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Global Economic Weekly

The Blame Game

Global: The Blame Game Complaints about Chinese currency misalignment are getting louder. Do not be surprised if there is a lot of talk but no action.

United States: We have met the enemy and he is us We expect policy uncertainty to continue undercutting growth into 2012.

Canada: risk-on-ish We think RRB breakevens could hit 2.5% on a slight moderation of risk aversion in the next couple of months.

Euro area: A credit crunch? How likely? How large? The chance of a severe credit crunch in the Eurozone is small, in our view. While deleveraging is likely to continue for many years to come, it is unlikely that annual growth in credit to the private sector is going to fall as sharply as it did in 2008-09.

UK: credit easing for smaller companies Lending to credit-constrained small and medium-sized companies could be a relatively inexpensive fiscal stimulus measure. But the benefits may not be dramatic either.

Japan: reduction in trade surplus due to yen strength We estimate that the 5-10% appreciation of the yen in real term since September could knock the equivalent of an additional 0.3–0.5% of GDP (¥2-3trn) off the balance of trade through next year.

Emerging Asia: indebted households We take a more detailed look at household leverage in Korea. Contrary to the concerns voiced in many quarters, we find that household debt is currently at a manageable level, and that the challenge lies in its future course.

Emerging EMEA: Turkey - aiming for a soft landing The government has announced the long-awaited medium-term program with a focus on taming the current account deficit and bringing GDP growth to sustainable levels.

Latin America: inventory cycle, not 2009 déjà vu With inventories above desired levels in some LatAm countries, risks are biased for them to become a drag on growth. Nevertheless, in our opinion conditions are substantially different than in 2008-2009, and there is less downward potential.

Economic Analysis

Economics | Global 13 October 2011

Global Economics Team +1 646 855 9322 MLPF&S Ethan S. Harris +1 646 855 3755 North American Economist MLPF&S ethan.harris@baml.com Gustavo Reis +1 646 855 6356 Economist MLPF&S gustavo.reis@baml.com

See Team Page for Full List of Contributors

Table of Contents Global overview 2 Global economic calendar 4 United States 5 Canada 8 Euro area 10 United Kingdom 18 Japan 20 Emerging Asia 22 Emerging EMEA 25 Latin America 28 Global forecasts 32

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Global overview The Blame Game

Review: Global industrial production has been resilient but central bankers continue to worry about downside risks.

Hot topic: Complaints about Chinese currency misalignment are getting louder. Do not be surprised if there is a lot of talk but no action.

Preview: The markets will focus on whether Europe will deliver on its promise of more proactive policy.

Review: The allure of Cannes The market improvement continued last week, as the crisis in Europe seemed to ease a bit. Markets were soothed by the conclusion of the protracted Troika review of Greece. The release of the €8bn tranche is now expected in early November. The markets also responded to signs of more decisive policymaking in the Eurozone and better data in both Europe and the US. The S&P 500 rose by 4.5% on the week, and key benchmark government bonds sold off while the dollar tumbled (Chart 1). The commodities complex also shook off some of the recent pessimism, with Brent prices climbing 6%.

With all 17 Eurozone members now having approved the EFSF II, the stage is set for the G-20 meeting in Cannes. European leaders will meet on October 23 to iron out differences over bank recapitalization and private sector involvement in the new Greek program. Meanwhile, Italian politics continue to lurk in the background as European negotiations continue. Prime Minister Berlusconi is to host a make-or-break vote in parliament.

Manufacturing data dominated in the past week, suggesting continue moderate growth. Industrial production figures for the UK, Eurozone, India, Turkey and Malaysia all got a boost from recovering supply chains. Global industrial output rose 0.4% in August, matching the July gain (Chart 2). Policymakers, however, continued to council caution. Bank Indonesia unexpectedly cut rates, while the Bank of Korea underscored downside risks to growth. The FOMC minutes highlighted that QE3 is still on the table. We do not see the Fed expanding asset purchases near term but if the economy “triple dips” in 2012, as we expect, QE3 is likely.

Trading jabs This week the US Senate passed legislation allowing firms to seek penalties against countries with “misaligned” currencies. This sparked some alarm over the specter of a trade war with China. This prompted a flurry of questions from clients, but the bill is unlikely to pass voting in the House, let alone be signed into law by the President. However, with an election looming and a chronically weak US economy, we expect the anti-China rhetoric to escalate.

Actions speak louder than words. Despite the protectionist rhetoric, this week also saw Congressional approval of three free trade agreements (FTA). After years on the sidelines, agreements with Korea, Colombia and Panama were finally approved by US legislators. After a long string of policy impasses in the US, this is a hopeful sign not only for global trade, but for more sensible US policy in general.

In our view, fears of a major surge in protectionism are overdone. The World Trade Organization estimates that, despite the depth of the last global recession, less than 1% of global trade has been subject to new protectionist measures. A

Gustavo Reis +1 646 855 6356 Ethan S. Harris +1 646 855 3755

Chart 1: USD weakening further (index level)

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Chart 2: Global industrial production holds up (%mom)

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survey on protectionism published by the ECB last year as well as more timely monitoring run by Global Trade Alert suggest there has not been a significant increase in discriminatory measures1. WTO membership and expanding FTAs restrict traditional discrimination.

Fighting the last war The biggest risk comes from currency manipulation. There are no binding international agreements against a managed weak currency. This was not lost on China when it joined the WTO in 2001. Our emerging markets team estimates that the Chinese currency is undervalued 6.6%, consistent with the 6% undervaluation for the Asian region as a whole.

Both the US and China have good reasons dig in their heels. The US can no longer act as the world’s “consumer of last resort”. Moreover, the US economy is still in “rehab” from its banking and real estate crisis and historically, exports are a major source of support for rehab economies. A weak dollar is helping keep the US economy afloat. Using econometric contribution analysis we recently estimated that a weaker dollar can explain 0.4 - 0.5 pp of annualized GDP growth during this recovery. In other words, the lower dollar can account for almost a fourth of US growth since the end of the last recession. Historically, the dollar has played a relatively small role in driving trade, but the influence of the currency seems to have increased over the past five years (Chart 3).

China also wants a weak currency. According to a recent study, yuan undervaluation has worked better than any other unorthodox industrial policy in supporting growth.2 With Chinese growth slowing the government is reluctant to let go of this tried and true growth stimulus tool. Moreover, a unilateral appreciation of the renminbi may not deliver the powerful trade effect that many hope for. Almost half of China’s trade flows consists of processed imports and exports. The degree of Chinese value added embedded in a significant portion of its exports is therefore low. Thus, a renminbi appreciation without FX strengthening in China’s main Asian suppliers may result in an only moderate hit to Chinese competitiveness.

Both China and the US have already been trimming their external imbalances. The US current account deficit has fallen in half as a share of GDP, 6% of GDP in 2006, to an estimated 3% this year and, we reckon, closer to 2% in 2012. Likewise China has seen its surplus drop from 10% in 2007 to 5.2% last year. We look for further narrowing next year. This week’s trade data also suggest the adjustment is ongoing. Import growth in China can consistently top export growth and diminish the trade surplus in the months ahead.

Banging the drums of currency war? So US-China relations seem to be in an awkward equilibrium. The trade and currency imbalance seems to be adjusting just fast enough to prevent tough talk from turning into tough action. We look for this status quo to persist. We expect the usual escalation of China bashing during the election year, but no major protectionist measures.

1 Bussiere et al (2010), “Protectionist Responses to the Crisis – Global Trends and Implications”, ECB Occasional Paper no. 110. 2 Rodrik (2011), “The Future of Economic Convergence”, NBER working paper 17400.

Chart 3: Contributions to US export growth (pp)

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Global economic calendar Sovereign debt crisis leaves central banks cautious Central banks around the world are pausing or cutting rates in light of the ongoing sovereign debt crisis in Europe. This week we expect the following countries central banks to leave monetary policy unchanged: Norway, Thailand, Philippines and Turkey. Meanwhile, Brazil’s central bank is expected to aggressively cut rates by 50 bps. In the US, the consumer and producer inflation reports will take center stage this week. Consumer prices are expected to rise 0.3% MoM in September, slightly slower than the recent pace. Core consumer prices are poised to rise 0.2% monthly in September, similar to the pace of increase for the prior two months.

Key events in the week ahead NYT Country Data/Event For BofAMLe Cons. Previous

Monday, 17 October 9:15 US Industrial Production (mom) Sep 0.3% 0.2% 0.2% 9:15 US Capacity Utilization Sep 77.5% 77.5% 77.4%

22:00 China Real GDP (yoy) 3Q 9.3% 9.3% 9.5% – Peru GDP (yoy; nsa) Aug 7.30% n.a. 6.50%

Tuesday, 18 October 4:30 UK CPI (yoy) Sep 4.9% 4.9% 4.5% 4:30 UK Core CPI (yoy) Sep 3.1% 3.2% 3.1% 5:00 Germany ZEW survey - current situation Oct 35.0 44.0 43.6 5:00 Germany ZEW survey - econ. sentiment Oct -46.0 -45.0 -43.3 8:30 US Producer Price Index Sep 0.0% 0.2% 0.0% 8:30 US PPI Ex Food & Energy (mom) Sep 0.1% 0.1% 0.1%

Wednesday, 19 October 3:30 Thailand BoT rate decision – 3.50% 3.50% 3.50% 4:00 South Africa CPI (yoy) Sep 5.7% n.a. 5.3% 8:00 Norway Norges Bank rates decision Oct 2.25% 2.25% 2.25% 8:30 US Housing Starts Sep 585k 590k 571k 8:30 US Building Permits Sep 610k 610k 625k 8:30 US Consumer Price Index (mom) Sep 0.3% 0.3% 0.4% 8:30 US CPI Ex Food & Energy (mom) Sep 0.2% 0.2% 0.2%

– Brazil SELIC Target - Central Bank 19-Oct 11.50% 11.50% 12.00% Thursday, 20 October 4:00 Philippines BSP rate decision – 4.50% 4.50% 4.50% 4:00 Taiwan Export orders (yoy) Sep 6.0% n.a. 5.3% 7:00 Turkey CBT rates decision – 5.75% n.a. 5.75%

Friday, 21 October 4:00 Germany IFO survey - business climate Oct 107.0 106.6 107.5 4:00 Germany IFO survey - current assessment Oct 117.0 116.7 117.9 4:00 Germany IFO survey - expectations Oct 97.0 97.4 98.0 7:00 CA CPI (y/y) Sep 3.2% n.a. 3.1% 7:00 CA BoC core CPI (y/y) Sep 2.1% n.a. 1.9%

Source: Bloomberg, BofA Merrill Lynch Global Research

Cross Reference Global Economic Calendar, 13 October 2011

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United States We have met the enemy and he is us

Review: In August, trade deficit came in basically in line with our expectations. That left our 3Q GDP tracking estimate at roughly 2.5%.

Hot topic: We expect policy uncertainty to continue undercutting growth into 2012.

Preview: This focus will be on the consumer price report on Wednesday and Fed Chairman Ben Bernanke’s speech on Tuesday.

Nothing is certain, except uncertainty While it is very hard to quantify, a central part of our forecast is that policy uncertainty is undercutting growth. Economic “soft patches” both this summer and last summer seem to be associated with policy uncertainty. A year ago, companies seemed to pull back due to concerns about new regulations and the expiration of the Bush tax cuts; this summer, threats of either a government shutdown or default seemed to have a similar effect. Of course, other factors have been at play: the recovery was not very robust to begin with and the crises in Europe, the Middle East and Japan have also uncut growth.

More rigorous evidence is harder to come by, but we continue to follow work by Nicholas Bloom at Stanford. Bloom measures uncertainty by looking at stock market volatility and using Google searches of the words “uncertainty” and “economy.” He finds that these uncertainty proxies correlate with periods of economic weakness. Chart 4 highlights three periods – the latest recession and two periods of payroll weakness – along with the VIX measure of stock market volatility.

More recent work by Bloom and others digs a little deeper and attempts to measure the uncertainty created by government policy. Like us, they point to “deliberate policy decisions, harmful rhetorical attacks on business and ‘millionaires’, failure to tackle entitlement reforms and fiscal imbalances, and political brinkmanship.”3 Their measure captures three indicators of policy uncertainty: (1) the frequency of the newspaper articles that refer to economic uncertainty and the role of policy, (2) the number of Federal tax codes set to expire, and (3) the amount of disagreement among forecasters about future inflation and government spending.

Of course, there is a lot of subjectivity in choosing what to include in such an index. For example, the uncertainty created by the expiration of the Bush tax cuts is probably even worse than suggested by the number of specific tax provisions that expire. We would also question the way the authors measure monetary policy uncertainty. In both their news search approach and their year-ahead forecast disagreement approach, they assume that all of the inflation uncertainty comes from Fed policy. In reality, while Fed policy is very important to the long term prospect for inflation, near term inflation uncertainty has been caused mainly by swings in commodity prices.

3 Scott R. Baker, Nicholas Bloom and Steven J. Davis, “Policy Uncertainty is Choking Recovery,” Bloomberg View, October 6, 2011.

Ethan S. Harris +1 646 855 3755

Chart 4: Uncertainty is the enemy of growth

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Despite these caveats, this broad-brush approach to measuring uncertainty makes sense to us. In our view, uncertainty is a bi-partisan issue, and the process matters as much as the actual policies. Sudden policy shifts hurt growth whether it is the threat of higher taxes, new regulations, cutting off unemployment benefits or general uncertainty about whether the government will come to terms with its run-away deficit. Their measure confirms what we have feared: policy uncertainty is at the highest in the 26 years that they track (Chart 5).

Okay, so policy uncertainty is high; what does this mean for the economy? Bloom et al go on to link their policy uncertainty variable to general uncertainty and growth.4 They look at the frequency of news articles that mention the words “uncertain” and “economy” and then see how many of these also refer to “tax”, “spending” or “regulation.” They find that about that policy uncertainty not only explains more than half of overall uncertainty, but that proportion has increased notably in the last 10 years. For this July, the last month in their sample, policy uncertainty accounted for a record 80% of overall uncertainty.

Finally, they add their policy uncertainty variable to a simple statistical model of the economy. They find that the more than doubling of policy uncertainty this year should yield a peak loss in the level of GDP by almost 1½ percent 15 months later and a peak loss in jobs by about 2½ million at 18 months. Again, we would not take these results too literally, but they confirm that uncertainty shocks coming out of Washington are hurting the economy.

MacGyver or McGruber? With the election campaign underway we expect uncertainty to remain at high levels. We expect another debt downgrade in December when the deficit commission decides to fight rather than compromise. We think campaign rhetoric will focus on policy purity rather than practical compromise. We expect a big spike in uncertainty in front of the election itself. As we have noted before, with politicians digging in their heals, three “time bombs” will await post election—a major tax increase, a major cut in spending and the expiration of the debt ceiling.

All of these highly contentions decisions will have to be handled by a lame duck Congress. In the TV show “MacGyver,” the hero always managed to defuse the bomb in time. Will Congress dismantle all three bombs in time? In a sense it doesn’t matter, because the economy could suffer a heart attack while waiting.

We have met the enemy and he is us On the surface, the current policy debate is between a liberal and a conservative view of the future. Should regulations be tight or loose? Should systemically important financial institutions be allowed to fail without government support (e.g. Lehman) or subsidized (e.g. Bear Stearns)? Should the budget deficit be closed purely with spending cuts or with a significant revenue contribution? Should healthcare be mandated or left to the free market?

However important these issues are, the immediate concern is governance. Is the political system going to move quickly to the inevitable compromise, or will we suffer endless games of brinkmanship? According to the latest Gallup poll President Obama has a mediocre approval rating of 41%, while Democrats and Republicans in Congress are even worse—both have a record low approval rating of 13%. Despite these abysmal ratings, pundits argue, with a straight face, that they have a mandate to demand no compromise. 4 Scott R. Baker, Nicholas Bloom and Steven J. Davis, “Measuring Economic Policy Uncertainty,” manuscript, September 12, 2011.

Chart 5: Policy uncertainty index (index level)

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“Our problems are man-made—therefore they can be solved by man.” JFK The tragedy in all of this is that the looming US fiscal crisis is surmountable. The US is in a better position than many other developed economies: we have a growing working age population, our spending on military and medical is very high and our taxes are relatively low. What we don’t have is a sensible decision process. The current “policy” is to repeatedly threaten, but not deliver, serious fiscal consolidation. We have already had several threatened shutdowns, and one threatened default. Politicians are already talking about dismantling the defense portion of the “automatic” discretionary cuts in 2013 – of course we won’t know what will happen until the last minute. Threatening and then not delivering austerity hurts confidence and growth, adding to the budget deficit. This is the opposite of what we need: a gradual austerity plan that takes into account the fragile nature of the recovery.

Will the election bring better policy? Maybe. Unified government would help end the games of chicken. If one party captures all branches of government, they will have no one to blame for inaction. However, even unified government does not guarantee better policy. At one extreme liberal government could refuse to control entitlement spending, ensuring an eventual government funding crisis; at the other extreme a conservative government could decide to freeze the debt ceiling, causing an immediate 8% of GDP fiscal consolidation, and pushing the economy into a deep recession. No one wins if no one compromises.

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Canada Risk-on-ish

Review: The Canadian economy is still on track for 3.75% GDP growth in 2H after reports on trade and construction.

Hot topic: We think RRB breakevens could hit 2.5% on a slight moderation of risk aversion in the next couple of months.

Preview: Quarterly business survey and CPI are on tap next week.

Review: Data flow still surprisingly strong There were no changes to our economic forecasts in the past week. Building on the outsized September monthly employment report, which quadrupled consensus expectations, the data continue to on balance surprise to the high side. The August trade deficit narrowed more than we expected, driven by a rise in the terms of trade. Both export and import volumes contracted in August but a sizable upward revision to July exports keeps trade on track to add to 3Q GDP. We are tracking 3.2% and 4.3% QoQ annualized GDP growth for 3Q and 4Q respectively, vs consensus forecast of just over 2%. Construction reports were mixed with a sharp pullback in building permits after several outsized gains earlier in the summer and an unexpectedly robust housing starts print of 206k units in September.

Hot topic: Canada 30y breakevens to hit 2.50% Canada inflation breakevens (BE) bounced off nearby lows in the past week with 30-year breakevens now firmly above the 2% mark. In our view, BE’s have further room to rise over the next several months, with a near-term target of 2.40% to 2.50%. Our estimates indicate all of the 50bp narrowing in breakevens since the spike in risk aversion in July is attributable to a rise in the risk premium. Meanwhile, in the no-recession scenario we envisage, inflation pressures will continue be remain elevated in the economy amid capacity pressures and sluggish productivity growth.

BE drivers will be 2H resilience and lower risk aversion Both factors will contribute to breakeven widening with rising inflation expectations to emerge a driver by the end of the year as the Bank of Canada remains sidelined at negative real policy rates. Our longer-term target for breakevens is still over 3.00%, but we will need to see a more settled global macro and financial market environment to reinitiate that recommendation.

Capacity pressures unlikely to abate without recession Indeed, barring a recession or a protracted period of no growth, inflation pressures are unlikely to abate over the next several quarters. The BofAML output gap model suggests the Canadian entered overheating territory in mid-2011. Potential GDP growth has slumped since 2007, averaging just 1.0% per year since 2008. Potential GDP growth picked up somewhat in 2010 to about 2.3% and then slowed slightly in the first half of 2011. Assuming potential GDP growth maintains the same 2.3% pace in 2012, means actual GDP must slow to below that rate to reduce the output gap.

Other indicators of capacity pressure bear this out. In particular, unit labor costs continue to run at an above trend rate, posting a yearly gain of 2.8% in 2Q. This was the strongest result in two years, and almost double the average pace over the last 20 years.

Sheryl King +1 416 369 8756

Chart 6: No capacity let-up in sight (real GDP % of potential GDP)

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Achieving a sub 2% GDP trend is unlikely over the next several quarters with the US economy just muddling along rather than slipping into recession. Our US economics team believes this is the most likely outcome, barring significant deterioration in the sovereign debt crisis currently overshadowing Europe. So it is likely the Canadian economy will stay in excess demand through 2012.

Breakeven compression strongly correlated with risk aversion spikes As can be seen in Chart 7 of RRB breakevens and the VIX measure of equity volatility, periods of severe breakeven compression correspond well to spikes in market risk aversion. We constructed a simple model to quantify this impact. The breakeven between real and nominal bonds is driven by investors’ expected inflation over the maturity of the bond and the term, or liquidity premium. We took a two stage model approach, first estimating the impact of evolving inflation expectations and then extracting the term premium from that model.

Inflation expectations partially backward looking In the first model, we regressed 30-year breakevens against two measures of inflation expectations. The inputs are a combination of backward looking (realized core CPI) and forward looking (10-year-ahead inflation expectations – essentially a linear 2% trend.) plus a constant term. According to this model, the forward looking component is the main driver of inflation expectations. However, the backward looking component accounts for about 20% of the evolution of inflation expectations embedded in breakevens. This result is important to watch in the next several months as the Bank of Canada has indicated it will remain on hold over the near term even if core CPI moves above the BoC’s 2% inflation target.

VIX is good risk aversion proxy The second stage of the model estimated the impact of risk aversion on changing the term premium embedded in RRB breakevens. We calculated the normalized term premium, which is the residual between actual 30-year breakevens and the estimated model in the first stage. Then we estimated a second model of the normalized term premium against the VIX and a constant. We found that the contemporaneous value of the VIX and two lags had best results.

A lower, but still high, VIX corresponds to 2.50% breakeven As can be seen in Chart 8, the model captures well the sharp decline in the term premium in 2008 and the most recent few months of 2011. According to this model, if the VIX remains below 35 and drifts down to just 25 over the next couple of months, RRB breakevens will rise to around 2.40% to 2.50%. At this level, risk aversion would still be considered elevated and discounting a slow-growth and fairly high probability of a mild US recession in the next 12 months.

Preview: Business survey and CPI The main events next week will be the quarterly business surveys conducted by the Bank of Canada and the September inflation report. The business surveys are key inputs to the upcoming policy rate decision on 25 October. We expect the survey to show a pullback in the growth of expected future sales (the headline number) and hiring. The inflation expectations and capacity will also be important to watch as they were at elevated levels in the first half of the year. The September CPI report will be notable as we expect core CPI to move above the 2% BoC target for the first time since February 2010. Base effects suppressing core CPI have now dissipated and we expect the yearly rate to remain above 2% in the near term. The Bank has acknowledged this possibility, but it remains unclear how high of a target breech will be tolerated. Headline CPI will probably nudge up to 3.2% YoY in September from 3.1% in August.

Chart 7: VIX a good proxy for risk premium

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Past values of core CPI accounts for about 20% of the evolution of inflation expectations embedded in breakevens. This result is an important factor to watch in the next several months as the Bank of Canada has indicated it will remain on hold over the near term even if core CPI moves above the BoC’s 2% inflation target.

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Euro area A credit crunch? How likely? How large?

Review: August industrial production data were stronger than expected, posing some upside risk to our current Q3 GDP growth forecast. The IMF/ECB/EU concluded the fifth review on Greece, which will allow the next tranche of aid (€8bn) to be disbursed by the beginning of November.

Hot topic: We discuss the likelihood of a severe credit crunch in Europe triggered by a deterioration of the sovereign crisis. We conclude that the chances of a severe credit crunch in the Eurozone are small. While deleveraging is likely to continue for many years to come, it is unlikely that annual growth in credit to the private sector is going to fall as sharply as it did in 2008-09.

Preview: We expect confidence indicators to offer more evidence of deterioration in consumer and investors confidence in September.

Review: August IP stronger than expected August industrial production data for Germany, France, Italy and the Eurozone surprised on the upside. In the Eurozone, industrial production increased 1.2%mom in August (Mkt-0.8%mom) and was 5.3% higher than a year ago. Strong rises in output were widespread across industries, with consumer goods and durable goods the outperformers. In Germany, industrial production fell back (1% MoM), after a strong 4% rise in July. In France, output rose 0.5% MoM, notably above market expectations of a 0.7% decline. In Italy, output surged 4.3% MoM – the largest monthly gain in a decade, and well above expectations of a 0.2% rise.

Manufacturing output across many countries is very volatile on a short-term basis. And the PMIs and confidence indicators, for example, suggest some weakening ahead. Nevertheless, the industrial sector is holding up better than expected thus far. Average growth in output in July and August is stronger than the increase in Q2, posing some upside risk to our current Q3 GDP growth estimate of 0.1%qoq.

Turning to the sovereign crisis, the IMF/ECB/EU concluded its fifth review on Greece, which will allow the next tranche of aid (€8bn) to be disbursed by the beginning of November, subject to the formal approval of the IMF Executive Board and the EU. While this reduces near-term uncertainty, the Troika’s report contains clear warnings that Greece must significantly improve on implementation and structural reforms. More importantly, discussions over the size of the PSI continue as policymakers try to find ways to increase the implied haircut from about 20% up to 60%.

The Eurozone summit on 23 October could shed some light on where the European leaders stand on the PSI. In our view, the most likely solution is that participation in Greek debt restructuring will still be voluntary, with a haircut of 40-50%. We doubt that banks will voluntarily participate in a restructuring if the haircut becomes much more severe. Finally, after a negative first vote, the Slovakian government has reached a deal with the opposition: in exchange for earlier elections, to be held in March, parliament is expected to approve the new rules governing the EFSF on 14 October.

Laurence Boone +44 20 7995 6706 Silvia Ardagna +44 20 7996 1512 Industrial production: volatile measure, but still a pleasant surprise in August. Eurozone summit should shed light on leaders’ views on PSI.

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Hot topic: a credit crunch? Since the beginning of the summer, the Euro sovereign crisis has been exacerbated as concerns about the sustainability of government debt in Greece, Ireland and Portugal spilled over to Italy. This impaired the Euro area banks’ balance sheets and limited their access to wholesale funding. The banks’ funding difficulties have started to affect their ability to lend to households and firms. And, because of the banks’ predominant position in the Eurozone financial system, any impediment to the provision of credit has severe ramifications for real economic activity. The monetary policy actions taken by the European Central Bank on 6 October were aimed at easing bank funding pressure and alleviating the repercussions for credit supply from constraints on bank balance sheets. A recapitalization of the banking sector could also prevent sharp cuts in lending.

This week, we discuss the likelihood of a severe credit crunch in Europe triggered by a deterioration of the sovereign crisis. Specifically, we: (1) discuss the ways in which conditions in the financial sector could affect the economy in the short term; (2) provide some evidence of the funding pressures banks are facing and their effect on credit growth; (3) evaluate the effects of changes in credit supply on output in the Euro area; (4) discuss the potential of the liquidity operations announced by the ECB on 6 October and a recapitalization of the banking system to lower the risks of a credit crunch.

We conclude that the chances of a severe credit crunch in the Eurozone are small. While deleveraging is likely to continue for many years, it is unlikely that annual growth in credit to the private sector is going to fall as sharply as it did in 2008-09. Our banking analysts expect loan growth to decrease from 3.3% in 2011 to 2.6% in 2012, a decline of 20% or a 0.7ppt. Using estimates from two different ECB studies, we conclude that, ceteris paribus, the effect on GDP of such a small decline in credit growth is likely to be very limited. Our real GDP growth estimate of 0.8% for 2012 would decrease by only 0.03ppt to 0.77% or by 0.17ppt to 0.63%, depending on the survey.

There are risks to this baseline scenario. Should Greece default in a disorderly manner, it would probably lead to market panic similar to that which occurred after Lehman’s collapse. In that case, a much sharper decline in credit growth and a faster and more severe deleveraging of the banks would have dire consequences for real economic activity (see our report Euro zone outlook: risks aplenty).

Financial conditions and the business cycle – the theory There are several ways in which financial and credit conditions may affect the economy in both the short and long term. Focusing on the short term, economic research has identified two main ways: (1) the financial accelerator mechanism; (2) the credit channel.

The financial accelerator mechanism According to the financial accelerator model, short-lived economic shocks may have long-lasting and significant effects on the business cycle. This is because in response to a negative shock, the creditworthiness of borrowers deteriorates and borrowing becomes more and more expensive. Raising funds from lenders (external finance) is generally more expensive than using internally generated cash flows to finance investment projects (internal finance). This stems from the cost for lenders of evaluating borrowers' prospects and monitoring their actions in a world in which information is imperfect and asymmetric. Also, the external finance premium that a borrower pays depends inversely on the strength of the financial position, measured in terms of factors such as net worth, liquidity, and current and future expected cash flows. As a result, borrowers in weak financial condition generally pay a higher premium for external finance and are less able to get funding for investment projects.

Our view: small chances of a severe credit crunch next year. Deleveraging likely to continue for many years to come. Our banking analysts expect loan growth to decrease from 3.3% in 2011 to 2.6% in 2012, a decline of 20% or a 0.7ppt. This translates into a decrease in our real GDP growth estimate for 2012 of 0.03ppt-0.17ppt, from our baseline forecast of 0.8% to 0.77%-0.63%.

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The credit channel This theory suggests that monetary policy influences real variables more than the traditional cost-of-capital channel, according to which monetary policy affects borrowing, investment, and spending decisions solely through its effect on market interest rates. In particular, the credit channel theory identifies a bank lending and a balance sheet channel. The bank lending channel suggests that monetary policy works by affecting the supply of loans offered by depository institutions. Monetary policy tightening, for example, raises the opportunity costs of holding deposits and leads to a reduction in the banks’ loan portfolio because banks’ funding sources fall. The balance sheet channel suggests that changes in interest rates implemented by the central bank affect the value of the assets and cash flows of potential borrowers and thus their creditworthiness. This, in turn, affects the external finance premium that borrowers face. According to this view, a tightening of monetary policy reduces the net worth and liquidity of borrowers and increases the effective cost of credit by more than the change in risk-free rates.

Implications for the Eurozone Going back to the Eurozone, first, a slowdown in growth triggered by a fall in business and consumer confidence related to the sovereign crisis could have severe consequences via the financial accelerator channel. Second, impairments to Euro area banks’ balance sheets and a decline in their creditworthiness can hinder their ability to lend, as predicted by the bank-lending channel (ie, via a reduction in funding sources). Third, the 50bp increase in the interest rate that the European Central Bank implemented in spring 2011 might have damaged borrowers’ creditworthiness and amplified the effect on economic activity as predicted by the credit channel. However, a reduction in the interest rate (we expect the ECB to reverse its 50bp hike in its key policy rate in the months ahead) would help more than via the standard traditional channel. This is because it would increase the net worth and liquidity of borrowers and decrease the effective cost of credit by more than the change in risk-free rates. A recapitalization of the banking system would also help along the same lines.

The empirical evidence The major economic downturn experienced in the Euro area between 2008 and 2009, and the subsequent recovery, coincided with strong movements in the growth rate of credit to the private sector. In particular, the annual growth rate of MFI loans to the private sector declined, in nominal terms, from above 11% to slightly negative values in late 2009 and early 2010, before moving into positive territory thereafter and stabilizing around an average of 2.5% YoY since Q1 2011. So far, lending data do not support any deterioration of this picture. In August 2011, growth in loans to various sectors of the economy remained stable or improved relative to the month of July. The annual growth rate of total credit granted to Euro area residents stood at 2.5% in August 2011, unchanged from the previous month, and the annual growth rate of loans increased to 2.6% from 2.4% in July.

Loans to Euro area households and to non-financial corporations, which, on average, have accounted for about 90% of the total growth in loans to the private sector since 1998, showed a somewhat different pattern. Growth in lending to non-financial corporations started to decline gradually in 2008 and continued to do so throughout the first half of 2010. This prolonged weakness can be partly attributed to companies using internal or market-based funding in order to reduce their indebtedness and dependence on banks. This was because bank loans were more difficult to access and also relatively more expensive.

Chart 9: Eurozone MFI loans to the private sector (% YoY)

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Source: European Central Bank and BofA Merrill Lynch Global Research

Chart 10: Breakdown of Eurozone MFI loans to the private sector

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Note: the chart shows the percentage point contribution from loans to households, non-financial corporations, other financial institutions and insurance corporations and pension funds to total credit growth to the private sector. Source: European Central Bank and BofA Merrill Lynch Global Research

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Between H1 2009 and H1 2010 a relatively high level of bank loans were replaced by the issuance of debt securities and quoted shares. Since Jan 2011 credit growth to non-financial corporations has turned positive and, in August 2011, the annual growth rate of loans to non-financial corporations stood at 1.6% as in July 2011.

Growth in mortgage lending recovered significantly after a steep decline between 2007 and mid-2009. By contrast, consumer credit growth, which experienced a similarly steep fall over the same period, remained in negative territory for a longer period of time. We believe this disparity is attributable to two things. On the one hand, we have seen weak growth in disposable income, low levels of consumer confidence and high levels of uncertainty. On the other hand, in periods of perceived macroeconomic risks, banks prefer to grant loans for house purchases, which are collateralized and can more easily be used to back covered bonds. In August 2011, the annual growth rates of loans to households and mortgage lending stood at 3.0% and 3.9%, respectively, both unchanged from the previous month.

The credit outlook in the Eurozone has significantly improved since the trough of the crisis, but there is considerable cross-country heterogeneity. In August 2011, the annual growth rate of loans to households and non-financial corporations was very low or negative in Ireland (-8% and -20%), Portugal (0.1%, -1.3%) and Greece (-1.6%, -6.5%), while it was above the Eurozone average in Italy (.7%, 5%) and France (7.4%, 4.3%). In Germany, it stood at 0.7%, and 0.2%.

Banks under funding pressure Since the summer, banks have experienced difficulties in raising funds for the medium and long term. In September, long-term debt issuance for banks covered by our banking team was €37bn, a significant improvement on the €19bn in August, but about 40-45% below its long-term average. In Q3, banks raised only €83bn of long-term debt and, at the end of September long-term debt issuance was down 9% compared with the same period last year. Covered bond issuance picked up in September, corresponding to about 46% of the total issuance, against 20-25% in more ‘normal’ times. Our team estimates that banks are in a good position regarding their 2011 long-term funding needs, having already issued about 83% of 2011 maturities. However, that might not be the case in 2012, when the BofAML coverage universe has roughly €575bn of expiring long-term debt. Also, our team expects covered bond issuance to continue at a healthy pace but unsecured issuance to remain subdued in the near term.

Credit supply The October 2011 ECB banks lending survey (BLS) conducted between 5 and 27 September indicated a deterioration in banks' funding conditions too. In particularly, Euro area banks signaled a substantial worsening in access to the money markets, securitization, and debt securities issuance in Q3 2011. Banks expect access to wholesale funding to deteriorate further in Q4, although at a slower pace. This has already led to a tightening in credit standards. More banks in the October survey reported that they had tightened lending standards than in the June survey. And the situation is expected to persist in Q4. The net tightening of credit standards by Euro area banks picked up significantly, both for loans to non-financial corporations (16% in Q3 compared with 2% in Q2) and for mortgage loans to households (18% in Q3 versus 9% in Q2). The degree of net tightening of credit standards in consumer credit also increased to 10% from 7% in the previous quarter. The banks expect an increase in net tightening of credit standards in loans to NFC and house purchases in Q4 2011 compared with Q3.

Chart 11: Credit standards banks apply to loans to non financial corporations (net %)

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Note: the chart shows the response to unweighted net percentage balance of the responses to the following questions (1) over the past three months, how have your bank’s credit standards as applied to the approval of loans or credit lines to enterprises changed? (2) Indicate how you expect your bank’s credit standards as applied to the approval of loans or credit lines to enterprises to change over the next three months. There are 5 possible responses to each question, for example: tightened considerably, tightened somewhat, remained basically unchanged, eased somewhat or eased considerably. The net percentage balance is calculated as the difference between the sum of the sum of the percentage of responses for tightened considerably and tightened somewhat minus the sum of the percentage of responses for eased considerably and eased somewhat. Source: ECB Banks’ lending survey and BofA Merrill Lynch Global Research

See the report Wholesale funding monitor – September 2011

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If we go back to 2008, the net tightening of credit standards as a result of balance sheet constraints was at its highest since the first BLS (early 2003, with information starting at the end of 2002) for both non-financial corporations and households. This indicated that “pure” supply-side constraints may have accounted for a significant proportion of the slowdown observed in bank lending activity. The survey data also indicate that, in relative terms, the factors that are summarized in the ’perceptions of risk’ group have clearly played a larger role. There seems to be a return to this pattern now.

Credit demand In October, Euro area banks reported a net decline in loan demand from non-financial corporations for the first time in more than a year (-8% compared with 4% in Q2). Data also indicated a net drop in demand for loans from households (-24% in mortgage loans compared with -3% in Q2, and -15% in consumer credit after -8% in Q2), driven mainly by weakening prospects in the housing market and falling consumer confidence.

Euro area banks continue to expect a negative development of net demand for loans’ demand in Q4 2011. Compared with Q3 2011, the net demand for loans to non-financial corporations is expected to worsen in the final quarter of the year, to -19%. The change in households’ net demand for loans in Q4 is likely to be broadly similar to Q3 (-22% for mortgage loans and -11% for consumer credit).

This evidence suggests that a significant contraction of loan demand from the corporate and households sectors occurred over the summer and that this is likely to continue in the months ahead, particularly if uncertainty over the Euro area sovereign crisis persists.

The predominant role of banks While the size of capital markets relative to the private sector is not that much smaller in the Euro zone than in the US (311% of GDP versus 375% of GDP in 2007), the Euro area has traditionally had a largely bank-based financial system. Loans to the private sector that remain on banks’ balance sheets amounted to 145% of GDP in 2007. By contrast, in the United States bank lending (with loans being originated and held by banks) to the private sector is much less important, amounting to 63% of GDP in 2007. Capitalizations in the Euro area stock market (quoted shares issued) and corporate bond market (debt securities issued by the private sector) have increased in the past decade and stood at 85% and 81% of GDP respectively in 2007. But these markets are still considerably smaller than those in the United States, where the market capitalizations amounted to 144% and 168% of GDP respectively in 2007.5

The dominant role of banks in financing and the smaller scale of securitization activities in the Euro area limit the scope for re-intermediation and the possible substitution of bank lending with non-bank and market-based funding. Hence, non-financial corporations in the Euro area could be more susceptible to changes in financial conditions. Also, Euro area SMEs are more likely to be affected than their US counterparts by cuts in bank lending as alternative sources of funding such as private equity or venture capital are more readily available in the US, even for smaller enterprises. On the other hand, lower household debt levels and higher saving ratios should make Euro area households less dependent on external financing to sustain consumption and less sensitive to variations in asset values.

5 Data are from the European Central Bank Monthly Bulletin, April 2009, page 70.

Chart 12: Reasons behind the credit tightening

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Note: the chart shows the response to unweighted net percentage balance of the responses to the questions asking the reason for changes in credit standards. Source: ECB Banks’ lending survey and BofA Merrill Lynch Global Research

Chart 13: Loans’ demand

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Note: the chart shows the response to unweighted net percentage balance of the responses to the following question (1) over the past three months, how has the demand for loans o credit lines to enterprises changed at your banks, apart from normal seasonal fluctuations? There are 5 possible responses to each question, for example: tightened considerably, tightened somewhat, remained basically unchanged, eased somewhat or eased considerably. The net percentage balance is calculated as the difference between the sum of the sum of the percentage of responses for tightened considerably and tightened somewhat minus the sum of the percentage of responses for eased considerably and eased somewhat. Source: ECB Banks’ lending survey and BofA Merrill Lynch Global Research

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From credit growth to the real economy The impact of a decline in credit growth on GDP growth depends on: (1) the tightness of the relationship between these two variables; (2) the size of the decline in credit to the private sector; (3) the extent to which monetary policy eases banks’ funding pressures; and (4) the effect of a future recapitalization of the Euro area banks on their creditworthiness. In its January 2011 bulletin, the European Central Bank attempted to quantify the impact of loan supply shocks on real economic activity using three different models. The bottom line of the analysis is that during the initial phases of the financial crisis, loan supply shocks had only a minor impact on economic activity. But by the fourth quarter of 2008, the effect of loan supply shocks had amplified. Overall, they accounted for about one-third of the downward deviation of real GDP growth from the trend between Q3 2008 and Q1 2010. In H1 2009, when the negative effect from the credit tightening on real GDP was at its strongest, loan supply shocks accounted for almost 2ppt of the decline in real GDP growth. At the same time, other shocks contributed markedly to the fall in real GDP growth observed in 2008 and 2009.

The growth rate of loans to non-financial corporations declined from 14.3% in 2007 to 10% in 2008, -2.8% in 2009 and -0.5% in 2010. In H1 2009 credit growth decelerated from 10% YoY in Q4 2008 to 2.8% YoY in Q2 2009, implying a decline of about 7ppt. If we assume that the decline in credit growth to non-financial corporations was due entirely to loan supply shocks and use the estimates above (in H1 2009 loan supply shocks accounted for almost 2ppt of the decline in real GDP growth), we conclude that a 1ppt decline in credit growth accounts for a 0.28ppt decline in real GDP growth.

The ECB paper by Cappiello et al produced another set of estimates. They show that if banks’ deleveraging in a particular country leads to a 5% decrease in credit growth to below the Euro area average, the country would experience a real output growth reduction below its average growth of 0.4%.

We can use the estimates from these studies to gauge the impact of banks’ deleveraging on the real economy. Our banking analysts estimate that credit growth will decline from 3.3% in 2011 to 2.6% in 2012, a drop of 20% or 0.7ppt. If try to assess the impact on real GDP growth using the estimates of the two ECB studies, we conclude that, ceteris paribus, the effect on GDP growth of such a small decline in credit growth is likely to be very limited. In fact, using the estimates of the ECB study by Cappiello, real GDP growth would decrease from our estimate of 0.8% in 2012 to 0.77% in 2012, a decline of 1.6% or 0.03ppt. Using the estimates from the ECB January 2011 bulletin, the effect would be a bit larger, implying a 0.17ppt decline in real GDP growth from 0.8% in 2011 to 0.63% in 2012.

The effect of credit growth on the real economy ECB working paper 1150, Cappiello et al. January 2010 A 5% decrease in credit in credit growth below the Euro area average leads to a real output growth reduction below the corresponding average of 0.4% on impact 1.6% in the long-run A 30% tightening in credit standards leads to a real output growth reduction below the corresponding average of 0.066% on impact ECB Monthly Bulletin, January 2010 Loan supply shocks accounted for about one-third of the downward deviation of real GDP growth from the trend between Q3 2008 and Q1 2010 Loan supply shocks accounted for almost 2ppt of the decline in real GDP growth In H1 2009 Source: European Central Bank

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The effect of unconventional monetary policy measures Research by Lenza, Pill and Reichlin quantifies the impact of the non-standard measures the ECB implemented between November 2008 and August 2009 on monetary (M1, M3, loans) and macro variables (inflation, unemployment and industrial production).

In normal times, the spread between the EONIA and the ECB’s key policy rate at its main refinancing operation is small and positive. However, after the ECB switched to fixed rate full allotment procedures, the EONIA declined and the MRO/EONIA spread turned negative, falling to approximately 65bp. Moreover, the introduction of non-standard measures by the ECB also appears to have reduced the spread between the EURIBOR and OIS rates in the money market and may also (other things equal) have led to some flattening of the money market yield curve.

When assessing the impact of these non-standard measures on monetary and macro variables, Lenza et al assume that the difference between the observed path of money market rates and their value in October 2008 reflected non-standard monetary policy measures and compared two counterfactual scenarios: (1) a no policy scenario in which they assume that the spreads between money market rates and the policy rate have not changed since October 2008 and the slope of the yield curve has not been affected by non-standard policy measures; (2) a policy scenario in which they forecast all variables of interest conditional exclusively on the true path of money market rates observed between November 2008 and August 2009.

They conclude that the effect of non-standard measures on consumer loans and mortgage loans is large and positive, while the impact on loans to non-financial corporations is smaller and becomes positive only after a delay. Specifically, at its peak, the growth rate in loans to households would have been 1.5ppt lower than the observed value in the absence of non-standard policy measures. The annual growth rate of loans to non-financial corporations would have been 0.4ppt lower in the absence of non-standard measures.

Looking at the monetary aggregates, they find that the effect is large and positive on M1, but negligible on M3. This supports the view that the non-standard measures affected the macroeconomy via their impact on interest rates and spread, rather than via quantity effects through the evolution of broad money.

The results regarding real activity (industrial production and unemployment) show a positive effect of non-standard measures only after a delay of several months. While the impact of the introduction of such measures is negative, the relationship shows the expected positive signs after a few months. At the peak of the effect, the annual growth rate in industrial production was about 3ppt higher and unemployment was 0.2ppt lower thanks to the introduction of the non-standard measures. Finally, inflation is affected positively with a lag but the size of the effect was small, indicting that the non-standard policy measures were not inflationary.

The historical experience Finally, some evidence from previous financial crises also points in the direction of further deleveraging but with contained risks of a sharp credit crunch. The McKinsey Global Institute published a report in January 2010 revisiting the aftermath of financial crises. The report analyses 32 episodes of deleveraging that have occurred since the Great Depression.

Chart 14: Eonia and ECB key interest rates

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Table 1: Peak effect of ECB non-standard measures Growth rate in loans to households +1.5ppt Growth rate of loans to non-financial corporations +0.4ppt Growth rate in industrial production +3ppt Unemployment -0.2ppt Source: Lenza, Pill, Reichlin, Monetary policy in exceptional times, ECB working paper 1253, October 2010

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Deleveraging fits into four categories: (1) austerity or belt-tightening, (2) massive defaults, (3) high inflation, and (4) growing out of debt through very rapid real GDP growth caused by a war effort, a pace dividend following a war or an oil boom. In 16 out of 32 cases deleveraging occurred via belt-tightening, in eight it resulted from high inflation, in seven massive defaults occurred and only one country managed to grow out of its debt.

In the belt-tightening cases, which we consider to be the mostly likely outcome for the Euro zone, deleveraging began two years after the start of the crisis and lasted for about six to seven years. GDP contracted for the first two to three years and then start growing again, although at a very slow rate, while the deleveraging was still going on. This evidence is very similar to studies by Rogoff and Reinhart, who highlight how the recovery from a financial crisis is slow and more painful than the recovery from a normal recession. However, as Rogoff discusses in his article, the Great Contraction, given the current conjuncture, a slow timid growth outlook is more likely than a sharp double-dip scenario.

Preview: confidence indicators in focus We expect confidence indicators to offer more evidence of deterioration in consumer and investors confidence in September. We expect the Eurozone consumer confidence index to decline from -19 in September to -21 in October. We also expect further deterioration in the ZEW indices – both that measuring the current economic situation and that capturing investors’ expectations over the next six months.

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United Kingdom Credit easing for smaller companies

Review: The labor market has deteriorated sharply in recent months.

Hot Topic: Lending to credit-constrained small and medium-sized companies could be a relatively inexpensive fiscal stimulus measure. But the benefits may not be dramatic either.

Preview: We expect CPI to have picked up to 4.9% in September, and the MPC’s decision to expand QE in October to have been unanimous.

Review: Labour market deteriorates sharply The labor market deteriorated notably in the three months to August, continuing the trend since the start of the year. The unemployment rate picked up from 7.9% to 8.1%, having previously remained within a very tight range of 7.7% to 8.0% since spring 2009. Moreover, driving that increase, there were significant declines in employment, and significant increases in unemployment (Chart 15). While the rapid cuts in public sector jobs in recent months should slow, very soft GDP growth since late 2010 and muted near-term prospects suggest that there is further deterioration in the labor market to come.

Hot topic: Credit easing for smaller companies Small and medium-sized enterprises (SMEs) account for around 60% of UK private sector employment and around 50% of private sector turnover. They are perceived to have been particularly hard-hit by the tightening in credit conditions since the onset of the financial crisis, so the Chancellor has announced he is exploring policy options to try to help the supply of credit to SMEs. Because SME-specific data are relatively scarce, it may be useful trying to assess the potential broad-brush magnitude of any potential support measures.

Corporate lending now contracting notably The net flow of bank lending to the corporate sector as a whole (not just SMEs) has fallen back from peaks of around +£70bn in 2007 to around -£10bn more recently (Chart 16). However, to a significant extent that is likely to reflect weaker demand for bank lending, rather than being wholly driven by tighter credit conditions. For example, below-average rates of capacity utilization and relatively weak demand prospects are reported to have contributed significantly to the weakness of firms’ investment plans1. At the same time, with firms running large surpluses, the availability of internal finance (retained profits) may have been relatively strong (Chart 17, next page). And as a result of banks tightening credit conditions, the option of tapping other forms of financing if required – such as equity and bond markets – may also have become more attractive.

But what about SMEs specifically? Evidence from the Bank of England2 suggests that large companies account for around two-thirds of total UK business investment. But statistics on borrowing by firm size are relatively scarce. In aggregate, the stock of bank lending to the non-bank corporate sector has fallen back from peaks of around £500bn in mid 2008 to around £440bn most recently. And the BBA reports that firms with an annual turnover of £1m or less have outstanding bank debts of about £40bn. If we scale that up proportionately on the basis of firms’ annual turnover (a simplifying assumption, Table 2), that could suggest the stock of bank lending to all SMEs is roughly £100bn. So, if the reduction in bank lending to the corporate sector in recent years has been uniform across company sizes, net bank lending to SMEs might have fallen back by around £20bn per annum compared to its peaks in 2007: roughly 25% of the fall in bank lending to the corporate sector as a whole.

Nick Bate +44 20 7995 4262

Chart 15: Labour market changes (‘000)

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Chart 16: Net bank lending to the corporate sector (rolling 12m sum, £bn)

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Source: Bank of England, BofA Merrill Lynch Global Research.

Table 2: Corporate statistics, by # of employees Employees 0-9 10-49 50-249 250 or more # Firms 4,300,000 170,000 27,800 5,900 Employment 7.2m 3.4m 2.7m 9.2m Turnover 643bn 482bn 436bn 1650bn Source: Department for Business Innovation and Skills, BofA Merrill Lynch Global Research

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There are risks in both directions to those very broad-brush estimates. To the extent that some of the reduction in bank lending from its peaks in 2007 is due to weaker demand, then the above will over-estimate the tightening in credit supply conditions to SMEs. But set against that, credit conditions for SMEs might have tightened somewhat more than for larger companies in recent years. Overall, evidence from the Bank of England’s Credit Conditions survey tends to suggest that SMEs have been more credit-constrained than large companies over the last few quarters. Notwithstanding the considerable volatility from quarter to quarter, on average since the start of 2010 demand for bank lending by SMEs has been a little higher than for large companies – potentially consistent with SMEs being more reliant on bank funding than large companies as they have less access to debt or equity markets. At the same time, some credit supply conditions for small companies – for example spreads on loans (Chart 18), collateral requirements, credit lines, and fees on loans - have reportedly been somewhat tighter than for medium-sized and larger companies.

Credit was arguably too loose prior the financial crisis Credit conditions prior to the financial crisis are widely judged to have been too loose. That weighs weighing against aiming to restore net lending to its 2007 peaks. Thus, alongside SMEs’ demand for loans having fallen back notably from their pre-crisis peaks, overall, the potential supply of lending to SMEs that the government might want to restore might only be around £10bn a year – potentially less than that. At 0.7% of GDP, that would not be a significant burden on the public finances. And note that if the government issues new debt to finance such loans, it would also be acquiring an asset at the same time. That is different than normal government debt, which is not secured against an asset. Moreover, it has also been suggested that the government could package up SME loans and sell them on to other investors, rather than retaining them.

But while the costs of increasing lending to SMEs may be relatively small, the benefits could be relatively small too. For example, the level of real GDP is now around 11% (roughly £175bn) below a continuation of its pre-crisis trend. In that context, increasing SME lending by around £10bn a year may have only relatively modest effects on economic activity. Nevertheless, with the growth outlook having deteriorated over the last few months, and taken in conjunction with the additional £75bn of QE announced by the BoE last week, it may offer at least some stimulus.

Preview: CPI inflation to climb higher, MPC unanimous? We expect CPI inflation to have picked up from 4.4% in August to 4.9% in September, attributable to double-digit gas and electricity price rises by some of the major UK energy suppliers. The BRC survey reported that food price inflation was steady, while we expect core CPI inflation to have been flat too. Comments from a number of MPC members in recent days have taken a notably more downbeat of growth prospects compared to before the £75bn expansion of QE in October. In our view, such vocal support for the further expansion of QE could suggest that the vote at the October MPC vote was unanimous – showing unity with the Committee at the time of such a significant decision. 1 See November 2007 Inflation Report. 2 See BoE’s Agents summary of business conditions, November 2010.

Chart 17: Net corporate financing (£bn)

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Japan Reduction in trade surplus due to yen strength

Review: Prime Minister Yoshihiko Noda met with BoJ Governor Masaaki Shirakawa on the 11th and probably discussed the strong yen's negative impact on the economy. Economic data sent mixed signals.

Hot topic: We estimate that the 5-10% appreciation of the yen in real term since September could knock the equivalent of an additional 0.3–0.5% of GDP (¥2-3trn) off the balance of trade through next year.

Preview: September retail sales data (the 18th and 20th), the Cabinet Office's monthly economic report for October (the 17th) and the August Index of All Industries Activity (the 19th) are due for release.

Review: Yen, flooding in Thailand, mixed economic data The yen has weakened slightly to rates above ¥77/US$ and ¥106/€, but its effective rate (indexed to 100 as of 4 January 1999) is still over 130. Prime Minister Yoshihiko Noda met with BoJ Governor Masaaki Shirakawa at the former's office on the 11th, as part of regular quarterly meetings between the two top officials. After the meeting, Governor Shirakawa told the press corps that the prime minister asked for monetary policy support for the economy, suggesting the two probably discussed the strong yen's negative impact on the economy.

Impact of the flooding in Thailand to require some caution A new uncertainty that has developed is the impact of the flooding in Thailand on the supply chain, as a result of a suspension of production by Japanese companies in Thailand. We would be cautious on the extent of the effects on production, although they are likely to be issues for the short term (1-3 months).

Machinery orders: Contrast between domestic and overseas demand August machinery orders (core, excluding orders for ships and from electrical power companies) rose 11.0% MoM, better than the market's expectation (of 3.9% growth). Overseas demand, which is not included in the core order data, also rose 32.3% MoM but the Cabinet Office noted that thermal- and hydro-power boilers and power units had a major impact on the August data and if adjusted for this one-off special factor, machinery orders from overseas were soft.

Noteworthy changes in trade and balance of payments data Trade data for the first 20 days of September show exports rose 1.0% YoY and imports increased 12.7%. The export data show that the impact on international trade from the European crisis was limited at least up to recently.

A noteworthy aspect of the balance of payments data for August was the large amount of investments in Japan, ¥6.1tn, through short-term bonds (money market instruments). The data suggest that flows of foreign currency reserves into Japan, mainly from emerging countries, were a major factor behind the yen's strength.

Sentiment indicators mixed The consumer confidence index for September improved 1.6pt from the previous month, mainly because perceptions of employment improved. But in the Economy Watchers Survey, which is targeted at business managers, the DI for current economic conditions came in at 45.3, down 2pt from August, suggesting that they have started to recognize the risks of the strong yen starting to hurt the overall economy.

Masayuki Kichikawa +81 3 6225 8214

Chart 19: Capital inflows into Japan through S-T bonds investments

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Hot topic: Reduction in trade surplus due to yen strength The ongoing climb in the yen associated with Europe's financial crisis has started to develop into the biggest risk factor for the Japanese economy in 2012. Chart 20 shows the relationship between the real effective exchange rate (REER) and Japan's non-oil balance of trade (balance of trade less mineral fuels). This suggests that changes in the REER are likely to have an impact on the balance of trade after a time-lag of 1–2 years.

A 1 point rise in the effective exchange rate pushes down the balance of trade by 0.04% of GDP, taking all sample periods (Jan–Mar 1990 through Apr–Jun 2011) in our estimated model explaining the impact of the REER a year earlier on the balance of trade. Dividing up our test sample periods into the 1990s (Jan–Mar 1990 through Oct–Dec 1999) and thereafter reveals that the impact of a 1 point rise in the REER index of the yen has had a greater affect since 2000 (0.05%) than in the 1990s (0.02%). We can infer that the impact the effective exchange rate on the balance of trade has been rising in recent years (Chart 21).

Turning to the impact that the so-called globalization of trade has had on the relationship between exchange rates and the balance of trade, the effects are said to be contradictory, with the impact of forex (1) strengthening when competitive trade within industries – as opposed to between- increases, but (2) weakening when vertical trade such as through the supply chain grows. In Japan's case, however, the former appears to be outweighing the latter.

As shown in the graph (again, Chart 20), the REER bottomed in July 2007 and rose 28% by mid 2010, after which the rate of appreciation has significantly slowed through August 2011 (the most recent data disclosed by BoJ) thanks to the government's yen intervention and BoJ's comprehensive monetary easing package. However, the yen has recently been climbing not only against the US dollar but also against the euro and emerging markets' currencies. The BoJ has yet to release September and October data, but we estimate that the yen climbed a further 5–10% in real term. Bearing in mind that a 1 point rise in the effective exchange rate has led to a reduction of around 0.05% of GDP in the balance of trade since 2000, we estimate that this could knock the equivalent of an additional 0.3–0.5% of GDP (¥2-3trn) off the balance of trade through next year, assuming yen strength since September becomes established.

This indicates that the question of whether or not exchange rates can stabilized will have a significant impact on Japanese economic growth in 2012. Bearing in mind that there are limits to effects of intervention without cooperation from Europe and the US, efforts by BoJ to ease monetary policy are becoming increasingly important, in our view.

Preview: Overseas factors, retail sales, tax negotiations Policy responses to the European debt crisis and other overseas factors are likely to drive financial markets in Japan. Among domestic factors, September retail sales data (department store sales on the 18th and convenience store sales on the 20th) should provide indications of household spending trends. Other noteworthy data releases include the Cabinet Office's monthly economic report for October (the 17th) and the August Index of All Industries Activity (the 19th).

On the political front, the government and the ruling party plan to submit a third supplementary budget in October. One noteworthy issue is likely to be progress on negotiations between the ruling and opposition parties regarding a reconstruction tax increase.

Chart 20: Non-oil trade balance (% of nominal GDP) and the REER of JPY

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Chart 21: Impact of 1pt rise in the REER index on non-oil trade balance (ppt of nominal GDP)

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Emerging Asia Indebted households

Review: Bank Indonesia unexpectedly cut the policy rate by 25bp to 6.50%, against consensus and our view for a hold. Bank of Korea kept its key interest rate on hold. Malaysia’s IP expanded a modest 3% in August, recovering from the 0.5% contraction in July. China’s export growth decelerated to 17.1% YoY from 24.5% YoY.

Hot topic: Following up on our first review of overall leverage in Korea, we take a more detailed look at household leverage. Contrary to the concerns voiced in many quarters, we find that household debt is currently at a manageable level, and that the challenge lies in its future course.

Preview: Attention next week will be on policy rate decisions by the central banks of Thailand and Philippines. Both BoT and BSP will likely keep their policy rates on hold. We expect China 3Q GDP to come in at 9.3% YoY; China IP and FAI will likely decelerate moderately. Singapore’s non-oil domestic exports would probably slow down further. Also watch for Taiwan export orders and Hong Kong CPI.

Following up on our first review of overall leverage in Korea, we take a more detailed look at household leverage. Contrary to the concerns voiced in many quarters, we find that household debt is currently at a manageable level, and that the challenge lies in its future course. Slowing the recent rapid growth in the ratio of household debt to GDP is crucial in preventing renewed vulnerability.

Our first look at Korean leverage Given the role of excessive leverage in the current crisis, it is no surprise that much attention is being paid to the leverage of different sectors in Korea. In particular, concerns have been raised regarding household liabilities, which have been on the high side relative to the OECD average at 80-85% vis-à-vis 77%, both calculated as the liabilities of households in terms of GDP.

Since late 2010, household liabilities have been about 85% of GDP, which is high not only relative to the OECD average, but also to the growth threshold estimated in a recent BIS study6. As discussed in our first look at Korea’s leverage issues, this study estimates the thresholds beyond which debt levels begin to have an adverse effect on economic growth. It provides useful objective information about the level at which leverage should become a cause for worry.

A certain level of leverage is desirable, as it helps channel savings toward the best possible use. So it is likely that there is a form of non-linearity in the benefit and cost of leverage. Increasing leverage has economic benefits up to a point. Beyond a certain threshold, leverage begins to result in rising fragility, often associated with a bubble, which leads to a highly costly collapse.

The estimated thresholds for each sector were: 85% of GDP for both government and household debt and 90% for corporate debt. Leverage for different sectors in Korea was on the benign side of the threshold, but household leverage turned out to be closest to the threshold (of 85%).

6 “The real effects of debt,” Stephen G. Cecchetti, M S Mohanty and Fabrizio Zampolli, BIS manuscript 2011.

Jaewoo Lee +82 2 3707 0465 Marcella Chow +852 2161 7236

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Measuring household leverage not so simple However, this reading overlooks one subtle but important difficulty with measurement. The flows of funds data (in Korea) do not necessarily measure the household debt per se, but rather the liabilities of individuals (which include non-profit and small enterprises). And the disparity is not small: the flow of funds measure is at about the 85% threshold, while the “credit to household” measure is well below it (Chart 22).

The Bank of Korea recently improved the measurement, and so far has published the new measure of household debt from 4Q09 through 2Q11. This is close to the old measure of credit to household, and much smaller than the liabilities of individuals reported in the flow of funds. We produced an updated chart of household debt proper, combining the old and the newly released data where available (Chart 23). Correctly measured not a macroeconomic concern … yet The properly measured household debt is less than 70% of GDP, which we believe is manageable and does not pose a significant problem in aggregate terms. Rather, the recent growth rate and those households with relatively high debt burdens are the areas of concern and vulnerability.

In recent years, household debt has risen rapidly. Between 2006 and 2011, debt increased by nearly 9ppt of GDP (Chart 24, next page). The majority of that growth has been due to non-bank financial institutions, with banks accounting for about a quarter.

The debt burdens of low-income households are highly sensitive to an increase in interest rates, according to a joint study by the National Statistical Office, the Financial Services Commission and the Bank of Korea. A 1ppt rise in the interest rate was estimated to increase the debt service burden of households in the lowest-income quintile by 3.2% of their average income, while the impact on the general population was an increase of 0.4% of their income.

Concerns on aggregate vulnerability relate primarily to the speed of increase. If household debt keeps rising at the pace of recent years, the aggregate level could soon exceed the OECD average of 77%. Since this includes the liabilities of non-profit enterprises in some countries, the actual OECD average of household debt alone will be even lower than 77%. If household debt continues to rise at the pace of the past several years, it will have an impact on the macro economy in a few years, or even sooner if the current global environment of extreme volatility persists. Judging by the composition of the increase, greater regulatory attention on non-bank institutions seems to be needed.

Chart 22: Liabilities of “individuals” are close to the threshold.

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Chart 23: Household debt, using the new data where available.

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The high debt burden of low-income households (the second bullet) should not lead to much greater aggregate vulnerability, not least because the majority of household debt is being borne by those in the top three income quintiles (Chart 25). Instead, a greater issue lies with distribution issues and the hardship of low-income households. This “hardship” does not necessarily mean financial distress such as personal bankruptcies; it can easily squeeze the purchasing capacity of low income households.

Both aspects require caution, but there are several developments that augur well, not least proactive policy responses. In their policy decisions, the central bank and government appear to have been paying close attention to the interest rate burdens of households as well as small and medium-sized firms. In June 2011 the government issued its Comprehensive Measures on Household Debt intended to rein in rising household debt. Household debt has since shown signs of moderating, probably due to the policy initiative as well as increasing economic uncertainty.

Desired: Goldilocks temperature Based on the properly measured statistics, household debt in Korea does not currently pose a major macroeconomic threat, in our view, but its future trajectory warrants close monitoring. The prospects look good, in light of policy responses and the incipient signs of moderation in the growth of household debt. But a long-run concern is that a healthy increase of leverage not be hampered, because this is necessary to the further maturation of the Korean economy. The preference would be for an ideal Goldilocks temperature between the two sides of leverage: its positive role of facilitating the efficient use of savings and its negative role of increasing the fragility of an economy.

Preview BoT, BSP rate decision, China GDP, Singapore NODX exports Attention next week will be on policy rate decisions by central banks of Thailand and Philippines. Both BoT (Wednesday) and BSP (Thursday) will likely keep their policy rates on hold. We expect China 3Q GDP to come in at 9.3% YoY, IP, FAI will likely decelerate moderately (Thursday). Singapore’s non oil domestic exports would probably slow further (Monday).

Chart 24: Increase in household debt since early 2006

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Chart 25: Distribution of household debt by income quintile

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Emerging EMEA Turkey: aiming for a soft landing

Review: September inflation releases surprised mostly to the downside. August IP growth was lower than expected in Turkey, and surprised to the upside in S. Africa.

Hot topic: The government has announced the long-awaited medium-term program with a focus on taming the current account deficit and bringing GDP growth to sustainable levels.

Preview: The focus next week will be on Turkey’s rates decision along with September inflation data for Poland and S Africa.

Review: Inflation surprises to the downside September inflation releases surprised mostly to the downside. CPI inflation in Poland eased and overall demand-led pressures appear muted. In Hungary, annual inflation was flat, confirming strong deflationary pressures despite the weakness in the currency. Inflation in Romania has returned to the 3.5% target earlier than expected, opening the door for monetary easing in coming months. Annual inflation in Egypt continued to come down as well. Czech R. was the exception with a higher than expected reading. August IP growth in Turkey was lower than anticipated, while S. African manufacturing production expanded 5.6% YoY. August current account deficit (CAD) in Turkey and Poland narrowed to US$4bn and EUR1.7bn, respectively. Finally, the CBE kept policy rates unchanged, as expected.

Hot topic: Turkey: aiming for a soft landing The government announced the long-awaited medium-term program with a focus on taming the current account deficit and bringing GDP growth to sustainable levels. Although the government’s growth and inflation forecasts are more optimistic than ours, the fiscal and CAD forecasts are quite reasonable to achieve, in our view. Looking beyond the forecasts, it is positive that fiscal policy is now supporting efforts to bring down the CAD, in our view, though the contribution comes through higher taxes, which will push inflation higher in the short term, rather than lower primary spending.

Adding some orthodoxy to the policy stance The medium-term program’s (MTP) main focus has been addressing Turkey’s structural CAD, which reached almost 10% of GDP as of August, in our view. Until midsummer, the CAD was investors’ main concern about Turkey due to the shaky global backdrop, especially in Europe. The efforts of the Central Bank of Turkey (CBT) to tame domestic demand and credit growth while keeping the TRY competitive with its unorthodox policy mix fell short of convincing investors of a soft-landing scenario, in our view.

The external shock that pushed USD-TRY 15% higher since mid July, rapid deterioration in the global growth outlook, capital outflows from the emerging markets and the expectation that commodity prices would adjust lower pushed investors to review their views on Turkey, in our opinion. After all, fundamentals are relatively sound and there is a low level of leverage in the system despite the worrying high increase. From this perspective, the government’s medium-term program supported by additional tax increases to tighten the fiscal stance and tame CAD serves as a reasonable policy stance that supports CBT’s controversial policy mix.

Turker Hamzaoglu +44 20 7996 2417

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A too-smooth rebalancing The government expects GDP growth to slow down only gradually. According to the MTP, GDP growth is going to amount to 7.5% in 2011, slow to 4% in 2012, and recover to 5% in 2013 and 2014. This is a very optimistic trajectory, in our view. First of all, 7.5% GDP growth for 2011 implies 5.2% GDP growth on average in H211 compared to our 2.3% forecast. And, the government pencils in a further 4% of GDP growth on top of this year’s strong growth in 2012 (our forecast is 3%), mainly driven by strong investments, which probably assumes increasing confidence in the economy due to a lower USD-TRY and low interest rates. The government and the CBT remain too optimistic on inflation, in our view, given the soft-landing scenario MTP pencils in. Our higher budget deficit and lower CAD forecasts of 2.0% and 7.0% for 2012 compared to the government’s program is broadly in line with our lower GDP growth forecast of 3%.

The government underlines that there is a need to bring GDP growth to sustainable levels and tame CAD. It also stated that such a rebalancing should take place on private sector balance sheets rather than in the public sector. The central government budget is expected to post a deficit of 1.5% of GDP in 2011, 1.5% in 2012, 1.4% in 2013, and 1% in 2014. While the numbers are much less impressive when cyclically adjusted, the decline in headline budget deficit is still good news and adds an orthodox element in the fight against the CAD.

In order to tame the CAD and tighten the fiscal stance, the government significantly hiked the special consumption tax on autos, mobile phones and alcohol and tobacco. It also increased the resource utilization support fund (KKDF) for imports on credit. Total tax increases are expected to generate some TRY5.5bn additional revenue (about 0.4% of GDP), almost two-thirds coming from alcohol and tobacco.

The adjustment in the CAD is rather slow; but consistent with the government’s optimistic growth trajectory. The MTP sees CAD going up to 9.4% of GDP in 2011 and coming down to only 8% of GDP in 2012. Even GDP growth picks up to 5% in 2013 and 2014 and TRY appreciates 2.5% on average, the CAD continues to improve to 7% by 2014, probably reflecting the government’s structural reforms on the issue. Table 3: Medium-term economic program 2011 2012 2013 2014 GDP (TRY bn) 1,281 1,426 1,572 1,733 GDP (USD bn) 766 822 888 952 USD-TRY (average) 1.67 1.73 1.77 1.82 GDP growth (%) 7.5 4.0 5.0 5.0 Consumption 6.2 3.0 3.5 3.4 Gross fixed capital formation 19.3 6.2 8.8 8.5 Unemployment rate (%) 10.5 10.4 10.2 9.9 CPI inflation (%, YE) 7.8 5.2 5.0 5.0 CA balance ($bn) -71.7 -65.4 -67.0 -67.1 CA balance (% GDP) -9.4 -8.0 -7.5 -7.0 Oil prices (average) 104.7 97.0 101.5 102.2 Budget balance (% GDP) -1.7 -1.5 -1.4 -1.0 Primary balance (% GDP) 1.6 2.0 2.0 2.1 Total revenues (% GDP) 22.7 23.1 22.9 22.5 Total expenditures (% GDP) 24.4 24.6 24.2 23.6 Gross public debt (% GDP) 39.8 37.0 35.0 32.0 Source: Government's Medium Term Program (2012-14)

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We are curious about the measures in the MTP that promote import substitution and preference of domestic origin goods in public procurement, and those that “encourage” international companies to use domestic supply chain as they may not go down well under the customs union with the EU. While the government’s move to increase taxes on some consumer goods to curb CAD is encouraging, Chart 26 shows that the main problem has been the rapidly increasing investments and intermediate goods excluding fuels, not consumer goods. While the trade deficit has contracted by US$40bn from its peak in August 2008 to the trough in October 2009, it has deteriorated by some US$65bn since then.

Inflation moves down on government’s to do list One interesting change in this year’s MTP is that the price stability goal in the main objective of the MTP has dropped out. It can still be argued that macroeconomic stability in the statement already assumes price stability (and price stability does not ensure macroeconomic stability alone), but it would not be shocking to suggest, at the risk of reading too much from the tea leaves, that breaking the back of inflation once and for all does not top Ankara’s priorities (unfortunately nor does it top the public’s given sticky wage increases and the blurred perception of price increases due to widely used “pay in installments schemes”). Although the price increases imposed by the tax hikes will depend on the degree the companies will reflect the hikes to consumers, we calculate the potential impact on CPI inflation around 0.8ppt. As a result, we pushed our already higher than consensus YE11 CPI inflation forecast from 8.0% to 8.5%, leaving 2012 forecast unchanged at 6.5%.

Preview: CBT to keep policy rates and RRRs unchanged The focus next week will be on CBT’s rates decision along with September inflation data for Poland and S. Africa. CBT is likely to keep both policy rates and RRRs unchanged. In S. Africa, we expect the rise in both food and petrol price to drive the inflation to 5.7% YoY; August retail sales are likely to accelerate to 5.6% YoY on the back of positive base effects. In Poland, the core inflation is likely to remain stable around centre of the NBP's target; September IP growth is expected to ease to 5.5% YoY; additionally CB’s minutes will also be released. In Russia, the economy is likely to benefit from a sharp slowdown in inflation, which in turn should boost real component consumer income and spending. Rising market volatility is likely to weigh on investment demand and raise concerns over the sustainability of economic growth in the future. Coming on top of the persistent shortage of liquidity demand on the local money market, the latter is likely to trigger another rate cut of liquidity provisioning rates by the CBR during its next policy meeting in late October.

Chart 26: Breakdown of trade balance (BEC, 12m trailing)

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Latin America Inventory cycle, not 2009 déjà vu

Review: In Brazil, retail sales declined 0.4% MoM in August, down sharply from a 1.2% MoM gain in July. Similarly, in Mexico, IP grew 3.1% YoY in August below market expectations but in line with our forecast.

Hot topic: With inventories above desired levels in some LatAm countries, risks are biased for them to become a drag on growth. Nevertheless, in our opinion conditions are substantially different than in 2008-2009, and there is less downward potential.

Preview: The focus next week will be on Wednesday’s Copom meeting in Brazil. Following the surprising 50bp cut in August, we expect the BCB to cut the Selic rate by another 50bp to 11.50%.

Review: activity continues to moderate In Brazil, retail sales declined 0.4% MoM in August, down sharply from a 1.2% MoM gain in July. The result came below our and consensus forecasts at 0.3% MoM and a -0.1% MoM, respectively. Annual growth declined to 6.2% YoY, the lowest result since March. Domestic demand gives clear signs of deceleration at the margin, sustaining our view of economic deceleration towards year-end. Moreover, today’s result gives the Brazilian Central Bank (BCB) more freedom, once it supports the bank’s view of increasing downside risks for economic activity ahead. For now, we maintain our forecast of a 50bp cut in the Selic rate next week.

Similarly, in Mexico, industrial activity grew 3.1% YoY in August, below market expectations but in line with our forecast of a moderation in manufacturing activity. Industrial production dropped 1.08% MoM in seasonally adjusted terms, the highest decline since August 2009. As we anticipated, industrial production moderated following a setback in auto-related manufactures. However, we expect IP to rebound next month as a result of positive September auto production results. Nonetheless, we reaffirm our view that the manufacturing sector will moderate, consistent with a slow growth outlook in the US.

Hot Topic: LatAm - inventory cycle, not 2009 déjà vu Soft patch continues as exports slow down The latest activity data batch in the largest LatAm countries shows weakness. In August, retail sales and industrial production in Brazil dropped 0.4% and 0.2% MoM, respectively. In Mexico, industrial production dropped 1.1% MoM, although September vehicle production remained robust. In Chile, activity expanded 4.6% YoY, significantly slower than in Q2 but flat on a monthly basis.

These data points continue a Q2 trend. As highlighted previously (A mild soft patch reaches LatAm shores), GDP growth weakened in all LatAm countries except Colombia in Q2, although part is due to base effects. July activity data supports the view that LatAm entered a mild soft patch, again excluding Colombia.

Some deceleration in activity seems likely given the linkages to a weak global economy. GEM exports growth appears to be slowing. GEM-10 3-month/3-month real export growth was 7.5% in Q1 and down to 3.3% in July. Moreover, our GEMs team estimates that exports have nearly stagnated more recently (GEM exports: a clink in the armor?).

Marcos Buscaglia + 1 646 855 2582

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Focus on trade means focus on inventories Recent research shows that during the 2008 crisis the big swings in international trade reflected adjustments to inventory holdings.7 Given the lags and friction of international trade, firms involved in international trade maintain much larger inventories than firms that trade only locally. So when firms trading internationally suffer persistent demand shocks, they adjust inventories faster than those involved in purely domestic trade. For example, in the US, two-thirds of the decline in automobile imports during the crisis can be attributed to firms running down their inventories, as opposed to lower sales (Alessandria et al., 2010).

Inventory accumulation is much more volatile than activity on a macro level. Although inventory investment accounts for only 1% of GNP in the US, during recessions drawdowns in inventories may explain up to 50% of the fall in output.8 So, we think a deeper look at what is going on to the accumulation of inventories in LatAm is handy at this juncture.

Inventories investment has slowed down in 2011 According to our estimates, in LatAm the contribution of inventory build-up to GDP growth was nearly zero in H1 (Chart 27). For the LatAm estimates, we included Brazil, Chile, Colombia, Mexico and Peru (Chart 28). The contribution of inventories to GDP growth was negative in Argentina, and positive and high in Venezuela.

This behavior contrasts with the huge accumulation of inventories in 2010 following the 2009 decline. In 2009, the liquidation of inventories accounted for 1.8 percentage points of lower activity. This means that excluding the change in inventories, LatAm growth would have been -0.2% instead of -2.0% in 2009. In Q1 and Q2 2009, LatAm GDP growth was 2.7% and 2.6% lower due to the reduction of inventories.

In 2010 the accumulation of inventories added 1.3 percentage points to LatAm growth. In fact, once this effect is removed, 2010 growth does not look much different from the growth this year in LatAm.

7 See Alessandria, G., J. Kaboski and V. Midrigian, “U.S. Trade and Inventory Dynamics”, Federal Reserve Bank of Philadelphia Working Paper, 2010. 8 See Blanchard, O. and S. Fischer, Lectures on Macroeconomics, 1989.

Chart 27: Wild swings in the contribution of inventories to growth

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Chart 28: LatAm inventory levels at sync during the crisis

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The correlation between LatAm and US inventories’ contribution to growth has increased since 2008. From 2004 to Q2 2011 the correlation between both measures was 35%, but has increased to 50% since 2008. In our opinion, this relates to activity dropping in both LatAm and the US due to the same shocks, which were propagated through more integrated trade.

PMIs show that inventories are somewhat high Surveys show that inventory levels in August were somewhat high at 53.3 and 53.6 in Brazil and Chile, respectively. 9 The PMI in the US was also somewhat high at 52 in September. In contrast, inventories were in line with desired levels in Mexico last month (Chart 29), which suggests there may be an impending inventory adjustment in some countries unless demand picks up.

Inventories not expected to weigh on growth in 2012 We do not expect inventories to be a drag on growth in 2012 to the same extent as in 2008-2009 for two main reasons:

Exports from GEMs seem to be slowing down, but they are far from the contraction of 2008-2009 when US imports dropped by around 20% from peak to trough, or over US$430bn. This will likely lead to a lower inventory adjustment this time.

Financial conditions are not nearly as tight as in 2008-2009, so trade finance is unlikely to freeze to the same extent as then. The Index of Financial Stress produced by the Kansas Fed showed in Chart 30 illustrates this point.

However, the balance of risks is biased for a sharper inventory adjustment. This is because inventory levels seem to be high in some LatAm countries, and because of the downside risks prevailing on global activity. This, in turn, poses some downside risks to our 2012 GDP growth forecasts.

Preview: BCB’s monetary policy meeting to take center stage Brazil: all eyes on Wednesday’s Copom meeting In Brazil, focus will be on the Copom meeting on Wednesday. Following the surprising 50bp cut in August, we expect the BCB to cut the Selic rate by another 50bp to 11.50%. The statement should continue to highlight the possible effects of the global slowdown on domestic activity, and also highlight rising uncertainty on the ongoing deceleration led by domestic factors.

9 Higher than 50 means that actual inventories are higher than desired. For Brazil, we use the CNI data on inventories of finished goods; for Chile the IMCE index produced by ICARE and for Mexico the IMEF.

Chart 29: Inventories higher than desired in Brazil and Chile

37

42

47

52

57

Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11

Mex ico Chile Brazil 50 = div iding line US

Source: BofA Merrill Lynch Global Research

Chart 30: Not as stressed as in 2008

-2

-1

0

1

2

3

4

5

6

Dec-

94

Dec-

95

Dec-

96

Dec-

97

Dec-

98

Dec-

99

Dec-

00

Dec-

01

Dec-

02

Dec-

03

Dec-

04

Dec-

05

Dec-

06

Dec-

07

Dec-

08

Dec-

09

Dec-

10

Source: Federal Reserve Bank of Kansas, BofA Merrill Lynch Global Research

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On Thursday, we expect the October IPCA-15 to decelerate slightly to 0.50% MoM. This would bring annual inflation to 7.20% YoY, from 7.33% YoY in September, the first decline in the annual figure since August 2010. Market participants should focus on core measures, which remain pressured.

Mexico: slight moderation expected on August retail sales Next week will be relatively calm in Mexico with releases signaling still slack conditions in consumption and the labor market. On Thursday, we expect retail sales to have moderated slightly to 2.9% in August, on the back of a modest performance in department store sales and domestic auto sales. Note that in addition to a setback in consumer confidence, Antad and Wal-Mart same-store sales advanced only 1.8% and 0.9% YoY, respectively. On Friday, the unemployment rate for September will be released. We expect it to remain almost unchanged at 5.79%. This figure will be consistent with the gradual employment in formal job creation which advanced 4.19% YoY in September.

Argentina: Presidential elections in the horizon In Argentina, the 23 October presidential elections will take center stage. With Cristina Kirchner’s victory all but guaranteed, the focus will be on whether Kirchner will increase the percentage of votes in the national primaries (a likely scenario) and if the voters will give the second place to a different candidate, as Hermes Binner, after that Alfonsín took the second place in the primaries. Also, INDEC will report the August economic activity index EMAE on Tuesday the 18th. Our model predicts some moderation to 7.1% YoY (from 7.6% YoY in July) resulting from weaker industrial production figures, but risks are on the upside. Finally, the statistics agency will post September’s trade surplus on Friday the 21st. We expect some upside from the previous figure (US$640mn in August) to US$850mn due to some moderation in import growth. We are not yet taking into account the impact on trade of more sluggish demand for Brazil, although we do expect a considerable impact on exports in October.

Colombia: August IP and retail sales will be the main highlights We expect industrial production and retail sales data, published on Wednesday, to remain resilient as Colombia's domestic activity was likely to maintain its solid trend in August.

Peru: economic activity likely remained strong in August On Monday, we expect August economic activity to have maintained the positive trend shown in July. We estimate GDP grew 7.3% YoY supported by strong advances in coincident indicators (electricity production and cement consumption).

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Global forecasts Economic forecasts Global economic forecasts GDP growth, % CPI inflation*, % Short term interest rates**, % 2009 2010 2011F 2012F 2009 2010 2011F 2012F Current 2010 2011F 2012F Global and Regional Aggregates Global -0.9 5.1 3.8 4.2 1.6 3.2 4.3 3.5 3.36 3.08 3.51 3.82 Global ex US -0.2 5.6 4.4 4.9 2.2 3.7 4.5 4.0 4.25 3.88 4.42 4.86 Developed Markets -3.9 2.8 1.5 1.8 0.0 1.4 2.6 1.6 0.80 0.58 0.66 0.65 G5 -4.1 2.6 1.4 1.6 -0.1 1.4 2.6 1.5 0.69 0.46 0.54 0.50 Emerging Markets 2.6 7.6 6.3 6.2 3.6 5.2 6.0 5.0 6.50 5.83 6.51 6.60 Europe, Middle East and Africa (EMEA) -4.2 2.6 2.3 1.8 3.1 3.3 4.1 3.1 2.99 2.61 2.80 2.63 European Union -4.1 1.8 1.7 1.2 0.9 2.0 2.9 2.0 1.64 1.20 1.45 1.25 Emerging EMEA -3.5 4.4 4.0 3.6 7.9 6.0 6.5 5.5 6.68 6.30 6.36 6.12 PacRim 3.9 8.1 6.1 6.8 0.5 3.5 4.5 3.5 4.59 4.12 4.93 5.16 PacRim ex Japan 6.1 9.0 7.4 7.6 0.9 4.4 5.5 4.2 5.70 4.97 5.89 6.12 Emerging Asia 6.6 9.2 7.8 7.8 0.9 4.6 5.6 4.3 5.94 5.14 6.11 6.32 Americas -3.1 3.9 2.5 2.5 1.4 2.9 4.1 3.1 2.64 2.50 2.69 2.82 Latin America -2.0 6.3 4.6 4.1 6.4 6.3 6.7 6.6 9.37 8.88 9.51 9.65 G5 US -3.5 3.0 1.7 1.8 -0.4 1.6 3.2 1.7 0.250 0.130 0.125 0.125 Euro area -4.1 1.7 1.6 0.8 0.3 1.6 2.5 1.8 1.50 1.00 1.25 1.00 Japan -6.3 4.0 -0.5 2.7 -1.3 -1.0 -0.5 -0.4 0.10 0.05 0.05 0.05 UK -4.9 1.4 1.1 1.6 2.2 3.3 4.4 2.3 0.50 0.50 0.50 0.50 Canada -2.8 3.2 2.5 2.4 0.3 1.8 3.1 2.7 1.00 1.00 1.00 2.00 Euro area Germany -4.7 3.6 2.8 1.3 0.2 1.2 2.4 2.0 1.50 1.00 1.25 1.00 France -2.6 1.4 1.5 1.0 0.1 1.7 2.2 1.9 1.50 1.00 1.25 1.00 Italy -5.2 1.2 0.7 0.4 0.8 1.6 2.4 1.6 1.50 1.00 1.25 1.00 Spain -3.7 -0.1 0.9 0.8 -0.2 2.0 2.8 1.4 1.50 1.00 1.25 1.00 Netherlands 1.6 1.9 1.3 1.0 0.9 2.4 2.3 1.50 1.00 1.25 1.00 Belgium -2.7 2.1 2.2 0.9 0.0 2.3 3.3 2.2 1.50 1.00 1.25 1.00 Greece -2.3 -4.4 -5.3 -1.8 1.3 4.7 2.7 1.9 1.50 1.00 1.25 1.00 Austria -3.8 2.3 3.0 1.4 0.4 1.7 3.3 2.2 1.50 1.00 1.25 1.00 Portugal -2.5 1.3 -2.2 -2.0 -0.9 1.4 3.2 1.5 1.50 1.00 1.25 1.00 Finland -8.2 3.6 3.1 2.0 1.6 1.7 3.3 2.4 1.50 1.00 1.25 1.00 Ireland -7.0 -0.4 2.1 1.6 -1.7 -1.6 1.0 0.7 1.50 1.00 1.25 1.00 Other Developed Europe Sweden -5.1 5.4 4.3 2.1 -0.5 1.2 3.0 2.5 2.00 1.25 2.00 2.50 Switzerland -1.9 2.7 1.9 0.5 -0.5 0.7 0.3 -0.1 0.00 0.25 0.00 0.00 Norway -1.6 2.1 2.5 2.7 2.2 2.4 1.3 1.4 2.25 2.00 2.25 2.75 Asia Pacific China 9.2 10.4 9.3 9.0 -0.7 3.3 5.2 4.0 6.56 5.81 6.56 7.06 India 8.0 8.5 7.5 7.8 3.6 9.5 8.5 6.0 7.25 5.75 7.50 6.50 Korea 0.2 6.1 3.9 4.6 2.7 3.0 4.3 3.4 3.25 2.50 3.25 3.75 Indonesia 4.5 6.1 6.3 6.0 4.9 5.0 5.6 4.7 6.50 6.50 6.75 7.25 Australia 1.3 2.7 2.0 4.3 1.8 2.8 3.5 3.0 4.75 4.75 5.00 5.75 Taiwan -1.9 10.9 4.9 5.2 -0.9 1.0 2.1 1.9 1.88 1.63 2.13 2.88 Thailand -2.5 7.8 4.1 4.5 -0.9 3.3 3.9 3.4 3.50 2.00 3.75 4.50 Malaysia -1.7 7.2 4.3 5.0 0.6 1.7 3.2 2.5 3.00 2.75 3.00 3.25 Philippines 0.9 7.3 3.9 5.2 3.2 3.9 4.5 5.0 4.50 4.00 4.50 4.50 Hong Kong -2.7 7.0 5.6 5.3 0.5 2.4 5.2 4.5 0.50 0.25 0.25 0.25 Singapore -0.8 14.5 4.5 4.3 0.6 2.7 4.6 2.7 0.18 - - - New Zealand -2.1 1.5 1.4 4.5 2.1 2.3 4.2 2.5 2.50 3.00 2.75 4.50

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Global economic forecasts GDP growth, % CPI inflation*, % Short term interest rates**, % 2009 2010 2011F 2012F 2009 2010 2011F 2012F Current 2010 2011F 2012F Latin America Mexico -6.1 5.4 3.7 3.6 5.3 4.2 3.4 3.6 4.50 4.50 4.00 4.00 Brazil -0.6 7.5 3.6 4.2 4.9 5.0 6.6 5.7 12.00 10.75 11.00 10.50 Argentina 0.9 9.2 8.9 2.5 6.3 10.5 9.8 9.9 15.50 11.08 15.00 18.00 Colombia 0.8 4.3 5.0 5.0 4.2 2.3 3.2 3.2 4.50 3.00 4.50 5.50 Venezuela -3.3 -1.7 3.5 4.7 28.6 29.1 26.4 32.7 18.03 29.50 29.50 29.50 Chile -1.5 5.2 6.3 4.5 0.4 1.4 3.2 3.0 5.25 3.25 5.25 4.25 Peru 0.9 8.8 6.5 6.0 2.9 1.5 2.8 2.5 4.25 3.00 4.25 4.00 Uruguay 2.9 8.5 6.3 5.0 5.9 6.9 7.3 6.0 8.00 6.50 8.00 8.00 EEMEA Russia -7.9 4.0 4.0 4.0 11.7 6.9 8.7 5.9 8.25 7.75 7.75 7.00 Turkey -4.7 9.0 6.0 3.0 6.3 8.6 6.2 7.5 6.50 6.50 5.75 5.75 Poland 1.7 3.8 3.5 2.9 4.0 2.7 4.0 2.5 4.50 3.50 4.50 4.00 South Africa -1.7 2.8 3.1 3.5 7.1 4.4 5.0 6.2 5.50 5.50 5.50 6.50 Egypt 4.7 5.1 0.0 3.0 16.2 11.7 11.0 10.0 8.25 8.25 8.25 8.25 Ukraine -15.1 4.3 4.9 2.9 15.9 9.4 8.7 7.3 7.75 7.75 7.75 8.25 Romania -7.1 -1.3 1.5 3.5 5.6 6.1 6.3 3.2 6.25 6.25 6.25 6.25 Czech Republic -4.1 2.3 2.2 2.5 1.1 1.5 2.2 2.6 0.75 0.75 0.75 1.25 Israel 0.8 4.5 3.9 3.5 3.3 2.7 3.7 2.8 3.00 2.00 2.75 2.50 Hungary -6.7 1.2 1.5 1.0 4.2 4.9 3.7 2.4 6.00 5.75 6.00 5.00 Kazakhstan 1.2 7.0 6.2 4.6 7.3 7.1 8.5 7.3 7.50 7.00 7.50 7.00 GCC Saudi Arabia 0.6 3.2 4.9 4.2 5.1 5.7 5.5 5.4 United Arab Emirates -1.4 2.0 2.8 3.1 1.6 1.0 2.8 3.2 Kuwait -2.2 2.5 3.1 5.0 4.0 3.0 4.0 4.2 Qatar 9.0 13.3 13.0 7.5 -4.9 -2.9 2.5 3.5 Oman 0.8 3.8 3.7 4.0 3.5 4.0 4.1 4.0 Bahrain 1.822 2.4257 -2.2 2.9 2.8 2.5 3.0 2.7 Notes: Global and regional aggregates are based on the IMF PPP weights unless stated otherwise. Countries within each region are ordered according to these weights. * Annual averages. The HICP measure of inflation is used for Euro area economies. ** Central bank target rate, year-end, where available, short-term rates elsewhere. † US short-term rate forecast for 2008, 2009 and 2010 year end is 0-0.25%. Midpoint used in table above for global and regional aggregation purposes. Source: BofA Merrill Lynch Global Research

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Bond yields forecasts Quarter-end bond yield forecasts Latest 4Q11 1Q12 2Q12 3Q12 US 3m Libor 0.40 0.45 0.45 0.45 0.50 2y 0.27 0.20 0.25 0.40 0.60 5y 1.07 1.00 1.10 1.25 1.50 10y 2.16 2.30 2.50 2.75 3.00 30y 3.14 3.70 3.90 4.20 4.50 Euroland 3m Euribor 1.57 1.00 1.00 1.00 1.10 2y 0.63 0.40 0.45 0.50 0.55 5y 1.33 0.85 0.90 0.95 1.05 10y 2.11 1.70 1.70 1.75 1.80 30y 2.86 2.55 2.55 2.60 2.65 Japan 3m Libor 0.19 0.20 0.21 0.21 0.21 2y 0.14 0.15 0.23 0.22 0.20 5y 0.37 0.30 0.60 0.50 0.40 10y 1.02 1.05 1.35 1.25 1.20 20y 1.74 1.75 2.10 2.00 1.90 30y 1.95 1.95 2.25 2.15 2.05 U.K. 3m Libor 0.96 0.95 1.00 1.10 1.20 2y 0.60 0.50 0.55 0.60 0.65 5y 1.38 1.10 1.25 1.40 1.50 10y 2.56 2.15 2.40 2.60 2.75 30y 3.48 3.35 3.60 3.75 3.85 Australia 3m BBSW 4.74 4.85 4.85 4.85 4.85 2y 3.93 4.65 4.50 4.65 4.75 3y 3.85 4.70 4.55 4.75 4.80 5y 4.04 4.80 4.70 4.90 5.00 10y 4.46 5.00 4.90 5.00 5.10 Canada 2y 0.97 1.15 1.50 1.75 2.00 5y 1.52 1.60 1.85 2.20 2.25 10y 2.31 2.35 2.50 2.60 2.70 Source: BofAML Global Research

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Monetary policy forecasts Key meeting dates and expected rate change (bp) Current First Hike 11-Sep 11-Oct 11-Nov 11-Dec 12-Jan 12-Feb Developed Markets Fed 0.25 +25 (Q1 2014) 20th – 2nd 13th 24-25th – ECB 1.50 +25 (Apr 2011) unch -50 (6th) 3rd 8th 12th 9th BoJ 0.10 +15 (Mar 2013) 7th 7th / 27th 16th 21st 24th 14th BoE 0.50 +25 (Feb 2013) unch 6th 10th 8th 12th 9th BoC 1.00 +25 (Jun 2010) (7th) (25th) – +25 (6th) +25 (17th) – Riksbank 2.00 +25 (Jul 2010) unch 27th – 20th – +25 (16th) SNB 0.00 +25 (Q2 2012) unch – – 15th – – Norges Bank 2.25 +25 (Oct 2009) unch 19th – 14th – – RBA 4.75 +25 (Oct 2009) 6th 4th 1st – (TBA) (TBA) RBNZ 2.50 +25 (Jun 2010) 15th 27th – – (TBA) (TBA) Emerging Asia China (lending rate) 6.56 +25 (Oct 2010) – – – – (TBA) (TBA) Req. res. ratio* 21.50 +50 (Jan 2010) – – – – (TBA) (TBA) India** 6.00 +25 (Mar 2010) +25 (16th) (25th) – – (TBA) (TBA) Repo rate 8.25 +25 (Mar 2010) +25 (16th) (25th) – – (TBA) (TBA) Cash res. ratio 6.00 +75 (Jan 2010) – – – – (TBA) (TBA) Korea 3.25 +25 (July 2010) 8th 13th 11th 8th (TBA) (TBA) Indonesia 6.50 +25 (Dec 2010) 8th 11th 10th 8th (TBA) (TBA) Taiwan 1.88 +12.5(June 2010) (30th) – – (30th) (TBA) (TBA) Thailand 3.50 +25 (July 2010) – 19th +25 (30th) – (TBA) (TBA) Malaysia 3.00 +25 (Mar 2010) (8th) – 11th – (TBA) (TBA) Philippines 4.50 +25 (March 2011) (8th) +25 (20th) – +25 (1st) (TBA) (TBA) Latin America Brazil 12.00 +75 (Apr 2010) – -50 (19th) -50 (30th) – -50 (18th) – Chile 5.25 +50 (June 2010) 15th 14th 16th 16th -25 -25 Colombia 4.50 +25 (Feb 2011) 30th 28th +25 (25th) 16th (TBA) (TBA) Mexico 4.50 +25 (2013) – 14th – 2nd (TBA) (TBA) Peru 4.25 +25 (May 2010) 8th 6th 10th 7th (TBA) (TBA) Emerging EMEA Czech Republic 0.75 +25 (2012) unch – (3rd) (21st) (TBA) (TBA) Hungary 6.00 +25 (Nov 2010) unch (25th) (29th) (20th) -25 (TBA) (TBA) Israel 3.00 +25 (Aug 2009) -25 (24th) -25 (28th) (26th) (TBA) -25 (TBA) Poland 4.50 +25 (Jan 2011) unch unch (9th) (7th) (TBA) (TBA) Romania 6.25 – unch – (2nd) – (5th) (2nd) South Africa 5.50 +50 (Sep 2012) unch – (10th) – (TBA) (TBA) Turkey 5.75 – unch (20th) (23rd) (22nd) (TBA) (TBA) Note: Bolded data are expectations in basis points. “–“ denotes no meeting. TBA: MPC meeting not yet set. *Major five banks. **Reverse repo rate. Source: BofA Merrill Lynch Global Research, Central Banks

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FX forecasts Quarterly forecasts – G10 currencies Spot Dec '11 Mar '12 Jun '12 Sep '12 Dec '12 G3 EUR-USD 1.37 1.30 1.28 1.30 1.35 1.40 USD-JPY 77 75 77 80 83 86 EUR-JPY 106 98 99 104 112 120 Dollar Bloc USD-CAD 1.02 1.07 1.07 1.05 1.03 1.01 AUD-USD 1.01 0.95 0.94 0.96 0.94 0.93 NZD-USD 0.79 0.75 0.75 0.77 0.76 0.75 Europe EUR-GBP 0.87 0.86 0.86 0.85 0.83 0.85 GBP-USD 1.57 1.51 1.49 1.53 1.63 1.65 EUR-CHF 1.24 1.22 1.24 1.26 1.28 1.30 USD-CHF 0.90 0.94 0.97 0.97 0.95 0.93 EUR-SEK 9.18 9.20 9.10 9.00 9.00 9.00 USD-SEK 6.68 7.08 7.11 6.92 6.67 6.43 EUR-NOK 7.75 7.80 7.70 7.60 7.60 7.60 USD-NOK 5.64 6.00 6.02 5.85 5.63 5.43 Source: Spot exchange rate as of day of publishing. The left of the currency pair is the denominator of the exchange rate. Currency forecasts are for end of period. Source: BofA Merrill Lynch Global Research

Quarterly forecasts – EM currencies Spot Dec '11 Mar '12 Jun '12 Sep '12 Dec '12 Latin America USD-BRL 1.75 1.75 1.77 1.80 1.82 1.85 USD-MXN 13.36 12.80 13.05 13.10 13.15 13.20 USD-CLP 505 480 485 490 495 500 USD-COP 1909 1,850 1,850 1,850 1,850 1,850 USD-ARS 4.21 4.35 4.60 4.80 5.00 5.20 USD-VEF 4.29 4.30 4.30 4.30 4.30 4.30 USD-PEN 2.73 2.70 2.65 2.65 2.60 2.60 Emerging Europe EUR-PLN 4.31 4.20 3.95 3.95 3.95 3.95 EUR-HUF 293 285 270 270 270 270 EUR-CZK 24.73 24.50 23.75 23.70 23.65 23.65 USD-UAH 8.00 8.00 8.00 8.00 8.00 8.00 USD-RUB 31.22 30.00 29.00 29.00 29.00 29.00 USD-ZAR 7.90 7.30 7.25 7.35 7.50 7.60 USD-TRY 1.83 1.85 1.65 1.65 1.65 1.65 EUR-RON 4.32 4.30 4.30 4.30 4.30 4.30 USD-EGP 5.97 6.00 6.30 6.50 6.75 7.00 USD-ILS 3.66 3.60 3.35 3.30 3.25 3.20 USD-AED 3.67 3.75 3.75 3.75 3.75 3.75 USD-KWD 0.28 0.29 0.29 0.29 0.29 0.29 USD-SAR 3.75 3.75 3.75 3.75 3.75 3.75 USD-QAR 3.64 3.64 3.64 3.64 3.64 3.64 Asian Bloc USD-KRW 1156 1,160 1,120 1,050 1,000 980 USD-TWD 30.27 30.00 31.00 30.50 30.00 29.00 USD-SGD 1.28 1.25 1.24 1.22 1.22 1.23 USD-THB 30.90 30.50 30.00 30.00 30.50 30.80 USD-HKD 7.78 7.82 7.75 7.76 7.76 7.78 USD-CNY 6.38 6.30 6.30 6.25 6.20 6.20 USD-IDR 8870 8,500 8,400 8,500 8,500 8,400 USD-PHP 43.41 43.00 42.00 41.00 42.00 42.00 USD-MYR 3.14 3.20 3.00 2.90 2.90 3.00 USD-INR 49.13 48.50 47.50 46.00 46.00 45.00 Source: Spot exchange rate as of day of publishing. The left of the currency pair is the denominator of the exchange rate. Currency forecasts are for end of period. Source: BofA Merrill Lynch Global Research

Link to Definitions Macro Click here for definitions of commonly used terms.

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Team Page Global Economics Ethan S. Harris +1 646 855 3755 North American Economist MLPF&S ethan.harris@baml.com Gustavo Reis +1 646 855 6356 Economist MLPF&S gustavo.reis@baml.com United States Economics Michael S. Hanson +1 646 855 6854 Economist MLPF&S michael.s.hanson@baml.com Michelle Meyer +1 646 855 6261 Economist MLPF&S mmeyer2@baml.com Neil Dutta +1 646 855 9322 Economist MLPF&S indraneil.dutta@baml.com Joshua Dennerlein +1 646 855 8027 Economist MLPF&S joshua.dennerlein@baml.com Gary Bigg +1 646 855 9880 Economist MLPF&S gary.bigg@baml.com Developed Europe Economics Laurence Boone +44 20 7995 6706 European Economist Merrill Lynch (France) laurence.boone@baml.com Nick Bate +44 20 7995 4262 UK Economist MLI (UK) nick.bate@baml.com Silvia Ardagna +44 20 7996 1512 European Economist MLI (UK) silvia.ardagna@baml.com Tina Sidemark +44 20 7995 9237 European Economist MLI (UK) tina.sidemark@baml.com Japan Economics Masayuki Kichikawa +81 3 6225 8214 Economist Merrill Lynch (Japan) masayuki.kichikawa@baml.com Setsuko Yamashita +81 3 6225 7139 Economist Merrill Lynch (Japan) setsuko.yamashita@baml.com

Canada Economics Sheryl King +1 416 369 8756 Economist Merrill Lynch (Canada) sheryl.king@baml.com Ryan Bohren +1 416 369 8764 Economist Merrill Lynch (Canada) ryan.bohren@baml.com Global Emerging Markets Fixed Income Strategy and Economics Alberto Ades +1 646 855 4044 GEM FI Strategist, Economist MLPF&S alberto.ades@baml.com Vasileios Gkionakis +44 20 7995 0143 GEM FI Strategist, Economist MLI (UK) vasileios.gkionakis@baml.com Isidore Smart +1 646 855 8083 GEM Economist MLPF&S isidore.smart@baml.com Emerging Asia Economics Regional, China, Hong Kong, Taiwan TJ Bond +852 2161 7152 Emerging Asia Economist Merrill Lynch (Hong Kong) timothy.bond@baml.com Marcella Chow +852 2161 7236 Emerging Asia Economist Merrill Lynch (Hong Kong) marcella.chow@baml.com Indonesia, Malaysia, Singapore Hak Bin Chua +65 6591 0409 Emerging Asia Economist Merrill Lynch (Singapore) hakbin.chua@baml.com Korea Jaewoo Lee +82 2 3707 0465 Emerging Asia Economist Merrill Lynch (Seoul) jaewoo.lee@baml.com China Ting Lu +852 2536 3718 Emerging Asia Economist Merrill Lynch (Hong Kong) ting.lu@baml.com Xiaojia Zhi +852 2161 7815 Emerging Asia Economist Merrill Lynch (Hong Kong) xiaojia.zhi@baml.com Larry Hu +852 2536 3419 Emerging Asia Economist Merrill Lynch (Hong Kong) weijun.hu@baml.com India Indranil Sen Gupta +91 22 6632 8653 Emerging Asia Economist DSP Merrill Lynch (India) indranil.sengupta@baml.com

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EEMEA Fixed Income Strategy and Economics Regional economics and strategy David Hauner, CFA +44 20 7996 1241 EEMEA FI Strategist, Economist MLI (UK) david.hauner@baml.com Turkey, MENA Turker Hamzaoglu +44 20 7996 2417 EEMEA Economist MLI (UK) turker.hamzaoglu@baml.com Jean-Michel Saliba +44 20 7995 8568 EEMEA Economist MLI (UK) jean-michel.saliba@baml.com Russia, Kazakhstan Vladimir Osakovskiy +7 495 662 6168 EEMEA Economist Merrill Lynch (Russia) vladimir.osakovskiy@baml.com South Africa, Nigeria Matthew Sharratt +27 21 815 2625 EEMEA Economist Merrill Lynch (South Africa) matthew.sharratt@baml.com CEE, Ukraine Raffaella Tenconi +44 20 7995 9173 EEMEA Economist MLI (UK) raffaella.tenconi@baml.com Latin America Economics Regional, Argentina, Chile, Uruguay Marcos Buscaglia +1 646 855 2582 LatAm Economist MLPF&S marcos.buscaglia@baml.com Oscar Munoz +1 646 855 2308 LatAm Economist MLPF&S oscar.munoz@baml.com Brazil economics, regional strategy David Beker +55 11 2188 4371 LatAm FI Strategist Merrill Lynch (Brazil) david.beker@baml.com Mexico Carlos Capistran +52 555 2013350 LatAm Economist Merrill Lynch (Mexico) carlos.capistran@baml.com Andean Francisco Rodriguez +1 646 855 5910 LatAm Economist MLPF&S francisco.rodriguez_caballero@baml.com

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