South Africa
South Africa: International Trade Dynamics and Implications for USDZAR
April 13, 2010

By Michael Kafe, CFA & Andrea Masia l Johannesburg|

Summary

Thanks to an upward revision to our commodity price outlook, we expect South Africa's current account deficit to be capped at 4.3% of GDP this year (4.7% previously) and 4.9% in 2011 (5.3% previously). We have also upgraded our GDP estimates to 3.3% (from 3.0%) in 2010 and 3.7% (from 3.6%) in 2011. The narrower current account deficit is likely to combine with our strategists' view of a tripling of capital flows into emerging markets in 2010 to place a lid on currency weakness. Even so, we caution that the country's inordinate reliance on fickle portfolio capital increases its susceptibility to the vicissitudes of global risk appetite.

Bearing these important potential developments and necessary caveats in mind, we now expect USDZAR to close the year at 8.00 (8.50 previously), before depreciating further to 8.50 by end-2011 (8.80 previously). Our more constructive outlook on the currency is also driven by a view that fiscal outperformance may lead to a sovereign ratings (outlook) upgrade this year. 

Broad Structure of South Africa's Trade Basket

The structure of South Africa's trade basket highlights the country's leverage to the commodity cycle and, in particular, the shift in global demand away from DM to EM. Exports account for some 23% of GDP - down from 28% in 2002 and 26% in 2007, thanks to import compression and other structural impediments. Commodity exports (minerals, precious stones and base metals) account for some 60% of total exports, of which platinum group metals, gold and coal account for roughly three-quarters. 

On the import front, machinery accounts for roughly 45% of imports - down from 50% at the turn of the decade - and has been largely displaced by rising imports of crude oil and refined petroleum products, whose share in imports has risen from 15% in 2000 to 22% presently. Imports account for some 23% of GDP, down from 32% in 2008 and 28% in 2007. The sharp slowdown here is partly explained by a fall in imports of intermediate capital goods by the private sector as global demand slowed. Household demand for white goods has slowed too. 

Historically, Europe has been South Africa's most important export destination, accounting for a third of the country's exports. However, since the turn of the decade, Asia has become an increasingly important trading partner, with its share of exports rising from less than 20% to just under 30% presently. On a country (as opposed to regional) basis, China rose to become South Africa's single most important trading partner in 2009, overshadowing its exports to traditional markets such as the UK, US, Germany and Japan. China's share of South Africa's exports has risen eight-fold from 1.2% in 2000 through 2.7% in 2005 to 9.4% presently.

Within the CEEMEA region, South Africa has less exposure to Europe than its regional CEEMEA peers. Thus, although it won't be completely immune to sluggish European economic performance, we expect Europe to have a disproportionately smaller impact on South Africa's export prospects.

Revisions to Commodity Price Forecasts

Our commodities team now expects gold, platinum and coal prices to come in at US$1,159/oz, US$1,569/oz and US$95/ton in 2010, compared to their earlier estimates of US$1,200/oz, US$1,525/oz and US$85/ton, respectively (see Global Metals Playbook, March 31, 2010). Incorporating these revised price assumptions into our balance of payments analytical framework, and assuming import and export volumes unchanged at 5% and 10% respectively (in line with 5-year averages preceding the 2009 crisis), we maintain our view that the trade balance will return to deficit territory though 2010 and 2011 - although these prices should help cap the shortfall at no more than R10 billion in 1H10 (R20 billion previously), before widening to R15 billion in 2H10 (R25 billion previously). On the net invisible account, we expect World Cup-related receipts to boost net travel inflows by some R2 billion (excluding savings by South Africans who would normally have travelled overseas for holiday). Other flows such as hotel, food, telephony, travel & tour and personal care expenses by foreign tourists should also boost ‘other' receipts by some R10-13 billion, capping the net service component at some R10 billion in 2Q/3Q10.

On the whole, thanks to our more sanguine commodity price outlook, our estimates of World Cup-related inflows, and technical base effects associated with 4Q09 data revisions, we revise our 2010 current account deficit from 4.7% of GDP to 4.3%. We expect rising imports, interest and dividend payments to lift the current account deficit towards 5% of GDP in 2H10 (5.5% previously).

CAD Sensitivity to Commodity Price Moves

Based on a partial equilibrium framework, we estimate that, ceteris paribus, for every 10% increase in South Africa's commodity export price index (calculated from the weighted shares of gold, platinum and coal in the export basket and their respective price targets), the current account balance narrows by roughly 1.6pp of GDP. On the other hand, a 10% increase in commodity import prices (mainly crude oil) leads to a 0.7pp widening in the current account gap. This implies a net improvement of roughly 1pp of GDP for each 10% general rally in commodity prices (i.e., a beta of roughly 0.1x). Assuming an oil price of US$80/bbl and gold, platinum and coal prices as discussed earlier, we find that a 10% fall in these commodities will lift the current account deficit from 4.1% to 5.1% of GDP, while a 10% rally results in a 3.2%-of-GDP deficit.

BoP Funding Abundant as EM Capital Flows Swell

Our emerging market strategy team expects a significant increase in the size of capital inflows into emerging markets this year. South Africa, which has one of the highest interest rates in the region, certainly stands to benefit from the fixed income component of these dedicated and crossover inflows. Also, the upward revisions to commodity prices will likely result in higher equity inflows (the dominant form of portfolio inflows by far). Third, the fact that the national electricity producer, Eskom, has successfully negotiated a US$3.75 billion loan with the World Bank to help fund its capital import requirements should help take some pressure of the currency too. Finally, the country is likely to attract even more foreign capital were it to receive a rating upgrade as its fiscal position improves. We have therefore upgraded our forecast of 2010 portfolio inflows from R35 billion to R110 billion - and downgraded FDI by much less.

Therefore, although a widening current account deficit and some post-World Cup fatigue (we see average GDP growth decelerating to 2.7%Q in 2H10 from 5.9%Q in 1H10) should exert downward pressure on the rand - especially if the USD were to strengthen from present levels of EURUSD 1.35 to EURUSD 1.24 as our currency strategists expect - such fundamentally driven currency weakness may be capped by the huge tide of capital flows to the region this year, thereby pushing out potential currency weakness into 2011.

Even so, the fact that South Africa relies predominantly on fickle portfolio and other forms of volatile capital suggests that, although capital flows are fungible, the currency could remain susceptible to the vagaries of global risk-love (see South Africa: Heavy Reliance on Portfolio Capital, March 24, 2010). We expect portfolio flows to account for 70% of net inward financial transactions on the capital account in 2010 (66% in 2009 and 100% in 4Q09).

Fiscal Outperformance May Prompt Ratings (Outlook) Upgrade

We believe that the fiscal accounts are likely to outperform the Treasury's conservative estimates. The latest data from the Treasury show that, with just one more month of data to go in the 2009/10 fiscal year, tax revenues (R531 billion) are some 2pp ahead of schedule, and pointing to an overshoot of some R10-12 billion relative to budgeted estimates.

For the Treasury to meet its 2009/10 tax revenue target of R590 billion, it needs to rake in some R60 billion in the final month of the fiscal year. For our estimate of R601 billion to be reached, one needs to see a R70 billion tax revenue print in March. In our opinion, these are not tall orders, given that tax revenues were R75.5 billion in the final month of 1Q09 - a quarter where GDP collapsed by 7.4%Q. With GDP likely to come in around 4%Q in 1Q10, on our estimates, we remain comfortable with our call for a R10 billion outperformance in revenues this year. We are equally comfortable with our out-of-consensus call for a whopping R50 billion overshoot in the upcoming 2010/11 fiscal year. This should help reduce the fiscal deficit to some 5% of GDP, compared to the Treasury's 6.2% estimate.

We believe that, thanks to fiscal outperformance, a sovereign ratings downgrade is now firmly off the agenda. If anything, an outlook upgrade (from negative to stable) appears increasingly likely. This could be as early as in April/May from R&I (currently A-, negative outlook), or in July/November from Fitch/S&P (BBB+, negative outlook).

USDZAR Implications

We incorporate our revised set of macro aggregates outlined into our USDZAR fair value model and find that, at current levels of 7.30, USDZAR is some 10% overvalued relative to its 2Q10 fair value estimate of 8.10. Were the overvaluation to correct over the course of the year, we should see the rand weaken to USDZAR 8.45 by year-end. However, the model also suggests that the rand is only likely to weaken by a cumulative 4.4% over 2H10. On a mark-to-market basis (i.e., were USDZAR to remain this overvalued - e.g., thanks to strong capital inflows that completely overwhelm macro fundamentals - during the remainder of this year), this implies a year-end target of 7.65 from the current spot rate of 7.30.

Our BoP analytics framework suggests that, were inward capital flows to be as much as we expect (i.e., more than enough to fund the burgeoning deficit on the current account), ZAR weakness should be capped at no more than 7.80 by year-end. However, we caution that the country's inordinate reliance on fickle portfolio capital increases its susceptibility to the vicissitudes of global risk appetite.

Bearing this important caveat in mind, we forecast USDZAR to close the year at 8.00 (8.50 previously), before depreciating further to 8.50 by end-2011 (previously 8.80).

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Middle East
Saudi Arabia: Will Liquidity Hamper Recovery?
April 13, 2010

By Mohamed Jaber l Dubai|

Saudi Arabia has been able to successfully weather the impact of the Great Recession, mainly thanks to proactive government policies and a generally sound banking system. Non-oil economic activity continued to grow in 2009, albeit at a slower pace. Moreover, we expect last year's significant decline in fiscal and external balances to reverse in 2010 on the back of higher average oil prices, which should also facilitate the continued implementation of counter-cyclical policies. The main impediment to a robust recovery in Saudi Arabia could be the continued weakness in domestic credit markets, in our view.

We expect the oil sector, which contracted by about 6% last year, to record mild growth of about 1.4% in 2010. Saudi Arabia's near full-compliance with OPEC's oil production ceilings - which were cut by about 4.2 million barrels per day (mbpd) in 4Q08 - was the main factor behind the real contraction in the oil sector in 2009. However, given the current market dynamics and the recent upward pressures on oil prices, we believe that the risks of any potential change in production levels are heavily skewed to the upside. Saudi Arabia has by far the largest crude oil production capacity in OPEC. The International Energy Agency's data show that, as of February 2010, Saudi Arabia produced an average of 8.2 mbpd, about 68% of its total sustainable capacity of 12 mbpd.

The impact of the global downturn on non-oil output has been mitigated by large government spending, which will likely continue to fuel growth in 2010. Recently released official estimates indicate that real non-oil GDP grew by 3% in 2009. As a clear indicator of the authorities' expansionary fiscal stance, the government sector accounted for around 43% of the growth in the non-oil sector in 2009, compared to an average of 23% during the previous five years. The private sector also grew in real terms by 2.5% last year, which was around half the pace of 2008. We believe that the government's continued expansionary policies will likely provide the necessary support for the non-oil sector to grow by an estimated 4% in 2010.

However, supply-side data indicate that although the non-oil economy expanded last year, some sectors saw a non-trivial deceleration in growth, including wholesale and retail trade, transport and communication, and non-petroleum manufacturing. Going forward, we believe that activity in these sectors will likely increase this year, spurred by stronger consumer and business confidence, and by a gradual resumption of credit growth (discussed below). A breakdown of real GDP by expenditures is not yet available, so it is not possible to get a measured estimate of how real domestic demand fared last year. This said, there are some early signs of a recovery in business activity, as exemplified by the central bank's point-of-sale data. Yet, the lack of quarterly national accounts data makes it difficult for us to gauge the strength of the recovery at the current juncture.

Inflationary pressures dropped significantly in 2009 and we expect them to remain somewhat stable in the near term. Average annual CPI inflation dropped by about 5pp last year to c.5%. This was mainly due to the 12pp drop in the food price inflation. Expenditures on food and beverages account for 26% of the CPI basket, the largest of all major categories. Increases in housing costs, which at 18% have the second-biggest weight in the basket, accounted for about 50% of headline inflation in 2009 and early 2010. This said, it is notable that inflation in housing costs has been consistently declining since its peak in July 2008 and has fallen by about 9pp since then. We expect this trend to continue in the near term as more residential units are delivered to meet the growing demand for housing. In aggregate, we expect increases in average consumer prices to decline mildly in the near term, decreasing by about 1p by 2011 to around 4%. However, the risks to our outlook are skewed to the upside, with the main possible catalysts being: (i) population growth that is higher than our currently projected 2.3% per year; (ii) significant supply bottlenecks in the housing market; and (iii) a sharp pick-up in international food prices.

We expect Saudi Arabia's external balance, which weakened in 2009, to rebound this year. The significant decline in the average price of oil in 2009 led to an estimated drop of 26pp in the current account balance to GDP. However, based on the current futures curve, we see average WTI crude oil prices averaging around US$84 in 2010, which would constitute a 35% increase over the 2009 average oil price. We estimate that the resultant pick-up in Saudi oil export revenues - which in turn constitute around 85% of the country's overall exports of goods and services - will help raise the current account balance to about 11% in 2010. We believe that the average 2010-11 current account balance will remain positive at oil prices of US$70 per barrel or higher. On the capital account side, we expect the net inflow of direct and portfolio investments this year to be more than offset by the outflow of official foreign assets. We project that official reserves grow by about US$40 billion this year, following an estimated drop of about US$33 billion in 2009.

Higher oil revenues should allow the government to continue its expansionary fiscal policy, with minimal impact on the overall budget balance. The official budget announced in December foresaw an increase of about 15% in government revenues in 2010, with budgeted oil prices of around US$45-50 per barrel, according our estimates. However, we believe that government revenues will likely increase by around 50% this year on the back of: (i) higher average oil (WTI) prices of about US$84 per barrel; (ii) a marginal expected increase in oil production of around 2%; and (iii) an increase in the government's share of oil production revenues, which last year was about 10pp lower than an average of about 80% over 2003-08, per our estimates. This significant increase in revenues should more than offset the projected 13% hike in public expenditures in 2010. The latter will be driven by the government's ambitious US$400 billion, 5-year investment programme announced in early 2009. In aggregate, we therefore expect the fiscal balance to move back to positive territory in 2010 and record a surplus of about 7% of GDP. Given the increase in the level of public expenditures, we raise our estimate of break-even oil prices for the average fiscal balance during 2010-11 by US$10 to US$71 per barrel.

In addition to our base case scenario discussed so far, we present below two alternative bull and bear case scenarios. In these scenarios, we have attempted to explore the impact of some of the risks that could affect our near-term outlook. At this stage, we believe that these risks are mostly symmetrical around the base case. As such, we assign a subjective probability of 20%, 60% and 20% to our bear, base and bull scenarios, respectively.

The growth in money supply has continued to weaken over the past year. Broad money (M3) expanded by less than 6%Y in February 2010, compared to about 16% a year earlier. This downward trend was partly due to the weak build-up in private sector deposits. These grew by no more than 7%Y in February 2010, compared to 13% and 26% during the same periods in 2009 and 2008. The weak growth in M3 can also be attributed to the recent decline in government deposits in commercial banks. After increasing by about 39% from 4Q08 to 2Q09, government deposits have decreased by about 14% since June 2009.

Although money supply growth may have been weak, Saudi banks themselves remain highly liquid and generally well funded. The average excess reserves of Saudi banks in 2009 were double those of 2008. Banks have also been increasingly funding their operations through stable deposits, which now cover about 81% of their loans, versus 85% a year earlier. Moreover, despite a slight dip in January 2010, the banks still managed to increase their foreign asset base by about 24%Y in February. This significant liquidity in the banking system is also reflected in the interbank rate, which has dropped by about 43bp over the past year to 0.725% as of April 7, 2010. Moreover, the current excess liquidity in the banking system may partly explain why the government has been reducing its deposits with banks since mid-2009, as discussed previously.

Despite the excess liquidity in the banking system, credit growth has been very weak. Total bank credit declined by about 1% during 2009, in sharp contrast to an increase of about 25% during the preceding year. The sectors most affected by the decline in credit were construction and commerce. On the positive side, however, the data show a slight pick-up of about 1% in total bank credit to the private sector during the first two months of this year. This may be a sign of renewed activity in the credit market, although it may be too early to tell at this stage. Our base case scenario assumes that credit growth gains momentum over the year as business confidence builds up and the banks' appetite for consumer and corporate lending regains strength. In this scenario, credit to the private sector is projected to grow by about 7-8% in 2010. However, as discussed below, there are risks to the downside.

The slowdown in money growth brings into question whether domestic liquidity in Saudi Arabia has tightened over the past year. It would be reasonable to ask whether the amount of money currently available to conduct business transactions in the country has kept pace with the level of economic activity. If the level of activity in the non-oil economy has been growing at an even weaker pace than money supply, then the current modest growth in broad money may not necessarily be indicative of tighter liquidity, and vice versa. One way to measure this is to look at the ratios of money supply measures (M1 and M3) to nominal non-oil GDP (for a deeper discussion of this issue, see The Global Monetary Analyst: Liquidity Liquidation? January 27, 2010). These ratios seem to show that, contrary to expectations, the growth in money supply seems to have outpaced that of nominal non-oil GDP. In other words, the amount of money available to support domestic business activity seems to be more than sufficient, so why then isn't this being reflected in credit growth?

Weak credit growth continues to be the main potential impediment to a strong recovery, in our view. The fact that private sector deposits and loans have not grown in line with higher banking sector liquidity points to a potential mispricing of credit risk. This view is further reinforced by the feedback we received from both banking and non-banking sector participants in Saudi Arabia. In order for bank lending to start flowing again, interest rates need to be set at a level that would help credit markets clear. But in the absence of sufficient transparency at the corporate level, banks seem to be attaching a significant risk premium to private sector lending. This may be a premium that private sector borrowers - especially the most solid and least exposed among them - may not be willing to pay. Given this asymmetric information problem, banks seem to have opted for the safety of low-yielding sovereign and foreign assets over potentially risky lending to corporate entities who would be willing to pay the higher rates. The global banking crisis of 2009 and the recent debt-restructuring issues in Dubai may have fundamentally changed lending practices in this region. Banks seem to be increasingly scrutinising the financial and corporate standing of potential borrowers and placing greater value on higher transparency and disclosure. In the long term, this is surely a positive development that will help to ensure better resource allocation and greater economic efficiency. In the short term, however, it will require additional effort from all participants in the Saudi and regional markets to adjust to these new credit market dynamics.

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Spain
The Housing Market and Fiscal Policy - the Risks
April 13, 2010

By Daniele Antonucci|

Summary and conclusions

Sovereign risk and the so-called EMU periphery are once again taking centre stage. We have argued that the countries generally associated with this group (Italy, Spain, Greece, Portugal and Ireland) are a very heterogeneous bunch and that some of them are no longer a ‘pure' peripheral country (see Italy Economics - Inching into the Core, March 15, 2010).

However, we share investors' concerns on the Spanish economy. But while everyone seems to have a bearish view, we are more bearish than most. In this report, we focus on the ongoing structural adjustment in the economy, mainly in the construction sector. We also explore the challenges to the fiscal consolidation process. We reach six main conclusions:

•           First, Spain is still dealing with the housing bubble aftermath. We expect a further 10% decline in house prices this year alone. The adjustment in the construction sector has further to go, in our view, and the backlog of unsold homes remains very sizeable.

•           Second, there is no clear replacement as a growth engine for the construction sector - at least not in the short term, in our opinion.  We feel comfortable with our below-consensus GDP growth forecast this year and next.

•           Third, we believe that the probability of our bear case playing out has increased and the magnitude of the drop in GDP is likely to be bigger, should the downside risks associated with this scenario materialise.

•           Fourth, we turned more bearish on the medium-term outlook too. Spain far outpaced the euro area over the five years prior to the financial crisis; we expect it to lag behind over the next five years and to expand at half the pace of the 2004-08 period.

•           Fifth, overly optimistic GDP growth assumptions might make the fiscal consolidation targets more difficult to achieve - especially next year. Hence, market discipline might force Spain to step up its fiscal efforts, which so far have been very gradual.

•           Sixth, with a sizeable debt redemption in July and two-thirds of the funding plan yet to complete, Spain might come under the market spotlight. The low degree of centralisation in its public finances is another factor that might raise some concerns.

What's more, there is a degree of uncertainty surrounding the outlook for the public finances. The debt markets' persistently negative view on the savings banks, for example, may force the government to provide additional debt guarantees. Should these contingent liabilities materialise, Spain's public finances might come under further pressure.

Quantifying the impact of these liabilities (or of an increase in the size of the Fund for Bank Restructuring) is subject to uncertainty. Indeed, the chances are that the emergency fiscal packages and financial operations of the past couple of years - which do not have an immediate impact anyway - could well be treated differently from the ordinary fiscal operations.

Eurostat, for example, has decided that "the final impact on government deficit and debt figures of these operations will be recorded in the core accounts if and when the associated risks crystallise, and can be measured objectively". But even so, the fact is that the outlook for Spain's public finances might turn out to be even more challenging.

1. Ongoing Adjustment in the Housing Market

The key driver of our below-consensus outlook is the structural weakness in the housing market. Of course, with the economy still shrinking in Spain - unlike in most other euro area countries - the decline in house prices we have seen so far was almost predictable. But the chances are that GDP growth will come back in positive territory over the next quarter or two. Will this trigger a renewed bout of activity in the housing market? We doubt it.

Despite a remarkable housing bubble, Spanish house prices have declined by about 11% from their peak in 1Q08. This compares with a peak-to-trough fall of around one-fifth in the UK, one-quarter in Ireland and one-third in the US. The first leg of the adjustment in the housing market had to do mainly with the volumes transacted rather than the prices of the transactions: sellers did not want to sell because they could not get an attractive price, thus triggering a fall in home sales.

However, this does not prevent the second leg of the adjustment from taking place through a further correction in prices too, which we see more as a lagging indicator at this stage. House prices might not continue to fall at the same pace - as the recent trend seems to suggest - but we believe that there are four reasons to expect further declines, to the tune of a further 10% this year alone:

1.         The adjustment in the construction sector is not yet complete. Despite a 32% drop from its peak in 4Q07, construction investment still accounts for 13.8% of total economic output - half a percentage point above its long-term average. The equivalent figure for the euro area is 11.2% - half a percentage point below its long-term average. So, an additional 5% decline in Spanish construction investment would be required just to bring it, as a proportion of GDP, in line with the historical average. But this decade's construction boom has pushed up the average, which was just 12.1% from 1980 to mid-1998, i.e., before the housing bubble. To go back to that level, construction investment would need to fall by another 15%.

2.         The backlog of unsold homes remains very sizeable. Indeed, to eliminate the existing oversupply, construction investment may need to fall by an even larger margin than envisaged above. The past five years witnessed the construction of 2.8 million new homes, but sales were far less dynamic, at just over 1.5 million. This means that more than half of the newly built homes may sit unoccupied. If new home sales remained at the current level - and assuming that homebuilding stopped altogether - it would take until 2015 to clear the existing oversupply of homes. Of course, building approvals seem to have picked up, but the housing overhang will last until 2012 even if they quickly return to pre-crisis levels.

3.         Doubtful loans may continue to rise for most of this year. Indeed, they are unusually low relative to the spike in the unemployment rate. During the recession in the early 1990s, when the unemployment rate was close to 20% as it is today, doubtful loans accounted for about 6% of the total - twice the current share. Of course, ultra-low interest rates and the extension of unemployment benefits helped Spanish households cope with mortgage payments and the job shakeout. But these factors will not remain so favourable for much longer: the subsidy to the unemployed whose benefits have run out will expire, and longer-dated Euribor rates will rise - as the ECB reduces the maturity of its refinancing operations.

4.         With an over-stretched private sector, a further period of belt-tightening is on the cards. The sum of household and corporate debt amounts to 220% of GDP in Spain, far higher than the euro area average of 165%, and its increase has been almost 400% from the inception of the EMU - the strongest expansion across the euro area. With variable-rate loans making up 90% of total mortgages - compared with an average of 50% in the euro area - Spain is very sensitive to changes in interest rates. When they resume their upward trend, Spain will struggle more than the ‘typical' EMU country.

The upshot is that a stabilisation in the construction sector is still far off, in our view. With house prices having fallen to a much lesser degree than in other hotspots - and, apart from Ireland, an arguably bigger credit-fuelled housing and consumer boom-turned-bust - we think that a further decline of around 10% this year is very much on the cards.

2. The Growth Outlook - How Poor? Three Scenarios

Thus, we conclude that the chances are that the structural adjustment in the housing market has further to run. The implications for the growth outlook are clearly negative and the drag on economic growth is likely to be significant, in our view. Indeed, the construction sector was one of the main drivers behind Spain's success story in the decade prior to the financial crisis, contributing to GDP growth both directly and indirectly - by supporting the purchasing power of low-income workers in the sector, thus boosting consumer spending.

Of course, the weakening of the euro - coupled with the strengthening of the global economy - suggests that a partial offset might come from a positive contribution to GDP growth of net trade. Indeed, this is already happening - though it has to do not only with strong exports over the past couple of quarters, but also with weak imports. However, while we acknowledge that an export-led recovery is clearly a positive development, the fact is that the downward pressures on the economy stemming from the ongoing downsizing of the construction sector are very substantial.

In all, we feel comfortable with our below-consensus GDP growth forecast. We expect the Spanish economy to contract outright this year too - unlike the other major European countries - and expand far slower than the euro area as a whole in 2011. The latest published median prediction across several market economists is a contraction of 0.4% in 2010 and an expansion of 1.1% next year. Both these forecasts are too optimistic, we think. Our base case is a deeper fall in GDP this year - to the tune of 0.7% - and a more muted recovery in 2011 of around 0.8%.

Moreover, the challenges for the Spanish economy go well beyond poor prospects of a swift recovery over the next couple of years. While Spain far outpaced the euro area over the five years prior to the financial crisis, we expect it to lag behind over the next five years. In other words, the Spanish economy expanded twice as fast as the euro area during the boom years. But with no clear substitute for the construction sector as its economic engine - and with still a lot of work to do in terms of rebalancing its economy away from domestic demand and towards external demand - it will now be a growth laggard and underperform the other major euro area countries, from an economic standpoint.

We present three scenarios - base, bull and bear cases - for 2010-11.

Scenario #1 - Base Case

The new underperformer: Further economic contraction this year - unlike in the other major euro area countries - followed by a much weaker recovery in 2011. Watch the labour market.

In this scenario, to which we assign a 45% probability, the economy continues to shrink for most of 2010, but starts expanding again before year-end - courtesy of the lagged effects of the policy stimulus on both the monetary and fiscal fronts. But house prices decline by a further 10% and construction investment drops by over 7% on a year earlier. In all, GDP growth remains in negative territory on average in 2010, to the tune of -0.7%.

Although the economy should start recovering next year, domestic demand stays remarkably weak on both a cross-country and historical basis - courtesy of a more restrictive fiscal policy and somewhat higher interest rates. Net trade will likely boost GDP growth - thanks to a weaker currency and stronger foreign demand - but this should be a partial offset. In all, GDP growth comes back in positive territory in 2011, to the tune of 0.8%.

The key driver behind our base case scenario is the labour market. Clearly, the job shakeout has been sharper (but probably shorter) in Spain than in the rest of the euro area. Indeed, despite accounting for less than 12% of the euro area GDP, Spain accounts for over one-quarter of total unemployment - up from about 15% at the start of 2007, i.e., prior to the financial crisis and economic recession. Despite having slightly more than half the population of Germany, Spain has now over one million more unemployed (using harmonised Eurostat data, 4.3 million in Spain versus 3.2 million in Germany).

Although most of the adjustment is probably already behind us, the labour market outlook remains challenging, we think. GDP growth and employment growth exhibit a very high correlation (95%). With no replacement in sight for the construction sector, the chances are that they will both remain subdued for quite some time. We don't expect any job creation whatsoever throughout the forecast horizon (end-2011): after having declined by 6.8% last year, employment should contract by a further 2% in 2010 and virtually stagnate next year. No wonder that the economic recovery will lag behind that of most euro area countries.

Scenario #2 - Bear Case

Three in a row: The economy continues to shrink - and at a substantial pace - not only this year, but also the next. Watch the housing market and bank lending to the private sector.

In this scenario, to which we assign a 40% probability, credit conditions remain restrictive for longer than expected. This is a key economic risk, in our view. Indeed, loan growth has declined more sharply in Spain than in the euro area as a whole across the board - and for a good reason: the loan exposure of the domestic banking sector to the property developers. The chances are that this trend will continue well into this year and possibly extend into the first part of 2011.

The likely restructuring of the domestic banking sector - which we expect to happen in our base case scenario too, but to a lesser degree - triggers a late-cycle credit crunch. Coupled with the announced fiscal tightening at around mid-year, this hits the economy hard. In turn, house prices fall more sharply than anticipated, to the tune of 15% this year alone, and construction investment drops by 20% - more than twice as much as in our baseline. Of course, this puts Spain's public finances under additional pressure.

The upshot is that a ‘growth scare' - which will negatively affect market sentiment - might well materialise, thus setting off a drying up of the capital flows that have been financing the current account deficit. In turn, with a more limited access to external financing, and an impaired domestic lending channel, a further downward correction in asset prices takes place. In this scenario, not only does the Spanish economy underperform the euro area economy as in the base case, but it also shrinks for an unprecedented three years in a row.

Scenario #3 - Bull Case

Export-led recovery: The further weakening of the exchange rate - and stronger global demand - boosts exports and helps Spain's economic rebalancing. Watch foreign trade data.

In this scenario, to which we assign a 15% probability, the Spanish economy broadly stagnates this year and expands by around 1.5% in 2011 - approximately twice the pace assumed in our central forecast. The main driver behind this more favourable outcome is a stronger-than-expected pick-up in exports. In part, this is already happening: courtesy of the strengthening in global demand, Spain's exports of goods and services rose sharply on a quarter earlier in the second half of last year.

The depreciation of the euro, which we expect at 1.24 against the dollar at year-end, will contribute to lift exports too - both in Spain and in the euro area as a whole. Should this happen, Spain might benefit from an export-led recovery further down the line. In turn, this might help the rebalancing of an economy that has been driven primarily by domestic factors during the boom years. However, although the likelihood of this more benign scenario is not negligible, we think that exchange rate changes alone are not enough to boost exports durably.

So, Where Does This Leave Us?

Of course, other plausible scenarios could be constructed by slight alterations of the above-mentioned assumptions; and different subjective probabilities could be assigned to the same scenarios. Bearing these caveats in mind, the main takeaway from our scenarios is that risks to the Spanish economy remain skewed to the downside. In other words, we think that the likelihood of our bear case playing out is relatively close to that of our base case. What's more, the upside is likely to be limited even in the bull case, not only in the short term, but also over the medium term.

What has changed from our previous in-depth report on the Spanish economy (see Finding a Balance - Where We Are, What's Next? November 25, 2009) is that we now believe that the probability of the bear case playing out has increased from around one-third to 40% or so. What's more, we turned more bearish on our bear case relative to our assessment at the end of last year. We now think that, should the risks associated with our more pessimistic scenario materialise, the magnitude of the drop in GDP is likely to be bigger. In particular, the restructuring of the domestic banking sector - coupled with the ongoing structural adjustment in the housing market - is a key risk, in our view.

3. Fiscal Tightening - Not an Easy Task

Spain is in the midst of a structural adjustment, as shown in the previous sections. The implications for its public finances are likely to be quite substantial. Indeed, Spain has to cut its budget deficit from an estimated 10% of GDP this year to below 3% in 2013, to meet the European Commission's demands.

The Commission has recommended an annual adjustment of Spain's structural budget balance (i.e., the budget balance adjusting for the cycle and one-off factors) greater than 1.5ppt - a more demanding request than in any other euro area country apart from Greece and Ireland.

Apart from overly optimistic GDP growth assumptions - which might make the fiscal targets more difficult to achieve - three different angles are relevant from a fiscal standpoint: what's already in place in terms of fiscal tightening; short-term rollover risk; and Spain's fiscal setup relative to the rest of the EMU.

Shrinking the Budget Deficit - How Much This Year?

Although fiscal policy has already turned somewhat more restrictive, Spain is adopting a gradual approach. For example, it aims at cutting the budget deficit from 11.2% of GDP in 2009 to about 9.5% this year. This compares with an upfront fiscal consolidation of around 4% of GDP in Greece - should the government implement the various announced measures in full. This is not to suggest that Spain and Greece should tighten their belts following the same agenda. Rather, it is an observation that, should markets start worrying about the fiscal position of other countries too, they might force them to pursue a more restrictive fiscal policy within a shorter timeframe.

Clearly, Greece is in a unique situation in Europe at this stage. From Portugal to Spain, the other EMU peripherals currently under the market spotlight - despite sharing some of Greece's economic and fiscal deficiencies - seem better placed on several fronts (see Portugal and the EMU Periphery, February 15, 2010). In particular, Spain's government debt is about half Greece's, as a share of GDP. And Spain has a good record of fiscal achievements. For example, it managed to run a budget surplus in 2005-07 - quite an improvement from a deficit of over 6% in the mid-1990s. What's more, the reliability of Spain's public finance figures has never been questioned.

The public purse has already become more stringent in Spain. For example, the standard VAT rate will be raised by two percentage points to 18% in July (and the reduced rate will be increased too), the €400 tax rebate has been eliminated except for low-income households, and dividend income, interest and capital gains have already been taxed more aggressively since the start of this year. This is appreciable. And, clearly, with the economy still in recession, an excessively aggressive - or perhaps too premature - fiscal consolidation agenda might further delay the recovery. These considerations are important too, in our view, and should play a role in defining Spain's fiscal strategy over the next few years.

Still, the fiscal challenges are bigger this time, and the risk is that markets may not differentiate to a great extent among the various EMU peripherals - if they are not constantly reminded of the heterogeneity within this group of countries. From this perspective, we believe that markets will respond differently to the various fiscal consolidation efforts in Europe, based on three factors: the pace of the fiscal tightening (gradual versus front-loaded); its quality (spending cuts versus revenue-raising measures); and the social tolerance that makes the belt-tightening easier or more difficult to implement in some countries than in others. In particular:

1.         The pace of the fiscal tightening is gradual in Spain. The risk is that markets might perceive it as too gradual and only feel reassured with further belt-tightening measures - as was the case, to various degrees, with Greece and Ireland. An additional reduction in expenditure worth about half a percentage point of GDP has recently been announced; but the Central Government Austerity Plan - which aims at cutting spending by more than 2.5% of GDP - will only kick in next year.

2.         Half of the fiscal restraint will happen on the revenue side this year. There is nothing wrong with higher taxes as part of a fiscal consolidation effort. Indeed, this is the case in all countries in the euro area. But the market seems to attach a higher value to spending cuts - which are under direct government control - than to revenue-raising measures. The hope is that the emerging emphasis on restraining wage outlays for all public administrations and reducing transfers and subsidies will continue.

3.         Implementation delays are the key risk for the Spanish economy. There are different ways to tackle the same fiscal challenges. But regardless of the chosen policy mix, it is important to stick to a substantial belt-tightening within a set timeframe, we think. From this perspective, the (non-binding) senate motions protesting against plans to raise the VAT rate passed in late March, as well as the opposition appeal against the 2010 budget before the constitutional court, might result in a fiscal setback.

Rollover Risk - Biggest Payout Month in July

Another risk related to the fiscal prospects for the Spanish economy is the difficulty in refinancing the debt. So far, this risk has concerned mostly Greece, but to various degrees Spain and Portugal have come under the spotlight too. The schedule of coupons and redemptions helps us get a sense of the pressure points. Spain faces a sizeable €30 billion in July. For Portugal, May is the big payout month. For Greece, the pressure points are April and May.

Event risk and volatility are likely to remain high/increase at around those months. What's more, short-term rollover worries are likely to be magnified in the countries where there is still a lot to do in terms of issuance - all else being equal. From this perspective, Spain has so far raised less than one-third of its total funding needs - the same as Italy and Germany, but less than all other EMU countries apart from Portugal.

The Degree of Centralisation in Government Finances

Besides budgetary policy and debt refinancing issues, it is also worth exploring the role of regional and local governments. Obviously, a high degree of centralisation would make the pursuing of a given fiscal agenda easier - abstracting from other conditions. The Spanish government has announced regional and local government spending cuts worth about 0.5% of GDP. This is good news. But whether more can come from the local administrations - if needed - remains to be seen.

In several countries in the euro area - both at its core and at its periphery - the non-central government, i.e., regional and local administrations, carries a considerable weight:

•           Non-central government spending accounts for over one-fifth of GDP in Spain - way above the euro area average of about 15% and the highest share across the region.

•           Non-central government revenue too accounts for approximately one-fifth of GDP in Spain - some five percentage points above the euro area average and second only to the share of Belgium.

For the accompany charts and tables, and the effects on savings banks, please see The Housing Market and the Savings Banks' Restructuring, April 12, 2010.

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UK
General Election Preview
April 13, 2010

By Melanie Baker & Cath Sleeman l London|

The general election has been called for Thursday, May 6.  The odds are on a change of government and this is implied by the latest polls too.  The UK has not had a change in government since 1997 (when Labour, under Tony Blair, came to power) and before that since 1979 (when the Conservatives came to power under Margaret Thatcher).  However, the UK's first-past-the-post system makes translating the polls into election outcomes especially tricky.  Assuming a uniform swing in votes across constituencies, many recent polls look consistent with the opposition Conservative Party gaining the most seats, but without an absolute majority - in other words, a ‘hung parliament'.  While such outcomes are commonplace in many other economies, the UK has little recent experience of hung parliaments (the last was in 1974).  Hence, investors are understandably nervous about such an outcome. 

What the latest polls imply: The average of the last eight polls shows the Conservative Party on 39% of the vote, Labour on 30% and the Liberal Democrats on 19%, with ‘others' on 8%.  Note that the polls can be quite variable. 

How the polls translate into seats won: There is no easy way to translate the share of the vote won into seats won in the UK's first-past-the-post system.  In general, a lead of around 10pp of the popular vote is thought likely to give a workable majority in parliament.  However, smaller leads in the popular share of the vote have resulted in working majorities in the past.  For example, in the last election Labour won a 64 seat majority with only a 3pp lead.  Using uniform swing analysis, even a 10pp lead for the Conservative party wouldn't necessarily be consistent with an absolute majority Conservative victory; this would also depend on the scale of the vote for the Liberal Democrats and other smaller parties.

A change in government is implied by the polls, but a hung parliament is a distinct possibility: The polls look consistent with a Conservative win in the upcoming election, but it is not clear that this would be a majority Conservative victory. 

Box: Some Background on Hung Parliaments

What is a hung parliament?  A hung parliament simply means a situation where no single party has an absolute majority.  This is a relatively common occurrence in some other economies, but is relatively unusual in the UK. 

Labour will have ‘first refusal': Gordon Brown, as the incumbent prime minister, has the right to try to form a new government, but always with the need to ultimately be able to win a confidence vote in parliament.  In the case of a hung parliament where the Conservative Party has won more seats than the Labour Party and by a clear margin, we think it is unlikely that Gordon Brown would try to form a government. 

Different types of government possible: There are several different ‘formations' of government that could result from a hung parliament: 1) a minority government; 2) a minority government with explicit backing for major planks of policy from other parties; and 3) a coalition government with another party. 

Government formation likely to take days rather than weeks: Given that hung parliaments are relatively unusual in recent UK history, it is unclear how long it might take before the form of any new government was clear.  The UK electorate (and media) are used to knowing very quickly the result of an election and the pressure to form a new government quickly will therefore be very strong, in our view.  In the 1974 election, the result of negotiation was known after only a few days.  Our central case is that a similar timescale seems likely again.  However, we recognise that in other economies this process can take weeks rather than days, so the balance of risk is strongly towards a more drawn-out process than a quicker one.  During the process of government formation, ‘significant' policy decisions are unlikely to be taken.

Implications of the Election for the UK Economy

The economic implications in terms of spending cuts and deficit reduction may not be that different no matter who wins the election.  The parties' positions do not look vastly different to us, and we think some investors worry too much about a lack of fiscal tightening in a ‘hung parliament'.  In particular: 1) A hung parliament might increase the chances of cross-party agreement on the scale/method of deficit reduction, which could increase its chance of success.  2) If markets don't like the outcome of the election and fiscal policy proposals that emerge from it, they will likely force a more aggressive fiscal tightening on the government of the day.

Policy Round-Up: What the Main Parties Are Promising

Details on many policies of the three largest parties are still sketchy and changes or additions may well be announced over the coming weeks. 

The main difference between the two major parties' fiscal consolidation plans is that the Conservatives want to begin sooner and do more consolidation than Labour.  The Conservatives also want to carry out the consolidation using a mix that is more weighted towards spending as opposed to tax measures than Labour has proposed.  The Liberal Democrats do not want to tighten as quickly as the Conservatives, though they have stressed the need to begin tightening as soon as the economy permits it.

All three parties have promised to protect some areas of expenditure and to limit increases in public sector pay. 

The main difference between the parties looks to be their tax policies.  The Conservatives have said that they would reverse the effects of Labour's planned rise in National Insurance contributions (using savings from efficiency gains) and would view the new top tax rate as only being ‘temporary'.  They also plan to make cuts to corporation tax.  The Liberal Democrats plan to raise the threshold at which people start paying income tax to £10,000 and fund this partly from changes in capital gains tax.   All parties have denied that an increase in VAT is part of their plans, though none have ruled it out emphatically.

Hung Parliaments: How Worried Should We Be?

We recognise that market movements may be very varied, given different election outcomes.  However, the ultimate policy outcomes may not look that different, particularly with all major parties committed to significant deficit reduction and the market itself likely to act as a disciplining force against inaction. 

Why people worry about hung parliaments: Some investors express the concern that in a hung parliament little will get done in terms of deficit reduction:

1)         A hung parliament could mean a more protracted negotiation on a fiscal platform. 

2)         There is a higher probability that proposals for fiscal tightening could ultimately be watered down since any very significant fiscal tightening measures will likely be unpopular (absent a sense of fiscal crisis). 

3)         Westminster does not have a recent history of hung parliaments (the last being 1974) and its style of politics is more adversarial than consensual. 

4)         There is a reasonable probability of the country going back to the polls later in the year to try to form a clearer mandate to govern.  In 1974, for example, a second general election was held only around seven months after the first election resulted in a hung parliament outcome.  Arguably, if you plan to return the country to the polls, then it is even less likely that you will push for painful deficit reduction measures in the meantime. 

Why we think that some of these worries are overdone: Inaction on the deficit seems unlikely to us and, ironically, a hung parliament outcome might even make a more aggressive fiscal settlement more likely rather than less:

1)         Other countries manage to get things done despite the lack of absolute majority governments.

2)         The chance of an adverse market reaction to a ‘hung parliament' makes it more likely that early and substantial action will be taken to reduce the deficit. The Liberal Democrats (potential ‘kingmakers' in a hung parliament scenario) have explicitly made ‘market conditions' one of their conditions for tightening policy.

3)         All the main political parties are committed to significant fiscal consolidation and there is no huge apparent difference between the deficit-reduction platforms of the main parties. 

4)         Significant deficit reduction would benefit from broad support.  In the event of a coalition or explicit multiparty support for a minority government's deficit proposals, this could make it more rather than less likely that we see significant and successful deficit reduction.

Fiscal Outlook: How Much Needs to Be Done?

We estimate how the numbers stack up under four different scenarios.  All envisage considerable fiscal tightening (6pp to 9pp of deficit reduction over five years). We continue to think that the government should target a somewhat more aggressive deficit reduction in order to build in more ‘wriggle room' in the event of a weaker-than-expected recovery.  Either way, substantial political will is likely to be required to push through what will be painful spending adjustments on the public sector and on the public more generally.

Four fiscal scenarios: 2009/10-2014/15:

Deficit scenario 1: Government's current forecasts:
Deficit reduction of £93 billion (7.8% of GDP). 
Spending 5.6pp of GDP lower, Receipts 2.2pp higher.
Avg. nom. govt. spending growth (2010/11-2014/15): 2.8%

Deficit scenario 2: Lower growth:
Deficit reduction of £63 billion (5.9% of GDP). 
Spending 3.9pp of GDP lower, Receipts 2.0pp higher.
Avg. nom. govt. spending growth (2010/11-2014/15): 2.8%

Deficit scenario 3: Lower growth with lower government spending:
Deficit reduction of £91 billion (7.5% of GDP). 
Spending 5.5pp of GDP lower, Receipts 2.0pp higher.
Avg. nom. govt. spending growth (2010/11-2014/15): 2.0%

Deficit scenario 4: Lower growth and more aggressive deficit reduction.
Deficit reduction of £114 billion (8.9% of GDP). 
Spending 6.9pp of GDP lower, Receipts 2.0pp higher.
Avg. nom. govt. spending growth (2010/11-2014/15): 1.4%

A few things concern us with the government's current plans (deficit scenario 1):  First, the reduction in the deficit by 2014/15 (to 4.0% of GDP) is less than rating agencies and many investors would seem to want.  Second, the GDP growth forecasts that underpin the projections continue to look distinctly optimistic to us.  If we plug in our own forecasts for GDP growth and inflation (deficit scenario 2), we reach a deficit of 5.9% of GDP in 2014/15. With those growth and inflation scenarios, we think you'd need almost a percentage point less annual spending growth to meet the government's targets (deficit scenario 3).  This scenario is close to what we have as a central case.  If the government were to aim for an even more aggressive fiscal tightening (deficit scenario 4), without tax changes average spending growth would need to be more than 0.5pp lower again on our calculations (and that's before altering our GDP projection for the effect of lower government spending). 

What shape could additional fiscal tightening take?  The Canadian fiscal consolidation of the mid-1990s is much admired.  In 1994 the incoming Canadian government established a government spending programme review and no area of spending was protected.  There were firm fiscal targets, but spending cuts were not arbitrary.  Six tests were put in place for spending programmes, compelling all departments to subject all programmes and activities to scrutiny.  The focus of fiscal tightening was very much on spending cuts.  However, in a more aggressive UK fiscal tightening than currently planned, we could envisage some specific programme cuts, some lowering in benefit payments and some additional revenue raising.

Some observations:

1)         The scale of planned deficit reduction looks attainable, at least judging by the recent past.  The scale of deficit reduction planned by the UK government is not unprecedented and, aside from the much higher starting point, it actually looks fairly average against the scale of deficit reductions seen in the recent past in the UK.  In terms of revenue and expenditure, we have been at lower levels of expenditure as a percentage of GDP before and we have seen higher tax revenues as a percentage of GDP.  In other words, on these simple metrics, the deficit reduction planned looks achievable and is not without precedent.

2)         Things could turn out better than expected... The government's GDP forecasts look too optimistic to us for a ‘central case' but they are not implausible and look close to the kind of GDP profile that the Bank of England envisages.  There is evidence to suggest that fiscal consolidations can have a positive effect on GDP growth.  The government's built-in assumptions on unemployment look pessimistic to us. 

3)         ...but the government needs more wriggle room: We think that the government needs to build in a lot more ‘wriggle room' in the case of a weaker-than-expected economy (let alone aim for an even lower deficit).

4)         Political will required for spending adjustments: All of these scenarios envisage painful adjustments in the public sector.  Spending adjustments will be uncomfortable, seem likely to meet considerable resistance in parts of the public sector (and the public more widely) and will likely need considerable political will to push them through.

Economic Implications of Election Outcomes

We outline five election scenarios:  1) Conservative Party wins an absolute majority; 2) Conservative Party falls just short of an absolute majority; 3) Conservative Party falls clearly short of an absolute majority, while winning the most seats; 4) Labour Party falls short of an absolute majority, while winning the most seats; and 5) Labour Party wins an absolute majority. 

We hazard a first guess at what this means for the economic outlook.  However, bear in mind that the market reaction (beyond any initial knee-jerk response) and what actually emerges in a post-election Budget (if there is one) will ultimately play a big role (if not the biggest role) in determining what the election outcome means for the economy: 

Election Scenario 1: Conservative Party Absolute Majority

We assume that the Conservative Party follows through with its policy of starting tightening fiscal policy earlier, that it cuts spending by more and raises taxes by less than on the government's current plans.  Although fiscal tightening starts earlier, we are not convinced that the scale will be enough to significantly affect our view on inflation, interest rates or GDP growth.  We have already built into our forecasts weaker consumer spending in 2H (as households come to anticipate tightening) and somewhat weaker government spending growth than on the government's current plans for 2011.  However, we would expect to lower our forecasts for government spending in 2010. The key things that would change our current economic forecasts further: 1) A quick announcement of further near-term tightening (e.g., a VAT rise, that would also feed directly into our inflation forecasts).  2) A sharp rally in sterling on the back of a clear election victory.  That would dampen our growth and inflation forecasts. 

Election Scenario 2: Conservative Party Falls Just Short of an Absolute Majority

We assume that the policy outcomes are broadly as above.  However, there may be compromises at the ‘edges' in order to secure backbencher support and the support of some of the smaller parties in pushing through key legislation (particularly the Budget).  There would be less risk of pre-election fiscal plans being compromised than in election scenario 3.  However, election scenario 2 could run a high risk of leading to another general election later in the year. The key things that would change our current economic forecasts:  1) Signs that pressure to ensure the full support of more traditional wings of the party was pointing towards an even more aggressive deficit-reduction plan or a significantly different mix of tax and spending. 2) Signs that pressure to ensure the support of members of other parties/independents was pointing towards a less aggressive deficit reduction plan.

Election Scenario 3: Conservative Party Falls Clearly Short of an Absolute Majority, While Winning the Most Seats

With this election outcome, we think that the pressure will be on the Conservatives to form a working relationship with the third-largest party, the Liberal Democrats.  As a central case, we would expect this to reduce some of the dampening effect on consumer spending for 2H10 as the public might envisage a somewhat delayed start to fiscal tightening.  The key things that would change our current economic forecasts further: 1) Significant points of compromise on economic policy (rather than, for example, on electoral reform).  2) An adverse market reaction to this hung parliament scenario.  Both parties talk in strong terms about the need for public spending cuts.  If the market reaction to this hung parliament scenario was adverse, that would also likely bring agreement on an early start to fiscal tightening.

Election Scenario 4: Labour Party Falls Short of an Absolute Majority, While Winning the Most Seats

We assume that the Labour Party would try to form a government with the Liberal Democrats.  As a central case, we would expect this to reduce some of the dampening effect on consumer spending for 2H10 and lessen some of the cuts in government spending we have ‘plugged in' for 2011.  The key things that would change our forecasts further: 1) An adverse market reaction.  This seems likely to prompt earlier and more aggressive action on cutting the deficit.  2) Points of policy compromise.

Election Scenario 5: Labour Party Absolute Majority

We assume that the Labour Party would then continue to follow the path of deficit reduction set out in Budget 2010.  In our current forecasts, we have built in weaker consumer spending in 2H (as households come to anticipate tightening) and somewhat weaker government spending growth than on the government's current plans for 2011.  Hence in this scenario, we would expect this to reduce some of the dampening effect on consumer spending for 2H10 and lessen some of the cuts in government spending we have ‘plugged in' for 2011.  The key thing that would change our forecasts further: An adverse market reaction.  This could prompt earlier and more aggressive action on cutting the deficit.

For accompanying charts and tables, and the implications for UK equities, FX and rates, please see UK General Election Preview, April 9, 2010.

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Europe
On the Safety Net for Greece
April 13, 2010

By Daniele Antonucci & Elga Bartsch l London|

What's new: The outcome of the teleconference among the euro area finance ministers (i.e., the Eurogroup), together with the ECB and the European Commission, is that Greece will get up to €30 billion in the first year from the euro area countries alone, if it asks for financial help. The IMF's contribution is unclear at this stage, but it was once again mentioned that the split two-thirds from the euro area governments and one-third from the IMF is a "correct order of magnitude".

There was no decision to activate the financial aid package, as Greece did not ask for any financial help to date. Should it be activated, the various euro area governments will make the funds available through bilateral loans for a three-year period at an interest rate of around 5% (3-month Libor + 300bp + one-off charge of 50bp to cover for operational costs). A further 100bp will be charged for amounts outstanding for more than three years. The ECB will be the paying agent.

The procedure to activate the package is as follows (as was mentioned in a previous statement from the euro area head of states and governments):

1. Greece has to seek financial help and declare that it cannot access market financing;

2. The European Commission and the ECB have to establish that this is indeed the case and that Greece is on track with all the fiscal consolidation measures it has been asked to implement;

3. All the euro area countries have to decide unanimously on the bilateral loans.

Point #3 has already happened, i.e., there is unanimous agreement. So, bearing in mind that point #2 will require some time to be executed, all that needs to happen for the disbursement is point #1, i.e., Greece has to declare it cannot access market financing.

Bottom line: The interest rate is more or less in line with what could reasonably be expected, neither too high nor too low, for the European part. The amount of the package is bigger than expected. Press reports over the past few days mentioned something around €25 billion in total. The bigger-than-expected magnitude of the package - especially considering that there will also be IMF funds available - was probably meant to ‘shock' the market by showing that there are substantial resources on the table to support Greece in the short term. Of course, whether this will have the desired effect remains to be seen, but we acknowledge that the magnitude of the package is quite substantial: the maximum that the euro area governments might disburse (€30 billion) plus an IMF contribution of, say, €45 billion, would amount to almost 20% of Greece's GDP.

What's next: While short-term liquidity risks have diminished (i.e., the difficulty or inability to rollover the debt), long-term solvency risks remain firmly in place, in our view. Basically, the financial aid package, if needed, should support Greece's funding programme, especially in the light of a heavy redemption schedule this month and next. However, the situation will likely get even more challenging next year in terms of long-term solvency risk, as the redemption schedule will be even heavier, the unemployment rate higher, the economy weaker, and the government will have to push through further fiscal austerity measures. At this stage, we remain bearish on the Greek economy, and think that it will contract outright this year, to the tune of 2.5% - way below the consensus forecast of around half a percentage point.

Given the terms of the deal, and if Greece applies for it, what matters is whether this will be enough to act as catalyst for private capital flows into Greece. Looking at previous IMF programmes, the evidence for them acting as a catalyst is very mixed. Clearly, the better this works, the less daunting the debt burden becomes. The magnitude of the interest rate relief is key. As an illustrative example, if the interest rate turns out to be 200bp below market rates for a €30 billion loan, it would save something close to €1 billion, or about 8.5% of last year's interest expenses.

What to watch: There is a T-bill auction for about €1.2 billion on April 13. On the policy front, there is an informal Ecofin Council meeting on April 15-16.

Statement on the Support to Greece by Euro Area Member States, Brussels, April 11, 2010

Following the statement by the Heads of State and Government of the euro area on March 25, euro area member states have agreed upon the terms of the financial support that will be given to Greece, when needed, to safeguard financial stability in the euro area as a whole.

Euro area member states are ready to provide financing via bilateral loans centrally pooled by the European Commission as part of a package including International Monetary Fund financing.

The Commission, in liaison with the ECB, will start working on Monday, April 12 with the International Monetary Fund and the Greek authorities on a joint programme (including amounts and conditionality, building on the recommendations adopted by the Ecofin Council in February). In parallel, euro area member states will engage the necessary steps, at national level, in order to be able to deliver a swift assistance to Greece.

Euro area member states will decide the activation of the support when needed and disbursements will be decided by participating member states.

The programme will cover a three-year period. The euro area member states are ready to contribute for their part up to €30 billion in the first year to cover financing needs in a joint programme to be designed with and cofinanced by the IMF. Financial support for the following years will be decided upon the agreement of the joint programme.

In order to set incentives for Greece to return to market financing, euro area member states' loans will be granted on non-concessional interest rates. The pricing formula used by the IMF is an appropriate benchmark for setting euro area member states' bilateral loan conditions, albeit with some adjustments. Variable-rate loans will be based on 3-month Euribor. Fixed-rate loans will be based upon the rates corresponding to Euribor swap rates for the relevant maturities. A charge of 300bp will be applied. A further 100bp is charged for amounts outstanding for more than three years. In conformity with IMF charges, a one-off service fee of a maximum 50bp will be charged to cover operational costs. For instance, as of April 9, for a three-year fixed-rate loan granted to Greece, the rate would be around 5%.

The Eurogroup is confident that the determined efforts of the Greek authorities and of its European Partners will allow them to overcome the fiscal and structural challenges of the Greek economy. In this context, the Eurogroup welcomes the budget execution in the first months of the year, which shows that the measures taken so far are bearing fruit.

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United States
Review and Preview
April 13, 2010

By Ted Wieseman l New York|

Treasuries posted moderate gains over the past week as a run of four strong auctions took some of the near-term supply fears out of the market after the miserable run of auctions a couple of weeks earlier helped spark the big sell-off that began in mid-March.  Supply fears are not likely to go away any time soon, though, and aside from a big rally after a particularly strong 10-year auction Wednesday, market reaction to the better run of auctions was muted.  And the market was showing signs of supply indigestion from the $82 billion in new issuance Thursday and Friday.  Clearly this is a global problem, and renewed fears in Europe provided some flight-to-safety support to Treasuries.  Greece's 2-year yield spread over Germany blew out 230bp in the three trading sessions through Thursday to a new high before pulling back about 50bp Friday on hopes for new support efforts possibly being announced imminently.  There was also some continued nervousness about the possibility of a hung parliament in the UK delaying fiscal consolidation there after the May election was officially scheduled.  Indecisive FOMC minutes that showed a high level of complacency about inflation risks gave the curve a steepening bias that worked against the positive response to the 10-year auction - which saw a record bid/cover and record high distribution to final investors - so the Treasury yield curve ended up not moving much for the week, leaving 2s-10s within 10bp of a record high.  Inflation expectations also moved significantly higher in the TIPS market after holding steady during the big sell-off in the second half of March and first few days of April despite flat commodity prices as the dollar rallied and the gains in the nominal market. The lack of any signs of FOMC urgency to move further towards an exit strategy came as economic data continued to surprise to the upside.  The past week's economic calendar was very light, but key numbers were notably positive.  The non-manufacturing ISM index surged to a four-year high in March, and chain store sales results were very strong.  On top of the previously reported surge in auto sales, the chain store sales results pointed to a very strong March retail sales report in the coming week, and we slightly boosted our 1Q consumption forecast to +3.5% from +3.4%.  Also adding to upside in 1Q growth was a stronger-than-expected wholesale trade report, which on top of the better consumption outlook led us to raise our 1Q GDP forecast to +3.0% from +2.5%. 

On the week, benchmark Treasury yields fell 3-6bp, leaving them a couple of basis points higher than Thursday's close after big losses Friday and Monday that were in large part drive by worries about this week's supply were largely reversed when the auctions went well.  The 2-year yield fell to 1.06%, 5-year 3bp to 2.64%, 7-year 6bp to 3.34%, 10-year 6bp to 3.89%, and 30-year 6bp to 4.75%.  After some typical volatility around quarter-end, financing rates have settled down at their recently more elevated levels over the past week-and-a-half.  The overnight Treasury general collateral repo rate averaged about 0.20% for the week and effective fed funds marginally lower, which represents effectively about 8bp rate hike from the 0.12% level that prevailed before the SFP program began draining reserves in late February.  Excess reserves have declined from a peak daily average of $1,194 billion in the two-week period ending February 10 to $1,094 billion in the two weeks ending April 7.  This initial start to the Fed's liquidity draining will end Thursday, however, when the last weekly SFP bill raising new money settles.  After that, the weekly $25 billion SFP bill auctions will just be rolling over the $200 billion in outstanding supply.  And the Fed still hasn't taken delivery of about $50 billion of its MBS purchase yet, so excess reserves will likely see some renewed upside starting after mid-month.  TIPS had a very good week, significantly outpacing the nominal gains even with flat oil prices after a reversal of significant early week gains as the dollar rallied.  The 5-year TIPS yield fell 10bp to 0.35%, 10-year 13bp to 1.54%, and 30-year 11bp to 2.11%.  This boosted the 10-year inflation expectation 7bp to a two-month high of 2.34%.  Supply pressures contributed to underperformance of Treasuries versus swaps and mortgages on the week.  The benchmark 10-year swap spread swung back into negative territory, falling 3bp to -1.5bp.  Current coupon mortgage yields fell about 10bp to near 4.5%, with Fannie 4.5% MBS outperforming Treasuries by about a third of a point.  A bit of moderation in interest rate volatility, which has been fairly stable recently after correcting somewhat from cycle lows hit just before the mid-March start of the big market sell-off, was MBS-supportive.  3-month x 10-year normalized swaption volatility fell a couple of basis points on the week to 101bp, up about 11bp from the lows since November 2007 hit in the middle of last month, but significantly down still from near 125bp at the end of 2009 and over 200bp at the 2009 highs hit in June. 

Volatility in risk markets also remains quite low, but for stocks at least this has been marked by a return in the past week to the recently familiar pattern of persistent small daily moves mostly to the upside, cumulating to decent gains.  For the week, the S&P 500 gained 1.4% to end the week at another new high since September 2008 after extending its year-to-date gain to +7.1%.  Financials and consumer discretionary stocks, boosted by the strength in chain store sales, were the best sectors on the week with gains of a bit less than 3%.  These two sectors are also among the three best performing so far this year, along with industrials seeing rallies over 14%.  Credit seemed to be more negatively impacted by Greece spread pressure and ended little changed, with the investment grade CDX index flat at 86bp.  High yield did better with about a 25bp tightening to near 510bp.  The new series 14 leveraged loan LCDX index started trading and surged out of the gate, moving from a dollar price near 97 on Monday to 99 on Friday, while the series 13 only gained about 1 point.  There was an important change in the specifications of the latest LCDX index that apparently investors were putting a high value on.  In series 14 LCDX, even if no syndicated or secured loans are available for a component company, it will remain in the index until maturity barring a credit event, eliminating ‘optional early termination rights' in previous LCDX series if all loans were paid off by a company, which made valuation more difficult.  Meanwhile, the rally in non-agency mortgages continued to gather momentum since the White House announced its principal forgiveness plan to add to prior mortgage delinquency mitigation programs.  The AAA subprime ABX index surged 7% over the past week for a 13% gain the past two weeks and 18% rise for the year.  This is far ahead of the commercial mortgage CMBX market, where the AAA index gained 1% this week for a 4% year-to-date rally.  The muni bond MCDX market saw a bit of widening in sympathy with Greece, but the impact was muted, and spreads remain quite tight despite a continued negative flow of news on state and local government finances.  The 5-year MCDX index hit a midweek high of 138bp and was near 135bp Friday, not too far from the low for the year of 124bp hit Monday and well below the wide for the year of 180bp reached in early February when Greece was last under major widening pressure. 

It was a light week for economic data, but the positive recent trend continued in the non-manufacturing ISM, chain store and wholesale trade reports.  The composite non-manufacturing ISM index surged 2.4 points in March to 55.4, a four-year high.  Manufacturing continues to lead the recovery, but activity in non-manufacturing has started to pick up sharply in early 2010.  Big upside in March was seen in the business activity (60.0 versus 54.8) and orders (62.3 versus 55.0) components.  Employment (49.8 versus 48.6) saw less improvement but reached its least negative level since the recession began in December 2007.  Growth was very broadly based by industry, with 14 of 18 sectors reporting expansion in March, up from 9 in February and 4 in January and matching the best result (last seen in 2007) in the five years of data.

Meanwhile, upside in consumer spending and inventory accumulation pointed to a stronger trajectory for all of 1Q at the same time that the robust run of March results provides a strong starting point for further upside in 2Q.  Chain store sales results were extremely strong in March, and while they were significantly helped by the earlier Easter, even accounting for this the results were far better than expected, with weighted average same-store sales showing their biggest gain in a decade as most of the biggest companies posted double-digit increases.  Along with the surge in auto sales last week, the March retail sales report should be very strong.  We boosted our 1Q consumption forecast to +3.5% from +3.4% as a result, and with such a strong likely starting point for 2Q, not too much in the way of further sequential upside will be needed from April to June to see a similar sized gain in 2Q.  Meanwhile, wholesale inventories rose a much-higher-than-expected +0.6% in February, and January was revised up to +0.1% from -0.1%.  Incorporating this upside, we now see inventories adding 1.1pp to 1Q GDP growth instead of +0.7pp.  Even with the bigger gains in recent months, wholesale inventories are not keeping up with robust gains in wholesale sales of 0.8% in February and 0.9% in January, so the I/S ratio has fallen to a near-record low 1.16 early this year.  This is true broadly - even with a further 1.1pp add to GDP in 1Q on top of a 3.8pp add in 4Q, the rate of inventory accumulation would remain unsustainably low in a growing economy, and more upside will be needed to stabilize currently low economy-wide I/S ratios over the rest of the year.  Combining the better outlooks for consumption and inventories, we raised our 1Q GDP forecast to +3.0% from +2.5%. 

The economic calendar is a lot busier in the coming week.  The biggest data focus will be the retail sales report on Wednesday.  There is another heavy schedule of Fed speakers, including Chairman Bernanke testifying on the economic outlook on Wednesday.  The Fed will also release the Beige Book prepared for the upcoming FOMC meeting on Wednesday, which should have a positive tone given the upside seen in the March data so far.  Other data releases due out include Treasury budget Monday, trade balance Tuesday, CPI and business inventories Wednesday, IP Thursday, and housing starts Friday:

* We expect the Treasury to report a $63 billion budget deficit in March, far smaller than the $192 billion reported a year ago, though mostly as a result of a non-cash accounting change.  The CBO has indicated that the Treasury will lower its projected TARP cost by $114 billion - and that all of this adjustment will show up in the March budget statement (note: most budget items are measured on a cash basis, but a present value approach was used to derive the budget impact of the TARP).  Even excluding this special item, the March results should still be some underlying improvement, driven by a jump in tax receipts.  We estimate that withheld income and payroll taxes rose 6%, the first increase in a year-and-a-half.  Corporate payments also showed a big gain, up an estimated 34%.

* We look for the trade deficit to widen by $1.5 billion in February to $38.8 billion, with exports up 0.7% and imports up 1.4%.  Imports should be boosted by a surge in services from the royalty payments for Olympic broadcast rights.  Port data point to renewed upside in non-energy goods imports also after a pause last month, but lower prices should offset higher volumes to keep petroleum imports little changed.  On the export side, factory shipments figures pointed to a good rise in capital goods, but lower prices should restrain food and industrial materials. 

* We forecast a 1.3% surge in overall retail sales in March and a 0.8% gain ex autos.  Unit sales of motor vehicles posted a sharp jump in March, so the auto dealer component of retail sales is likely to show a solid rise.  Meanwhile, chain store results were also very strong, and thus we look for big gains in categories such as general merchandise and home electronics.  However, the Easter calendar shift represents an important wildcard, meaning that it will probably be necessary to average the March and April results before drawing any conclusions on underlying sales momentum.  Gasoline prices were little changed in March (on a seasonally adjusted basis), so we look for only a fractional uptick in the service station component.  Finally, the key retail control gauge that feeds directly into the calculation of personal consumption is expected to be +0.8%.

* We look for fractional 0.1% increases in both the headline and core consumer price index in March.  The run-up in gasoline prices seen during the month was just about in line with seasonal norms, so the energy category is expected to be little changed on an adjusted basis.  Meanwhile, the core is expected to round up to +0.1%, as continued softness in shelter acts as a major restraint.  Otherwise, we expect some flattening in the apparel category following an unusually large dip in February.  Also, tax increases are expected to lead to a modest boost in the tobacco sector.  Still, the core is expected to slip to +1.1% on a year-on-year basis.

* Based on the results from the manufacturing and wholesale sectors, overall business inventories are expected to rise 0.5%, the sharpest gain since mid-2008.  However, sales are keeping pace.  So, the I/S ratio should be unchanged at 1.27.

* We look for a 1.0% surge in March industrial production.  The employment report showed a very sharp increase in hours worked within the manufacturing sector.  Also, auto industry assembly schedules point to a solid gain in the motor vehicle sector.  As a result, the key manufacturing category is expected to post a rise of +1.3% - best since last July. The headline reading would be even stronger were it not for a weather-related pullback in utility output.

* We expect housing starts to edge a bit lower in March to a 565,000 unit annual rate after a nearly 6% drop in February.  While there was a sense that weakness in February might reflect unusually severe weather conditions in parts of the nation, the report revealed that the declines were concentrated in the South and West.  So we don't see much likelihood of a weather-related rebound in March.  However, the multi-family category is so depressed, relative to historical trends, that it may show a bit of upside in March.

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