FEBRUARY 12, 2013

CREDIT POLICY

GLOBAL RISK PERSPECTIVES

Global Macro Outlook 2013-14: Downside Risks Have Diminished

Executive Summary
After deteriorating during the past year, global economic prospects appear to have stabilized in recent months. Financial market conditions have been relatively benign, compared with the turmoil seen during the first half of 2012, and there are encouraging signs that growth could strengthen in the worlds three largest economies during the course of this year. In the G-20 advanced economies, survey evidence continues to suggest a gradual strengthening in growth prospects. However, European economies continue to lag behind the US, and only Japan has announced significant policy stimulus. While business confidence should strengthen as the economic situation improves, fiscal consolidation and high unemployment will continue to impede recovery. Overall, we expect real GDP growth in the G-20 advanced economies of around 1.4% in 2013, followed by 2.0% in 2014. Growth during the coming year is expected to be a little weaker than we previously thought, reflecting recent poor data outturns. We continue to expect growth in the G-20 emerging economies to outpace other G-20 members. But there is limited prospect of a swift return to the strong pace of expansion seen during 2010 and 2011, despite encouraging developments in China, as emerging economies continue to rebalance away from external demand in the face of weak world trade growth. Overall, we expect real GDP growth in these economies to be a little over 5% in 2013, followed by a modest pickup towards 6% in 2014. This forecast is broadly unchanged from November 2012. Given the relative stability of our forecasts since November, the most notable change to our global outlook is that downside risks to growth appear to have significantly diminished. In particular, the full scale of the potential disruption to the US economy from the so-called fiscal cliff was avoided, financing stresses in the euro area have somewhat eased, and there are increasing signs that key emerging markets will manage to avoid an overly sharp slowdown in growth. Yet despite these developments the risks to our forecasts remain skewed to the downside, stemming in particular from the following scenarios: A deeper than currently expected recession in the euro area accompanied by deeper credit contraction, potentially triggered by a further intensification of the sovereign debt crisis. Weaker-than-expected growth in major emerging markets after the recent slowdown. An escalation of geopolitical tensions, resulting in adverse economic developments.

Table of Contents:
EXECUTIVE SUMMARY 1 FORECASTS FOR 2013-14: DOWNSIDE RISKS HAVE DIMINISHED 2 Global synthesis 2 Continued weak growth in advanced economies 3 Prospects for emerging markets are broadly unchanged 8 DOWNSIDE RISKS TO THE FORECASTS HAVE DIMINISHED 10 The risk of a deeper than currently expected recession in the euro area 11 Weaker-than-expected growth in major emerging markets 11 An escalation of geopolitical tensions 12 MOODYS RELATED RESEARCH 13

Analyst Contacts:
NEW YORK +1.212.553.1653

Elena Duggar +1.212.553.1911 Group Credit Officer - Sovereign Risk elena.duggar@moodys.com Richard Cantor +1.212.553.3628 Chief Risk Officer richard.cantor@moodys.com Bart Oosterveld +1.212.553.7914 Managing Director - Sovereign Risk bart.oosterveld@moodys.com Madhi Sekhon +1.212.553.3780 Associate Analyst madhi.sekhon@moodys.com LONDON Colin Ellis Senior Vice President colin.ellis@moodys.com +44.20.7772.5454 +44.20.7772.1609

Antonio Garre +44.20.7772.1089 Associate Analyst antonio.garre@moodys.com

CREDIT POLICY

Moodys Global Macro Outlook underpins our universe of ratings, providing a consistent benchmark for analysts and investors. This report is an update to our November 2012 Global Macro Risk Scenarios report.1 It reviews key recent developments, provides an update on our baseline forecasts for 2013-2014 and discusses the key risks around our forecasts.

Forecasts for 2013-14: Downside Risks have Diminished

Global synthesis
Global economic growth has shown signs of stabilization in recent months. Most advanced economies are still seeing very slow recoveries or further declines following the recessions of 2008/9, reflecting gradual adjustments to excesses built up prior to the financial crisis. As such, our overall outlook for economic growth is broadly unchanged from three months ago. We still expect relatively weak growth to persist for several economies over the next few years, but we now see fewer potential stumbling blocks on the path to global recovery . In particular, US policymakers avoided the full scale of fiscal tightening implied by the so-called fiscal cliff, and there have also been encouraging signs of improvement in some major emerging markets, most notably China. Also, financial markets, most notably in the euro area, have experienced a period of relative calm, which contrasts with the turbulence they saw during the first half of last year. However, these factors are unlikely to spur economic activity significantly, with private sector deleveraging and public sector austerity still the dominant impediments to growth. As a result, our forecasts are little changed from those in our previous Global Outlook. We expect real GDP growth in the G-20 economies (weighted by nominal GDP at market exchange rates) to be around 2.9% in 2013, followed by 3.3% in 2014. These growth rates remain materially lower than the pace of expansion in 2010 and 2011. The risks to our forecasts have significantly diminished since the November 2012 update, but remain skewed to the downside despite recent positive developments. Moodys believes that the three most immediate risks are: i) the risk of a deeper than currently expected recession in the euro area accompanied by deeper credit contraction, potentially triggered by a further intensification of the sovereign debt crisis; ii) slower-than-expected recovery in major emerging markets following the recent slowdown; and iii) an escalation of geopolitical tensions, resulting in adverse economic developments. We present our central scenario in Exhibit 1 but highlight the following: We express our forecasts for annual GDP growth and unemployment as a range of one percentage point (ppt) to avoid spurious precision and to focus on significant changes that could potentially influence rating decisions. We indicate the level of uncertainty for our central forecast. We present ranges from the forecasts that we survey and compare them to the historical standard deviation of the countries real growth. The blue shading in Exhibit 1 denotes countries with somewhat greater forecast uncertainty relative to historical GDP volatility.

Update to the Global Macro Risk Outlook 2012-14: Slow Adjustment to Weigh on Growth (146944), 12 November 2012.

FEBRUARY 12, 2013

GLOBAL RISK PERSPECTIVES: GLOBAL MACRO OUTLOOK 2013-14: DOWNSIDE RISKS HAVE DIMINISHED

CREDIT POLICY

EXHIBIT 1

Moodys Central Forecast Scenarios for 2013-14

Past growth Countries 2011
8.9 2.1 2.7 2.4 9.2 1.4 1.7 3.1 6.8 6.5 0.4 -0.8 3.9 4.3 7.1 3.1 3.6 8.5 0.8 1.8 3.3 1.4 6.7

2013F
Growth central range 3.0/4.0 2.5/3.5 3.0/4.0 1.5/2.5 7.5/8.5 -0.5/0.5 -0.5/0.5 0.0/1.0 5.5/6.5 5.5/6.5 -1.0/0.0 0.5/1.5 3.0/4.0 3.0/4.0 3.5/4.5 3.0/4.0 2.5/3.5 3.5/4.5 0.5/1.5 1.5/2.5 2.5/3.5 1.0/2.0 5.0/6.0 Unemp't central range -4.5/5.5 -6.5/7.5 --10.0/11.0 5.0/6.0 --11.0/12.0 4.0/5.0 ------7.5/8.5 7.0/8.0 ----

2014F
Growth central range 3.0/4.0 2.5/3.5 3.5/4.5 2.0/3.0 7.0/8.0 0.5/1.5 0.5/1.5 1.0/2.0 6.0/7.0 6.0/7.0 0.0/1.0 1.0/2.0 3.0/4.0 3.5/4.5 3.5/4.5 3.5/4.5 3.0/4.0 3.5/4.5 1.5/2.5 2.0/3.0 3.0/4.0 1.5/2.5 5.5/6.5 Unemp't central range -4.5/5.5 -6.5/7.5 --10.0/11.0 5.0/6.0 --11.0/12.0 4.0/5.0 ------7.0/8.0 6.5/7.5 ----

Forecast uncertainty measures

2013 growth range [2] 1.1 0.7 2.4 0.6 0.9 0.9 0.6 1.0 0.7 0.7 0.6 1.0 0.6 1.0 0.7 1.0 0.9 1.3 0.6 0.6 ---2014 growth range [2] 1.3 1.1 2.2 0.5 1.2 0.8 1.0 0.6 0.8 0.5 1.2 1.2 0.9 0.5 0.8 1.0 1.5 1.5 0.5 1.7 ---GDP volatility [3] 6.4 1.0 2.4 2.0 1.8 1.9 1.7 2.3 2.0 4.9 2.1 2.4 3.8 3.3 4.9 2.6 1.9 5.1 2.2 2.0 ----

2012 (E)
3.2 3.5 1.5 1.8 7.8 -0.5 0.2 0.7 5.4 6.0 -2.4 1.8 3.8 3.5 6.5 2.5 2.0 3.0 0.0 2.2 2.8 1.5 5.2

Argenti na Aus tra l i a Bra zi l Ca na da Chi na Euro a rea Fra nce Germa ny Indi a Indones i a Ita l y Ja pa n Mexi co Rus s i a Sa udi Ara bi a South Afri ca South Korea Turkey UK US G-20 All G-20 Advanced G-20 Emerging

Notes: Green shading denotes improvement from the November 2012 update, orange denotes deterioration. Blue shading denotes considerable forecast uncertainty relative to historical GDP volatility. Growth figures for 2012 are estimates where official data have not yet been published. [1] G20 All includes nominal USD GDP-weighted data for the 19 individual countries that comprise the G-20. G-20 Advanced includes Australia, Canada, France, Germany, Italy, Japan, the UK, and the US. [2] The percentage point difference between the highest and lowest forecasts of sources such as the IMF, WB, OECD, Eurostat, JPMorgan, Barclays, and Moodys. [3] The standard deviation of real GDP growth over the 15 years to 2011. [4] In February 2012, the IMF approved a decision that calls on Argentina to implement specific measures to address the quality of reported GDP and Consumer Price Index data; on 1 February 2013, the IMFs Executive Board found that progress had not been sufficient and issued a declaration of censure against Argentina under its Articles of Agreement.

Continued weak growth in advanced economies

The outlook for advanced economies is little changed from three months ago, with many countries still struggling with the legacy and fallout from the financial crises and recessions of 2008/9. The long, painful process of deleveraging in parts of the private sector still has much further to run, and fiscal consolidation remains a priority for many governments. Confidence is relatively weak, and there is still considerable uncertainty around the global economic outlook, despite the dissipation of some downside risks. Without strong impetus from external demand, this picture of a weak appetite for risk in the private sector , alongside declining government support as deficits are cut, implies a slow, gradual process of adjustment and weak economic growth in many advanced economies. This gradual pace suggests that the crisis will leave lasting scars on many economies, and in some instances national incomes may struggle to make up the lost ground implied by pre-crisis trends. It also means that we

FEBRUARY 12, 2013

GLOBAL RISK PERSPECTIVES: GLOBAL MACRO OUTLOOK 2013-14: DOWNSIDE RISKS HAVE DIMINISHED

CREDIT POLICY

are unlikely to see a rapid return to more normal growth rates in many economies, let alone the sort of above-trend rates that are often seen once recessions have ended. We expect the G-20 advanced economies to grow by around 1.4% in 2013, followed by 2.0% in 2014. One positive development over recent months has been the stabilization of financial markets, spurred by the ECBs announcement of its Outright Monetary Transactions (OMTs) programme in September. This stabilization should reduce uncertainty and aid the process of recovery in many advanced economies, but any positive impact on growth will probably be small. Fundamentally, households are still hesitant to spend given high unemployment and debt levels, and the uncertain economic outlook continues to weigh on firms hiring and investment decisions. One positive factor is that commodity price pressures still appear to be relatively contained (Exhibit 2). The spot price of West Texas Intermediate (WTI) crude oil has picked up slightly since November, standing at around $96/barrel at the start of February, but remains significantly lower than its 2008 peak. The price of Brent crude has also risen over the past three months. Moodys central macroeconomic scenario is consistent with oil prices rising gradually from these levels over the next two years.
EXHIBIT 2

Selected commodity prices

Jan 2008-Jan 2013; 1 January 2008 = 100
350 300 250 200 150 100 50 0 2008 Corn Gold Soybean Silver

EXHIBIT 3

WTI spot oil price and futures curve

Jan 2008-Dec 2014
160 140 120 100 80 60 40 20 0 2008 WTI spot price WTI forward curve (a)

2009

2010

2011

2012

2013

Source: Haver Analytics.

2009 2010 2011 2012 (a) At 8 February 2013. Sources: Haver Analytics and CME Group.

2013

2014

The US economic outlook remains one of subdued growth during 2013. While politicians managed to avoid the full extent of the so-called fiscal cliff, the package passed by both houses of Congress on 1 January still encompassed fiscal tightening of around 1% of GDP this year. In addition, expenditure cuts that may be decided on in the coming months could also still impede US growth. As such, although the 1 January package mitigated much of the fiscal drag associated with the cliff, it did not eliminate it altogether. Fiscal policy will weigh on US activity this year, and policymakers still need to agree on further fiscal measures that lower future deficits and stabilize US government debt dynamics over the longer term.2 Further fiscal tightening will weigh on US growth, as was evident in the advance reading of GDP for Q4 2012. The US economy stagnated at the end of last year, with GDP falling 0.1% on an annualized basis, with the weakness reflecting large drops in inventories and defense spending. However, that weak outturn followed upwardly revised growth of 3.1% in Q3. During 2012 as a whole the US economy expanded by 2.2%, the fastest pace of growth in the G7 (Exhibit 4), and the prospects for
2

See US Fiscal Package Has Limited Positive Credit Implications, 10 January 2013.

FEBRUARY 12, 2013

GLOBAL RISK PERSPECTIVES: GLOBAL MACRO OUTLOOK 2013-14: DOWNSIDE RISKS HAVE DIMINISHED

CREDIT POLICY

private sector activity are brightening. New housing starts have continued to increase, reaching the highest level since June 2008. US energy production is also likely to jump significantly in coming years, following the discovery of vast reserves of shale oil, providing a boost to the domestic economy and limiting US reliance on foreign oil imports. In addition, although the unemployment rate edged up to 7.9% in January (Exhibit 5), non-farm employment increased by 157,000, continuing the strong pace of job creation seen during the second half of 2012.
EXHIBIT 4

G7 GDP growth
2012 (a)
3 2 1 0 -1 -2 -3 Percentage change on previous year

EXHIBIT 5

US housing starts and unemployment

Jan 2007-Jan 2013
Housing starts (LHS) Thousands of units 1600 1400 1200 1000 800 600 400 200 0 2007 2008 2009 2010 2011 2012 2013 2.0 0.0 8.0 6.0 4.0 Unemployment rate (RHS) Per cent 12.0 10.0

(a) Estimates where official data are not yet published. Sources: Haver Analystics and Moodys estimates.

Source: Haver Analytics.

All told, the greater impetus from the US private sector is likely to broadly offset the drag on activity from more restrictive fiscal policy, so that GDP growth in 2013 is likely to remain close to 2%. Thereafter, we expect the US economy to expand at a somewhat faster pace than is likely this year, closer to its long-run average pace of growth. In contrast, economic conditions in the euro area have continued to deteriorate. Euro area GDP declined by 0.1% in Q3 2012 compared with the previous quarter, marking a return to technical recession following the decline of 0.2% in the second quarter. The euro area economy is also likely to have shrunk in Q4, following the revelation that German GDP declined by around 0.5% during that period. During 2012 as a whole, euro area GDP is likely to have fallen by around 0.5%.3 Among member states, peripheral economies continue to be hit hardest. Portuguese GDP has now fallen by more than 5% since the current decline started in late 2010, while Spain and Italy have now both seen five consecutive quarters of economic decline (Exhibit 6). Although data quality is poor, the Greek economy has undoubtedly suffered the most, and has probably now shrunk by more than a quarter since the start of the debt crisis. The necessary structural adjustments in these economies have included painful cuts in prices and wages often termed internal devaluations in order to regain competitiveness and close external imbalances. At the same time, austerity programmes designed to stabilize sovereign debt dynamics have amplified declines in GDP and rises in unemployment, while continued dislocations in credit markets mean that finance is still more expensive in Italy and Spain than in Germany or France (Exhibit 7).

The first estimate of Q4 2012 growth is scheduled for publication on 14 February.

FEBRUARY 12, 2013

GLOBAL RISK PERSPECTIVES: GLOBAL MACRO OUTLOOK 2013-14: DOWNSIDE RISKS HAVE DIMINISHED

CREDIT POLICY

EXHIBIT 6

Euro area GDP levels

Q1 2008-Q3 2012, Q1 2008 = 100
Germany 104 102 100 98 96 94 92 90 88 2008 2009 2010 2011 2012 Spain France Portugal Italy

EXHIBIT 7

Non-financial corporations cost of bank funding (a)

Jan 2007-Dec 2012
Germany France Annualised agreed rate (%) 7 6 5 4 3 2 1 0 2007 2008 2009 2010 2011 2012 Spain Italy

Source: Haver Analytics.

(a) New business excluding revolving loans and overdrafts. Source: ECB.

While progress has been made in addressing structural imbalances the necessary adjustments have much further to run, and the decline in German national income at the end of 2012 is consistent with the idea that weakness in the periphery is being transmitted throughout the rest of the currency union. The aggregate unemployment rate reached 11.7% in November and December 2012, a new record high. Short-term indicators such as retail sales and industrial production suggest that the euro area economy as a whole could contract further in the first half of 2013. And the scope for further policy support appears limited. Against this discouraging backdrop, the period of relative calm in financial markets has been accompanied by further positive developments. Long-term government bond yields for Italy and Spain have fallen further since November (Exhibit 8), boosting the likelihood that these governments may not need to enter explicit aid programmes. Concerns about deposit outflows from peripheral banking systems have eased as levels have evened out (Exhibit 9). And there have also been signs of stabilization in survey indicators such as the European Commissions economic sentiment indices and the Purchasing Managers Indices (PMIs), raising hopes that the current recession will prove to be relatively shallow and brief compared with the deep recession in 2008/9. However, it remains to be seen whether this stabilisation will presage improvements in confidence and orders; and indeed whether any improvement in the survey data will be reflected in official figures.

FEBRUARY 12, 2013

GLOBAL RISK PERSPECTIVES: GLOBAL MACRO OUTLOOK 2013-14: DOWNSIDE RISKS HAVE DIMINISHED

CREDIT POLICY

EXHIBIT 8

Ten-year government bond yields

Jan 2009-Jan 2013
Germany Per cent 20 18 16 14 12 10 8 6 4 2 0 Jan-09 Spain France Portugal Italy Ireland

EXHIBIT 9

Banking system deposits (a)

Jan 2007-Dec 2012; Indices, January 2007 = 100
Spain 160 150 140 130 120 110 100 90 80 Ireland Greece Portugal

Jan-10

Jan-11

Jan-12

Jan-13

2007

2008

2009

2010

2011

2012

Source: Haver Analytics.

(a) Non-MFIs (monetary and financial institutions) excluding central government. Source: Haver Analytics.

In light of these mixed developments, the euro area economy as a whole is likely to broadly stagnate during 2013, with positive growth in the likes of Germany and Ireland offset by further declines in national income in Spain, Italy, Portugal and Greece. While our central view is that positive growth will resume during 2014 for several peripheral member states, the main downside risk to our global forecast is that the current euro area recession proves to be longer and deeper than expected. After a strong GDP reading in the third quarter, boosted by temporary factors, the UK economy fell back at the end of 2012. The preliminary estimate of UK GDP growth was -0.3% in Q4 2012, raising the potential prospect of triple-dip recession, and the economy saw zero growth during 2012 as a whole. In the absence of effective policy stimulus, we have again revised down our growth profile. The broad outlook for the UK economy remains one of slow and bumpy recovery over the next two years, with GDP growth likely to remain below-trend in both 2013 and 2014. The Japanese economy shrank by 0.9% in Q3 2012 compared with the previous quarter. The scale of this sharp contraction was unanticipated, and suggests that underlying weaknesses in the worlds thirdlargest economy could be more pervasive than previously thought. In the near term, Japanese growth is likely to strengthen during 2013 and 2014 following Prime Minister Abes announcement of a new fiscal stimulus, which is aimed at boosting GDP by around 2%. However, previous fiscal stimuli have failed to have much lasting impact on Japans economic performance. As such, changes to the monetary policy regime could have a more durable effect, particularly if the Bank of Japan (BoJ) successfully meets its new 2% CPI inflation target. The BoJs recent announcement that it will pursue open-ended purchases of government debt starting in January 2014 suggests that it is prepared to shift to a more aggressive policy stance. This is a critical step in order to raise inflation expectations, which in turn is a pre-requisite condition for meeting the new inflation target over the longer term. At the same time, the steps taken by Prime Minister Abe could intensify Japans credit challenges, in particular the need to reduce the budget deficit in order to prevent deterioration in creditworthiness to a level that could induce a funding crisis.4

See Japans New Leader Faces Intensifying Credit Challenges, 18 December 2012.

FEBRUARY 12, 2013

GLOBAL RISK PERSPECTIVES: GLOBAL MACRO OUTLOOK 2013-14: DOWNSIDE RISKS HAVE DIMINISHED

CREDIT POLICY

Prospects for emerging markets are broadly unchanged

Alongside our relatively stable expectations for advanced economies over the past three months, our forecasts for emerging markets are also broadly unchanged. We continue to expect real GDP growth in the G-20 emerging economies of a little over 5% in 2013, followed by a modest pickup towards 6% in 2014. This significant growth still represents a notable deceleration from the robust growth rates seen during 2010 and 2011, following the financial crisis and accompanying recessions in advanced economies. The Chinese economy appears to have adjusted well during 2012. Although exports to the EU declined last year, and exports to the US also decelerated in the second half of the year, China managed to grow its Asian export market, diversifying its customer base. However, trade growth during 2012 as a whole fell back to single-digit levels after the more rapid expansion in Chinese trade during the preceding two years. Against this backdrop, the domestic economy has shown signs of improvement, with short-term indicators such as retail sales and industrial production suggesting a recent gentle acceleration in activity (Exhibit 10). According to the National Bureau of Statistics, Chinese GDP grew by 7.9% over the four quarters to Q4 2012, a pick up from the corresponding figure of 7.4% in Q3. Some of this near-term momentum could persist into the first half of this year, as the lagged effect of past policy loosening is still felt. However, we expect the Chinese authorities to shift to a more neutral policy stance over the course of 2013. Such a change would be consistent with a more moderate pace of growth compared with the rapid expansion seen in recent years.
EXHIBIT 10

Chinese retail sales and industrial production

Jan 2008-Dec 2012
Industrial production Percentage changes on a year earlier 45 40 35 30 25 20 15 10 5 0 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Wholesale and retail sales

EXHIBIT 11

Emerging market composite PMIs

Jan 2008-Jan 2013, Indices (50 = no change)
Brazil 70 65 60 55 50 45 40 35 30 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 India China Russia

Source: Haver Analytics.

Source: Haver Analytics.

Other major emerging economies have struggled to match Chinas recent shift towards more domestic-led growth. Indian industrial output has been volatile, partly reflecting the timing of the Diwali holiday, but has slowed with the deceleration in world trade. The trade deficit may have peaked towards the end of last year, but the persistent current account deficit indicates that the economy is still struggling to rebalance towards domestic demand. Survey indicators such as the PMIs also suggest some recent improvement (Exhibit 11), but the mapping between these surveys and official data is often imprecise at best. After several disruptions, the Indian government has taken steps designed to foster both short- and longer-term growth by boosting infrastructure investment, including a new bill to speed up land acquisition and more certainty around project timescales. However, the economic

FEBRUARY 12, 2013

GLOBAL RISK PERSPECTIVES: GLOBAL MACRO OUTLOOK 2013-14: DOWNSIDE RISKS HAVE DIMINISHED

CREDIT POLICY

impact of these measures remains to be seen. Overall, the Indian economy still looks unlikely to see a swift pickup in growth to the pace seen during 2010 and 2011. After GDP growth slipped to a three-year low of around 1% in 2012, the Brazilian economy should see some acceleration in economic activity during the current year. The slower pace of world trade growth has hit Brazilian exports, with little sign of domestic sales growth making up the difference. In part, the weakness of domestic demand last year reflected relatively high CPI inflation hitting households spending power. Inflation is set to remain high in the near term, but should ease somewhat over the course of 2013. The infrastructure spending associated with the 2014 Football World Cup and 2016 Olympics should also provide some boost to activity, although the full impact is likely to materialize only gradually. In the meantime, residual concerns about energy supply could weigh on businesses appetite for expansion, undermining growth in the face of relatively weak external demand. Smaller emerging economies generally continue to exhibit steady growth compared with advanced economies. Emerging European countries have been most affected by the euro area debt crisis, with uncertainty and private sector retrenchment hitting confidence and capital flows.5 But growth in other emerging markets, most notably developing Asia and Africa, continues to hold up relatively well.6 We expect this process to continue, thereby further closing the gap albeit slowly between per capita income levels in advanced and emerging economies. One challenge will be balancing the growing desire among emerging economies to control potentially destabilizing capital flows against their other monetary policy objectives: Box 1 discusses this in more detail.
Box 1: Monetary policy in emerging economies Over the past few years, central banks in a number of advanced economies have cut policy rates to record lows, and then expanded their balance sheets in order to provide further monetary stimulus.7 This has posed something of a challenge for central banks in emerging markets, with some accusations that the US and other advanced economies have been debasing their currencies or exporting inflation to the rest of the world. This box examines the recent role and impact of monetary policy in emerging market economies.

Many emerging markets are relatively small, open economies. In the absence of other policy instruments, this means that monetary policy can do one of two things: it can either seek to maintain a certain exchange rate, vis--vis some other currency; or it can seek to control domestic inflation. Importantly, by itself monetary policy cannot achieve both aims. Exchange rates are relative prices, so by anchoring their currency to the US dollar, for example, the monetary authorities essentially have to mirror developments in US monetary conditions. Given the substantial expansion of the Federal Reserves balance sheet, any central bank wishing to peg its currency against the US dollar would have had to similarly loosen policy, potentially leading to overheating in the domestic economy. In contrast, an inflation-targeting central bank would probably have let its currency appreciate against the US dollar in order to contain the upward pressure on prices that would have arisen from maintaining an artificially low exchange rate.

5 6 7

See Central & Eastern European 2013 Sovereign Outlook: Subdued Macro Picture Tempers Credit Strengths, 15 January 2013. See for example Asia-Pacific 2013 Sovereign Outlook: Resilient to Global Headwinds, 11 January 2013. See Box 1 in Update to the Global Macro Risk Outlook 2012-14: Slow Adjustment to Weigh on Growth (146944), 12 November 2012.

FEBRUARY 12, 2013

GLOBAL RISK PERSPECTIVES: GLOBAL MACRO OUTLOOK 2013-14: DOWNSIDE RISKS HAVE DIMINISHED

CREDIT POLICY

These contrasting outcomes are visible in the recent experience of some emerging economies. Cambodia, for instance, has seen a relatively stable exchange rate against the US dollar since 2005, but relatively large increases in consumer prices. In contrast, countries like Malaysia and Peru have seen a less pronounced pace of inflation, while at the same time their currencies have appreciated significantly against the US dollar. Other emerging economies have seen their currencies depreciate against the US dollar, and have seen very substantial increases in consumer prices as a consequence (Exhibit B1).
EXHIBIT B1

Changes in emerging market exchange rates and consumer prices

Percentage change in CPI (2005 to 2012) 400 350 300 250 200 150 100 50 0 -80 -60 -40 -20 0 20 40 60 Percentage change in domestic currency vs US dollar (2005 to 2012)

Sources: IMF and Moodys calculations.

This trade-off has led some emerging economies to return to alternative policy instruments, in particular the re-introduction of capital controls. These controls regulate capital flows into and out of an economy, which have been a concern for many emerging economies in the wake of the large capital inflows seen in recent years, and can stabilize currency movements. However, the efficacy of capital controls is uncertain, particularly short-term measures. They can also have knock-on implications for other economies and potentially impede the efficiency of global capital markets. Ultimately, emerging market policymakers still face a difficult balance in using the instruments at their disposal to foster sustainable increases in real incomes.

Downside Risks to the Forecasts Have Diminished

The main downside risks to our forecast have diminished from three months ago, and stem from the following: A deeper than currently expected recession in the euro area accompanied by deeper credit contraction, potentially triggered by a further intensification of the sovereign debt crisis. Weaker-than-expected growth in major emerging markets following the recent slowdown. An escalation of geopolitical tensions resulting in adverse economic developments.

The crystallization of any one of these risks would pose a threat to the outlook for global growth.

10

FEBRUARY 12, 2013

GLOBAL RISK PERSPECTIVES: GLOBAL MACRO OUTLOOK 2013-14: DOWNSIDE RISKS HAVE DIMINISHED

CREDIT POLICY

The risk of a deeper than currently expected recession in the euro area
Our central view is that the euro area economy will start growing again during the second half of 2013. However, there remain considerable downside risks to this forecast. In particular, there is substantial uncertainty about the potential impact of the further austerity that we expect in peripheral euro area member states over the next few years: some peripheral countries are only likely to achieve balanced primary budgets by 2015 or even later. These deficit-cutting processes will weigh on growth, and fiscal multipliers may be significantly larger than first thought. With peripheral countries likely to be mired in austerity over the medium term, there is a clear risk that this process acts as more of a drag on aggregate euro area growth than we have assumed in our central forecasts. Intra-euro trade is still critically important for many members states, and prolonged weakness in the periphery could spread to core countries. If Spain and Italy, in particular, were to see further declines in GDP through to 2015 instead of a return to growth next year, that would weigh significantly on the region as a whole, driving unemployment even higher and threatening the fragile political consensus between European leaders. At the same time, any relaxation in governments commitments to get their debt dynamics under control could trigger renewed market disruption and financial pressure. Throughout the crisis, the willingness of European policymakers to undertake painful yet necessary reforms has waxed and waned as market pressure has intensified and subsequently eased. As such, although market conditions currently appear relatively benign, the situation remains very fragile. Investors are currently giving policymakers the benefit of the doubt, but that could change rapidly if concerns about sovereign refinancing profiles resurfaced against the backdrop of further falls in GDP and employment. The risk of a disorderly outcome to the European debt crisis, which would result in significant financial market dislocation and trigger a much deeper and sharper downturn in the European economy, remains the key downside risk to the global economy.

Weaker-than-expected growth in major emerging markets

The second serious threat to the global recovery is the possibility of slower-than-expected growth in key emerging markets. During 2012, our concerns about a possible hard landing in emerging markets originally centred on China, but spread to other major emerging economies such as Brazil and India, which were also exhibiting decelerations in activity. Recent data suggest that China, in particular, may have managed to avoid a sharp and uncontrolled decline in its pace of economic growth. But short-term indicators can be volatile, and the modest recent improvement in retail sales and production growth could prove partly ephemeral. In addition, the Chinese government is likely to put economic policy on a more neutral footing in the coming months, following the introduction of various stimulus measures to cushion the downturn in growth. The recent robust growth in non-bank financing, for instance, is unlikely to be tolerated indefinitely by regulators. Even if the growth cycle has turned, China will not expand at the rapid pace that was seen during 2010 and 2011. This has implications for Brazil and India, which to date have not seen the same strengthening in domestic conditions as in China. These economies are still struggling to make up for subdued export demand in the wake of the deceleration in world trade. Given the weak outlook for advanced economies and the moderation in China, growth in India and Brazil could take longer than expected to bounce back from the slowdown seen last year. Indian policymakers previous efforts to liberalise the economy have been somewhat sporadic, and it remains to be seen whether recent developments act

11

FEBRUARY 12, 2013

GLOBAL RISK PERSPECTIVES: GLOBAL MACRO OUTLOOK 2013-14: DOWNSIDE RISKS HAVE DIMINISHED

CREDIT POLICY

as a spur to growth. Meanwhile, although Brazilian GDP growth picked up to 0.6% in Q3 2012 (from 0.2% in the second quarter) that was still a relatively weak pace of expansion. Industrial production and retail trade both subsequently fell in November, suggesting that the Brazilian economy is still struggling to regain momentum. In summary, while the possibility of a hard landing in key emerging markets looks to have been averted, the near-term balance of risks to growth in these economies remains on the downside. With most advanced economies likely to see only sub-trend growth over the next two years, key emerging economies will continue to act as an important driver of worldwide economic activity. Weaker-thanexpected growth in these major emerging markets could therefore have a significant impact on global growth.

An escalation of geopolitical tensions

Another key risk to our forecasts is the potential economic fallout from growing geopolitical risks. Conflicts in Syria and parts of Africa could spill over into neighbouring nations, and tensions elsewhere could also damage global growth prospects. There are two scenarios in particular that are of significant concern. First, tensions in the Middle East could potentially trigger a supply-side oil shock, resulting in a significant jump in prices. Such an increase, if sustained, would weigh on growth in most large economies. While the recent discovery of US shale oil could reduce the impact of Middle East supply disruptions over the longer term, for now oil supply remains highly concentrated within the region. The direct impact of an increase in oil prices on growth is likely to be much less pronounced than in historic episodes, given the reduced energy-intensity of economic activity in many advanced economies. Nevertheless, the global recovery remains relatively fragile and the impact of a sudden supply-led increase in oil prices could be more significant than would be the case if the economic backdrop were stronger. Options prices currently suggest roughly a 20% chance that the price of WTI oil could increase by $20 a barrel or more over the coming year. As such, Moodys continues to believe that this risk remains a high severity tail event with significant global implications.8 Second, the dispute between China and Japan over the Senkaku-Diaoyu islands also poses a particular threat to global growth. The likelihood of outright conflict remains relatively low, but recent escalations in rhetoric and military presence indicate the seriousness of this disagreement. Given the US defence guarantee to Japan, the dispute has the potential to embroil the worlds three largest economies in a damaging struggle. Even if direct military action is avoided, as still seems most likely, there are already signs that it could significantly disrupt trade developments in Eastern Asia, most notably the trilateral free trade negotiations between China, Japan and South Korea that began in May last year.9 A further escalation of tensions could potentially undermine growth in these economies and more broadly in Developing Asia, one of the few regions to come through the recent financial crisis relatively unscathed.

For more detail and past analysis, see Update to Our Global Macro-Risk Outlook 2012-2013: Modest Growth and Resurfacing Oil Price Risks, April 2012 and Global Macro-Risk Scenarios 2011-2012: Oil Price Supply Shock Downside Scenario, April 2011. See In Japan-China Island Dispute, Both Sides Have Something to Lose, 20 December 2012.

12

FEBRUARY 12, 2013

GLOBAL RISK PERSPECTIVES: GLOBAL MACRO OUTLOOK 2013-14: DOWNSIDE RISKS HAVE DIMINISHED

CREDIT POLICY

Moodys Related Research

Recent Global Macro Risk Scenarios:

Update to the Global Macro Risk Outlook 2012-14: Slow Adjustment to Weigh on Growth, November 2012 (146944) Update to the Global Macro Risk Outlook 2012-13: Euro Area Debt Crisis Continues to Pose the Greatest Risk, August 2012 (145035) Update to Our Global Macro Risk Outlook 2012-13: Modest Growth and Resurfacing Oil Price Risks, April 2012 (141580) Argentinas Six Years of Underreporting Inflation is Credit Negative, January 2013 (149310) Brazils regulation to extend duration in fixed-income portfolios is credit positive, January 2013 (148993) Central & Eastern European 2013 Sovereign Outlook: Subdued Macro Picture Tempers Credit Strengths, January 2013 (148700) Irelands Bond Issue Is a Step Toward Regaining Full Capital Market Access, January 2013 (148994) Asia-Pacific 2013 Sovereign Outlook: Resilient to Global Headwinds, January 2013 (148774) US Fiscal Package Has Limited Positive Credit Implications, January 2013 (148908) In Japan-China Island Dispute, Both Sides Have Something to Lose, December 2012 (148574) Japans New Leader Faces Intensifying Credit Challenges, December 2012 (148472) Debt Sustainability Remains a Concern Following Greeces Second Default, December 2012 (148288) Italys Political Turmoil Has Limited Credit Implications for Sovereign, December 2012 (148250) Moodys downgrades Frances government bond rating to Aa1 from Aaa, maintains negative outlook, November 2012 European Commissions Upward Revision of Spains Deficit Targets is Credit Negative, November 2012 (147509) No Detrimental Effect from Sandy on US Sovereign Creditworthiness, November 2012 (147013) Rising Risks, Receding Government Support, Cause Shift in Bank Credit Profiles, December 2012 (147334) EU Single Supervisory Agreement Is Credit Positive for Banks and Sovereigns, December 2012 (148351) Liikanen Group Proposals for Tougher EU Bank Regulation Are Credit Positive, October 2012 (145993)

Sovereign Related Research:

Selected Banking and Corporate Sector Research:

13

FEBRUARY 12, 2013

GLOBAL RISK PERSPECTIVES: GLOBAL MACRO OUTLOOK 2013-14: DOWNSIDE RISKS HAVE DIMINISHED

CREDIT POLICY

Spanish Banks Upcoming Recapitalization is Credit Positive, but May Be Insufficient, October 2012 (145834) EU Sovereign Crisis Poses Growing Risks For Some European Non-Financial Companies, July 2012 (143282) London 2012 Olympics Provide a Short-term Boost, But No Gold Medal for Corporates, May 2012 (141487) Euro Area Debt Crisis Weakens Bank Credit Profiles, January 2012 (139781)

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients.

14

FEBRUARY 12, 2013

GLOBAL RISK PERSPECTIVES: GLOBAL MACRO OUTLOOK 2013-14: DOWNSIDE RISKS HAVE DIMINISHED

CREDIT POLICY

Report Number: 149555

Author Colin Ellis

Production Associate Sarah Warburton

2013 Moodys Investors Service, Inc. and/or its licensors and affiliates (collectively, MOODYS). All rights reserved. CREDIT RATINGS ISSUED BY MOODY'S INVESTORS SERVICE, INC. (MIS) AND ITS AFFILIATES ARE MOODYS CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES, AND CREDIT RATINGS AND RESEARCH PUBLICATIONS PUBLISHED BY MOODYS (MOODYS PUBLICATIONS) MAY INCLUDE MOODYS CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES. MOODYS DEFINES CREDIT RISK AS THE RISK THAT AN ENTITY MAY NOT MEET ITS CONTRACTUAL, FINANCIAL OBLIGATIONS AS THEY COME DUE AND ANY ESTIMATED FINANCIAL LOSS IN THE EVENT OF DEFAULT. CREDIT RATINGS DO NOT ADDRESS ANY OTHER RISK, INCLUDING BUT NOT LIMITED TO: LIQUIDITY RISK, MARKET VALUE RISK, OR PRICE VOLATILITY. CREDIT RATINGS AND MOODYS OPINIONS INCLUDED IN MOODYS PUBLICATIONS ARE NOT STATEMENTS OF CURRENT OR HISTORICAL FACT. CREDIT RATINGS AND MOODYS PUBLICATIONS DO NOT CONSTITUTE OR PROVIDE INVESTMENT OR FINANCIAL ADVICE, AND CREDIT RATINGS AND MOODYS PUBLICATIONS ARE NOT AND DO NOT PROVIDE RECOMMENDATIONS TO PURCHASE, SELL, OR HOLD PARTICULAR SECURITIES. NEITHER CREDIT RATINGS NOR MOODYS PUBLICATIONS COMMENT ON THE SUITABILITY OF AN INVESTMENT FOR ANY PARTICULAR INVESTOR. MOODYS ISSUES ITS CREDIT RATINGS AND PUBLISHES MOODYS PUBLICATIONS WITH THE EXPECTATION AND UNDERSTANDING THAT EACH INVESTOR WILL MAKE ITS OWN STUDY AND EVALUATION OF EACH SECURITY THAT IS UNDER CONSIDERATION FOR PURCHASE, HOLDING, OR SALE. ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY LAW, INCLUDING BUT NOT LIMITED TO, COPYRIGHT LAW, AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODYS PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODYS from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, all information contained herein is provided AS IS without warranty of any kind. MOODY'S adopts all necessary measures so that the information it uses in assigning a credit rating is of sufficient quality and from sources MOODY'S considers to be reliable including, when appropriate, independent third-party sources. However, MOODYS is not an auditor and cannot in every instance independently verify or validate information received in the rating process. Under no circumstances shall MOODYS have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODYS or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODYS is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. The ratings, financial reporting analysis, projections, and other observations, if any, constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. Each user of the information contained herein must make its own study and evaluation of each security it may consider purchasing, holding or selling. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODYS IN ANY FORM OR MANNER WHATSOEVER. MIS, a wholly-owned credit rating agency subsidiary of Moodys Corporation (MCO), hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MIS have, prior to assignment of any rating, agreed to pay to MIS for appraisal and rating services rendered by it fees ranging from $1,500 to approximately $2,500,000. MCO and MIS also maintain policies and procedures to address the independence of MISs ratings and rating processes. Information regarding certain affiliations that may exist between directors of MCO and rated entities, and between entities who hold ratings from MIS and have also publicly reported to the SEC an ownership interest in MCO of more than 5%, is posted annually at www.moodys.com under the heading Shareholder Relations Corporate Governance Director and Shareholder Affiliation Policy. For Australia only: Any publication into Australia of this document is pursuant to the Australian Financial Services License of MOODYS affiliate, Moodys Investors Service Pty Limited ABN 61 003 399 657AFSL 336969 and/or Moodys Analytics Australia Pty Ltd ABN 94 105 136 972 AFSL 383569 (as applicable). This document is intended to be provided only to wholesale clients within the meaning of section 761G of the Corporations Act 2001. By continuing to access this document from within Australia, you represent to MOODYS that you are, or are accessing the document as a representative of, a wholesale client and that neither you nor the entity you represent will directly or indirectly disseminate this document or its contents to retail clients within the meaning of section 761G of the Corporations Act 2001. MOODYS credit rating is an opinion as to the creditworthiness of a debt obligation of the issuer, not on the equity securities of the issuer or any form of security that is available to retail clients. It would be dangerous for retail clients to make any investment decision based on MOODYS credit rating. If in doubt you should contact your financial or other professional adviser.

15

FEBRUARY 12, 2013

GLOBAL RISK PERSPECTIVES: GLOBAL MACRO OUTLOOK 2013-14: DOWNSIDE RISKS HAVE DIMINISHED