NOMURA 2011 Outlook-All

2011 Global Economic Outlook
NOMURA GLOBAL ECONOMICS
Rocky Road of Recovery

Emerging economies thrive, but risk mishandling rebalancing. Developed
ones advance, but into post-crisis headwinds. Now the twain must meet.
Nomura Securities International Inc.
See Disclosure Appendix A1 for the Analyst Certification and Other Important Disclosures
Contents
GLOBAL
Forecast summary 3
Our view on 2011 in a nutshell 4
Global Outlook 2011: A rocky road of recovery 6
One year on: a 2010 forecast post-mortem 5
QE: Back to basics, again 7
GEMaRI: Brave new world 8
Global imbalances: Putting the basic macro identity to work 10
Global politics outlook 2011 12
NORTH AMERICA
US Outlook 2011: Debt hangover limits recovery 13
Household deleveraging 14
The output gap 16
The new fiscal debate 17
Fed policy in the crosshairs 19
US Economic Outlook: Firmer turf on the recovery road 20
Canada Economic Outlook: In need of a push from the neighbours 21
EURO AREA
Euro Area Outlook 2011: A slippery road lies ahead 22
Turning now to credit 23
House price prospects 24
Are the periphery countries solvent? 26
Liquidity withdrawal: When the time is right 28
Euro Area Economic Outlook: Breaking up is hard to do 29
European Countries Economic Outlook: Germany, France, Netherlands 30
European Countries Economic Outlook: Italy, Spain, Switzerland 31
Scandinavian Economic Outlook: Norway, Denmark, Sweden 32
Periphery Europe Economic Outlook: Greece, Portugal, Ireland 33
UNITED KINGDOM
UK Outlook 2011: Rebalancing the books 34
Counting the cost of fiscal consolidation 35
Permanent impairment in productive potential 36
UK Economic Outlook: Gale-force rebalancing 38
JAPAN
Japan Outlook 2011: Export-led recovery on the horizon 39
Underlying growth in consumer spending 40
The BOJ’s risk tolerance 42
Japan’s deflation and the output gap 43
Japan Economic Outlook: Emerging from the soft patch 45
Nomura Global Economics 1 6 December 2010

ASIA
Asia Outlook 2011: Challenges of rebalancing 46
China: Gearing up for further reforms 47
Asia macro policy: Not enough to fight inflation 48
Asia politics outlook 2011-2012 51
Australia Economic Outlook: Tiger taming 52
New Zealand Economic Outlook: A patchy recovery 53
China Economic Outlook: GDP growth of 9-10% to continue 54
Hong Kong Economic Outlook: Robust growth continues 55
India Economic Outlook: The consolidation year 56
Indonesia Economic Outlook: Poised for take off 57
Malaysia Economic Outlook: Reform awaits a mandate 58
Philippines Economic Outlook: Making inroads 59
Singapore Economic Outlook: Back to trend 60
South Korea Economic Outlook: Twin imbalances 61
Taiwan Economic Outlook: Balanced growth ahead 62
Thailand Economic Outlook: Still all about political risks 63
Vietnam Economic Outlook: Higher growth and inflation ahead 64
EMERGING EUROPE, MIDDLE EAST AND AFRICA

EEMEA Outlook 2011: Policy design for postmodern times 65
Forecast sensitivity to oil prices 66
Sovereign wealth funds: Repositioning post-crisis 68
Politics across EEMEA 70
Hungary Economic Outlook: Investor unfriendly policies dampen growth 71
Poland Economic Outlook: Racing ahead, fiscal clouds 72
Russia Economic Outlook: Lacking momentum 73
South Africa Economic Outlook: Unexciting growth, policy more interesting 74
Turkey Economic Outlook: Widening imbalances 75
Rest of EEMEA Economic Outlook: Czech Republic, Romania, Israel 76
Rest of EEMEA Economic Outlook: Ukraine, Kazakhstan, Egypt 77
Rest of EEMEA Economic Outlook: Saudi Arabia, Qatar, United Arab Emirates 78
LATIN AMERICA
LatAm Outlook 2011: Too much of a good thing 79
What drives inflation in Latin America 80
Key elections in Latin America 82
Brazil Economic Outlook: Inflation risks challenge outlook 84
Mexico Economic Outlook: A stronger recovery on the way 85
Rest of LatAm Economic Outlook: Argentina, Chile, Colombia 86
FOREIGN EXCHANGE
Foreign Exchange Outlook 2011: A global rebalancing act 88
EQUITY MARKET
Equity Market Outlook 2011: Reducing the risk premium 89

Forecast Summary
Real GDP (% y-o-y) Consum er Prices (% y-o-y) Policy Rate (% end of period)
2010 2011 2012 2010 2011 2012 2010 2011 2012
Global 4.8 4.3 4.5 3.2 3.6 3.5 2.96 3.47 4.00
Developed 2.6 2.2 2.5 1.5 1.7 1.5 0.60 0.87 1.17
Emerging Markets 7.4 6.6 6.7 5.3 5.7 5.7 5.73 6.41 7.06
Americas 3.7 2.9 3.1 3.0 2.8 2.6 1.94 2.07 2.46
United States* 2.8 2.5 2.7 1.6 1.6 1.3 0.13 0.13 0.13
Canada 2.9 2.4 2.8 1.7 2.0 2.0 1.00 2.25 3.75
Latin America 6.6 4.3 4.4 7.3 6.7 6.7 7.59 7.71 8.82
Argentina 9.0 5.0 4.7 26.4 24.4 25.4 9.23 12.00 11.00
Brazil 7.4 4.0 4.9 5.8 4.9 4.5 10.75 10.00 10.00
Chile 5.5 6.5 5.0 2.5 2.7 3.0 3.25 4.00 5.00
Colombia 4.8 5.0 4.5 2.5 3.5 3.7 3.00 4.00 7.00
Mexico 5.3 4.0 3.4 4.0 3.9 4.0 4.50 4.50 7.50
Asia/Pacific 7.9 6.7 7.1 3.5 4.1 4.3 4.15 4.90 5.43
Japan† 3.7 1.1 2.0 -0.8 -0.1 0.1 0.05 0.05 0.05
Australia 2.8 3.3 3.6 3.0 3.1 3.1 4.75 5.25 5.25
New Zealand 1.8 2.8 3.4 2.3 3.9 2.4 3.00 3.75 4.50
Asia ex Japan, Aust, NZ 9.1 8.1 8.3 4.5 5.1 5.2 5.05 5.92 6.52
China 10.2 9.8 9.5 3.3 4.5 5.0 5.56 6.56 7.31
Hong Kong*** 6.5 4.7 5.3 2.4 4.5 4.9 0.40 0.40 0.40
India** 8.8 8.0 8.6 9.2 7.3 6.7 6.25 7.00 7.50
Indonesia 5.9 6.5 7.0 5.1 6.6 5.8 6.50 7.50 7.50
Malaysia 7.0 5.2 5.5 1.7 3.3 3.2 2.75 3.25 3.25
Philippines 7.0 5.4 5.7 3.7 5.0 5.4 4.00 5.00 6.50
Singapore*** 15.5 5.3 5.8 2.8 3.2 3.0 0.40 0.40 0.40
South Korea 5.9 3.5 5.0 2.9 3.7 3.0 2.50 3.00 3.25
Taiw an 9.9 4.9 5.3 1.0 2.5 3.1 1.63 2.13 2.63
Thailand 7.7 4.8 5.2 3.3 4.2 4.4 2.00 2.75 3.25
Vietnam 6.7 7.2 7.5 9.1 10.8 8.7 9.00 10.00 10.00
Western Europe 1.8 2.0 2.3 1.9 2.2 1.9 0.95 1.49 2.11
Euro area 1.7 1.9 2.2 1.6 2.0 2.0 1.00 1.50 2.00
France 1.6 1.7 2.0 1.7 1.8 1.9 1.00 1.50 2.00
Germany 3.6 3.0 2.5 1.1 1.7 1.8 1.00 1.50 2.00
Greece -4.0 -3.0 0.9 4.6 2.5 0.5 1.00 1.50 2.00
Ireland -0.5 0.1 1.7 -0.6 0.3 0.7 1.00 1.50 2.00
Italy 1.0 1.1 1.5 1.6 2.4 2.1 1.00 1.50 2.00
Netherlands 1.7 1.8 2.2 1.0 1.8 2.1 1.00 1.50 2.00
Portugal 1.5 -1.2 0.6 1.4 2.5 1.3 1.00 1.50 2.00
Spain -0.2 0.5 1.0 1.7 2.2 1.9 1.00 1.50 2.00
United Kingdom 1.8 2.0 2.8 3.2 3.3 1.7 0.50 1.00 2.00
Denmark 2.1 2.3 2.2 2.3 1.8 1.7 1.05 1.55 2.05
Norw ay 1.9 2.9 3.3 2.5 1.4 2.1 2.00 2.75 3.75
Sw eden 5.2 3.9 2.5 1.2 1.8 2.3 1.25 2.25 3.75
Sw itzerland 2.7 2.2 2.3 0.6 0.3 1.1 0.75 1.75 2.75
EEMEA 3.8 3.8 3.5 5.7 6.6 6.3 5.81 6.35 6.82
Czech Republic 2.3 1.4 2.6 1.5 1.6 2.0 0.75 1.25 2.00
Egypt 5.3 5.5 5.5 10.9 12.1 9.5 8.25 9.00 9.00
Hungary 1.0 1.5 2.0 4.8 4.1 3.8 5.75 6.25 6.25
Israel 3.3 4.0 4.0 2.9 3.3 3.4 2.00 3.25 3.75
Kazakhstan 6.2 5.3 4.8 7.1 7.6 6.5 7.00 7.25 7.00
Poland 3.8 4.5 4.6 2.6 3.5 3.4 3.50 4.50 5.50
Qatar 16.5 19.0 14.0 1.5 3.6 3.5 1.50 1.50 2.00
Romania -2.0 1.5 2.5 6.1 4.0 3.0 6.25 6.25 7.50
Russia 3.8 3.5 3.3 6.8 8.7 7.7 7.75 8.25 8.25
Saudi Arabia 4.0 4.4 4.0 5.4 5.6 5.0 2.00 2.00 2.50
South Africa 2.8 3.3 3.8 4.3 4.8 6.1 5.50 6.00 8.50
Turkey 7.2 5.4 4.3 8.6 6.0 7.0 7.00 8.00 8.50
Ukraine 4.7 4.8 5.0 9.5 11.2 10.5 7.75 7.75 7.50
United Arab Emirates 2.3 3.6 3.5 -0.3 2.0 3.0 2.00 2.00 2.50
Note: Aggregates calculated using purchasing power parity (PPP) adjusted shares of world GDP; Our forecasts incorporate
assumptions on the future path of oil prices based on oil price futures, consensus forecasts and Nomura in-house analysis. Currently
assumed average Brent oil prices for 2010, 2011 and 2012 are $79, $89 and $96 respectively, after $62 in 2009. *2010 and 2011 policy
rate forecasts are midpoint of 0-0.25% target federal funds rate range. **Inflation refers to wholesale prices. ***For Hong Kong and
†
Singapore, the policy rate refers to 3M Hibor and 3M Sibor, respectively. Policy rate forecasts in 2010-2012 are midpoint of BOJ’s 0-
0.10% target unsecured overnight call rate range. Source: Nomura Global Economics.

Our View on 2011 in a Nutshell
Global
• The developed world recovery is set to stay muted due to ongoing de-leveraging, fiscal restraint and other crisis legacies.
• With better fundamentals and fewer aftermath issues, much of the emerging world, led by Asia, is set to keep growing briskly.
• Developed-world inflation should stay contained, but we see the ECB and BOE raising rates way ahead of the Fed and BOJ.
• We see inflationary pressures mounting in EM as funds keep flowing in and the authorities intervene to stem rising currencies.
• Downside risks: euro area fiscal crisis escalates and spreads; an investment pull-back in China; EM overheating turns sour.
• An upside surprise?: animal spirits stir and crisis-calibrated monetary policies help release pent-up developed world demand.
• We anticipate the US dollar consolidating in 2011 against other major currencies, but weakening against EM currencies.
United States
• We expect the heavy debt burden to restrain the pace of recovery consistent with the growth patterns after financial crises.
• We expect the Fed’s $600bn Treasuries-buying program to be enough to boost growth and stabilize inflation expectations.
• With the recovery on a firmer path, the focus of fiscal policy will shift toward long-run reforms of taxes and entitlements.
• A gradual reduction in economic slack should help stabilize inflation but below the rate consistent with price stability.
• Improving confidence about the outlook should lead to rising employment and renewed capital spending.
Europe
• We see the euro area staying intact and fiscal austerity backed by ongoing official financing helping prevent periphery default.
• We expect euro-area growth in 2011 to be sustained by stronger investment and net trade despite fiscal headwinds.
• We expect a continued gradual recovery in UK growth despite the damping effect of deleveraging and fiscal consolidation.
• Inflation will likely stay above target during 2011 in the UK and hover around the 2% target ceiling in the euro area.
• We expect no further QE with a first BOE rate hike in August 2011, the ECB’s in September 2011, and risks skewed to later.
Japan
• We see a more pronounced recovery from mid-2011 on government stimulus measures and overseas economic recovery.
• We project Japan to pull out of deflation around end-2012 on the back of a shrinking output gap and higher crude oil prices.
• We expect the BOJ to expand its asset purchase program from ¥5trn to ¥8-10trn if the yen strengthens and stocks fall again.
• The main risks are greater-than-expected yen strength and political disruptions surrounding the FY11 budget.
Asia
• Rising inflation is the big macro theme: it will be difficult to control if countries keep holding back appreciating exchange rates.
• China: We expect 9-10% growth in 2011-12 as the government implements structural policies to promote consumption.
• Korea: With growth slowing yet inflation high, we expect policymakers to allow a stronger KRW but hike rates only modestly.
• India: We expect supply constraints to keep inflationary pressures elevated, even as growth consolidates in 2011.
• Australia: We see GDP growth lifting sharply from mid-2011 on much stronger capex in the resource sector.
• Indonesia: Building on robust domestic demand, infrastructure development is likely to unleash growth of above 7% by 2012.
EEMEA (Emerging Europe, Middle East and Africa) and Latin America
• South Africa: A fundamental policy shift is occurring with faster fiscal consolidation to allow more room for lower interest rates.
• Hungary’s anti-growth fiscal policy is concerning and with a more political MPC and pension changes markets will be volatile.
• Poland’s monetary policy normalisation with resume but there is complacency in fiscal policy ahead of elections in October.
• Russia’s growth will probably be lacklustre even though pre-election spending should support consumption.
• Turkey: We see domestic demand firming; bigger imbalances resulting in core inflation and current account deficit pressures.
• Middle East: Growth is picking up on higher oil prices and fiscal stimulus. Inflation is subdued, except in Saudi Arabia.
• Brazil’s economic growth will moderate next year due to fiscal tightening, which will allow policy rates to fall in H2 2011.
• Mexico stands to reap the most from a US recovery in 2011. The pick-up in domestic demand will add momentum to growth.
• With the output gap closed, Argentina’s strong growth is likely to keep inflation high in 2011.

One year on: a 2010 forecast post-mortem Paul Sheard

In previewing 2011, it is salutary to see how our 2010 forecasts fared. We did not see the EA fiscal crisis coming, but our
big picture forecast fared quite well. Growth and inflation were a bit higher than expected; central banks kept rates lower.
In our 2010 Global Economic Outlook, we summarized our outlook for 2010 thus: “The aftermath of the crisis should
constrain the developed world recovery, but, led by a booming China, emerging markets look set for strong growth”. With
three quarters worth of 2010 GDP in the bag, qualitatively this view has been vindicated: the developed world looks set
to grow by 2.6%, much slower than it could have grown coming out of such a severe recession, and the emerging world
by 7.4%, with China looking set to grow by 10.2% (close to its 30-year annual average growth rate).
But we missed two signal events in 2010. One was the eruption of the euro area (EA) fiscal crisis early in the year – we
had identified the financial crisis re-erupting as the key downside risk rather than its transmuting so quickly into a fiscal
crisis. The other was the Fed feeling that it needed to launch a second round of balance sheet expansion (“QE2”).
Global growth has turned out to be quite a bit stronger than we expected, likely coming in at 4.8% rather than 4.2%
(Figure 1), with surprises (to us) coming in both the developed (2.6% vs 2.0%) and the emerging worlds (7.4% vs 6.6%).
The main growth surprises came in Japan and Latin America (specifically Brazil and Argentina). But the growth surprise
was concentrated in the first half of the year, particularly the first quarter, as inventories and fiscal stimulus kicked in –
growth was coming in and looking weaker than we had expected in the second half. So the numerical upward surprise
belies the fact that, from around about the end of Q2, the outlook started to darken a bit, in the US in particular to the
point where the Fed needed to reverse course from de facto tightening to quite an aggressive quantitative ease.
Interestingly, as attention-grabbing as the euro area fiscal crisis was, it does not seem to have done euro area growth
much harm (relative to expectation). It looks like the euro area will grow by 1.7% (rather than the 1.1% we expected),
with Germany providing the biggest upside surprise (3.6% vs 1.6%). The euro ended up being weaker and long-term
interest rates (particularly in the core of the euro area) much lower than we expected, both helping Germany in particular.
Inflation globally turned out to be a little higher than we expected, particularly in LatAm and the UK, although the US (and
EEMEA) bucked that trend. Notwithstanding that, official interest rates turned out to be a bit lower than we expected, the
ECB and the Bank of England not making the first hikes we had penciled in for late in the year and EM central banks
generally being less aggressive in their tightening than we foreshadowed. Although we missed the details, we did
forecast that the Bank of Japan was “likely to adopt additional easing measures”.
Our biggest forecast error was to expect long-term interest rates to end the year much higher than they look like doing.
On exchange rates, the euro and sterling weakened against the dollar rather than strengthening as we expected, the yen
strengthened more than we expected, and the Chinese authorities were a little slower to start letting the renminbi
exchange rate against the dollar rise again than we had penciled in.
Figure 1. Nomura forecasts for 2010 at end-2009 and latest estimates for 2010
Forecast date Global US Euro area UK Japan Asia EEMEA LatAm
16-Dec-09 4.2 2.7 1.1 1.4 1.3 8.4 3.7 4.6
GDP grow th (% y-o-y) 6-Dec-10 4.8 2.8 1.7 1.8 3.7 9.1 3.8 6.6
Error, pp 0.6 0.1 0.6 0.4 2.4 0.7 0.1 2.0
16-Dec-09 2.8 1.9 1.2 2.0 -1.3 3.9 6.3 4.4

CPI inflation (% y-o-y) 6-Dec-10 3.2 1.6 1.6 3.2 -0.8 4.5 5.7 7.3
Error, pp 0.4 -0.3 0.4 1.2 0.5 0.6 -0.6 2.9
16-Dec-09 3.28 0.13 1.25 0.75 0.10 5.45 6.04 8.84

Official interest rates (%) 6-Dec-10 2.96 0.13 1.00 0.50 0.05 5.05 5.81 7.59
Error, pp -0.32 0.00 -0.25 -0.25 -0.05 -0.40 -0.23 -1.25
16-Dec-09 3.80 3.70 4.60 1.55

10-year bond yields (%) 6-Dec-10 3.00 2.90 3.40 1.15
Error, pp -0.80 -0.80 -1.20 -0.40
$/€ $/£ ¥/$ RMB/$ TRY/$ BRL/$

16-Dec-09 1.60 1.95 87.0 6.45 1.35 1.60
Exchange rates 6-Dec-10 1.30 1.57 80.0 6.60 1.47 1.70
Error, % -18.8 -19.5 -8.0 2.3 8.9 6.3
Note: GDP growth and CPI inflation forecasts/estimates are period averages; interest and exchange rates are end of period.
Source: Nomura Global Economics.

Global ⏐ Outlook 2011 Paul Sheard
A rocky road of recovery

We forecast global growth of 4.3% in 2011. Emerging economies are set to keep growing
strongly but risk overheating while the developed world recovery faces continued stiff headwinds.
Three premises In our 2010 Global Economic Outlook, we forecast “a strong recovery in most of EM and a
underpin our 2011 shallow one in the developed world”, positing that the financial crisis would cast a long shadow
forecast on the recovery in the latter but that EM would likely post strong domestic-demand-driven growth.
This is largely how things turned out (see Box: One year on: a 2010 forecast post-mortem). Our
global economic forecast for 2011 remains in this vein and reflects three key premises.
Two-track recovery to continue

We expect the First, we expect the economic expansion that began in early- to mid-2009 after the 2008-09
economic expansion crisis and Great Recession to continue (Figure 1), looking for global growth of 4.3% in 2011,
to continue after 2010’s likely 4.8%: it would take major shocks or policy errors to push the global economy,
or any of the major economies, back into recession.
We expect EM to Second, we expect the global recovery to remain a two-track one (Figure 2), with the emerging
drive the developed economies growing much faster (6.6% after 2010’s likely 7.4%) than the developed world
world to limp economies (2.2% after 2.6%): emerging economies, particularly those in emerging Asia,
generally have good domestic fundamentals, whereas developed economies, particularly the US
and Europe, continue to face headwinds to growth from the aftermath of the financial crisis.
Emerging economies look set to account for almost three-quarters of global growth in 2011 (on a
purchasing power parity basis), with China and India alone accounting for almost half (Figure 3).
On our forecasts, China will contribute three times as much as the US to global growth in 2011,
and India will contribute as much to global growth as Western Europe and Japan combined.
Global rebalancing is Third, the post-crisis global economy is struggling to rebalance smoothly: the tensions and
unlikely to be smooth imbalances in the global economy are likely to remain sources of market volatility and downside
risk to the economic outlook (Figure 4). Output gaps in many emerging economies, some very
small to begin with, have closed or are closing way ahead of those in developed economies, and
high growth in the former is likely to continue to attract strong global capital flows, complicating
policy management and raising risks of overheating and policy errors.
Developed economy headwinds

We live in historic The concept of “path dependence” in economics says sensibly that where an economy has
times come from influences where it is likely going: history matters. This is always true but is
particularly germane when the economy has been hit by major shocks. The financial crisis of
2008 happened for a reason – various excesses and imbalances had built up over a long period
of time – and the aftermath and their unwinding will continue to weigh on the economy and
Figure 1. GDP growth forecasts: 2011, key countries/regions Figure 2. Path of GDP for selected countries/regions
% y-o-y Index, Q1 2008 = 100

10 140 China
Forecast
9 135
8 India
130
7 125
6 120
5 115
4 110 Global
3 105
US
2 100 Euro
1 area
95
Japan
0 90
Japan WE US EEMEA LatAm ROA India China Mar-08 Mar-09 Mar-10 Mar-11
Note: WE is Western Europe; ROA is Rest of Asia. Source: Nomura Global Economics estimates.

QE: Back to basics, again Paul Sheard

A central bank can keep easing monetary conditions at the zero bound by expanding its balance sheet; that is QE.
There continues to be a great deal of misunderstanding surrounding what is referred to as “quantitative easing” (QE),
and the communications of central bankers do not always help. To some, QE is little more than the monetary policy
equivalent of a placebo; to others, it is the evil of all evils, the unfettered printing of money that can only lead to monetary
ruin. In this space last year, we tried to demystify QE (see “QE: back to basics”, 2010 Global Economic Outlook, 16
December 2009) and we have written a number of pieces on it since (see the Global Weekly Economic Monitor).
In our view, the appropriate way to understand QE is to see it as a natural extension (at the zero interest rate bound) of
what central banks normally do, and therefore as neither a monetary silver bullet nor a monetary demon. Normally,
central banks set an overnight interest rate (eg, in the US the federal funds rate). In isolation the overnight rate is a pretty
trivial interest rate; but it is linked to all other rates out on the yield curve via the expectations of future overnight rates,
and all other financial asset prices are linked to interest rates. So the central bank, by setting the overnight rate and, with
a view to favorably influencing the public’s expectations, by signaling what its objectives are and how it intends to set the
rate in the future to meet them, can influence (loosen or tighten as the case may be) financial conditions in the economy.
The central bank is able to set the overnight interest rate because it, and it alone, controls the supply of reserves to the
banking system (reserves are deposits of banks with the central bank, so-called “central bank liquidity”). Central banks
can do this because the overnight interest rate is the rate at which banks lend and borrow reserves among themselves; if
the central bank wants to push that interest rate up it can do so by draining reserves and if it wants to push it down it can
flood the banking system with reserves. But precisely because it has this power and banks know it, the central bank does
not have to use it. All it needs to do is to announce its target interest rate and ensure that it is supplying enough but not
too many reserves, usually roughly the level corresponding to the required reserve ratio; but (given the ratio set by the
central bank) this level depends on the amount of deposits in the banking system, which changes only slowly over time.
Reserves are a liability of the central bank. The other key liability is currency in circulation. This too changes only slowly
and indirectly (via the impact on the demand for money) with changes in the overnight interest rate. So in normal times
an interest-rate-setting central bank does not actively control the size of its balance sheet and the balance sheet is quite
stable in size because its two main components on the liability side (reserves and currency) are; these basically reflect
decisions taken by the public (how much money to hold on deposit and how much currency to hold, respectively).
But what happens when the central bank has cut the overnight interest rate to zero and still wants to ease monetary
conditions? It cannot use the interest rate any more. But it can now start to do something that it was not actively doing
before: expand the size of its balance sheet by purchasing assets or increasing its lending (the former is more powerful
because, whereas the banking system may not want to borrow from the central bank, there is nothing, in principle, to
stop the central bank from buying assets from either the banking system or from other holders of assets).
When the central bank buys assets, it has to pay for them and it does this typically by creating reserves. This is often
called “printing money” but the term is misleading because the reserves created are not money (banknotes) that anybody
can spend; they are assets that the central bank supplies to the banking system in exchange for the ones it takes out. So
where does the monetary easing effect come from? Economists talk of the “portfolio rebalance effect”: when a central
bank acquires a large amount of securities or other assets it is altering the relative supply of (imperfectly substitutable)
assets residing in private sector portfolios, exchanging the assets it purchases for a very liquid asset – central bank
reserves. Individual portfolio holders, having had the composition of their portfolios altered in a more liquid direction, will
start to rebalance those portfolios, and this process will have an impact on asset prices – and importantly on the public’s
expectations – in a way not unlike normal monetary easing. QE is just another way of easing financial conditions.
This is quite different from the image conjured up by describing central banks as “pumping liquidity into the system” as if
that liquidity was like water in a bucket waiting to “flow” to firms as credit and fuel inflation. The excess reserves created
by QE are the balance sheet counterpart to the assets the central bank “sucks out of the system”. Individual banks do not
(and cannot) use reserves to directly lend to non-bank borrowers; they can get rid of their reserves in only two ways: by
lending them to other banks or using them to buy assets, which just shifts them around the banking system, or by making
a new loan, thus creating a new deposit, and seeing their reserves drain when the borrower withdraws the money.
Fed Chairman Ben Bernanke is not being very helpful when he says: “In my view, the use of the term ‘quantitative
easing’ to refer to the Federal Reserve’s policies is inappropriate. Quantitative easing typically refers to policies that seek
to have effects by changing the quantity of bank reserves, a channel which seems relatively weak, at least in the U.S.
context. In contrast, securities purchases work by affecting the yields on the acquired securities and, via substitution
effects in investors’ portfolios, on a wider range of assets.” This is a spurious distinction. A balance sheet has two sides
and the Fed creates excess reserves when it purchases securities. “Changing the quantity of bank reserves” is precisely
the other side of the balance sheet coin to the asset purchases and is an integral part of the portfolio rebalance effect.

GEMaRI: Brave new world Peter Attard Montalto

The G20 has shifted its attention to imbalances and the potential effects of cash flowing into EM. GEMaRI, Nomura’s
Global Emerging Market’s risk index, can provide pointers.
Our Global Emerging Market Risk Index (GEMaRI) measures the risk that a currency crisis will occur in the next 12
months. Our GEMaRI scores as of Q3 continue to suggest that the emerging market (EM) macroeconomic and financial
environment is relatively benign. For the 37 countries that we cover, only Iceland’s GEMaRI score has risen above the
initial danger threshold of 73.
Aggregate regional scores fell back (indicating a reduced likelihood of a currency crisis) in Q3 for EEMEA and to a lesser
extent Asia after falling in the previous quarter too. LatAm scores, however, increased in aggregate given the strong
recovery that is taking place in that region. Turkey, the fastest riser in Q2, has now fallen back, while a number of
stressed CEE (Central and Eastern European) countries have increased their scores. EEMEA scores remain volatile as
growth softened in Q3 on lower external demand.
Asia’s GEMaRI scores fell on aggregate in Q3 as the strong recovery continued there. Asia has the strongest growth
prospects of any region in GEMaRI because of its loose macro policies, sound economic fundamentals and positive spill-
over effects from the robust China. High and rising FX reserves, current account surpluses and low public debt suggest
that full-blown exchange rate crises are highly unlikely. The one possible exception is Vietnam, which at 64, has Asia’s
highest GEMaRI score, because of low FX reserves and twin trade and fiscal deficits. India’s GEMaRI score (43) is the
second highest in Asia because it too has large current account and fiscal deficits and high inflation.
The moves in GEMaRI scores this quarter are eclipsed by the developments in periphery Europe. These countries
would almost certainly score at the very highest end of GEMaRI in view of significant external and public sector debt,
fiscal deficits and other imbalances. But, being within the euro, they cannot have balance of payments-related stresses;
instead such stresses and imbalances are exposed through liquidity issues. Such “developed” market issues, however,
highlight a dissociation between risk and reward in many EM countries: the correlation between FX/CDS moves and
GEMaRI has broken down as strong capital inflows have continued into EM. If further contagion occurs around the
periphery, this financial decoupling is unlikely to last and spreads could spring back to higher levels and again move
more in step with developed market spreads. At such a juncture, markets may well hone back in on fundamentals and on
imbalances in particular. Hence markets could return to moving in step with GEMaRI risk indications.
On the flip side, however, we believe that some degree of economic decoupling can continue, even if financial market
recouping is the order of the day. However, economic decoupling does risk a continued flow of liquidity entering EM and
finding its way through the banking system to household leverage, higher real rates, burgeoning current account deficits
and other imbalances monitored by GEMaRI. GEMaRI provided an early warning of such previous inflow-led imbalances
before the Asia crisis, LatAm crisis and then from 2007 onwards globally with easy money again flowing in EM. However,
the issue is more that a structural asset allocation shift is occurring within global portfolios to increase weight on EM
given growth outperformance. Such a move can be targeted by looking at individual country risks and imbalances (in
other words, where GEMaRI can be of some use). Alternatively, if the shift is more indiscriminate, not based as much on
country specifics, then it risks a leveraging up of imbalances and so GEMaRI will still be of use in highlighting the risks
building here. Offsetting policy with reserve accumulation and tighter rates, as well as macro-prudential policy on bank
lending and fiscal discipline, will all be needed to prevent the build-up in imbalances and a rise in GEMaRI scores.
A full version of the latest GEMaRI update can be found here: “Brave New World”, published 2 December 2010.
Figure 1. Nomura’s GEMaRI index

Scores 1-in-2 chance of a
100
currency crisis
79
75 1-in-3 chance of a
64 61
60 currency crisis
51 51 50 50
50 44 43 43
39 37 37 36
33 33 30
28 26 25 25 25
23 22 21 19
25 19 17 17 16
10 10 8 7 7
0
0

influence it in 2011 and beyond. And the crisis, and policy responses to it, create their own
legacies and unintended consequences. Forecasting in this kind of environment is likely to
continue to have a strong element of slow-motion watching of history in the making.
The developed world For the developed economies, the post-crisis/Great Recession world likely means prolonged
is set for prolonged anemic growth. Growth is likely to be too slow, relative to how far GDP has fallen, to close the
weak growth output gap quickly, leaving unemployment stubbornly high, inflation pressures muted, fiscal
authorities eager to repair the damage to government finances (Figure 5), but constrained by
low growth in their ability to do so, and central banks needing and being able to keep monetary
policy loose, and for those deeply in unconventional territory, for long (on the latter, and why we
do not see it as sowing the seeds of future high inflation, see Box: QE: Back to basics, again).
Household debt In the US, where we forecast 2.5% growth in 2011 after likely 2.8% growth in 2010, the key
deleveraging is crisis-aftermath headwind is continued household debt deleveraging, which we see as taking
crimping US growth another 4-5 years to run its course (see US Outlook 2011: Debt hangover limits recovery).
Uncertainty about the financial regulatory regime, how landmark health care reforms are going
to be implemented, and whether a grid-locked government can come to grips with longer-term
fiscal challenges is also likely damping animal spirits.
In Europe there are In Europe, where we forecast 2.0% growth after likely 1.8% in 2010, the aftermath of the
fiscal crisis financial crisis is making its mark as a fiscal crisis, and associated earlier-than-expected
headwinds headwinds from fiscal austerity, and a crisis of confidence about the future of the euro (see Euro
Area Outlook 2011: A slippery road lies ahead and UK Outlook 2011: Rebalancing the books).
We think European We are not in the doomsday camp on the outlook for the euro area. Taken as a whole, the euro
policymakers will rise area is in reasonable macroeconomic shape (Figures 4 and 5) and at the end of the day we
to the challenge believe European policymakers will “do whatever it takes” to keep the European project on the
rails and that electorates, after venting plenty of anger, will support them. The problem lies in an
economic governance system whose deficiencies have been exposed by the financial crisis and
whose institutional rules of the game remain work-in-progress. In such circumstances, markets,
unsentimental as they are, are prone to test policymakers’ mettle, even if it does mean biting the
hand that feeds them. We look for the politicians eventually to regain the upper hand.
Japan, back in In Japan, where we forecast growth of just 1.1% in 2011 after a base-effect-flattered likely 3.7%
deflation, is looking in 2010, the Great Recession pushed an economy that was finally emerging from deflation back
to exports into that state, and set real estate prices tumbling again, chilling animal spirits. Policymakers
again are having to take rear-guard action, as most put their hopes in an export- rather than
domestic-demand-led recovery (see Japan Outlook 2011: Export-led recovery on the horizon).
Emerging worries
In EM, real exchange For the emerging economies, it is an entirely different kettle of fish. With growth so strong and so
rates should rise weak in the developed world, and emerging market (EM) risk appearing to be contained (see
Box: GEMaRI: Brave new world), capital is naturally flowing into EM in search of the higher
potential returns on offer. Given their differential growth performance and outlooks (Figure 2),
Figure 3. Contributions to global GDP growth Figure 4. Current account balances: 2008 vs 2011-12 forecast
2010 2011 2012 % GDP

Global growth (% y-o-y) 4.8 4.3 4.5 10
2008 2011 F 2012 F
8
Contributions to growth (pp): 6

Developed World 1.4 1.2 1.3 4
United States 0.6 0.5 0.6 2
Western Europe 0.4 0.4 0.5
0
Japan 0.2 0.1 0.1
-2
Emerging Markets 3.4 3.1 3.2
-4
China 1.5 1.5 1.5
-6
India 0.5 0.5 0.5
US Euro area Japan China
Source: Nomura Global Economics estimates. Note: Contributions Source: Nomura Global Economics estimates.
to growth are on a purchasing power parity (PPP) basis.

Global imbalances: Putting the basic macro identity to work Paul Sheard
Current account balances link the real and monetary activities of countries across time and space.
One of the most useful and powerful analytic devices in macroeconomics is the savings-investment identity. In words,
this says that a country’s total net savings in each period – that is, its savings net of investment – must be equal to its
current account surplus or equivalently to the increase in its net claims on the rest of the world. This simple but surprising
little identity yields a number of important insights when thinking about global imbalances.
The macro identity is easily derived from the basics of national output accounting (symbols below are all in real terms).
The output of a country, denoted by Y, must find its way into one of the following: private consumption, C; consumption
or investment by the government, G; investment, I; and exports X; all these expenditure categories being net of imports,
M, to leave expenditure on domestically produced goods. That is, Y = C + I + G + X – M. But the output of a nation also
accrues to the suppliers of the factors of production as income, denoted by the same Y. Income can be disposed off,
exhaustively, in one of three ways: it can be used to finance consumption, C; it can be saved (accumulating as financial
assets), S; or it can be taxed by the government, T. That is, Y = C + S + T.
Putting the two together, the identity part yields: C + I + G + X = C + S + T. Cancelling the common consumption term,
and rearranging terms yields the result: (S – I) + (T – G) = (X – M). The first term is private sector net savings and the
second term is the government’s net savings or budget surplus; together they represent the nation’s total net savings.
The term on the right-hand side is the current account balance (surplus, if positive). So the macro savings-investment
identity says that total national net savings equals the current account balance, which is also the increase (if positive) in
the nation’s financial claims on foreigners, given that net savings can be deployed only by lending them to somebody –
and for a whole country, that ‘somebody’ has to be foreigners.
There are a few important things to note about the macro identity. First, being an identity, it is always true. Tell me that a
country is running a current account deficit and a budget surplus and I will tell you that the private sector is running a
deficit. But second, also by virtual of being an identity, it says nothing about causality; for instance, as tempting as it may
be to say things like, an increase in the budget surplus (if private net savings do not change) causes the current account
surplus to increase, the macro identity says nothing of the sort. Third, the macro identity holds ex post but it need not (in
fact, generally does not) hold ex ante. It is the operation of the decentralized price system of the market for goods and
services and financial claims that makes inconsistencies in planned savings and investment consistent after the fact.
Now, to put the macro identity to some economic use, note five simple points:
First, it shows that the monetary economy is intricately linked to the real economy, a point too often lost on those who
seem to think that only the manufacturing or production sector adds value and that the financial sector is purely parasitic.
Second, by running current account surpluses or deficits is how countries save or dis-save, respectively, over time. The
first pass at looking at current account surpluses and deficits should be through this spectrum rather than immediately
labeling them as “imbalances”. In a world of autarky there would be no current account “imbalances”, but countries would
be extremely impoverished by their inability to trade with the rest of the world and transfer consumption opportunities
through time as a result. That said, it has puzzled many economists why many emerging market economies, China being
the notable example, have been running such large current account surpluses given that low income developing
economies might be expected to finance their investment and growth by drawing on the savings of more developed,
richer and often more mature, aging economies.
Third, for the world as a whole, current account balances sum to zero, so if some countries are saving, others must be
dis-saving (in a two-country world, think China and the US, respectively). This means that, if some countries want to
increase their net savings, they can do so only if others are willing to increase their net borrowing. Hence, all the talk of
the need for global coordination of the unwinding of current account imbalances under the aegis of such fora as the G20.
Fourth, the macro identity reminds us that there is a big difference between government net savings and national net
savings. Too often observers speak of government budgets, and the associated stock of government debt, as if they
were synonymous with the country’s net savings and stocks of indebtedness, respectively, when the government deficit
is just one half of the national savings equation. Japan is a good example: it consistently runs a budget deficit and a
current account surplus, which means that its private sector (household and/or corporate sector) must be running an
even bigger net savings surplus. The government deficit says little about national indebtedness.
Fifth, the macro identity shows that in a global recession, when desired private sector net savings are prone to spike
(because savings rise and investment falls) in many if not all countries, and as current account balances necessarily sum
to zero at the global level, there is a useful role for governments to run large deficits. Such government dis-saving
provides the necessary offset to absorb the surge in private sector net savings, lest the economy otherwise spiral into a
great depression, falling victim to what Keynes called the “paradox of thrift”.

real exchange rates in emerging economies in general should be appreciating relative to the
developed world and this is both indicated by, and should contribute to, the global rebalancing of
current accounts that needs to take place over time, the blowout in such imbalances having
been part of the jig-saw of factors precipitating the crisis in the first place (Figure 4) (see Box:
Global imbalances: Putting the basic macro identity to work).
Resisting nominal However, with demand weak in their developed world export markets, EM policymakers are
appreciation risks prone to resist nominal exchange rate appreciation by stepping up foreign exchange intervention
overheating and imposing distortionary capital controls, with the result that over time the real exchange rate
appreciation will likely end up occurring via domestic overheating and inflation (see Asia Outlook
2011: Challenges of rebalancing; EEMEA Outlook 2011: Policy design for postmodern times;
and LatAm Outlook 2011: Too much of a good thing). There are signs of this starting to happen.
Commodities pose an Rising food and commodity prices, partly fuelled by strong EM growth, create particular
inflation challenge challenges for emerging economies given the importance of food in CPI baskets; more flexible
exchange rates would also allow these economies to better absorb such price shocks. We are
bullish on the outlook for EM growth and are forecasting only a modest pick-up in inflation from
5.3% in 2010 to 5.7% in 2011, but the scope for inflation to overshoot on the upside, testing the
inflation-targeting mettle of central banks, is on the rise.
Risks to the forecast

The fiscal crisis Given the long shadow that the 2008-09 crisis and recession is likely to cast, we continue to see
spinning out of the risks as more tilted to the downside. We see three main downside risks, implicit in the above
control is the key risk description of our baseline forecast. At the top of the list is that the fiscal crisis in Europe spins
out of control and even spreads beyond Europe, precipitating too much fiscal austerity for
economies to bear and triggering another round of financial system distress.
Investment pulling A second is a pullback in investment in China, perhaps triggered by attempts to cool an
back in China is a overheating economy. Given how investment-intensive its economy has become, most recently
serious risk accentuated by its investment surge response to the crisis, anything that caused investment
growth in China to slow markedly, let alone go negative, would have a dramatic downward
impact on GDP growth (Figure 6). And given how important China has become in the global
economy (Figure 3), a slowdown in Chinese growth would ricochet around the global economy.
EM overheating A third downside risk is that “currency war” tensions and capital control mania escalate and spill
poses risks over into trade protectionism, with negative impacts for growth and market sentiment.
Politics aplenty There are also political risks, amid a busy election calendar, and geopolitical risks, which by their
nature tend to be to the downside (see Box: Global politics outlook 2011).
DW pent-up demand The main upside risk to our baseline forecast is that developed world (DW) growth turns out to
being released is an be stronger than we forecast. If the euro area fiscal crisis subsides and none of the negative risk
upside risk factors surface, and with monetary policy calibrated to deflation risks, it is possible that animal
spirits stir and “pent-up” demand, particularly in the US, is released. Now that would be nice.
Figure 5. Fiscal balances, 2008-2012F Figure 6. China’s 2011 GDP simulated growth: sensitivity to
rate of investment growth
% GDP Real GDP , % y-o-y
15
0
-2
10
-4
-6 5
-8
0
-10
-12
US EA UK Japan -5
20 15 10 5 0 -5 -10 -15 -20
2008 2009 2010 2011 2012 Real gross capital formation, % y-o-y
Source: Nomura Global Economics estimates. Source: China Statistical Yearbook; CEIC; Nomura Global
Economics.

Global politics outlook 2011 Alastair Newton

Politics and policy will continue to be key drivers of market sentiment in 2011 as governments pursue exit strategies from
the financial crisis.
• The United States: Barring an out-of-left-field event, decisions in the US stand to be the main focus of markets as
the outcome of the 2010 mid-term elections points to legislative gridlock (often seen, rightly or wrongly, as a positive
by markets). We look for bipartisan agreement to extend the Bush-era tax cuts (hopefully before they expire at the
end of 2010) but see little hope of progress on medium-term fiscal consolidation. We expect the Republican Party to
seek to minimize the additional burden on business of healthcare and financial market regulatory reform.
Furthermore, bipartisan agreement may form on anti-China legislation (see below) and on enhancing political
oversight of the Fed.
• Eurozone: We continue to take the view that the Eurozone will probably manage to avoid another major crisis in
2011. However, the recent deepening and broadening of sovereign debt worries looks set to continue into next year.
Domestic politics in Portugal and Spain, as well as a now probable early general election in Ireland, all give
markets continued cause for concern, while weak governance in both Belgium and Italy may further unsettle bond
markets. Furthermore, especially with key local elections in Germany in March, investors remain to be convinced
that Eurozone leaders will yet find the wherewithal to avert a re-run of the early 2010 crisis.
• The United Kingdom: The 5 May 2011 local elections and referendum on electoral reform stand to test the ruling
coalition’s resilience as the impact of the government’s ambitious fiscal consolidation programme is increasingly felt
by the electorate. We expect the coalition to survive the likely set-backs at the ballot box and to stay the course.
• The Middle East: Domestic politics in a number of economies – e.g. Egypt, Iraq, Lebanon – stand to fuel tensions
locally and the regional and wider terrorism threat posed by al Qa’ida in Yemen may yet unsettle markets. However,
we see only a low probability of a global shock emanating from the region in the next 12 months (e.g., an Israeli
military strike on Iran).
th
• China: The rolling out of the 12 Five-Year Plan will be a key element in ensuring a smooth economic trajectory
through the handover of power to the incoming Fifth Generation leadership between October 2012 and March 2013.
Internationally, Sino-US relations remain paramount and we look to President Hu Jintao’s proposed visit to
Washington In January 2011 to help defuse tensions. However, even though we expect RMB appreciation to
accelerate, we doubt that it will do so fast enough to satisfy some of China’s critics in Washington.
• Korea: South Korea’s recent tougher stance towards North Korea in the wake of the latter’s most recent act of
aggression may not be sufficient to deter Pyongyang from further malfeasance (e.g. missile launches and/or a third
nuclear test). We therefore expect tensions to remain high for the time being, but do not rule out the parties involved
in the six-party talks returning to the negotiating table in the foreseeable future. However, we see little prospect of
North Korea being prepared to abandon its nuclear programme, regardless of whatever incentives the international
community offers.
• Generic issues where policy decisions stand to play a particularly important role, perhaps especially in emerging
markets, include the management of capital inflows and food price inflation.
• Other top “issues” to follow (in alphabetical order):
o Argentina: After Kirchner;

o Brazil: A change at the helm still points to policy continuity;
o Nigeria: Oil and troubled waters;
o Pakistan: Possible terrorism spillover into India;
o Peru: An unpredictable election;
o Russia: What will Mr Putin do next?
o Thailand: Still troubled;
o Turkey: A third term for AKP?
o Ukraine: Back in bed with the IMF?
o Venezuela: The Bolívar revolution presses on regardless;
o Vietnam: The next generation
Note: A full assessment of all the issues noted above can be found in Issues Which Keep Me Awake at Night 2011 Forecast: Politics
Remain Pivotal Even As Risk Aversion Recedes (Nomura International plc, 24 November 2010).

United States ⏐ Outlook 2011 David Resler
Debt hangover limits recovery

The recovery from the “Great Recession” is likely to remain a slow and arduous climb. We
forecast growth to remain below its underlying potential for most of the coming year.
Growth in 2010 lived The National Bureau of Economic Research (NBER) determined that the longest and deepest
up to modest business contraction since the 1930s ended in June 2009, but the recovery so far has been as
expectations disappointingly slow as we had expected. With three quarters of 2010 real GDP already known
and available data tracking a 2.3% rate in the fourth quarter, our year-ago forecast of 2.7%
growth during 2010 looks to have been about right, although the quarterly pattern has been
more erratic than we had envisioned (Figure 1). Moreover, owing to the lackluster growth during
the middle two quarters of 2010, real output will end the year a tad softer than we forecast in
Outlook 2010. Consequently, we expect 2.5% year-on-year growth in 2011, down slightly from
the 2.6% clip envisioned at the end of 2010. The nature and severity of the Great Recession
continues to shape the profile of recovery. Indeed, the recovery is tracking the same sort of
trajectory that has prevailed after other financial crises (Figure 2).
The debt reckoning continues

Household debt Although the recent contraction shared a number of elements common to all cyclical downturns,
remains excessive it also left a legacy of unique and debilitating effects. As with all previous slumps, the end of a
housing boom initiated the contraction and the subsequent downturn as rising interest rates
triggered a supply/demand imbalance that required an inventory correction. But this housing
cycle has been unlike any other, featuring a brutal debt-financed real estate price bubble. From
2001 to 2006, mortgage debt of households grew at an average annual rate of about 12.2%.
Initially, the extra leverage seemed to be paying off as real estate values rose even faster
(12.9%). But when the bubble burst, the heavily leveraged equity cushion collapsed, with
outstanding household mortgage debt now exceeding the remaining equity stake (Figure 3).
Although financial institutions seem to have largely dealt with the consequences of that leverage,
household balance sheets remain bloated with mortgage debt. As a result, household debt
relative to income remains extraordinarily high (see Figure 1 in Box: Household deleveraging).
The wheels of debt Historically low interest rates have eased the debt service burden, but the collapse in prices of
resolution turn slowly the real estate financed by mortgages has shattered the incentive to meet those debt obligations.
Unprecedented millions of homeowners are irrevocably insolvent, owing much more than their
property is worth. Upwards of one-in-five homeowners owe more than their home is worth, and
although mortgage debt delinquencies and foreclosure starts have retreated a bit, they remain
near record levels. Although record numbers of these debtors are in arrears and facing
foreclosure, the legal wheels of debt resolution – foreclosure proceedings and bankruptcy –
have been turning too slowly to quickly resolve the crisis. However well-intended, government
efforts to help homeowners modify mortgages have done little to improve mortgage market
fundamentals. Indeed, a large backlog of homes in foreclosure further delays the price
Figure 1. Actual and forecasted growth in real GDP: 2008-2012 Figure 2. Recoveries from financial crises: now and then
% q-o-q ar Index, time, t = 100

6 Start of recession or financial crisis
Dec 2009 forecast (red line) 120
4
2 115 Earlier US
0 110
-2 OECD big five Our forecast
105
-4 Dec 2010 forecast
(red bars)
-6 Actual (black bars) 100
Recovery to date
-8 95
Mar-08
Mar-09
Mar-10
Mar-11
Mar-12
Sep-08
Sep-09
Sep-10
Sep-11
Sep-12
t-4 t t+4 t+8 t+12 t+16 t+20

Quarters from peak
Source: Bureau of Economic Analysis; Nomura Global Economics. Source: BEA; OECD; Nomura Global Economics.

Household deleveraging Zach Pandl

Household debt ratios should continue to fall in 2011, weighing on growth and real estate prices.
Since the start of the 2008-09 recession, the ratio of credit market debt of US households to disposable personal income
has fallen by 12 percentage points (pp): from 130% to 118% (Figure 1). Sharply declining debt levels are a distinctive
aspect of the current recovery. The household debt ratio declined after the 1969-70, 1973-75, 1981-82 and 1990-91
recessions, but the average decline at this point in the recovery was just 1pp. During and after the other post-war US
recessions, debt levels actually rose. Mortgage debt dominated the increase in household leverage – accounting for 94%
of the increase in the debt-to-disposable income ratio since 1997 – and has also accounted for most of the decline.
Mortgage debt has fallen by 10pp as a share of disposable income, and other debt by just 2pp.
What accounts for this big decline in household debt? The single most important reason seems to be defaults. According
to Federal Reserve data, as of Q2 2010 home mortgage debt had declined by $463 billion from its peak in Q3 2008.
Over that same period, commercial banks charged-off about $90bn in defaulted mortgage debt, and we estimate that
other mortgage holders wrote off about $375bn in US home mortgages (extrapolating the Fed’s commercial bank default
rates to the broader mortgage universe). The total amount of charged-off mortgages (around $465bn) is therefore almost
exactly equal to the decline in mortgage debt. Similarly, commercial banks have charged-off about $80bn in credit card
debt, auto loans and related debt, which is equal to about half of the decline in consumer credit from its peak. A very
large portion of the decline in the household debt-to-disposable income ratio is therefore not voluntary “belt tightening”
but reflects the extinction of debt through default. For mortgages at least, this makes intuitive sense: households cannot
realistically pay off their mortgage debt by trimming other expenditures.
In addition to defaults, a number of secondary factors likely contribute to falling debt-to-income ratios. One is the decline
in house prices. A drop in house prices reduces wealth and expected lifetime resources, and therefore the appropriate
level of debt that households should carry. It also cuts available collateral, which may be particularly important for
household debt tied to small businesses. A second is lower expected income. Surveys suggest households have turned
quite pessimistic about their future income prospects (Figure 2). Lower expected income growth means lower targeted
debt levels and perhaps the need for higher precautionary reserves of liquid assets (particularly if income uncertainty has
also increased). A third is supply constraints. At the height of the financial crisis, surveys and other data indicated a
severe tightening of credit supply. We think these constraints have dissipated a lot – as indicated by the Fed’s Senior
Loan Officer Surveys – but they likely helped cause some of the initial decline in debt levels.
We expect the debt-to-disposable income ratio to continue to fall, but it is difficult to know where it will stop. The post-war
average of this ratio is 74.6%, and the average since 1916 is 38.7%. However, financial innovation and changes in
consumer preferences may have increased the structural level of debt. Across the OECD, we estimate that the debt-to-
disposable income ratio averaged 91% in 1995, 107% in 2000 and 129% in 2005. Our working assumption is that the US
debt-to-disposable income ratio will fall to 90%, which is where it stood in the late 1990s before the housing boom over
the last business cycle. On current trends this decline would take another four to five years.
The economic impact of deleveraging is one of short-term pain for longer-term gain. Over the near term, households
targeting lower debt ratios will likely raise their savings rates, depressing consumption relative to income. In addition, and
especially if falling debt levels are caused mostly by defaults, deleveraging will cause households to shed assets, putting
downward pressure on prices (particularly for real estate). Over time, however, lower debt ratios should make spending
and the financial system less vulnerable to asset prices, presumably making the economy more stable.
Figure 1. Ratio of household debt to disposable income Figure 2. Median income growth expectations for next 12m
% %
140 5
120 4
Nominal
Total 3
100
2
80 1 Real
Mortgages
60 0
-1
40
Consumer credit -2
20
-3
Other
0 -4
Mar-55 Mar-65 Mar-75 Mar-85 Mar-95 Mar-05 Mar-85 Mar-90 Mar-95 Mar-00 Mar-05 Mar-10
Source: Federal Reserve, BEA. Source: Univ. of Michigan; Note: Shading indicates recessions.

realignment necessary to establish confidence that the “correction” has ended. Until more
households fully extinguish that debt, the growth in consumer spending is likely to be restrained.
Uncertainty impedes Meanwhile, with some 14.5% of the existing housing stock still unoccupied, builders remain
the housing recovery hesitant to construct new homes. The result has been an unusually protracted housing slump
and a housing market that increasingly seems unlikely to bounce back soon. As with our
forecast of a year ago, we envision only a slow rebound in homebuilding, with housing starts
remaining below the lowest point of all previous recessions throughout 2011 and most of 2012.
But a QE2-assisted While facing a protracted period of debt-constrained spending, the household sector, as a result
boost to equities is a of rising stock prices, has recovered part of the wealth lost when asset prices collapsed during
welcome lift 2008-09. Through Q2 2010, the combined net worth of all US households stood at about $53.5
trillion, down somewhat from the first quarter but about $4.7trn higher than at the nadir of the
recession when the cumulative loss stood at $17trn. Thanks in part to stock prices resurging in
anticipation of the Fed’s latest phase of quantitative easing (QE2), the second quarter’s $1.2trn
drop in households’ equity and mutual fund balances was more than recovered in the third
quarter. With the Fed likely to complete its QE program, solid earnings growth and ample cash
flow make it likely that the equity markets will continue to recover. That extra wealth lift should
complement the growth in personal incomes – the mainstay of consumer spending.
Improving, but still slow, job growth

The labor market The key driver of income growth, of course, is wage and salary income, which depends primarily
should continue to on the state of the job market. Labor market conditions began to improve in 2010 and we expect
improve, but slowly them to continue to do so in 2011 and 2012. Private sector employment has risen by more than
1.2 million (in net terms) since its December 2009 low. With overall demand improving gradually,
we expect the jobs recovery to accelerate and forecast total payroll gains of some 1.5mn jobs
from Q4 2010 to Q4 2011 and about 2.5mn over the four quarters ending in Q4 2012. Still, five
full years after the previous business cycle peak and some two and a half years after the trough,
forecast employment remains about 2.3% (3.2mn) below the previous peak (Figure 4). It seems
unlikely that employment will regain that peak before the end of 2013.
Home-building and Such a slow recovery in employment is unprecedented and reflects what are likely to be
construction face a profound structural changes. Arguably, no industry has been hit harder than construction where
slow recovery about 2.1 million jobs have been eliminated, nearly double the number added during the 2002-
07 expansion. With about 14.4% of the housing stock still vacant, home-building is forecast to
recover only slowly so most of the lost 2.1 million construction jobs are likely to be permanent.
Manufacturers have The Great Recession also accelerated the decades-long slide in manufacturing employment but
raised their that sector has grown so lean that some industries are likely to restore some of the jobs they
capital/labor ratio have cut. Still, many of the job cuts in manufacturing also reflect a widespread industrial “right-
sizing” as industries substitute capital for labor. Indeed, this long-standing trend accelerated
during the recession (Figure 5). Even though capital spending declined by more than 20% from
the Q1 2008 peak to the Q4 2009 low and businesses’ stock of real business equipment fell for
Figure 3. Mortgage debt and home-owners’ equity Figure 4. Payroll employment relative to cycle peak
$trn Index (100 at time t)

14 Business cycle peak
108
12 Equity in residential real estate
106 Post-war
average
10
104
8
102
6 100
Actual Forecast
4 98
Mortgage debt
2 96
0 94
1980 1985 1990 1995 2000 2005 2010 t-4 t t+4 t+8 t+12 t+16 t+20
Quarters from peak
Source: Federal Reserve; Nomura Global Economics. Source: Bureau of Labor Statistics; Nomura Global Economics.

The output gap Aichi Amemiya

Although the output gap is a key determinant of inflation, it is unclear how much slack exists in the system.
The “core” consumer price index – the CPI excluding food and energy – advanced by just 0.59% in the 12 months ending
October, its lowest reading since the series began in 1957. With most other inflation indicators tracking a disinflationary
trend, many argue that the slide in inflation can be attributed to the huge excess of productive capacity in the economy.
For instance, during the 2008-09 recession, the capital utilization rate in the industrial sector plunged from an April 2007
peak of 81.7% to a record low of 68.2% in June 2009. Meanwhile, the jobless rate reached double-digits in Q4 2009 and
has remained above 9% longer than at any time since the Great Depression. Although the economy continues to operate
with a lot of slack, there are several ways to measure economic slack, making it debatable just how big the output gap is.
The output gap is defined as the difference between actual GDP and potential GDP. The latter is defined as the level of
output attained when labor and capital are used at a normal (economic-trend adjusted) level. The Congressional Budget
Office (CBO) calculates perhaps the most frequently cited estimate of the output gap; its latest estimates put it at a
sizable 6.1% of GDP. The CBO’s methodology relies on a number of assumptions and estimates of its component parts,
including the labor input gap, which is primarily determined by the divergence between the actual rate of unemployment
and its “natural rate”. Thus, the overall output gap depends on the level of the natural unemployment rate, which
corresponds to the CBO’s NAIRU (non-accelerating inflation rate of unemployment), defined as the unemployment rate
that is consistent with a stable rate of inflation. The CBO currently pegs the NAIRU at 5.0%, more than 4.5 percentage
points (pp) below the current jobless rate, suggesting there is considerable deflationary pressure on inflation.
However, some economists question the CBO’s estimate of NAIRU, noting that its inter-temporal stability seems
unreasonable. The combination of a fairly high unemployment rate and a falling but still positive inflation rate, suggests
that the inflation rate has been boosted by some factor other than the unemployment rate or that the natural rate of
unemployment may be temporarily elevated for some reason. Thus, the relationship between the unemployment rate and
inflation has either become unstable, or there has been some structural shift in this relationship in recent years. While the
CBO took into account other factors such as “changes in productivity trends, oil price shocks and wage and price
controls” in estimating the natural unemployment rate, many economists argue that a mismatch between job seekers and
employers has been widening, resulting in a higher natural unemployment rate than current estimates of NAIRU suggest.
Federal Reserve Chairman Ben Bernanke recently noted that protracted episodes of joblessness “may also convert what
might otherwise be temporary cyclical unemployment into much more intractable long-term structural unemployment.”
Reflecting this possibility, the central tendency of FOMC members’ projections of the longer-run unemployment rate was
revised up to 5.0~6.0% in November from June’s projections of 5.0~5.3%.
To assess those arguments, we derived an estimate of the natural unemployment rate to incorporate variation in job
mismatches. By removing the cyclical element from the so-called Beveridge curve, which relates the unemployment rate
to the job vacancy rate, we extracted a structural component from the unemployment rate (Figure1). We estimate that
the persistently elevated job vacancy rate coinciding with a rising unemployment rate would effectively raise NAIRU to
about 6.2%. Incorporating this estimate into output gap accounting, which is similar to the CBO’s methodology, we
calculate an output gap of -3.3%, about 2.8pp smaller than the CBO’s estimate of -6.1% (Figure 2). A further increase in
this job mismatch could convert some cyclical unemployment into permanent unemployment and thereby reduce the
economy’s potential GDP growth rate. Thus, if a labor market mismatch has effectively narrowed the output gap, inflation
pressures could surface sooner than conventional estimates of the output gap may imply.
Figure 1. Natural unemployment rate: CBO and our alternative Figure 2. Output gap: CBO and our alternative
% % output gap based on the

7.0 6 Beveridge curve analysis
CBO's estimate
6.5 4
6.0 2
5.5
0
5.0
-2
4.5 -3.3
natural unemployment rate based
on the Beveridge curve -4
4.0
3.5 CBO's estimate -6 -6.1
3.0 -8
Mar-64 Jan-72 Nov-79 Sep-87 Jul-95 May-03 Mar-67 Mar-74 Mar-81 Mar-88 Mar-95 Mar-02 Mar-09
Source: CBO; Nomura Global Economics. Source: CBO; Nomura Global Economics.

The new fiscal debate David Resler

In 2009 government policies focused on economic stimulus and in 2010 on sweeping health care and financial services
reforms. In the year ahead, the compelling case for long-run fiscal policy reforms takes center stage.
History sometimes creates its own imperative. The Great Recession has left a legacy of depleted revenues and
expanded outlays. Relative to GDP, revenues have never been lower nor outlays higher than in the past three fiscal
years (Figure 1). Complicating the task of setting policies to resolve these cyclical imbalances, policymakers also now
face the consequences of procrastinating for decades over addressing the effects of an aging population on entitlement
spending. Although many insist that a still struggling economy requires more fiscal stimulus, the perceived failure of
nearly three years of stimulatory policies to secure a strong recovery has all but foreclosed consideration of new
spending measures. Instead, the fiscal policy debate is rapidly shifting to concerns about the long-run budget outlook.
The 1 December report from the president’s special bi-partisan deficit reduction commission has brought that debate to
center stage. Even before the commission issued its report, co-chairs Alan Simpson, a former Republican senator, and
Erskine Bowles, once President Clinton’s chief of staff, outlined their own five-part plan. The Bowles-Simpson plan would
cap revenues “at or below” 21% of GDP and would cut spending to about 22% of GDP before eventually falling in line
with the revenue cap. However, as Figure 1 illustrates, revenues have been remarkably stable, averaging 18.1% since
1951, never exceeding 20.9% or falling short of 16.1% until the current cycle. Decade-long averages have fallen in an
even narrower range: from 17.2% to 18.6%. This remarkable stability has occurred despite a wide range of marginal tax
rates, exemptions and deductions, and other defining tax regime characteristics. Spending on the other hand has
trended higher as recessions ratchet outlays up to levels that fall only grudgingly when the economy improves. This
simple graphic encapsulating decades of diverse experience leaves little room to doubt that only structural reform of both
spending and taxes can materially reduce the deficit.
Whether the revenue and spending goals can be achieved, the proposals themselves represent a watershed in the
debate about fiscal priorities and the “guiding principles” behind the plan could serve as a template for informed debate
on structuring a credible fiscal policy fix. The commission recommends meaningful reforms both to sacrosanct
entitlement programs as well as to the Byzantine tax code. Notwithstanding the intense resistance to changing
entitlements, thoughtful measures to address the long-run problems in Medicare and Social Security can no longer be
blithely dismissed as politically impossible. Although enacting all the commission’s recommendations seems out of reach
th
in the near future, some specific proposals within the plan could find their way into legislation sometime during the 112
Congress, which will convene its two-year session in early January.
In our view, the commission’s tax proposals hold particular promise and may find a warmer reception in the new supply-
side-oriented Congress than the more controversial entitlement reforms. Encouragingly, the commission implicitly
acknowledges that “comprehensive tax reform” can help promote growth. Notably, the Bowles-Simpson tax plan would
repeal the alternative minimum tax and state and local income tax deductions, and would limit or cap various tax
deductions including mortgage interest and charitable deductions. Perhaps most importantly, it would also simplify the
tax code to just three marginal individual tax rates 8%, 14%, and 23% and a single corporate tax rate of 26%. Current
law, with its seven marginal rates and complexity of deductions and exemptions totaling some $1.3 trillion in 2007, has
created a distorted and unstable revenue base in which most income tax revenues flow from those in the highest
brackets (Figure 2). Flattening the rate structure, broadening the base, and simplifying the code could both boost output
and secure a more stable source of income. The new Congress is likely to be receptive to such proposals.
Figure 1. Federal receipts and outlays: shares of GDP. Figure 2. Tax filings and yield by marginal rate.
%
25 %
100
Outlays Share of returns
20 75
Deficit
50
15
Receipts
25
10 Share of taxes paid

0
2000-07
2008
2009
2010
1950s
1960s
1970s
1980s
1990s
2010s
0 5 10 15 25 28 33 35
Marginal tax rate
Decade/Years
Source: Congressional Budget Office; Nomura Global Economics. Source: US Treasury: Statistics of Income; Nomura.

the first time, the real value of business capital per employed worker jumped to a record high.
That capital downsizing undoubtedly reflects the effect of a net decline of nearly 200,000
businesses in four key industries: construction, shipping and transport, financial services, and
manufacturing. As these industries gradually recover, new firms and the survivors that deferred
or cancelled projects during the recession will need to invest in new equipment and hire more
workers. Consequently, we expect increases in business investment in equipment and software
to be quite robust: 11.4% in 2011 and 11.2% in 2012. Nonetheless, it is likely to take many more
years before the economy will require the number of workers that were employed at the peak of
the last expansion.
A lower level of potential output

The Great Recession These observations suggest that the Great Recession has cut into the economy’s productive
has cut potential potential (see Box: The output gap). A lower level of potential output also implies the need for
output fewer workers (i.e., a higher unemployment rate) than in the past and policymakers seem to
agree. Long-range forecasts from Federal Open Market Committee participants show that more
policymakers expect a higher unemployment rate than in the past. Although this also suggests
that inflation pressures could begin to surface at a higher unemployment rate, the degree of
“slack” that we expect to persist should limit any price pressures that might develop.
Consequently, we have not altered our long-standing forecast that inflation will remain below the
Federal Reserve’s “mandate consistent inflation rate” – i.e., a rate of about 2% in the PCE price
index. Accordingly, we expect the FOMC to maintain an unusually accommodative policy stance
but we do not envision the need for a further expansion of the QE program already announced.
Booming Asia should With the lingering effects of the debt-financed housing bubble still restraining domestic demand,
boost exports production growth will depend increasingly on demand from markets overseas. Owing to their
exceptional growth over the past year, China, India, and Brazil have become increasingly
important destinations for US exports. For instance, the 12-month cumulative total of US exports
to China and to Brazil were about 35% and 25%, respectively, higher in September than their
comparable totals a year ago. The dollar’s sharp decline in advance of the Fed’s QE2 decision
made it seem likely that a weaker dollar would generate a further lift to exports, but the
resurrection of sovereign debt concerns has heightened uncertainty in the foreign exchange
markets. Nonetheless, barring an overwhelming reversal of the dollar’s weaker trend, US
exports are likely to grow at a considerably faster pace than imports. We expect trade to
contribute about 0.5pp to overall GDP growth in 2011, but to play a much less important role in
2012 as the dollar begins to recover some of its recent decline (Figure 6).
Government Like households, virtually all levels of government are laden with debt and must limit spending.
spending will be a The temporary boost from the 2008 and 2009 fiscal stimulus programs will likely turn to being a
drag on growth drag on growth. Without the temporary aid from the federal government, state and local
governments will continue to trim spending. Meanwhile, concerns about the US government’s
long-run finances now seem likely to outweigh arguments for another short-term stimulus. With
the new Congress likely to shift the fiscal policy debate toward long-run concerns (see Box: The
new fiscal debate) and to intensify its scrutiny of monetary policy (see Box: Fed policy in the
crosshairs), economic policies are unlikely to provide much extra stimulus in the year ahead.
Figure 5. Capital stock per private sector employee Figure 6. Contributions to GDP growth by sector
$ 000s percentage points, ar

140 2009:3 to 2010:3
2.0
135 2010:4 to 2011:4
Estimated 1.5
130 2012
1.0
125
Actual 0.5
120
115 0.0
110 -0.5
105 -1.0
Inventories
100
Govt
Consumption
Equipment
Trade
Housing
Structures
95
90
1980 1985 1990 1995 2000 2005 2010
Source: BEA; BLS: Nomura Global Economics. Source: BEA; Nomura Global Economics.

Fed policy in the crosshairs David Resler

Policy innovations by the Federal Reserve since the onset of the financial crisis helped stabilize markets and pave the
road to recovery, but have alarmed some. Critics now seek to debate the proper role of the central bank.
Since the earliest signs of the financial crisis surfaced in the summer of 2007, the Federal Reserve has taken the lead in
devising policies to minimize harm to the world economy. The evolution of those efforts reflects the shifting perceptions
about the very nature of the crisis. From August 2007 until the fall of Bear-Stearns in March 2008, the Fed relied mainly
on its conventional tools to address market dysfunction and illiquidity. Beginning in March 2008, however, it began to use
some of these standards tools in unconventional ways, including granting discount-window lending access to non-bank
primary dealers. But from Bear-Stearns’ demise until the September 2008 bankruptcy filing by Lehman Brothers, the Fed
largely offset the increase in dealer and bank lending with reductions in its holdings of US Treasury debt. Nonetheless,
the invocation of the “exigent circumstances” clause in Section 13(3) of the Federal Reserve Act (FRA) began to raise
questions about the Fed’s conduct. In particular, critics zeroed in on the Fed’s creation of the Maiden Lane funds as an
unauthorized intrusion into the market’s role of allocating credit. Nonetheless, over that six-month span, the Fed’s
balance sheet increased by a modest $22 billon, an amount consistent with its long-term trend.
The collapse of Lehman Brothers changed everything. Initially, the Fed’s actions provoked little more than a few raised
eyebrows among its critics as it stretched the interpretation of the powers granted it under section 13(3) of the FRA.
These measures helped prevent a collapse of liquidity in the financial system but also resulted in a massive expansion of
the Fed’s balance sheet, which had increased by more than 165% by the end of 2008. Convinced that it would need to
keep the size of its balance sheet elevated (a policy the Federal Open Market Committee (FOMC] announced in its 16
December 2008 statement), the Fed decided to expand its securities holdings to prevent the contraction of its balance
sheet that would have resulted from the natural phase-out of the emergency lending programs. However, by
concentrating its purchases on mortgage backed securities (MBS), the Fed once again provoked its long-time critics.
Opponents of this first phase of “quantitative easing” objected to the Fed’s “money printing” operations and to its singling
out of a particular sector for credit injections.
By the time the Fed had completed its MBS purchase program early in 2010, its balance sheet had swelled to $2.339
trillion and most expected the Fed to gradually contract the portfolio. But in August, perceiving an increasing threat of
deflation, the Fed decided that it must not allow any further contraction of its balance sheet. Judging that threat not to
have diminished, the FOMC in November announced its intention to increase its US Treasury securities holdings at a
pace of about $75 billion per month until it reaches a target of about $$600 billion at the end of Q2 2011. The FOMC has
also made clear that the pace of implementing this policy will depend on evolving economic conditions. Our forecast that
inflation will stabilize and begin edging higher as the economy gradually strengthens implies the Fed will fulfill its stated
plans, but that no further operations will be needed.
Nonetheless, the Fed’s expansion of its balance sheet – and indeed the whole array of unconventional policies it has
used to tackle the crisis – has triggered a growing wave of skepticism about the conduct of monetary policy. Critics’
concerns have ranged from the Fed’s mandated goals to the need for greater oversight and indeed for its very existence.
For instance, Representative Michael Pence (R., Indiana) has introduced legislation that would redefine the mission of
the Fed. He links problems of monetary policy to the Federal Reserve Reform Act of 1977 that established the “goals of
maximum employment, stable prices and moderate long-term interest rates.” In the tradition of most such discussions,
Mr Pence ignores the last of those three goals and directs his criticism at the first two – the so-called “dual mandate.”
The Congressman contends that “this conflicting mandate has pitted short-term hopes for job gains against long-term
costs to the economy [and that] QE2 is an example of what happens when the Fed involves itself too much in
macroeconomic meddling.” Accordingly, his proposed legislation would “return the Fed to its original, single mandate –
price stability.” While Mr Pence is incorrect in his reading of the “original” mandate – the FRA of 1913 made no mention
of such macroeconomic goals – his arguments for a single goal have a solid theoretic foundation. The Fed however does
not necessarily see the dual mandate as an impediment but believes that it can best achieve both by pursuing a
“mandate consistent inflation rate.” To that end, the FOMC is contemplating “a number of possible strategies… including
providing more detailed information about the rates of inflation the Committee considered consistent with its dual
mandate, targeting a path for the price level rather than the rate of inflation, and targeting a path for the level of nominal
GDP.” Legislative initiatives by Mr Pence and others will likely sharpen the Fed’s focus on such reforms.
Others have focused on other aspects of Fed policy. For instance, Stanford Professor John Taylor (of Taylor-rule fame)
has proposed that Congress reinstate “reporting and accountability” rules for the Fed that would modernize earlier
oversight rules “to incorporate policy decisions about the interest rate.” Professor Taylor proposes that as part of its
reporting requirements, the Fed set a “strategy or rule” for systematically adjusting its interest rate target to achieve its
goals and a ”procedure for adjusting the supply of bank reserves.” The accountability provision must explain and account
for “any revisions to or deviations from such objectives or plans.” An activist Congress is likely to give Professor Taylor’s
proposal or others like it a serious hearing in the year ahead.

United States ⏐ Economic Outlook David Resler ⏐ Zach Pandl ⏐ Aichi Amemiya
Firmer turf on the recovery road

We see modest growth, low but stabilizing core inflation, and the Fed on hold in 2011.
Activity: Emerging from a mid-2010 “soft-patch,” the US economy appears to be entering a

more secure phase of recovery. Nonetheless, powerful headwinds are likely to keep the pace of
growth quite moderate in 2011. First, the sweeping reforms of the health care and financial
services industries could impede hiring and investment. Second, household deleveraging should
restrain consumption and put downward pressure on real estate prices. Third, fiscal policy is
expected to be less favorable for growth. The positive impulse from the 2009 Recovery Act has
now turned into drag, while state and local government budget pressures should weigh on
outlays and employment. Finally, while we see some improvement in the housing sector, sales
volumes and home-building are likely to remain depressed compared to pre-recession levels.
Inflation: We believe the four-year slide in core inflation will come to an end in 2011. Domestic
fundamentals remain deflationary, with widespread spare capacity across many sectors (for
background, see our report Deflation: causes, consequences and cures). On the other hand, the
dollar has weakened, commodity prices have picked up, and rent inflation has started to turn
(rents make up a large share in US consumer price indexes). In addition, most measures of
inflation expectations look stable. Putting it together, we forecast that core inflation will hold at
current levels (0.6% y-o-y) for a few months, before rising very slowly to 1% by the end of 2011.
Policy: We expect that QE2 will be “one and done” – that the Fed will complete, but not add to,
the second round of quantitative easing. If growth falls below trend, inflation expectations slip, or
actual inflation fails to stabilize, the Fed could purchase more. The additional easing of monetary
policy late in 2010 makes it unlikely that the FOMC will begin raising its interest rate targets
before 2013. However, we do expect some modest tightening in the form of balance sheet
contraction to begin in 2012. The outlook for fiscal policy remains highly uncertain, especially
over the near-term. A delay in extending Bush-era tax cuts could dent growth in early 2011.
Risks: Risks are roughly balanced. On the downside, we are concerned about a step down in
real estate prices and its impact on consumer spending and the financial system. Alternatively,
higher business confidence and better financial conditions could lead to faster growth.
Details of the forecast

% 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 2010 2011 2012
Real GDP 2.5 2.3 2.6 2.8 2.8 2.5 2.7 2.7 2.8 2.5 2.7
Personal consumption 2.8 2.5 2.7 2.8 2.7 2.7 2.7 2.6 1.7 2.6 2.7
Non residential fixed invest 10.3 6.0 3.9 6.8 7.9 8.0 8.0 7.4 5.7 7.1 7.3
Residential fixed invest -27.5 -1.4 -1.0 6.0 7.5 7.1 8.1 17.6 -3.3 -0.7 10.5
Government expenditure 4.0 -4.1 -1.6 -1.7 -1.9 -3.2 -2.4 -1.8 0.9 -1.2 -2.1
Exports 6.3 3.8 8.1 6.9 5.8 7.2 7.5 7.8 11.3 6.6 7.4
Imports 16.8 -7.7 1.6 2.6 2.5 3.8 4.0 5.8 13.0 3.7 4.4
Contributions to GDP:
Domestic final sales 2.9 1.4 1.9 2.4 2.5 2.2 2.4 2.7 1.9 2.3 2.6
Inventories 1.3 -0.9 0.0 -0.1 0.0 0.0 0.0 0.0 1.5 0.0 0.0
Net trade -1.7 1.8 0.7 0.4 0.3 0.3 0.3 0.1 -0.6 0.2 0.1
Unemployment rate 9.6 9.7 9.8 9.7 9.4 9.3 9.1 9.0 9.7 9.6 8.9
Non-farm payrolls, 000 -73 75 100 100 125 150 175 200 74 119 213
Housing starts, 000 saar 589 542 582 619 637 659 706 754 588 624 769
Consumer prices 1.2 1.2 1.5 1.7 1.7 1.3 1.0 1.3 1.6 1.6 1.3
Core CPI 0.9 0.6 0.8 0.8 0.7 0.9 1.0 1.1 0.9 0.8 1.1
Federal budget (% GDP) -9.0 -7.8 -5.9
Current account balance (% GDP) -3.4 -3.6 -3.4
Fed securities portfolio ($trn) 2.04 2.24 2.54 2.64 2.64 2.64 2.64 2.54 2.24 2.64 2.34
Fed funds 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25
3-month LIBOR 0.29 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.75
TSY 2-year note 0.42 0.50 0.50 0.75 0.75 1.00 1.00 1.00 0.50 1.00 1.25
TSY 5-year note 1.26 1.50 1.75 1.80 1.90 2.00 2.00 2.25 1.50 2.00 2.25
TSY 10-year note 2.51 3.00 3.00 3.10 3.10 3.25 3.25 3.25 3.00 3.25 3.50
30-year mortgage 4.32 4.40 4.65 4.75 4.75 4.85 4.85 4.85 4.40 4.85 5.15
Notes: Quarterly real GDP and its contributions are seasonally adjusted annualized rates (saar). The unemployment rate is a quarterly
average as a percentage of the labor force. Nonfarm payrolls are average monthly change during the period. Inflation measures and
calendar year GDP are year-over-year percent changes. Interest rate forecasts are end of period. Housing starts are period averages.
Numbers in bold are actual values. Table reflects data available as of 6 December.

Canada ⏐ Economic Outlook Charles St-Arnaud
In need of a push from the neighbours

Growth is expected to very gradually increase, but remains highly dependent on exports. As the
excess capacity gradually fades, the BoC should resume tightening monetary policy.
Activity: We expect activity to gradually pickup in 2011 and to be slightly above the long term
trend of 2.0%. This is in sharp contrast to the growth rate of the Canadian economy during the
recovery. Consumer spending is expected to moderate gradually, as households increase their
saving rate to reduce their debt burden. Residential investment is expected to remain tame in
2010, as the housing market gradually return to more sustainable levels. Business investment in
machinery and equipment is expected to remain robust over the forecast period supported by
the need to rebuild capital after almost two years of weak investment. In addition, the strong
Canadian dollar provides an incentive to invest by reducing the cost of imported capital goods,
reversing some of the competitiveness lost due to the higher dollar. However, the strong
domestic demand should continue to boost imports, while the gradually pickup in global and US
growth should provide some much needed support for exports. In addition, the gradual increase
in commodity prices should boost Canada’s terms of trade and national income.
Inflation: With significant spare capacity in the economy and growth not strong enough to close
the output gap until 2012, inflationary pressures are expected to remain well contained. Headline
inflation is expected to be slightly higher than the Bank of Canada’s 2% target in the first half of
2011, before declining below 2% in the second half as the effect from the July-2010 introduction
of the Harmonized Sales Tax disappear. Core inflation is expected to remain below the BoC’s
target in 2011 and then gradually converge to 2%, as the output gap narrows to zero.
Policy: With considerable monetary stimulus in place, the growth outlook remaining fairly
positive, especially for domestic demand. With the output gap expected to close in 2012, we
believe that the BoC will continue to gradually remove some of the monetary stimulus over the
next years. We expect the Bank of Canada to resume tightening at the end of 2011Q1 and to
proceed very gradually reaching 2.25% by year end. Fiscal policy is expected to be neutral over
the projection period, as the government unwinds the stimulus put in place during 2009.
Risks: We think that the risks to our scenario are balance, but uncertainty remains elevated.
Most of the downside risk is linked to external factors, with the risk of a slower US and global
economy at the forefront given the impact on exports and commodity prices. On the positive side,
growth could surprise on the upside and consumer spending and residential construction could
prove more resilient than expected.

% 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 2010 2011 2012
Real GDP 1.0 2.2 2.4 2.5 3.2 2.9 2.7 2.5 2.9 2.4 2.8
Non residential fixed invest 19.8 10.0 6.5 6.5 6.5 7.1 7.5 8.0 5.1 9.3 7.5
Residential fixed invest -5.3 -3.0 0.0 2.0 4.0 3.0 5.0 4.0 10.1 -0.1 4.0
Government expenditure 0.9 2.8 1.7 -1.1 0.3 0.3 0.4 0.4 4.1 1.0 0.3
Exports -5.0 5.5 6.5 6.7 6.7 5.7 4.8 4.8 5.7 4.8 5.2
Imports 6.4 6.5 6.2 5.8 5.8 5.8 4.8 4.4 13.5 6.9 4.9
Inventories 0.6 -0.7 -0.3 0.1 0.4 0.3 0.0 -0.4 5.2 3.1 0.0
Net trade -3.5 -0.4 -0.1 0.1 0.1 -0.2 -0.1 0.0 -2.2 -0.8 0.0
Employment, 000 83 60 60 80 80 90 90 70 96 78 70
Consumer prices 1.8 2.1 2.1 2.2 1.8 1.9 1.9 2.0 1.7 2.0 2.0
Core CPI 1.6 1.8 1.8 1.8 1.9 2.0 2.0 2.0 1.8 1.9 2.0
Federal deficit (% GDP) -4.9 -3.4 -2.1
Overnight target rate 1.00 1.00 1.25 1.50 1.75 2.25 2.75 3.25 1.00 2.25 3.75
3-month T-Bill 0.87 0.90 1.20 1.40 1.75 2.30 2.80 3.30 0.90 2.30 3.90
10-year government bond 2.75 3.00 3.10 3.20 3.30 2.50 3.70 3.90 3.00 2.50 4.20
USD/CAD 1.03 0.99 0.97 0.97 0.99 1.00 1.00 1.00 0.99 1.00 1.00
Notes: Quarterly real GDP and its contributions are seasonally adjusted annualized rates (saar). The unemployment rate is a quarterly
average as a percentage of the labour force. Employment is the average monthly change during the period. Inflation measures and
calendar year GDP are year-over-year percent changes. Interest rate forecasts are end of period. Numbers in bold are actual values.
Table reflects data available as of 6 December 2010.
Source: Bank of Canada, Statistics Canada, Nomura

Euro area ⏐ Outlook 2011 Peter Westaway ⏐ Jens Sondergaard ⏐ Lavinia Santovetti
A slippery road lies ahead

We forecast the recovery to become more evenly driven by domestic and external demand.
Cross-country divergences look set to widen further in 2011, complicating the ECB’s exit path.
Despite market The upturn has gained more traction in 2010, broadening out from being purely export-driven.
turmoil, we revise up We forecast this trend to continue: stronger private and external demand should thus offset the
our 2011 outlook headwinds from the fiscal tightening that is expected in 2011 and beyond. We expect the
economic recovery to remain intact and growth to re-accelerate over the forecast horizon. We
have therefore revised up our euro-area GDP forecasts to 1.7% (from 1.3% in July) in 2010, to
1.9% (from 1.5%) in 2011 and to 2.2% (from 1.8%) in 2012 (Figure 1). In view of the ongoing
market turmoil, however, the level of uncertainty surrounding these projections is unusually high.
Investment, and then consumption, up, finally!

There are signs that Since our last major forecast write-up (European Economic Outlook: The Hazardous Journey,
the recovery is... 31 July 2010), the euro-area recovery has turned out stronger and more resilient than we were
expecting, and relatively broad-based, with private domestic demand growing in both Q2 and Q3.
...and should We have previously argued that the recovery will be kick-started by strong exports, to be
increasingly become followed by investment picking up. Encouragingly, investment seems to have responded earlier
broad-based than expected: after eight consecutive quarterly declines, it finally increased in both Q2 and Q3.
Several factors suggest that firms will continue to invest to add to their productive capacity. First,
the recent pick-up in bank lending is an early sign that the corporate deleveraging cycle is
coming to end (see Box: Turning now to credit). Second, the sustained increases in consumer
confidence and business surveys – many are now at multi-year highs – suggest that capex will
continue to contribute to GDP growth, underpinned by the revival in domestic demand. As a
result, fixed investment growth looks set to accelerate further over the forecast horizon: we
expect it to rise by 1.9% in 2011 and 3.6% in 2012.
Furthermore, consumption growth should regain speed as well, as the recovery should gradually
trigger an improvement in labour market conditions. Confidence effects and early signs of
housing market stabilisation (see Box: House price prospects) should also induce households to
increase their spending: we forecast growth of 0.8% in 2011, increasing to 1.1% in 2012.
Two-speed euro area to continue

Euro-area aggregate growth has so far been mainly supported by a stronger-than-expected
recovery in the so-called “core countries”, and in Germany, in particular. By contrast, economic
conditions in the “periphery” economies have weakened further: activity in Greece and Ireland
has continued to contract, while activity has stagnated in Spain and Portugal.
Growth divergences We think these growth divergences will persist in 2011 and 2012: strong global demand, lower
will likely persist into bond yields, a lower euro and better credit conditions should help support growth in the core
2011 countries, while headwinds from deleveraging and fiscal austerity measures should continue to
Figure 1. Main euro area forecast changes Figure 2. Euro area GDP levels: to date and forecast
Index, 1Q08 = 100

% July Decem ber Core - Germany, France, Netherlands (58%)
104 Semi-core - Italy, Austria, Belgium (24%)
2010 2011 2012 2010 2011 2012 Periphery - Spain, Greece, Portugal, Ireland (17%)
Euro area
102 forecast
Real GDP grow th 1.3 1.5 1.8 1.7 1.9 2.2
HICP inflation 1.6 1.8 1.8 1.6 2.0 2.0 100
Unem ploym ent rate 10.1 10.3 9.9 10.0 9.9 9.6
98
ECB policy rate 1.00 1.75 2.50 1.00 1.50 2.00
10-year Bund yield 3.00 3.40 3.80 2.90 3.70 4.10 96
Fiscal balance -6.4 -5.6 -4.7 -6.3 -4.6 -3.4 94
Note: Annual averages, except interest rates which are end of 92

period. Unemployment rate is % of labour force and fiscal balance 1Q08 1Q09 1Q10 1Q11 1Q12
is % of GDP.
Source: Eurostat, ECB, Bloomberg, Nomura Global Economics. Note: The numbers in parenthesis denotes share of EA GDP.

Turning now to credit Jens Sondergaard

There are early signs that the euro-area credit cycle is turning decisively. Assuming that the sovereign debt crisis
gradually abates in 2011, we project a further rise in euro-area credit growth over the next two quarters.
Money and credit developments play an important role in the ECB’s policy decision-making. At the height of the financial
crisis in February 2009, the ECB pointed to a “deceleration in the underlying pace of monetary expansion” as supporting
evidence that inflationary pressures were diminishing. But after having fallen sharply during 2008-09, euro-area credit
growth now appears to be picking up, driven mainly by stronger lending to households, particularly for house purchases
in France and Italy (Figure 1). But there are also signs that the deleveraging cycle by non-financial corporations is
coming to an end, with monthly lending flows to firms picking up and the annual growth rate of credit to firms becoming
less negative in 2010.
What does the recent pick-up in credit suggest for the ECB’s policy stance? The ECB has lately become cautiously more
optimistic about the outlook for credit, stating explicitly that “a turning point” was reached in early 2010. This more upbeat
assessment is consistent with the results in the September 2010 ECB Bank Lending Survey (BLS), which confirmed that
credit conditions had improved in the euro area in Q3 and are expected to continue to do so in Q4. The survey reported
that net demand by firms for bank loans turned positive for the first time in more than two years, mainly because of
greater corporate demand for inventory and working capital financing (Figure 2). In addition, net loan demand for
financing fixed investment may finally be turning a corner, which is encouraging for the investment outlook.
How much weight should be put on the results in the bank lending survey? A recent ECB Working Paper (The euro area
Bank Lending Survey matters) showed that the BLS results are leading indicators for bank lending growth in the euro
area. Specifically, the work – using an estimated suite of models – shows how an easing in credit conditions in a
particular quarter is generally followed by an uptick in bank lending growth (both corporate and households) in the
following quarters. We used the suite of models to gauge what the current upbeat signals from the September BLS
results suggest for euro-area credit growth in Q4 2010 and Q1 2011. To use the set of models for a credit growth
projection, we had to make assumptions on the results of the next two Bank Lending Surveys (the next one is in January
2011 and the one after in April 2011). First, we assume banks will report a further loosening in credit conditions over the
next two quarters (with the size of the reported easing calibrated to match what was observed between Q2 and Q3 2010).
At the same time, we assume that banks will continue to report a further gradual uptick in net demand for both household
and corporate lending (again the size of the demand uptick every quarter calibrated as above). We also used our EONIA
forecast, which has the main policy rate rising to 0.7% by the end of Q1 2011.
We calculate that the annual private sector credit growth will increase to 2.5% by the end of Q1 2011 with y-o-y
household credit growth stabilising at 3.6% and non-financial credit growth increasing to 1.5%. These levels suggest a
fairly moderate credit expansion that is well below the monthly 2000-10 average. While we do not expect the ECB to
sound the alarms with credit growth at those levels, there are monetary hawks on the Governing Council that have
repeatedly emphasised that keeping interest rates too low for too long may create a new credit bubble. In our view, a
substantial pick-up in lending growth in the euro area would be needed before money and credit growth would be a
source of upside risk to price stability. But if credit growth continues to trend upwards throughout Q2 and Q3 2011, we
think the ECB will become more concerned, thus supporting the case for the ECB to begin raising interest rates in the
second half of 2011 This assumes that the current tensions in the periphery are short-lived and do not have major
negative implications for the banking sector’s ability to supply credit.
Figure 1. Euro-area private sector credit growth Figure 2. ECB Bank Lending Survey: corporate sector
% y-o-y forecast % balance, increased demand % balance, net loosening

20 40 -20
Private sector lending
Lending to non-financial corporations 30 -10
15 Loans to households 20 0
10 10
10 0 20
-10 30
-20 40
5
-30 50
-40 60
0 -50 70
1Q06 1Q07 1Q08 1Q09 1Q10
-5 Demand: present (lhs) Demand: future (lhs)
1Q00 1Q02 1Q04 1Q06 1Q08 1Q10 Supply: present (rhs) Supply: future (rhs)
Note: Horizontal dotted line represents 2000Q1-2010Q3 average. Note: Latest data point is Q3 2010.
Source: ECB and Nomura Global Economics. Source: ECB and Nomura Global Economics.

House price prospects Stella Wang

The euro-area housing market should soften in 2011 and we expect prices to be 2% above their pre-crisis levels by end-
2012. Meanwhile, we expect divergence in house price developments across the euro area.
Euro-area housing markets have stabilised in 2010, house prices in the region having risen by 2% y-o-y. But concerns
about a sizable decline linger, so it is worth asking whether house prices in the euro area have really hit the bottom.
A higher price-to-income ratio than its long-term average provides a standard first-pass measure of house price
overvaluation and indicates the potential for house prices to decline (Figure 1). Of the five biggest euro-area countries,
this metric suggests that there was a 9% undervaluation in Germany at the end of Q3 2010, with apparent overvaluation
in the housing markets of France (13%), Italy (11%), Spain (17%) and the Netherlands (4%).
The above results suggest that a double-dip in some euro-area housing markets may lie ahead. But this model is rather
crude as it excludes the possibility of a favourable evolution of fundamentals, such as increasing income and population.
We have therefore developed an advanced model that includes an inverted housing demand equation and incorporates
the user cost of housing, as well as other key variables determining house prices, such as demographics and inflation.
• Our new model suggests that, buoyed by strong economic and employment growth, house prices in Germany
should rise, converging to their long-term equilibrium (Figure 2). Interestingly, the degree of undervaluation does
not appear large because the oversupply of housing in the 1990s has pushed down the equilibrium level of
house prices. We look for prices to increase by 2% in real terms and 5% in nominal terms through 2011-12.
• In France, Italy and Spain, our new model suggests that the degree of overvaluation is not that significant. In
France, the tepid growth of housing stock, a rising population and decreasing user costs have lifted equilibrium
levels, so current house prices are not significantly different from their equilibrium. And despite strong increases
in the first three quarters of 2010, we think deficit cutting is likely to weigh on the housing market in the coming
years. Overall, we expect a cumulative 2% increase in nominal house prices by end-2012. The situation in Italy
is similar: A conservative banking sector has protected the housing market from the credit crunch, but high
transaction costs, fiscal headwinds and political instability will probably adversely affect the Italian housing
market in 2011. We look for nominal house prices to stall in 2011, but rise by 3% in 2012.
• In Spain, we think the large supply of unoccupied dwellings will delay its housing market recovery. Assuming no
structural changes in tax and lending systems, our model suggests that a further 7-9% drop is likely, with no
signs of a revival by end-2012. In the Netherlands, although the high indebtedness of households constitutes a
drag on the housing market, we think an increase in line with inflation is likely because of the country’s low
share of home ownership and tax deduction initiatives for home buyers.
In summary, the euro-area housing market should continue to recover but only moderately over the next two years,
mainly driven by the German housing market. In real terms, however, we expect downward adjustments to last until the
end of 2011 before house prices pick up in 2012. Importantly, we do not expect a major house price decline in four of the
five major countries as we think that, as well as valuations based on our models not being too far out of line, the
improving employment market and a gradual easing in credit conditions should provide firm support.
Figure 1. House price to income ratios Figure 2. Nominal house prices
% y-o-y
% deviation from long-term average 25 Forecast
30
20
20 15
10 10
0 5
0
-10
-5 Big 5 GE
-20 GE FR IT
SP NL FR IT
-10
SP NL
-30
1Q00 1Q02 1Q04 1Q06 1Q08 1Q10 -15
1Q00 3Q01 1Q03 3Q04 1Q06 3Q07 1Q09 3Q10 1Q12
Note: The house price to income ratio is the average price of a Source: Datastream and Nomura Global Economics.
2
100m unit, compared with per capita compensation.
Source: Datastream and Nomura Global Economics.

weigh on activity in the periphery. As a result, we forecast that the core countries will have
recovered to their pre-crisis GDP levels by mid-2011, while the periphery economies will not
have reached their pre-crisis GDP levels by the end of 2012 (Figure 2). It is this prospect of slow
growth in the periphery, combined with a challenging starting point for public finances, that has
recently increased market concerns about sovereign debt sustainability in the periphery.
Sovereign debt crisis, again

We view the While the ongoing turmoil is worrying, we expect the sovereign debt crisis to gradually abate in
periphery economies 2011. This view is based on our analysis that the periphery economies are fundamentally
as basically solvent solvent. We consider that they have fiscal plans that will gradually stabilise their debt-to-GDP
ratios, albeit rather slowly (for more details, see Box: Are the periphery countries solvent?). In
some cases (Spain and Ireland) we believe that official forecasts err on the optimistic side, so
further austerity measures may yet need to be announced. But so far, budget execution has
been promising, not least in Greece and Ireland; Portugal has fared less well and may need to
do more. We are expecting these policies to be implemented despite the uncertainty
surrounding politically weak governments in Spain, Portugal and Ireland.
A credible last resort These countries are only solvent, however, at reasonable levels of interest rates. If markets
financing framework remain unconvinced of their credibility, the interest rates at which they can borrow in the market
is crucial would remain too high (Figure 3). In these circumstances, official financing is necessary and
appropriate, subject to strict conditionality on fiscal austerity. So far, such financing from the EU
and IMF has allowed Greece and Ireland to be financed until well into 2012. Currently, it seems
likely that Portugal may also need support. If Spain ultimately also requires support, although it
is unlikely in our view, this would put a strain on the capacity of the existing financing facilities.
However, we are confident that EU governments will stand behind the periphery despite some
ambiguous statements, which had caused markets to doubt that commitment. Importantly too,
EU policymakers have begun to provide clarification on the permanent crisis resolution
mechanism to apply beyond 2013.
Competitiveness Looking beyond the acute need for periphery countries to correct fiscal imbalances, the
differences need to challenge remains as to how the same countries can regain lost competitiveness relative to the
be closed core owing to their relatively high rates of inflation during the first decade of EMU. In the
absence of an independent interest rate or exchange rate, this can only be corrected by a
prolonged period of lower inflation, a process that is slowly beginning (Figure 4). This can only
happen if labour and product markets are sufficiently flexible, hence the importance of
implementing structural reforms in the periphery. If these reforms are successful, productivity
growth stands to be stimulated, which would further enhance their debt solvency.
Inflation above the 2% ceiling

Inflation above 2% We now forecast HICP inflation to hover around the ECB’s target ceiling over the forecast
reflects higher horizon as the ongoing acceleration in commodity prices and mild domestic price pressures
commodity prices... should push up inflation. The food price shock looks set to be stronger than originally thought.
Our food commodity price index, which tracks the euro-area HICP food component well and is
Figure 3. Divergences in euro area bond yields Figure 4. Divergences in euro area competitiveness
% Index, 1Q99=100
8 Core - Germany, France, Netherlands (55%)
140 Germany Ireland
Periphery - Spain, Greece, Portugal, Ireland (18%) Greece Spain
7
Semi-core - Italy, Belgium, Austria, Finland (26%) 130 France Italy
6
120
5
110
4
100
3
90
2
80
Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10
1Q99 1Q01 1Q03 1Q05 1Q07 1Q09
Source: Datastream and Nomura Global Economics. Note: Harmonized competitiveness indicator index (Unit Labour
Costs based).
Source: ECB and Nomura Global Economics.

Are the periphery countries solvent? Dimitris Drakopoulos ⏐ Peter Westaway

Fiscal plans in the periphery should stabilise debt ratios, but this is a slow process and downside risks abound.
A common metric for evaluating fiscal sustainability is to analyse the fiscal scenarios and growth and financing cost
scenarios that are necessary to deliver a stable debt-to-GDP ratio. As we previously explained in “The arithmetic of debt
dynamics” (p.30) the tendency of the debt-to-GDP ratio to increase or decrease depends on the speed with which
countries can eliminate their primary fiscal deficits (the deficit net of interest payments) and by the differential between
the nominal growth rate and the average interest rate on existing debt (known as the “snowball effect”).
Figure 1 compares the prevailing primary balances in each of the four periphery countries (Greece, Ireland, Portugal and
Spain) with the primary balance they need to achieve in order to stabilize their debt ratios. Not only does this emphasise
the scale of the adjustment required, but also the difficulty of achieving a primary surplus (which was often not achieved
in the last 10 years, even during the boom years). Figure 2 shows the path that we forecast each country to follow in
terms of its primary balance (x-axis) and interest rate growth differential (“snowball effect”) (y-axis) out to end-2012 (the
dot is the starting point for both values and the arrow is the end point). Spain and Ireland start from the largest primary
balances in the euro area and require the largest fiscal adjustments to reach the debt-stabilising point (the dotted line).
• The recently agreed official support package for Ireland increases the sovereign’s support to the banking sector
considerably, causing the debt ratio to almost quintuple from 2007 levels. However, we feel this provides a
necessary “shock absorber” to stop the banking crisis from taking an even more negative turn. Our baseline
assumption is that Ireland can stabilise its debt-to-GDP ratio at a much lower level than Greece, with a much
lower primary surplus requirement; however it will take about two years longer.
• Portugal’s current debt and deficit figures are closer to the euro area average. However chronic low productivity
growth makes it hard for Portugal to “grow out” of its indebtedness. We see growth-enhancing reforms, a
stronger commitment to consolidation and an average cost of debt that remains capped (potentially by using the
European Financial Stability Facility/Stabilisation Mechanism) giving Portugal the best chance of stabilising its
debt ratio ahead of others and of maintaining it at much lower levels.
• Greece, despite being closer to stabilising its debt ratio than Spain or Ireland, has the most problematic debt
dynamics. Even if official financing continues, the average cost of debt will slowly drift up to 6%. In our baseline,
Greece needs to maintain primary surpluses of close to 6% to return its debt ratio back to 2009 levels by 2020.
• Spain has a better starting point in its public indebtedness but is suffering from most of the problems mentioned
above, albeit to a lesser extent. Banking sector uncertainties remain both in liquidity and solvency terms for the
smaller savings banks, but overall these are not comparable to the Irish problems. Fiscal consolidation efforts
so far are unconvincing, with implementation risks stemming from the regional governments. Debt will take a
long time to stabilize, but should remain comfortably affordable (unlike Greece). As with Portugal, it is most
important that structural problems are addressed to enhance Spain’s long-run growth prospects.
Overall, our view is that in the face of these challenges, appropriately extended timeframes need to be given to allow
these economies to adjust. Patience is needed. If markets are not prepared to give it, but policies are moving in the right
direction, as we believe they currently are, then official financing is the right response in our view.
Figure 1. Primary balances in the periphery Figure 2. Primary balance and snowball paths in 2010-12
% GDP Snowball effect Italy Spain

7 (pp GDP)
Greece Portugal
14
5 Ireland
12
3
10 Increasing
debt ratio
1 8
6
-1
4
-3
2
Average 1990-1999
-5 Average 2000-2009 0
2010 -2 Falling
-7 debt ratio
Max 2000-2009 -4
-9 Debt stabilizing primary balance in 2012
-10.0 -8.0 -6.0 -4.0 -2.0 0.0 2.0 4.0 6.0
Spain Greece Portugal Ireland Primary balance (%GDP)
Source: AMECO and Nomura Global Economics estimates. Note: Dot = 2010 forecast level, Cross=2011, Arrow = 2012
Source: Nomura Global Economics estimates.

based on agricultural prices in the European Union (for more, see Food price shock: estimating
the pass-through), grew by 18% y-o-y in October, its highest level since May 2008. We forecast
food price inflation to contribute around 0.5pp to headline HICP inflation in 2011. Energy prices
and the ongoing surge in the prices of raw materials should also contribute to higher inflation.
Finally, exchange rate pass-through effects from the past and the expected depreciation of the
euro (our FX team expects the trade-weighted index to drop by 5% between now and the end of
2012), coupled with potential further increases in indirect taxes, should also drive inflation higher.
...but wage growth is But there are also early signs that underlying inflationary pressures are increasing. Looking at
picking up the ECB’s preferred measure (the compensation per employee series), labour cost growth
increased to 2% y-o-y in Q2. This is still low by historical standards, but worryingly high as the
euro-area unemployment rate was as elevated as 10% in Q2. We think domestically generated
price pressures will mildly increase further in 2011 because of the expected improvement in
labour market conditions, due in particular to the robust recovery in the core countries. We
expect the unemployment rate to start falling soon, reaching 9.5% by end-2012 (Figure 5). This
would push up labour costs: we expect compensation per employee to increase by 2.1% in 2011
and 2.7% in 2012 – above the 2.3% average between 2000 and 2007. To sum up, we forecast
HICP inflation to increase from 1.6% y-o-y in 2010 to 2.0% in both 2011 and 2012 (Figure 6).
Timing is everything
The ECB will likely The ECB has repeatedly stated that it sees no conflict between its price stability mandate and
normalise liquidity by preserving financial stability as long as the interest rate tool targets the former and liquidity
mid-2011... operations/ bond purchases the latter. But at the time of writing, the ECB’s balancing act looks
even more challenging as systemic risk remains a serious concern, despite the ECB announcing a
pause in its liquidity withdrawal policy and is stepping up its bond purchases. Even so, the ECB
has repeatedly signalled throughout 2010 that it remains committed to completely withdrawing its
liquidity support provided to the European banking system. Under our central assumption that
periphery tensions gradually abate in 2011, we expect the ECB to resume its liquidity withdrawal
process and to complete it by Q3 2011 (see Box: Liquidity withdrawal: When the time is right).
...and hike in With headline inflation set to break the 2% ceiling and GDP growth close to trend in 2011, we
September think the ECB will likely become increasingly uncomfortable with a monetary policy stance that
implies negative real interest rates. We expect President Trichet to be more “vigilant” on inflation
and to adopt an increasingly more hawkish tone throughout the first half of 2011, preparing the
markets for a first rate hike, which we expect in September 2011. However, continued market
turmoil into early 2011 is a source of downside risk both to our forecast and interest rate call.
The ECB will also have a new president in 2011. The sitting ECB President Trichet will chair his
final Governing Council in October 2011 and a replacement has to be named beforehand (we
think by June 2011). The appointment is made by the European Council, following a
recommendation by the euro area finance ministers and is typically the outcome of a political
deal-making process. The top candidates for the position include current ECB Governing
Council Members Bundesbank President Axel Weber (probably the most likely to become the
next ECB President) and Banca d’Italia Governor Mario Draghi, but it is possible that a non-
council member candidate is appointed.
Figure 5. Euro area wages and unemployment Figure 6. Euro area inflation: to date and forecast
% y-o-y % of labour force % y-o-y

4.0 10.5 5
3.5 10.0
4
9.5
3.0
9.0 3
2.5
8.5
2
2.0
8.0
1.5 7.5 1
1.0 7.0 0
1Q00 1Q02 1Q04 1Q06 1Q08 1Q10 1Q12
Compensation per employee (lhs) -1
Unemployment rate (rhs) Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12
Source: Eurostat, ECB and Nomura Global Economics. Source: Eurostat and Nomura Global Economics.

Liquidity withdrawal: When the time is right Jens Sondergaard

The recent intensification of the European sovereign debt crisis caused the ECB to pause its liquidity withdrawal process
until April 2011. We expect the ECB to announce that it will shift to 3-month fixed allotments at its March meeting.
After Lehman Brothers collapsed in September 2008, the ECB introduced “fixed rate tenders with full allotment” long-
term refinancing operations (LTROs), and these have fully covered the liquidity needs of the European banking system
as a whole. As a result of these operations, banks are, in effect, supplied with ECB liquidity in excess of what they would
1
receive in normal circumstances. With “excess liquidity” in the banking system, banks need to access money markets
less and EONIA is now below the ECB’s main rate. This capacity to get funding from the ECB is now disproportionately
used by banks in the periphery: it is effectively one of the instruments that the ECB uses to ease specific tensions.
The problem is that this has created a dependency relationship and, in some cases, an exceptionally generous liquidity
facility has become an important, if not overriding, funding source. Keeping a liquidity facility in place for too long may
prevent a longer-term solution to the underlying problem: a weak and undercapitalised banking sector in several
periphery economies. The ECB has repeatedly made it clear that European governments need to take steps to
reorganise and restructure the banking sector where necessary. But the governments in question do not have the
financial resources to do this. The IMF/EU financing packages for both Ireland and Greece contained financial assistance
for substantial banking-sector recapitalisation. We expect that a forthcoming set of credible stress tests on the Greek and
Irish banking systems will determine their capital needs and allow policymakers to start recapitalising the banks. It
remains to be seen whether Portugal, or even Spain, will need to request a similar financing package. Because of the
possible contagion risks to the semi-core countries, we think the ECB will engage in further sovereign debt purchases to
avoid this outcome (although pressure will likely be on the Spanish government to inject more capital into its banks).
We have previously described a roadmap for how we see the ECB completing its withdrawal of liquidity (see “Banking
without liquidity support” in European Economic Outlook: The Hazardous Journey, 31 July 2010). In short, we think the
next step will involve the ECB eliminating the 3-month full allotment operations. Back in July, we expected the ECB to
make this move by December 2010. But following the intensification of the sovereign debt crisis, the ECB announced at
its December meeting that it would continue offering 3-month LTRO operations at full allotment throughout Q1 2011. This
effectively means that the ECB has put on hold its already ongoing liquidity withdrawal policy until Q2 2011.
Assuming that the sovereign debt crisis subsides from its current critical phase in Q1 2011, we expect the ECB to
announce at its March meeting that it is reverting back to 3-month LTROs fixed by generous amounts, while still keeping
the full allotment for weekly and 1-month operations. Importantly, by announcing a very generous amount, the ECB
would be “over-allotting” those operations. So this would still keep excess liquidity in the system and would allow EONIA
to gradually drift up towards the main refinancing rate. The next and final step, which we expect the ECB to take in Q3
2011, would be to stop offering the full allotment at both 1-month and 1-week operations, effectively fully normalising
liquidity operations. Our Interest Rates Strategy team has developed a model that projects the effects of liquidity
normalisation on excess liquidity and the level of EONIA (see “Normalization is one thing, rate hikes are another”). Using
the withdrawal roadmap outlined above, the model projects that by Q3 2011 excess liquidity should have returned to its
pre-crisis levels (Figure 1). At the same time, we expect EONIA to move above the main refinancing rate (Figure 2).
1
“Excess liquidity” means that liquidity supply exceeds liquidity demand; “liquidity demand”, however, is a technical term and is defined
as the sum of the banks’ reserve requirement + banknotes in circulation + government deposits in local central banks (the sum of the
latter two is also called autonomous factors).
Figure 1. Excess liquidity in the Eurosystem Figure 2. Interest rates forecasts
€bn %
450 2.50
400
Forecast 2.00
350
300 Actual 1.50
250
1.00
200
150
0.50
100
50 0.00
1Q10 3Q10 1Q11 3Q11 1Q12 3Q12
0
Mar-10 Jul-10 Nov-10 Mar-11 Jul-11 ECB main rate EONIA 3mth Libor
Source: ECB and Nomura Global Economics. Source: Datastream and Nomura Global Economics.

Euro area ⏐ Economic Outlook Lavinia Santovetti ⏐ Jens Sondergaard
Breaking up is hard to do
We expect the sovereign crisis to linger and gradually abate in 2011, but the euro area and its
recovery should remain intact.
Activity: The recovery has started to broaden out. Exports kick-started the upturn in 2009, but
are now triggering a pick-up in domestic demand, which is expected to gain momentum over the
forecast horizon. The investment cycle should gain more strength in the second half of 2011 and
beyond, also aided by signs that the corporate deleveraging cycle is coming to an end.
Moreover, consumer spending looks set to increase in 2011 and 2012, as labour market
conditions improve and the unemployment rate starts to decline from early 2011. However, the
recovery looks set to remain unbalanced, with the core countries providing the impetus to growth,
while deleveraging and fiscal tightening should keep growth subdued in the periphery.
Inflation: We expect inflation to hover around the ECB’s target of 2% in both 2011 and 2012.
The improvement in labour market conditions should push up domestically generated price
pressure (we expect compensation per employee to increase by 2.1% in 2011 and 2.7% in
2012 – above the 2.3% recorded on average between 2000 and 2007). Moreover, commodity
price increases should continue to exert upward pressure on headline inflation. Finally,
exchange rate pass-through effects from the past and expected depreciation of the euro and
potential further increases in indirect taxes should also drive inflation higher.
Policy: With growth close to trend and headline inflation hovering around the 2% target in 2011,
the ECB will likely become increasingly uncomfortable with a monetary policy stance that implies
negative real interest rates. Once the sovereign debt crisis gradually abates in 2011, we expect
the ECB to continue its liquidity withdrawal policy and adopt a more hawkish tone preparing the
markets for its first rate hike by September 2011. We expect full normalisation of liquidity by the
third quarter of 2011.
Risks: Domestic demand may surprise on the upside, but the exacerbation of the sovereign
debt crisis casts a shadow over on the recovery. However, we think that the core economies will
prove strong enough to offset the weakness in the periphery. Overall, we remain convinced that
the euro area will survive this crisis and that no countries will leave the monetary union.

% 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 2010 2011 2012
Real GDP 1.4 1.5 1.7 1.9 2.0 2.1 2.1 2.3 1.7 1.9 2.2
Household consumption 1.0 1.7 0.1 0.6 1.1 1.3 0.9 1.2 0.8 0.8 1.1
Fixed investment 0.1 3.6 0.0 1.5 2.4 2.7 4.0 4.3 -0.9 1.9 3.6
Government consumption 1.5 -0.2 -0.2 -0.2 -0.4 0.0 0.0 0.0 0.7 0.0 -0.1
Exports of goods and services 7.8 5.5 6.2 6.3 6.5 6.9 7.0 7.3 9.8 7.1 7.0
Imports of goods and services 7.0 7.0 2.4 3.6 4.5 5.3 5.6 6.1 10.3 5.4 5.6
Inventories 0.1 0.5 0.0 0.1 0.1 0.1 0.1 0.1 1.4 0.1 0.0
Net trade 0.4 -0.6 1.7 1.3 0.9 0.8 0.7 0.6 -0.1 0.8 0.7
Compensation per employee 2.1 2.1 2.3 2.0 1.8 2.1 2.4 2.6 1.9 2.1 2.7
Labour productivity 1.9 1.6 1.6 0.9 1.0 1.2 1.3 1.3 2.0 1.2 1.4
Unit labour costs 0.2 0.5 0.7 1.1 0.8 0.9 1.1 1.3 -0.1 0.9 1.3
Fiscal balance (% GDP) -6.3 -4.6 -3.4
Consumer prices 1.7 2.0 2.1 1.9 2.1 2.0 1.9 1.9 1.6 2.0 2.0
ECB main refi. rate 1.00 1.00 1.00 1.00 1.25 1.50 1.50 1.50 1.00 1.50 2.00
3-month rates 0.89 1.04 1.05 1.30 1.52 1.77 1.77 1.77 1.04 1.77 2.27
10-yr bund yields 2.26 2.90 3.05 3.25 3.55 3.70 3.80 3.90 2.90 3.70 4.10
$/euro 1.31 1.30 1.32 1.34 1.35 1.35 1.34 1.33 1.30 1.35 1.30
Notes: Quarterly real GDP and its contributions are seasonally adjusted annualised rates. Unemployment rate is a quarterly average as
a percentage of the labour force. Compensation per employee, labour productivity, unit labour costs and inflation are y-o-y percent
changes. Interest rate and exchange rate forecasts are end of period levels. Numbers in bold are actual values, others forecast. Table
reflects data available as of 6 December 2010.
Source: Eurostat, ECB, DataStream and Nomura Global Economics.

European Countries ⏐ Economic Outlook J. Sondergaard ⏐ D. Drakopoulos ⏐S. Wang

Germany: Impressive ongoing recovery
Economy is on a strong footing with low levels of unemployment underpinning domestic demand
• The German economy rebounded strongly in 2010,
% 2009 2010 2011 2012 initially driven by net exports and then by a pickup in
GDP growth -4.7 3.6 3.0 2.5 investment and consumption. The German labour
Private consumption -0.1 0.5 1.6 1.6 market has performed impressively in 2010 with
Fixed investment -10.0 6.2 5.2 4.7 unemployment at an 18-year low.
Government consumption 2.9 2.1 1.1 0.8 • Given the low level of unemployment with business
Exports -14.3 14.8 9.6 7.4 (Ifo) and consumer confidence (GfK) at multi-year
Imports -9.4 14.3 8.8 7.2 highs, we expect domestic demand to remain robust
in 2011 and 2012. The degree of spare capacity has
HICP inflation 0.2 1.1 1.7 1.8 declined rapidly in 2010 and we think investment can
grow further in 2011.
Unemployment (% of labour force) 8.2 7.7 7.4 7.2
• Price and wage inflation should remain moderate.
Fiscal balance (% GDP) -3.0 -3.7 -2.7 -1.8 Overall, German trade unions have demanded fairly
Government debt (% GDP) 73.4 76.4 76.4 75.7 moderate wage rises and seem to prefer greater job
security instead. But we see upside risks to wages in
Note: Table reflects data available as of 6 December.
2011 and 2012.
France: Slowly gaining strength

Economy is recovering well, but stronger focus in restoring sound public finances and job creation is needed
• Following a moderate slowing of activity in recent
% 2009 2010 2011 2012 months, France’s recovery should slowly gain
GDP growth -2.5 1.6 1.7 2.0 strength with GDP growth rising to 1.7% in 2011 and
Private consumption 0.6 1.6 1.6 1.7 to 2.0% in 2012.
Fixed investment -7.0 -1.6 2.3 4.1 • Economic expansion will again rely heavily on
Government consumption 2.8 1.4 0.6 0.1 domestic demand. However, the slowdown in public
Exports -12.2 9.9 7.8 7.0 sector compensation along with small tax increases
Imports -10.6 9.3 8.7 5.8 should weaken disposable income growth, and keep
private consumption below pre-crisis growth rates.
HICP inflation 0.1 1.7 1.8 1.9
• The unemployment picture has been slowly
Unemployment (% of labour force) 9.5 9.8 9.5 9.3 improving since Q1 2010. We expect the trend to
continue but at a slow pace.
Fiscal balance (% GDP) -7.5 -7.6 -6.1 -5.0
• On the fiscal side, steps have been taken towards
Government debt (% GDP) 78.7 83.5 87.1 89.1
achieving a credible consolidation strategy
Note: Table reflects data available as of 6 December. underpinned by pension reform. We view the 2011
Source: Datastream and Nomura Global Economics. targets as feasible, but further tough consolidation
efforts will be left to the new government in 2012.
Netherlands: Moderate growth

Although benefitting from its strong neighbour, Germany, subdued consumption points to moderate growth
• We expect Dutch economic growth to be gradual
% 2009 2010 2011 2012 owing to slowly recovering household consumption.
GDP growth -3.9 1.7 1.8 2.2 • High export and import growth is likely over the next
Private consumption -2.5 0.2 0.6 0.6 two years but their net contribution should be lower.
Fixed investment -12.7 -4.4 1.3 3.5
• The cut in the corporate tax rate, combined with
Government consumption 3.7 1.8 0.3 -0.3 improving business sentiment, makes us optimistic
Exports -7.9 10.3 6.9 6.7 about fixed investment in 2011-12.
Imports -8.5 10.5 4.9 6.0
• We think that increasing hours and unit labour costs
HICP inflation 1.0 1.0 1.8 2.1 will hamper the improvement in employment and
keep the unemployment rate above 5% until the end
Unemployment (% of labour force) 4.8 5.5 5.0 4.8 of 2011.
Fiscal balance (% GDP) -5.4 -5.8 -4.0 -3.2 • The new government has committed to a strong
Government debt (% GDP) 60.8 64.8 66.6 67.3 consolidation package, which should lead to a
sizable improvement in public finances in 2011.
• However, the coalition government is vulnerable,
which adds more uncertainties to the Dutch outlook.

European Countries ⏐ Economic Outlook Lavinia Santovetti ⏐ Takuma Ikeda

Italy: Fragile ongoing recovery
Fiscal challenges, albeit significant, are of a considerably different order of magnitude than in the periphery.
• Italy will likely grow below the euro-area average, at
% 2009 2010 2011 2012 1.1% in 2011 and 1.5% in 2012. We expect exports
GDP growth -5.1 1.0 1.1 1.5 to be the most dynamic component and investment
Private consumption -1.8 0.5 0.6 0.9 to recover only moderately.
Fixed investment -12.2 2.4 1.9 3.5 • We expect the unemployment rate to average 8.3%
Government consumption 0.6 -0.2 -0.1 0.0 in 2010 and hover around 8.0% in 2011 and 2012.
Exports -19.1 7.7 6.0 6.3 • Inflation, at 2.4% and 2.1% for 2011 and 2012,
Imports -14.6 6.8 3.7 5.1 should remain above the euro-area average.
HICP inflation 0.8 1.6 2.4 2.1 • Structural weakness remains Italy’s Achilles’ heel
and will likely continue to weigh on future economic
Unemployment (% of labour force) 7.8 8.3 8.1 8.0 performance: additional reforms are needed.
Fiscal balance (% GDP) -5.3 -5.0 -4.3 -3.6 • The ongoing fiscal consolidation is encouraging, but
Government debt (% GDP) 116.0 119.0 120.2 120.1 more needs to be done to curb some of the
structurally high expenditure components.
• Elections in the spring look increasingly likely.
Spain: Slow moving, but solvent

Political willingness to take determined action on fiscal policy, reforms and the banking sector is essential.
• Spain’s macro fundamentals are weak and austerity
% 2009 2010 2011 2012 measures should start to bite into growth soon. We
GDP growth -3.7 -0.2 0.5 1.0 expect GDP to pick up by 0.5% in 2011 and rise by
Private consumption -4.2 1.2 0.1 0.5 1% in 2012. Weak household consumption and
Fixed investment -16.0 -7.3 -1.5 2.5 shrinking investment will remain a drag on activity.
Government consumption 3.2 -0.1 -1.2 -0.5 • The unemployment rate will likely remain high,
Exports -11.6 9.1 5.1 6.3 because of sluggish growth and the slower reaction
Imports -17.8 4.9 1.0 4.7 of the labour market to activity growth.
• We expect the deficit to narrow to 6.9% of GDP in
HICP inflation -0.2 1.7 2.2 1.9
2011, thus the government will likely need to
Unemployment (% of labour force) 18.0 20.0 19.6 18.5 announce more measures to hit the 6% deficit target.

• We do not expect the debt-to-GDP ratio to stabilise
until around 2015.
Government debt (% GDP) 53.2 64.3 70.3 74.0
• However, we view Spain as fundamentally solvent.
Note: Table reflects data available as of 6 December. There seems to be political determination to prevent
Source: Nomura Global Economics. Spain from having to access EU/IMF financing.
Switzerland: Currency appreciation contains inflation

Healthy growth ahead underpinned by domestic demand.
• We expect Switzerland to grow steadily, supported
2009 2010 2011 2012
by domestic demand over the forecast horizon.
GDP growth % y-o-y -1.9 2.7 2.2 2.3
Private consumption 1.0 1.7 1.4 1.7 • However, relative to 2010 growth looks set to
moderate over the next two years: we forecast GDP
Fixed investment -4.9 3.7 2.4 3.0
growth at 2.2% in 2011 followed by growth of 2.3% in
Government consumption 1.6 0.0 0.1 0.0 2012.
Exports -8.7 7.9 3.4 5.9
• In its September monetary policy assessment report,
Imports -5.4 7.4 5.1 6.1 the Swiss National Bank (SNB) revised down its CPI
CPI -0.5 0.6 0.3 1.1 inflation forecast to 0.3% from 1.0% for 2011,
Unemployment rate 3.7 3.9 3.7 3.6 reflecting the CHF’s strong appreciation.
Current account 11.9 10.0 10.2 10.6 • In addition, renewed turmoil over European periphery
Policy rate (3m LIBOR), high % * 0.75 0.75 1.25 2.25 debt sustainability has ignited further CHF
Policy rate (3m LIBOR), low % * 0.00 0.00 0.25 1.25 appreciation and could cause SNB’s concern over
EURCHF * 1.50 1.34 1.44 1.42 the possibility of deflation to increase. Thus we push
Note: Table reflects data available as of 6 December. forward SNB’s rate hike call to September 2011.
Source: Federal statistics office and Nomura Global Economics.

Scandinavia ⏐ Economic Outlook Jens Sondergaard
Norway: Robust consumption ahead

Low unemployment and interest rates support healthy consumption growth
% 2009 2010 2011 2012 • Declining household saving ratios from their highs
GDP growth (Mainland) -1.2 1.9 2.9 3.3 combined with low levels of unemployment should
GDP growth (Total) -1.3 0.0 1.8 2.9 support robust consumption growth in 2011. We also
Private consumption 0.2 3.3 3.5 3.6 expect investment to bounce back in 2011 following
Fixed investment -7.4 -9.7 4.2 5.8 falls in both 2009 and 2010. Hence, a pick-up in
Government consumption 4.7 3.1 2.1 1.4
domestic demand should help GDP growth re-
accelerate over the forecast horizon.
Exports -3.9 -1.3 2.0 3.7
Imports -11.4 9.7 6.4 5.0 • Low levels of capacity utilisation and low wage growth
should continue to keep inflationary pressures low in
CPI inflation 2.1 2.5 1.4 2.1 the near term. But as growth accelerates, we expect a
Unemployment rate 2.7 3.0 3.0 3.0 tightening in the labour market, the output gap to
close and inflation to reach 2.1% by 2012.
Policy rate* 1.75 2.00 2.75 3.75
• As we expect the sovereign debt crisis to gradually
EURNOK* 8.41 7.90 7.70 7.70 abate in 2011, we expect the Norges Bank to assume
* End of period its rate hiking, increasing rates by 75bp in 2011 and a
Note: Table reflects data available as of 6 December. further 100bp in 2012.
Sweden: Strong rebound from crisis

The challenge is normalising monetary policy
% 2009 2010 2011 2012 • The Swedish recovery’s momentum remains strong
GDP growth -5.3 5.2 3.9 2.5 with low interest rates and robust credit growth
Private consumption -0.4 3.3 3.2 2.2 fuelling domestic consumption. The high level of
Fixed investment 5.7 9.0 5.8
household indebtedness clouds the consumption
-16.2
outlook as interest rates rise further.
Exports -13.3 11.0 7.8 5.6 • Sweden should reach its pre-crisis level of GDP in
Imports -13.4 12.4 7.9 6.0 early 2011, closing the output gap shortly thereafter.
Inflationary pressures should be building in 2011, with
CPI inflation -0.3 1.2 1.8 2.3 CPI inflation reaching 2.3% by 2012.
Unemployment rate 8.3 8.5 8.0 7.6 • Faced with strong growth and inflationary pressures,
we think the Riksbank is keen to continue its rate
Policy rate* 0.25 1.25 2.25 3.75 hiking. We expect the Riksbank to raise rates to
2.25% by end-2011 and by 3.75% by end-2012. The
EURSEK* 10.41 9.00 9.00 9.00
risk are tilted towards more hiking in the coming year.
* End of period.
Source: Datastream and Nomura Global Economics
Denmark: Subdued growth ahead

Robust consumption remains the bright spot
% 2009 2010 2011 2012 • The Danish recovery from its deepest post-war slump
GDP growth -5.2 2.1 2.3 2.2 has been unimpressive and we expect continued
Private consumption -4.5 2.0 2.8 3.3 subdued GDP growth in 2011 and 2012. The
Fixed investment -4.6 1.9 3.8
headwinds from the housing market slump together
-14.3
with a large supply of unsold houses continue to
constrain residential investment and weigh on house
Exports -9.7 2.6 4.8 3.7
prices.
Imports -12.5 2.4 5.1 4.0
• The high level of consumer confidence, higher
CPI inflation 1.4 2.3 1.8 1.7 employment levels and rising disposable real
household income should support consumption in
Unemployment rate 3.6 4.1 4.0 4.0
2011 and 2012.
Policy rate* 1.20 1.05 1.55 2.05 • The weak export performance in 2010 is worrying
particularly in view of the strong growth in Denmark’s
EURDKK* 7.44 7.45 7.45 7.45
largest trading partners – Germany and Sweden. But
* End of period increased competitiveness should help export
Note: Table reflects data available as of 6 December. prospects in 2011 and 2012.

Periphery Europe ⏐ Economic Outlook Dimitris Drakopoulos

Greece: Swimming against the tide
Weak growth prospects owing to fiscal measures and a long road ahead until regaining competiveness.
% 2009 2010 2011 2012 • We expect growth in 2010-12 to be in line with official
GDP growth -2.3 -4.0 -3.0 0.9 forecasts. After 12 consecutive negative quarters we
Private consumption -1.8 -4.7 -3.8 0.7 expect GDP to start growing in the second half of
Fixed investment -8.8 -11.1 1.1
2011, entirely driven by the external sector (mostly
-13.4
in services like tourism and merchant shipping)
Government consumption 9.6 -10.1 -7.6 -6.0
Exports -18.1 -1.0 6.8 5.9 • Despite having a credible fiscal consolidation
Imports -14.1 -11.4 -7.2 -0.1 program, further risks will arise in 2011. Reducing
deficits in loss making public companies would be
GDP deflator 1.2 2.9 1.7 0.3 the main challenge, besides weak tax receipts.
Unemployment (% of labour force) 9.5 12.5 14.9 15.0 • Recent revisions of debt and deficit figures make
debt dynamics look more challenging and reinforce
Fiscal balance (% GDP) -15.4 -9.4 -7.2 -6.2 the need for a longer adjustment period (see “Greece
Government debt (% GDP) 128 143 153 158 extensions and revisions”).
Note: Table reflects data available as of 6 December. • The high (tax driven) rates of inflation will continue in
Source: Datastream and Nomura Global Economics. 2011, however external imbalances are decreasing
and competitiveness is recovering but at a slow
pace.
Portugal: Triptych of problems and an unstable political situation

Economy suffers from low productivity, weak competitiveness and high (mostly private until now) debt.
• We expect the economy to contract in 2011 owing to
% 2009 2010 2011 2012 austerity efforts. Households will continue their
GDP growth -2.6 1.5 -1.2 0.6 balance sheet repair amidst weak labour market
Private consumption -1.0 1.9 -2.5 -1.5 environment. Private consumption should decrease
Fixed investment -11.9 -3.8 -5.3 -0.4 substantially in both 2011 and 2012. Growth will
Government consumption 2.9 3.6 -7.2 -5.6
resume in 2012 as external demand and wage
moderation support exports and private investment.
Exports -11.8 9.1 6.4 4.1
Imports -10.9 6.2 -1.9 -3.0 • We are less concerned about debt sustainability
prospects compared to Ireland and Greece, however
GDP deflator 0.1 0.9 1.6 1.2 yields may remain too high for the sovereign to reduce its
debt/GDP ratio, making a support package necessary.
Unemployment (% of labour force) 9.6 10.5 11.1 11.2
• Fiscal prospects might come weaker than expected
Fiscal balance (% GDP) -9.3 -7.3 -5.1 -4.0 particularly given large one-off revenues recorded in 2010,
Government debt (% GDP) 76 82 89 91 and weaker than expected VAT-related tax revenues.
Ireland: Maintaining credibility requires a clear plan for the banking sector
Uncertainty about the plan for the banking sector remains, as politics seem to be getting in the way
% 2009 2010 2011 2012 • Growth prospects remain weak, reflecting a drawn-
GDP growth -7.6 -0.5 0.1 1.7 out adjustment process, with domestic demand
Private consumption -7.0 -1.1 -1.6 -0.2 acting as a drag on growth.
Fixed investment -24.6 -22.2 -5.5 1.6 • Households remain in a period of debt reduction with
Government consumption -4.4 -3.3 -5.1 -4.5 the saving rate well above its historical average.
Exports -4.2 8.2 4.6 4.2 Some potential for an increase domestic demand in
Imports -9.8 5.9 2.0 2.1 2012 remains as consumer bring forward planned
expenditures before VAT hikes in 2013/2014.
GDP deflator -4.0 -1.6 0.7 1.0
• Exports will be the only driver of GDP growth;
Unemployment (% of labour force) 11.8 13.7 13.5 13.0 however they are strongly influenced by global
demand and exchange rate developments.
• Increases of the sovereign’s support to the banking
Government debt (% GDP) 66 99 109 114
sector will cause the debt ratio to almost quintuple
Note: Table reflects data available as of 6 December. from 2007 levels. However, we feel this provides a
Source: Datastream and Nomura Global Economics. necessary “shock absorber” to stop the banking crisis
from taking an even more negative turn.

United Kingdom ⏐ Outlook 2011 Philip Rush
Rebalancing the books

Growth in net exports and investment will likely offset the fall in public spending and the impaired
growth in private consumption. Inflation is stubbornly high but policy is on hold for now.
Imbalances in the UK economy are multifaceted and have been persistent. In some respects the
recession has helped the necessary rebalancing but in others, especially with the expansion of
the public sector, it has exacerbated them. Imbalance between domestic and external demand
opened a sizable current account surplus that has remained stubbornly large, despite the
persistent weakness in sterling. Developments in recent months have been consistent with the
tentative unwind of these imbalances though. In the years ahead, we forecast the UK to
rebalance as these factors normalise toward a more sustainable state and policy appropriately
moves away from its current crisis setting.
Picking winners
External trade should Partly because of the capital flows captured by the UK as a global financial centre, the UK can
improve as foreign sustain a structural deficit in its external trade in goods and services. Indeed, a surplus has not
demand recovers been recorded on this measure since 1997 and we do not expect a return to this situation within
our forecast horizon. Nevertheless, the persistent weakness of sterling, albeit with some modest
appreciation in our forecast, is likely to rebalance the economy toward external demand. We
forecast the trade in goods and services deficit to narrow by 0.9% of GDP to 2.3% between
2010 and 2011 and for this to pull the overall current account deficit in to 1.3%. Underlying this
likely positive development is an improvement in external demand for goods and services, due
to recovering demand growth in external markets. Although the service sector has struggled to
gain global market share, in no small part due to the financial industry, other industries have
successfully capitalised on the persistent weakness of sterling. We expect the negativity of the
real share of net external trade in GDP to halve between 2010 and 2012 to 1.5%.
We see private and Accommodating the improvement in the share of net trade to GDP is mainly the retrenchment in
investment demand the public sector (see Box: Counting the cost of fiscal consolidation). While we expect both net
gaining ground trade and domestic final sales to drive growth in 2011 and 2012 (Figure 1), the domestic
contribution contains a marked divergence between the private and public sectors. Indeed, we
expect real terms cuts in both consumption and investment by the government to cause the real
share of the public sector in GDP to shrink by over 2%. Naturally, this leaves the private sector
as a whole to slightly increase its size relative to GDP, but we also expect some rebalancing of
the UK economy within the private sector away from its previous reliance on private
consumption where impaired growth in real incomes, credit constraints and suppressed
consumer confidence weigh on the outlook.. As such, we expect the share of private
consumption in GDP to shrink slightly but for private investment’s share to rally by around 1% of
GDP. Although excess productive capacity weighs on business investment, we think that the
extremely stimulative monetary policy setting will entice private investment, including in
dwellings, up from its current low base.
Figure 1. Contributions to GDP growth Figure 2. Employment growth
pp q-o-q, saar Change in employment, 1000's

6 Forecast 600 Forecast
4 400
2 200
0 0
-2 -200
-4 -400
Net trade Private sector
-6 Inventories -600 Public sector
-8 Domestic final sales -800
-10 -1000
1Q09 3Q09 1Q10 3Q10 1Q11 3Q11 1Q12 3Q12 2000 2002 2004 2006 2008 2010 2012
Source: ONS and Nomura Global Economics. Source: ONS and Nomura Global Economics.

Counting the cost of fiscal consolidation Philip Rush
A painful, front-loaded fiscal consolidation programme will be a significant drag on GDP growth throughout the
parliamentary term. We believe GDP will be 3.8% lower in 2014-15 because of the discretionary fiscal consolidation.
In the UK’s “emergency” budget, the government spelt out its total consolidation plans as it sought to balance the current
structural deficit by the end of the parliamentary term in May 2015. By defining the fiscal target in this way, the
government is aiming to remove the part of the deficit that will not go away with the economic cycle without encouraging
additional cuts to capital spending (investment). Indeed, in the Comprehensive Spending Review, the government was
able to revise up its capital expenditure budget without affecting its fiscal mandate. Under current plans, the government
is set to beat its target by achieving a small current structural budget surplus of 0.5% of GDP in 2014-15. This implies a
5.8% of GDP consolidation in the current structural deficit from 2009-10 levels, and the magnitude of the total structural
fiscal tightening is even larger at 8.0% of GDP over this period (Figure 1).
Particular focus has been placed on the £81bn of spending cuts as part of a £110.3bn discretionary fiscal tightening by
2014-15. Despite this emphasis, the definition of the counterfactual fiscal policy against which this is applied is not
necessarily useful for determining the hit to the economy and it is, in any case, poorly defined. Regarding the impact of
the fiscal consolidation programme on GDP, the simple counterfactual that we consider most illuminating is one where
there are no discretionary tax changes and government spending is constant in real terms. Although this would constitute
an unsustainable fiscal policy, we still find it to be a useful benchmark against which to contrast budget plans, because
deviations from this scenario represent an expenditure drag on the economy. Our interest in withdrawn expenditures
causes us to exclude from the comparison expenditure on debt interest and net expenditure transfers to the EU, as we
do not consider changes in this unavoidable expenditure to have direct implications for domestic GDP growth. On this
basis, the headline fiscal consolidation we expect by 2014-15 would be significantly less, at £68bn, of which 40% would
be through taxation, versus 26% in the budget. That is equivalent to an average burden of over £1k per UK citizen.
Although we believe that the drag on GDP growth is likely to be less than the headline statistics in the “emergency”
budget imply, these cuts are still very considerable. By front-loading the fiscal contraction and the tax increases in
particular, the economy is set to take a significant hit in 2011-12, which is worth about 1.5% of GDP. This then slows to a
more manageable but non-negligible 0.9% of GDP (Figure 2). Cumulatively, we think GDP will be 3.8% lower than it
would have been had discretionary fiscal tightening not been pursued. However, this is subject to the unrealistic caveat
that such an unsustainable fiscal policy could have been pursued without inducing a sufficiently negative market reaction
to force such action. Although the government may have been able to avoid angering the markets with a slightly less
onerous consolidation programme (see UK Fiscal Consolidation Programme – Assessment, 25 October 2010 for details),
we cannot believe markets would have accepted the prospect of a perpetually large fiscal deficit.
With fiscal consolidation being so costly for the economy, monetary policy will need to remain more accommodative than
it might otherwise have been. We expect it to be quite some time before monetary policy can be described as “tight”
again. The impact costs of the fiscal consolidation programme are not necessarily the end of the story either, as the
effect of a Keynesian fiscal multiplier leans against the supportive factors that have elsewhere led to examples of
expansionary fiscal contractions. On aggregate, we believe that the direct fiscal multiplier is likely to be small enough to
keep the direct drag on GDP from fiscal consolidation (as in Figure 2) reasonably close to the total hit that the UK
economy is likely to endure. Despite this pain, supportive growth tailwinds for the private sector should survive the
headwind from retrenchment in the public sector, preventing contractions in terms of both total output and employment.
Figure 1. Decomposition of the fiscal deficit Figure 2. Fiscal consolidation’s drag on GDP
% of GDP % GDP
Cyclical deficit
12 0.0
Capital structural deficit
10 Current structural deficit -0.2
Combined= PSNB -0.4

8
-0.6
6 -0.8
4 -1.0
-1.2
2
-1.4
0 -1.6
-1.8
-2
07-08 08-09 09-10 10-11 11-12 12-13 13-14 14-15 2010-11 2011-12 2012-13 2013-14 2014-15
Source: OBR, HM Treasury and Nomura Global Economics. Source: Nomura Global Economics.

Permanent impairment in productive potential Philip Rush⏐Peter Westaway

The UK’s potential productive capacity was seriously impaired during the crisis and its growth is also likely to remain well
below its previous trend rate for some time.
Economists can, and do, debate the extent to which productive capacity has been destroyed by the recent financial crisis.
This matters greatly for monetary policy prospects. Falls in activity relative to pre-crisis trends may over-state the degree
of spare capacity in the economy and therefore give too relaxed a view on the necessary pace of monetary tightening.
Survey-based measures of excess productive capacity, for example, indicate considerably less spare capacity than
those derived from empirical analysis based on a theoretical production function, such as our own or the OECD’s (Figure
1). But the experience of deep recessions can also influence the rate of growth of productive potential which, given the
forward-looking nature of monetary policy, can have an equally important influence on interest rate decisions.
Productive potential will naturally fall if investment falls sharply during a recession since the capital stock will be lower
than it otherwise would have been. So this means that the productive potential conditional on the current capital stock
may fall short of its eventual long-run desired level once investment has been given time to recover. This short-run
measure of productive potential is the one that matters for inflationary pressure.
But productive potential may have fallen for other reasons that are less likely to correct quickly. When unemployed
workers become disillusioned with the labour force, become unemployable or perhaps fall out of an industry experiencing
a permanent structural decline, labour supply is diminished. Pre-existing capital stock may be scrapped in industries that
have suffered a structural decline in demand. The situation is more complicated if productive capacity is temporarily shut
down, which might explain the very low effective excess capacity reported in business surveys. If so, and demand
recovers quickly enough, some productive potential may be brought back on stream and not be lost permanently. This
so-called “endogenous supply-side response” is even trickier to gauge. In fact, long-term unemployment and business
liquidations have been lower in the UK than might have been expected given the falls in activity, but even so, we
estimate the level of potential GDP to have fallen by 5% relative to its pre-crisis trend (Figure 2).
In practice, too, it may be difficult to distinguish between a one-off fall in potential and a protracted slow-down in its
growth rate since many of the underlying causes are similar. Long term unemployment itself also limits growth in the
productivity of labour as workers outside of active employment (or education) are not acquiring new skills. And more
generally, growth in total factor productivity may also be inhibited in firms that are concentrating on staying in business
rather than looking for growth opportunities. In particular, small firms, often the source of productive new ideas, are likely
to have been particularly badly constrained by a lack of funding from the banking sector. As a result, underlying
productive potential in the UK will grow below either trend or actual output until beyond 2012, in our view. The
combination of these levels and growth rate effects leaves potential some 7.4% below its pre-crisis trend by Q4 2012.
Particular care needs to be exercised in interpreting these estimates at the current juncture. But the impact of output gap
uncertainty is ambiguous. Although so-called Brainard uncertainty about policy parameters might point towards a less
activist approach, there is also a respectable case for an activist increase in rates which pre-empts the risk of a de-
anchoring of inflation expectations. Overall, we are taking a fairly downbeat view of the ability of the UK’s productive
potential to recover and the extent to which monetary policy can influence it. As such, we are more concerned about
inflation and think that the BoE will need to start removing stimulus in August 2011, which is earlier than the markets
currently expect.
Figure 1. Measures of excess capacity Figure 2. The permanent loss of UK productive capacity
Standardised capacity index % of potential GDP Index, 1985Q1 = 100

103 4 210
3 205 Pre-crisis trend
102
2 200 Potential GDP
101 1 195 GDP
100 0
190
-1
99 185
-2
98 180
Range of surveys (lhs) -3
-4 175
97 Nomura output gap (rhs)
-5 170
OECD output gap (rhs)
96 165
-6
95 -7 160
1Q98 1Q00 1Q02 1Q04 1Q06 1Q08 1Q10 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12
Note: Index level of 100 corresponds to output at potential. Source: ONS and Nomura Global Economics.
Source: BoE, CBI, OECD and Nomura Global Economics.

To me, to you
We expect the private Rebalancing in expenditure also requires a rebalancing in employment or to make some
sector to absorb the extreme assumptions in relative productivity growth. While the real cuts in public sector
public sector job cuts spending in the ambitious fiscal consolidation programme make job cuts in the public sector
highly likely, strong growth in the private sector should lead to decent gains in private sector
employment. On balance, we remain comfortable with our long-held view that private sector job
creation will be more than sufficient to absorb the job cuts in the public sector (Figure 2).
We see the level of On an economy-wide basis, the fall in employment during the recession was small relative to the
productivity as being fall in output, when judged against what might have been expected under Okun’s law. There are
permanently impaired many potential reasons for this, including the sectoral composition of the recession, which
involved high productivity industries, like financial services, suffering to an unusually high degree.
As such, the level of whole economy productivity has fallen. If this fall in productivity reflected
deliberate temporary labour hoarding, then it might be expected to be reversed. However, we
think that it mainly reflects a permanent hit, explained by the sectoral composition of the
recession. If so, it would not be easy for output to expand without employment increasing and
this makes us relatively optimistic about employment growth in the next few years.
Raising the roof

Productive potential In our view, permanent hits relative to pre-crisis trends are not isolated to whole economy
in the UK has been productivity. We see evidence that the recession permanently damaged the productive potential
permanently lost of the UK (see Box: Permanent impairment in productive potential). If true, the economy will not
be able to sustainably return to its pre-crisis output trend and thus the amount of effective
excess productive capacity is probably smaller than what might otherwise have been thought.
As a result, the disinflationary pressure in the economy would be smaller and fade more quickly.
“One-off” shocks Inflation has remained stubbornly above target throughout 2010 and it will likely remain so until
boost inflation above 2012 (Figure 3). We agree with the Bank of England that this is the result of a series of “one-off”
underlying weakness shocks to the price level, including VAT changes, surging commodity prices and the large
depreciation of sterling. Underlying inflation is probably much lower than the headline inflation
rate suggests, but it is not obvious how weak it is, especially to consumers. With inflation
remaining above target for so long, there is a risk that inflation expectations begin to become un-
anchored to the upside and that would be costly for policymakers to correct at a later date.
Literate accommodation in the age of austerity

Monetary policy is There is growing acknowledgement of the risk to inflation expectations on the MPC. Under our
set to remain loose, forecasts, Mervyn King will have to write eight consecutive letters explaining why inflation is so
even with rate hikes far above target. While the MPC will likely continue to look through the current elevated inflation
prints to its more subdued forecasts, the appropriate policy stance will change if its credibility is
threatened. Assuming, as we do, that this does not happen, monetary policy will need to remain
loose to close the persistently large output gap, accommodating tight fiscal policy in the process.
However, in our view, this does not prevent rate hikes from the MPC which may seek to remove
some stimulus. We expect the next move to be a 25bp rate hike in August 2011 but see it as
more a case of appropriate accommodation rather than tightening per se.
Figure 3. UK inflation Figure 4. Bank of England base rate
% y-o-y %
6 16
5 14
12 Nominal base rate
4
10 Real base rate
3 8
2 6
4
1
2
0
0
RPI
-1 -2
CPI
-2 CPI target -4
Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 1Q90 1Q94 1Q98 1Q02 1Q06 1Q10
Source: ONS and Nomura Global Economics. Source: Bank of England, ONS and Nomura Global Economics.

United Kingdom ⏐ Economic Outlook Philip Rush⏐Peter Westaway
Gale-force rebalancing
Fiscal austerity bites into GDP growth in H1 2011 but it should pick up in H2 while the economy
rebalances. Stubbornly high inflation will likely remain a common feature once again in 2011.
Activity: With another 2.5pp VAT hike booked to ring in the New Year, 2011 is likely to get off to
a slow start, continuing the slowdown started in H2 2010. However, we expect Q1 to mark the
trough and supportive tailwinds to maintain the economy’s momentum throughout. Extremely
loose monetary policy and the persistent weakness of sterling continue to provide considerable
stimulus throughout our forecast horizon. Headwinds come from the fiscal consolidation
programme, poor credit availability, a deterioration of real wages and a shaky housing market,
but we think the tailwinds will win out. Together, these considerable offsetting gales should
provide an environment conducive to rebalancing toward external demand and private sector
investment while moving away from public spending and to a lesser extent private consumption.
Inflation: Inflation has been and should continue to be boosted by “one-off” shocks such as
changes to VAT and surging commodity prices. We expect these factors to force CPI inflation
back above 3.5% y-o-y by February 2011 and for it to remain above 3% until the end of 2011.
This would require eight consecutive letters from the BoE governor explaining why inflation is so
far above the 2% target. Beyond that, the persistently large negative output gap and base
effects will likely drag CPI inflation back below target. However, if realised, inflation will have
been above target for more than two years and averaged 2.9% over the preceding five years.
Policy: The Bank of England is likely to leave monetary policy unchanged at its current
extremely stimulative setting throughout the first half of 2011. We have consistently asserted
that further easing is neither necessary nor likely to occur and we stand by that view. Moreover,
we expect the next move by the MPC to be the removal of some stimulus with an initial 25bp
rate hike in August 2011. Fiscal consolidation plans aiming to take the current structural deficit
into surplus by 2014-15 engage in earnest at the start of 2011. We expect this to subtract 1.5%
from GDP in fiscal year 2011-12. With the details now known (see Europe Special Report: UK
fiscal consolidation - assessment, 25 October), 2011 should mark a return toward more normal
levels of fiscal changes. However, implementation risks and substantial structural changes in the
public sector should keep the policy debate going at a brisk pace.
Risks: Although the risks to our growth forecasts lie to the downside, we think that they lie to the
upside of our inflation forecasts. The risks to our rate call are skewed toward a later increase.
3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 2010 2011 2012
Real GDP 3.1 2.4 0.7 0.9 2.6 3.0 3.2 2.6 1.8 2.0 2.8
Private consumption 1.0 1.6 0.3 1.4 2.9 2.6 2.9 2.5 1.0 1.5 2.6
Fixed investment 2.5 5.4 0.3 -0.4 0.6 2.7 5.4 4.9 2.3 1.9 3.8
Government consumption 1.4 -1.6 -0.5 -1.1 -0.5 -1.1 -1.6 -1.6 1.8 -0.3 -1.3
Exports of goods and services 9.3 9.5 5.1 5.5 6.4 7.0 7.2 6.7 5.6 7.1 6.7
Imports of goods and services 3.0 6.3 2.5 3.5 3.6 3.0 3.7 3.8 8.0 4.1 3.5
Inventories 0.3 0.2 -0.1 -0.1 0.1 0.1 0.0 -0.1 1.2 0.1 0.0
Net trade 1.5 0.6 0.6 0.4 0.7 1.0 0.9 0.7 -0.8 0.7 0.8
Consumer prices (CPI) 3.1 3.1 3.5 3.3 3.4 3.1 1.9 1.8 3.2 3.3 1.7
Retail prices (RPI) 4.7 4.3 4.4 4.0 4.0 3.7 2.4 2.4 4.5 4.0 2.3
Official Bank rate 0.50 0.50 0.50 0.50 0.75 1.00 1.25 1.50 0.50 1.00 2.00
10-year gilt 3.06 3.40 3.40 3.45 3.75 3.90 4.00 4.10 3.40 3.90 4.30
£ per euro 0.84 0.83 0.81 0.80 0.79 0.78 0.78 0.77 0.83 0.78 0.76
$ per £ 1.56 1.57 1.63 1.68 1.71 1.73 1.73 1.72 1.57 1.73 1.71
Notes: Quarterly figures are % q-o-q changes at a seasonally adjusted annualised rate. Annual figures are % y-o-y changes. Inventories
include statistical discrepancy. Inflation is % y-o-y. Interest rates and currencies are end-of-period levels. The fiscal deficit is based on
the PSNB measure for the calendar year. Numbers in bold are actual values; others forecast. Table reflects data available as of 6
December 2010.
Source: ONS, Bank of England, DataStream and Nomura Global Economics.

Japan ⏐ Outlook 2011 Takahide Kiuchi
Export-led recovery on the horizon

The Japanese economy has slowed sharply. However, we expect it to avoid a full-blown
recession.
2011 should see the This year the Japanese economy entered a soft patch, but we expect it to return to stronger growth
economy emerge in 2011 driven by exports. Now that companies have completed their structural adjustments (eg, by
from its soft patch clearing their excess debts), an export-led recovery is more likely to feed through to a recovery in
domestic demand. Exports need to pick up if companies are to use their unprecedented surplus
liquidity to boost domestic investment, wages and employment and trigger a full-fledged domestic
recovery. The main risk to the economy in 2011 – on both the upside and the downside – is likely
to be the yen. Political instability at home is also likely to be a wildcard factor.
Economy in a soft patch

The economy has In Q3 2010 Japan’s real GDP (first preliminary estimate) grew at an unexpectedly high rate of
slowed sharply 3.9% q-o-q annualized, up from 1.8% in Q2. However, the latest statistics indicate that the
domestic economy has been slowing. For example, Q3 industrial production declined (falling
1.8% q-o-q) for the first time in six quarters. Furthermore, company production forecasts point to
production in Q4 also being likely to decline in q-o-q terms (Figure 1). We expect real consumer
spending to decline by 0.6% q-o-q in Q4. This is because of: (1) payback after the surge in last-
minute demand for automobiles just before the eco-car subsidy scheme expired and after this
summer's heat wave; as well as: (2) the increase in the cigarette tax in October (See Box:
Underlying growth in consumer spending). We think the Japanese economy has probably
entered a soft patch within a longer-term recovery, which has been caused by a slowdown in
export growth and the fading impact of previous stimulus measures, and that this soft patch may
continue until Q2 2011 (Figure 2).
A full-blown However, we think that the current slowdown is unlikely to turn into a full-blown recession
recession should be because of the stimulus from measures taken by the government and the BOJ and the modest
averted but sustained recovery in private demand. We think that the recovery in 2011 will be led by a
pick-up in exports. We expect USD/JPY to enter a gentle uptrend after bottoming at 80 at the
end of March 2011. The end of the yen's uptrend and a pick-up in external demand should boost
the pick-up in exports we expect from Q3 2011.
Figure 1. Breakdown of industrial production by contributing

Figure 2. Our quarterly forecasts for the Japanese economy
sectors
pp contribution to q-o-q chg % y-o-y, annualized
10 6.5 5.9 7.0 11 Estimates
5.3 9
5 1.5
7
5
0 3
-1.3 1
-3.2 -1.8 -1
-5 -2.6
-3
-5
-10 Other -7
General machinery -11.3 -9
-15 -11 Consensus (ESP forecast survey)
Transportation equipment
IT & digital
-13
-15 Nomura CY
-20 Basic materials
-20.0 -17
Mining and manufacturing
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
-25
05 06 07 08 09 10 CY 08 09 10 11 12 13
Note: Latest two months based on METI's Survey of Production Note: Data for Q4 2010 and thereafter are Nomura estimates.
Forecasts in Manufacturing. Adjusted using realization and Source: Nomura Global Economics, ESP Forecast Survey.
amendment ratios. Materials = steel + nonferrous metals +
chemicals. IT/digital = electrical machinery + IT/telecom equipment
+ electronic parts & devices.
Source: Nomura Global Economics, Ministry of Economy, Trade &
Industry

Underlying growth in consumer spending Mika Ikeda

Consumer spending continues to be affected by temporary factors: government stimulus measures (and adverse
reactions to their discontinuation), tax changes and this summer’s heatwave. But the underlying trend remains positive.
In Q3 2010, consumer spending rose 1.1% q-o-q, contributing 0.7pp to real GDP growth. Spending on durable goods
rose sharply (11.1% q-o-q), probably as a result of stimulus measures such as the eco-point scheme and the eco-car
subsidy scheme. Due to the narrowing in April of the range of products to which the eco-point scheme applied, in Q1
2010 there was a last-minute surge in demand for TVs, followed by a decline in demand in Q2. The impact of this faded
in Q3 and spending on TVs began to increase again. A record hot summer caused spending on air conditioners and
refrigerators to spike, while the end of eco-car subsidies in early September sparked a last-minute surge in spending on
automobiles. A 0.6% q-o-q rise in nondurables spending reflected, we believe, firm sales of drinks and frozen desserts
through the summer and a surge in demand ahead of the tobacco tax hike in October.
However, these factors were transitory and spending could see a reactive decline in Q4. We estimate that special factors
contributed 1.3pp to consumer spending in Q3, but are likely to detract -0.9pp and depress consumer spending in Q4.
Furthermore, while households benefited in FY10 from policies such as the new child benefit scheme and the de facto
abolition of fees at public senior high schools, in FY11 they can expect to feel the negative effects of policies such as
cuts in income and resident’s tax dependency allowances, that were decided at the same time. Although the government
pans to raise child benefits in FY11, other measures such as a possible limit on the married couple’s allowance, may be
needed to fund it. In these circumstances, we think a boost to household income from government measures looks
unlikely (Figure 1). The government's outline for tax reforms, which is being considered by the Tax Commission, includes
measures that would increase household tax bills, such as reducing allowances for adult dependents, imposing limits on
earned income allowances and reducing the basic inheritance tax allowance. With the boost from existing measures
fading, some are concerned that consumer spending could fall sharply.
However, we need to remember that the underlying trend in consumer spending has generally remained positive ever
since Q2 2009 (Figure 2). Since measures to boost consumer spending can have a (negative) substitution effect on other
goods and services, we think the underlying component may have outweighed the impact of such measures. Although
the underlying component fell in Q3 2010, we think this was probably outweighed by the negative substitution effect from
special factors such as the surge in demand for automobiles.
Ongoing improvement in incomes, as indicated by three consecutive quarters of growth in real employee compensation
so far in 2010, should also be positive for consumer spending. While we cannot rule out the possibility that employment
growth may stall with the economy slowing as production declines, our view is that any adjustment to production activity
is likely to be short-lived and that incomes will continue to grow steadily. As a result of government stimulus measures,
consumer spending has risen ahead of any improvement in the employment situation. However, once the impact of
these measures drops out of the picture, we look for spending to follow a more autonomous and stable recovery path,
supported by an upturn in personal incomes.
Figure 1. Proposed tax system reforms affecting households Figure 2. Underlying growth in consumer spending
Change of
Measures being considered % y-o-y
household income
1.5 Est
(JPY bn)
Increase in new child benefit 250 1.0
Limits on income and residents’ tax married
Decrease 0.5
couple’s allowance
Reduction in adult (23-69 year-old) 0.0
dependents’ income and residents’ tax Decrease
allowance -0.5 Extraordinary factors
Limits on earned income allowance Decrease
-1.0
Reduction in basic inheritance tax allowance Decrease Excluding extraordinary
New gift tax rates Increase -1.5 factors
Real private-sector final
Abolition of fixed-asset tax on new homes -154
-2.0 consumption expenditure
Abolition of reduced rates of tax on listed 08 09 10 CY
Decrease
company dividends and share sales
Note: “Extraordinary factors” refers to the combined impact of and subsequent fallout from the disappearance of government stimulus
measures directed at the household sector (such as the new child allowance and the abolition of fees for public senior high schools),
consumer appliance sales under the eco-point scheme, auto sales qualifying for eco-car subsidies, the hot summer and last-minute
demand ahead of a hike in cigarette tax.
Source: Tax Commission; Cabinet Office; Ministry of Internal Affairs and Communications; Japan Meteorological Agency; JADA;
Tobacco Institute Of Japan data and Nomura Global Economics.

The government and The recent sharp economic slowdown and strength of the yen have forced the government and
the BOJ have been the BOJ to pull out all the stops on the policy front. In September 2010, in an attempt to halt the
pulling out all stops yen's ascent, the government intervened in the forex market for the first time in six-and-a-half
years. In October, the BOJ announced a program of "comprehensive monetary easing"
incorporating an asset purchase program. Assuming that the yen continues its ascent, we
expect the BOJ to carry out a further round of easing by expanding this asset purchase program
(Box: The BOJ’s risk tolerance). We expect this to bolster the economy, mainly by stabilizing the
exchange rate.
In November, the Diet passed a supplementary budget for FY10. At its core is a package of
stimulus measures worth a total of about ¥5,090bn. We expect it to boost GDP by about 0.6pp.
In particular, we expect the public investment it contains to bolster real GDP in Q1–Q2 2011. As
a result, we expect to see negative growth for only one quarter (namely, Q4 2010).
Unprecedented corporate surplus liquidity

Companies have We expect private domestic demand to continue to pick up slowly despite the domestic economy's
unprecedented soft patch. What we think will bolster the domestic economy is the corporate sector's
surplus liquidity unprecedented surplus funds, now that it has cleared its excess debts from the bubble years, as
the ratio of the corporate sector’s interest-bearing debt to cash flow indicates (Figure 3). These
excess debts, in our view, have been the main cause of Japan’s prolonged deflation in terms of
both supply and demand.
As a result, companies are under increasingly less pressure to curb their employment costs and
capital investment (See Box: Japan’s deflation and the output gap). According to the latest data
(on a four-quarter moving average basis), the cash surplus – cash flow minus capital investment
(free cash flow) – at companies with capital of at least ¥10mn (excluding the financial and
insurance sectors; same hereafter) had reached an all-time high of ¥22.5tn on an annualized
basis as of June 2010 (Figure 4). This equates to 4.7% of nominal GDP for FY10 (Nomura
estimate). We expect a portion of this unprecedented surplus corporate liquidity to find its way
into domestic investment and wage increases, and thereby to continue to bolster a gradual
recovery in domestic demand.
The economy is We see a continuing decline in USD/JPY as the biggest downside risk to the Japanese economy
highly sensitive to in both the short and medium term. We estimate that a 10% appreciation of the yen against the
USD/JPY US dollar would depress Japan’s real GDP by about 0.3pp a year, mainly as a result of a
slowdown in exports.
Figure 3. Interest-bearing debt/cash flow ratio Figure 4. Corporate sector’s surplus cash (free cash flow)
x ¥trn
13 80 Cash flow
12 70 Free cash flow
Capex
11 60
10 50
40
9
30
8
20
7
10
6 0
5 -10
CY CY
4 -20
1955 60 65 70 75 80 85 90 95 2000 05 10 55 60 65 70 75 80 85 90 95 00 05 10
Note: (1) Interest-bearing debt + borrowing from banks + other Note: (1) 4-Q mov avg, annualized. (2) Cash flow = recurring
borrowings + bonds. (2) Cash flow = recurring profits / 2 + profits / 2 + depreciation. (3) Free cash flow = (cash flow) -
depreciation. (3) Data for companies with a capital of ¥10mn or (capex). (4) Data for companies with a capital of ¥10mn or more
more (excluding financial and insurance). (4) 4-Q mov avg. (excluding financial and insurance)
Source: Ministry of Finance. Source: Ministry of Finance.

The BOJ’s risk tolerance Shuichi Obata

We expect the yen to strengthen again in Q1 2011 and the BOJ to further ease monetary policy, probably expanding its
asset purchases from the current ¥5trn to ¥8-10trn. However, the level of the BOJ’s risk tolerance is the unknown factor.
On 5 October 2010, the BOJ announced its Comprehensive Monetary Easing: (1) lowering its target for the
uncollateralized overnight call rate to 0.0-0.1%; (2) clarifyin its definition of “price stability” (its condition for discontinuing
its zero interest rate policy (ZIRP)); and (3) establishing a ¥35trn asset purchase program that includes fixed-rate fund-
supplying operations (of about ¥30trn) against pooled collateral. Since the start of November, the BOJ has begun to use
some of the ¥5trn that constitutes the new part of the program to buy JGBs and is due to start purchasing corporate
bonds and commercial paper next month.
Although the Japanese economy has recently shown signs of slowing, pressure on the BOJ to further ease monetary
policy, if anything, has eased. One reason for this is that the Japanese stock market has held up quite well since the yen
stopped appreciating. Since the BOJ’s additional easing was in response to yen strength and stock market weakness,
and as many within the BOJ want to see both the effectiveness and the side-effects of measures taken so far, we expect
the BOJ to remain on the sidelines for the time being. As before, we see further bouts of yen strength and stock market
weakness as conditions for any further monetary easing. We expect the yen to appreciate again in Q1 2011 and think
USD/JPY is likely to break below 80, albeit briefly. We expect the BOJ to further ease monetary policy in Q1 2011.
We expect this easing to take the form of an expansion of the asset purchase program that the BOJ announced in October.
We think the main considerations in trying to judge by how much the BOJ is likely to increase its purchases of individual
assets are the size of each market and the BOJ’s risk tolerance. It is can be seen from Figure 1 how carefully the BOJ must
have considered the size and risks to each market when it decided on the maximum purchase amounts for each asset class
in the ¥5trn program. We think the BOJ is most likely to increase the size of the program from ¥5trn to ¥8-10trn and believe
that if the BOJ wants to increase the size of the program while minimizing risk it will have to increase its weighting of JGBs.
In the past, when the BOJ has increased its JGB purchases, it has done so by ¥2.4trn per annum at a time. For commercial
paper and corporate bonds, maximum purchase amounts of ¥3trn and ¥1trn, respectively, were set in 2009. As its aim then
was to calm financial markets, half that amount might be a more likely figure this time. We therefore think that the increase
for bonds and CP may be ¥1-2trn.
More problematic is the BOJ’s tolerance of risk involved in purchasing ETFs and J-REITs. As there is only about ¥1.6trn of
J-REITs rated AA or higher, we see limited scope for the BOJ to increase purchases in this asset class. As for ETFs, while
the size of the market may not be a problem, increasing purchases would expose the BOJ to considerably more risk (Figure
2). Assuming that purchases of both ETFs and J-REITs double, we estimate a total purchase limit of about ¥8.5trn.
However, as the weighted-average risk would increase as a result, the BOJ would have to either increase its JGB (and
corporate bond) purchases, or buy less equity-related products to maintain the risk level. To allow for both possibilities, we
assume that the BOJ will increase the size of the program to ¥8-10trn.
During this period we think the BOJ is unlikely to discontinue its de facto ZIRP. The BOJ has made it clear that it will only
discontinue this policy if its definition of price stability is satisfied (i.e., “in a positive range of 2% or lower”). Assuming a
core CPI rate of 0.5% y-o-y is the trigger, we do not expect an end to the ZIRP until 2014.
Figure 1. Overview of BOJ's new asset purchase program Figure 2. Comparison of asset risks
Maximum purchase Risk as a multiple of the risk of US Treasuries, x

Eligible securities
amount 11.2
12
9.8
¥trn 10
Long-term JGBs 1.5 8
6
Treasury discount bonds 2.0
4
0.5 2 1.0
Commercial paper, etc 0.1 0.1 0.1 0.2
0
Nikkei Average
AA-rated corporate
5-yr US Treasuries
A-rated corporate
BBB-rated corporate
TSE REIT Index

2-yr JGBs
0.5
Corporate bonds, etc
bonds
bonds
bonds
ETFs 0.45
0.05
J-REITs
Note: 1) Max purchase amounts are yardsticks; 2) Conventional Note: (1) We estimated risk as the daily return corresponding to
method in which counterparties' bid yield spreads calculated by the bottom 1%. (2) The sample period was form 1 October 2008 to
subtracting min yield of 0.1% from the yield at which counterparties 30 September 2010. (3) All corporate bonds had a maturity of two
wish to sell to the BOJ. 3) The BOJ plans to continue making years.Source: Bloomberg; Nomura Global Economics.
purchases for about 12 months after its first program purchase.
Source: BOJ; Nomura Global Economics

Japan’s deflation and the output gap Naokazu Koshimizu

The structural factors that have caused Japan’s deflationary pressures have now eased.
Because of the large negative output gap, the Japanese economy entered another deflationary phase in 2009. However,
recently the economy has begun to recover rapidly and as a result the negative output gap has narrowed. Therefore,
deflationary pressures may start to ease. As Figure 1 shows, core CPI inflation tends to gather upward momentum as the
output gap turns positive. However, this relationship is not necessarily stable. From the late 1990s until the early 2000s
the output gap failed to turn decisively upwards despite several economic recoveries. In addition, the elasticity of inflation
with respect to the output gap has turned negative. This shows that deflation increased despite the negative output gap
narrowing.
We think that the output gap has failed to turn positive despite the economic recoveries, and the relationship between the
output gap and inflation has become more tenuous, because the Japanese economy has been hit by the after-effects of
the 1980s asset boom turning to burst in the 1990s. As the bubble inflated in the late 1980s and early 1990s,
employment, capital investment and debt increased in line with growth expectations. However, after the bubble burst
great efforts were made to halt and reverse the excessive growth in employment, capital investment and debt.
Reductions in excessive stock severely depressed growth, resulting in the growth rate forecast by corporations to be
lowered further (Figure 2). In terms of employment, companies were eager to contain their employment costs by
increasingly taking on temporary workers with relatively low wages, even during economic recovery periods. As a result,
average wage growth per head in Japan trended lower, even though there were several recovery periods from the 1990s
onwards. Although the Japanese economy experienced several cyclical recoveries, as a result of stronger external
demand, the benefits seem to have failed to feed through to domestic demand.
However, as the expected growth rate continued to rise during the last economic recovery, it suggests that these after-
effects eased. Wages and lending began to pick up. Although Japan’s expected growth rate declined sharply during
2008’s recession, it has turned upwards this year. Furthermore, the expected growth rate tends to follow a pattern,
whereby it corrects forecasting errors that result from the difference between the previous year’s expected and actual
growth rates. This relationship suggests that the expected growth rate at the end of 2011 is likely to be (a four-quarter
trailing average of) 0.9%, higher than the 0.1% expected at the end of 2009. We think that the sharp decline in the
expected rate of growth during the recent recession is likely to have been temporary. Although wages and lending also
declined substantially, we view this as a cyclical concomitant of the recession rather than a reduction from the excesses
of the 1980s, as happened during the 1990s.
The elasticity of inflation with respect to the output gap has turned positive again, as the benefits of the economic
recovery of the late 2000s have begun to have a positive knock-on effect on domestic demand. We believe this indicates
that deflationary pressures have begun to ease as the output gap narrows. As reducing surplus stock is no longer a long-
term deflationary factor in Japan, we think the economic recovery could feed through to domestic demand and expect
deflationary pressures to ease as a result of a better supply-demand balance.
Figure 1. Elasticity of inflation with respect to the output gap Figure 2. Expected growth rate, wages and lending
% y-o-y , as % of output gap pp % y-o-y annualized, % y-o-y

Output gap and price elasticity (rhs)
8 Core CPI (lhs) 0.3 15 Corporate loans (lhs) 6
Output gap (lagged by two quarters, lhs) 5
6 Est Scheduled cash earnings (rhs)
0.2 10 Est 4
Expected grow th rate (rhs)
4 3
0.1
2 5 2
0 0.0 1
0 0
-2
-0.1 -1
-4
-5 -2
-0.2
-6 -3
-8 -0.3 -10 -4
90 92 94 96 98 00 02 04 06 08 10 12 CY 90 92 94 96 98 00 02 04 06 08 10 CY
Note: (1) Output gap calculated: (actual GDP - potential GDP) / Note: (1) The expected growth rate is the "industry demand real
potential GDP. (2) Data for Q4 2010 and thereafter are Nomura growth rate outlook (average for the next three years)" from the
forecasts. (3) To calculate the elasticity, we have used the core "Annual Survey of Corporate Behavior," divided into quarters and
CPI, which excludes food and energy, as it is likely to be a better plotted as a four-quarter trailing average. (2) The expected growth
reflection of supply-demand. rates for Q2 2010 and thereafter, and scheduled cash earnings for
Source: Nomura Global Economics, Cabinet Office and Ministry of Q4 2010 and thereafter are Nomura forecasts.
Internal Affairs and Communications. Source: Nomura Global Economics, Cabinet Office, Ministry of
Health, Labour and Welfare and BOJ.

A stronger yen would also have a big negative impact on corporate earnings. According to our
estimates for about 400 leading Japanese companies (NOMURA 400, ex-financials), a 10%
appreciation of the yen against the dollar would depress their recurring profits by about 7%.
Exports to the US now account for just under 15% of Japanese exports, considerably less than
the peak figure of 40% in the early 1980s. Although Japanese exporters are now much less
dependent on the US, 49% of their export contracts are denominated in USD. In contrast, only
41% is denominated in yen. As a result, if the yen appreciates against the dollar, Japanese
companies’ export receipts decline in value in yen terms, squeezing their profit margins. This, in
turn, hits their share prices, thereby dampening domestic demand in general and consumer
spending in particular. This tendency for the yen to damage the Japanese economy via its
impact on the stock market strikes us as Japan’s Achilles heel.
Action to boost Japanese exports

We see a medium- In the medium term, we are concerned that the strength of the yen could lead Japanese
term risk of industry companies to transfer production overseas faster than they would otherwise have done and
hollowing out eventually hollow out Japanese industry, thereby threatening both production and jobs in Japan
itself. While it may make perfectly good sense for individual companies to transfer their
production overseas, the cumulative result is a severe blow to the Japanese economy and a
possible obstacle to overcoming deflation. It is therefore the job of the government to try to
counteract such moves. In our view, action is needed on four fronts to reduce the pressure on
companies to transfer production overseas: (1) more stable exchange rates; (2) more
competitive corporate tax rates; (3) more support for new industries; and (4) more
encouragement of free trade.
Corporate taxes are With regard to the second front, we think the government is likely to include a 5pp cut in the
set to be cut basic rate of corporate income tax in its tax revisions for FY11, due to be announced in mid-
December. This would be the first cut in corporate income tax in 12 years.
This should spur Using the Cabinet Office's short-term economic model, we estimate that a 5pp cut in the rate
investment ... would boost real capital investment by 1.3pp and real GDP by 0.2pp (annual average of
quarterly impact). The biggest boost to real GDP from a cut in the corporate income tax rate
would come via capital investment; we think an increase in per capita wages or a rise in share
prices would also give consumer spending quite a boost. Furthermore, the prospect of a further
cut in the corporate income tax rate at some point in the future might persuade companies to
refrain from transferring production overseas despite the strength of the yen and, possibly, even
to transfer production back to Japan. Similarly, it might help to attract investment in Japan by
foreign companies. A 5pp cut in the corporate income tax rate, although quite modest, would
therefore be very significant.
... and help unleash If the government implements policies such as these that are aimed at making life easier for
firms’ surplus Japanese exporters and making them more competitive, and if these policies are successful, we
liquidity think that the prospect of continued export expansion could give companies the confidence to
use their unprecedented surplus liquidity to invest in Japan and boost wages and employment.
This could eventually trigger a recovery in domestic demand.
We expect the soft We expect the Japanese economy to emerge from its soft patch around the middle of 2011 in an
patch to end by mid- export-led recovery helped by an end to the yen's ascent and by strong demand overseas,
year especially in the rest of Asia. We expect the government will implement policies which may help
export-led recovery cause recovery in domestic demand that spells the end of deflation in the
future.

Japan ⏐ Economic Outlook Takahide Kiuchi
Emerging from the soft patch

We think that the Japanese economy will resume its recovery trend in mid-2011, as exports
gather momentum again and government stimulus measures kick in.
Economy: Hit by the slowdown in overseas economies and the strong yen, the Japanese
economy has entered a soft patch, characterized by a sharp loss of momentum in the pace of
recovery. However, we think it will resume its recovery in mid-2011, as the negative impact of the
strong yen runs its course, exports pick up led by renewed momentum in overseas economies,
and aggressive fiscal and monetary stimulus measures take effect. Once expectations of a
recovery start to grow, the plentiful funds amassed in the corporate sector will likely aid the
recovery in corporate capital investment.
Inflation: We expect a gradual slowdown in the pace of decline in the CPI on the back of the
economic recovery. With real GDP growth continuing to outpace potential growth, the negative
output gap is likely to narrow. We look for CPI to turn positive at the end of 2012, marking
Japan’s exit from its deflationary phase.
Fiscal and monetary policy: The Democratic Party of Japan (DPJ) administration has pulled
out all the stops with its economic stimulus measures. After an emergency package of around
¥920bn, the government has decided to implement a supplementary budget worth around ¥5trn
in FY10. For the FY11 budget, deliberations are under way to reduce Japan's corporate tax rate
for the first time in about 12 years. The BOJ has carried out its "comprehensive easing" package
of extraordinary monetary easing measures. We expect Japan's central bank to implement
additional monetary easing measures in response to a renewed upsurge of the yen, resulting in
an increase in the asset purchase program to ¥8–10trn.
Risks: There could be upside for the economy if emerging Asian economies continue to grow
more strongly than expected. However, the economy's performance could fall short of
expectations in the event of sharp yen appreciation, economic developments in the US and
Europe and political turmoil sparked by budget deliberations in Japan. Further yen appreciation
would harm the export environment as well as fuel deflation by causing import prices to drop. It
would also almost certainly dent consumer spending via the negative impact on equity markets.
If we were to see the renewed spectre of financial market turmoil sparked by fiscal restructuring
efforts and concerns over fiscal deterioration in the US and Europe, causing those economies to
be plunged back into recession, the Japanese economy would also be hit by the negative fallout.

% 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 2010 2011 2012
Real GDP 4.4 -2.1 1.3 1.4 1.4 1.7 2.2 2.0 3.7 1.1 2.0
Private consumption 4.7 -2.4 1.6 0.8 0.4 1.0 1.0 0.9 2.3 0.8 0.9
Private non res fixed invest 5.6 2.4 3.2 4.5 5.0 6.1 6.8 6.9 1.8 4.3 6.4
Residential fixed invest 5.4 6.0 4.8 2.3 7.2 8.0 3.1 2.5 -6.8 4.6 4.0
Government consumption 0.5 0.5 0.6 0.7 1.0 0.5 0.6 0.7 1.4 0.6 0.7
Public investment -3.4 -9.0 11.2 4.9 -12.6 -12.2 -2.0 -5.1 -2.8 -1.9 -4.8
Exports 10.0 -2.8 2.4 3.6 4.9 5.6 6.1 6.6 24.5 4.3 6.1
Imports 11.2 1.0 3.4 5.0 4.3 5.1 6.6 6.9 10.2 5.1 6.1
Domestic final sales 3.6 -1.2 2.0 1.4 0.8 1.3 1.5 1.5 1.5 1.1 1.5
Inventories 0.8 -0.4 -0.7 0.0 0.3 0.1 0.4 0.2 0.0 -0.1 0.2
Net trade 0.0 -0.5 0.0 0.0 0.3 0.3 0.3 0.3 2.2 0.1 0.3
Consumer prices -0.8 -0.2 -0.3 -0.1 0.1 0.0 0.0 0.1 -0.8 -0.1 0.1
Core CPI -1.0 -0.7 -0.7 -0.3 -0.2 -0.2 -0.1 0.0 -1.1 -0.3 0.0
Fiscal balance (fiscal yr, % GDP) -8.5 -8.9 -9.1

Current account balance (% GDP) 3.7 3.7 4.1
Unsecured overnight call rate 0.10 0-0.10 0-0.10 0-0.10 0-0.10 0-0.10 0-0.10 0-0.10 0-0.10 0-0.10 0-0.10
JGB 5-year yield 0.26 0.45 0.55 0.70 0.80 0.85 0.90 0.90 0.45 0.85 1.00
JGB 10-year yield 0.93 1.15 1.25 1.40 1.50 1.55 1.60 1.60 1.15 1.55 1.70
JPY/USD 83.5 80.0 82.5 85.0 85.0 86.3 87.5 88.8 80.0 86.3 90.0
Notes: Quarterly real GDP and its contributions are seasonally adjusted annualized rates. Unemployment rate is as a percentage of the
labour force. Inflation measures and CY GDP are year-on-year percent changes. Interest rate forecasts are end of period. Fiscal
balances are for fiscal year and based on general account. Table reflects data available as of 6 December 2010. All forecasts are modal
(i.e., the single most likely outcome). Numbers in bold are actual values, others forecast.
Source: Cabinet Office, Ministry of Finance, Statistics Bureau, BOJ, and Nomura Global Economics.

Asia ⏐ Outlook 2011 Rob Subbaraman
Challenges of rebalancing
Asia’s economies are rebalancing, but unless macro policies also rebalance, setbacks are likely.
Asia is becoming The debate over Asia “decoupling” is too black and white for our liking; Asia will never fully
less reliant on the G3 decouple from the advanced economies – global financial markets are too integrated for that.
economies ... We do feel strongly, however, that Asia’s economies are in the process of rebalancing toward: 1)
domestic demand; 2) China; and 3) emerging markets (EM) more generally, and that this
process is happening faster than most people realise. In 2011-12, we expect the economies of
Asia ex-Japan to collectively grow by over 8%, led by 9-10% growth in China. Asia is becoming
less reliant on the G3 (US, euro area and Japan) economies: it is well on the way to being able
to achieve its full growth potential, even with only 1-2% growth in the G3. If, on the other hand,
there is another G3 recession (not our base case) Asia would be hit hard again, but its fiscal
firepower and sound fundamentals would position it well to bounce back ahead of other regions
(see our Special Report, The heat is on, 28 May 2010). Recently, Asia has been losing some
growth momentum but we see this as temporary. The bigger macro picture is Asia rebalancing:
… as policymakers 1. Domestic demand. Asia is fast becoming too big a slice of the global economic pie to keep
look more inward for relying on export-led growth. We believe that, since the 2008-09 crisis, Asian policymakers have
growth grasped this and have switched their focus to generating domestic demand (Figure 1). Real
policy interest rates are still negative in most Asian countries, but more important is the
increased focus on strengthening social safety nets, the huge pipeline of new private-public
infrastructure projects in India and Southeast Asia, and China moving to unwind government
subsidies that have long-favoured exporters/producers over workers/consumers (See Box:
China: Gearing up for further reform). In the first three quarters of 2010, domestic demand
contributed 93% of GDP growth in China and 94% in the rest of Asia.
Asia now has a large, 2. China juggernaut. China is now the world’s second-largest economy, but with GDP per
dynamic growth pool capita of only USD4,500, its high-growth phase of development is far from over (for details of our
in its own backyard ... forecast, see the China Economic Outlook: GDP growth of 9-10% to continue). A good example
is high-speed rail: by the end of 2012, China will have more track than the rest of the world
combined (Figure 2). Put simply, China’s economy has reached a size where continued high
growth rates mean the rest of Asia now has a large, autonomous growth engine in its own region.
Consider China’s so-called “ordinary” imports (goods catered to China’s own demand instead of
exports). In 2010, these are on track to total USD0.75trn versus US imports of USD2trn. But in
the past five years, China’s ordinary imports have grown on average by 24% per year versus 5%
for US imports. At this pace, China’s ordinary imports will exceed those of the US by 2016.
... and is rapidly 3. Increased links with other EMs. One reason is the tepid G3 recovery; another is the sheer
diversifying to other size of Asia’s expanding middle class, wanting bigger homes and more consumer durables, the
emerging markets materials and manufacturing of which are largely sourced from within Asia and other emerging
markets and commodity producers. This year, only one-third of Asia’s total imports came from
G3 economies. It is telling that this year China’s combined imports from Africa, Latin America
and Saudi Arabia will for the first time exceed its total imports from the US, Germany and France.
Figure 1. Size of economies, actual and projected nominal Figure 2. The amount of high-speed (>250km/hr) rail lines in
GDP, in USD at market exchange rates the world as of May 2010
Km
USD trn Rest of Asia
16 14,000
Korea
India 12,000
14
China Planned
12 US 10,000
Japan Under construction
8,000
10 In operation
6,000
8
4,000
6
2,000
4
0
2
0
1996 1998 2000 2002 2004 2006 2008 2010E 2012F
Source: CEIC and Nomura Global Economics. Source: International Union of Railways.

China: Gearing up for further reform Tomo Kinoshita │ Chi Sun

We expect a long, sizable rate hiking cycle and the government to use the new five-year plan to accelerate reforms.
Macroeconomic policies. We expect less accommodative fiscal policy and tighter monetary conditions in 2011-12 to
address rising inflation pressure. But we expect the overall macro policy stance to stay mildly supportive of the economy.
On monetary policy, we expect the central bank to raise the one-year benchmark lending rate by 175bp in 2011-12; four
25bp increments in 2011 and three more in 2012 (for details of our forecast, see the China Economic Outlook: GDP
growth of 9-10% to continue). We expect the rate hikes to be asymmetric, so over the same period the one-year deposit
rate should rise by a larger 225bp, resulting in a narrowing in banks’ currently wide interest rate margins. We expect
China to implement an aggressive rate hiking cycle not only to contain inflation but also for the longer-run structural
reason of making the financial system more market-oriented. This would involve the phasing out of quantitative bank
lending restrictions, internationalizing the RMB, liberalizing the capital account and moving to a more flexible exchange
rate regime (we forecast CNY/USD to appreciate to 6.22 by the end of 2011 and 5.90 by the end of 2012). All this means
that interest rate policy should become China’s primary monetary policy tool over time, heightening the need to raise
rates from their current excessively low levels. While we are forecasting significant interest rate hikes, we are also expect
a large rise in inflation, so real deposit rates should barely turn positive by late 2012 (Figure 1). On fiscal policy, we
expect the central government’s budget deficit to narrow from 2.5% of GDP in 2010 to 1.3% in 2011 and 1.0% in 2012 on
stronger tax revenues and a slower rate of expansion in public investment, although spending on social welfare and new
strategic industries should accelerate.
Structural reforms. We expect China to implement various structural measures in 2011, aiming for sustained, relatively-
high medium-term growth. In our view, there are three key policy directions:
• Shifting the pattern of growth from investment-driven to more consumption-oriented growth. This topped
the agenda in the draft of the 12th Five-Year Plan (FYP; for 2011-15) (Figure 2). With a very high investment-to-
GDP ratio of 47.7% in 2009, the government intends to sustain relatively high growth by promoting private
consumption. For that purpose, we expect the government to conduct agricultural reform to raise farmers’
incomes; to continue social welfare reform in such areas as social security, health care and education, in order
to raise consumers’ propensity to consume in the medium run; to raise minimum wages with the aim of raising
the income of low-income consumers; and to encourage urbanization.
• Promoting regional development, with a focus on the central and western regions. Rather than simply
continuing its existing policy, we expect China to encourage manufacturers and service providers to relocate
from coastal regions to central and western regions by implementing policy favoring those regions. Also, we
expect the so-called “New 36”, by which the government now allows investment in projects that were previously
restricted to private investment, to mitigate the concerns about financing of local government projects.
• Improving energy efficiency. Policy efforts to reduce energy usage per unit GDP accelerated in mid-2010
when the government ordered 2,087 companies to close energy-inefficient facilities. While the government is
likely to strengthen its policy to consolidate heavy industries to remove inefficient facilities, China announced its
intention to develop and promote the seven strategic industries (energy-saving, alternative energy, advanced
materials, alternative-fuel cars, new-generation information technology, biotechnology and high-end equipment
industries) with which the government is trying to encourage energy efficiency. Price deregulation for resources
such as gas, electricity and water should also encourage efficient use of natural resources.
th
Figure 1. CPI and 1-year deposit rate Figure 2. Summary of draft on China’s 12 Five-Year Plan
% 1 Shift China's economic growth pattern and build new stage of

scientific development
10 CPI, y-o-y 2 Expand domestic demand and maintain relatively fast
1yr deposit rate economic growth.
8
3 Modernise agricultural sector to construct New Socialist
F
Countryside
6 4 Modernise industrial structure
5 Enhance the coordinated regional development and
4 urbanization
6 Construct a resource-saving, environment-friendly society
2 7 Invigorate China through science and education and construct
an innovation-oriented nation.
0 8 Improve public service system
9 Promote China's culture and soft power
-2 10 Perfect system of socialist market economy
Mar-01 Mar-03 Mar-05 Mar-07 Mar-09 Mar-11 11 Pursue the win-win opening-up strategy
Source: CEIC and Nomura Global Economics. Source: Xinhua News Agency and Nomura Global Economics.

Macro policy: Not enough to fight inflation Young Sun Kwon ⏐ Sonal Varma
We expect real policy rates in Asia (GDP weighted) to remain low in 2011. Combining real policy rates and exchange
rates, overall monetary conditions are likely to remain relatively loose, particularly in Greater China and Korea.
Greater China and Korea to keep monetary conditions loose

The current account can be a useful barometer of whether an economy shows signs of overheating, and for Asia we find
a strong inverse relationship between the amount of rate hikes that have been implemented recently and are forecast for
next year, and the current account balance (Figure 2). With inflation rising, the two countries with large current account
deficits (India and Vietnam) have hiked rates the most, whereas countries with large current account surpluses (ASEAN)
have allowed more of the tightening of monetary conditions to happen through real currency appreciation.
However, this pattern breaks down for Hong Kong, Korea and Taiwan. These three have a large current account surplus
and high inflation, but have kept their real policy rates and real effective exchange rates (REER) well below their long-run
averages, so their real monetary conditions indexes (MCI) were the loosest as of October 2010 (Figure 1). We would
also add China to this group as its REER has hardly moved in recent years and bank loan growth has remained high.
Figure 1. Real monetary conditions index (MCI), October 2010

China HK India Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand
Real policy rate -2.7 -4.7 -4.2 -1.3 -2.6 0.1 -0.6 -3.2 -0.5 -1.0
REERs 8.5 -18.0 7.5 16.8 -9.1 2.7 15.1 8.0 -12.6 13.1
Real MCI 0.1 -7.8 -0.3 2.3 -4.8 1.7 2.5 0.5 -8.8 3.3
Note: MCI estimated as weighed average of real effective exchange rate (deviation from long-run average since 2000) and real policy
rates (deviation from long-run average since 2000). MCI value of zero indicates neutral monetary conditions, higher value suggests
tighter monetary conditions and negative values suggest loose monetary conditions. In Hong Kong and Singapore, we used the 3-month
interbank rate as a proxy for the policy rate. Source: BIS; CEIC and Nomura Global Economics estimates.
Policymakers to miss their inflation targets

In 2011, we expect all Asian central banks to raise interest rates, ranging from 50bp (Taiwan, Korea, Malaysia) to 100bp
(China, Indonesia, Philippines, Vietnam), but not enough to significantly raise real policy rates, given our forecast of CPI
inflation rising and remaining above central bank targets. We believe the greater use of macro-prudential measures will
be partly at the expense of rate hikes, even though these interventionist policies tend to lose effectiveness over time. The
scope for monetary tightening to respond to commodity price-driven inflation is also limited, given it hurts GDP growth,
too. Finally, while allowing an undervalued currency to appreciate can help contain inflation, we expect the authorities,
eager to support exporters, to resist rapid currency appreciation, including by using more capital controls.
Risks from “growth over inflation” policymaking

We forecast Asia ex-Japan CPI inflation to rise from 4.5% y-o-y in 2010 to 5.1% in 2011, such that real policy rates rise
to only 0.6% from 0.3%, far lower than the historical average of around 2% (Figure 3). Such a loose monetary policy, for
fear of attracting capital inflows, can be positive for domestic growth only in the short run. The longer-term consequences
can be asset price bubbles, excessive CPI inflation or worsening current account positions, any of which could eventually
result in a costly macro adjustment and be counterproductive. In the end, we think Asia will not be able to escape
significant real exchange rate appreciation; the rising risk is that a large part of this comes via higher domestic inflation.
Figure 2. Current accounts and policy rates Figure 3. Policy rates in Asia ex-Japan, Australia, NZ
Current account, % of GDP in 2010-11 % y-o-y

20 Real policy rates
8
Singapore Nominal policy rates
15
Malaysia
6
10 Taiwan
HK Philippines 4
5 China
Korea Thailand
0 2
Indonesia
India
-5 0
-10 Vietnam
-2
-15 Cumulative rate hikes , bp in 2010-11 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11
-50 0 50 100 150 200 250
Note: In Singapore and Hong Kong, we use the 3-month interbank Note: Weighted by GDP (on a purchasing power parity basis).
rate since the monetary authorities target the exchange rate. India inflation refers to wholesale price index.
Source: CEIC and Nomura Global Economics estimates. Source: IMF, CEIC and Nomura Global Economics estimates.

Myopic policy responses

Excess net capital Asia’s rapid ascent is creating new policy challenges. One is the attraction of massive net capital
inflows pose a policy inflows because of Asia’s superior economic fundamentals and higher growth rates vis-à-vis the
dilemma advanced economies, conditions that we expect to continue through 2011-12. These capital
inflows rarely trickle in – they come in waves which, on top of Asia’s large current account
surpluses, have placed significant appreciation pressure on Asian currencies. Herein lies the rub.
Asian policymakers are willing to tolerate gradual currency appreciation, but not at the speed
that market forces would dictate. Their rationale: after relying on an export-led growth model for
decades, the shifting of capital and labour from export-orientated industries to domestic
industries, and the deepening of local debt markets to absorb the capital inflows, takes time.
The new trend in Asia In response, Asia has limited currency appreciation through FX intervention. Asia’s FX reserves
is to micro-manage have surged to USD5.5trn (Figure 3). China tends to grab all the attention, but scaled by GDP,
the economy the biggest FX accumulators have been Hong Kong, Singapore, Taiwan and Thailand (Figure 4).
Asia’s FX reserves are now more than adequate to insure against a crisis. They also involve
rising costs when the interest paid on sterilisation bonds is higher than the interest earned on FX
reserves. As a result, there has been a contagious shift in Asia this year to micro-manage the
economy though capital controls and macro-prudential policies (see our Special Report, The
case for capital controls in Asia, 1 November 2010). On our count, there have been 25 such
measures imposed across the region this year, spanning nine of the 11 countries we cover.
The “impossible This trend can be understood as a manifestation of the so-called “impossible trinity”: a country
trinity” is starting to can simultaneously choose any two, but not all, of: a managed exchange rate, an open capital
bite account and monetary policy autonomy. Countries that attempt to manage the exchange rate
when capital is flowing freely lose control of their domestic monetary policy – they end up having
to keep interest rates too low so as not attract more capital inflows, which becomes inflationary.
If they want to manage the exchange rate while trying to regain control over domestic monetary
policy, the only thing they can do is to clamp down on capital flows. However, using capital
controls to slow currency appreciation and imposing higher mortgage downpayment ratios,
credit quotas and property taxes in lieu of raising interest rates may seem to work in the short
term, but the international experience is that these sorts of measures become less effective over
time as investors find loopholes. The upshot is that many countries in Asia will be hard-pressed
to avoid inflation problems in 2011-12 (See Box: Macro policy: not enough to fight inflation).
Inflation looms
Inflation will be the Another challenge created by Asia’s ascent is rising commodity prices, especially that of food,
macro story in 2011 which we believe will continue to rise sharply (see our Special Report, The coming surge in food
prices, 8 September 2010). While food prices comprise 14% of the US CPI basket, in Asia that
weighting is more than double, and so rapidly rising food prices have a large impact on Asian
inflation. Inflation pressures are also percolating, because the economies are operating at near-
full capacity. Unemployment rates have mostly fallen back to pre-crisis levels and, on cue, wage
inflation is rising and could accelerate in China as the supply of young rural workers willing to
migrate to manufacturing jobs continues to dwindle. Heated property markets are another
inflation driver, given the imputed cost of housing feeds into Asian CPI with lags of 6-24 months
and have hefty CPI weights in Hong Kong (29.2%), Singapore (20.0%) and Taiwan (18.5%).
Figure 3. FX reserves in Asia Figure 4. FX reserves and currencies, 12 months to Sept-2010
USD trn % y-o-y % of GDP

3.0 20 Change in nominal effective 20
China exchange rate, lhs
15 Change in FX reserves, rhs
2.5 Japan 15
Rest of Asia
10 10
2.0
5 5
1.5
0 0
1.0 -5 -5
-10 -10
0.5
0.0
Oct-98 Oct-00 Oct-02 Oct-04 Oct-06 Oct-08 Oct-10
Source: CEIC and Nomura Global Economics. Source: BIS; CEIC and Nomura Global Economics.

Hence our 2011 CPI inflation forecasts are above-consensus in all Asian countries.
India and Hong Kong So how does Asia fare in the face of the dual shocks of surging capital inflows and commodity
look most vulnerable, prices? In terms of rising food and energy prices, Australia, New Zealand and possibly Malaysia
for different reasons could be net beneficiaries, whereas India and the Philippines seem most exposed (Figure 5).
Yet policy responses and economic fundamentals must also be considered. Others may well
follow China’s lead in introducing food and energy subsidies and price controls to shield low-
income households, or cut import tariffs to boost local supply, particularly in India and Southeast
Asia, where commodities comprise such a large share of the consumption basket. The result:
worsening fiscal and current account balances. From this perspective, the Philippines, Vietnam
and most of all India, look most vulnerable to a “sudden stop” – when investors start to focus on
sovereign risks (Figure 6). In terms of continued surging net capital inflows, Hong Kong is by far
the most exposed to an asset price bubble that, by definition, will burst. The HKD/USD peg
means Hong Kong is importing the Fed’s QE2 and experiencing deeply negative and falling
short-term real interest rates, which is completely at odds with the stage of its economic cycle.
Surprises and themes

We highlight two possible out-of-the-blue surprises and three big picture macro themes:
As economies HKD/USD peg. It is not our base case, but the HKD could be re-pegged to the RMB in 2011-12.
transform, policies This would allow monetary conditions to be more in sync with an economy increasingly geared
may need to as well to China’s and is consistent with Hong Kong fast becoming the RMB offshore financing centre.
China’s economy is China’s challenging GDP arithmetic. We are bullish on China, but also aware that the
very unbalanced economy is very unbalanced. Investment is nearly half of GDP; if for whatever reason it were to
stop growing, it could cut China’s GDP growth in half (in most Asian countries, investment falls
at least one year per decade – in China, it has not fallen since 1989).
Policy is set to favour Productivity drive in China. China’s one-child policy means the contribution from labour to
quality over quantity potential output growth will soon dwindle to zero and, with such a high investment-GDP ratio, it will
be hard for capital to contribute more than it already is. Using labour and capital more efficiently (i.e.
total factor productivity) is key for China to avoid a noticeable slowdown in its potential growth rate.
In 2011-12, we expect reforms to focus on: phasing out government subsidies to producers,
promoting the private sector and service industries; making banks more accountable for properly
pricing credit risk; and promoting human capital, automation and a more efficient use of resources.
Korea is set to be the Seoul searching. In our forecasts, Korea is the region’s growth laggard in 2011, due to
laggard in 2011 KRW/USD appreciation sapping export competitiveness, a rising North Korea risk premium (see
Box: Asia politics outlook 2011-12), having one of the few property markets with oversupply and
a household sector constrained by debts exceeding 150% of disposable income.
There could be an Infrastructure boom. China aside, Asian investment-to-GDP ratios are too low, but with solid
infrastructure boom fundamentals, low interest rates, fiscal space and strong capital inflows, expect a wave of public-
private infrastructure projects, from Taiwan to India and across Southeast Asia in between.
Figure 5. Net imports of food and energy-related items and Figure 6. Current account and fiscal balance forecasts, 2011
their weighting in CPI baskets, 2009 (circles = size of gross public debt as a % of GDP)
% weighting in CPI % of GDP
65 20
Philippines Malay Sing
60 15
Indonesia Taiwan
55 India
Current account balance
Food and energy items
10
50 Vietnam
Phil
Malaysia China Japan
45 5 China HK
Singapore HK
Thailand Ireland UK Thai Indo Korea
40 0
Taiwan Brazil
35 Japan US India
-5 NZ
30 Korea
NZ Viet
Greece Aust
25 -10
Australia Portugal
20 -15
0 -10 5 -5 10 15 -15 -10 -5 0 5
Net imports of food and energy % of GDP Fiscal balance % of GDP
Source: CEIC and Nomura Global Economics. Note: Singapore’s public debt is excluded, as it does not reflect
fiscal deficits.
Source: IMF and Nomura Global Economics.

Asia politics outlook 2011-12 Alastair Newton │ Asia economics team

A particularly full political calendar in 2011-12 will shape policy direction, market sentiment and the economic outlook.
The direction of Sino-US relations and geopolitical tension between the two Koreas could fundamentally change Asia’s
economic outlook, while at the country level we see elections in Thailand and possibly Malaysia as potential game-
changers. Here is how we see the main political events ahead:
• China: We judge that in 2011 China’s leaders will be focused on ensuring a smooth economic trajectory through the
handover of power to the incoming Fifth Generation leadership between October 2012 and March 2013. A key
element in that process will be the 12th Five-Year Plan (to be unveiled in March 2011), which we think will focus on
improving the quality and hence sustainability of economic growth. Internationally, Sino-US relations remain
paramount and we look to President Hu Jintao’s proposed visit to Washington in January to help defuse tensions;
however, even though we expect RMB appreciation to accelerate, we doubt that it will do so fast enough to satisfy
China’s critics in Washington. Despite continuing differences, we do not expect escalation of territorial disputes
between China and its neighbours in 2011.
• India: Corruption scandals have disrupted the Parliamentary session, with the opposition demanding that the prime
minister resign. While this is a near-term risk to investment inflows, we do not place a high probability on the prime
minister resigning. The negative sentiment could rumble on into the early months of 2011, but we do not expect
much political fallout beyond the near term. In Pakistan, if (as looks increasingly likely) the army elects to broaden its
campaign against Islamic militants into North Waziristan, we believe that the risk of another major Pakistani terrorist
attack on India could increase.
• Malaysia: We expect Prime Minister Najib Razak to call a general election, due by April 2013, in 2011 (and possibly
as early as H1) as he seeks his own mandate and tries to leverage Malaysia’s strong economic recovery and
opposition disarray. If elections are held in H1, we think the government would boost fiscal policy and put reforms on
hold until after the elections. We would expect the ruling coalition to achieve a sufficient mandate to move ahead
with structural reforms.
• South Korea: The 26 March sinking of the South Korean corvette Cheonan and the 23 November artillery assault
on the South Korean island of Yeonpyeong (the first attack on South Korean soil since the Korean War) has
returned brinkmanship to the peninsula. We judge that these events will push South Korea towards a “Sunset policy”,
away from a “Sunshine policy”, but do not rule out a return to negotiations. We expect tensions to remain high, but
view a major escalation (major military confrontations) as a low probability – albeit high-risk – event for South Korea.
Foreign investors are likely to demand a higher risk premium. It is one of the reasons why we have Korea’s GDP
growing by only 3.5% in 2011, making it the laggard in the region.
• Taiwan: We expect China/Taiwan economic ties to continue to deepen and for the KMT to win the legislature and
presidential elections due in early 2012. We believe closer ties with China (including the Economic Cooperation
Framework Agreement effective September 2010), by lowering tariffs imposed on Taiwan’s electronics and other
products and enhancing investment from China, will be a major positive for Taiwan’s medium-term growth outlook.
• Thailand: Despite recent relative calm, persistent political tensions could erupt again between now and the general
election, due no later than December 2011. Potential flashpoints include the ongoing trial of UDD leaders and the
dismissal of the electoral fraud case against the Democrat Party. Renewed violence would likely hit domestic
demand and tourism. The deep-seated political divide is likely to continue to cast a cloud over the economic outlook.
• Vietnam: The 11th Communist Party Congress (CPC) in January 2011 is expected to usher in a new generation of
leaders. We believe there could be greater scope after the CPC for tighter policies to avoid overheating and
structural reforms, such as improving efficiency of public investment and strengthening of the financial sector – all of
this should allow the country to attract stronger FDI and will be positive for its longer-run economic outlook.
Some important dates, 2011-2012
2011 2012
January: China – President Hu Jintao’s state visit to Washington January: Taiwan – Legislature elections
January: Vietnam – Communist Party 11th National Congress February: Singapore – Deadline for parliamentary elections
15 Apr: North Korea – 100th anniversary of the birth of Kim Il-
March: China – National People’s Congress (approval of FYP)
sung
23 July: Malaysia – Last date for Sarawak state elections April: South Korea – Parliamentary elections
26 December: Thailand – Last date for parliamentary elections September: Hong Kong – Legislative Council elections
October: China – Chinese Communist Party 18th Congress
December: South Korea – Presidential election

Australia ⏐ Economic Outlook Stephen Roberts ⏐ Tatiana Byrne
Tiger taming
Above-trend GDP growth later in 2011, driven by a major increase in investment spending in the
resources sector, will have policymakers trying to tame growth and limit inflationary pressure.
Activity: We expect persistently strong GDP growth from mid-2011 and in 2012, above the
long-term trend (3.3%), with very rapid growth in exports and business investment balanced by
cautious household and government spending. Forecast increases in export volumes and a
record lift in spending on resource projects, both derive from our view of robust growth in major
Asian export markets, especially China, keeping commodity prices elevated. In contrast, we see
a high household debt burden weighing on household spending in 2011, especially with
borrowing interest rates pushing above the average of the past decade on further policy rate
hikes. We also see weaker government spending acting as a drag on growth through 2011.
Inflation: Economic spare capacity is limited, especially in the labour market where we see the
unemployment rate falling below 5% in 2011 – a level that in the past has been consistent with
higher wage increases and rising inflation. While Australian dollar strength and forward-looking
monetary policy tightening by the Reserve Bank (RBA) may limit how far inflation rises, we still
expect CPI inflation to move a little above the RBA’s 2-3% target band in 2011 and 2012.
Policy: Policymakers will have to deal with the consequences of a massive, positive shock to
national income and GDP growth from a once-in-a-century improvement in the terms of trade.
We see policy to be set to partly offset this, making space by limiting growth in government and
household spending. The post-crisis fiscal spending boost to growth is likely to be allowed to run
down as initially planned through 2011, providing 1.3 percentage points (pp) less impetus to
GDP growth than in 2010. We see the RBA working to establish a cash rate early in 2011
consistent with commercial banks’ standard variable mortgage interest rates of around 8.50%,
about 1pp above their long-term average. Our forecast is that two more 25bp rate hikes to
5.25% should suffice and, given that the RBA wants to establish the rate level ahead of
accelerating business investment in mid-2011, these should be complete by Q3 2011.
Risks: Worse global financial market conditions through the channel of higher Australian bank
funding costs and borrowing interest rates could intensify deleveraging in the heavily indebted
household sector. Any substantial setback in Asian growth, particularly Chinese growth, would
also present downside risk. A major improvement in sentiment on risk assets could lift growth.

% y-o-y growth unless otherwise stated 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 2010 2011 2012
Real GDP (sa, % q-o-q, annualized) 0.8 4.0 3.2 3.2 4.0 4.0 3.6 3.6
- % q-o-q, sa 0.2 1.0 0.8 0.8 1.0 1.0 0.9 0.9
- % y-o-y 2.7 3.0 3.2 2.8 3.6 3.6 3.8 3.9 2.8 3.3 3.6
Government (total spending) 9.0 4.3 -0.2 -2.0 -1.6 -1.0 1.0 2.2 8.7 -1.2 2.0
Investment (private) 2.6 1.1 7.6 10.8 12.0 13.5 11.3 7.9 0.8 11.0 7.0
Exports 4.2 4.2 9.3 6.7 5.4 5.5 7.4 9.5 5.1 6.7 9.0
imports 12.9 5.3 7.9 8.4 4.8 7.1 9.2 9.9 12.2 6.2 7.9
Contributions to GDP growth (% points):
Inventories and statistical discrepancy 0.1 -0.2 0.1 0.0 -0.1 0.0 0.0 0.0 0.6 -0.4 -0.1
Net trade -1.7 0.4 0.0 -0.4 0.2 -0.4 -0.5 -0.3 -1.4 0.2 0.3
Employment, 000 35.7 30.0 25.0 25.0 25.0 25.0 28.0 28.0 30.1 25.0 28.0
Consumer prices 2.8 3.0 2.9 3.0 3.2 3.3 3.3 3.2 3.0 3.1 3.1
Trimmed mean 2.5 2.5 2.5 2.8 3.0 3.1 3.1 3.1 2.7 2.9 3.1
Weighted median 2.3 2.8 2.6 2.9 3.1 3.2 3.2 3.1 2.7 3.0 3.1
Federal deficit (% of GDP) FY end-June -4.2 -2.8 -1.0
Current account deficit (% GDP) -2.6 -1.8 -2.3
Cash rate 4.50 4.75 5.00 5.25 5.25 5.25 5.25 5.25 4.75 5.25 5.25
90-day bank bill 4.97 5.00 5.25 5.50 5.50 5.50 5.50 5.50 5.00 5.50 5.50
3-year bond 4.75 5.20 5.30 5.60 5.90 6.20 6.20 6.10 5.20 6.20 6.00
10-year bond 4.96 5.50 5.70 5.90 6.10 6.30 6.30 6.20 5.50 6.30 6.10
AUD/USD 0.97 0.96 0.96 0.98 1.00 1.02 1.02 1.02 0.96 1.02 1.02
Note: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are
period average. All forecasts are modal forecasts (i.e., the single most likely outcome). Table reflects data available as of 6 December
2010.
Source: Australian Bureau of Statistics; Reserve Bank of Australia and Nomura Global Economics.

New Zealand ⏐ Economic Outlook Stephen Roberts ⏐ Tatiana Byrne
A patchy recovery
We see GDP growth accelerating to its long-term trend through 2011, but with earthquake
reconstruction spending masking patchier underlying improvement.
Activity: We expect real GDP growth to lift to 2.8% y-o-y in 2011 and 3.4% in 2012, but much of
the lift in 2011 is one-off investments related to reconstruction efforts in the wake of the
Canterbury district earthquake on 4 September, 2010. Apart from reconstruction spending –
contributing on our estimates 2.2 percentage points to GDP growth in 2011-12 – we also expect
a modest improvement in household consumption spending, with household confidence
improving as employment continues to grow through 2011. Consumption is also likely to receive
a boost through 2011 from higher farm incomes as soft commodity prices continue to rise,
although this may be tempered by a desire to reduce high debt levels in the household sector.
Comparatively strong growth in Australia and Asia should support strong growth in export
volumes in 2011, but improving domestic spending should also drive imports higher too. Thus,
we see an erratic net export contribution to GDP growth through the year.
Inflation: CPI inflation is set to spike above the top of the Reserve Bank of New Zealand’s
(RBNZ) 1%-3% target band in 2011, but should fall back from Q4 as the 2.5pp lift in the goods
and services tax falls out of the annual calculation. A still-wide negative output gap by our
calculations at the end of 2011 should help contain inflation expectations and help lower annual
inflation to the upper part of the target band in 2012.
Policy: The Treasury and the RBNZ agree that the build-up of government and private debt has
been excessive over the past decade and made worse by the economic downturn through 2008-
09. Both highlight periodically potential capital flight risk from a small, open, relatively
undiversified economy, with a market-driven exchange rate. We expect a pro-saving theme in
policy. We expect government budgets to be restrained, bar the earthquake recovery spending
in 2011 and early 2012. We see the RBNZ moving gradually to normalise borrowing interest
rates in 2011 and 2012 while taking into account higher spreads charged by commercial banks
on their lending rates. We expect three well spread out 25bp RBNZ rate hikes in 2011 to 3.75%.
Risks: The biggest downside growth risk we see is weaker than expected spending by the
heavily indebted farm and household sectors. An important two-way risk (ie, to the up/downside)
is if economic growth in Australia and in Asia proves to be stronger/weaker than we forecast.

Real GDP - % q-o-q saar 0.8 2.4 3.2 3.6 4.0 3.6 3.6 3.8
- % q-o-q, sa 0.2 0.6 0.8 0.9 1.0 0.9 0.9 1.0
- % y-o-y 1.9 1.5 1.8 2.5 3.3 3.6 3.5 3.4 1.8 2.8 3.4
Investment (private and public) 1.0 2.9 3.8 5.1 5.9 6.1 5.6 5.2 -2.4 5.5 5.4
Exports 2.8 5.0 5.7 5.4 4.4 4.5 4.6 4.7 4.0 4.9 5.0
Imports 6.3 4.0 3.7 4.1 4.2 4.2 4.1 4.1 6.5 4.1 3.9
Inventories and statistical discrepancy 1.5 -0.3 -0.4 -0.2 -0.1 -0.1 0.0 -0.1 1.4 -0.2 -0.3
Net trade -1.1 0.2 0.4 0.3 -0.1 -0.1 0.2 0.2 -0.8 0.1 0.3
Employment, 000 23.0 18.0 18.0 18.0 20.0 20.0 20.0 22.0 14.0 19.0 22.0
Consumer prices 1.5 3.5 4.0 4.4 4.4 2.6 2.2 2.5 2.3 3.9 2.4
Trimmed mean (15% trim) 1.7 4.0 4.5 4.7 4.7 2.9 2.4 2.6 2.5 4.2 2.6
Weighted median 1.6 3.9 4.4 4.6 4.6 2.9 2.4 2.5 2.3 4.1 2.5
Federal deficit (% of GDP) FY end-June -2.4 -2.0 -1.5
Current account deficit (% GDP) -5.5 -6.0 -5.2
Cash rate 3.00 3.00 3.25 3.50 3.50 3.75 4.00 4.25 3.00 3.75 4.50
90-day bank bill 3.17 3.20 3.50 3.75 3.75 4.00 4.20 4.50 3.20 4.00 4.75
3-year bond 3.81 4.30 4.60 5.00 5.10 5.40 5.50 5.80 4.30 5.40 6.00
10-year bond 5.01 5.60 5.80 6.00 6.20 6.40 6.40 6.30 5.60 6.40 6.20
NZD/USD 0.76 0.75 0.77 0.80 0.82 0.84 0.84 0.84 0.75 0.84 0.84
Note: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are
2010.
Source: Statistics New Zealand, Reserve Bank of New Zealand and Nomura Global Economics.

China ⏐ Economic Outlook Tomo Kinoshita ⏐Chi Sun
GDP growth of 9-10% to continue

We expect GDP growth to rise steadily through 2011, led by domestic demand. Policymakers
will have their work cut out checking inflation and rebalancing the economy toward consumption.
Activity: After bottoming in Q4 2010, we forecast real GDP growth to steadily rise over the next
four quarters, to average 9.8% in 2011. We expect the contribution from private consumption to
GDP growth to rise from 3.1 percentage points (pp) in 2010 to 3.2pp in 2011 and 3.3pp in 2012,
due to rapid income growth, urbanisation and proactive government policies, including enforcing
better working conditions, large minimum wage hikes and social welfare reform. We expect
investment to remain the chief GDP driver – contributing 5.2pp in 2011 and 4.9pp in 2012 – as
th
strong pipeline projects and new projects under the 12 Five-Year Plan kick in. Government
consumption should contribute a smaller 1.1pp in 2011. On trade, we forecast exports to grow at
12%, low by Chinese standards due to subdued growth in the advanced economies, but we
expect stronger 13.8% import growth due to strengthening domestic demand and rising
commodity prices. As a result, we expect net trade to make a 0.3pp contribution to 2011 growth.
Inflation: We expect high producer price index (PPI) inflation of 6.0% in 2011, due to strong
investment demand for raw materials and the deregulation of natural-resource prices. We expect
CPI inflation to rise to 4.5% in 2011, driven by rising input costs (raw materials and wages),
excess liquidity and reduced overcapacity in the manufacturing sector, due to strengthening
consumption. Some industries could face a squeeze in profit margins. Excluding food and
energy prices, we expect core CPI inflation to steadily rise through our forecast horizon.
Policy: In response to excess liquidity and rising inflation we expect interest rate hikes of 100bp,
bank reserve requirement ratio hikes of 250bp and more macro-prudential measures in 2011.
We expect a net increase in loans of close to RMB8trn in 2011, translating to 16.7% y-o-y loan
growth, in line with nominal GDP growth. Stringent measures to counter property market
th
speculation are likely to continue. The 12 Five-Year Plan, to be unveiled in March 2011, is
likely to jump-start the reform effort to achieve higher quality, more sustainable economic growth.
Risks: Policymakers are walking a tightrope. If authorities over-react to inflation and implement
a strict RMB6-7trn loan quota, investment could weaken sharply, raising the risk of a hard
landing. On the other hand, too lax policy, such as keeping the real deposit rate deeply negative,
could fuel asset price bubbles that, by definition, eventually burst. Of these two risks, we worry
about the latter developing over several years. Also at the back of our minds is China’s
challenging GDP arithmetic: investment is approaching half of GDP. If, for whatever reason,
investment stopped growing one year it would halve China’s GDP growth rate.

Real GDP 9.6 9.2 9.4 9.7 9.9 10.0 9.0 9.4 10.2 9.8 9.5
Consumer prices 3.5 4.5 4.1 4.5 4.9 4.4 5.0 5.2 3.3 4.5 5.0
Core CPI (excl. food & energy) 1.1 1.6 2.0 2.2 2.4 2.5 2.3 2.4 1.0 2.3 2.5
Retail sales (nominal) 18.4 18.6 20.1 19.7 19.9 20.1 20.3 20.6 18.4 20.0 21.0
Fixed-asset investment (nominal, ytd) 24.0 23.5 23.0 23.5 22.5 22.0 20.5 22.5 23.5 22.0 21.0
Industrial production (real) 13.5 13.7 12.8 14.2 15.1 16.0 15.1 14.1 15.8 14.5 14.2
Exports (value) 32.3 17.0 18.0 10.0 9.5 12.0 17.5 11.2 29.0 12.0 12.0
Imports (value) 27.1 18.5 12.0 14.0 13.0 16.0 14.0 17.0 35.6 13.8 16.0
Trade surplus (US$bn) 65.7 35.4 35.3 31.4 59.1 61.9 53.2 12.1 189 188 147
Current account (% of GDP) 5.0 4.1 3.1
Fiscal balance (% of GDP) -2.5 -1.3 -1.0
Net increase in RMB Loans (RMBtrn) 8.0 8.0 8.4

1-yr bank lending rate (%) 5.31 5.56 5.81 6.06 6.31 6.56 6.81 7.06 5.56 6.56 7.31
1-yr bank deposit rate (%) 2.25 2.50 2.75 3.00 3.25 3.50 3.75 4.25 2.50 3.50 4.75
Reserve requirement ratio (%) 17.00 18.50 19.00 19.50 20.00 20.50 20.50 20.50 18.00 20.50 20.50
Exchange rate (CNY/USD) 6.70 6.60 6.50 6.40 6.30 6.22 6.14 6.06 6.60 6.22 5.90
Notes: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are
period average. All forecasts are modal forecasts (i.e., the single most likely outcome). Our RRR forecasts apply only to the large banks
and where they cover more than half the banking sector’s deposits. Our 4Q10 forecast includes the temporary hike that expires 31 Dec
2010. Table reflects data available as of 6 December 2010.
Source: CEIC and Nomura Global Economics.

Hong Kong ⏐ Economic Outlook Tomo Kinoshita
Robust growth continues

We expect multiple factors to drive growth in 2011-12, including private consumption, investment
and service-sector exports.
Activity: We expect robust economic growth of 4.7% in 2011, driven by three demand-side
factors. First, we expect private consumption to remain robust. In fact, consumption has been
quite strong in recent months even though post-crisis pent-up demand has waned, due mainly to
improved employment conditions, rising wages and wealth effects from higher property and
stock prices. Although authorities imposed strict tightening measures on the property sector on
19 November, the tight labour market and low borrowing costs should keep private consumption
strong. Second, we expect investment in both the public and private sectors to maintain strength.
Public investment should be buoyed by large, government-led infrastructure projects while
private investment growth should rise steadily on a shrinking output gap. Third, service-sector
exports, especially tourist-related demand, are likely to increase further. Robust growth in
neighbouring economies, especially China, is likely to contribute to an increase in tourist arrivals.
Inflation: We believe a sharp rise in CPI inflation is likely, reflecting the lagged feed-through
effects from rising rental price inflation, a very weak effective exchange rate, higher imported
food prices from China and hikes in the minimum wage from May 2011. We expect the
government to mitigate inflation pressures by reducing housing-related tax and public housing
rental in FY11 (starting April 2011). Nonetheless, we expect CPI inflation to accelerate to 4.5%
in 2011 and 4.9% in 2012.
Policy: As Hong Kong uses a currency board system with HKD pegged to USD, monetary
policy easing in the US brought very accommodative monetary conditions to Hong Kong. As a
result, residential property prices have risen sharply, up a cumulative 47.4% since December
2009. Authorities have implemented numerous macro-prudential measures to try to contain the
excessive rise in prices over the past several months but they may need to impose more if
property prices continue to rise at such a pace, especially given that, because of the HKD-USD
peg, Hong Kong cannot autonomously raise interest rates.
Risks: Being a small, open economy and a major financial hub, Hong Kong is one of Asia’s
most vulnerable economies to a double-dip in advanced economies. As Hong Kong is one of the
economies least likely to impose any capital control measures in Asia, the rising possibility of
capital controls in other Asian economies might encourage further capital inflows in to Hong
Kong, thus raising the risk of bigger asset bubbles.
[sa, % q-o-q; annualized] 2.9 1.9 5.7 6.9 5.1 3.9 3.7 8.0
Real GDP 6.8 4.8 4.0 4.3 4.9 5.4 4.9 5.2 6.5 4.7 5.3
Gross fixed capital formation 0.3 4.8 6.0 6.3 6.5 7.7 8.0 8.5 7.0 6.6 8.6
Exports (goods & services) 19.3 14.1 12.4 10.7 10.3 10.0 10.2 11.3 18.2 10.8 11.2
Imports (goods & services) 15.8 13.9 12.5 10.4 10.5 10.0 10.2 11.4 19.0 10.8 11.4
Inventories -4.9 -0.7 -1.0 -1.2 0.0 0.4 0.0 -0.1 1.6 -0.4 0.0
Net trade (goods & services) 7.9 1.3 0.2 0.9 1.0 0.7 0.1 0.1 -0.3 0.7 0.4
Unemployment rate (sa, %) 4.2 3.9 3.8 3.7 3.6 3.5 3.5 3.5 4.3 3.7 3.3
Consumer prices 2.3 2.8 3.3 3.8 6.1 4.7 4.4 4.9 2.4 4.5 4.9
Exports 27.4 20.3 18.4 16.9 16.9 16.3 16.9 18.0 24.2 17.0 17.9
Imports 23.8 22.0 19.4 16.9 16.3 15.6 16.2 17.4 26.7 16.9 17.5
Trade balance (US$bn) -8.6 -13.1 -14.4 -13.7 -9.4 -14.4 -16.1 -15.5 -44.7 -51.9 -59.0
Current account (US$bn) 12.5 10.5 7.5
Current account (% GDP) 5.5 4.2 2.8
Fiscal balance (% of GDP) 3.4 2.3 2.1
3-month Hibor (%) 0.33 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40
Exchange rate (HKD/USD) 7.76 7.75 7.75 7.75 7.75 7.75 7.75 7.75 7.75 7.75 7.75
2010.

India ⏐ Economic Outlook Sonal Varma
The consolidation year

We expect economic growth to consolidate in 2011 after a strong rebound in 2010. Inflation is
likely to remain above the comfort zone, prompting 75bp of rate hikes through next year.
Activity: We expect real GDP growth to consolidate at 8% y-o-y in 2011 after a strong 8.8% in
2010 due to three factors. First, we expect growth in agricultural output to normalise and year-
on-year growth to be pulled lower by adverse base effects. Second, we expect growth in
government consumption to slow after the above-normal increases since the onset of the crisis.
Third, we expect net exports to be a larger drag on growth as imports pick up in line with
improving domestic private demand. We forecast underlying private demand – both investment
and private consumption – to remain strong. We expect private consumption to remain
supported by rising wages and strong rural demand. We expect investment to be led by
infrastructure, real estate and services-sector capex. Overall, 2011 should see growth
consolidating before rising to 8.6% in 2012.
Inflation: We expect headline WPI inflation to remain elevated, averaging 7.3% y-o-y in 2011,
despite favourable base effects. We see inflation remaining sticky due to what we see as a
structural rise in commodity prices (we build in a 15% rise in the CRB index) and a closing
output gap, which should result in greater demand-side inflation. We expect inflation to bottom in
Q1 2011 and start to climb from the 6%-handle in H1 2011 to above 7.5% in H2 2011. We
expect CPI inflation to average 8.4% in 2011, compared with 11.9% in 2010.
Policy: We expect inflation to persistently exceed the Reserve Bank of India’s (RBI) comfort
zone of 5.0-5.5%, prompting 75bp of rate hikes in 2011. This will come on top of the aggressive
150bp of hikes in 2010 shifting the monetary policy stance to modestly tight. In terms of profile,
we expect the RBI to deliver a 25bp rate hike in January 2011, followed by a pause, before
resuming with 25bp hikes each in Q3 and Q4 2011. On the fiscal front, with less scope for
proceeds from asset sales and high subsidy burden, we expect the central government’s fiscal
deficit to remain unchanged at 5.2% of GDP in FY12 (year ending March 2012).
Risks: A reversal in capital flows and lack of an investment revival are downside risks. A
sharper-than-expected global rebound and falling commodity prices are an upside risk to our
growth outlook.

Real GDP (sa, % q-o-q, annualized) 10.7 4.6 8.1 8.5 8.5 8.1 8.6 9.0
Real GDP 8.9 8.9 8.1 7.9 7.6 8.2 8.4 8.6 8.8 8.0 8.6
Fixed investment 11.1 11.5 9.5 12.0 15.0 15.5 13.5 15.3 14.7 12.9 15.1
Contributions to GDP (% points):
Inventories 0.2 0.1 0.1 0.1 0.1 0.0 0.1 0.1 0.2 0.1 0.1
Net trade (goods & services) 0.2 -0.9 -0.2 -0.3 -1.5 -1.4 -0.3 -1.2 0.7 -0.8 -1.1
Wholesale price index 9.1 7.8 6.6 6.8 7.7 7.9 7.5 6.9 9.2 7.3 6.7
Consumer price index 10.3 9.0 7.4 8.3 9.2 8.8 9.8 9.8 11.9 8.4 9.2

Repo rate (%) 6.00 6.25 6.50 6.50 6.75 7.00 7.25 7.50 6.25 7.00 7.50
Reverse repo rate (%) 5.00 5.25 5.50 5.50 5.75 6.00 6.25 6.50 5.25 6.00 6.50
Cash reserve ratio (%) 6.00 6.00 6.00 6.00 6.00 6.00 6.00 6.00 6.00 6.00 6.00
10-year bond yield (%) 7.90 8.10 7.90 7.70 7.90 8.10 8.20 8.25 8.10 8.10 8.25
Exchange rate (INR/USD) 44.9 44.6 44.4 44.2 44.1 43.9 43.6 43.4 44.6 42.3 40.3
period average. CPI is for industrial workers. Fiscal deficit is for the central government and for fiscal year, eg, 2010 is for year ending
March 2011. Table reflects data available as of 6 December 2010.

Indonesia ⏐ Economic Outlook Yougesh Khatri | Euben Paracuelles
Poised for take off

Building on robust domestic demand, infrastructure development is likely to unleash growth.
Activity: We expect domestic demand driven growth to rise from a forecast 5.9% in 2010 to
6.5% in 2011 and 7% in 2012. We expect favourable demographics with a rapidly expanding
middle class, a strengthening IDR, higher wages, and fast growing credit (from a low base) to
keep consumption growth above 5%. Investment is likely to be driven by a robust consumption
growth outlook, political stability, booming commodity exports, likely further sovereign credit
rating upgrades on sound economic fundamentals and fiscal space for accelerated infrastructure
spending. We believe the government’s aim of raising GDP growth to above 7% by 2014 will be
achieved sooner given constraints to infrastructure development – land acquisition, financing,
conflicting regulations – are being addressed through a soon to be tabled land acquisition bill, an
increased fiscal allocation for infrastructure and the donor-supported Indonesia Infrastructure
Guarantee Fund. Stronger import growth (associated with stronger consumption and
investment) and higher net income outflows (associated with the increase in foreign holdings of
Indonesian equity and debt) are expected to reduce the current account balance to 0.8% and
0.6% of GDP in 2011 and 2012, respectively, and lead to an eventual deficit in the medium term.
Inflation and monetary policy: Bank Indonesia (BI) kept its policy rate on hold at 6.50%
throughout 2010 as it expects inflation to remain within the 4-6% y-o-y target through 2011. In
contrast, we forecast a pick-up in inflation to 6.6% and see upside risks relating to commodity
and administered price increases and capacity constraints starting to bite. BI raised the primary
reserve requirement (RR) for banks from 5% to 8% in November 2010 and from March 2011,
will re-link the RR to banks’ loan-to-deposit ratios outside a 78-100% range. We do not expect
the first rate hike until Q2 2011 given BI’s inflation forecast and its concerns about excessive
capital inflows, IDR strength, and the March RR change. BI has taken measures to reduce
foreign holdings of central bank bills (SBI). Unless there is a prolonged pull back from risk (e.g.,
sparked by EU debt problems), strong capital flows to Indonesia are expected to continue and
we expect further capital control measures on short-term debt.
Fiscal policy: The 2011 budget targets a pick-up in infrastructure spending to IDR122trn (10%
of spending) and a modest fiscal deficit of 1.7% of GDP (from our forecast of 1.2% in 2010).
With the government’s planned revisions to procurement regulations we also expect higher rates
of expenditure realization in 2011.
Risks: Renewed global financial turmoil is a key external risk. Better/worse than expected
progress with infrastructure is a key up/downside risk to the outlook. A substantial and
unexpected rise in international oil prices could trigger an administered fuel price increase and a
stepped increase in inflation. The end-2010 deadline for establishing a consolidated financial
supervisor (OJK) is approaching, but its form is still unclear, creating regulatory uncertainty/risks
which will likely spill over into 2011.
Real GDP 5.8 5.8 6.4 6.4 6.4 6.9 6.6 6.7 5.9 6.5 7.0
Government consumption 3.0 1.0 4.0 5.0 3.0 5.0 6.0 5.0 -2.8 4.3 4.9
Inventories 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.2 0.0 0.0
Net trade (goods & services) 1.3 0.3 0.8 0.7 0.6 0.4 0.4 0.3 0.7 0.6 0.4
Consumer prices index 6.2 6.1 6.5 7.1 6.2 6.6 6.2 6.1 5.1 6.6 5.8
Exports 25.4 16.5 10.3 10.0 9.9 6.4 9.5 9.7 28.3 9.1 9.6
Imports 32.1 24.7 13.7 11.4 12.1 12.2 12.2 12.3 37.0 12.3 12.2
Merchandise trade balance (US$bn) 9.1 11.2 8.8 9.1 9.4 10.2 8.8 9.2 37.8 37.4 37.6
Current account balance (% of GDP) 0.7 1.4 0.8 1.0 0.7 0.6 0.6 0.8 1.1 0.8 0.6
Fiscal Balance (% of GDP) -1.2 -1.7 -1.6
Bank Indonesia rate (%) 6.50 6.50 6.50 6.75 7.50 7.50 7.50 7.50 6.50 7.50 7.50
Exchange rate (IDR/USD) 8908 8970 8900 8800 8680 8520 8440 8360 8970 8520 8200
Notes: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are period
average. All forecasts are modal forecasts (i.e., the single most likely outcome). Table reflects data available as of 6 December 2010.

Malaysia ⏐ Economic Outlook Yougesh Khatri ⏐ Euben Paracuelles
Reform awaits a mandate

Reforms may stall until elections, likely in 2011, can deliver a firm mandate for the prime minister.
Activity: With our real GDP growth forecast of 7% in 2010, we estimate the output gap has
turned positive. We thus expect below-trend growth of 5.2% in 2011 to return to trend output
levels (the government targets 5-6%). This is consistent with the fading of temporary growth
drivers such as inventory re-stocking, policy stimulus and pent-up demand for electronics. We
expect private consumption to hold up in 2011, supported by a growing “middle class”, a strong
labour market and rising commodity prices. Investment-to-GDP plummeted after the Asia crisis,
but is now targeted by the government to increase due to ambitious infrastructure plans under
the Economic Transformation Program. We expect buoyant commodity exports in 2011, but
these may mask an underlying deterioration in export competitiveness. Aware of this, the
authorities are aiming to increase productivity and competitiveness in their array of development
plans. Execution is the key risk and this will in turn depend on the outcome of the next elections.
Inflation and monetary policy: Monetary conditions tightened in 2010 via real effective
exchange rate appreciation and three 25bp rate hikes. We expect Bank Negara (BNM) to keep
its monetary policy on hold in Q1 2011 until there is more clarity on the global picture and given
its "moderate inflation" projection through 2011. We are more concerned about CPI inflation,
expecting it to rise to 3.3% in 2011. This should impel BNM to resume raising rates, with 25bp
hikes each in Q2 and Q3 2011. Monetary conditions should also tighten through further MYR
appreciation, given the large current account surplus and potential for larger capital inflows. We
do not expect Malaysia to impose controls on inflows in the near future – BNM recently further
liberalized the capital account and set a 70% loan-to-valuation ratio cap on third mortgages in a
bid to curb property market speculation. More macro-prudential measures are likely.
Politics and fiscal policy: We expect an election to be called in 2011 (as early as H1), which
could see further fiscal support for growth. Reforms are likely to pause in the meantime, but we
would expect to see them gain momentum after the elections – in our base case the ruling
coalition maintains a majority providing Prime Minister Najib with a “legitimate” mandate. The
2011 budget targets a deficit of 5.4% of GDP, less than the 5.6% estimated for 2010, but higher
than expectations. The budget and the deferral of the goods and services tax (GST) may cast
doubt on the government’s commitment to fiscal consolidation given the 10th Malaysia Plan
targets a federal government fiscal deficit of 5.3% in 2011 and 2.8% by 2015.
Risks: The major downside risks relate to a relapse in the global recovery and lower commodity
prices. A medium-term upside risk is a rapid reform progress leading to an investment boom; a
key downside risk is insufficient reform momentum to escape the “middle-income trap”.

Real GDP 5.3 4.4 4.6 4.7 5.6 5.7 6.0 5.2 7.0 5.2 5.5
Government consumption -10.2 3.0 7.0 7.0 7.0 7.0 5.5 5.6 1.2 7.0 6.0
Inventories 4.4 1.0 1.0 1.0 1.3 1.3 0.7 -4.6 4.8 1.1 -1.1
Net trade (goods & services) -3.5 -1.4 -1.2 -1.6 -0.8 -1.0 -0.3 3.5 -3.2 -1.1 0.5
Unemployment rate (%) 3.2 3.2 3.1 3.1 3.0 3.0 3.0 3.0 3.4 3.1 3.0
Exports 23.2 16.5 13.2 13.2 15.0 16.0 16.7 18.6 27.2 14.4 15.7
Imports 29.9 12.6 11.2 11.2 12.3 12.9 18.6 15.8 30.7 11.9 15.9
Fiscal Balance (% of GDP) -5.6 -5.3 -4.2
Overnight policy rate (%) 2.75 2.75 2.75 3.00 3.25 3.25 3.25 3.25 2.75 3.25 3.25
Exchange rate (MYR/USD) 3.09 3.08 3.00 2.97 2.93 2.88 2.84 2.80 3.08 2.88 2.72

Philippines ⏐ Economic Outlook Yougesh Khatri ⏐ Euben Paracuelles
Making inroads
Fiscal improvements are likely to continue in 2011 and the government is starting to address
infrastructure deficiencies, which should attract more private investment.
Activity: In 2011 we forecast GDP growth of 5.4%, and rising to 5.7% in 2012. Consumption
should remain a steady source of growth, driven by strong overseas Filipino worker remittances
which, in turn, has benefitted from increased worker deployment earlier this year. Deployment is
likely to rise further given demand for higher skilled workers, e.g. medical workers to ageing
developed economies. The business process outsourcing sector, which grew 22.5% in 2008-09
despite the crisis, will likely continue to see solid expansion. The Aquino administration’s strong
mandate, the perception of its firm commitment to improving governance and the recent credit
ratings upgrade by S&P are bolstering business sentiment, which reached a record high in Q3
2010. Testimony to all this was the larger-than-expected turnout by private investors at the
November infrastructure summit, where. PHP130bn (1.4% of GDP) of planned infrastructure
projects were announced. While 100% rollout of these projects is unlikely in the near-term, a
successful and transparent tender process by mid-2011 could kick-start further implementation
against a backdrop of an increasingly upbeat private sector. Private investment, after stagnating
since the mid-1990s, could finally take off.
Fiscal policy: Inroads have been made in narrowing the fiscal deficit, via rationalization of
expenditures and importantly, some improvement in revenue collections via tax administration
measures. Given these tie in with the President’s anti-corruption platform, we expect the
momentum on fiscal consolidation to continue into 2011. But sustaining it into 2012 will be more
challenging. Achieving tax-to-GDP targets will involve unpopular reforms to widen the tax base
and the president breaking his electoral promise not to pass new tax measures – possibly at a
time when his approval ratings start to decline (if history is any guide). A key test is the large
revenue-generating, but politically unpopular, measures to be tabled in Congress by 2012.
Inflation and monetary policy: We forecast CPI inflation of 4.2% in 2011 and 5.0% in 2012,
well above Bangko Sentral’s (BSP) forecasts of 2.4% and 2.8%, respectively. While inflation is
likely to remain tame over the next few months, we expect it to rise due to global commodity
prices and an already positive output gap. We expect BSP to hike rates from Q2 2011, although
in a measured way given an ambitious 7-8% GDP growth target for 2011, and limited fiscal
space to support it. Some of the tightening is also likely to be done via currency appreciation.
Risks: S&P’s credit ratings upgrade (with others likely soon), coming early in the administration,
could risk engendering government complacency in terms of the fiscal reform agenda. A surge
in commodity prices, in particular those of oil and rice, are key downside risks to growth.
Real GDP [sa, % q-o-q, annualized] -1.9 5.1 9.0 13.1 -5.7 7.2 10.8 13.0
Real GDP 6.5 5.9 4.4 6.2 5.1 5.6 6.1 6.1 7.0 5.4 5.7
Government consumption -6.1 6.1 4.0 3.8 3.7 2.9 5.0 7.0 6.2 3.6 7.4
Exports (goods & services) 29.9 17.2 8.0 6.6 -10.2 0.4 6.0 5.0 25.3 0.4 6.1
Contribution to GDP growth (% points):
Inventories -0.9 1.6 0.0 0.8 0.8 -1.5 -1.8 0.7 -0.2 0.0 0.4
Net trade (goods & services) 6.1 -0.7 -1.8 -2.4 -6.4 -1.3 -0.6 -3.4 2.2 -2.9 -1.6
Exports 39.9 17.2 8.0 6.6 -10.2 0.4 6.0 5.0 32.6 0.6 8.2
Imports 21.1 13.8 12.0 12.2 0.4 2.9 7.0 12.0 22.8 6.8 10.0
Merchandise trade balance (US$bn) 0.9 -0.3 -2.0 -1.9 -0.7 -0.7 -2.3 -3.1 -2.0 -5.3 -6.7
Current account balance (US$bn) 1.3 1.9 1.4 2.0 2.3 3.2 2.1 1.2 7.6 8.8 8.7
(% of GDP) 2.8 3.5 2.9 3.6 4.1 4.9 3.6 1.9 4.0 4.0 3.3
Consumer prices 3.8 2.7 3.4 4.3 5.8 6.5 6.0 5.4 3.7 5.0 5.4
Reverse repo rate (%) 4.00 4.00 4.00 4.50 4.75 5.00 5.50 6.00 4.00 5.00 6.50
91-day T-Bill yield (%) 3.99 4.00 4.13 4.75 5.00 5.25 6.00 6.75 4.00 5.25 7.25
Exchange rate (PHP/USD) 44.0 43.2 42.4 41.9 41.4 40.9 40.4 39.9 43.2 40.9 38.9

Singapore ⏐ Economic Outlook Yougesh Khatri ⏐ Euben Paracuelles
Back to trend
After a stellar recovery, Singapore’s economy is likely operating at full potential and we expect
growth to revert to the 5-6% medium-term trend which, for an advanced economy, is impressive.
Activity: Asia’s most open economy was also the fastest growing in 2010 at an estimated
15.5% y-o-y. We expect growth to slow to 5.3% in 2011, while the government targets 4-6%. As
a hub for a fast growing Asia, with diversifying drivers of growth, we believe Singapore can
maintain growth rates of 5-6% into the medium term. Services are expected to continue to
perform well, with rising tourism and new attractions such as the integrated resorts. Financial
and trade services are also well positioned to continue to grow as Asian growth in general
expands and becomes more integrated. Manufacturing will likely continue to diversify and move
further up the value chain: the electronics sector has seen a resurgence in investment
commitments in 2010, led by electronics services and R&D activities. Bio-med, having
contributed nearly a fifth of the remarkable 2010 growth, is becoming increasingly important.
Inflation and monetary policy: The Monetary Authority of Singapore (MAS) surprised markets
again in October by increasing the slope and width of the SGD NEER band. MAS indicated price
pressures are building given: 1) high resource utilization levels; 2) a tight labour market; 3) a
diminishing cyclical productivity boost; and 4) greater pass-through from rising commodity prices
given buoyant domestic demand. We share this concern about increasing inflation – our
estimates of a positive output gap suggest demand-side pressures could push inflation beyond
the 2-3% MAS target in 2011 and so we could see further tightening in 2011.
Policies: The MAS move of targeting stronger SGD NEER appreciation has put further
downward pressure on record-low SGD short-term rates, and is likely contributing to property
price pressures (and bubble concerns). During 2010, the government took various measures to
cool the property market (e.g. extending the holding period to impose the seller’s stamp duty
and decreasing loan-to-valuation ratios to 70% for buyers with other mortgages). If these
measures fail to cool prices, we expect more macro-prudential and administrative measures in
2011. The fiscal stance was contractionary in 2010, and we expect a larger fiscal surplus to be
run in 2011, which complements monetary policy in addressing overheating. Fiscal policy has
appropriately shifted from counter-cyclical support towards structural measures to boost
productivity. The government is likely to call elections in 2011 which will usher in the next
generation of leaders. We expect policy continuity.
Risks: Key downside risks are external, such as a renewed slump in the global economy or an
escalation of tensions on the Korean peninsula. Potential large-scale capital inflows and low
interest rates raise the risk of asset bubbles and disruptive corrections. Singapore’s ever more
important but volatile biomed sector increases volatility and reduces the predictability of output.

Real GDP [sa, % q-o-q, annualized] -18.7 18.1 1.6 22.4 -15.5 17.9 -1.9 26.3
Real GDP 10.6 15.5 5.5 4.5 5.6 5.5 4.6 5.4 15.5 5.3 5.8
Inventories -3.7 5.4 1.0 0.8 0.4 0.2 0.6 0.3 1.9 0.6 0.9
Net trade (goods & services) 11.4 4.9 -1.3 -1.2 0.2 0.2 1.5 0.9 8.8 -0.5 0.5
Exports 27.5 11.3 13.2 11.6 9.2 15.4 12.9 12.3 27.3 12.3 14.3
Imports 22.5 14.7 21.1 17.4 20.7 15.1 12.9 12.8 25.7 18.5 15.4
Fiscal Balance (% of GDP) 0.4 0.8 0.8
3 month SIBOR (%) 0.51 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40
Exchange rate (SGD/USD) 1.32 1.29 1.27 1.25 1.24 1.22 1.21 1.20 1.29 1.22 1.17

South Korea | Economic Outlook Young Sun Kwon
Twin imbalances
With slowing growth and the twin imbalances of a large current account surplus and high
inflation, we expect policymakers to allow KRW appreciation but hike policy rates only modestly.
Activity: We see growth momentum picking up modestly in 2011 after sequential GDP growth
eased markedly in H2 2010. The positive feedback loop between strong corporate earnings and
household income/job creation should gain more traction. Low interest rates should also support
consumption and business investment, but construction investment is likely to suffer given
elevated housing inventory. In addition to solid emerging market demand, we expect G3 (US,
euro area and Japan) demand to improve gradually, but KRW appreciation should erode some
competitiveness. In 2012, the government’s stimulus measures ahead of the presidential
election should help boost domestic demand. All in all, we expect GDP growth to slow from
5.9% in 2010 to 3.5% in 2011, before rising to 5.0% in 2012. Meanwhile, we look for the current
account surplus to narrow to USD21bn (1.8% of GDP) in 2011 from USD35bn (3.5%) in 2010,
mainly due to higher oil prices and a stronger KRW.
Inflation: A stronger KRW (we forecast KRW/USD appreciating to 1,020 by end-2011) should
offset cost-push inflation from higher oil prices, but rising nominal wages and housing rents are
adding to inflation pressures. We forecast CPI inflation to rise from 2.9% in 2010 to 3.7% in 2011,
before easing to 3.0% in 2012. We expect house prices to recover only gradually in 2011-12,
supported by government policy designed to prevent a housing market slump.
Policy: With slowing growth and the twin imbalances of a large current account surplus and high
inflation, we expect policymakers to choose a compromise policy mix: implementing modest
fiscal consolidation, tightening macro-prudential measures further, allowing KRW appreciation
and hiking policy rates slowly. In the next two years, we expect the BOK to raise rates three
times in 25bp increments in Q2 and Q4 2011 and Q1 2012, lifting the terminal rate to 3.25%.
Risks: The economy is heavily reliant externally: in 2009, exports accounted for 50% of GDP; its
external debt was equivalent to 48% of GDP and Korea was one of Asia’s largest net importers
of oil (5.8% of GDP). As such, the economy is vulnerable to sudden changes in global economic
conditions, credit markets and commodity prices. Domestically, if the BOK hikes rates without
allowing KRW appreciation, it may leave Korea’s twin imbalances unresolved, failing to contain
inflation. On the other hand, protracted low rates, in association with high competition in the
banks, should risk adding to higher financial leverage, making the economy vulnerable to an
inflation shock. Despite recent events, we view a major escalation of geopolitical tensions on the
Korean peninsula as a low probability, but admittedly high-risk event.

Real GDP (sa, % q-o-q, annualized) 3.0 -0.4 4.1 4.9 5.3 4.5 4.9 4.9
Real GDP (sa, % q-o-q) 0.7 -0.1 1.0 1.2 1.3 1.1 1.2 1.2
Real GDP 4.4 4.2 3.1 2.9 3.4 4.7 4.9 4.9 5.9 3.5 5.0
Business investment 24.3 19.1 17.4 9.8 5.1 6.1 6.1 5.1 25.5 9.3 6.9
Construction investment -2.3 -2.6 -4.1 -0.5 -2.3 -0.3 0.5 1.0 -1.2 -1.8 1.7
Inventories 1.8 0.9 -0.1 0.4 1.1 1.1 0.0 0.0 2.0 0.7 0.7
Net trade (goods & services) -1.2 -0.5 -0.4 -0.5 -0.3 0.4 0.7 0.9 -0.6 -0.2 0.7
Consumer prices 2.9 3.6 3.8 4.0 3.8 3.2 3.1 3.0 2.9 3.7 3.0
Current account balance (% of GDP) 3.5 1.8 0.9
Fiscal balance (% of GDP) -1.9 -0.2 0.4
Fiscal balance ex-social security (% of GDP) -2.6 -2.1 -1.1
Money supply (M2) 9.0 8.0 8.0 8.5 9.0 9.5 10.0 10.0 9.0 9.0 11.0
House prices (% q-o-q) -0.1 0.3 0.6 0.6 0.4 0.4 1.0 1.0 1.2 2.0 3.0
BOK official base rate (%) 2.25 2.50 2.50 2.75 2.75 3.00 3.25 3.25 2.50 3.00 3.25
3-year T-bond yield (%) 3.37 3.20 3.30 3.30 3.40 3.50 3.60 3.70 3.20 3.50 3.70
5-year T-bond yield (%) 3.76 3.90 3.40 4.00 4.10 4.20 4.30 4.30 3.90 4.20 4.30
Exchange rate (KRW/USD) 1180 1110 1080 1060 1040 1020 1005 990 1110 1020 960
Source: Bank of Korea; CEIC and Nomura Global Economics.

Taiwan ⏐ Economic Outlook Tomo Kinoshita
Balanced growth ahead

We expect both domestic and external demand to drive robust growth in 2011-12.
Activity: We expect the economy to maintain robust growth of 4.9% in 2011 and 5.3% in 2011.
Although we expect growth to slow from 9.9% in 2010, this reflects the disappearance of one-off
base effects that came with the economic rebound in 2010. We expect both domestic and
external demand to support future growth. On domestic demand, steady growth in private
consumption should be supported by improving labour market conditions and higher wages. The
consumer confidence index in October recorded its highest level since 2004. Investment growth
should remain strong as the output gap is likely to shrink further in domestic demand-oriented
industries. We also expect exports to remain strong as the major electronics manufacturers have
increased production capacity.
ECFA: Under the Economic Cooperation Framework Agreement (ECFA) with China, which
became effective in September 2010, China will start to reduce tariffs on 539 Taiwanese goods
worth 16% of the island’s China-bound exports. Taiwan is also relaxing restrictions on visitor
arrivals and investment from China. Strengthening economic ties with Asia’s largest and fastest
growing economy stands to be a major boon for Taiwan’s economy.
Monetary and fiscal policy: We expect CPI inflation to pick up to 2.5% in 2011 and to 3.1% in
2012, from 1.0% in 2010, due to higher commodity prices, limited spare economic capacity and
accelerating import prices from China. We expect higher inflation to cause the Central Bank of
China (CBC) to raise benchmark interest rates by 12.5bp every quarter until end-2012, with an
eye on a gradual rise in inflation. On property, the central bank’s stricter loan-to-value ratio for
new residential property lending in Taipei, implemented in June 2010, appears to have
effectively reduced speculative activity for now – though we cannot rule out the possibility that
further tightening measures will be introduced if property prices rise further. On fiscal policy, we
expect overall government spending to increase moderately in 2011 to support growth.
Risks: As Taiwan is a very open economy with a high exports-to-GDP ratio of 54% in 2009, the
state of the advanced economies continues to be a major risk. We believe that the further
increase in capital inflows through the banking sector and the resulting TWD appreciation may
prompt authorities to limit such inflows by using capital controls. We believe that ECFA
developments, which will be heavily influenced by the political situation, pose both up- and
downside risks to the economy.

Real GDP [sa, % q-o-q, annualized] 0.1 -0.9 12.2 6.0 6.3 1.2 8.0 5.2
Real GDP 9.8 4.4 3.2 4.2 5.8 6.3 5.3 5.1 9.9 4.9 5.3
Inventories 1.6 -0.1 -0.9 0.4 0.6 0.7 0.2 0.1 2.1 0.2 0.1
Net trade (goods & services) 1.4 0.6 0.0 0.6 1.4 1.7 1.2 1.3 1.6 0.9 1.4
Exports 27.1 17.5 14.6 11.1 11.7 12.3 14.2 14.2 33.8 12.4 14.5
Imports 31.5 21.0 17.9 12.5 11.6 11.9 14.4 14.8 42.0 13.4 14.9
Current account balance (US$bn) 9.0 17.3 9.5 10.1 8.5 18.3 9.9 10.6 47.7 46.4 48.9
(% of GDP) 8.3 14.8 8.2 8.4 6.6 13.6 7.6 7.9 11.1 9.3 8.7
Unemployment rate (%) 5.1 5.0 4.9 4.7 4.6 4.3 4.3 4.2 5.7 4.3 4.0
Discount rate (%) 1.50 1.63 1.75 1.88 2.00 2.13 2.25 2.38 1.63 2.13 2.63
Overnight call rate (%) 0.22 0.35 0.47 0.60 0.72 0.85 0.97 1.10 0.35 0.85 1.35
10-year T-bond (%) 1.20 1.32 1.45 1.57 1.82 2.30 2.43 2.55 1.32 2.30 2.80
Exchange rate (NTD/USD) 31.3 30.0 29.6 29.3 29.0 28.7 28.4 28.1 30.0 28.7 27.5

Thailand ⏐ Economic Outlook Yougesh Khatri ⏐ Euben Paracuelles
Still all about political risks

The economy proved itself resilient in the face of a raft of negative political events in 2010,
largely on a strong bounce-back in external demand. But a repeat in 2011 may be difficult.
Activity: We expect GDP growth to ease to 4.8% in 2011 from an estimated 7.7% in 2010,
driven mainly by the fading of the extraordinary contribution of the large inventory build-up in
2010, as well as weak net exports. In addition, consumer spending is also likely to slow as
sentiment weakens again amid rising political uncertainty. This has been the case in the past
four election cycles: private consumption has tended to be weak in the run-up to elections, and
recover modestly afterwards. That said, investment spending is still likely to grow by a solid 7%
in 2011, led by an acceleration in government-led infrastructure projects (under the second
stimulus plan, SP2), particularly following recent floods and ahead of the elections. Funds for
SP2 are already secured and with the slow progress in implementation so far, some of these
funds may be put to use to repair infrastructure damaged by the floods in late October 2010.
Politics: Despite leading a fragmented coalition, the ruling Democrat Party (DP) has stayed in
power longer than most expected, surviving a series of violent protests and a legal case calling
for its dissolution. Regardless, the bigger test still lies ahead: elections must be called before
December 2011. The government is likely to push these out as far as possible to allow more
time to implement populist policies, but even so we do not rule out a pro-Thaksin government
returning to power. Parliament has approved a first reading to change a constitutional provision
from multi-seat to single-seat constituency, which arguably could favour the opposition.
Meanwhile, the dismissal of the electoral fraud case against the DP on a small technicality,
along with the trial of jailed opposition leaders, could spur more anti-government protests,
accusing the courts of applying double standards. Political uncertainty looks set to rise in 2011.
Monetary and FX policy: We expect the Bank of Thailand (BoT) to hike rates again in Q2 2011,
consistent with our forecast of CPI inflation rising to 4.2% in 2011 and 4.4% in 2012. The BoT
likely sees real policy rates as too low, which explains the rhetoric that the normalization process
is still incomplete. However, the pace of future hikes will also depend on capital inflows, THB
movement and external conditions. Thailand re-imposed a withholding tax on government bond
purchases by foreign investors. We believe capital controls, as well as continued sterilized FX
intervention, capital outflow liberalization and macro-prudential measures are in store (but we do
not expect draconian capital controls in the near term such as those imposed in 2006).
Risks: Growth remains externally dependent, with large spill-over effects from the export and
tourism sectors to domestic demand, so, politics aside, a renewed global downturn is a key
downside risk. Higher global food prices are positive for Thai growth but oil prices are negative.
Real GDP [sa, % q-o-q, annualized] -2.7 2.4 20.1 -1.4 0.0 3.8 6.3 9.4
Real GDP 6.7 3.3 4.5 4.7 4.9 5.3 5.2 5.7 7.7 4.8 5.2
Public consumption 2.0 5.0 4.0 4.0 5.0 5.0 10.1 11.0 6.3 4.5 8.8
Contribution to GDP (%points):
Inventories 4.9 -1.3 0.2 0.2 0.2 0.2 0.0 2.3 3.2 0.2 -0.2
Net trade (goods & services) -2.6 0.3 0.5 0.2 -0.4 0.5 -1.3 -1.4 -0.7 0.2 -0.1
Exports 21.9 5.0 7.5 10.8 11.4 11.8 13.3 14.7 23.7 10.4 14.9
Imports 30.5 9.1 10.2 15.4 14.5 13.4 6.2 8.8 33.1 13.4 8.3
Current account balance (US$bn) 2.0 3.1 3.6 1.0 2.1 0.3 3.8 -0.1 13.2 7.0 5.1
(% of GDP) 2.6 3.8 3.8 1.1 2.1 0.3 3.5 -0.1 4.0 1.8 1.2
Fiscal balance (% of GDP, fiscal year basis) -1.3 -2.3 -2.6
Consumer prices 3.3 3.0 3.5 4.2 4.7 4.2 3.4 4.4 3.3 4.2 4.4
Overnight repo rate (%) 1.75 2.00 2.00 2.25 2.75 2.75 3.00 3.25 2.00 2.75 3.25
Exchange rate (THB/USD) 32.3 29.5 29.0 28.5 28.1 27.8 27.6 27.3 29.5 27.8 26.8

Vietnam ⏐ Economic Outlook Yougesh Khatri ⏐Euben Paracuelles
Higher growth and inflation ahead

High inflation and VND devaluation are symptoms of weak fundamentals, but we are optimistic
that policy and reforms are getting back on track, so the economy can grow at its full potential.
Activity: Vietnam’s favourable demographics, size, location and natural resources underlie its
huge potential and we think the 2011 GDP growth target of 7.0-7.5% is achievable. Vietnam’s
impressive growth has been accompanied by large growth and inflation swings in recent years.
The associated “stop-go” policies and “twin deficits” have made investors more cautious. With
strong growth momentum in recent quarters, policymakers seem to have re-focused on stability,
marked by rate hikes in October. Beyond the 11th Communist Party Congress in January 2011,
we believe there is scope for tighter policies and reforms – such as improving the efficiency of
public investment, further reforming state-owned enterprises/banks and strengthening the
financial sector. Progress in delivering sounder fundamentals – which we expect in H1 – should
attract foreign investment, boost competitiveness and be positive for the longer-term outlook.
Inflation and monetary policy: Inflation is likely to exceed 9% in 2010 (versus the target of 8%)
and is expected to pick up further with international food and commodity prices and minimum
wage hikes expected in January. Upside inflation risks stem from demand-side pressures, more
administrative (power and fuel) price hikes and more/larger VND devaluations. Benchmark
interest rates were hiked 100bp on 5 November (given VND pressures and rising inflation) and
we expect another 100bp hike and a VND devaluation in Q1 2011 (following two devaluations in
2010). We also expect the government to impose further price controls in 2011 as inflation rises.
Fiscal and other policies: We forecast a fiscal deficit of 4.2% of GDP in 2010 and expect
further consolidation into 2011, with a deficit of 3.6% versus a targeted 5.3%. Bank capital
adequacy requirements were raised from 8% to 9% on 1 October and the loan-to-deposit ratio
capped at 80% of deposits (after allowing a more liberal definition of deposits). The large trade
deficit and a heavily managed exchange rate have eroded FX reserves (estimated to be
USD13.5bn at end-June). There are signs that the trade deficit is beginning to narrow (on a 12-
month rolling basis) which could help rebuild FX reserves - a likely policy priority in 2011.
Risks: Inconsistent macro policies could trigger further downgrades (after Fitch downgraded its
long-term FX debt rating by one notch to B+ in July, citing external vulnerabilities, a weak
banking system and inconsistent macro policy). Given still elevated vulnerabilities, a loss of
investor confidence (triggered, for example, by another boom-bust policy cycle) could result in a
vicious spiral which, in the worst case, could lead to a balance of payments crisis. Other key
risks are external (such as spill-over effects from problems in Europe).
Real GDP [sa, % q-o-q, annualized] 8.2 5.7 5.0 8.3 10.2 7.1 3.8 7.3
Real GDP 7.2 7.2 6.9 6.4 7.5 7.9 7.1 6.9 6.7 7.2 7.5
Private consumption 8.0 8.0 8.2
Public consumption 5.0 6.0 6.5
Gross fixed capital formation 8.2 8.5 10.0
Contribution to GDP growth (% points):
Domestic final sales 9.0 9.2 10.1
Inventories 0.5 0.5 0.0
Net trade (goods & services) -2.7 -2.7 -2.9
Exports 36.2 21.0 19.5 17.6 17.7 18.4 17.1 17.3 23.1 18.2 16.8
Imports 13.0 8.4 14.9 13.9 15.8 13.3 13.7 14.6 19.0 14.4 14.2
Merchandise trade balance (US$bn) -2.1 -4.5 -3.3 -2.6 -2.1 -4.2 -3.1 -2.4 -12.9 -12.1 -11.7
Current account balance (US$bn) -10.0 -9.2 -8.7
(% of GDP) -9.8 -8.0 -6.5
Consumer prices 8.4 10.5 10.8 11.6 11.6 9.2 8.0 8.6 9.1 10.8 8.7
Unemployment rate (%) 5.5 5.0 4.5
Base rate (%) 8.00 9.00 10.00 10.00 10.00 10.00 10.00 10.00 9.00 10.00 10.00
Refinance rate (%) 8.00 9.00 10.00 10.00 10.00 10.00 10.00 10.00 9.00 10.00 10.00
Exchange rate (VND/USD) 19,490 19,500 20,000 20,000 20,000 20,000 20,000 20,000 19,500 20,000 20,000
Source: General Statistics Office of Vietnam, State Bank of Vietnam, World Bank, CEIC and Nomura Global Economics.

EEMEA ⏐ Outlook 2011 Ann Wyman
Policy design for postmodern times

Structural changes, combined with cyclical trends, are leading EEMEA policymakers to adopt
new strategies to cope with shifting global growth, rising inflation and increased fiscal scrutiny.
Postmodernism: “A style and concept characterised by distrust of theories and ideologies, and
by the drawing of attention to conventions,” Oxford English dictionary.
Policy in EEMEA is Exceptional circumstances often require exceptional measures. This view was often invoked by
confronting changing policymakers during the 2008-09 crisis. But even as the crisis fades into history, global
economic dynamics... economic conditions remain fragile and a new set of realities are settling into the emerging world
that still require less conventional policy responses. In Emerging Europe, Middle East and Africa
(EEMEA), a host of structural changes are under way—most a derivative of the continued
adjustment towards a world where developing countries, particularly in Asia, drive economic
activity, resulting in long-term increases in commodity prices and more permanent shifts in
investment flows. These changes, combined with the continued cyclical global recovery, which is
progressing within EEMEA at a varied pace, are likely to result in new challenges for regional
policymakers. We think that authorities will increasingly focus on less traditional monetary,
currency and fiscal tools to confront these challenges. Some of these approaches are likely to
be successful and others less so. Politicization of decision-making remains a key risk factor.
Structural changes are afoot

Shifting sources of Many of the important structural changes currently under way in EEMEA are a function of the
global growth are an ongoing shift of global growth away from the developed world and toward emerging markets.
important influence There are several implications of this for EEMEA:
Inflows into the Rising fund flows to EM. Persistent growth differentials between developed and developing
region represent a markets have led investment allocations to the emerging markets to grow at a record pace
key structural change (Figure 1). In aggregate, flows to Asia have outstripped those into EEMEA and Latin America
since the crisis, but flows into EEMEA fixed income markets have been more significant. The
pace of inflows may consolidate (though remain firmly positive) at the start of 2011, as global
risk appetite pauses with deepening European concerns. While investors may prefer to be
modestly underweight EEMEA, the continued growth of EM investment funds should still lead to
capital flows into the region, given EEMEA’s importance many local currency benchmark indices.
Currencies face Ongoing strong capital inflows to EEMEA create conditions for many currencies to continue to
appreciation appreciate, particularly where interest rates remain high, impairing competitiveness. This comes
pressure at a bad time for some countries whose current accounts (CAs) are widening. Currency
appreciation pressures in EEMEA are less pronounced than in other emerging market regions,
and many policymakers are contemplating how to calibrate their policy responses.
High commodity High commodity prices—a mixed blessing for EEMEA. Another repercussion of strong
prices affect emerging markets growth is the pressure it places on the global demand for commodities,
countries differently effectively supporting longer-term price increases. In 2010, crude oil prices have already
increased significantly and agricultural commodities prices have surged; we expect that prices
Figure 1. EM cumulative fund flows since Sept 2008 Figure 2. Weight of oil and food in EEMEA CPI baskets
CPI food weight

USD bn USD bn % UA
100 21.5 70 CPI oil weight
EEMEA bond flows(rhs) IL 60 KZ
80 16.5 50 Oil&food weight
AEJ (equity + bond fund flows)
40
EEMEA (equity + bond fund flows)
60 30
LatAm (equity+ bond fund flows) 11.5 CZ 20 RU
40 10
6.5 0
20
1.5 HU EG
0
-20 -3.5
ZA PL
-40 -8.5
Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 TR
Source: EPFR, Nomura Global Economics. Source: CEIC, Nomura Global Economics.

EEMEA: Forecast sensitivity to oil prices Olgay Buyukkayali ⏐ Tatiana Orlova

Energy prices affect current accounts and inflation, and to some extent, policy rates in countries that have persistent
inflation. Effects on growth and the fiscal impact are more relevant for oil exporters than importers.
Nomura’s oil price view: Nomura sees oil prices rising linearly to US$91/barrel by end-2011 and to US$98 by end-2012,
representing 5% and 7.5% increases, respectively. Because of the importance of global energy prices in the outlook for
many EEMEA countries, and because of the uncertain outlook for commodity prices, we see value in providing a
sensitivity analysis (Figure 1) which explores the expected impact of an additional 10% increase in energy prices in 2011.
Current accounts are the most affected: For oil producers and importers the impact on current accounts from the
trade channel is obvious. Turkey is the most sensitive among energy importers. Every 10% increase adds about 0.3
percentage points (pp) of GDP to the current account deficit. Further oil price increases beyond 10% could have an even
larger negative impact as non-oil imports may also rise with projected increased capital inflows (around a 0.1pp extra
burden for every 10% increase outlined in Figure 1). For the surplus countries, Russia and Saudi Arabia the positive
effect is the largest. For Russia every 10% gain in oil prices leads to the current account surplus widening by 2.4pp of
GDP, while in Saudi Arabia the impact is well over 4pp of GDP.
Inflation sensitivity follows headline inflation levels: A 10% increase in oil prices pushes headline inflation up by as
much as 0.3-0.4 pp in Turkey and Poland. Oil price changes have a surprisingly low impact on headline inflation in South
Africa as inflation has been sticky in the past. In the Middle East, large government subsidies limit pass-through,
particularly for smaller price swings.
No major growth or fiscal implications for oil importers: A 10% rise in energy prices does not have much effect on
oil importers. Because of substantial energy subsidies in Egypt, the negative fiscal implications are strongest of all the
EEMEA. Growth in Russia and the Middle East are positively affected: a 10% rise causes growth to increase by more
than 2pp in some cases. Fiscally, the biggest beneficiaries are Saudi Arabia, Qatar and Kuwait. However, of note, there
is around a 0.2-0.3pp benefit to Turkey and South Africa – due to VAT on imports – which is probably the only aspect of
the benefits of higher commodities to these two countries.
Policy rates do have some sensitivities to oil prices as well: While energy prices have been treated as exogenous
variables by most central banks, we are of the view that oil price increases (in contrast with declines) influence policy rate
decisions, especially through the inflation expectations channel. A 10% rise in oil prices has no influence on policy rates.
However, for a 20% rise in oil prices we expect 25bp hikes in South Africa and Turkey, while declines would not influence
policy rates. For Poland and Russia oil prices matter for monetary policy, but not for Hungary and Egypt.
Deciphering some asymmetric shocks for Russia: Russia responds differently to different oil price shocks. In our
view, a 10% increase in oil prices in Russia has the biggest impact on the current account, widening its surplus by 2.4pp
of GDP, but the impact of further price increases decreases in magnitude. For instance, a further 10% price increase
causes the current account surplus to rise by just 0.4pp of GDP due to asymmetric effects on import demand. Lower oil
prices have a more linear profile, and in our base case narrow the surplus by 0.4pp of GDP for every 10% fall. CPI
inflation is another counter-intuitive case. In our models, higher (lower) oil prices will result in lower (higher) CPI inflation
in Russia because of their low weighting in the CPI basket and the likely influence of a stronger exchange rate reducing
imported inflation. Russia is moving towards an inflation-targeting regime and the Central Bank of Russia will likely allow
more significant strengthening of RUB than previously should oil prices rise.
Figure 1. Sensitivity of EEMEA 2011 base case to 10% higher oil prices vs Nomura base case
GDP Current Account Inflation Budget balance Policy rate Public debt
(pp grow th) (pp of GDP) (pp, period average) (pp of GDP) (basis points) (pp of GDP)
Turkey 0.0 -0.3 0.3 0.3 0 -0.1
Russia 0.4 2.4 -0.4 1.1 0 0.0
South Africa 0.0 -0.2 0.1 0.2 0 0.4
Hungary -0.1 -0.2 0.2 0.3 0 0.5
Poland 0.0 -0.2 0.4 -0.4 0 -1.1
Egypt -0.1 0.1 0.2 -0.3 0 -0.4
Kuwait 2.2 4.0 0.1 3.6 0 0.0
Qatar 2.1 3.9 0.1 4.1 0 0.0
Saudi Arabia 0.8 4.9 0.0 4.3 0 0.0
UAE 0.6 2.5 0.0 2.3 0 0.0
Note: pp – percentage points.

will continue to drift higher still over 2011. This upward pressure on commodity prices will likely
affect countries in EEMEA through several channels:
...but maintaining Inflation: The spill-over from international commodity prices to domestic inflation can be
price stability will be influenced by many factors, including price changes in local currency terms, hedging/purchasing
a challenge for all practices, government support policies (such as subsidies, taxes and tariffs), the pricing power
of local firms, and, importantly, the weight of commodities in countries’ consumer price indexes
(Figure 2). The spike in food prices has been particularly troublesome for the region, given the
high share of food in the composition of many consumer baskets. Oil prices also have an
inflationary effect, even if less pronounced (see Box: EEMEA: Forecast sensitivity to oil prices).
High oil prices could Fiscal accounts and balance of payments: Given the political importance of maintaining an
further widen affordable supply of food in countries with large poor populations, authorities sometimes use
Turkey’s CA deficit subsidies to smooth the impact of international food price changes, effectively loosening fiscal
policy. Egypt is the EEMEA country most exposed to such fiscal risks. Egypt also has a
significant food trade deficit of 3.3% of GDP (2008), leaving it exposed to balance of payments
(BoP) pressures from high commodity prices as well. Conversely, Ukraine stands out as a net
food exporter, benefitting from price rises. Oil prices can also have a meaningful effect on trade
and fiscal balances. The region’s biggest oil importer, Turkey, is likely to see most substantial
negative impact on its currency account; Russia and the Gulf states are clear beneficiaries. As
trade balances of oil exporters grow, the accumulation of international reserves is reaccelerating,
increasing the investment funds available for sovereign wealth funds. (See the Box: Sovereign
wealth funds: Repositioning post-crisis for a discussion of their evolving investment preferences).
A deeper Eurozone Changing European dynamics. While the dynamics of the sovereign crisis in Western Europe
crisis can complicate remain fluid, their implications for countries in EEMEA should not be underestimated. The
EEEMEA policy economic linkages between EEMEA and Europe’s periphery are limited, but if the crisis spreads
toward core Europe, contagion risks will increase considerably. The first channel where this
contagion is likely to emerge is through financial markets. CDS spreads, which have already
widened, could widen further, especially in those EEMEA countries with troublesome fiscal
deficits or balance of payments trends, or in those with generally poor policy. The trade channel
may also become an increasingly important link of contagion if the crisis spreads to the core.
Figure 3 highlights where some of the trade risks are greatest—namely in Bulgaria, Hungary and
the Czech Republic. (As EEMEA’s exports to Europe are part of a supply chain with links to
Asian demand, which is expected to remain strong, this effect may be offset somewhat). Finally,
banking sector linkages with Europe’s periphery are relatively limited, but if a more severe
scenario were to emerge for core European banks, greater focus will likely emerge on the
almost US$900bn in Western European bank claims on Eastern European institutions.
Other cyclical developments under way

Cyclical effects also Against a backdrop of important structural shifts, there are a number of cyclical factors that can
contribute to a post- amplify the need for less orthodox, or postmodern, policy responses. First, output gaps are
modern environment
closing: growth has recovered in many countries, but the speed of the recovery is likely to
accelerate in 2011 (Figure 4). Turkey’s output gap may have closed by end-2010, while gaps
should close in both South Africa and Poland in 2011. Also, inflation is turning around from its
cyclical base: In many countries, inflation bottomed during H2 2010 and is now starting climb.
Figure 3. Trade links: vulnerability to European uncertainty Figure 4. EEMEA economic growth
% growth
8 GDP growth 2011
Exports to EU as
% of Total more vulnerable
120 GDP growth 2010
6
BH
100
CZ
PL 4
80 RO
LV HU
RS 2
60
HR BG
TR RU
40
KZ 0
20 ZA EG IL
less vulnerable UAE -2
SA
0
0 20 40 60 80 100
Exports as % of GDP (5y avg) -4
EG TR KZ UA SA PL IL RU ZA HU RO CZ
Source: CEIC, Nomura Global Economics. Source: Nomura Global Economics.

Sovereign wealth funds: Repositioning post-crisis A. Wyman │ I. Rebolledo

Sovereign wealth funds (SWFs) were hard hit by the 2008-09 crisis, but their activity will likely pick up in 2011 as
international reserves grow (Figure 1). Investment strategies are likely to be more diverse and leverage higher.
SWF investment activity has picked up in 2010 (Figure 2), and should increase further in 2011. Funds are employing
“postmodern” strategies such as increasing exposure to emerging markets and taking on leverage, as shown below:
Increasing focus on emerging markets (EM), especially LatAm. SWFs are becoming much more attuned to the value
of investing in EM and its expected growth outperformance versus the developed world. Particularly notable transactions
have been taking place in Brazil where Qatar Holding purchased a 5% stake in Banco Santander Brazil for US$2.7bn
and Temasek purchased a 14% stake in Odebract Oleo and Gas for US$400mn. SWFs are also expanding into so-
called “frontier markets,” via International Finance Corporation funds for development and infrastructure investments.
Greater exposure to commodities. SWFs are taking an increased interest in commodities, investing in both the hard
assets and the companies that produce, process and trade them. This trend is being driven by an expectation of high
returns, as well as a strategic effort to help secure natural resources, particularly energy and food. Investments often
take the form of exposure to companies based in the developed world, but with large operations in EM.
Retreating from financial services. SWFs emerged as important sources of funding for financial sector stabilization
during the crisis, making significant investments in faltering western banks—many of which did not pay off. SWFs have
also provided funding for the recapitalization of their own banking sectors. Given their heavy exposure to the sector and
the poor performance that has in some cases increased domestic political pressure, SWFs are now shying away from
direct equity stakes in financial services firms—though investments in private equity/alternatives are a notable exception.
SWFs as borrowers and lenders, both. One of the most striking emerging trends is the increasing leverage being
assumed by some SWFs. Many, including Temasek (Singapore), Mubadala (UAE), Mumtalakat (Bahrain) and Khazanah
(Malaysia), have raised funding through the capital markets. This is inevitably eliciting questions about the very nature
and definition of SWFs. While accessing private capital can have beneficial effects, acting as an incentive to improve
efficiency and discipline, it also changes the long-term nature of the role of SWFs by altering their liability profile.
Expanding real estate investments. Middle East SWFs are well-known for their taste for real estate, but developed
world SWFs have more recently begun to increase their property exposure given distressed prices in many countries.
Norway’s SWF has made its first investment in commercial property, in London’s Regent Street, while Australia’s Future
Fund has indicated that it is targeting an increase in its property exposure from 9.5% of total assets to 14.5% in 2011.
Europe as a “risky” asset. As sovereign risk assessments of European countries deteriorate, some SWFs including
Russia’s have forbidden the purchase of specific government bonds (Ireland and Spain), while others such as Norway’s
have expressed pessimism about peripheral bonds. But SWFs are also slowly coming into the frame as potential sources
of stabilization funds for Europe. China has promised to buy Greek bonds and has indicated it may consider Portuguese
debt investments. SWF funding could play a role in support of the EFSF, though the politics are admittedly daunting.
Re-evaluation of dollar exposure. It is notoriously difficult to gauge the currency composition of SWF assets.
Nevertheless, the US dollar currency pegs of the Middle East region together with the dollar pricing of their main exports
suggest that their SWFs are highly exposed to the dollar. Longer-term global dynamics would argue for a gradual
reduction of dollar exposure, but increasing concerns about the euro have lessened its appeal as an “alternative.” In
2011, SWFs are likely to continue to explore options for further diversification, which may include greater EM exposure.
Figure 1. Global reserves growth led by emerging markets Figure 2. SWF equity transactions by number and volume
USD trn USD bn #

10 250 250
9
Emerging markets' Number (rhs)
8 reserves
200 200
7 Total reserves Value, $Bn (lhs)
6 150 150
5
100 100
4
3
50 50
2
1
0 0
0 2000 2002 2004 2006 2008 (H1) (H1)
1999 2001 2003 2005 2007 2009 2011f 2009 2010
Source: IMF, COFER, Nomura Global Economics. Source: Monitor Group, Nomura Global Economics.

The closing of output gaps along with the recovery in some labour markets is feeding into this
dynamic. Finally, current account deficits are widening as the strengthening of domestic
recoveries in some parts of EEMEA contributes to increased import demand.
Postmodern policy implications

2011 has many Monetary and exchange rate policy—a focus on the macro-prudential. The current
challenges in store environment provides regional central bankers with many challenges: from pressures
for EM central banks surrounding increasing capital inflows and associated currency appreciation, to confronting
commodity price increases that may be more structural; from gauging likely changes in output
potential, to preparing for possible tail-risk events in peripheral (and even core) Europe.
Alternative monetary On balance, we see EEMEA central banks erring on the side of loose policy, even at the
policy tools are being expense of higher inflation. Where there is concern about capital inflows, various policy tools are
employed to tighten being used to decrease the carry appeal while not easing monetary conditions as much as rate
cuts (or postponed hikes): Turkey’s recent 400bp cut in the borrowing rate (and leaving the
lending rate unchanged), while at the same time raising reserve requirements is one of the best
examples of this creative policy in practice. Israel’s efforts to ensure that implied forward rates
remain at least 100bp below policy rates, or the Central Bank of Romania’s operations in the
basis swap market to minimise speculative capital flows are others. Meanwhile, the South
African Reserve Bank appears to be maintaining an easing bias, despite real rates approaching
negative territory, as it attempts to balance its concerns about the strength of the currency with
stimulus being provided via looser fiscal policy. And in Hungary, the need for risk premia to
secure inflation expectations against government policy changes is now leading to rate hikes,
where none would have been expected otherwise (see Figure 5 for our policy rate forecasts).
Stress on fiscal Fiscal policy—tighter, faster, and sometimes unorthodox. As the European crisis deepens,
discipline requires countries in EEMEA are likely to feel increasing pressure to tighten their fiscal deficits more
effective action quickly than previously planned. Although many have already set in motion consolidation plans
to address the deterioration in their debt levels—with the Czech Republic, Romania and Latvia
some of the most aggressive—numerous other countries in the region, including Poland and
Hungary, have set off on a much slower consolidation track (Figure 6). As the crisis in Europe
intensifies, pressure to improve overall fiscal deficit and public debt ratios is leading to less
orthodox policy choices in some countries: Hungary’s response through dismantling its reformed
pension system and distorting sectoral taxes is a prime example.
Are traditional politicians ready for postmodern policy?

Postmodern policy in While financial markets increasingly demand that policymakers cope cleverly with the difficult
the wrong hands economic environment, it is ultimately politicians who oversee the implementation of postmodern
risks being misused policy. With a heavy political calendar in EEMEA scheduled for 2011 (see Box: Politics across
EEMEA), there is an increased risk of perversions of postmodern policy, with the goal of gaining
votes. Central bank independence is already suffering credibility blows in places such as Hungary,
and loose monetary policy could raise questions elsewhere. Moreover, the abandonment of
necessary fiscal tightening and/or the use of less orthodox tightening measures may be invoked in
the name of postmodern policy. In the end, the markets may well judge the efficacy of postmodern
policy in EEMEA by its ability to help the regional economies face the rebalancing challenges
emanating from the east while at the same time, warding off the potential drags in the west.
Figure 5. Policy rates in post-modern economic times Figure 6. Fiscal policy efforts: budget balance
bp % of GDP
150
0
(3.25%) -1
125
Change in policy rate in 2011
(8.00%) (Interest rate levels) -2
(4.50%)
100 -3
(9.00%) -4
75
(6.25%) (1.25%) -5
(6.00%) (8.25%)
50 -6
(7.25%) -7 2011
25 (2.00%) (7.75%)
-8 2010
(6.25%)
0 -9
IL TR PL EG HU ZA CZ RU KZ SA RO UA CZ EG HU IL KZ PL RO RU ZA TR UA
Source: Nomura Global Economics. Source: Nomura Global Economics.

Politics across EEMEA Tatiana Orlova

The 2011 calendar is rich in elections, mainly in H2, but only in Poland and Romania could they cause major policy shifts.
Hungary (H1) and Poland (H2), EU Council Presidency: Although EU president van Rompuy will continue to chair the
Council per se, CEE will be in the driving seat for EU finance ministers’ meetings (Ecofin), raising the profile of the region
during key negotiations on possible Treaty changes and establishing a new EU Economic Governance Framework. The
convergence theme and prospects for EMU (Economic and Monetary Union) may come to the fore again.
South Africa, local elections (likely Q2): These are important sub-provincial elections. Given different systems and
seat allocations across the different elections, key will be proportion of control of municipalities and proportion of votes.
Overall, we think the vote share of the ANC (African National Congress) may fall from 65% at the 2009 parliamentary
elections to close to 60%. We expect the total proportion of control to drop from around 85% to closer to 70% thanks to
the opposition DA (Democratic Alliance) maintaining its momentum of the past two years, its alliance with the ID
(Independent Democrats) and possible coalitions with COPE (Congress of the People) in some areas. COPE has had
leadership issues, but locally it may do fairly well. Jobs will be a major issue, as will corruption and sentiment towards the
ANC government. Worried about these elections, the ANC may launch some policy moves in the February budget.
Turkey, parliamentary elections (July 2011 though possibly as early as April) and presidential elections in 2012:
The events are unlikely to create major volatility in the markets, and the political climate should remain stable with the
status quo maintained. Our base case remains an AK Party (AKP) election victory once again, with no need for a
coalition. The continued decline in unemployment and the recent tax amnesty could generate some support for the AKP
ahead of the elections. There are no major differences in the opposition’s local, foreign or economic policies to challenge
the stability provided by the AKP governments of the past eight years.
Romania, elections (risk of being called early, H2 2011): The political landscape in Romania is very precarious. The
loose coalition government has a slim majority, but we expect a series of no-confidence votes in the coming months from
a more united opposition. As fiscal austerity hits home and the coalition’s popularity falls further we see a meaningful risk
that one of these no-confidence votes is passed. While this would not necessarily cause an immediate collapse of the
government, we believe that, after a cabinet reshuffle and new prime minister, early elections would be unavoidable
(brought forward from 2012). A switch of power to the opposition would cause a major slowdown in fiscal consolidation.
Poland, Sejm elections (likely October): The 2011 parliamentary elections, which we think will take place in October,
are already disrupting fiscal policy and postponing fiscal consolidation. Once the elections are out of the way it should be
possible to make necessarily expenditure-side fiscal reforms. The presidential election in 2010 was very close: 53% for
ruling PO (Civic Platform) and 47% for opposition PiS (Law and Justice); the parliamentary contest is likely to be close
too. The PO (despite being more left wing than the conservative PiS) is seen as the more investor-friendly option.
Current polls put the PO well ahead of PiS at 50% vs 35%. It will be interesting to see how the newly resurgent SLD
(Democratic Left Alliance) performs; again while leftist it is seen as more pro-investor than the current coalition member,
PSL (Polish People’s Party). The SLD is currently at 8% in the polls vs PSL’s 3%. The PO could decide to form another
coalition but with a different partner. That may allow for easier reforms in some areas.
Kazakhstan, elections for the Majilis (the parliamentary lower house), in early H2: The long-standing political regime
is unlikely to change. The pro-government party, Nur Otan, which currently fully occupies the Majilis, should retain its
dominant position; it should be tough for any other party to clear the required 7% threshold.
Egypt, presidential elections in September 2011: Current president Hosni Mubarak, who has been in poor health in
recent years, has not yet stated whether he plans to stand for re-election, but we expect he will. The overwhelming
victory of the ruling National Democratic Party in the November 2010 parliamentary elections has served to wrest
representative power from the Muslim Brotherhood (which performed well in the 2005 elections) and should minimise
uncertainty around presidential candidate selection and approval (by parliament). Should Mubarak senior decide not to
stand for re-election, his son, Gamal Mubarak, is widely seen as a possible successor. But his lack of military
background has caused some commentators to question whether his candidature would command the support of the
military, causing the local media to speculate about other possible candidates, such as Omar Suleiman, head of the
Egyptian General Intelligence Directorate (EGID).
Russia, parliamentary elections at end-2011: The election season should begin in spring, and we expect no serious
challenge to Putin’s United Russia party which currently holds more than two-thirds of the seats in parliament (the Duma).
As the incumbent, United Russia should be able to use its access to administrative resources and budget revenues to
ensure high turnout and secure a majority of seats. The main question is who will be the candidates in the 2012
presidential elections. We believe that either Vladimir Putin or Dmitry Medvedev, but not both, will participate in the
presidential race. Putin is very likely to run again following his four-year break. We would expect his candidacy to be
announced early in the Duma election campaign to help United Russia secure a constitutional majority; but it is also
possible that there will be no announcement until after the Duma election. Of the opposition parties, only the Communists
should easily overcome the 7% minimum threshold for obtaining seats in the Duma.

Hungary ⏐ Economic Outlook Peter Attard Montalto
Investor unfriendly policies dampen growth

We believe the 2011 policy mix will not encourage growth and is investor unfriendly.
Fiscal and Politics: The focus of next year’s outlook is the interplay between fiscal policy and
politics. The ruling FIDESZ has a very strong mandate after winning the 2010 parliamentary and
local elections. The party is both fiscally conservative, but also deeply populist. The 2011 budget
(and beyond) does not include expenditure reforms and the burden is placed on revenues.
Hence its set of measures will hurt growth and are inflationary and investor unfriendly (both
portfolio and FDI) over the medium run. Sectoral taxes should feed through to consumers and
banking taxes (the toughest globally) will probably lead to the recovery in credit growth stalling
as in H2 2010 and continue to act as a drag on growth. For 2011 these measures should offset
other growth-boosting longer-term measures, such as a new flat personal tax system and the
cutting of corporate tax. Overall these taxes combined with asset sales and additional
contributions, resulting from the dismantling of the mandatory private pension savings system
should mean that the government can meet its deficit target of 2.9% of GDP next year even
under lower growth assumptions. However, a hole of some HUF500bn remains in the budget in
2013 and beyond.
Risks: We think the market needs to decide if such unsustainable and growth-discouraging
fiscal policy while meeting fiscal targets (and falling debt on the pension system changes) is
correct. An external shock from periphery Europe, further downgrades or a reassessment of
Hungarian growth prospects through 2011 could lead to funding problems and capital flight.
Activity: We look for growth of 1.5% in 2011 from 1.0% in 2010. The external sector should
drive most of the recovery, particularly export demand from Germany for onward export to Asia.
Household consumption should stop contracting in Q1 2011 for the first time since the crisis with
its growth averaging 1.3% in 2011 after -2.1% in 2010. However, the lack of credit growth given
the banking tax should limit capital formation and household consumption growth for the year.
Upside risks to growth are mainly from the external sector, while negative risks stem from the
spill-over of fiscal policy.
Currency and debt markets: Although we look for the forint to be weaker through 2011
because of a market reassessment of growth and fiscal policy, external risks are the ones to
watch. Debt market dynamics will likely be complicated by structural changes including the
removal of the private sector mandatory pension savings system. This should decrease debt
demand by some 4.6% of total issuance (HUF2.4bn), but also because of reduced issuance of
some HUF456bn the impact on rates is unlikely to be negative.
Inflation and rates: There is considerable monetary policy uncertainty given the government
wants to change both the inflation target and the MPC members in March. Whilst the current
MPC may hike in December, January and February, this could well be reversed afterwards. We
expect inflation to remain sticky and above target, ending 2011 at 3.7%.
Figure 1. Details of the forecast Figure 2. Debt dynamics

2009 2010 2011 2012 90 Pre-budget baseline
Real GDP % y-o-y -6.3 1.0 1.5 2.0
Nominal GDP USD bn 170.7 159.7 172.4 172.7 Orban/ Baseline
81.0
Current account % GDP 0.2 0.5 -1.0 -2.0
80
Fiscal balance % GDP -4.0 -3.8 -2.9 -3.0 73.1
CPI % y-o-y * 5.6 4.2 3.7 3.4
CPI % y-o-y ** 4.2 4.8 4.1 3.8
70 75.6
Population mn 9.91 9.88 9.86 9.84
Bajnai
Unemployment rate % 10.5 10.8 10.0 9.5
Reserves USD bn *** 40.9 40.5 42.0 35.0
External debt % GDP*** 114.4 103.5 93.3 91.4 60
Public debt % GDP 78.3 79.8 75.1 74.4
MNB policy rate %* 6.25 5.75 6.25 6.25
EURHUF* 270 280 285 290
50
*End of period, **Period average, Bold is actual data 2003 2005 2007 2009 2011 2013 2015
***Includes IMF/EU funds
Note: Table reflects data available as of 6 December 2010. Source: Nomura Global Economics. Note: Bajnai stands for policy
Source: Nomura Global Economics. under previous Prime Minister. Orban is current PM.

Poland ⏐ Economic Outlook Peter Attard Montalto
Racing ahead, fiscal clouds

Investment, external demand and strong domestic demand should see growth surge ahead.
However, growth is unlikely to mask the fiscal policy fudge that is ongoing until after the elections.
Activity: Growth should accelerate to 4.5% y-o-y in 2011 supported by a broad-based recovery.
In particular, we see export demand from Asia (both direct and indirect via Germany) offsetting
increased import demand, such that the trade balance only makes a small negative contribution
to growth. We see household consumption moving ahead from 3.4% growth in 2010 to 4.1% in
2011, as credit expansion and a natural cyclical recovery in real wages and employment provide
a boost to households. Interest rate rises through the year should act as a drag on growth, but
not meaningfully as policy will likely remain in loose territory overall. Equally expansionary fiscal
policy should provide support for another year. Investment should be a new contributor with
attractive valuations prompting additional capital inflows, though it should principally get its boost
from construction in preparation for the 2012 European Football Cup. All in all, this should take
growth in investment from -3.1% in 2010 to +12.2% in 2011.
Inflation and rates: Poland will be one of the only countries in the region with demand-side
inflationary pressures in our view, compounded by the domestic recovery and credit growth. We
see inflation rising to average 3.5% during 2011 from 2.6% in 2010. Risks are broadly balanced,
with upside inflation risks from commodities and risks on the downside from a stronger currency.
We see the National Bank of Poland responding with a stop-start tightening policy (in response
to currency strength fears) beginning in February, with rates reaching 4.50% by year-end.
Fiscal and politics: Policy for the year will be focused solely on the Sejm elections, which we
expect to take place in October. The ruling PO is still significantly ahead in the polls, but a close
Presidential election mid-2010 has kept the party on the edge and nervous of opposition PiS.
We expect the PO to cement its position, though it may swap coalition partners from the leftist
PSL to the more centre-left SLD. The 2011 budget provides little policy change, with a
concentration on revenue from a 1pp VAT increase and some other smaller measures. The
government is unwilling to undertake difficult but necessary expenditure reforms before the
elections, but must do so in its 2012 budget to keep markets on side and be on a sustainable
track towards euro adoption in 2015 (with ERM II entry we believe at 3.70 in H1 2012). The
government has moved out its 3% of GDP deficit goal to 2013. In 2011, we expect the budget
deficit to come in at a very large (considering growth) 6.9% of GDP. Public debt levels will be
watched closely and will likely be close to the key constitutional 55% of GDP debt limit.
Risks: A broad-based recovery and more closed economy suggests there is insulation against
any possible growth dip in the eurozone, though Asia and global growth more generally are
probably more significant drivers. Rates may well rise at a slower pace if there is excessive PLN
appreciation, which curbs inflation. A credit rating downgrade post Sejm elections is possible,
though remains a tail risk. Markets’ assessment of the fiscal situation and the government’s
commitment to (eventual fiscal consolidation) will dictate the success of debt issuance.
Figure 1. Details of the forecast Figure 2. Inflation outlook

2009 2010 2011 2012 % y-o-y
Real GDP % y-o-y 1.7 3.8 4.5 4.6 6
Net core
Nominal GDP USD bn 635.5 635.8 752.5 804.9
Current account % GDP -1.6 -1.8 -2.5 -3.0 5 Headline
Fiscal balance % GDP -7.1 -7.8 -6.9 -5.0
CPI % y-o-y * 3.5 3.2 3.6 3.1 4
CPI % y-o-y ** 3.4 2.6 3.5 3.4
Population mn 38.1 38.0 38.0 37.9 3
Unemployment rate % 11.9 9.5 9.0 8.0
Target
Reserves USD bn ** 69.4 85.0 90.0 100.0 2
External debt % GDP 64.9 65.8 62.8 59.3
Public debt % GDP 51.0 54.5 54.7 54.9 1
NBP policy rate %* 3.50 3.50 4.50 5.50
EURPLN* 4.10 4.0 3.8 3.70 0
*End of period, **Period average, Bold is actual data Jan-08 Nov-08 Sep-09 Jul-10 May-11 Mar-12
Note: Table reflects data available as of 6 December 2010. Source: Nomura Global Economics.

Russia ⏐ Economic Outlook Tatiana Orlova
Lacking momentum
Next year’s focus is likely to be on the year-end parliamentary elections, the announcement of
the candidates for the presidential race and the possibility of WTO accession in H2 2011.
Activity: Unless oil prices rise sharply, we think growth will probably be lacklustre compared
with the previous decade. The severe drought last summer dealt a blow to the still-fragile
economy, and the speed of recovery slowed in H2 2010. Rising inflation reversed the benign
trend in real wage growth and dented consumer confidence. The government accepts that the
development of the economy is being hindered by the high level of state ownership, and has
therefore announced a large privatisation programme for 2011-15, which should generate about
$50bn in revenue. However, it is not planning to sell a controlling stake in any of the state-owned
flagship enterprises in 2011. As the country approaches the elections, the government has
stopped channelling any windfall oil revenues into the sovereign wealth funds, and will likely use
these revenues for pre-election handouts. This should support household consumption, but fixed
investment may remain anaemic, as companies will be hit by an increase in the effective rate of
social tax from 26% to 34%. This rise should bring in an extra 1.6% of GDP in revenues, and
together with rises in the gas extraction tax and excise duties for alcohol and tobacco should
help reduce the budget deficit from about 4% of GDP this year to the 3.6% pencilled in the 2011
budget. Russia has nearly ironed out all differences with the EU and US, and WTO entry may
take place in H2 2011; this would provide a boost to market confidence.
Inflation: The second-round effects of last summer’s drought are likely to persist until mid-2011.
Other inflationary factors include the lagged effects of loose fiscal and monetary policies, regulated
tariff hikes in January and the likely rise in meat prices due to short supply. We forecast CPI
inflation of 8-9% y-o-y for most of 2011, way above the government’s target of 6.5% y-o-y.
Policy: The Central Bank of Russia may be forced to react to lingering high inflation with a rise
in interest rates in Q1 2011, though there is a risk that policy will remain unchanged and focused
on growth rather than inflation. Although the 2011 budget includes certain tightening measures,
we think they will achieve little in trimming spending as the forthcoming elections will constrain
tightening. The consolidated budget, which now balances at a Urals price of above $100/bbl
following years of fiscal expansion, will likely post a smaller deficit than in 2009. Still, given the
near-depletion of the Reserve Fund, the government will need to place Eurobonds and increase
domestic borrowing markedly to finance it.
Politics: Although parliamentary elections are due at the end of 2011, the most interesting
political question next year will be the identity of the candidates for the presidential election
expected in early 2012. Because of the weakness of the opposition and the high (7%) threshold
for representation in the Duma, the ruling party, United Russia, has a good chance of retaining a
constitutional majority (or two-thirds of the seats) in the Duma. If Vladimir Putin puts himself
forward as a presidential candidate, which we think is very likely, he will probably do it during the
parliamentary campaign to boost United Russia’s popularity.
Figure 1. Details of the forecast Figure 2. Official fiscal projections for 2010-13
2009 2010 2011 2012
% of GDP $/bbl
Real GDP % y-o-y -7.9 3.8 3.5 3.3 8 90
Contributions to GDP (pp) 6 80
Consumption -5.0 1.2 1.5 2.3
4 70
Gross investment -4.3 0.9 1.9 2.4
Net exports 11.0 -2.5 -2.8 -0.5 2 60
CPI % y-o-y ** 11.7 6.8 8.7 7.7
0 50
Federal budget % GDP -6.8 -4.2 -3.6 -1.6
Current account % GDP 3.8 4.8 2.5 1.1 -2 40
FX reserves, gross USD bn 439 505 540 590 -4 30
Budget deficit
CRB policy rate %* 8.75 7.75 8.25 8.25
-6 Reserve Fund 20
USDRUB, end of period 30.27 30.83 30.67 31.49 Welfare Fund
RUB Basket*** 36.20 34.99 35.50 35.74 -8 Net domestic borrowing 10
*End of period, **Period average, Bold is actual data, Table last revised
Net external borrowing
-10 Urals, rhs 0
on 3 December 2010
2009 2010 2011 2012 2013
***45% EURRUB and 55% USDRUB
Source: Nomura Global Economics. Source: Russian Finance Ministry, Nomura Global Economics.

South Africa ⏐ Economic Outlook Peter Attard Montalto
Unexciting growth, policy more interesting

Underlying growth should recover further, albeit slowly, and become more sustainable. Fiscal
policy is the area to watch, especially its interaction with monetary policy.
Activity: Despite suffering only a mild recession during the crisis, South Africa will probably only
experience a sluggish recovery. We look for growth of 3.3% in 2011 after 2.8% in 2010. An early
growth spurt in exports during the past year, led by Asian demand is trailing off, while the effects
of a slowdown in demand outside Asia has been compounded by a currency overvalued by
some 25% in our view. Overall, we expect the recovery to be achieved largely through a
renewed spurt in infrastructure investment and household spending, with corporates still
deleveraging through much of H1. However, households will probably be constrained by the rise
in employment taking much longer than the fall on the way down. Very high real wage growth
however will offset this to some extent when combined with asset price appreciation. According
to our estimates the economy will not reach its potential of 3.5% growth until mid 2012.
Currency: The government has taken actions to weaken the ZAR with outflow exchange control
relaxation starting in 2011 and by providing the South African Reserve Bank with more funds to
cover the sterilisation costs of more rapid reserve accumulation. Foreign debt issuance is also
being reduced. But given the global currency wars and yields in South Africa these measures
are likely to only have a limited effect. Therefore, we expect the government to go further.
Inflation and rates: There is significant uncertainty on whether the rate-cutting cycle has ended
because of the MPC’s ability to accept such late, pro-cyclical policy adjustment. We believe
there is a strong likelihood of a cut in rates in January, even though this is not our baseline
forecast, but it will be highly data dependent after the overly dovish MPC statement in November.
Rates should then stay on hold until the last meeting of the year (December), where we see the
MPC having to normalise rates owing to a worsening inflation outlook. Risks are to rates on hold
for longer. Questions remain over the role of monetary policy in the government’s New Growth
Plan as it is meant to be doing more of the macroeconomic heavy lifting. Although we think this
means a dovish bias over a whole cycle, the risks of an MPC mandate change are material.
Overall, we see inflation remaining in its target for the whole year, ending at 5.5%, though the
outlook for 2012 looks more bearish with higher commodity prices, second-round effects and a
weak ZAR. We therefore see inflation ending 2012 outside its target at 6.6%.
Politics and fiscal: The focus in the year ahead will be the interplay between policy and the
locals elections (expected in Q2). We expect the ANC to lose some ground in terms of its control
over the number of local authorities (dropping from around 80% to 65%) owing to the opposition
DA-led coalition. Such a move should re-energise the debate within the ANC about the New
Growth Plan, state intervention in industry and other developmental state interventions on jobs
and education. However, overall we expect a pretty rapid narrowing of the budget deficit to 4.9%
of GDP next year (a touch higher than the budgeted -4.6% given post election spending
pressures). The ability to sustain such consolidation is however unclear.
Figure 1. Details of the forecast Figure 2. Real GDP growth and breakdown
2009 2010 2011 2012 pp contribution % q-o-q saar
Real GDP % y-o-y -1.8 2.8 3.3 3.8 12 8.0
Current account % GDP -4.0 -3.2 -5.5 -5.9 10 6.0
PSCE % y-o-y* -0.1 5.3 10.3 11.9 8
4.0
Fiscal balance % GDP -6.8 -5.5 -4.9 -4.5 6
FX reserves, gross USD bn* 39.7 44.5 45.7 46.8 4 2.0
CPI(X) % y-o-y * 6.3 3.7 5.5 6.6 2 0.0
CPI(X) % y-o-y ** 7.2 4.3 4.8 6.1 0 -2.0
Manufacturing output % y-o-y -12.9 4.3 3.3 7.6 -2
-4.0
Retail sales output % y-o-y -3.6 4.8 6.4 6.7 -4
SARB policy rate %* 7.00 5.50 6.00 8.50 -6 -6.0
EURZAR* 10.6 9.0 10.8 11.1 -8 -8.0
USDZAR* 7.48 6.90 8.00 8.50 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12
*End of period, **Period average, Bold is actual data Trade Balance Government Other
PSCE- Private sector credit extentions GFCF Consumption GDP (rhs)
Note: Table reflects data available as of 6 December 2010. Source: Nomura Global Economics.

Turkey ⏐ Economic Outlook Olgay Buyukkayali
Widening imbalances
Loose monetary and fiscal policy has supported the continuation in domestic demand-led growth.
Macro-prudential policy measures are unlikely to stop the widening of the current account deficit.
Activity: According to our forecasts Turkey has come out of the recession with relatively strong
growth of 7.2% in 2010. We expect growth in 2011 to remain above-potential at 5.4%, driven
largely by continued double-digit growth in private investment. Private consumption contribution
should moderate and this should reduce net import’s negative contributions to GDP. We think
risks are on the upside owing to the strong policy response from construction and public
investment ahead of the elections. Furthermore, our scenarios do not assume aggressive stock
building, which is also an upside risk for our base case. Our calculations suggest the output gap
probably closed during Q4 2010.
Inflation: We expect food price disinflation and core inflation in 2011 that would still leave
headline inflation above the 5.5% target at around 7.0% y-o-y. With pricing power rising, real
wages together with lower unemployment are all pointing to risks on the upside for core inflation.
The government is keen to address food price inflation, which is currently running above 15% y-
o-y, and meat imports and base effects could bring some relief.
Policy: Monetary and fiscal policy remains loose. We expect the first hike in May because of
core inflation pressures. Our baseline is an overall 150bp rise through 2012, with 100bp taking
place during 2011. We expect the TCMB to actively raise TRY and FX reserve requirements to
stabilise corporate and individual credit growth. Fiscal policy does not help the monetary
authorities as much as it could – due to elections in 2011 – with the government spending the
cyclical revenue overshoots in the primary surplus during 2010 and 2011. The authorities are
aware of the widening imbalances and seem to be addressing the issue. We think success could
bring an investment grade rating as early as Q3 2011 by at least one agency. The debt
dynamics remain stable, and highlight the case for an investment grade rating by 2011 (which is
largely priced in by the markets). Leverage in the economy, despite rapid growth, looks low.
Risks: Overheating and terms-of-trade shocks (oil prices) are the main risks because the
current account deficit is running above 6% of GDP. Even though parliamentary elections are
set for July 2011 (we see significant risks of them taking place a few months earlier due to
logistical reasons), the political climate looks extremely stable following the Constitutional Court
referendum. An AKP majority government is our base case in the elections. We think the risks of
capital controls being implemented should the currency appreciate rapidly are extremely low.

% y-o-y unless otherw ise 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2010 2011 2012
Real GDP 11.7 10.3 5.8 2.3 5.9 4.2 5.5 6.0 3.4 7.2 5.4 4.3
Personal consumption 8.5 6.2 5.2 1.9 1.5 1.7 3.0 4.5 4.1 5.4 2.7 3.6
Private investment 23.1 32.1 31.2 20.4 10.2 9.8 10.2 14.1 13.5 26.6 11.1 11.3
Government expenditure 1.0 3.6 -0.2 -8.1 1.8 7.0 3.8 2.2 -2.6 -1.7 3.6 -1.9
Exports -0.3 12.1 7.8 5.8 10.9 6.0 9.7 8.7 9.3 6.5 8.8 11.0
Imports 22.3 17.8 13.0 5.4 4.2 8.0 9.0 16.4 15.3 14.1 9.5 13.1
Contributions to GDP (pp):
Personal consumption 6.4 4.5 3.5 1.3 1.1 1.2 2.0 3.1 2.8 3.8 1.9 2.4
Private Investment 4.1 5.3 4.5 3.3 2.0 1.9 1.8 2.7 2.7 4.3 2.1 2.3
Government expenditure 0.1 0.4 0.0 -1.1 0.2 0.7 0.3 0.3 -0.1 -0.2 0.4 -0.2
Stocks 7.6 1.2 -1.2 -1.5 0.9 1.1 1.2 1.9 0.0 1.2 1.3 0.8
Exports -0.1 3.0 1.9 1.5 2.6 1.5 2.5 2.3 2.3 1.6 2.2 2.9
Imports 5.6 4.6 3.2 1.4 1.2 2.2 2.3 4.4 4.1 3.6 2.6 3.7
CPI (period end) 9.6 8.4 9.2 6.9 5.0 6.4 6.3 7.0 6.7 8.7 6.0 6.9
CPI -ex- food (period end) 8.9 9.4 6.9 5.8 4.5 5.1 5.9 6.5 6.7 5.8 6.5 6.8
CPI (period avg - 12m) 6.5 7.4 8.2 8.6 7.5 6.7 6.2 6.0 6.2 8.6 6.0 7.0
Current account (% GDP) -3.5 -4.1 -5.3 -6.1 -6.2 -6.6 -6.3 -6.4 -6.5 -6.1 -6.4 -6
Fiscal balance (% GDP) -4.5 -4.3 -3.9 -3.7 -3.7 -3.6 -3.4 -3.3 -3.1 -3.7 -3.3 -3
Net public debt (% GDP) 32.0 30.5 30.7 31.0 31.0 30.7 30.6 30.5 30.4 31.0 30.5 30
TCMB policy rate % 6.50 7.00 7.00 7.00 7.00 7.25 7.75 8.00 8.25 7.00 8.00 8.50
TRY/USD 1.51 1.58 1.45 1.47 1.45 1.47 1.40 1.40 1.44 1.47 1.40 1.5
TCMB policy rate denotes O/N borrow ing rate until 1Q10 and 1-w eek repo rate thereafter
Note: TCMB policy rate denotes O/N borrowing rate until 1Q10 and 1-week repo rate thereafter. Table reflects data available as of 6
December 2010.

Rest of EEMEA ⏐ Economic Outlook Peter Attard Montalto ⏐ Olgay Buyukkayali
Czech Republic: Fiscal/growth trade-off

The fiscally hawkish coalition will likely continue to correct the situation it inherited but growth will likely suffer
2009 2010 2011 2012
• A strong rebound in 2010 owing to stronger external
Real GDP % y-o-y -4.5 2.3 1.4 2.6
demand from the EU and Asia will probably dissipate
Nominal GDP USD bn 223.4 222.7 253.8 255.8
in 2011 when fiscal austerity measures hit domestic
Current account % GDP -1.0 -0.5 -2.5 -3.5
demand, which we expect to fall throughout the year.
CPI % y-o-y * 1.0 2.2 1.3 2.0 • We see inflation hovering just above target on
CPI % y-o-y ** 1.1 1.5 1.6 2.0 commodity price pressures throughout the year,
Population mn 10.2 10.1 10.1 10.0 though tempered by a strong currency. However,
Unemployment rate % 9.2 8.4 8.0 7.0 lower GDP growth probably means rate rises are
Reserves USD bn ** 41.1 44.0 45.0 48.0 unlikely before Q4 2011 and will be slow.
External debt % GDP 43.3 45.7 45.9 45.9
Public debt % GDP 35.4 41.2 43.8 45.3 • The surprise victory of the centre-right coalition in the
CNB policy rate %* 1.00 0.75 1.25 2.00 election suggests fiscal consolidation in 2011 should
EURCZK* 26.2 25 23.5 23.5 be impressive and put the economy on a more solid
*End of period, **Period average, Bold is actual data course after more than a year of policy stagnation.
Note: table reflects data available as of 6 December 2010. While fiscal consolidation will drag on growth, it is an
Source: CSO, CNB, Nomura Global Economics. important boost to credibility, though a loss in
domestic competiveness needs to be watched.
Romania: A challenging road ahead

Twin deficits leave little room for supporting growth
2009 2010 2011 2012 • The political background remains testing, with
Real GDP % y-o-y -7.0 -2.0 1.5 2.5 increasing political instability owing to a more united
Current account % GDP -4.4 -4.8 -5.5 -6.0 opposition, fiscal challenges and heightening risk
perceptions on periphery Europe. With a plethora of
CPI % y-o-y * 4.7 7.7 3.2 3.0
no confidence votes, early elections are possible.
CPI % y-o-y ** 5.8 6.1 4.0 3.0 • Romania was one of the few countries to suffer three
External debt % GDP 69.3 73.0 70.0 70.0 full years of contracting output and the expected
Public debt % GDP 28.2 35 38.0 36.0 rebound in headline growth in 2012 should be mainly
NBR policy rate %* 8.00 6.25 6.25 7.50 due to base effects and FDI. Fiscal consolidation may
EURRON* 4.2 4.30 4.50 4.25 dampen household demand, as may sluggish growth
*End of period; **Period average; Bold is actual data in periphery Europe.
Note: table reflects data available as of 6 December 2010.
Source: Ministry of Statistics. • Core inflation should continue to ease given excess
capacity and reduced wage pressures, but the VAT
increase, currency pass-through and commodity price
pressures suggest inflation should remain high and
sticky throughout the year. In our view, there is
reduced room for interest rate cuts and we see no
hikes until 2012.
Israel: Growth continues to advance

Israel’s output gap has closed, inflation pressures are rising
2009 2010 2011 2012 • Israel’s export-driven economy outperformed the

Real GDP % y-o-y 0.3 3.3 4.0 4.0 region in the post-crisis environment thanks to an
Consumption % y-o-y -0.3 3.0 3.5 3.0 aggressive monetary policy response resulting in a
Gross investment % y-o-y -6.5 2.5 3.2 3.8 healthy domestic demand.
Exports % y-o-y -7.8 2.5 3.8 4.5
Imports % y-o-y -5.0 3.3 4.0 3.9
• Inflationary pressures should remain fairly high, not
CPI % y-o-y * 2.8 2.9 3.2 3.5 only because of a housing market boom, but also
CPI % y-o-y ** 2.7 2.9 3.3 3.4 because of a rise in real wages.
Budget balance % GDP -5.3 -3.8 -3.5 -4.0
• Strong domestic demand not only risks inflation
Current account % GDP 3.7 3.0 2.5 2.0
moving above the upper band of the target, but also
Policy rate %* 1.00 2.00 3.25 3.75
shrinks the current account surplus. Monetary policy
USDILS* 3.79 3.70 3.50 3.60
should continue to tighten in 2011: in our view with
*End of period, **Period average, Bold is actual data
Note: table reflects data available as of 6 December 2010. the BoI is likely to hike policy rates by 125bp in 2011.
Source: BOI, Nomura Global Economics.

Rest of EEMEA ⏐ Economic Outlook Tatiana Orlova ⏐ Ann Wyman
Ukraine: Slow stabilisation

The new standby agreement with the IMF paves the way for reform, but the path may be thorny
2009 2010 2011 2012
Real GDP % y-o-y -15.1 4.7 4.8 5.0
• The pace of recovery will likely remain gradual. The
Consumption, % y-o-y -14.2 0.2 2.5 2.8 government will have to balance the need to fulfil
Gross investment -52.2 4.0 3.5 4.0 harsh conditions of the IMF stand-by programme with
Exports, % y-o-y -40.4 27.9 6.5 12.1 preserving political stability. Luckily for it, the next
Imports, % y-o-y -46.3 28.1 11.3 8.0 Rada elections are not happening until 2012.
CPI % y-o-y ** 16.7 9.5 11.2 10.5
Consolidated budget % GDP -6.0 -5.5 -4.0 -3.0 • The current account should remain in deficit but
Current account % GDP -0.6 -1.5 -3.5 -0.5 renewed FDI inflows and IMF support should help
FX reserves, gross USD bn 29.1 29.0 31 33.2 keep the hryvnia stable. We see a small chance of
NBU discount rate %* 10.25 7.75 7.75 7.50 inflation returning to single digits but policy hikes are
USDUAH* 7.99 7.90 7.70 7.50
unlikely.
*End of period, **Period average, Bold is actual data.
• IMF funds and external borrowing will likely remain
the main tools for financing the budget deficit which
the government has pledged to cut to 3.5% of GDP
from 5.5% of GDP in 2010.
Kazakhstan: Driven by industrial recovery

The change in the FX regime expected in March should lead to moderate KZT appreciation
2009 2010 2011 2012
Real GDP % y-o-y 1.2 6.2 5.3 4.8
• Manufacturing, which propelled the economy in 2010,
Consumption % y-o-y -3.0 3.5 3.1 3.0 will likely retain some of its momentum in 2011. We
Gross investment % y-o-y 1.9 9.1 7.8 11.0 expect robust growth supported by high FDI inflows
Exports % y-o-y -39.0 41.0 20 17.2 and continued improvements in the business climate.
Imports % y-o-y -25.0 8.9 26.2 30
CPI % y-o-y ** 7.3 7.1 7.6 6.5 • The NBK intends to change the FX regime in March
Government budget % GDP -1.5 -2.6 -1.1 2.0 2011, and has hinted at the possibility of a managed
Current account % GDP -3.2 4.6 6.2 4.3 float. We expect it to intervene in the FX market to
FX reserves, gross USD bn 20.6 28.2 34.0 42.3 prevent USD/KZT from strengthening beyond 141-
NBK official rate %* 7.00 7.00 7.25 7.00 142 by year-end; this should translate into a further
USDKZT* 148.7 146.5 142 138
build-up in the National Fund and FX reserves.
*End of period, **Period average, Bold is actual data.
Note: table reflects data available as of 6 December 2010. .
• The parliamentary elections to be held in H2 2011
carry little risk for stability, as the ruling party should
retain its dominance in parliament.
Egypt: Anticipating political transition

Growth prospects remain strong while concerns about potential political changes simmer
2009 2010 2011 2012
Real GDP % y-o-y 4.8 5.3 5.5 5.5
• The economy fared well through the crisis, supported
CPI % y-o-y * 13.3 10.9 12.1 9.5 by wider Middle East linkages. Growth is expected to
Budget balance % GDP** -6.9 -8.3 -8.5 -7.1 remain above 5% in 2011, driven by domestic
Current account % GDP -3.0 -2.5 0.0 1.0 demand, though reform progress has slowed.
FX reserves, gross USD bn 30.0 35.1 37.0 38.4
External debt % GDP 17.1 16.3 15.7 16.2 • Inflation is likely to remain sticky given domestic
Policy rate %* 8.25 8.25 9.00 9.00 demand and global oil price increases, with some
USDEGP* 5.50 5.80 6.10 6.40 upside risks from further upward shifts in commodity
*End of period, **Fiscal year ending April, Bold is actual data prices or subsidy reductions. The Central Bank of
Note: table reflects data available as of 6 December 2010. Egypt (CBE) should resume rate hikes in 2011, with
the pace of increases dependent on inflation.
• The Mubarak succession debate should take centre

stage in 2011. Presidential elections are due in
September, and Mubarak may run again, but his
health issues heighten risks of a disorderly transition.

Rest of EEMEA ⏐ Economic Outlook Ann Wyman
Saudi Arabia: Stronger through oil

Increasing oil prices, combined with ongoing fiscal stimulus, are supporting an accelerating recovery
2009 2010 2011 2012 • Saudi Arabia continues to recover, having prudently
Real GDP % y-o-y 0.2 4.0 4.4 4.0 managed the effects of the global recession. Its pre-
Hydrocarbon % y-o-y -8.7 2.4 3.0 2.9 emptive financial sector response and counter-
Nonhydrocarbon % y-o-y 3.0 3.7 3.5 3.2 cyclical fiscal policy paid off, but growth remains
CPI % y-o-y * 5.0 5.4 5.6 5.0 constrained by a modest recovery in bank lending.
Budget balance % GDP 0.9 4.5 4.8 6.5
Current account % GDP 6.0 11.5 12.3 15.0 • Non-hydrocarbon growth should continue to increase
Short-term interest rates % 0.70 2.00 2.00 2.50 over the next five years, as should its share in output,
USDSAR* 3.75 3.75 3.75 3.75 driven by government-led infrastructure spending.
*End of period, **Period average, Bold is actual data
• The USD peg remains firmly in place given the
Source: Ministry of Statistics, SAMA, Nomura Global Economics.
economy’s dollar links and the government’s long-
standing commitment; monetary policy will thus stay
anchored to the US interest rate cycle.
Qatar: Powering ahead

Economic growth should continue to surge as more gas production comes on line
2009 2010 2011 2012 • Qatar’s outlook remains driven by hydrocarbons. With
Real GDP, % y-o-y 9.6 16.5 19.0 14.0 two new LNG production facilities coming online,
Hydrocarbon % y-o-y 13.2 25.0 18.1 12.7 growth is surging, though it should moderate into
CPI % y-o-y ** 0.5 1.5 3.6 3.5 2012. Despite strong growth in output, inflation
Budget balance % GDP 12.2 10.0 12.0 10.0 remains subdued given the fall in real estate prices,
Current account, USDbn 9.6 22.8 34.0 36.0 which take up a large share of the consumer basket.
Current account % GDP 10.3 19.9 25.8 23.9
Short-term interest rates % 2.00 1.50 1.50 2.00 • The authorities’ strong policy response to the crisis,
USDAED* 3.67 3.67 3.67 3.67 especially in the banking sector, has helped ensure a
*End of period, **Period average, Bold is actual data healthy backdrop to the recovery.
Source: Ministry of Statistics, Qatar Central Bank, Nomura Global
• The cut in the deposit rate to 1.5% has reduced the
Economics. appeal of capital inflows and is hoped to discourage
banks from keeping high levels of reserves with the
central bank. Nevertheless, private sector credit
growth has yet to pick up noticeably.
United Arab Emirates: A long road to real estate recovery

Ongoing deleveraging and real estate oversupply constrain growth, but oil prices provide support
2009 2010 2011 2012 • Growth should remain constrained by the ongoing
Real GDP, UAE % y-o-y -1.0 2.3 3.6 3.5 process of deleveraging, as well the continued drag
Hydrocarbon % y-o-y -8.4 2.0 3.0 3.0 from the real estate overhang. Nonetheless, the
Non H/C Abu Dhabi % y-o-y 4.0 5.6 6.4 4.0 higher oil price environment will continue to support
Non H/C Dubai % y-o-y -4.0 -1.5 2.0 2.0 external accounts, and allow further amassing of
CPI % y-o-y ** 1.6 -0.3 2.0 3.0 international reserves, underpinning the overall credit
Budget balance % GDP 1.8 5.5 8.2 10.5 picture, particularly for Abu Dhabi.
Current account % GDP -0.2 7.0 8.2 10.0
Short-term interest rates % 0.70 2.00 2.00 2.50 • The completion of the Dubai World restructuring has
USDAED* 3.67 3.67 3.67 3.67 removed some uncertainty, but concerns about other
*End of period, **Period average, Bold is actual data entities remain.
Source: Central Bank of UAE, Nomura Global Economics. • Given the subdued economic outlook, inflation
pressures are likely to remain at bay. Although the
UAE has opted out of the GCC monetary union, the
USD peg is likely to remain firmly in place.
Consequently, monetary policy should remain tightly
linked to that in the US.

Latin America ⏐ Outlook 2011 Tony Volpon ⏐ Benito Berber⏐ Boris Segura
Too much of a good thing

We expect the region to begin 2011 with a surge in commodity-driven inflation. Fears of further
currency appreciation will likely result in a slow policy response, leading to higher inflation.
Inflation is the The recovery from the late-2008 financial crisis continued strongly this year across most of Latin
biggest challenge for America, driven by still-expansive fiscal and monetary policies, the continuing rally in commodity
2011 prices, and the expansion of credit availability to the “new middle class”. But the region faces
“too much of a good thing”: higher growth and higher commodity prices combined with concerns
that tightening monetary policy will amplify currency appreciation are risking the region’s inflation
outlook. A common inflation problem will be the major policy challenge for 2011, even as growth
begins to be affected by more idiosyncratic factors.
Brazil
Fiscal policies have Brazil is facing a commodity-induced inflation surge just as a new government is taking power,
been loose in 2010 generating doubts over the continuity of economic policy. Specifically, since the 2008 crisis the
government has been running very expansive fiscal, wage and credit policies, which should take
the nominal deficit in 2010 to around 3% of GDP. Although it may be justified as part of the
vogue for counter-cyclical fiscal policies, spending has kept on climbing strongly during 2010
when we expect the economy to grow by 7.4% y-o-y. Added to this, there has been a 5.1% real
increase in the minimum wage in 2010 (to which many salaries and pensions are indexed) and
increased lending by official institutions equivalent to around 2.5% of GDP. This may be
explained by the fact that 2010 has been an election year.
Non-food inflation Faced with a highly stimulative policy, perhaps the biggest conundrum in 2010 has been the
remains stable relative stability of non-food price inflation (Figure 1). Thus, even though food price inflation in
despite the stimulus October rose 7.45% y-o-y, non-food price inflation of 4.53% y-o-y was very close to the Central
Bank of Brazil’s (BCB) 4.5% inflation target. Furthermore, economic performance has been
mixed, with de-trended retail sales (a proxy for demand) rising from mid-2010, while de-trended
industrial production keeps falling (Figure 2). The continuing rise in service price inflation, now at
7.18% y-o-y, is worrisome in the context of tightening labor markets, but could be best
addressed by controlling the rise in wages.
We believe the new We expect the government to tighten spending enough and moderate wage and credit growth to
administration will slow economic growth to 4.0% in 2011. Due to high start-of-the-year inflation and indexation of
start fiscal tightening utility prices, we think inflation will still close the year at an above-target 4.85%. We see the BCB
having room to cut rates in the second half as activity slows and commodity price inflation wanes
(see Box: What drives inflation in Latin America). That said, we do recognize a risk: the new
BCB team, to reaffirm its credibility and manage rising inflation expectations, might undertake a
short tightening cycle of around 100bp, only to then lower interest rates later in the year.
Figure 1. Brazil food vs non-food price inflation Figure 2. Brazil cyclical industrial production and retail sales
6 Index
12 % y-o-y
4
Food IPCA ex-Food
10
2
8 0
-2
6
-4
4
Industrial production
-6
Retail sales
2 -8
0 -10
Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10
Source: Nomura Global Economics, Haver Analytics, Bloomberg. Note: Data seasonally adjusted indices; 0 indicates the HP-filtered
trend; +/- indicates deviations from trend.
Source: Nomura Global Economics, Haver Analytics, Bloomberg.

What drives inflation in Latin America? T. Volpon │ G. Lei │ S. Ozcan

As Latin America expects a new year with higher prices, we attempt to pin down the main drivers of inflation.
If there is one overarching theme for Latin America in 2011, it is inflation. Factors at both home and abroad are likely to
push prices higher across the region. Domestically, promptly-closing (or already closed) output gaps and tighter labor
markets are pressuring non-tradable goods inflation. Globally, ample liquidity has driven up prices in both hard and soft
commodities. The former, via favorable terms of trade, boosts domestic demand and causes price pressure, while the
latter has a more direct and lasting impact on food prices, the item that carries the highest weight in LatAm consumer
price indexes (CPIs). In sum, risks of higher inflation abound in 2011.
Having identified the big picture, it is more difficult to foretell the exact causes of inflation, as externally-determined food
prices, oftentimes volatile, coupled with government-set administrative prices that do not always follow economic cycles,
make accurately forecasting inflation a daunting task. Nevertheless, we attempt to better understand the key contributors
of LatAm inflation, looking at both domestic and international factors. In Figure 1, we found two interesting facts in all
countries: (1) inflation inertia is very high; (2) coefficients for the policy rate have a positive sign, implying that monetary
tightening cycles largely trail inflation movements. Results for individual countries are equally informative:
Brazil: The output gap has a regression coefficient of 0.42, implying that a 1% positive output gap (actual output above
potential) will translate into a 0.42% increase in headline inflation, ceteris paribus. As a large and relatively closed
economy, domestic demand is expected to have more impact on headline CPI. We estimate that Brazil’s output gap
already closed in Q4 2009 and will remain slightly above potential in 2011. As we expect the new government to tighten
spending, inflation pressure from output gap closure should be quite limited. Soaring global food prices do feed into local
prices, though a stronger real (BRL) can partially offset the effect. We forecast high headline inflation in much of 2011,
with a slight moderation by Q4, closing the year at 4.85%, above the 4.5% central bank target.
Mexico: The regression coefficient for the output gap at 0.08 is the lowest, suggesting that output gap variations do not
necessarily translate into CPI changes. A steady FX path (at least before the financial crises) coupled with stable, albeit
high, inflation expectations might cushion the impact of the output gap into inflation. Mexico is also least affected by
international food prices. Given that in 2011 we project the output gap not to close until June, coupled with our view of a
moderate peso (MXN) appreciation, makes us believe that headline inflation will remain stable throughout next year,
slightly below the 4% upper bound of the target.
Chile: The output gap has the largest pass-through effect among the four countries, a puzzling observation as Chile is
the most open economy. In fact, Chile’s output gap may be sensitive to external factors through copper exports, as high
copper prices can lead to increased mining investment and private consumption (an income effect), resulting in a positive
output gap and higher inflation, especially in non-tradable goods (6% y-o-y in October vs. -0.96% for tradable goods).
Should global food prices continue to rise, inflation in Chile is likely to surge, a major upside risk to our mild CPI forecast.
Colombia: The output gap has a low pass-through effect to CPI, while the exchange rate has the highest pass-through
coefficient. As we expect the output gap to close by H2 2011 and the currency to resume appreciation, inflation should
be well-contained. Colombia can suffer badly from external food price shocks, but as tensions with Venezuela have led
to plummeting agricultural exports and an oversupply of foodstuff at home, food price surges should be largely mitigated.
Figure 1. Modelling domestic drivers of headline CPI Figure 2. Headline inflation in LatAm
% y-o-y
Brazil
12
Mexico
Brazil Mexico Chile Colombia 10 Chile
Output gap 0.4180 0.0834 0.5834 0.1063 8 Colombia
Policy rate 0.3122 0.5207 0.9805 0.6048 6
Exchange rate 0.0076 0.0156 0.0184 0.0256
4
AR(1) 0.9710 0.9231 0.9438 0.8782
2
Adjusted R-squared 95.39% 93.26% 96.92% 98.66%
0
Durbin-Watson statistic 1.8574 1.9057 1.6369 1.6812
S.E. of regression 0.2413 0.2448 0.5312 0.1907 -2
-4
Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
Note: All coefficients significant at 5% level except BRL and MXN Source: Haver Analytics; Nomura Global Economics.
which are at 10% level; sample period from Jan-2005 to Oct-2010.

Mexico
Growth is picking up We are positive about Mexico’s economic outlook for two reasons. First, we believe domestic
due to domestic aggregate demand will finally recover. Second, the combination of US monetary and fiscal
consumption policies (highly likely an extension of the Bush tax cuts) will improve the likelihood of stabilization
in US consumption. We believe that Mexico will benefit the most from a US recovery.
We project the economy to expand by 4.0% y-o-y in 2011, above the potential growth rate of
3.0%. While labor employment has returned to pre-crisis levels, most of the increase in the total
has been in the unskilled sub-component. Domestic consumption is looking better due to an
expected increase in government spending, particularly at the states’ level, a gradual recovery of
credit card lending and low inflation. While a few months ago we projected the output gap to
close by Q4 2011, we now believe it will close by around June 2011 (Figure 3).
Inflation is set to The faster-than-expected closure of the output gap, coupled with rising commodity prices and
remain just within the increasing government-set prices, could pressure inflation in 2011. We project inflation at 3.9%
2.0-4.0% band y-o-y, above the 3% target but within the 2-4% band. We maintain our view that Banxico will
leave the policy rate unchanged at 4.5% throughout 2011, consistent with a zero federal funds
rate in the US, low albeit rising domestic demand pressures and expected MXN appreciation.
There will be major Three proposals will be discussed and potentially approved by Congress in 2011: the first to
national legislations strengthen the anti-trust agency (COFECO in Spanish), the second to increase flexibility in the
and state elections labor market and the third to unify the municipal police forces under one control per state. The
gubernatorial election in the State of Mexico in July 2011 will be closely watched by the market.
The current governor, Enrique Peña Nieto (PRI party), is one of the most popular political figures
in the country and is ahead in the polls for the 2012 presidential election. Although the PRI will
most likely retain control of the State of Mexico, anything other than a decisive victory might
signal that the party is not as strongly positioned to win the 2012 elections as reflected by the
polls that give Peña Nieto more than a 20 point lead.
Chile
Chilean growth has Chile has had some of the most balanced growth in the region, led by strong investment
been strong and demand (due in part to post-earthquake rebuilding) and imports, as the country’s terms of trade
balanced have improved strongly as copper prices have risen (Figure 5). We expect growth in 2011 to rise
to 6.5% from an already strong 5.5% in 2010.
In addition to the above factors, still easy monetary and fiscal policies have been contributing to
growth, with worries over the appreciation of CLP leading to a slowdown in an already gradual
process of monetary policy normalization. With CLP rising, overall inflation is still at a low 1.98%
y-o-y (against a 3.0% inflation target), even though non-tradable goods and service inflation is
rising by 6.00%, with tradable still falling by 0.96% y-o-y.
The central bank will We expect the Central Bank of Chile (BCCh) to continue the current pace of rate hikes until its
likely keep hiking policy rate reaches 4.0%, even though strong demand is likely to lead to an overshoot in inflation
until 4% to around 3.5%, owing to higher commodity and food prices raising inflation in tradable goods
and services.
Figure 3. Mexico output gap Figure 4. Mexico headline and core inflation
125 Index (2003) % y-o-y

7
Headline
Core
120
6 Inflation target
(upper bound)
115
5
Potential GDP Actual GDP
110
4
105 Output Gap
3
100
Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11
Source: Nomura Global Economics, Haver Analytics, Source: Nomura Global Economics, Haver Analytics, Bloomberg.
Bloomberg.

Key elections in Latin America Boris Segura │ Benito Berber │ George Lei
In 2011, financial markets will keep a close eye on the presidential elections in Argentina and Peru.
Argentina
Argentina will be holding general elections on 24 October 2011. According to the new Law of Political Parties, open and
simultaneous primaries are to take place on 14 August 2011.
The recent death of former President Nestor Kirchner, leader of the Kirchnerista faction of the Peronist Party (PJ) and
purported presidential candidate, changed the political landscape of Argentina. His wife, current President Cristina
Fernandez, is now likely to run for re-election and, as per recent polls, is the early frontrunner (Figure 1).
Ironically, former President Kirchner’s death left the opposition dazed and confused, particularly the dissident Peronism,
who all of a sudden was left without a reason to exist. The recent departure of Senator Carlos Reutemann from the race
is very telling, and represents a heavy blow to the aspirations of the dissident Peronists.
The centre-left opposition Radical Party (UCR – Radical Civic Union) has two candidates: Vice-President (and Head of
the Senate) Julio Cobos, who parted ways with the Kirchners during the conflict with the farmers in 2008, and
Congressman Ricardo Alfonsin, son of former President Raul Alfonsin. Mr. Alfonsin brings the added bonus of a possible
alliance with the Socialist Party (PS) and other members of the so-called Pan-Radicalismo.
Mr. Mauricio Macri, right-wing Mayor of the City of Buenos Aires, might as well make a run for the Presidency. However,
his political party PRO (Republican Proposal) lacks electoral machinery and does not enjoy much popularity outside
Buenos Aires, making his run all the more difficult.
Peru
Peru’s general election will be held on 10 April 2011 to elect the country’s new President and Congress, both serving
five-year terms (2011-2016). If no presidential candidate obtains 50% of the votes plus one, a second round runoff
election will be contested between the top two contenders in roughly 2 months. The winner will be inaugurated on July 28,
2011. Incumbent president Alan Garcia (APRA – American Popular Revolutionary Alliance) is barred from seeking re-
election by the constitution.
The official nominations process will start in late December 2010 and end in early January 2011, and five popular politicians
are widely expected to run: 1) Luis Castañeda (SN – National Solidarity), former mayor of Lima (2002-10); 2) Keiko Fujimori
(Fuerza 2011), daughter of former president Alberto Fujimori (1990-2000); 3) Ollanta Humala (PNP – Peruvian Nationalist
Party), a former military officer narrowly defeated by Alan Garcia in the 2006 runoff Presidential election; 4) Alejandro
Toledo (PP – Possible Peru), a Stanford-trained economist who served as Peru’s president (2001-2006); 5) Mercedes
Araoz (APRA), former Economy Minister, is the ruling party candidate who just announced her bid on 2 November.
All frontrunners, except for Humala, have expressed strong commitments to maintain the current market-friendly
economic model of promoting growth through controlling inflation, upholding fiscal prudence, boosting infrastructure,
expanding free trade and attracting FDI. Humala’s pro-Chavez stance and nationalization rhetoric scared investors
during the 2006 runoff presidential race, causing CDS spreads to widen by 100bp to 250bp. A possible Humala victory
or election-related social unrest will present major risks for Peru’s asset prices. Based on opinion polls, K. Fujimori,
Castañeda and Toledo appear to have the best chances of emerging from the first round and face off in the second
round (Figure 2). The possibility of Humala in the second round is quite low, in our view. Having said that, it is important
to bear in mind that Election Day is still five months away and scenarios can change quickly.
Figure 1. Argentine presidential candidate support ratings Figure 2. Peru presidential candidate support ratings
% support
24
% support Scenario 1 (*) Scenario 2 (**) 22
Cristina Fernandez 46 48 20
Ricardo Alfonsín 19 - 18
Julio Cobos - 19 16
Mauricio Macri 15 13 14
Pino Solanas 10 11
12
No response 10 9
10
Total 100 100
8
Note: (*) Alfonsín running. (**) Cobos running.
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
Castañeda K. Fujimori
Toledo Humala
Source: Poliarquia; Nomura Global Economics. Source: Ipsos Apoyo; Nomura Global Economics.

Colombia
GDP growth is set to We expect Colombian growth to remain strong in 2011 because of robust domestic demand.
remain strong for a However, we do not expect inflationary pressures to accumulate as we forecast the currency to
second year in a row appreciate again, which would allow the central bank (BanRep) to keep its policy rate
unchanged for most of the year.
We expect GDP growth of 5.0% y-o-y in 2011 owing to very strong retail sales, which in 2010
expanded by more than 10% y-o-y. An improved outlook for the US economy should also
support above-potential growth. The commodity sector, led by an expanding oil industry, which
is set to double its production by 2015, should benefit from high commodity prices particularly for
oil, coal and coffee.
Robust FDI should Strong domestic demand will likely widen the current account deficit from 2.5% of GDP in 2010
finance the current to 3.0% in 2011. However, the widening deficit is unlikely to pressure the currency because of
account deficit robust FDI inflows that are set to continue in 2011 (Figure 6). We think net FDI inflows of more
than US$9bn will finance the current account deficit. We expect inflation to be around the central
bank’s 3.0% target, which would allow the central bank to delay its first hike until H2 2011.
For the fiscal accounts, the Achilles’ heel of the economy, the authorities project a deficit of 3.4%
of GDP for 2011, marginally narrower than in 2010. Congress will likely pass a fiscal rule, which
we think will encourage the three major rating agencies to grant Colombia investment grade.
Argentina
Argentina is likely to experience a volatile 2011, with general elections in October (see Box: Key
Elections in Latin America). The economy is already overheating, but we think the authorities are
unwilling to contain the expansion in aggregate demand before the elections. Loose fiscal and
monetary policies are likely to continue next year.
We expect economic We expect the pace of Argentina’s economic activity to decelerate in 2011 to 5% y-o-y from 9%
activity to slow in in 2010, partly because of the normalization of the agricultural harvest and owing to lower
2011 demand for industrial goods by Brazil. We also expect growth in private consumption and
investment to slow during the second half of the year.
The fiscal accounts are likely to deteriorate meaningfully next year. Our forecast for the
“adjusted” overall fiscal balance (excluding transfers of profits from central bank and investment
proceeds from Anses) is for it to deteriorate to -3.4% of GDP in 2011 from -2.2% in 2010.
However, because of the light amortization schedule, a low level of debt and plenty of intra-
public sector borrowing, we think the Republic’s probability of default remains well-contained.
Continued financing of public spending, via transfers of “paper profits” and advances from the
central bank to the National Treasury, is likely to keep putting upward pressure on inflation.
Capital may flee on However, in the second half of the year, with general elections approaching, locals are likely to
election uncertainties get anxious and capital flight may pick up. At that point, the authorities are likely to allow for a
“controlled” pace of depreciation, using international reserves in the process.
Figure 5. Chile investments and imports growth Figure 6. Colombia current account deficit vs net FDI
% y-o-y 3500 US$ mn Net FDI (lhs) US$ mn 0

40
CA deficit (rhs)
30 3000 -500
20 2500
-1000
10 2000
-1500
0 1500
-2000
-10 1000
Imports
500 -2500
-20 Investments
-30 0 -3000
Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-05 Apr-06 May-07 Jun-08 Jul-09
Source: Nomura Global Economics, Haver Analytics, Bloomberg. Source: Nomura Global Economics, Haver Analytics, Bloomberg.

Brazil ⏐ Economic Outlook Tony Volpon
Inflation risks challenge outlook

Overly expansive fiscal and wage policy combined with surging commodity prices have put the
inflation outlook at risk. Only tighter fiscal and wage policy will avoid higher policy rates.
Activity: After a successful recovery due to pro-cyclical fiscal policies and continued Chinese
demand for its exports, fiscal, wage and credit policy continued to be expansive even as the
economy tallied growth of over 7% in 2010. We expect growth to slow down to just below
potential in 2011 to around 4% as policy adjusts downward. Continued strong export prices will
assure a positive trade balance in 2011 even as the current account deficit stays in the 3%
region. Slower growth and eventually lower real rates will slow down the appreciation of BRL.
Inflation: At the beginning of 2010 headline inflation increased due to higher commodity
(especially food) prices, only to see collapse close to zero in the middle of the year. At the close
of 2010 we see inflation race ahead once again for basically the same reasons, which should
leave inflation for 2010 at around 5.85%, much above the 4.5% target. In 2011 inflation will
begin high again, especially due to seasonal adjustment to contracts indexed to the wholesale
IGPM index (which should rise by around 10.40% in 2010). An aggravating factor has been how
the decision to slow the nominal appreciation of BRL has allowed the recent surge in commodity
prices to pass-through. Nonetheless we expect inflation pressures to ease by Q2 2011, and as
tighter fiscal policy is executed, for the economy to slow and inflation to close the year at 4.85%,
above the 4.50% target but declining towards the end of 2011.
Policy: With a newly elected government and a new head of the Central Bank of Brazil (BCB),
policy uncertainty is high as we head into 2011. With strong headline inflation and doubts over
the execution of tighter fiscal and wage policy, the market expects an early-year rate hike. While
the risks of a hike are high, we believe the BCB will keep rates on hold to give the new
government time to tighten fiscal policy and better evaluate the international outlook. As inflation
recedes in the middle of the year and the inflation outlook improves, the BCB will be able to cut
rates towards the end of 2011 in our view.
Risks: The risks in 2011 are for higher inflation and higher policy rates in Brazil. An insufficiently
strong enough adjustment to fiscal, credit and wage policy, reverting the expansive policies
adopted after the 2008 crisis, will force the government into deciding between a mix of higher
inflation and tighter monetary policy. While a strong fiscal adjustment would be optimal, the
political constraints to its execution and the need to re-establish the monetary credibility of the
BCB may lead the government to opt to tighten policy rates early in the year, though this would
likely be reverted later in the year.
% y-o-y change unless noted 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 2010 2011 2012
Real GDP 6.5 5.5 3.6 2.8 4.3 5.2 5.2 5.8 7.4 4.0 4.9
Government expenditure 4.5 2.1 -2.3 -3.1 -1.2 -1.2 1.6 1.7 3.4 -2.0 0.5
Exports 7.5 6.6 6.8 4.4 8.3 9.4 12.3 13.8 8.7 7.2 12.2
Imports 39.7 32.6 18.3 10.5 5.1 0.3 1.4 5.4 37.4 7.9 6.5
Industry 10.4 6.4 0.5 3.6 4.2 5.2 5.2 2.9 11.1 3.5 2.8
Agriculture 10.0 13.6 11.0 4.0 5.4 -0.8 -3.0 -3.8 9.9 5.1 -7.6
Services 4.8 5.1 3.0 3.0 4.0 4.9 5.8 5.9 5.3 3.7 5.8
IPCA (consumer prices) 4.70 5.85 5.64 5.64 6.01 4.85 4.28 4.18 5.85 4.85 4.50
IGPM (w holesale prices) 7.77 10.40 8.93 7.21 6.39 5.54 5.33 5.12 10.40 5.54 4.49
Trade balance (US$ billion) 17 14 15 12 13 10 1 -3 14 10 -5

Current account (% GDP) -2.5 -3.0 -3

Net public debt (% GDP) 42.0 39.0 36
Selic % 10.75 10.75 10.75 10.75 10.00 10.00 10.00 10.00 10.75 10.00 10.00
BRL/USD 1.75 1.70 1.72 1.68 1.65 1.62 1.60 1.60 1.70 1.62 1.60
Notes: Annual forecasts for GDP and its components are year-over-year average growth rates. Trade data are a 12-month sum. Interest
rate and currency forecasts are end of period. Contributions to GDP do not include taxes. Numbers in bold are actual values, others
forecast. Table reflects data available as of 6 December 2010.

Mexico ⏐ Economic Outlook Benito Berber
A stronger recovery on the way

Mexico is rebounding stronger than expected, which should close the output gap by mid 2011.
We expect the first rise in the policy rate to come in Q1 2012.
Activity: With the prospect of the US recovery improving, we forecast the Mexican economy to
rebound by 5.3% y-o-y in 2010 and by 4.0% in 2011 after collapsing 6.5% in 2009. Indeed, we
remain optimistic on Mexican GDP growth because of the recovery of domestic demand. The
composition of growth should continue to gradually shift from the external sector to the domestic
one. In 2010, the Mexican GDP rebounded because of its strong exports to the US. Fortunately,
domestic demand in Mexico has started to pick up. In the previous two crises, growth of
consumption, which accounts for two-thirds of demand, has rebounded to around 5.0% y-o-y six
quarters after the year-over-year consumption growth bottomed. The economy bottomed this
time in Q2 2009.
Inflation: We expect inflation to be slightly below 4.0% in 2010 and 2011 due to the output gap
taking a while to close, with a more stable FX rate having a marginal impact in keeping a cap on
inflation. We estimate that administrative prices, which have been increasing at a rate of 5.0% y-
o-y in 2010, will adjust to around 3.0% y-o-y in 2011, which would push headline inflation below
4.0% y-o-y.
Policy: Banxico will keep the policy rate unchanged at 4.5% during 2011 in our view. We expect
the tightening cycle to start in Q1 2012 because of the negative output gap (actual GDP being
below potential GDP) projected for at least half of 2011, stable medium-term inflation
expectations and a gradual appreciative trend of the MXN. The Finance Ministry will target a
fiscal deficit of 2.5% of GDP in 2011, slightly higher than in 2010. Congress will likely approve
three major proposals in 2011: a) A proposal to strengthen the independent anti-trust entity. b) A
proposal to consolidate various municipal police forces into one unified police force per state. c)
A third proposal to increase the flexibility of the labor market.
Risks: The main risk to Mexico is a double dip recession in the US economy. In terms of
inflation, we see the following risks to our call: (1) rising commodity prices; (2) increases in
administrative prices; (3) an acceleration of domestic demand; and (4) a sizable depreciation of
the exchange rate.
% y-o-y change unless noted 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 2010 2011 2012
Real GDP 5.3 3.9 5.0 4.1 3.3 3.6 3.3 3.2 5.3 4.0 3.4
Government expenditure 5.3 6.2 5.8 3.5 3.8 3.6 3.4 3.4 4.5 4.2 3.4
Exports 31.6 25.0 22.9 19.5 17.5 17.0 15.6 15.0 28.4 19.0 15.6
Imports 22.4 23.1 20.1 18.8 17.5 17.0 15.5 16.0 24.2 18.3 15.6

Industry 2.3 1.3 1.5 1.4 1.3 1.2 1.0 1.0 2.0 1.3 1.0
Agriculture 0.3 0.3 0.1 0.1 0.1 0.1 0.1 0.1 0.3 0.1 0.1
Services 2.8 2.3 3.3 2.7 2.1 2.3 2.4 2.4 3.2 2.6 2.4
CPI 3.70 3.95 3.82 3.75 3.79 3.89 3.95 3.90 3.95 3.89 3.97
Trade balance (US$ billion) -3 -3 -4 -4 -5 -5 -4 -4 -4 -14 -12
Current account (% GDP) -1.0 -1.3 -1.5

Gross public debt (% GDP) 38.0 36.0 34.0
Overnight Rate % 4.50 4.50 4.50 4.50 4.50 4.50 6.50 7.00 4.50 4.50 7.50
MXN/USD 12.59 12.15 11.90 11.80 11.75 11.70 11.50 11.50 12.15 11.70 11.50
Notes: Annual forecasts for GDP and its components are year-over-year average growth rates. Trade data are a 12-month sum. Interest
rate and currency forecasts are end of period. Contributions to GDP do not include taxes. Numbers in bold are actual values, others
forecast. Table reflects data available as of 6 December 2010.

Rest of Latin America ⏐ Economic Outlook Boris Segura │Tony Volpon │ Benito Berber
Argentina: More moderate growth, but still high inflation

High inflation is likely to remain the main macro challenge to authorities.
2009 2010 2011 2012 • Argentina’s growth is likely to decelerate from its
Real GDP % y-o-y 0.9 9.0 5.0 4.7 rapid rate of growth 2010. The output gap has
Consumption % y-o-y 0.5 8.6 6.2 6.5 already closed and, as such, we are unlikely to
Gross Investment % y-o-y -10.2 17.2 9.3 11.1 see any inflation relief.
Exports % y-o-y -6.4 12.1 7.9 9.0
Imports % y-o-y -19.0 35.3 22.1 22.6 • Macro policy remains expansive and is likely to
CPI % y-o-y * 7.7 10.7 10.9 10.8 remain so until at least the general elections in
CPI % y-o-y ** 14.8 26.4 24.4 25.4 October 2011.
Primary budget balance % G 1.5 1.8 -0.5 1.0
Current account % GDP 3.7 1.8 1.3 1.0 • Inflation is the main policy challenge for the
Policy Rate % 9.52 9.23 12.0 11.0 authorities. They are likely to pursue a price-wage
USDARS 3.81 3.98 4.40 4.50 arrangement with the labor and business sectors.
* official stat, ** private estimate, Bold is actual data For this to be sustainable, the authorities would
Note: table reflects data available as of 6 December 2010. need to pursue consistent macroeconomic
Source: Nomura Global Economics. policies and promote a friendlier business
environment. That is no small feat given recent
experience and upcoming general elections.
Chile: Growth and inflation are set to accelerate

Continued strong external demand and durable goods consumption pushes growth up, but inflation is a risk.
2009 2010 2011 2012
• Chile’s economy has had a broad-based rebound
Real GDP % y-o-y 2.1 5.5 6.5 5.0 from the February earthquake, which has proven
Consumption % y-o-y 5.7 8.0 9.0 6.0 to be positive for growth, especially for durable
Gross Investment % y-o-y -11.9 20.0 22.0 18.0 goods consumption.
Exports % y-o-y -3.7 6.0 8.0 6.5
Imports % y-o-y -4.0 14.0 17.0 12.0 • Export demand has increased throughout 2010 as
CPI % y-o-y * -1.5 3.0 3.5 3.0 the prices of Chile’s commodity exports rose. This
CPI % y-o-y ** 1.5 2.5 2.7 3.0 has allowed strong growth in exports which,
Budget balance % GDP -3.4 -2.0 -1.0 1.0 alongside the appreciation of CLP, has damped
Current account % GDP 2.7 0.7 1.5 1.0 inflationary pressures even as the economy grew
Policy Rate % * 0.50 3.25 4.00 5.00 strongly.
USDCLP * 507.00 480.00 440.00 420.00
* End of period, ** Period average, Bold is actual data • The Central Bank of Chile (BCCh) has slowed the
Note: table reflects data available as of 6 December 2010. pace of monetary normalization partly because of
Source: Nomura Global Economics. fears about currency appreciation. We expect the
policy rate (TPM) to continue to rise to 4% p.a.
next year, and strong growth to lead to higher
headline inflation.
Colombia: Strong recovery

Economic recovery will likely continue in 2011 with robust FDI inflows supporting the currency.
2009 2010 2011 2012
• We have increased our GDP forecast for 2011 by
Real GDP % y-o-y 2.5 4.8 5.0 4.5 5.0% on the back of strong domestic demand. We
Consumption % y-o-y 2.0 6.0 5.0 4.5 maintain our view that the central bank will start
Gross Investment % y-o-y 3.0 10.0 8.0 9.0 the tightening cycle in Q4 2011 by increasing the
Exports % y-o-y -18.0 10.0 6.0 7.0 policy rate by 100bp to 4.0% by year-end.
Imports % y-o-y -11.4 30.0 8.0 9.0
CPI % y-o-y * 2.0 2.7 3.5 3.7 • We think Congress will probably pass a fiscal rule
CPI % y-o-y ** 4.2 2.5 3.5 3.7 to address some of the weakness in the fiscal
Budget balance % GDP -2.7 -3.6 -3.4 -3.0 accounts. We expect the three major rating
Current account % GDP -2.2 -2.5 -3.0 -3.5 agencies to upgrade the credit to investment
Policy Rate % * 3.50 3.00 4.00 7.00 during 2011.
USDCOP * 2044.00 1850.00 1760.00 1750.00
* End of period, ** Period average, Bold is actual data • Strong FDI inflows and monetization of government
Note: table reflects data available as of 6 December 2010. debt should keep COP strong. We forecast the
Source: Nomura Global Economics. COP to appreciate to 1,760 by year-end 2011.

Foreign Exchange | Outlook 2011 Simon Flint ⏐ Jens Nordvig
A global balancing act

Stronger EM currencies are crucial to global rebalancing, but cannot be taken for granted.
We see the US dollar The US dollar is set to consolidate in 2011 versus other major currencies (Figure 1). This view is
consolidating against based on the notion that a number of negatives, which drove US dollar weakening dynamics in
major currencies 2009 and 2010 are fading. First, the effect from the latest round of quantitative easing (QE2) has
already been incorporated in market pricing. Second, with growth set to increase and inflation
expectations currently close to the Fed’s preferred level, we find it unlikely that a “QE3” will be
needed. Third, the US dollar has weakened broadly and is looking cheap from a valuation
perspective against many currencies, especially in the G10 space (Figure 2). While some
negative pressure will likely abate, there is no structural growth recovery in the US to underpin
currency strength. Indeed, the housing market remains very weak, and with households still
deleveraging and fiscal policy set to impact growth negatively, the US economy is set to recover
slowly. Hence, we believe that dollar consolidation is more likely than a real recovery in the
aggregate. We are likely to see USD gains in selected crosses, while USD weakness can
extend versus EM.
A risk premium is set The euro has weakened in 2010 as a function of fiscal tensions in the periphery. We do not see
to weigh on the euro a clear resolution of the euro area fiscal crisis. The ongoing uncertainty will be a major factor
weighing on the euro and a drag on the currency, which is likely to be reflected in a persistent
risk premium (Figure 3). However, our baseline view is that Spain will gradually regain bond
market access in H1 2011 by delivering on its current fiscal targets. Moreover, we believe that
the political commitment towards monetary union will hold, and we regard the tail risk of an
ultimate break-up of the euro zone as being small. Thus, we expect downside to the euro to be
relatively limited from currently levels where a significant risk premium has already been
embedded. This implies that we expect euro to trade in a relatively tight range against the US
dollar next year as a result.
The Japanese yen is We expect the Japanese yen to trade in the low 80s against the US dollar in the early part of
sensitive to the 2011. This view is based primarily on the still relatively weak economic outlook for the US and
outlook for US rates large excess capacity in the US economy, which should keep US interest rates anchored at low
levels (also due to QE2). Looking further into 2011, we expect the yen to edge higher against
the US dollar towards 85, as US 2-year rates edge higher.
We see sterling With respect to sterling, we expect a gradual recovery versus G3 currencies after three year’s
recovering gradually of underperformance. Fiscal consolidation is set to reduce the risk premium on the pound, while
we think growth will hold up sufficiently well to avoid further QE. This should see the British
pound recover from a weak starting point versus the dollar, the euro and the Japanese yen.
Figure 1. Nomura’s major FX forecasts out to end-2012

Q4 10 Q1 11 Q2 11 Q3 11 End 2011 Q1 12 Q2 12 Q3 12 End 2012
Spot old new old new old new old new old new old new old new old new old new
(DXY) 80.1 80.7 79.1 78.4 78.3 78.3 79.0 79.7 80.4 81.1
(USD/JPY) 83.7 82.5 82.5 80.0 80.0 82.5 82.5 85.0 85.0 85.0 85.0 85.0 86.3 85.0 87.5 85.0 88.8 85.0 90.0
(EUR/JPY) 111 111 107 108 106 114 111 117 115 115 115 115 115 115 116 115 116 115 117
(EUR) 1.32 1.35 1.30 1.35 1.32 1.38 1.34 1.38 1.35 1.35 1.35 1.35 1.34 1.35 1.33 1.35 1.31 1.35 1.30
(CHF) 0.99 1.04 1.03 1.04 1.05 1.03 1.06 1.04 1.06 1.07 1.07 1.07 1.07 1.07 1.08 1.07 1.09 1.07 1.09
(EUR/CHF) 1.31 1.40 1.34 1.40 1.38 1.42 1.42 1.43 1.43 1.44 1.44 1.44 1.44 1.44 1.43 1.44 1.43 1.44 1.42
(GBP) 1.56 1.63 1.57 1.67 1.63 1.73 1.68 1.75 1.71 1.73 1.73 1.73 1.73 1.73 1.72 1.73 1.72 1.73 1.71
(EUR/GBP) 0.85 0.83 0.83 0.81 0.81 0.80 0.80 0.79 0.79 0.78 0.78 0.78 0.78 0.78 0.77 0.78 0.77 0.78 0.76
(AUD) 0.98 0.98 0.94 1.00 0.96 1.00 0.98 1.00 1.00 1.00 1.02 1.00 1.02 1.00 1.02 1.00 1.02 1.00 1.02
(CAD) 1.00 0.97 0.99 0.99 0.97 0.99 0.97 0.99 0.99 1.00 0.99 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00
(NZD) 0.76 0.78 0.75 0.80 0.77 0.81 0.80 0.82 0.82 0.82 0.84 0.82 0.84 0.82 0.84 0.82 0.84 0.82 0.84
(EUR/NOK) 8.01 7.90 7.90 7.80 7.80 7.70 7.60 7.70 7.60 7.70 7.70 7.70 7.70 7.70 7.70 7.70 7.70 7.70 7.70
(EUR/SEK) 9.13 9.00 9.00 8.90 8.90 9.00 8.80 9.00 8.90 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00
(CNY) 6.65 6.60 6.60 6.50 6.50 6.40 6.40 6.30 6.30 6.22 6.22 6.14 6.14 6.06 6.06 5.98 5.98 5.90 5.90
Note: “Old” is as published in the FX weekly on 15 November.
Source: Nomura Global FX Research.

We see a gently We believe the outlook for Emerging Market and commodity currencies to be gently positive for
positive outlook for 2011. This assessment is based on a consistent historical pattern of returns during similar points
risky currencies in the cycle. However, there are a number of risks to our constructive core scenario. The
situation in the Eurozone is one of the most important, as is a too-slow move towards greater
currency flexibility in China.
In Emerging Asia In Emerging Asia, some major themes are likely to dominate. First, capital inflows into
capital inflows may Emerging Asia should remain strong, driven by low interest rates in the US and many other
prompt more controls developed nations, at the same time as Asia growth should outperform. Second, the authorities
are likely to respond to these strong inflows by stepping up capital controls, although we expect
such capital controls to have only a limited impact in stemming Asian FX appreciation.
We see the Renminbi We expect appreciation of the Renminbi (CNY) against the US dollar to continue over the
at 6.22 to the US medium term, towards 6.22 by end-2011. Fears of a hard-landing in China have fallen markedly
dollar by end-2011 and we expect increased demand for CNY from the fast-paced FX liberalization and global
political pressure on China to remain. Against that backdrop, CNY should continue to appreciate
next year.
EEMEA is likely to One theme in EEMEA (Emerging Europe, Middle East and Africa) is a distancing of the region
avoid “currency from the first round of the notion of currency wars. We expect a broad lack of aggressive
wars” currency policy from EEMEA policymakers, and certainly no capital controls. We expect a far
more subtle, “post-modern” policy response (see EEMEA Outlook 2011 in this issue). The one
partial exception to this is South Africa, which we believe will more aggressively accumulate
reserves in 2011 and relax outflow exchange controls. In general, we expect continued
appreciation pressures on the back of inflows by global investors, albeit not at quite the pace
that occurred in 2010. Tighter fiscal and monetary policy should also aid this move, although,
while developed market policy rates looks set to remain low, we must watch longer-term yields
closely. Policy credibility and the progress of fiscal policy will also be important for Poland and
Hungary's currency moves in particular, where these issues are most pressing. Turkey’s
continued limbo dance of widening the offshore/onshore rate should add complications there,
while we expect Russia's undervaluation in a bullish commodity market to catch up with it.
LatAm currencies
Latin American exchange rates are under pressure from a variety of sources. With currencies
remain attractive
appreciating since the start of 2009, further quantitative easing by the Fed has led to a further
influx of capital. But this time authorities in the region are fighting back, by slowing the pace of
expected monetary tightening (all countries), intervening to buy US dollars (Brazil, Colombia and
Mexico), or by imposing capital controls (Brazil). Latin American currencies remain attractive, in
our opinion, despite risks of slower growth in the developed world, supported, for example, by
continued strong terms of trade. Essentially, how each country in the region responds to the
inflation threat will largely determine the currency and rates outlook for 2011.
Figure 2. Real FX rates vs. 20yr avg (against US dollar) Figure 3. Euro risk premium
% %
60 14
USD overvalued
50
40 12
30
10
20
10 8
0
-10 6
-20
4
-30
-40 USD undervalued 2
-50
0
GBP
NZD
TWD
INR
BRL
CHF
NOK
AUD
CAD
EUR
SEK
JPY
MXN
KRW
Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10
Note: Inflation adjusted; red dots are current valuation vs 20-year Note: the measure of the euro risk premium is based on the first
average; grey lines represent 20-year range in valuation. principal component of 10 European sovereign spreads corrected
Source: Nomura Global FX Research. for the general credit environment.
Source: Nomura Global FX Research.

Equity Market ⏐ Outlook 2011 Ian Scott
Reducing the risk premium

We expect the recovery in global equities to continue in 2011. Multiples have contracted in 2010
as the 8% total return to date has lagged the recovery in EPS. Lower bond yields mean that
there has been a big expansion in equity risk premiums and a reduction in implied growth rates.
The risk premium The 6% risk premium now embedded in global equities seems inappropriately high to us
looks too high compared with current volatility and credit spreads. As Figure 1 and Figure 2 indicate, the risk
premium embedded in equity valuation stands out as one of the highest of the past 20 years, yet
both volatility and credit spreads are at “normal levels”. This suggests that stocks are priced for
risks that other assets are not.
Valuations look too We expect earnings to continue growing in 2011. The recovery described by Figure 3 has been
pessimistic on much closer to a “V” than most had been expecting as they looked ahead to 2011. Current
earnings growth equity valuations imply medium-term growth rates close to zero, a scenario that is at odds with
the recovery over the past year and with recent quarterly earnings. We forecast earnings growth
of 16% in 2011, and a total return of 20% (Figure 4).
Asset allocations reflect continuing risk aversion, with investors heavily exposed to fixed-income
assets and relatively underexposed to equities and cash.
With valuations attractive and earnings set to continue growing, we expect asset allocators in
developed economies to respond by allocating more assets to equities in 2011.
Figure 1. Global equity risk premium* and implied volatility Figure 2. Global equity risk premium* and credit spreads
% Implied Volatility % Percentage points

10 70 10 8
9 9 7
60
8 8
Global Equity Risk Premium (lhs) 50 Global Equity Risk Premium (lhs) 6
7 7
6 6 5
40
5 5 4
4 30 4 3
3 20 3
2
2 2
10 1
1 1
Implied Volatility, VIX (rhs) Credit spread (lhs)
0 0 0 0
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
*Calculated by taking the normalised earnings yield less the *Calculated by taking the normalised earnings yield less the
(equity) weighted global sovereign real yield (nominal 10 year yield (equity) weighted global sovereign real yield (nominal 10 year yield
less contemporaneous headline inflation). less contemporaneous inflation) ** US BAA-AAA
Source: CBOE, MSCI, Nomura Strategy research. Source: Moody's, MSCI, Nomura Strategy research.
Figure 3. Global EPS: actual, trend and consensus Figure 4. Global EPS growth forecasts
Index Jan 1988 = 100

500 2010 2011 2012
450 US1 39% 15% 17%
400 Europe x UK2 28% 15% 15%
12m Forw ard
350 UK3 76% 10% 13%
Consensus Earnings Asia Ex Japan2 36% 17% 11%
300
250 Japan4 160% 27% 9%
Trend Emerging Markets2 29% 16% 16%
200
Global2 35% 16% 15%
150
100 EPS forecasts
50 Trailing 4 Quarter Earnings S&P Operating EPS 84 96 113
0 Topix Yen 50 64 69
1970 1975 1980 1985 1990 1995 2000 2005 2010
1 3
Source: MSCI, IBES, Nomura Strategy research. S&P Operating Earnings FTSE 100
2 4
FTSE All World Regional Indices Topix
Source: Nomura Strategy research.

We are reducing Regionally, we are reducing exposure to emerging markets as policy tightening and an already-
exposure to EM heavy inflow of capital limit the scope for further asset price gains (Figure 5). Earnings revisions
in recent months have moved to favour developed markets over emerging markets, while risk
premia for emerging markets are slightly below that for developed markets. We still expect
positive returns in emerging markets, but underweight the region in a global context (Figure 6).
We are increasing We are increasing exposure to Japanese and US equities because we think both regions will
exposure to Japan likely continue to benefit from loose monetary policy and the aforementioned asset shift, while
and the US equity valuations in Japan look especially appealing. Japanese companies are currently
generating a significant amount of free cash flow, and the high level of dividend cover should
mean that dividends should increase (Figure 7).
We are neutral on Earnings momentum has moved to favour the US relative to Europe and policy should also help
Europe the US market relative to Europe over the next year. Although we think the European market
has overreacted to the likely impact of the sovereign debt crisis, it is an additional source of risk
for the market and we are neutral on Europe.
We like sectors that In terms of sectors, we overweight those areas of the market that are robust to rising inflationary
are robust to inflation pressures and higher bond yields (Figure 8). If stock prices and bond yields rise, Financials
and rising yields should outperform. Banks have not responded to the improvements in credit quality, while
capital raising is past its peak and should be less of a concern.
Organically growing We think that sectors that can grow organically should also do well. The large amounts of free
sectors should do cash flow being generated and high levels of profitability, coupled with the low return on cash,
well should provide a strong incentive for companies to reinvest in their businesses. With capex low
and free cash plentiful, we like “B-to-B” exposure; we overweight the Tech sector and Media
sector as we expect these sectors to benefit from increased corporate spending.
We avoid cyclicals We underweight the traditional cyclical sectors that we find expensive and defensive sectors
and defensives such as consumer staples and utilities, given our bullish view on the market.
Figure 6. Developed and Emerging Equity markets’ sensitivity

Figure 5. Recommended regional allocation*
to bond markets
Correlation
1.0 EM stock-bond correlation
0.8
Previous Recommended
Benchmark Recommendation 0.6
Weighting Weighting
0.4
0.2
North America 44 36 46 Overweight
0.0
Europe Ex-UK 18 21 18 Neutral -0.2
UK 9 9 9 Neutral -0.4
Japan 8 8 14 Overweight -0.6
Asia Ex-Japan 8 9 5 Underweight -0.8
-1.0 Developed markets stock-bond correlation
Emerging Mkts 13 17 8 Underweight
Nov-98
Nov-99
Nov-00
Nov-01
Nov-02
Nov-03
Nov-04
Nov-05
Nov-06
Nov-07
Nov-08
Nov-09
Nov-10
*Benchmark: FTSE All-World (US$); units: % weighting. Source: Nomura Strategy research.
Source: Nomura Strategy research.
Figure 7. Japanese and world ex-Japan non-financial

Figure 8. Global EPS growth forecasts
companies’ free cash flow yields
% 0.4
B e ne f it f ro m de f la t io n
12 Co n Cyc 0.3
performance and US real rates
10 World ex Japan
Correlation of relative sector
Healthcare B e ne f it f ro m re f la t io n
8 0.2
6 0.1 Insurance
4 Co n Staple B anks
2 0.0
Utilities M edia
0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0
-0.1 Energy Cap Go o ds
-2 Teleco
Tech
-4 Japan -0.2
-6
-0.3
-8 B asic Industries
Jan-88
Jan-89
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
-0.4
Correlation of relative sector performance
w ith changes in US inflation expectations
Source: Worldscope, Nomura Strategy research. Source: Nomura Strategy research.

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2011 Global Economic Outlook

NOMURA GLOBAL ECONOMICS

Rocky Road of Recovery

Nomura Securities International Inc.

Nomura Global Economics 1 6 December 2010

EMERGING EUROPE, MIDDLE EAST AND AFRICA

Nomura Global Economics 2 6 December 2010

Nomura Global Economics 3 6 December 2010

Our View on 2011 in a Nutshell

Nomura Global Economics 4 6 December 2010

One year on: a 2010 forecast post-mortem Paul Sheard

16-Dec-09 2.8 1.9 1.2 2.0 -1.3 3.9 6.3 4.4

16-Dec-09 3.28 0.13 1.25 0.75 0.10 5.45 6.04 8.84

16-Dec-09 3.80 3.70 4.60 1.55

$/€ $/£ ¥/$ RMB/$ TRY/$ BRL/$

Nomura Global Economics 5 6 December 2010

Global ⏐ Outlook 2011 Paul Sheard

A rocky road of recovery

Two-track recovery to continue

Developed economy headwinds

% y-o-y Index, Q1 2008 = 100

Nomura Global Economics 6 6 December 2010

QE: Back to basics, again Paul Sheard

Nomura Global Economics 7 6 December 2010

GEMaRI: Brave new world Peter Attard Montalto

Figure 1. Nomura’s GEMaRI index

Source: Nomura Global Economics.

Nomura Global Economics 8 6 December 2010

2010 2011 2012 % GDP

Contributions to growth (pp): 6

Nomura Global Economics 9 6 December 2010

Nomura Global Economics 10 6 December 2010

Risks to the forecast

Nomura Global Economics 11 6 December 2010

Global politics outlook 2011 Alastair Newton

• Other top “issues” to follow (in alphabetical order):

o Argentina: After Kirchner;

Nomura Global Economics 12 6 December 2010

United States ⏐ Outlook 2011 David Resler

Debt hangover limits recovery

The debt reckoning continues

% q-o-q ar Index, time, t = 100

t-4 t t+4 t+8 t+12 t+16 t+20

Nomura Global Economics 13 6 December 2010

Household deleveraging Zach Pandl

Nomura Global Economics 14 6 December 2010

Improving, but still slow, job growth

$trn Index (100 at time t)

Nomura Global Economics 15 6 December 2010

The output gap Aichi Amemiya

% % output gap based on the

3.5 CBO's estimate -6 -6.1

Nomura Global Economics 16 6 December 2010

The new fiscal debate David Resler

10 Share of taxes paid

Nomura Global Economics 17 6 December 2010

A lower level of potential output

$ 000s percentage points, ar

Nomura Global Economics 18 6 December 2010

Fed policy in the crosshairs David Resler

Nomura Global Economics 19 6 December 2010

Firmer turf on the recovery road