Lloyds World Economic Quarterly 2Q2011

WORLD ECONOMIC QUARTERLY
SECOND QUARTER 2011

CONTENTS
CONTENTS
Foreword 2
G10 Economic Outlook 3
E10 Economic Outlook 4
G10 country summaries:
US 5
Japan 6
Euro Area 7
Germany 8
France 9
Italy 10
Spain 11
Netherlands 12
Canada 13
Australia 14
E10 country summaries:
China 15
Brazil 16
India 17
Russia 18
Mexico 19
South Korea 20
Turkey 21
Poland 22
Indonesia 23
South Africa 24
Lloyds Bank Corporate Markets contacts
CONTRIBUTORS
Jeavon Lolay
Director of Global Economics
T: +44 (0)20 7158 1742
E: jeavon.lolay@lloydsbanking.com
Mark Mil ler

Senior Global Macroeconomist
T: +44 (0)20 7158 2141
E:mark.miller2@lloydsbanking.com
Sian Fenner EDITORIAL COMMENTS TO:

Global Macroeconomist
T: +44 (0)20 7158 3975 Trevor Williams
E: sian.fenner@lloydsbanking.com Chief Economist
Lloyds Bank Corporate Markets
Jennifer Lee Economic Research
Graphic Designer 10 Gresham Street
T: +44 (0)20 7158 1744 London, EC2V 7AE
E: jennifer.lee@lloydsbanking.com T: +44 (0) 20 7158 1748
th 1
Lloyds Bank Corporate Markets WEQ - 14 APRIL 2011
FOREWORD
WATCH OUT, INFLATION’S ABOUT... CHART A: E10 GDP growth outperformance to continue...
Global output is now back above its pre-crisis peak. Driven % YoY
by robust expansion in world trade volumes, global GDP 10 Forecast
growth this year is expected to remain strong at 4.3%, 8 E10
following last year’s outturn of 4.7%. However, recent events 6
highlight that the ongoing recovery cannot be taken for
4
granted. Major uncertainties remain – most notably the
2
sovereign debt crisis in the euro area, serious unrest in the G10
0
MENA region and soaring commodity prices - particularly
-2
crude oil. Then there are the more predictable features that
follow a sharp slowdown – the normalisation of policy – -4
both fiscal and monetary. Here, the return of inflation has -6

2008 2009 2010 2011 2012
put added pressure on central banks to raise interest rates.
In many countries, fiscal tightening will start in earnest during Source: LBCM
2011, with the US and Japan important outliers holding back
on medium term consolidation plans. But conditions will CHART B: ...putting upward pressure on CPI inflation
be most acute in the euro area ‘periphery’.
Annual average change %
The continuing contrast in growth between the developed 8
and emerging economies is also creating new challenges. G10 E10 World
Our G10 grouping is predicted to grow by 2.3% in 2011,

6
while our E10 grouping is forecast to expand by 7.1%. Output
gaps have either almost closed or become positive in many
emerging markets, while significant spare capacity remains 4
in the major developed economies. It is now soaring inflation

that dominates concerns in the emerging markets, not growth. 2
However, real interest rates are still close to historical lows
and we expect significant further monetary tightening. This is 0
likely to lead to further upward pressure on their exchange 2010 2011 2012
rates. However, any appreciation should be gradual as Source: LBCM
policymakers also deal with the problem of continuing strong
capital inflows.
There is also a decent chance that global growth could prove stronger than we expect in 2011. Commodity price trends
will have a major say, particularly energy and food. Policymakers, especially in the emerging markets, could also keep
interest rates too low, encouraging domestic demand but risking medium-term prospects. In the developed economies,
the bounceback in Japan during the second half of 2011 could prove stronger than we currently expect. What is clear is
that ongoing volatility in currency, interest rates and asset markets is almost assured, reflecting the wide differentials in
economic performance and policy stance across countries.
Key macroeconomic forecasts for our G10 & E10 groupings

GDP growth % CPI inflation % GDP growth % CPI inflation %
2009 2010e 2011f 2012f 2009 2010 2011f 2012f 2009 2010e 2011f 2012f 2009 2010 2011f 2012f
World -0.8 4.7 4.3 4.6 2.2 3.4 3.0 2.1

G10 -3.5 2.6 2.3 2.7 0.0 1.4 2.4 1.9 E10 3.2 7.9 7.1 6.9 4.4 5.4 5.8 4.6
US -2.6 2.9 3.2 3.3 -0.3 1.6 2.7 2.3 China 9.2 10.3 9.3 8.8 -0.7 3.3 4.7 3.9
Japan -6.3 4.0 0.8 2.5 -1.4 -0.7 0.3 0.5 Brazil -0.7 7.5 5.0 4.6 5.7 4.9 5.0 5.6
Germany -4.7 3.5 2.4 2.0 0.3 1.1 2.4 1.9 India 7.0 8.6 8.1 8.3 8.3 12.0 7.9 4.8
UK -4.9 1.4 1.5 2.3 2.2 3.3 4.3 2.3 Russia -7.9 4.0 5.3 5.2 14.1 11.7 6.9 8.6
France -2.5 1.5 1.6 1.8 0.1 1.5 2.1 1.9 Mexico -6.1 5.5 4.6 4.9 5.1 5.3 4.2 4.1
Italy -5.1 1.1 1.1 1.2 0.8 1.5 1.8 2.2 South Korea 0.3 6.2 4.3 4.9 4.7 2.8 3.0 4.4
Spain -3.7 -0.1 0.6 1.1 -0.3 1.8 2.9 1.6 Turkey -4.8 8.9 6.5 4.7 9.8 4.8 5.1 6.7
Canada -2.5 3.1 3.2 3.0 0.3 1.8 2.4 2.0 Poland 1.7 3.8 4.0 4.4 4.3 3.8 2.7 3.8
Australia 1.3 2.7 3.2 4.3 1.8 2.8 3.2 3.0 Indonesia 4.6 6.1 6.4 6.0 9.8 4.8 5.1 6.7
Netherlands -3.9 1.7 1.7 1.9 1.2 1.3 2.1 1.8 South Africa -1.7 2.8 3.7 4.2 9.9 7.1 4.3 4.6
Source: Bloomberg Source: Bloomberg
2 th
WEQ - 14 APRIL 2011 Lloyds Bank Corporate Markets
G10 ECONOMIC OUTLOOK
OIL PRICE RISE PROMPTS DOWNGRADE TO G10 PROSPECTS
There have been a number of new events and risks which
shape our view of the G10 region. The recent application CHART A: G10 GDP growth - US & Australia lead the
way
by Portugal for EU financial assistance, the Japanese
%Yr
earthquake and its after-effects together with geopolitical 5
tensions in the MENA region are obvious examples. And 4.5 2011
4 2012
related to this, there has been a particularly sharp back-up
3.5
in crude oil prices to highs not seen since mid-2008. Our 3
G10 GDP growth forecast for this year has been lowered to 2.5
2.3% compared with an outturn in 2010 of 2.6%. 2
1.5
Within our G10 forecast we see a pick-up in US economic 1
activity to 3.2% compared with 2.9% last year. The overriding 0.5
0
theme is expected to be one where US consumer activity is a ia y e s
US an ad al an UK anc ly ai
n nd
p n str erm I ta Sp rla
supported by low interest rates, higher asset prices and Ja Ca Fr
Au G t he
crucially, improving labour market conditions. By contrast, Ne
Source: LBCM
we see economic activity in Japan slowing sharply from the
4.0% pace set last year. Our GDP projection for 2011 is just
0.8%, partly reflecting the impact of the recent earthquake CHART B: ‘Peripheral’ euro yields have been very volatile
and its after-effects. The euro area is also likely to register
10yr yield spread over German bunds, bp
slower GDP growth this year, with our 2011 forecast at 1.5% 1000
versus last year’s outturn of 1.7%. 900
800
Despite recent encouraging signs from ‘core’ countries such
700
as Germany, we perceive downside risks to euro area 600
growth stemming from high long-term interest rates in so- 500
called ‘peripheral ’ countries, despite the recent decision 400
300
by Portugal to seek EU financial assistance. A poorly-
200
received EU summit on 24-25 March, for example, failed
100
to finalise a permanent mechanism to resolve any future 0
sovereign debt crises in the euro region. And financial Apr 10 Jun 10 Jul 10 Aug 10 Oct 10 Nov 10 Dec 10 Feb 11 Mar 11
Greece Ireland Portugal Spain Italy UK France
markets remain alert to possible ‘contagion’ risks, watching
Spain very carefully for any signs that it may be deviating Source: LBCM
from its (thus far encouraging) fiscal consolidation path.
Our G10 GDP forecast for 2012 - of 2.7% - envisages an improvement compared with this year’s expected outturn of 2.3%.
We see a modest pick-up in US activity to 3.3%. In part, this reflects the lagged impact of higher energy costs on
households’ real pay, despite a more meaningful fall in unemployment. However, business investment looks set to recover
quite smartly. Another country providing substantial support to growth in the G10 next year is Australia, where we see 2012
GDP at 4.3% versus an expected 3.2% in 2011. In the euro area, meanwhile, we look for a modest pick-up in growth to
1.7% next year as the process of fiscal consolidation continues. Finally in Japan, some rebound in 2012 GDP seems likely
from a very low base this year. Our forecast stands at 2.5% from a projected 0.8% expansion this year.
Meanwhile, we expect CPI inflation in the G10 to accelerate this year, averaging 2.4% versus a relatively benign outturn of
1.4% in 2010. Next year, however, our CPI forecast stands at 1.9%. The main theme for this year and next is the powerful –
but temporary – impact of rising food and energy costs pushing up on inflation. In 2012, however, we see this process
being essentially reversed as base effects unwind and spare capacity in various economies starts to bear down on price
pressures. In Germany, for example, we see CPI inflation averaging 2.4% this year against an outturn of 1.1% in 2010,
before decelerating to 1.9% next year. We expect a similar pattern in a number of other Continental European countries.
In Japan, after two years of deflation measured on a year-average basis, we see a return to positive CPI this year (0.3%),
followed by a 0.5% outturn in 2012. Finally, we see US CPI averaging 2.7% this year, up from 1.6% in 2010, prior to a
moderation during 2012, to 2.3%.
th 3
E10 ECONOMIC OUTLOOK
ACCELERATING INFLATION A MAJOR THREAT
The E10 recorded a 7.9% rise in GDP for 2010 and, with the
CHART A: EMEA growth to strengthen but lag other
recovery firmly in place, attention has turned to removing the
E10 regions
very expansionary policy measures implemented during the %
global financial crisis. In particular, a number of economies, 10 BRICS
EMEA
notably the BRICs and emerging Asia, are facing strong 9 Emerging Asia
8
inflationary pressures, driven by buoyant demand and rising
7
commodity prices. Inflation for the E10 as a whole is forecast
6
to rise by 5.8% this year, from 5.4% in 2010. 5
4
China’s Premier Wen has noted that controlling inflation will
3
be important to sustaining households’ spending power. This
2
is the key challenge facing Chinese authorities this year with
1
consumer prices forecast to hover at or above 5% for the next 0
couple of months and to average 4.7% in 2011. In India, 2010 2011f 2012f
Source: Haver & LBCM
inflation has accelerated in recent months and is expected to
average 7.9% this year - our highest rate in the E10 grouping.
CHART B: Interest rates to head higher across the BRICs
With consumer price inflation above target in most E10 countries, in 2011
we look for further monetary policy tightening this year. While %
most countries have only begun to raise interest rates from their 16 forecast
Brazil
emergency lows, Brazil and India have been aggressively raising 14
rates since early 2010, with more hikes forecast over the next 18- 12
months. In addition to rate hikes, other monetary policy tools, 10

such as raising bank reserve ratios, will continue to be used as India Russia
8
countries attempt to limit further appreciation in their currencies. 6
Brazil and Indonesia have also used taxes on foreign capital 4 China
inflows to stem the appreciation of their currency. But in the case
2
of Brazil, this has been met with limited success as USD/BRL has
0
recently fallen to a decade-low of below 1.57. Dec 06 Dec 07 Dec 08 Dec 09 Dec 10 Dec 11

Although tighter fiscal and monetary policies within the E10
group are expected to see economic growth moderate to 7.1%
this year, if realized, it will be the second consecutive year of above trend growth. The BRICs are forecast to lead the way,
particularly China and India, which we predict to grow by 9.3% and 8.1% respectively. Indonesia and South Korea are also
expected to make strong contributions. Meanwhile, despite the improved economic outlook for Poland and South Africa, their
real GDP growth is forecast to lag the average performance of the Asian and Latin American countries.
In 2012, E10 GDP growth is forecast to slip slightly to 6.9%. We see a further slowing in growth in China, as government policies
continue to focus on shifting economic growth away from the export sector and towards household consumption. But at 8.8%
this will still remain above the latest 5-year government growth target of 7%. Solid growth in China is expected to continue to
support trade not only within the region but also with commodity-driven countries such as South Africa, which is benefiting from
China’s increasing appetite for coal. Meanwhile, despite Indian interest rates rising to a peak of 8% next year, we expect
increased infrastructure investment in 2012 to support another solid year of above 8% GDP growth (8.3%). Strong investment
is also forecast to underpin 4.6% GDP growth in Brazil, while robust global demand for oil and gas is expected to drive growth
of 5.2% in Russia. In Poland, we look for growth to accelerate to 4.4% in 2012, from 4.0% this year, despite continued fiscal
consolidation. Turkish GDP is forecast to grow by a solid 6.5% this year, albeit the prospect that the current account could
breach 8%, represents a major vulnerability to the economic outlook.
Overall, the key challenge faced by the E10 this year is controlling inflation. As well as continued strong growth, adding further
pressure is the risk that oil prices remain at or rise above their current levels. In this event, we would expect inflation to be
significantly higher than forecast, potentially yielding a softer outlook for consumer spending and business investment.
4 th
Jeavon Lolay
US +44 (0)20 7158 1742
jeavon.lolay@lloydsbanking.com
ENCOURAGING SIGNS OF SELF-SUSTAINING RECOVERY

• The economy has responded well to the additional stimuli provided by the government and Federal Reserve in late 2010.
The manufacturing and non-manufacturing ISM surveys have both rallied sharply higher, signalling buoyant activity, while
jobs growth has picked up noticeably in recent months and the unemployment rate has fallen to a two-year low of 8.8%.
However, the twin global shocks of the serious unrest in the MENA region, which has pushed crude oil prices sharply higher,
and a catastrophic earthquake off the coast of Japan has dented momentum recently. This is most acutely reflected in a
sharp drop in US consumer confidence and a noticeable pull back in capital spending by firms. Housing market data have
significantly disappointed at the start of 2011, highlighting a key vulnerability to the economic outlook.
• Annualised GDP growth in the first quarter of 2011 now looks likely to slow below the 3.1% pace in Q4 2010, leading to a
small downgrade to the generally optimistic full year growth predictions at the start of the year. However, we believe the
recovery is more self sustaining this year and the growing realisation of this will bolster consumer and business confidence
over the coming months. We forecast average real GDP growth of 3.2% in 2011, up from 2.9% last year, as strengthening
private final demand more than makes up for a markedly reduced contribution from stockbuilding. Nevertheless, significant
downside risks to the outlook remain and recovery cannot as yet be taken for granted.
• Household spending has been the main driver behind economic growth in recent quarters, rising at an annualised pace of
4% in Q4 2010. A timely tax boost from the additional fiscal stimulus last year has partly shielded disposable incomes from
rising food and gasoline prices, but consumer confidence slumped to a three month low in March. Nevertheless, prospects
appear favourable for household spending, supported by continuing low interest rates, higher asset prices and an improving
labour market. The key concerns are the fragile housing market, with sales and construction activity back in the doldrums,
and the worrying uptrend in oil prices. We look for household spending to grow by 3.4% in 2011, up from 1.7% in 2010.
• Corporate profitability has held up remarkably well during the downturn and should ultimately provide a key catalyst to
growth. Surveys show strong orders and buoyant production in both manufacturing and services, leading firms to become
more positive about capital spending and hiring. To date, business spending has been led by larger companies with access
to capital markets, but should broaden out as recovery progresses and access to funding improves. Although the recent
heightened global uncertainty appears to have weighed heavily on capital spending in the first quarter, we expect business
investment, particularly in equipment and software, to rebound strongly in the coming quarters.
• While US exports should continue to benefit from robust global growth, strengthening domestic demand and high oil
prices will limit the contribution to GDP growth from net trade as imports rise. The contribution from stockbuilding is likely
to be modest this year. Government consumption is forecast to turn modestly negative in 2011, with fiscal consolidation
unlikely to start meaningfully until 2012 at the earliest. The deficit is large and likely to dominate headlines but pressure for
a medium-term resolution is not immediate. But some state governments face extremely difficult circumstances in 2011.
• Looking at inflation, the underlying rate (core CPI) has edged above 1% and is forecast to trend higher. Our forecast shows
an average of 1.6% for this year and 1.9% in 2012. Headline CPI is seen at 2.7% and 2.3%, respectively. While the extent of
resource slack argues for monetary policy to remain stimulative for now, there is a strong case to say that emergency levels
may soon no longer be appropriate as the recovery becomes self sustaining. We look for the Fed to complete its QE2
programme by end-June 2011. The first hike in the fed funds rate is expected in Q4 2011, rising to 2.25% by end-2012.
CHART: Labour market conditions are improving TABLE: Key US macroeconomic forecasts
Monthly change, 000s Four-week ave, 000s

US (Yr % chg unless stated) 2009 2010e 2011f 2012f
400 700 Real GDP -2.6 2.9 3.2 3.3
200 650 Household consumer spending -1.2 1.7 3.4 3.3

600 Gross investment -16.1 4.7 7.1 8.5
0
Private sector 550 Government consumption 1.9 1.0 -0.7 -0.6
-200 payrolls, LHS 500 Exports -9.5 11.8 7.8 9.1
-400 450 Imports -13.8 12.7 7.7 8.8

400 Industrial production -9.3 5.7 4.6 4.7
-600
350 Unemployment rate (%, Q4) 10.0 9.6 8.2 7.8
Initial
-800 jobless claims, RHS CPI -0.3 1.6 2.7 2.3
300
-1000 250 Budget balance % GDP (cal yr) -10.4 -10.2 -9.0 -7.5
2001 2002 2003 2004 20052006 2007 2008 2009 2010
Current account % GDP -2.7 -3.2 -3.9 -3.9
Source: Datastream
th 5
Jeavon Lolay
JAPAN +44 (0)20 7158 1742
BACK INTO RECESSION, UNCERTAIN OUTLOOK

• With a sharp slowdown in economic growth already on the cards, a catastrophic earthquake and tsunami on the north eastern
coast of Japan in March has added a more worrying dimension to the outlook. At this still early stage, it is clear that there has been
significant human cost, temporary infrastructure and power damage and potentially serious environmental consequences from the
ongoing nuclear fallout.The immediate focus has turned to the crippled nuclear power station in Fukushima, with the severity rating
now at the highest level and the same as Chernobyl in 1986. The final consequences are difficult to assess but are likely to be
substantial both for confidence, domestic and external demand. We expect the economy to contract in the first half of 2011,
followed by a rebound in the second half as government and private sector reconstruction activity take hold. On balance, the
economy is estimated to grow by 0.8% this year (0.3pp below our pre-quake forecast), then by 2.5% in 2012 (up from 2.3%).
• Japanese economic growth averaged 4% in 2010 - the fastest rate since 1990, albeit following a sharp 6.3% contraction
in 2009. The rebound was underpinned by a marked recovery in global trade and stockbuilding, and supported by a series
of government initiatives to boost household consumption. However, the economy shrank by 0.3% in the final quarter of
2010, as consumer spending slumped and investment growth tailed off. The likely contraction in the first quarter of this year
will therefore mark a return to recession for Japan, with the fall in output projected to be much larger in the second quarter.
• However, the policy response to the earthquake has also been sizeable, via fiscal, monetary and exchange rate support. The BoJ
was swift to provide emergency funding and has since adopted additional measures, including the purchase of JGBs. Already
facing a massive fiscal challenge, which saw Japan’s sovereign credit rating cut earlier this year, the government will announce its
first package to fund reconstruction later this month. This will be partly financed by rolling back spending and tax measures
announced previously but government borrowing is also likely to rise sharply. With regards to the exchange rate, for the first time
since 2000, the G7 sanctioned co-ordinated action in March to weaken the yen after it surged to a record high against the dollar.
After rebounding swiftly to pre-quake levels, the currency pair has since trended higher, recently breaking 85. However, this is still
significantly above pre-financial crisis levels (see chart). Although anecdotal evidence suggests external demand has improved.
The performance of the US and China, Japan’s main export markets, will be crucial for prospects in the year ahead.
• The domestic economy looks increasingly fragile. Consumers front-loaded spending last year after a series of government
initiatives and face strong headwinds in 2011. We forecast consumer spending growth to slow to just 0.3%, after a 1.9% gain
last year, with the risks skewed to a softer outturn. The labour market is weak and we expect further downward pressure on
earnings. Annual real cash earnings turned negative in December and remain weak. There is also little chance of government
support, with the growing risk that some entitlements are cut to pay for the reconstruction effort. On the fixed investment side,
corporate profits have been bolstered by recovery but companies remain reluctant to invest. Excess capacity and an
uncertain outlook are unlikely to foster a strong recovery in 2011. The Q1 Tankan survey painted a cautious picture, with
corporate sentiment suffering after the earthquake and the likely return to recession. While we believe corporate spending
has the potential to strengthen it is likely to do so only gradually.
• The shadow of deflation also continues to loom large over the economy. Interest rates are set to remain at close to zero
for some time and further unorthodox monetary easing is more likely than not. Even before the earthquake, we predicted
Japan to be the last among major developed economies to raise official policy interest rates. This could potentially have
significant implications for the yen, particularly if interest rates start to normalise in other countries over the year ahead.
CHART: USD/JPY well below pre-crisis levels... TABLE: Key Japanese macroeconomic forecasts
$/Y
Japan (Yr % chg unless stated) 2009 2010e 2011f 2012f
125
Real GDP -6.3 4.0 0.8 2.5
120
Household consumer spending -2.0 1.9 0.3 1.3
115
Gross investment -11.6 0.1 2.1 4.5
110
Government consumption 3.0 2.2 1.7 1.2
105
Exports -24.2 24.2 2.0 12.1
100
Imports -15.4 9.8 6.3 9.4
85 CPI -1.4 -0.7 0.3 0.5
80 Budget balance % GDP (cal yr) -9.6 -7.7 -8.6 -8.3
2006 2007 2008 2009 2010 2011
Current account % GDP 2.8 3.5 1.0 1.9
Source: Datastream
6 th
Mark Miller
EURO AREA +44 (0)20 7158 2141
mark.miller2@lloydsbanking.com
ECB TO CONTINUE TIGHTENING. BOND MARKETS TO REMAIN

VOLATILE
• As widely expected the ECB sanctioned a quarter-point increase in its key refinancing rate, to 1.25%, at its 7 April
Governing Council meeting. Given ongoing volatility in ‘peripheral ’ euro area government bond markets, the ECB has
thus sent a strong signal that it is committed to preserving price stability over the medium term. In essence, the ECB’s
‘hawkish’ stance can be attributed to the fact that when faced with a price ‘shock’ (e.g. the commodity prices rises now
being seen) it is vital that ‘second round’ effects into wages are avoided. In its March staff economic projections, the ECB
raised sharply the mid-point of its 2011 CPI forecast range to 2.3% from 1.8% in December. While Mr. Trichet noted in
March that there was no sense of a ‘series of hikes’, we expect modest additional interest rate increases over the
remainder of this year (in Q3 and Q4), with our end-2011 forecast standing at 1.75%.
• Overall, euro area data remain encouraging. But tensions persist. Reflecting this, the ECB has extended its ‘non-
standard ’ policy measures (the 3m LTRO, for example, will continue with full allotment). In fact, the stability of euro
government bond markets remains a ‘hot’ topic, with volatile conditions seen since our last Quarterly. Tensions were
particularly acute last year, leading to the €85bn bail-out of Ireland using the European Financial Stability Facility (EFSF).
Further difficulties emerged in early January, with ‘peripheral ’ government bond yield spreads over German bunds
widening on concerns about sovereign funding. More recently, markets have pressured Portugal into applying for an EU
bailout under the EFSF following the rejection of further fiscal austerity measures in parliament.
• Progress at the 11 March EU summit had only a limited beneficial impact on ‘peripheral ’ government yield spreads with
Greece - though not Ireland - accepting a deal to reduce by 100bp the rate payable on its bail-out package. As part of
the deal, the EFSF will be able to use its full €440bn capacity (from around €250bn previously) to support a bail-out,
while its successor from mid-2013, the ESM, can lend €500bn. Both the EFSF and ESM will be able to purchase sovereign
debt - but only in the primary market. The later EU summit (held on 24 & 25 March) promised a ‘comprehensive’ final
package of measures. But it failed to deliver amid disagreement on how exactly higher capital guarantees associated
with a re-vamped EFSF would be financed. In any form, the new arrangement will disappoint the ECB, which had been
looking to wind down its Securities Market Programme, allowing it to focus on other aspects of monetary policy. But
crucially, there is no formal channel to enforce fiscal discipline on profligate euro area countries - this remains the key issue.
• An effective and permanent arrangement for solving potential future problems on euro sovereign debt is important
because lower long-term interest rates are needed to foster sustainable economic recovery. Long-term borrowing costs
impact significantly on spending decisions by both households and firms. As in our last Quarterly, the euro economy
continues to be driven by robust activity in Germany. Significantly, there are encouraging signs that the mix of economic
activity in Germany is shifting, with domestic demand playing an increasingly important role. Going forward, the
challenge will be to sustain this domestic momentum against a backdrop of weaker real pay growth, as inflation
pressures build during this year. Meanwhile, at the euro-wide level, forward-looking surveys continue to perform well.
March PMI manufacturing data indicated healthy expansion in the sector (57.5), not far off an 11-year high. A broadly
similar story holds true within services. Our euro area GDP forecasts stand at 1.5% and 1.7%, for this year and next.
CHART: The ECB has raised its CPI & GDP forecasts... TABLE: Key Euro zone macroeconomic forecasts
%
2.5 Euro zone (Yr % chg unless stated) 2009 2010e 2011f 2012f
2011
2012 Real GDP -4.0 1.7 1.5 1.7
2 Household consumer spending -1.1 0.7 0.8 1.1
Gross investment -11.3 -0.8 1.5 3.0
1.5 Government consumption 2.5 0.7 -0.1 -0.2
Exports -13.1 10.6 6.2 4.1
1
Imports -11.8 8.7 4.6 3.6
Industrial production -13.8 4.0 6.3 5.2
0.5
Unemployment rate (%, Q4) 9.9 10.0 10.0 9.6
0 CPI 0.3 1.6 2.5 1.8

December March December March Budget balance % GDP (cal yr) -6.3 -6.0 -4.5 -3.4
CPI GDP Current account % GDP -0.6 -0.6 0.3 0.4
Source: ECB
th 7
Mark Miller
GERMANY +44 (0)20 7158 2141
MIX OF GROWTH STARTING TO FAVOUR DOMESTIC DEMAND

• The German economy continues to expand at a healthy pace, providing support for the euro area as a whole. In early
January, the Federal Statistics Office estimated that German GDP grew by 3.5% in 2010, the strongest outturn for around
20 years. Official data for Q4 released subsequently recorded an expansion of 0.4% quarter-on-quarter compared with
0.7% in Q3, although this deceleration likely reflects the impact of severe winter weather conditions. Going forward, we
look for 2011 GDP growth at a more sustainable pace compared with last year, as Germany’s €80bn of government
spending cuts start to feed through. Our forecast stands at 2.4%, followed by growth of 2.0% in 2012.
• Significantly, there have been signs in recent quarters that the mix of economic activity in Germany is shifting, with
domestic demand becoming an increasingly important driver of growth. Over the past three quarters, for example,
private consumption has contributed almost 0.25 percentage points (pp) on average to quarter-on-quarter GDP, while
fixed investment has added close to 0.4pp over the same period. Net trade, meanwhile, continue to perform well,
supported by a strong appetite for German exports in key markets such as emerging Asia (and China in particular). The
contribution of net trade to quarter-on-quarter GDP in 2010Q4 was 0.7pp, the same as in Q3.
• Forward-looking business surveys suggest there is considerable momentum as we move further into 2011. At 111.1 in
March, the latest Ifo business climate index, for example, hovered close to its all-time high of 111.3. Indeed, the current
conditions index improved quite markedly, to 115.8 from 114.8 previously, likely reflecting continued optimism on the
part of exporters but also recent signs that the outlook for consumer spending has improved as joblessness has fallen
over a protracted period. Unemployment has fallen by around 825k since the start of the financial crisis in July 2007. The
Ifo expectations component, meanwhile, slowed to 106.5 in March from 107.9 in February perhaps reflecting the
looming fiscal consolidation over the next few years. Evidence from purchasing managers’ surveys in Germany has also
been encouraging, with the manufacturing index above the 60 level during the period December to March. The services
sector in Germany has performed strongly too, with March’s reading of 60.1 consistent with robust activity.
• But as in other many other countries, inflation pressures in Germany are now starting to build with more force. Preliminary
data for March revealed an annual rate of 2.2%, the highest since autumn 2008 (when oil prices were also very high).
With food and energy prices continuing their rise, German CPI looks set to move further above the ECB’s target of ‘below
but close, to 2%’, particularly during the first half of this year. This is a potential drag on households’ real spending power
just as consumer activity is beginning to show signs of life. Inflation is thus a notable downside risk for economic activity
in Germany going forward. For choice, however, we feel that lower real wage growth could be a price worth paying in
an environment of elevated price pressures. If German unions were to abandon their discipline on wage negotiations (in
fact, one of the key reforms implemented in Germany is that more wage-bargaining now occurs at the level of the firm),
then unemployment could potentially rise fairly quickly, undermining the improved balance in overall economic activity.
The desire to avoid a scenario where strong inflation pressures feed through into wages was behind the ECB’s decision
to raise interest rates at April’s Governing Council meeting. We expect modest additional interest rate increases over the
remainder of this year (in Q3 and Q4), with our end-2011 forecast standing at 1.75%.
CHART: German business surveys augur well for industrial TABLE: Key German macroeconomic forecasts
activity...
Germany (Yr % unless stated) 2009 2010e 2011f 2012f
% Yr
40 Real GDP -4.7 3.5 2.4 2.0
30
20
German factory orders
Government consumption 2.9 2.3 -0.1 -1.2
10
Exports -14.3 13.8 7.6 2.6
0
German Imports -9.4 12.4 4.5 2.3
-10 industrial
production Industrial production -15.5 10.0 4.6 3.9
-20
-30
CPI 0.3 1.1 2.4 1.9
-40
Budget balance % GDP (cal year) -4.3 -3.5 -2.9 -1.8
Feb 01 Feb 03 Feb 05 Feb 07 Feb 09 Feb 11
Source: LBCM
8 th
Mark Miller
FRANCE +44 (0)20 7158 2141
FRANCE NEEDS TO STRENGTHEN ITS DOMESTIC ECONOMY

• The French economy continues to expand at a steady pace. Economic activity rose by 0.4% quarter-on-quarter during
Q4 last year, with final domestic demand leading the way. This was particularly evident in household consumption,
which rose by 0.9% during the quarter against 0.5% in Q3. Importantly, forward-looking business surveys – such as the
Bank of France business confidence report – have been trending higher. We note that this survey has picked up
significantly early in 2011, with a reading of 110 in March versus 107 at the end of last year. The INSEE confidence index
has also been firm recently (109 in March against 106 in the previous month) - with net balances on components such
as new export orders, improving in March to -5 from -11 in February - perhaps underlining the firmness of economic
activity in key trading partners such as Germany.
• While this is encouraging, France is not a particularly ‘open’ economy which – compared to countries like Germany - may
limit the upside potential for economic activity from robust (Asia-led) global economic recovery. Moreover, we expect
growth in Germany itself to slow this year and next, in part reflecting the significant fiscal tightening underway there. The
burden therefore falls squarely on domestic demand growth to accelerate the pace of economic expansion in 2011 and
beyond. The broad pattern seen in the Q4 GDP data will need to be sustained going forward.
• In our view, this will not be easy to achieve. Employment growth in France has been trending higher for some time, but
a significant share of overall job creation has been accounted for by temporary positions. Besides, household
consumption is likely to face significant ‘headwinds’, notably in the form of weaker real disposable income growth.
Subdued wage growth in the public sector is a key element of this, given the large size of the public sector in France.
And as in many other countries, inflation pressures are mounting. French CPI registered 2.2% in the year to March –
with a further pick-up looking likely over the near term. Our projections for consumer spending stand at 1.8% and
2.0% for this year and next.
• Similarly, fixed investment cannot be relied upon to pick up sharply. Helpfully, long-term interest rates in France have
not risen by as much compared with some euro area members (e.g. the ‘peripheral ’ nations). On balance, this should
support capital spending decisions by firms. But capacity utilisation rates in France remain low in an historical context
and it may be that, for this year at least, fixed investment is confined to the replacement of existing capital stock. Our
GDP growth forecasts for France stand at 1.6% and 1.8% in 2011 and 2012.
• Thus far, financial markets have not penalised France for the poor state of its public finances, which may reflect the
perception of a credible deficit reduction plan. Ten-year government bond yield spreads over Germany have been
quite stable relative to those of other euro area countries. The current spread (which has been steady despite recent
volatility in the ‘periphery’ leading to a recent bailout application by Portugal) is around 30bp, compared with just
under 50bp towards the end of last year amid market concerns about Ireland. From a budget deficit in France of
around 7.7% of GDP at present, the government’s target for 2011 remains at 6%. But needless to say, a healthy,
sustainable pace of economic growth is required to ensure meaningful progress towards the government’s medium term
target of 3% by 2013.
CHART: Business surveys in France are trending higher... TABLE: Key French macroeconomic forecasts
3 115
France (Yr % unless stated) 2009 2010e 2011f 2012f
GDP (%Yr)
110
2 Real GDP -2.5 1.5 1.6 1.8
105
Household consumer spending 0.6 1.6 1.8 2.0
1 100 Gross investment -7.0 -1.6 2.0 2.4
95 Government consumption 2.8 1.4 0.1 -0.1
0
90 Exports -12.2 9.9 4.7 2.8
Bank of France business
-1 sentiment (RH Scale) 85 Imports -10.6 7.7 2.8 1.9
-2 80 Industrial production -12.3 5.8 5.9 4.8
-3
70 CPI 0.1 1.5 2.1 1.9
-4 65 Budget balance % GDP (cal year) -7.6 -7.4 -5.7 -4.4
2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: LBCM
th 9
Mark Miller
ITALY +44 (0)20 7158 2141
FRAGILE BOND MARKET SENTIMENT THREATENS GROWTH

• The Italian economy grew by just 0.1% quarter-on-quarter in 2010Q4, leaving it 1.5% higher than a year earlier. But more
timely forward-looking surveys suggest that net exports are performing well. The export orders component of Italy’s PMI
manufacturing survey averaged 60.4 during February and March – while the latest ISAE survey has a broadly similar feel
(see chart). This is perhaps unsurprising given Italy’s export sector is essentially geared towards the euro area where
“core” economies such as Germany are expanding strongly at present. But still fragile sentiment in euro government
bond markets is a downside risk to this source of growth. So like a number of Italy’s euro area peers, the challenge going
forward is to avoid over-reliance on net trade as the primary engine of growth. Domestic activity needs to provide more
meaningful support, while markets must be convinced that the government is pursuing a credible long-term fiscal
consolidation plan. Following a projected expansion of around 1.1% in 2010, our GDP growth forecasts for Italy are
broadly similar this year and next (1.1% and 1.2%).
• The outlook for household consumption in Italy for this year and next is mixed. Labour market conditions, though still
weak, did not deteriorate rapidly at the height of the financial crisis thanks to flexibility which allowed some workers to
retain their jobs through shorter hours and reduced pay. Italy’s unemployment rate stood at 8.5% in February, compared
with a euro average of close to 10%. But while this flexibility was welcome in a period of economic stress, the scope for
a meaningful rebound in employment seems limited. Consumer sentiment has weakened somewhat compared with the
position a year earlier - the ISAE survey registered a seven month low of 105.2 in March - and has been further impacted
by political uncertainty and scandals involving the Prime Minister, Silvio Berlusconi. As in other euro area countries, weak
real pay growth in Italy seems poised to drag on consumer spending, particularly in 2011, as inflation pressures
accelerate. We look for consumer spending to expand by just 0.7% this year, followed by growth of 1.2% in 2012.
• Nor is it clear that fixed investment by firms will provide a significant boost to economic activity during this year and next.
Capacity utilisation, for example, is at historically low levels. Moreover, continued de-leveraging by small and medium-
sized enterprises also has the potential to limit firms’ appetite for new capital spending projects. Meanwhile, government
expenditure on infrastructure will be constrained by the need for fiscal consolidation. Our fixed investment growth
forecast stands at 1.9% this year followed by expansion of 2.7% in 2012.
• Thus far, financial markets have given Italy the benefit of the doubt, though ‘all that glitters may not be gold ’. The yield
spread of Italian 10-year government bond (BTP) yields over equivalent German bunds has narrowed since Portugal ’s
application for an EU bailout and currently stands at 140bp compared with almost 200bp on 10 January, when concerns
about funding in ‘peripheral ’ euro area countries were particularly high. But the position is still fragile and progress
could potentially reverse, if, after the disappointing series of EU summits during March, there is another failure to agree
on the details of a permanent mechanism to address any future sovereign debt crises in the euro area. The crucial point
is that euro-wide issues cannot be allowed to distract from the central problem of the need for fiscal consolidation in
Italy. The government has approved austerity measures totalling €25bn during 2011 and 2012, equivalent to around
1.6% of GDP. But public debt in Italy remains worryingly high, at close to 130% of GDP.
CHART: Italian business confidence is trending higher... TABLE: Key Italian macroeconomic forecasts
140 6.0 Italy (Yr % unless stated) 2009 2010e 2011f 2012f
ISAE Business Real GDP -5.1 1.1 1.1 1.2
120 confidence 4.0
100 2.0
80 0.0 Government consumption 0.6 -0.6 0.1 1.0
GDP (%Yr) (RH Exports -19.1 8.7 6.8 4.6
60 Scale) -2.0
Imports -14.6 8.9 6.8 4.3
40 -4.0 Industrial production -18.2 5.4 2.6 3.5
20 -6.0 Unemployment rate (%, Q4) 8.3 8.6 8.3 8.0
CPI 0.8 1.5 1.8 2.2
0 -8.0
1999 2001 2002 2003 2004 2006 2007 2008 2009 2011 Budget balance % GDP (cal year) -5.4 -4.6 -3.9 -3.5
Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1
Source: LBCM
10 th
Mark Miller
SPAIN +44 (0)20 7158 2141
PORTUGAL BAILOUT APPLICATION PUTS SPOTLIGHT ON SPAIN

• Economic activity in Spain rose by a modest 0.2% quarter-on-quarter in 2010Q4. But this weak pace of growth –
characterised by a declining construction sector – is clearly not a new story. Financial markets are focused on ‘bigger
picture’ issues such as progress on fiscal consolidation and the strength of Spain’s domestic banking sector. The yield
spread of 10-year Spanish government bonds over equivalent German bunds has fallen back since concerns about
sovereign funding in ‘peripheral ’ euro area countries became elevated earlier this year. It currently stands at 190bp,
compared with around 268bp back on 10 January. In part, this reflects significant efforts in tightening fiscal policy,
where Spain has received praise from northern European countries such as Germany. We note that the Spanish yield
spread has not widened after Portugal ’s recent bailout application. But markets will be watching Spain closely - there is
no room for complacency.
• Specifically, Spain has announced a fiscal austerity package incorporating measures such as income tax increase for
those earning over €120,000, along with cuts in public sector salaries and a suspension of automatic increases in
pensions. This comes on top of a €50bn austerity plan implemented in January last year. More recently, Prime Minister
Zapatero has urged Spain’s seventeen autonomous regions to curtail their spending in a drive to achieve this year’s target
for the public sector deficit of 6% of GDP – agreed in September’s budget - en route to 3% by 2013.
• Meanwhile, the health of Spain’s domestic banking sector remains a concern - but remedial action is in the pipeline. In mid-
January, Prime Minister Zapatero announced a ‘second round ’ of restructuring for the cajas, or regional savings banks,
through an additional re-capitalisation over and above the €15bn spent to date. This, taken together with fiscal consolidation,
represents an attempt by Spain to ensure that its ability to raise funding in the government bond markets will not be called
into question again. But success is by no means guaranteed (indeed, Moody’s downgraded Spain’s credit rating by one
notch, to Aa2, in early March). Despite a trend improvement in retail deposit-taking by Spanish banks, the sector still relies
heavily on wholesale market funding. A further complication is that – if the first three quarters of 2010 were anything to go
by – impairments and provisions have been rather ‘sticky’ amid still weak economic conditions. This potentially compromises
earnings growth and risks dragging on their capital base. In short, there is no room for complacency.
• It is encouraging that Spain is attempting to address its structural fragilities. But from a cyclical perspective, significant
‘headwinds’ remain. Forward-looking business surveys, such as the PMI reports, are the weakest among the larger euro
area economies. March’s PMI manufacturing survey showed only a modest pace of expansion at 51.6 (compared with
60.9, 56.6 and 56.2 in Germany, France and Italy). High unemployment remains a key challenge. The unemployment rate
currently stands at some 20.4% of the workforce and we look for the jobless rate to remain above 20% until at least next
spring. Weak labour market conditions - and as in other euro area countries - a pull-back in households’ real pay
growth, is likely to mean that consumer spending struggles to make headway this year. Our 2011 household spending
forecast stands at 0.4% prior to expansion of 0.7% next year. Meanwhile, the outlook for fixed investment spending by
firms remains downbeat against a backdrop of an ongoing reduction of capacity in the construction sector and sizeable
cuts in public expenditure as part of Spain’s fiscal consolidation. Our overall GDP growth forecasts stand at 0.6% this
year accelerating slightly to 1.1% in 2012.
CHART: Spain’s PMI surveys barely signal expansion TABLE: Key Spanish macroeconomic forecasts
65 Spain (Yr % unless stated) 2009 2010e 2011f 2012f

60 Services Real GDP -3.7 -0.1 0.6 1.1
55 50 denotes Household consumer spending -4.3 1.2 0.4 0.7
stability
50 Gross investment -16.0 -7.6 -2.8 1.5
45 Government consumption 3.2 -0.7 -1.1 -0.9
Manufacturing
40 Exports -11.6 10.3 6.7 6.9
35 Imports -17.8 5.4 1.5 4.8
20 CPI -0.3 1.8 2.9 1.6

Mar 01 Mar 03 Mar 05 Mar 07 Mar 09 Mar 11 Budget balance % GDP (cal year) -11.1 -9.2 -6.5 -4.7
Source: LBCM Current account % GDP -5.5 -4.5 -4.1 -2.8
th 11
Mark Miller / Kathryn McGeough
NETHERLANDS +44 (0)20 7158 2141
‘OPEN’ NATURE OF ECONOMY SUPPORTS GROWTH PROSPECTS

• The Netherlands economy expanded at a stronger-than-expected pace in 2010Q4. Growth registered 0.6% quarter-on-
quarter, to yield an annual rate of 2.4% - the best outturn since autumn 2008. Within this, exports performed strongly,
rising by some 11.3% in the year to Q4. This underlines the Netherlands as a particularly ‘open’ economy benefiting from
stronger global growth and healthy expansion in key euro area trading partners such as Germany. Usefully, major
exports such as agricultural produce, chemicals & energy have generally held up well, affording the Netherlands an
opportunity to increase its share in world trade in these areas.
• But looking forward, export growth could slow this year and next relative to 2010, as the pace of global economic
expansion tails off modestly. We look for export growth in the Netherlands to average around 6% over both years, versus
10.9% in 2010. Interestingly, notwithstanding the open nature of the economy, there have been tentative signs (e.g. from
the middle of last year) that domestic demand is playing an increasingly important role as a driver of activity. This applies
in particular to fixed investment by non-financial corporations, although we caution that the upturn seen towards end-
2010 was largely confined to replacement of existing capital stock rather than new capital expenditure. This is entirely
natural in a climate of demand uncertainty following an economic and financial crisis. But we note that if new investment
is to come on-stream, long-term rates in the euro region will need to fall from their historically high rates to prevent the
cost of raising capital in bond markets from becoming prohibitively high. Failure to agree on the details of a permanent
mechanism to address any future sovereign debt crises in the euro area at the 24-25 March EU summit is unhelpful for
the capital spending outlook. Our fixed investment growth forecasts stand at 1.0% and 3.5% for this year and next.
• In terms of the public sector’s contribution to overall domestic demand, as in other euro area countries, the Netherlands
is now embarking on a substantial fiscal tightening programme, unwinding the stimulus implemented in response to the
economic and financial crisis. Previously, in 2009, government spending was the only component making a meaningful
contribution to GDP. The current fiscal consolidation essentially focuses on reducing public administration costs and
subsidies. Spending cuts announced in the 2011 Budget delivered by the ‘caretaker’ government last September amounted
to €3.2bn, with a deficit target of 3.9% of GDP in 2011.
• Encouragingly, consumer confidence in the Netherlands has been trending upwards for around 18 months now. March’s
European Commission consumer confidence survey registered 8.1 – close to its strongest since November 2007 – and
compares with a 10-year average of -1.3. This may reflect relatively healthy labour market conditions in the Netherlands.
The unemployment rate stood at just 5.1% in February against a euro region average of almost 10%. A large part of this
resilience can be attributed to labour hoarding by firms at the height of the crisis, to prevent potential difficulties in re-
hiring skilled and qualified staff during a subsequent upturn (the labour market was tight in the lead-up to the financial
crisis). In addition, the Netherlands has a high proportion of self-employed and part-time workers. Given this ‘flexible’
labour market structure, it seems unlikely that employment will recover rapidly going forward. We think the outlook for
consumer spending growth is correspondingly subdued, with our projections at just 1.0% in 2011, prior to a modest
acceleration to 1.5% next year. Following overall GDP growth of around 1.7% in 2010, we look for the economy to
register a broadly similar rate of expansion this year, prior to 1.9% growth in 2012.
CHART: Confidence in the Netherlands continues to rise... TABLE: Key Netherlands macroeconomic forecasts
% Net balance Netherlands (Yr % unless stated) 2009 2010e 2011f 2012f
30
Real GDP -3.9 1.7 1.7 1.9

Consumer confidence
10
0 Exports -7.9 10.9 6.3 5.5
Industrial confidence Imports -8.5 10.6 5.1 6.0
-10
-20 Unemployment rate (%, Q4) 5.4 5.2 5.3 5.1
CPI 1.2 1.3 2.1 1.8
-30
2005 2006 2007 2008 2009 2010 2011 Budget balance % GDP (cal year) -5.4 -5.8 -4.6 -2.7
Source: European Commission
12 th
Sian Fenner
CANADA +44 (0)20 7158 3975
sian.fenner@lloydsbanking.com
HOUSING MARKET TO UNWIND IN AN ORDERLY MANNER

• The Canadian economy grew by an annualised 3.3% in Q4, up from 1.8% in the previous quarter. The increase in GDP
growth was led by the external sector, where despite a strong CAD, export volumes surged 17.2%, driven by a recovery
in the US and stronger petroleum exports. Meanwhile, imports were broadly flat, resulting in net exports adding 5.2
percentage points to GDP growth. This was partly offset by a large fall in inventories. Economic growth was 3.1% for
2010 as a whole.
• Domestically, household consumption was a key driver of growth, accelerating by 1.2% in Q4 from 0.5% in Q3. And it
appears that consumer spending has started the year well. Retail sales volumes increased 3.4% year-on-year in January.
Moreover, employment has returned to pre-recession levels,with the unemployment rate having fallen from its peak of
8.5% in 2009 to 7.7% in March. However, while robust labour market conditions are expected to support consumption
this year, growth is likely to be tempered by a reduced wealth effect from a softening in the housing market. Moreover,
with recent GDP outcomes being stronger than anticipated by the Bank of Canada (GDP rose 0.5% m/m in January),
and inflation currently runnng above the official 2% target, we expect it to resume interest rate increases as early as
mid-2011 to 2.5% by the end of this year. With further hikes anticipated in 2012, this will become an increasing headwind
faced by households.
• The current low interest rate enviroment has contributed to the household debt-servicing ratio falling in recent quarters.
However, the household debt to income ratio has increased to 140% of disposable income in Q3 – the highest level on
record. Moreover, there is evidence that the proportion of households with debt servicing ratios above the generally
regarded ‘vulnerable’ 40% level has risen. This means that a larger percentage of households are more sensitive to
shocks to employment or the housing market, as well as significantly higher interest rates.
• After supporting the early stages of the recovery, residential investment is expected to slow substantially this year. Annual
growth in dwelling starts remains negative, falling 4.7% year-on-year in March, down for the fourth consecutive month.
Moreover, demand appears to be softening, with both mortgage approvals and house price growth slowing.
• Despite these headwinds facing the economy, the outlook remains favourable. In particular, businesses have been taking
advantage of the strong currency, firm commodity prices and government incentives to invest in machinery and equipment.
And while investment growth is expected to remain below the double-digit rate recorded in mid-2010, improving
corporate balance sheets are expected to support non-residential investment and drive economic growth this year.
• Stronger US economic growth (the US accounts for nearly 75% of total good exports) and robust demand for Canada’s
commodity exports are expected to support firm growth in exports this year. And consistent with an easing in household
spending, growth in consumer imports is expected to see net trade make a positive contribution to GDP growth in 2011.
• In 2011, we see a rebalancing of growth away from households and government spending, to business investment and
exports with the economy expected to grow by 3.2% and 3% in 2012. However, a key risk to our economic outlook
concerns exports. Both a strong CAD and higher oil prices may see export growth softer than currently anticipated. A
high CAD damages the competitiveness of Canadian exports, while higher oil prices could impinge on US and global
GDP growth prospects.
CHART: Continued recovery in corporate profits to TABLE: Key Canadian macroeconomic forecasts
support strong business investment going forward
Canada (Yr % chg unless stated) 2009 2010e 2011f 2012f
%, y-o-y % of GDP
18 forecast 17 Real GDP -2.5 3.1 3.2 3.0
Corporate profits
9 15 Gross investment -11.9 8.3 6.8 6.4
(RHS)
0 13
Exports -14.2 6.4 8.7 6.1
Imports -13.9 13.4 4.4 4.9
-9 11
-18 9
CPI 0.3 1.8 2.4 2.0
Business investment (LHS)
-27 7 Budget balance % GDP (cal yr) -3.7 -3.4 -3.0 -2.3
2006 2008 2010 2012
th 13
Sian Fenner
AUSTRALIA +44 (0)20 7158 3975
UNEVEN RIDE AHEAD

• After nearly stalling in Q3, the Australian economy expanded by 0.7% quarter-on-quarter in Q4, bringing 2010 GDP
growth to 2.7% . Growth in Q4 was underpinned by a strong rise in exports (despite the drag on coal exports from
heavy rain), government spending and a rebuilding of inventories. And while Q4 GDP once again expanded below the
0.9% trend rate,if the RBA estimates are correct and the impact of the floods on activity subtracted 0.5 percentage
points from growth, then the outcome could still be considered encouraging.
• While household spending and business investment both showed subdued growth in Q4, we continue to expect a
rebalancing of growth from the public sector towards private sector demand. Fiscal spending has slowed significantly
over H2 2010 and with the exception of a temporary boost from flood and disaster assistance, we expect government
expenditure to make a smaller contribution to GDP growth over 2011.
• Although our economic outlook remains favourable, quarterly GDP growth in 2011 is expected to be uneven. Damage to
agriculture and mining production caused by the floods, combined with disruptions to business operations is likely to have a
large impact on Q1 GDP growth. Furthermore, the recent natural disaster in Japan, a key trading partner, is likely to negatively
impact exports in the short-term, although on balance, our model shows no change to our GDP growth forecast.
• Household spending is also unlikely to lead to GDP growth returning to trend in H1. Retail sales continue to disappoint,
increasing 0.5% month-on-month in February, while passenger vehicle sales fell 2.5% quarter-on-quarter in Q1. The
subdued spending trend reflects the cautious nature of households, despite strong income growth. However, with the
unemployment rate forecast to fall to 4.6% by end-2011 and wages set to accelerate, improved confidence and higher
real disposable income are expected to encourage an increase in spending in H2. And, despite debt-servicing ratios
remaining high, an improving net wealth position is expected to support household consumption firming to 4.3% next
year, following a projected 3.2% rise in 2011.
• Latest national accounts data confirmed the dilemma facing Australian policy makers. Although inflation has been
subdued recently, the economy is awash with income from the terms of trade boom. Real net disposable income
surged 7.7% year-on-year in Q4. This is boosting both household disposable incomes and corporate balance sheets.
Accordingly, the latest CAPEX survey suggests that business investment is set to soar in 2011-12, led by the mining
sector. In particular, investment in buildings and structures is estimated to be over A$91million, up 18.1% from the
2010-11 estimate.
• Private sector investment is also expected to be a key driver of growth over the next two years but it will further tighten
already limited spare capacity, raising the risks to the medium-term inflation outlook. This will be reinforced by the
recent floods in the form of both higher food prices (a short-term phenomenon) and costs for labour and materials.
We have a first interest rate hike pencilled in for mid-2011 and expect rates to end-2011 at 5.75%, before peaking at
6.25% in 2012.
• On balance, while the natural disasters are likely to impact GDP growth in H1, a rebound in exports combined with
stronger household spending and private investment are expected to underpin GDP growth of 3.2% this year prior to
4.3% growth in 2012.
CHART: Capital spending survey suggests mining TABLE: Key Australian macroeconomic forecasts
investment will soar in 2011-12
Australia(Yr % chg unless stated) 2009 2010e 2011f 2012f
% of GDP
6 Forecast Real GDP 1.3 2.7 3.2 4.3
5
Total Gross investment -3.2 5.4 5.1 8.4
Buildings
4 Government consumption 1.6 3.5 2.2 1.3
Machinery and Equipment
Exports 2.8 5.3 6.7 6.6
3
Imports -9.0 13.2 7.2 8.1
Unemployment rate 5.6 5.2 4.6 4.2
1
CPI 1.8 2.8 3.0 2.8
0 Budget balance % GDP -3.4 -2.0 -1.7 -0.6
1991-92 1995-96 1999-00 2003-04 2007-08 2011-12
Source: ABS & LBCM
14 th
Sian Fenner
CHINA +44 (0)20 7158 3975
FOOT FIRMLY ON THE POLICY BRAKES

• The Chinese authorities have applied the policy brakes, and we believe that economic growth will moderate in 2011 to 9.3%
from 10.3% in 2010. We expect to see more evidence of a rebalancing of growth away from the housing market and heavy
industry towards the services sector in 2011. Q1 GDP is forecast to have grown 9.3% year-on-year, down from 9.8% in Q4.
• Industrial production has been surprisingly firm in the first two months of the year given the recent deterioration in the PMI
manufacturing survey. Moreover, despite a moderation in new loans, fixed urban investment continues to record solid
growth, up 24.9% year-on-year for the first two months of 2011. Dwellings investment has remained strong despite efforts
to cool the property market. In contrast, government investment has slowed sharply. Household spending also appears to
have moderated, with retail sales easing to 11.6% year-on-year in February, its slowest rate of growth for two years.
• In our view, accelerating consumer prices and low deposit interest rates have seen real disposable income growth ease
recently, despite average monthly minimum wages increasing by around 23% in 2010. And while wages are set to rise
further this year, managing higher inflation is a key challenge for the authorities. There are a number of significant price
pressures in the pipeline. In particular, producer prices are currently growing at rates experienced in late 2008 reflecting the
rise in USD-denominated commodities. And while government price controls may successfully restrain growth in consumer
goods prices, the latest data shows that services sector prices, which are generally more ‘sticky’ than goods, have accelerated
recently. We expect consumer prices to hover at or above 5% for the next couple of months, reflecting high commodity
prices. Adding to these cost-push pressures is the current threat of drought pushing up locally-sourced food prices.
Consumer inflation is forecast to average 4.7% in 2011, above the government’s target of 4%.
• To date, the People’s Bank of China (PBoC) has used quantitative measures aggressively, increasing bank reserve ratios nine
times since January 2010 to an all time high of 20% for large banks. But despite raising the prime lending and deposit
interest rates by 25bp on the 5th April – the fourth rate hike since October 2010 – they remain below their pre-crisis peaks.
Going forward, we expect the PBoC to tighten interest rates further, with the prime lending rate increasing to 6.61% by end-
2011 and 7.11% by end-2012. However, we do not anticipate reserve ratios being raised much further.
• With household earnings and interest returns set to rise, we expect household spending to pick up after Q1 and support the
services sector. In contrast, caps on mortgages and rising interest rates will result in residential investment moderating in the
coming quarters. That said, given the strength of demand outside the major cities such as Beijing and Shanghai, we believe
that the slowdown in investment will be milder than previously projected.
• Recently, China’s trade surplus has narrowed significantly, recording its first deficit in Q1 since 2004. However, we expect
import growth to move back broadly in line with exports, reflecting more moderate growth in fixed investment this year.
Moreover, at present we do not think that the recent natural disaster in Japan will have a significant effect on Chinese
exports. In fact, disruptions to Japanese steel production may actually benefit China’s steel industry.
• In conclusion, despite a projected slowing in investment over the next two years, we expect economic activity to remain
strong, albeit more geared towards service sectors compared with the past couple of years. Real GDP growth is expected
to ease to 9.3% this year and 8.8% in 2012. Moreover, we expect growth to average around 8% over the next five years,
above the latest 5-year government growth target of 7%, featuring a gradual shift towards consumption.
CHART: Accelerating inflationary pressures a key TABLE: Key Chinese macroeconomic forecasts
challenge for authorities
China (Yr % chg unless stated) 2009 2010e 2011f 2012f
% YoY DI
15 Input prices (RHS) 80 Real GDP 9.2 10.3 9.3 8.8
70
10 Gross investment 23.7 14.2 9.4 7.4
5
CPI Exports -11.2 26.5 11.7 11.0
50
Imports 5.3 17.1 9.1 10.8
0
40 Industrial production 9.9 12.2 9.5 8.3
-5 Unemployment rate (%, Q4) 4.3 4.1 4.3 4.2

PPI 30
CPI -0.7 3.3 4.7 3.9
-10 20 Budget balance % GDP (cal yr) -1.2 -0.4 0.4 0.5
Mar 07 Mar 08 Mar 09 Mar 10 Mar 11 Current account % GDP 6.0 4.6 4.0 4.1
Source: ABS & LBCM
th 15
Sian Fenner
BRAZIL +44 (0)20 7158 3975
MACROPOLICIES TO DAMPEN OVERHEATING ECONOMY

• The Brazilian economy expanded by 0.7% quarter-on-quarter in Q4, up from 0.5% in Q3. Although slightly weaker than
expected, this saw GDP growth for 2010 at 7.5% - the fastest rate in 24-years. Domestic demand remained the key driver
of growth in Q4, with household spending increasing 2.5% in the quarter and fixed investment growing by 0.7%. However,
robust demand led to import volumes increasing strongly, up 3.9%, outpacing growth in exports, up 3.6%.
• In 2011, a second year of above trend economic growth will continue to support employment growth. The unemployment
rate is expected to fall from 6.4% in February to 4.5% by end-Q4. Moreover, anecdotal evidence suggests that firms are
facing increasing difficulties in sourcing raw materials and labour. As such, we expect wages to increase, supporting real
earnings growth. However, while this bodes well for household spending, we anticipate growth will ease back this year on
the back of further monetary policy tightening to combat inflation. The Brazilian central bank has lifted interest rates by
300bp since March 2010. And while the latest COPOM minutes stated that that there was no bias in their current monetary
policy stance, we believe that the risks to the medium-term outlook warrant further rate hikes this year. Consistent with
consumer inflation to average 5.6% this year, up from 5.0% in 2010, we expect rates to end 2011 at 12.75%. The use of other
macroprudential instruments, such as the recent increase in consumer lending tax, are expected to play a bigger role in
monetary policy. However, there is a risk that the secondary impact of higher wages will add further fuel to both demand-
pull and cost-push inflationary pressures.
• While the outlook for households is favourable, we note that the surge in household debt has left a greater proportion
of households vulnerable to interest rate changes. Moreover, as households are able to purchase a wide range of goods
and services using an installment plan, we believe that a sizeable number of households are spending excessively. As
such, any change in circumstances could mean a sharp pull back in spending. While we have assigned a small
probability to this particular scenario, higher inflation and an increased debt burden are expected to result in household
consumption moderating to 5.9% in 2011, compared with 7.0% in 2010.
• While the annual expansion in investment expenditure is expected to slow to 11% after the 22% surge seen in 2010, the
level remains high, particularly in the mining and government sector. Government investment is forecast to be strong,
reflecting spending ahead of the football World Cup in 2014 and Olympics in 2016 to support infrastructure improvements
and building works. We believe that the cuts to federal expenditure, worth BRL50bn are unlikely to impact these
investment plans. However, there is a chance that other non-event related investment will be postponed.
• A key risk to the economic outlook is strength of the real may further reduce the competitiveness of Brazilian exports. The
Brazilian authorities have actively been trying to limit the real ’s appreciation against the USD, imposing capital controls
and increasing foreign reserves holdings. However, it has appreciated by nearly 10% against the USD over the past year,
and over 36% in the past two years. We expect the authorities to remain active this year, nonetheless we are looking for
only a modest rise in USD/BRL to 1.69 by end-2011.
• Our central forecast is for GDP growth to slow to 5.0% in 2011 as tighter fiscal and monetary policies dampen the
overheating economy. With demand for Brazilian exports expected to remain strong, GDP growth is projected to
increase 4.6% next year.
CHART: Strong labour market conditions have supported TABLE: Key Brazilian macroeconomic forecasts
robust growth in household spending
%, YoY % Brazil (Yr % chg unless stated) 2009 2010e 2011f 2012f
8 14 Real GDP -0.7 7.5 5.0 4.6
7 Retail sales, 3mma 13 Household consumer spending 4.2 7.0 5.9 4.4
6 12 Gross fixed investment -10.4 22.0 11.0 10.2
5 11 Government consumption 4.0 3.3 2.5 3.0

Exports -10.1 11.5 9.5 10.2
4 10
Imports -11.2 36.0 19.6 -0.8
3 Unemployment rate, 9
3mma (RHS) Industrial production -7.3 10.5 2.6 6.6
2 8
1 7 CPI 4.9 5.0 5.6 4.7
0 6 Budget balance % GDP (cal yr) -3.3 -2.6 -2.4 -2.6
Feb 07 Feb 08 Feb 09 Feb 10 Feb 11
16 th
Jeavon Lolay
INDIA +44 (0)20 7158 1742
TIGHTER POLICY STANCE TO HIT GROWTH

• The resilience shown by the Indian economy, both during and after the global financial crisis has been commendable. Real
GDP rose 8.6% in 2010, up from 7.0% in 2009, with the slowest pace of growth posted in the final quarter (8.2% year-on-
year). The 2010 rebound was driven by robust domestic demand, with fixed investment growth surging 16.5% and private
consumption up 6.9%. However, stubborn and elevated inflation has led the central bank to tighten monetary policy
significantly in the past year, with the prospect of further interest rate hikes to come. Taken together with a tighter fiscal stance
announced in the March Budget, the pace of economic growth looks set to moderate this year, albeit remaining robust at
8.1%. India’s medium-term prospects are favourable, with the potential growth rate estimated at slightly above 8%. Barring
a major policy mistake or global financial dislocation, we expect to see India post sustained high growth in the next decade.
• Although the pace of real GDP growth is set to slow to 8.1% in 2011, domestic demand growth is predicted to accelerate
as personal consumption firms on the back of rising employment, soaring incomes and robust bank lending growth. The
main risk is that inflation remains elevated for longer than expected, constraining growth in real incomes. We look for
consumer spending growth to accelerate to 8.4% in 2011. However, fixed investment growth looks set to slow markedly as
higher interest rates, soaring oil prices and supply-side bottlenecks weigh on confidence. We forecast growth of just 7.8%,
albeit coming after last year’s brisk 16.5% rate. Nevertheless, given India’s growth trajectory and the pressing need for
increased infrastructure spending, investment spending should return to double-digit pace in 2012 and 2013.
• The external trade deficit narrowed sharply in the final quarter of 2010, however the outlook is less favourable, particularly
given high global commodity prices and continuing buoyant domestic demand. We look for the trade deficit to widen
significantly in the coming years, registering around $180bn in 2012 from around $130bn in 2010. The current account
deficit already represents a key concern, averaging above $50bn in the last four quarters, equivalent to over 3% of GDP.
However, although it is set to widen to 3.5% of GDP in 2011, it should moderate in the coming years. We do not see financing
as a major problem, but India’s rising external vulnerability is a concern. Portfolio flows have provided the majority of the
coverage and net FDI is relatively small. This could lead to heightened volatility in the rupee in the year ahead.
• The government has announced plans to significantly reduce the fiscal deficit in the coming years, largely through expenditure
restraint. The target for the fiscal year ending March 2012 is at 5% of GDP, from 6.7% in the current fiscal year. We believe
the main risks to this forecast come from higher oil prices and state elections later this year. However, the need for increased
fiscal restraint has been widely acknowledged and we expect the deficit to be on a declining trend in the coming years.
• Inflation represents India’s main challenge at this time. It has been accentuated by the sharp rise in global commodity prices
and the soaring price of basic domestic foodstuffs, while surveys highlight that capacity constraints are also increasing.
After accelerating in the first two months of this year, to 8.31% in February, we expect favourable base effects to lead to a
significant slowing in the benchmark wholesale prices series in the coming months. However, underlying price pressures,
reflected in elevated inflation expectations, remain strong and inflation could accelerate in the second half of 2011. With
inflation set to exceed the RBI’s 4-4.5% ‘comfort’ range for some time, further monetary tightening seems inevitable. We look
for the benchmark repo rate to rise to 7.5% by end-2011, from 6.75% currently. The risk is that more tightening is required,
putting downward pressure on growth prospects this year and next.
CHART: Official interest rates have further to rise TABLE: Key Indian macroeconomic forecasts
%
12 India (Yr % chg unless stated) 2009 2010e 2011f 2012f
Real GDP (cal yr) 7.0 8.6 8.1 8.3
10
8
Fixed investment 2.9 16.5 7.8 13.0
Exports -7.4 14.6 10.0 13.4
4 Repurchase
rate Imports -7.0 3.5 11.8 15.9
WPI inflation
2 Industrial production 6.6 10.4 6.7 10.1
0 CPI 1.8 2.8 3.0 2.8

Budget balance % GDP (fiscal yr) -3.4 -2.0 -1.7 -0.6
-2
2006 2007 2008 2009 2010 2011 Current account % GDP -4.2 -2.6 -2.0 -2.4
Source: Datastream
th 17
Jeavon Lolay
RUSSIA +44 (0)20 7158 1742
INFLATION FEARS ABOUND DESPITE DISAPPOINTING GROWTH

• Although Russia has failed to match the growth performance of the other major emerging markets, such as Brazil, India
and China, its battle with inflation has been no less challenging. Sparked by a severe drought and heatwave last summer,
annual consumer price inflation was 9.5% in March, up from a low of 5.5% in July 2010. We expect inflation to remain
elevated on high oil prices, limited spare capacity and underlying structural bottlenecks. However, lower food price
inflation will be an offsetting factor. Stubborn inflation has intensified pressure on the central bank to tighten monetary
policy to reduce the risk of second round effects threatening the nascent economic recovery. The refinancing rate was
raised to 8% in February (from a record low 7.75%) and we predict it could be hiked a further 75bp this year. The
exchange rate will also provide an important safety valve to subdue price pressures. The trading band against the dollar-
euro basket was widened in March as rising oil prices saw the rouble appreciate sharply at the start of 2011. However,
the authorities have also started to intervene directly in the foreign exchange market to slow the pace of appreciation.
• The Federal Statistics Service estimated that the economy expanded by 4% in 2010, which is very disappointing considering
that output contracted by 7.9% in 2009. However, the drought had a significant impact on agriculture and industry in the
second half of 2010 and latest data show a much improved performance in the final quarter, with GDP growth accelerating
to 4.5% y/y, from 3.1% in Q3. Monthly indicators show considerable momentum in the first quarter of 2011, in large part
supported by a sharp rise in crude oil prices. Official estimates suggest Russian GDP growth increases by close to 0.5pp
for every $10 increase in oil prices. We look for GDP growth to average 5.3% in 2011, although with upside risks should
crude oil prices rise further. We have a relatively aggressive interest rate profile for this year and a less restrictive policy
stance could also see growth exceed our expectations, albeit raising concerns about medium-term prospects.
• Domestic demand should be supported by stronger consumer spending growth and fixed investment spending. Real
wages are increasing and the unemployment rate should trend downward. Consumer confidence has improved, while
low interest rates are underpinning particularly strong growth in retail lending. We forecast consumer spending to rise
by 4.9% in 2011, up from 3.0% in 2010. Pre-election government transfers to households and pensioners could further
bolster consumer spending this year (the presidential election is due in 2012). The main downside risk is that inflation
remains stubbornly high, hitting household real incomes and potentially leading to more aggressive monetary tightening.
Fixed investment growth was subdued last year, up by just 6.1% after falling 15.7% in 2009, but business confidence
should improve as the recovery consolidates. We look for fixed investment growth in the region of 8% in 2011 and 2012.
• However, the importance of the oil and gas sector to Russia’s prospects should not be underestimated, being equivalent
to around 15% of GDP and 65% of export earnings. The rise in crude oil prices has significantly improved economic
prospects in the year ahead. The current account is expected to post a surplus of around 4% of GDP, while the
government budget deficit should narrow to 3.1% of GDP on higher revenues. Russia posted its first fiscal deficit for a
decade in 2009. However, it is worth highlighting that the non-oil deficit is close to 13% of GDP, while the oil reserve fund
has been depleted. The need to improve fiscal sustainability is crucial to reducing Russia’s vulnerability to external
shocks. The severity of the economic contraction in 2009 also highlights the need for increased investment in the non-
oil sector and enacting structural reforms to put economic growth on a more sustainable footing. This is critical if Russia
hopes to match the growth exploits of its major emerging market peers.
CHART: Pipeline pressures suggest CPI inflation set to rise TABLE: Key Russian macroeconomic forecasts
% % Russia (Yr % unless stated) 2009 2010e 2011f 2012f
16 40
Real GDP -7.9 4.0 5.3 5.2
15
14
13 Gross investment -15.7 6.1 8.1 7.8
PPI inflation,
RHS 20 Government consumption 2.0 1.4 1.9 2.5
12
11 Exports -4.7 8.3 6.3 6.5
10
10 Imports -30.4 21.2 14.1 8.3
0
8
7 CPI inflation, -10 CPI 11.7 6.9 8.6 7.0
6 LHS
5 -20
2006 2007 2008 2009 2010 2011 Current account % GDP 3.9 5.0 3.8 1.9
Source: Datastream
18 th
Sian Fenner
MEXICO +44 (0)20 7158 3975
BENIGN INFLATIONARY PRESSURES TO KEEP RATES ON HOLD

• Mexican real GDP grew an annualised 1.3% quarter-on-quarter in Q4, up from 0.8% in Q3. This yielded a full year
expansion of 5.5% in 2010. Although not offsetting the annual contraction of 6.1% recorded in 2009, it does represent
a strong recovery, especially considering the relatively sluggish import demand from the US – Mexico’s largest trading
partner.
• Domestic demand remained robust in Q4, increasing by 1.3% quarter-on-quarter. Encouragingly, the rebalancing in
growth from the public to the private sector appears to be on track, with household spending and investment
increasing by 1.1% and 2.1% respectively. In contrast, export volumes contracted by 1.6% on the quarter, ending five
consecutive quarters of solid growth.
• The fall in exports largely reflected softer US demand for non-energy goods, which eased to 19.4% year-on-year in
Q4, from over 29% in the previous quarter. While trade with South America has increased, the US still accounts for
around 80% of Mexican manufacturing exports. However, with the US economy expected to strengthen in 2011, we
believe the weakness experienced in Q4 was temporary. We note that exports in January grew 26.8% year-on-year.
• Mexico’s industrial sector has started the year on a positive note, growing a robust 6.6% year-on-year in January.
While the manufacturing sector recorded another solid performance, supported by firm vehicle sales abroad,
construction activity was also strong. The recovery in the construction sector is expected to continue this year supported
by government infrastructure spending. Moreover, we expect investment in machinery and equipment to improve as
capacity utilisation rates rise on the back of firm growth in the manufacturing sector. That said, we believe that it will
not be until late 2011 and into 2012 that we see a significant uplift in machinery and equipment investment. Nonetheless,
total investment is still forecast to rise 7.8% this year, from just 1.9% in 2010.
• The recovery in household spending is expected to continue this year. Although January’s retail sales fell month-on-
month, they were up 3.3% year-on-year. Moreover, remittances have grown at a solid pace over the past three months.
Household disposable income is also benefiting from subdued inflation pressures and low interest rates. Unlike its
Latin American counterparts, annual inflation in Mexico has eased this year, recording 3% in March compared with
3.6% in February. This partly reflects the amount of slack still present in the economy. In particular, the unemployment
rate has yet to fall significantly during the economic recovery. In February, it stood at 5.3%, only 0.7 percentage points
below its peak in 2009. Although we expect stronger manufacturing and construction activity to result in the
unemployment rate falling to 4.7% by end-2011, we suspect that subdued labour market conditions and benign
inflationary pressures will see the central bank of Mexico keeping its benchmark interest rate on hold until Q4 2011,
when rates are projected to rise to 4.75%, from 4.5% currently. Rates are then forecast to rise to 5.5% by end-2012.
• For this year, we expect real GDP growth to ease to 4.7%, right at the upper end of the central bank’s forecast of 3.8%
- 4.8%. And, consistent with stronger US activity, we look for the Mexican economy to expand by 4.9% in 2012.
However, the economy remains vulnerable to any slowdown in the US economy and there is a risk that high oil prices
will drag on US household spending and thus Mexican economic growth.
CHART: Unemployment is expected to fall gradually over TABLE: Key Mexican macroeconomic forecasts
2011
Mexico (Yr % unless stated) 2009 2010e 2011f 2012f
%
7 Real GDP -6.1 5.5 4.7 4.9
Forecast
6
4 Exports -14.0 21.7 9.2 8.0

Imports -19.0 23.1 11.0 10.2
3
1 CPI 5.3 4.2 4.1 3.7

0
Dec 06 Dec 08 Dec 10 Dec 12 Current account % GDP -0.7 -0.3 -1.0 -1.1
th
WEQ - 14 APRIL 2011 19
Lloyds Bank Corporate Markets
Sian Fenner
SOUTH KOREA +44 (0)20 7158 3975
A RESURGENCE IN RESIDENTIAL INVESTMENT EXPECTED IN 2011

• South Korean real GDP growth exceeded expectations in Q4 2010, increasing by 0.5% quarter-on-quarter, albeit this
was down from the 0.7% pace set in Q3. As a result, GDP expanded by 6.2% in 2010 as a whole, compared to 0.3% in
2009. GDP growth in Q4 was driven by a strong positive contribution from net exports, which offset a slowing in
household spending and a fall in investment, down 0.9% quarter-on-quarter - the first decline in nearly two years.
• Looking ahead, the economic outlook for 2011 remains favourable. In line with a general improvement in business
conditions and trade across most of Asia towards the end of 2010, industrial activity has picked up again. Moreover,
export growth has remained strong, increasing 28.3% year-on-year in the three months to February. Despite a strong
Korean won, export volumes are forecast to remain robust, growing by 11.5% in 2011.
• While lower government spending on infrastructure is likely to weigh on total investment, residential investment is
forecast to pick-up in 2011. After two years of subdued growth, house prices and rents are both gathering pace and
housing affordability has improved over the past three years. As such, despite our forecast rise in interest rates we are
looking for a resurgence in residential investment this year. And with capacity utilisation rates already running above
pre-recession peaks, we also expect non-residential investment to remain strong, albeit grow at a more moderate
pace than last year. We look for fixed investment to increase by 3.9% this year, following a 7% rebound in 2010.
• To date, the strength in industrial activity has been the main source of job creation. However, in the absence of a
sustained pick-up in services employment (which accounts for around 75% of total employment) the unemployment
rate has yet to return to pre-crisis levels. In 2011, we expect a pick-up in activity in financial and real estate services to
drive the unemployment rate to 3.1% by the end of the year, from 4.0% in March. And with earnings rising we look for
household consumption to remain firm this year. However, there are also a number of headwinds facing consumers.
Consumer price inflation has recently accelerated, increasing 4.7% year-on-year in March – exceeding the BoK’s 2-4%
inflation target for the fourth consecutive month. Moreover, with demand pull pressures and higher commodity prices
threatening the medium-term inflation outlook, we expect interest rates to continue rising this year to 3.5% by the end
of 2011, with a further 100bp projected in 2012. This will weigh on household real disposable incomes and as such
we look for growth in household spending to ease to 3.9% from 4.1% in 2010.
• We expect exports and residential investment to be the key drivers of GDP growth in 2011. But, with government
spending and non-residential investment both predicted to ease this year, GDP growth is forecast to moderate to 4.3%
in 2011. However, the economic outlook is not without risk. Fiscal tightening in the eurozone is expected to see
external demand from this region slow this year. While the euro area only accounts for around 9% of total Korean
exports, the indirect effects via other major trading partners may be large. There also remains a significant amount of
geopolitical risk. An escalation in tensions with North Korea would have a damaging effect on confidence and could
see fixed investment and consumption both weaker than currently anticipated. Moreover, the threat of inflation remains
a key policy risk, with authorities needing to tread carefully between cultivating the recovery in domestic demand
whilst ensuring inflation expectations remain well anchored. Looking at the upside risks to growth, household spending
may come in stronger than anticipated as improving labour market conditions boost confidence.
CHART: Rising inflationary pressures will see more TABLE: Key South Korean macroeconomic forecasts
interest rate hikes this year
%, YoY South Korea (Yr % unless stated) 2009 2010e 2011f 2012f
14 Real GDP 0.3 6.2 4.3 4.9
11
PPI Gross investment -1.0 7.0 3.9 5.0
Benchmark
interest rate Exports -1.2 14.5 11.5 9.5
5
Imports -8.2 17.2 13.3 9.9
CPI
-1
CPI 2.8 3.0 4.4 2.8
-4 Budget balance % GDP (cal year) -1.9 0.9 0.3 0.9
Mar 07 Mar 08 Mar 09 Mar 10 Mar 11
20 th
Jeavon Lolay
TURKEY +44 (0)20 7158 1742
GROWING CURRENT ACCOUNT DEFICIT CLOUDS OUTLOOK

• The Turkish economy has posted a robust rebound following its sharp contraction in 2009, swiftly regaining its lost output.
It was among the fastest growing emerging market economies in 2010. Economic growth accelerated to 9.2% year-on-
year in the fourth quarter of 2010, up from 5.2% in Q3. For 2010 as a whole, real GDP growth averaged 8.9%, rebounding
from a 4.8% fall in output in 2009. The main driver has been double-digit growth in domestic demand, led by surging
consumer spending and fixed investment. However, as a consequence, imports have also soared, leading to a worryingly
sharp rise in the current account deficit. With domestic demand remaining robust, a further increase is expected in 2011.
• With the prospect that the current account deficit could breach 8.0% of GDP this year, we believe it represents a major
vulnerability to the Turkish economic outlook. This seems especially true given high oil prices and ongoing troubles in the
MENA region, a key destination for Turkish exports. The central bank said recently that containing, then reducing the current
account was its ‘main task’. But its unorthodox policy has not had the desired effect so far, raising concerns about its efficacy.
• Concerned about the upward pressure on the lira posed by short-term capital inflows, the central bank has followed an
‘intriguing’ policy mix of cutting the benchmark policy rate (by 50bp in December and 25bp in January), alongside sharp
hikes in minimum reserve requirements to curb domestic credit growth and help narrow the current account deficit.
Although the lira initially weakened significantly, credit growth has remained strong and the current account deficit has
widened modestly further. The deficit is estimated to average 6.8% of GDP in 2010, up from 2.3% in 2009. At the March
policy meeting, the central bank imposed a further aggressive hike to reserve requirements – indicating its rising concern
and commitment to act. However, the benchmark repo rate was held at a record low of 6.25%. Although the measures are
ultimately likely to be effective in dampening credit supply, we believe that lending constraints would work much better if
aligned with higher policy interest rates to dampen credit demand – particularly as inflation looks set to accelerate in the
year ahead. Should confidence in the policy stance deteriorate, the lira could come under selling pressure, pushing
inflation higher and threatening an abrupt rise in interest rates later this year.
• Recent data show economic activity remains buoyant, but we expect domestic demand to slow from last year’s double digit
pace, reducing GDP growth to 6.5% in 2011. However, consumer spending should be supported by credit availability and
improving labour market conditions. The unemployment rate has fallen recently and is set to average 10.8% this year. We
look for consumer spending to grow by 7%, up from 6.6% in 2010. Investment spending should remain brisk, rising by
13.8% after almost 30% last year. Moreover, Turkey’s fiscal fundamentals have improved since the financial crisis and look
relatively favourable. Government consumption looks set to rise significantly in this election year, but fiscal policy is likely
to be tightened in the future. Looking into 2012, GDP growth is predicted to slow further to 4.7%, as higher interest rates and
tighter credit conditions impact. Positively, the current account deficit should fall as a share of GDP.
• Inflation slowed to 4% in March – the lowest since 1970 – but underlying pressures appear to be rising as are general
inflation expectations. We expect annual inflation to accelerate in the year ahead, resulting from excess demand, a weak lira
and high commodity prices. Domestic bond yields have surged since the start of the year, with benchmark 2-year lira bonds
breaking 9% from 6.9% at the start of 2011. In response to rising inflation, we expect the central bank to start raising policy
interest rates later this year. The repo rate is predicted to end 2011 at 8%, from 6.25% currently, rising to 9.75% by end-2012.
CHART: Turkish inflation poised to accelerate in 2011 TABLE: Key Turkish macroeconomic forecasts
% $, pb
13 160 Turkey (Yr % chg unless stated) 2009 2010e 2011f 2012f
12 Real GDP -4.8 8.9 6.5 4.7

CPI inflation, 140
LHS
10 120 Gross investment -19.0 29.9 13.8 6.1
100
8 Exports -5.0 3.4 4.9 6.9
7 80
Imports -14.3 20.7 14.0 10.4
6 60 Industrial production -9.9 13.1 6.6 7.1
5 Unemployment rate 13.1 11.0 10.8 10.1
Brent 40
4 CPI 6.3 8.6 5.9 5.4
crude oil, RHS
3 20 Budget balance % GDP -5.6 -3.7 -2.6 -2.0
2006 2007 2008 2009 2010 2011
Source: Datastream
th 21
Mark Miller
POLAND +44 (0)20 7158 2141
EURO AREA PROSPECTS TO REMAIN KEY

• The Polish economy expanded by 0.8% quarter-on-quarter in 2010Q4 to yield annual growth of 3.9%. Going forward, we
see private consumption and fixed investment as the main drivers behind Poland ’s economic expansion in 2011 and
2012. Meanwhile, Poland’s exports have been supported by strong demand from its main trading partners. In particular,
Germany’s export-oriented economy is now also being propelled by firmer domestic demand. But stronger import
growth in Poland will likely mean that net trade will contribute little, if anything, to overall growth. Our Polish GDP growth
projections for this year and next stand at 4.0% and 4.4%, respectively. In our view, the trend economic growth rate is
likely to be around 3.5%, although in practice this hinges on longer-term developments in supply-side factors such as
trend labour productivity and population growth.
• The National Bank of Poland ’s (NBP) latest Senior Loan Officer survey suggests a majority of banks in Poland are
continuing to tighten credit standards to households, thus dragging on consumer sentiment. Nonetheless, we expect
consumer spending to expand by 3.8% this year, followed by 4.5%, next. In part, this reflects continuing employment
growth, although as activity accelerates going forward, higher wage growth seems likely. The outlook for fixed investment
is also encouraging. This is particularly true in the public sector where infrastructure spending (using EU funds) is
ongoing. But Poland still needs to undertake significant fiscal consolidation in the years ahead. From a projected 7.9%
of GDP in 2010, the government’s objective is to reduce this to below 3% by 2012. This will reduce the contribution to
GDP growth coming from government consumption, particularly in 2012.
• The Polish zloty (PLN), meanwhile, has trended higher versus both the euro and sterling over the past two years or so. But
there have been significant bouts of weakness during periods where the stability of the euro area was effectively called
into question (e.g. in May and November last year and the recent uncertainty surrounding Portugal). While Polish entry
into the euro area is not imminent, the government’s stated intention to join when conditions are “safe” means that the PLN
is still vulnerable to a failure by EU authorities to agree an effective permanent solution to the sovereign debt crisis
among ‘peripheral’ euro members. The details behind the EFSF’s enhanced lending capacity will be re-visited by the end
of June.
• In our view, a potentially weaker PLN exacerbates the problem of elevated inflation pressures, pushing CPI inflation
further above the 2.5% target. Poland recently implemented a VAT rate increase (to 23% from 22%), which has helped to
push CPI to a rate of 4.3% in March, from 3.6% in the year to February. In January, the National Bank of Poland (NBP)
raised its key policy rate for the first time since mid-2008, by 25bp to 3.75%. The minutes from the NBP’s meeting noted
that ‘…strong increases in global commodity prices and heightened inflation expectations, increased the risk of inflation
running above NBP’s inflation target in the medium term’. And significantly, the majority of Council members acknowledged
that January’s rate rise marked the beginning of a gradual policy tightening cycle. This statement was essentially repeated
in March prior to a further rate hike in April, to 4%. Our end-2011 NBP rate forecast stands at 4.75%. Further out, an
acceleration in the pace of economic growth to 4.4% in 2012 should see the NBP continue raising rates, lending support
to the PLN against sterling, the euro and to a lesser extent, the US dollar over the year or so. This theme of relatively high
interest rates in Poland is also relevant for the medium term outlook beyond 2012, although progress on fiscal tightening
will also be important.
CHART: Germany is Poland ’s key trading partner TABLE: Key Polish macroeconomic forecasts
GDP %Yr
Poland (Yr % chg unless stated) 2009 2010e 2011f 2012f
10
Real GDP 1.7 3.8 4.0 4.4
8 Poland
6
4
2
Exports -6.0 10.2 5.7 9.6
0
Imports -13.2 10.7 7.1 9.9
-2 Industrial production -3.7 10.7 6.3 5.5
-4 Germany
Unemployment rate (% Q4) 11.5 11.8 11.5 10.5
-6 CPI 3.8 2.7 3.8 3.0
-8 Budget balance % GDP (cal yr) -2.2 -3.2 -6.3 -5.1
2000 Q4 2002 Q4 2004 Q4 2006 Q4 2008 Q4 2010 Q4
Current account % GDP -4.9 1.4 1.8 2.3
Source: LBCM
22 th
Sian Fenner
INDONESIA +44 (0)20 7158 3975
ROBUST DEMAND FOR COMMODITIES TO SUPPORT GROWTH

• The Indonesian economy surged ahead in Q4 2010, growing 6.9% year-on-year, from 5.8% in the previous quarter. This
was the highest annual growth rate since Q4 2004 and saw GDP growth for 2010 at 6.1%, from 4.6% in 2009. Exports
were the key driver of growth in the quarter, increasing 16.1% on the year, while fixed investment rose 8.7%.
• We expect exports and fixed investment to be the remain the key drivers of economic growth over the next couple of
years. Real GDP is forecast to grow 6.4% this year and 6.0% in 2012. While Indonesia will clearly benefit from the
increase in global commodity prices since Q4 2010, demand for commodities outside of the Asia region has also
improved. In January, merchandise exports to the US and Japan increased 32.7% and 28.9% year-on-year respectively.
Moreover, commodity exports, in particular coal, are likely to pick-up further given rising demand for coal from China
and India, and a likely increase in Japanese coal demand. This should more than offset any temporary disruptions to
exports caused by potentially lower Japanese demand for other goods (Japan is Indonesia’s largest trading partner).
Consequently, we look for exports to increase by 11.3% this year, down from 14.9% in 2009.
• Strong commodity prices will also increase national income and support investment going forward. There are currently
a large number of projects in the pipeline. Moreover, real interest rates are forecast to remain low despite our projected
increase in official interest rates this year to 7.5% from 6.75% currently.
• Although favourable harvests have contributed to a moderation in consumer inflation, strong demand and higher
commodity prices are expected to drive inflation higher to average 6.7% in 2011 (above the Bank Indonesia’s target of
5% ± 1%). This does raise the risk that interest rates will need to be increased more aggressively than currently forecast.
However, we believe that the Indonesian authorities will also continue to use other quantitative tools, such as increasing
banks’ reserve ratios.
• Meanwhile, although household consumption growth slowed more than expected in Q4, indications are that this was a
temporary blip, with strong wage outcomes to support consumption going forward. Motor vehicle sales and consumer
confidence have both recorded solid gains in the first months of 2011. And against this backdrop, lending has swelled.
Moreover, the postponement of a government program (pending discussion with the parliament) aimed at limiting the
consumption of subsided fuels will also aid household spending in H1 2011. We expect consumption to increase 6.1%
this year.
• However, on the otherhand, this postponment is likely to see a further deterioration in the budget deficit, to what extent
will in part be determined by the level of oil price. The government forecast that fuel subisidy costs would equal IDR137
trillion, or 1.8% of GDP in 2011. However, this assumed oil prices at US$80 per barrel. Under our assumption that oil
prices will average US$100 per barrel we expect the budget shortfall to widen to 1.5% of GDP from 0.5% in 2010. While
oil prices above our assumption would obviously see the deficit worsen, it would also raise the possibility of cuts to fuel
subsidies. In this case, we would expect household consumption to be lower than forecast. Past decisions to cut fuel
subsidies – in October 2005 and May 2008 – were followed by a sharp deterioration in consumer confidence and slower
growth in retail spending.
CHART: Oil prices will see fiscal deficit deteriorate TABLE: Key Indonesian macroeconomic forecasts
% of GDP
Indonesia (Yr % unless stated) 2009 2010e 2011f 2012f
0.5 forecast
Real GDP 4.6 6.1 6.4 6.0
0.0 Household consumer spending 4.9 4.6 6.1 5.7
Gross investment 3.3 8.5 8.5 7.1
-0.5
Exports -9.7 14.9 11.3 4.5
-1.0
Imports -15.0 17.3 12.8 6.6
-1.5 Industrial production 1.3 4.4 4.4 4.7
-2.0
CPI 4.8 5.1 6.7 6.1
-2.5 Budget balance % GDP (cal year) -1.5 -0.5 -1.5 -1.8
2004 2005 2006 2007 2008 2009 2010 2011 2012 Current account % GDP 1.0 0.2 0.0 0.5
th 23
Sian Fenner
SOUTH AFRICA +44 (0)20 7158 3975
RECOVERY IN DOMESTIC DEMAND TO GATHER MOMENTUM

• The pace of South African GDP growth strengthened in Q4 2010, increasing by an annualised rate of 4.4%, from 2.7%
in the previous quarter. However, the economy only grew by 2.8% in 2010 as a whole, after contracting by 1.7% in 2009.
The pick-up in Q4 GDP growth has been led by strong activity in the mining sector and a rebound in manufacturing, after
strikes disrupted production in Q3. Looking at the expenditure components, although household consumption growth
slowed to 5.1%, fixed investment rose by 1.5% - significantly, the strongest quarterly growth since Q4 2008. This was
largely led by government investment, but favourable demand for South African commodities also helped sustain capital
spending by the mining sector.
• Government consumption rebounded in the quarter, contributing 0.8 percentage points to GDP growth. However, with
government spending increasingly limited by the large fiscal deficit, which widened from 0.7% of GDP in 2008 to 5.2%
in Q4 2010, the recovery is expected to become increasingly reliant on private sector demand.
• Household consumption is therefore forecast to be a key driver of GDP growth in 2011. Households have benefited from
a boost to real disposable incomes and an improving net wealth position. Moreover, households’ debt servicing
requirements continue to recede as a cumulative 750bp cut in interest rates since December 2008 has reduced households’
interest payments. Interest rates are forecast to remain at 5.5% until Q1 2012 finishing 2012 at 7.5%. This would still see
the policy rate significantly below its pre-crisis rate of 12%.
• The acceleration in infrastructure investment by the government and national electricity supplier Eskon is expected to be
complemented by increased private sector investment. In particular, we look for mining investment to rise strongly this
year in line with the positive outlook for global demand and the prices of South African commodities. Fixed investment
is expected to grow by 4.1% this year. However, after contracting in the previous two years, levels will still be 2% below
that before the recession.
• Currently, the strength of the rand and the ongoing uncertainties surrounding the euro area do not appear to have
dampened demand for South African exports. Exports rose 31.9% year-on-year in January after a 30.6% increase in
December. Within this, Asian demand has been particularly strong, growing 49.1%, but exports to Europe and the US
also recorded double-digit growth. Asia currently accounts for around 30% of South African exports and the positive
outlook for the region should underpin demand this year. Coal shipments are also set to rise, boosted by the disruption
to Australian coal production and exports caused by the Queensland floods. However, the South African economy
remains vulnerable to higher oil prices. This is expected to contribute to a deterioration in the current account this year.
The current account deficit is projected to widen from 0.6% of GDP in Q4 2010 - its lowest level since Q1 2003 - to an
average of 4.1% of GDP in 2011.
• In summary, while higher oil prices are a risk to our outlook, we expect the economy to grow by 3.7% this year as
monetary policy remains accommodative and household spending stays firm. In 2012, despite our forecast for interest
rates to rise to 7.5%, from 5.5% currently, real GDP is forecast to grow by 4.2%, albeit this will be the fourth consecutive
year of below trend growth.
CHART: Higher oil prices to contribute to a widening in the TABLE: Key South African macroeconmic forecasts
current account deficit
South Africa (Yr % unless stated) 2009 2010e 2011f 2012f
% of GDP
2 Real GDP -1.7 2.8 3.7 4.2
forecast
0 Gross investment -2.2 -3.7 4.1 6.5
-2 Exports -19.5 4.7 11.5 8.4
Imports -17.4 9.6 11.0 8.8
-4
-6
CPI 7.1 4.3 4.6 5.6
-8
2005 2006 2007 2008 2009 2010 2011 2012 Current account % GDP -4.1 -2.7 -4.1 -5.0
24 th
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Economic Research can be accessed Martin Bates
online at: +44 (0)20 7158 1783
http://www.lloydsbankcorporate martin.bates@lloydsbanking.com
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Commercial Sales
and on Bloomberg at: Matt Lawrence

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WORLD ECONOMIC QUARTERLY

SECOND QUARTER 2011

Mark Mil ler

Sian Fenner EDITORIAL COMMENTS TO:

both fiscal and monetary. Here, the return of inflation has -6

Our G10 grouping is predicted to grow by 2.3% in 2011,

in the major developed economies. It is now soaring inflation

Key macroeconomic forecasts for our G10 & E10 groupings

World -0.8 4.7 4.3 4.6 2.2 3.4 3.0 2.1

from its (thus far encouraging) fiscal consolidation path.

months. In addition to rate hikes, other monetary policy tools, 10

Source: Haver & LBCM

ENCOURAGING SIGNS OF SELF-SUSTAINING RECOVERY

Monthly change, 000s Four-week ave, 000s

200 650 Household consumer spending -1.2 1.7 3.4 3.3

-400 450 Imports -13.8 12.7 7.7 8.8

BACK INTO RECESSION, UNCERTAIN OUTLOOK

ECB TO CONTINUE TIGHTENING. BOND MARKETS TO REMAIN

0 CPI 0.3 1.6 2.5 1.8

MIX OF GROWTH STARTING TO FAVOUR DOMESTIC DEMAND

FRANCE NEEDS TO STRENGTHEN ITS DOMESTIC ECONOMY

FRAGILE BOND MARKET SENTIMENT THREATENS GROWTH

PORTUGAL BAILOUT APPLICATION PUTS SPOTLIGHT ON SPAIN

65 Spain (Yr % unless stated) 2009 2010e 2011f 2012f

35 Imports -17.8 5.4 1.5 4.8

30 Industrial production -15.5 0.8 0.4 2.9

25 Unemployment rate (%, Q4) 18.8 20.3 20.3 19.6

20 CPI -0.3 1.8 2.9 1.6

Source: LBCM Current account % GDP -5.5 -4.5 -4.1 -2.8

‘OPEN’ NATURE OF ECONOMY SUPPORTS GROWTH PROSPECTS

20 Household consumer spending -2.5 0.4 1.0 1.5

HOUSING MARKET TO UNWIND IN AN ORDERLY MANNER

UNEVEN RIDE AHEAD

FOOT FIRMLY ON THE POLICY BRAKES

-5 Unemployment rate (%, Q4) 4.3 4.1 4.3 4.2

MACROPOLICIES TO DAMPEN OVERHEATING ECONOMY

5 11 Government consumption 4.0 3.3 2.5 3.0

TIGHTER POLICY STANCE TO HIT GROWTH

0 CPI 1.8 2.8 3.0 2.8

INFLATION FEARS ABOUND DESPITE DISAPPOINTING GROWTH

BENIGN INFLATIONARY PRESSURES TO KEEP RATES ON HOLD

4 Exports -14.0 21.7 9.2 8.0

1 CPI 5.3 4.2 4.1 3.7

Source: Haver & LBCM

A RESURGENCE IN RESIDENTIAL INVESTMENT EXPECTED IN 2011

GROWING CURRENT ACCOUNT DEFICIT CLOUDS OUTLOOK

12 Real GDP -4.8 8.9 6.5 4.7

EURO AREA PROSPECTS TO REMAIN KEY

ROBUST DEMAND FOR COMMODITIES TO SUPPORT GROWTH

RECOVERY IN DOMESTIC DEMAND TO GATHER MOMENTUM

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