of policy inertia. In fact, some of the governments policy actions may have done more harm than good. For example, the proposal to tax cross-border transactions involving the transfer of Indian assets resulted in widespread concern among investors and pushed the government into damagecontrol mode.

Slipping away
There is little doubt that the pace of economic expansion has slowed significantly. Indias economy grew at 5.3 percent in the quarter that ended in March 2012, its lowest rate in seven years. The growth rate for the 20112012 fiscal year came in at 6.5 percent, substantially lower than the 8.5 percent achieved a year earlier in 20102011. Agriculture, the single largest employer in the country, grew at a dismal 1.7 percent in the last quarter of 20112012. Poor growth in the agriculture sector will likely impact the entire economy because rural consumption is a major contributor to GDP growth. Less money in the hands of the rural consumers will significantly constrain their purchasing power.

32

India

Geographies

33

Global Economic Outlook: 3rd Quarter 2012

contracted 0.3 percent after a 7.3 percent expansion over the same period a year ago. Furthermore, the corporate sector experienced one of its worst decelerations in recent times. Declining external demand added to the woes of export-oriented industries. Lower demand for Indian goods abroad and domestic weakness are weighing heavily on business sentiment. Meanwhile, interest rates are high, and borrowing costs remain elevated, resulting in a drag on business investment. However, the Reserve Bank of Indias (RBIs) mid-quarter monetary policy review suggests that the effective lending rate remains lower than levels seen between 2003 and 2008 when India managed robust growth. This suggests that Indias high interest rates are not the only drag on the countrys GDP.

Government proposes, and opposition disposes

One of most anticipated policy reforms pertaining to Indias $450 billion retail market has been marred by roadblocks. The government decided to allow 51 percent foreign direct investment (FDI) in multi-brand retail, which would have paved the way for global retail giants to enter the Indian market. However, stiff opposition and widespread protests forced the government to backtrack. Meanwhile, the government has allowed 100 percent FDI in single-brand retail. Similarly, the government was forced to defer the Pension Fund Regulatory and Development Bill. With little support from the other parties that form the coalition and a vociferous opposition,

In addition, growth in the industries and the services sector was lower than expected. In the last quarter of the 20112012 fiscal year, the industries and the services sector grew at 1.7 and 7.9 percent respectively compared to 7.0 and 10.6 percent during the same period in the previous year. The manufacturing sector

34

India

Geographies

Figure 1: Rupee-Dollar exchange rate

57 56 55 54 53 52 51 50 Mar 27 2012
Source: Oanda.com

INR/USD

Apr 11 2012

Apr 26 2012

May 11 2012

May 26 2012

Jun 10 2012

Jun 25 2012

proposals for allowing higher FDI in insurance, defense, and aviation may be further delayed. Other key reforms are unlikely to see the light of day anytime soon.

A rock and a hard place

In its monetary policy review meeting in June 2012, the RBI kept its policy rates unchanged even though the markets expected a rate cut. Clearly, the RBI is more concerned about high inflation than lackluster GDP growth. There could be two reasons for the current stance. First, the RBI surprised the market with a larger-than-expected rate cut in

April, so it held back this time around. Second, the RBI believes that the role of interest rates in holding back investment is relatively small in the current environment. As such, a reduction in interest rates could heighten inflationary pressure, which is lingering at fairly elevated levels. The RBI will continue to closely monitor both external and domestic factors, and it will likely focus on reining in inflation and managing liquidity. The choices before the RBI are limited, and its policy decisions will likely be heavily influenced by the growthinflation dynamic.

35

Global Economic Outlook: 3rd Quarter 2012

When will it stop?

The Indian rupee (INR) has been one of the worst performers among the BRIC currencies, setting record lows almost every other week. The rupee experienced significant volatility, alternating between periods of rapid decline and mild recoveries. Between April 1, 2012, and June 20, 2012, the rupee fluctuated between $51.19 and $56.49a decline of over 10.3 percentbefore recovering to $55.86. On June 19, the value of the rupee against the U.S. dollar fell 1.1 percent in a single day. As of this writing, the rupee has once again embarked on a depreciating path (see figure 1).

The Indian rupee (INR) has been one of the worst performers among the BRIC currencies, setting record lows almost every other week.
There are several reasons why the rupee has been under pressure over the past few months. Amid uncertain global macroeconomic conditions, investors tend to flock to safer assets. This predisposition resulted in a huge outflow of funds from India. Furthermore, European banks will likely continue to deleverage, exerting pressure on the rupee. Indias widening trade deficit is another factor that contributes to the slide of the rupee as importers demand more foreign currency to pay for their

purchases, resulting in a downward spiral. In addition, India runs a deficit on its current account and requires external capital flows to bridge the gap. Dismal economic performance and the possibility of weak exports while the Eurozones crisis deepens and Chinese growth decelerates are chipping away at investor confidence. As a result, India is unable to attract sufficient FDI inflows. Finally, Indias foreign exchange reserves, although sufficient to pay for over six months of imports, are not large enough to allow the reserve bank to frequently intervene in the foreign exchange market. In times of excessive volatility, the reserve bank has intervened in the foreign exchange market, but its ability to stem the slide has been compromised. Instead, the RBI initiated measures to restrict the rupees declining value. First, the RBI relaxed the interest rate ceiling on foreign currency non-resident (FCNR) deposits. Second, it allowed higher limits on intraday trading. Third, on May 10, 2012, the RBI instructed exporters to liquidate 50 percent of the dollars in their accounts within two weeks to help release greenbacks into the market. Furthermore, exporters were mandated to exhaust the available dollar balance in their accounts before tapping markets. Finally, the government deferred a controversial set of tax proposals, which brought some relief to the rupee by stemming the flight of capital. Improving investor sentimenteither

36

India

Geographies

because of a favorable development in Europe or breakthrough policy decisions in India could potentially reverse the rupees downward trend against the dollar. The others measures will, at best, have a temporary impact. Not surprisingly, rating agencies made downward revisions to their outlooks on India and suggested that the countrys sovereign credit rating faces the prospect of being downgraded to junk status. Markets did not respond negatively to the news, but India is likely to confront a spate of challenges in the coming months. Owing to a huge subsidy bill, the government is finding it extremely difficult

to bridge the fiscal gap. Furthermore, a rising import bill further exacerbated its current account deficit. Additionally, ongoing inflation suggests that India may need to address structural macroeconomic factors rather than simply relying on monetary policy. Moreover, the political situation does not bode well for the countrys growth prospects. India will experience slower GDP growth in the coming quarters, and growth forecasts for the 20122013 fiscal year range between 6.0 and 6.5 percent.

37

RUSSIA

Russia: External headwinds slow growth

By Dr. Ira Kalish
The Russian economy started 2012 on a positive note. Yet Russia is no more immune to the influences of the global economy than the other BRIC nations, and may be even more vulnerable. With Europe in crisis, China slowing, and oil prices declining, it is likely that growth in 2012 will be significantly slower than in 2011. fter real GDP grew 4.3 percent in 2011, first-quarter GDP was up 4.9 percent from a year earlier. This was the result of strong consumer spending and elevated oil prices. Then, in the second quarter, things started to change. First, Europes recession deepened, negatively affecting export revenue for Russia. Second, Chinas economy slowed, which also had a negative impact on exportsespecially given that China is Russias largest export market after the European Union. Third, the

price of oil dropped substantially, also reducing export revenue. Fourth, the crisis in Europe contributed to a renewed flight to safety among global investors, which included capital flight from Russia. This had an adverse effect on business investment. Indeed, business investment as a share of GDP in Russia is low relative to most emerging markets. Failure to invest not only reduces current growth; it also has a negative impact on future growth.

38

Russia

Geographies

39

Global Economic Outlook: 3rd Quarter 2012

Positive influences
Some positive factors contribute to the outlook for Russia: Consumer spending has remained reasonably robust, the result of strong real-wage gains, tax incentives, strong growth of consumer credit, and pent-up demand. Retail sales have been particularly strong. In addition, inflation lately has been surprisingly low. In April, consumer prices were up only 3.6 percent from a year earliera post-Soviet record low. This increase helps to boost real wages. It also provides the central bank with some wiggle room to loosen monetary policy without worrying about inflation. On the other hand, inflation was temporarily suppressed by some price controls. As these are removed, it is widely expected that inflation will rebound. Finally, the recent high price of oil enabled the government to run a deficit much smaller than anticipated. This provided the government with room to engage in a modest degree of stimulus through increased spending. Indeed, the government intends to boost investment in public infrastructurepartly as a way to offset the deceleration in private-sector investment. On the other hand, the recent drop in the price of oil means that the role of fiscal policy in boosting growth could be coming to an end.

Negative influences
There are many factors that will retard growth in the coming year. Naturally the troubles in Europe and the slowdown in China are top of mind, as is the drop in the price of oil. The impact on the industrial sector has been considerable. In April, industrial production was only 1.3 percent higher than a year earlier, having decelerated substantially from 2011. In addition, investment remains weak due to political uncertainty, worries about the Eurozone situation, and capital flight. The latter has been driven by the global flight to safety as well as by political uncertainty within Russia. Not only does capital flight influence the level of investment, it also has the effect of depressing the value of the ruble. While the ruble was riding high during the period of rising oil prices, lately it has come under pressure. This in turn will stymie the ability of the central bank to ease monetary policy further. After all, the central bank might feel compelled to intervene in currency markets in order to stabilize the ruble.

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Geographies

Risk
Perhaps the biggest risk to Russia comes from the Eurozone situation. To determine the vulnerability of Russias financial system to Europe, the central bank recently conducted stress tests on Russias top banks, analyzing the impact of GDP growth of 2 percent and a 1520 percent decline in the price of oil. The central bank concluded that such a scenario would lead banks to lose roughly one-quarter of their capital. This suggests that a more severe drop in economic growth and the price of oil could have a devastating impact on the health of Russias financial system.

41

BRAZIL

Brazil: Shifting capital flows, slowing growth

By Dr. Ira Kalish
number of things have changed in Brazil recently. In our last quarterly report, we noted that Brazils leaders were concerned about upward pressure on the currency stemming from an abundance of portfolio capital flowing into the country. Now they are concerned about downward pressure on the currency and a flight of capital. In early 2012, Brazil seemed headed for a modest deceleration in growth. Now Brazils economy appears headed for a considerable slowdown, the result of strong headwinds from Europe. Let us begin by considering the capital market situation. Two things have changed in the past few months. First, global markets

have been spooked by tremendous uncertainty, mainly about the future of the Eurozone. As such, there has been a general flight to safety. Brazil is not alone among emerging countries in experiencing a flight of capital heading to perceived safe havens. The United States, Japan, Switzerland, and the United Kingdom have all been the recipients of capital looking for safety. Second, Brazils central bank, like those of several other emerging countries, has significantly cut its benchmark interest rate in order to stimulate sagging economic activity. Indeed, in the past year, the benchmark rate has been reduced by 400 basis points. The effect, of course, is to make the country less

42

Brazil

Geographies

43

Global Economic Outlook: 3rd Quarter 2012

44

Brazil

Geographies

attractive to foreign portfolio investors who are in search of higher returns. Consequently, Brazil is no longer attracting vast amounts of portfolio capital. The end result has been downward pressure on the currency. While that is a good thing from the perspective of exporters, it has the potential to boost inflation beyond the already uncomfortably high level. Next, what about growth? On the negative side, the industrial sector has begun to witness declining activity. The latest purchasing managers index fell below the critical 50.0 level, below which activity is believed to be falling. This is due largely to the impact on exports from the slowdown in Europe and China. Moreover, the crisis in Europe has probably had a negative impact on business confidence and willingness to take risks. The result has been a sizable slowdown in the growth of overall economic activity. On the positive side, Brazil has experienced strong consumer spending growth, which has helped to offset the negative impact on industrial output stemming from the Eurozone crisis. In part, this spending has been fueled by consumer borrowing, itself due to the attractiveness of historically low interest rates. Unfortunately, consumers have borrowed a bit more than they can handle. The result has been a sizable increase in the default rate on consumer loans, especially automotive loans. This is likely to dampen consumer borrowing and spending going forward. Moreover, banks have tightened lending standards after witnessing an

increase in their rate of nonperforming loans. Thus, the boom in consumer spending may be coming to an end. The tightening of bank lending standards also means that the impact of lower interest rates is being negated. If banks are reluctant to lend, lower official rates will not matter. Indeed, the rate of private-sector credit expansion has decreased recently. To deal with this and offset the private-sector credit crunch, the government is stepping in with more subsidized loans for private-sector companies. There are a number of reasons to be cautiously optimistic about Brazils likely performance in the coming year. First, the central bank has managed to aggressively ease monetary policy while retaining its credibility regarding inflation. Second, the governments finances are in reasonably good shape. The recent announcements of modest fiscal stimulus are not likely to seriously impair Brazils fiscal probity or shake financial markets. Third, the banking system is believed to be reasonably robust; consequently, the rise in the rate of nonperforming loans is not expected to endanger the health of major banks. Finally, Brazils upcoming hosting of the World Cup (2014) and Summer Olympics (2016) is expected to boost the level of investment and, therefore, contribute to faster growth. Barring a disintegration of the Eurozone, Brazil is expected to experience acceleration in economic growth by 2013.

45

Global Economic Outlook: 3rd Quarter 2012

Appendix
GDP growth rates (YoY %)*
8 6 4 2 0 -2 -4 -6 -8 -10 -12 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 07 07 07 07 08 08 08 08 09 09 09 09 10 10 10 10 11 11 11 11 12 -10 -15 0 -5

GDP growth rates (YoY %)*

(Note: India's scal year is April-March)

20 15 10 5

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 07 07 07 07 08 08 08 08 09 09 09 09 10 10 10 10 11 11 11 11 12

U.S.

U.K.

Eurozone

Japan

Brazil

China

India

Russia

Ination rates (YoY %)*

6 5 4 3 2 1 0 -1 -2 -3 Jan 09

Ination rates (YoY %)*

(Note: Ination data for India is based on the WPI) 16 14 12 10 8 6 4 2 0 -2 -4

May 09

Sep 09

Jan 10

May 10

Sep 10

Jan 11

May 11

Sep 11

Jan 12

Mar 12

Jan 09

May 09

Sep 09

Jan 10

May 10

Sep 10

Jan 11

May 11

Sep 11

Jan 12

Mar 12

U.S.

U.K.

Eurozone

Japan USD-Yen
100

Brazil

China

India

Russia

Major currencies vs. the U.S. dollar*

1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1 Jan 09

95

90

85

80

75 May 09 Sep 09 Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11 Jan 12 Mar 12

GBP-USD
*Source: Bloomberg

Euro-USD

USD-Yen (RHS)

46

Appendix
Yield curves (as on April 6, 2012)*
U.S. Treasury Bonds & Notes 3 months 1 Year 5 Years 10 Years 0.09 0.18 0.62 1.49 UK Gilts 0.35 0.23 0.59 1.54 Eurozone Govt. Benchmark -0.02 0.01 0.32 1.25 Japan Sovereign 0.10 0.10 0.18 0.77 Brazil Govt. Benchmark 7.75 7.41 8.97 9.82 China Sovereign 2.78 2.23 2.74 3.26 India Govt. Actives 8.18 8.03 8.03 8.12 Russia 5.80 6.38 7.94 8.56

Composite median GDP forecasts (as on July 12, 2012)*

U.S. 2012 2013 2014 2.1 2.2 2.9 UK 0.1 1.5 2.0 Eurozone -0.4 0.7 1.3 Japan 2.5 1.4 1.05 Brazil 2.7 4.5 4.05 China 8.2 8.4 8.0 Russia 3.8 3.7 3.8

Composite median currency forecasts (as on January 9, 2012)*

Q3 12 Gbp-usD euro-usD usD-Yen usD-brazilian real usD-Chinese Yuan usD-indian rupee usD-russian ruble 0.8 1.24 99 2 6.32 56 32.55 Q4 12 0.8 1.23 100 1.97 6.3 54.5 32 Q1 13 0.79 1.24 101.5 1.74 6.12 49 31.91 Q2 13 0.79 1.25 104 1.94 6.21 52.75 32.1 2012 0.8 1.23 100 1.97 6.3 54.5 32 2013 0.79 1.25 102 1.9 6.15 50 31.55 2014 0.78 1.28 109.5 1.83 6.11 51 31.89

OECD composite leading indicators (Amplitude adjusted)

U.S. Jul 10 aug 10 sep 10 Oct 10 nov 10 Dec 10 Jan 11 feb 11 mar 11 apr 11 may 11 Jun 11 Jul 11 aug 11 sep 11 Oct 11 nov 11 Dec 11 Jan 12 feb 12 mar 12 apr 12 may 12
*source: bloomberg

UK 101.79 101.67 101.61 101.60 101.62 101.65 101.66 101.65 101.59 101.46 101.25 100.96 100.59 100.20 99.85 99.59 99.46 99.45 99.53 99.62 99.69 99.71 99.69
Source: OCeD

Eurozone 100.87 100.98 101.10 101.24 101.38 101.50 101.59 101.61 101.57 101.45 101.27 101.03 100.75 100.45 100.18 99.96 99.81 99.73 99.69 99.67 99.65 99.61 99.55

Japan 99.99 100.02 100.09 100.20 100.36 100.53 100.66 100.73 100.72 100.65 100.54 100.45 100.39 100.35 100.34 100.40 100.51 100.63 100.75 100.83 100.85 100.81 100.71

Brazil 101.04 101.02 101.07 101.18 101.26 101.29 101.22 101.05 100.84 100.55 100.19 99.74 99.26 98.83 98.48 98.22 98.07 98.07 98.22 98.49 98.77 98.99 99.15

China 100.99 101.00 101.17 101.43 101.64 101.72 101.66 101.49 101.30 101.09 100.92 100.78 100.67 100.55 100.43 100.28 100.12 99.94 99.79 99.68 99.54 99.37 99.22

India 101.43 101.37 101.32 101.26 101.15 101.02 100.80 100.49 100.11 99.69 99.29 98.97 98.74 98.60 98.54 98.56 98.62 98.63 98.55 98.40 98.18 97.97 97.79

Russia 100.43 100.94 101.45 101.93 102.34 102.65 102.79 102.81 102.67 102.43 102.18 101.99 101.83 101.74 101.73 101.78 101.87 101.95 101.98 101.91 101.60 101.04 100.32

99.92 99.93 100.01 100.16 100.36 100.58 100.78 100.91 100.94 100.87 100.72 100.51 100.29 100.12 100.08 100.19 100.42 100.70 100.95 101.12 101.17 101.11 100.94
miCeX rates

note: a rising Cli reading points to an economic expansion if the index is above 100 and a recovery if it is below 100. a Cli which is declining points to an economic downturn if it is above 100 and a slowdown if it is below 100.

47

Global Economic Outlook: 3rd Quarter 2012

Additional resources
Asia Pacific Economic Outlook
In thIs Issue:

China India Singapore Thailand

July 2012

Deloitte Research Thought Leadership

Deloitte Review Issue 11 From mad man to superwoman: The inevitable rise of the chief marketing officer in the age of the empowered customer. Cloud wars: How incumbents can respond to cloud disruption. The engagement economy: How gamification is reshaping businesses. The Ito factor: In the digital startup world, Joi Ito is a bona fide rock star, but the outspoken entrepreneur faces his biggest challenge yet in revitalizing MITs venerable Media Lab. Pulling ahead vs. catching up: Trade-offs and the quest for exceptional profitability. Asia Pacific Economic Outlook: China, India, Singapore, and Thailand. GovCloud: The future of government work Please visit www.deloitte.com/research for the latest Deloitte Research thought leadership or contact Deloitte Services LP at: research@deloitte.com. For more information about Deloitte Research, please contact John Shumadine, Director, Deloitte Research, part of Deloitte Services LP, at +1 703.251.1800 or via e-mail at jshumadine@deloitte.com.

48

Appendix

Contact information
Global Economics Team
Ryan Alvanos Deloitte Research Deloitte services lp usa tel: +1.617.437.3009 e-mail: ralvanos@deloitte.com Pralhad Burli Deloitte Research Deloitte services lp india tel : +91.40.6670.1886 e-mail: pburli@deloitte.com Dr. Alexander Brsch Deloitte & Touche GmbH Germany Tel: +49 (0)89 29036 8689 aboersch@deloitte.de Dr. Ira Kalish Deloitte Research Deloitte services lp usa tel: +1.213.688.4765 e-mail: ikalish@deloitte.com Dr. Carl Steidtmann Deloitte Research Deloitte services lp usa tel : +1.303.298.6725 e-mail: csteidtmann@deloitte.com Ian Stewart Deloitte Research Deloitte & touche llp uK tel: +44.20.7007.9386 e-mail: istewart@deloitte.co.uk

Global Industry Leaders

Consumer Business Lawrence Hutter Deloitte llp uK tel: +44.20.7303.8648 e-mail: lhutter@deloitte.co.uk Energy & Resources Peter Bommel Deloitte netherlands netherlands tel: +31.6.2127.2138 e-mail: pbommel@deloitte.nl Financial Services Chris Harvey Deloitte llp uK tel: +44.20.7007.1829 e-mail: caharvey@deloitte.co.uk Life Sciences & Health Care Robert Go Deloitte Consulting llp usa tel: +1.313.324.1191 e-mail: rgo@deloitte.com Manufacturing Hans Roehm Deloitte & touche Gmbh Germany tel: +49.711.16554.7130 e-mail: hroehm@deloitte.de Public Sector Greg Pellegrino Deloitte Consulting llp usa tel: +1.571.882.7600 e-mail: gpellegrino@deloitte.com Telecommunications, Media & Technology Jolyon Barker Deloitte & touche llp uK tel: +44 20 7007 1818 e-mail: jrbarker@deloitte.co.uk

U.S. Industry Leaders

Banking & Securities and Financial Services
robert Contri

Deloitte llp tel: +1 212 436 2043 e-mail: rcontri@deloitte.com

Consumer & industrial products

Craig Giffi Deloitte llp tel: +1.216.830.6604 e-mail: cgiffi@deloitte.com

health plans and health sciences & Government

John Bigalke Deloitte llp tel: +1.407.246.8235 e-mail: jbigalke@deloitte.com

power & utilities and energy & resources John mcCue

Deloitte llp tel: +216 830 6606 e-mail: jmccue@deloitte.com

public sector (federal)

Robin Lineberger Deloitte Consulting llp tel: +1.517.882.7100 e-mail: rlineberger@deloitte.com

public sector (state)

Bob Campbell Deloitte Consulting llp tel: +1.512.226.4210 e-mail: bcampbell@deloitte.com

telecommunications, media & technology eric Openshaw

Deloitte llp tel: +1 714 913 1370 e-mail: eopenshaw@deloitte.com

49

Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Deloitte provides audit, tax, consulting, and financial advisory services to public and private clients spanning multiple industries. With a globally connected network of member firms in more than 150 countries, Deloitte brings world-class capabilities and high-quality service to clients, delivering the insights they need to address their most complex business challenges. Deloittes more than 195,000 professionals are committed to becoming the standard of excellence. Disclaimer This publication contains general information only, and none of Deloitte Touche Tohmatsu Limited, its member firms, or their related entities (collectively the Deloitte Network) is, by means of this publication, rendering professional advice or services. Before making any decision or taking any action that may affect your finances or your business, you should consult a qualified professional adviser. No entity in the Deloitte Network shall be responsible for any loss whatsoever sustained by any person who relies on this publication. 2012 Deloitte Global Services Limited