bnp paribas - eco perspective_4tr_en 9.10.2014

8/11/2019 Bnp Paribas - Eco Perspective_4tr_en 9.10.2014

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BNP PARIBASECONOMIC RESEARCH

DEPARTMENT

Eco Perspectives //4thquarter 2014

Editorial

Two-speed world

The eurozone is still lagging behind the rest of the

developed world and its growth is likely to remain slow in

2015. Inflation will pick-up, mainly because of basis

effects, and will remain subdued. Looking at the FX

markets, the ECB action is proving effective

Detailed forecasts

EUROZONE

10

JAPAN

6

GERMANY

13

FRANCE

15

ITALY

17

SPAIN

19

BRAZIL

21

RUSSIA

23

INDIA

25

CHINA

27

This month:

2

Chief editor: William De Vijlder // Completed: 6 October2014 //economic-research.bnpparibas.com

IRELAND TURKEY

29 31

UNITED STATES

3

33

UNITED KINGDOM

8


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4thquarter 2014

2 economic-research.bnpparibas.com

Editorial

Two-speed worldThe eurozone is still lagging behind the rest of the developed world and its growth is likely to remain slow in 2015. Inflationwill pick-up, mainly because of basis effects, and will remain subdued. Looking at the FX markets, the ECB action isproving effective, although the institution chose not to opt for a massive program of plan quantitative easing throughsovereign security purchases. Money and credit will start to expand again in 2015, albeit modestly. In the United-States,firm growth is likely to persist, with a fiscal policy that will not get more restrictive. The slack in the labour market is rapidlydiminishing opening the door for normalisation of the monetary policy.

The recovery in the eurozone proved uneven and deceptive.Geopolitical tensions, especially the war in Ukraine,depressed business surveys by mid-2014. Firms postponed

some investment plans and growth prospects for 2015 remainlacklustre: no more than a 1% increase in GDP, with Germanyrunning at 1.4%, but France and Italy likely to be closer to0.5%. However, one has to remember that the EMU is aconvalescent area, still engaged in a deleveraging process. Itssituation looks much safer now. It attracts more thanEUR 100 bn of net portfolio investments per year, the risk ofconvertibility no more is a subject for markets. EMU memberStates that were under major stress in 2011 and 2012 are nowable to tap financial markets at a very low cost. Thecompression of spreads is coming along with an improvementof sovereign debt ratings. Countries at the "periphery" of theEMU are in a better shape and exhibits decent rates of growth.

The nominal effective exchange rate of the euro had gone up10% from mid-2012 to early 2014, putting a break on activityand inflation. But this trend has now been reverted. For thefirst time since the start of the global financial crisis, the ECBis implementing a policy more accommodative than the Feds .This will cause the euro to depreciate. The single currency isalready 9% below its previous peak against the US dollar andis likely to weaken further. This may help to counter thenegative effects of the tensions with Russia, along with thefact that, until now, geopolitical tensions failed to cause amajor shock on commodity market prices.

What is clear is that the action taken by the ECB (acombination of negative interest rate on the deposit facilityand an extension of the forward guidance) has prompted theeuro to weaken. In that sense, it proves effective. The weakoutcome of the first TLTRO does not tell a lot about thesuccess of the incoming five other operations, and we willhave to wait until December, and the second TLTRO, beforedrawing any conclusion. The ECB's balance sheet will expandagain as the institution will purchase private assets (ABS andcovered bonds). The aim is to bring the balance sheet towardsits previous peak of EUR 3 tr (the previous peak). Eventhough the ability of the ECB of reaching this target isunquestioned, the size of the ABS and covered bond markets

look too small. For this reason, some have argued that,eventually, the ECB will have to go plain QE, a program ofsovereign debt security purchases. The key question is notabout how to increase the monetary base (M0) but how M3

will react, considering that M3 is a key driver of core inflationin the eurozone. Much of the success of the ECB will bemeasured through the M0 multiplier (the ratio between M3

and M0). The fact that is has been up recently is encouraging.It shows that the money market relies more on its own forces -interbank loans are picking up - and becomes less dependenton ECB loans. Moreover, as part of the TLTRO will beconditional to the outstanding amounts of loans to the privatesector, the money base multiplier could become moreeffective. Data from the latest bank lending survey arecomforting the view that credit is stabilising. Despite a bindingregulatory environment, a majority of banks are now relaxingcredit standards on their loans to businesses. This is the firsttime since the second quarter of 2007. Ultimately, inflation is amonetary phenomenon. As lending activity and money growthmight stabilise in 2015, there is no reason to believe it could

fall in a negative territory.

The US will likely deliver above-trend growth in 2015. Activityshould be driven by steady gains in household consumptionand business investment. The consumer-credit channel,outside of auto lending, remains impaired, with growth inmortgage and personal loans limited. This suggests that theeconomy will rely on steady gains in employment and, later,pick-up in real wages. Meanwhile, business investment is duefor a pickup, although there is a risk of more share buybacks.Fiscal policy restraint is expected not to be larger than duringthe previous fiscal year, austerity not being increased for thefirst time in five years. The contribution from net exports is

likely to be limited, reflecting weakness in Japan and theeurozone as well as slowdown in China. Finally, global growthshould be around 3% in 2015. The US unemployment ratehas fallen and is probably only a point or less away from thelevel where inflation could start to accelerate. However, thereliability of this indicator as a leading indicator of wagepressures has been impaired, and the Fed will monitor alarger number of labour market indicators. With inflationexpectations stable and the core price index for PCE (theFeds favourite measure of inflation) running below 2%, itcould wait until way into 2015 before hiking rates. Oncestarted, the tightening path will be very gradual, and thebalance sheet will hold steady at least until 2016.

Jean-Luc Proutat

[email protected]
mailto:[email protected]:[email protected]


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United States 4thquarter 2014


United States

Discretion is the better part of valourThe pace of growth seems to be gaining momentum. If the development in international trade allows, exports could joinbusiness investment as the main engines of growth. This more balanced growth will also result in less eye-catchingperformances, while fiscal policy will not turn supportive before 2016. The decline in oil prices will definitely bring somerelief to households purchasing power. Together with the recent appreciation of the dollar, it makes it even less likely tha tinflation pressures are building. The Fed, which QE3 asset-purchase program will be terminated at the end of October, willremain on hold as long as necessary. This means that the first hike could come rather later than sooner.

Gathering steamAs expected, the US economy strongly rebounded in thesecond quarter, following a contraction in the first quarter. On

a quarterly annualised basis, GDP growth was -2.1% in Q1and 4.6% in Q2, i.e. an average of 1.2% over the first half of2014. As compared with 2013, the underlying trend seems tobe slightly upward, as final domestic demand gained anaverage 2.1% in H1 2014 versus 1.6%, as the deceleration inoverall GDP growth is more related to net exports. In 2013,they brought 0.2 pp to GDP growth, while they cut it by 1 pp inH1 2014. This is explained by the growth differential betweenthe US and its main trading partners. America grows faster,and imports more ; other developed countries grows slower(or even contracts), and import less.

Prospects for the second half of 2014 are for further firming,

even though some more volatility can be expected. Data forthe three months to September highlight a limited slowdown inconsumption. Still, the chances that households spendingcould disappoint and grow slower than 2% are rather large.This is partly due to the timing of ups and downs during thesummer: the second quarter ended on a strong note, the thirdquarter began on a soft one. For Q3 to be as strong as Q2(+2.5, quarterly annualised rate), real consumption spendingwould have to have gained 0.5% m/m in September, i.e. thesame performance as in August. Such a positive outcomecannot be ruled out as anecdotal evidence point to anotherstrong month for car retailers. Still, the August increase wasalso due to strong real spending on non-durable goods,

thanks to declining prices. Oil prices kept on easing inSeptember, but at a slower pace while the end of the summerholiday season is likely to have limited the increase in energyconsumption.

Whatever the final outcome, private consumption is set tostrengthen, as the improvement in the labour market willsupport households disposable income and confidence,allowing the underlying growth rate in consumer spending togently accelerate as from Q4. On top of that, the recovery inbusiness investment is gaining momentum. As othercomponents of demand, it slowed down markedly in Q1(+1,6% vs. +10.4% in Q4 2013), but recovered sharply

afterwards, gaining almost 10% in Q2. Monthly activity data ofthe durable goods industry lead to expect Q3 to be anotherdynamic quarter, as shipments for core capital goods (i.e.

1- Demand breakdown

Year-on-year rate of growth or contributions, %

-- Final domestic demand ; -- Inventory change (contribution, r.h.s.); -- Net exports

(contribution, r.h.s.)

Source : US Department of Commerce.excluding defence and aircrafts) were up an annualised 9.3%in August, the strongest reading since end-2011. As data forprivate non-residential investment in structures also provide apositive message, it definitely appears that GDP growth in Q3will be supported mainly by business investment.

A need for more investmentWe do expect business investment to gain momentum and tobe one of the main engines of the recovery in the quartersahead. Such a forecast can be seen as conflicting with ourassessment that the US economy is still suffering from a largelevel of unused capacities. The main point of our answer is

that the main under-utilised factor is labour, not capital. On topof that, the industries that may still suffer from excess capitalcohabits with the ones that are getting closer to full capacityutilisation. Finally, new investment spending always is needed,as capital ages.

The rate of capacity utilisation can be as difficult to estimateas the output gap, i.e. the difference between actual activityand the level of activity that would be reached if capacities(capital and labour) were fully used. For sectors whichproduction heavily relies on machinery and equipment, it isway easier than for industries relying less on physicalequipment, hence the availability of data for the industrial

sector. Data from the Fed show that the industrial capacityutilisation rate is currently closed to its long-term average:78.8% vs. 80.7%. It is even closer for the manufacturing

-1,5

-0,5

0,5

1,5

2,5

-4

-3

-2

-1

0

1

2

3

2008 2010 2012 2014


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sector, which is just 0.6 pp below its long-term average.Among the different industries, the measures vary widely. Themachinery industry is operating close to full capacity, with arate of capacity utilisation of 81%, 2.4 pp above the long-termaverage. Transportation equipment and car industries are inthe rather same situation, as is the mining industry. Still, thepace at which they expand their capacities is rather different:slower than the average for car and transportation equipment,faster for mining. In short, an elevated rate of capacityutilisation does not necessarily leads to more investmentspending. A striking example of such a counter-intuitivedevelopment is the computer industry: its rate of capacityutilisation is low (68.8%), both as compared with themanufacturing industry as a whole (78%) and on historicalperspective (78.6%). Still, it is among the industries recordingthe fastest pace of capacities expansion.

The solution to that apparent contradiction lies in the age ofcapital. Not all new investment spending is created equal:some actually corresponds with the willingness to expandproduction capacities, and some are just decided to replaceageing capacities. Gross investment is the sum of the two,and to extract the to-expand-capacity types, one has tosubtract the depreciation of capital (capital consumption as inthe US national account terminology. This leads to an eye-catching chart, which, once more, points to the severity of the2007-2009 recession: for the first time since the Fed provideswith those data, net investment has been negative, aphenomenon that lasted three full years. Details by sectorshow that the business sector indeed cut massively netinvestment (it was negative for four quarters in a row). Sincebottoming out in end-2009, the recovery is rather strong whileit should soon get back, as a percentage of GDP, to its 1994-2007 average. Households definitely played a key role, butsurprisingly, and according to that measure, they did not over-invest over the 1994-2007 period, as the average was just anotch above the 1954-1994 one. Still, their net investment,even if positive and in the vicinity of 1 point of GDP, still didnot recover, running 2 percentage points below average.

This leaves the general government as the under-investing

culprit. The trend towards less government investmentspending is not new. In the 1950s, net general governmentinvestment was around 3 points of GDP. It began to plummetin the mid-1960s, averaging 1.5 points of GDP in the 1970sand the 1990s. After a limited recovery in the Clinton andBush years (for different reasons), it once more began to fallat the exact moment the economy was emerging fromrecession. State and local governments had then to balancetheir budgets, an austerity line followed thereafter by thefederal government. This led to the destruction of publicinfrastructures, while their quality now judged as very poor bysurveyed business leaders.

This has been one of our biggest concerns for the USeconomy for a while ; a weakness that, if treated, could alsohelp revive the economy, as spending on infrastructures haslasting positive effects on growth. The IMF in its most recentrelease of the World Economic Outlook, points to the highmultiplier attached to those spending, adding that The effectsof public investment on output and debt tend to be strongerwhen there is economic slack, when public investmentefficiency is high, and when public investment is debtfinanced. In short, the US federal government would have itboth, stimulating activity and improving the debt sustainability,as debt-financed infrastructures boost the potential rate ofgrowth in such a proportion that, according to the IMF, moredebt now is the most efficient way to less debt tomorrow..

Fiscal dragThe chances that this will happen are close to zero, though.Currently, there is no way for the Democrats and Republicansto make such a deal. On top of that, the next Congress, whichwill start in January 2019 after having been elected onNovember 4, will most likely be an opposition Congress, asRepublicans will probably retain the House of Representativesand regain the Senate. This means that the next legislaturewill likely be ineffective: any piece of law passed by theCongress without support from the Democrats could (andprobably will, especially when it comes to lower taxes and/orhealth care be vetoed by President Obama.As for State and local governments, even if their fiscal policy

2- Net investment: Private domestic businessGross investment minus capital consumption, as a % of GDP

Source : Federal Reserve, Financial Accounts of the US.

3- Net investment: Government sectorGross investment minus capital consumption, as a % of GDP

Source : Federal Reserve, Financial Accounts of the US.

-2

0

2

4

6

8

1954 1964 1974 1984 1994 2004 2014 0

1

2

3

4

1954 1964 1974 1984 1994 2004 2014


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no more weighs on demand, the support is quite limited. Thecurrent level of their infrastructure spending remains around20% below the 2005-2009 average while just around 15% ofjobs previously cut have been recreated. A new index1fromthe Hutchins Center on Fiscal & Monetary Policy, which is partof the Brookings Institution and where Ben Bernankesis nowa distinguished fellow in residence, shows that even ifausterity is no more increasing, it still did not begin to abate.Looking forwards, fiscal policy is unlikely to turn supportivebefore 2016. This leaves the Fed and its aggressive monetarypolicy as the only possible policy-mix support.

Monetary supportIn August, the Federal Reserve of Kansas City hosts aconference in Jackson Hole. The so-called Economic

Symposium gets a lot of attention as it is traditionally openedwith remarks from the Feds Chair. At several occasions in therecent past, Ben Bernanke used this opportunity to pre-announce incoming changes in monetary policy, and theJackson Hole event, which is a very academic gathering thatused to be known about only by economists, began attractinga lot of attention from the press. This year, Janet Yellen gaveher first introductory remarks, and this speech was analysedas the sign she was turning less dovish and more hawkish.We tend to see Miss Yellens speech as not being theillustration of her change of mind. Providing introductoryremarks to an academic event, she was very academic, goingthrough all the questions that are worth asking about the

actual state of the labour market and its consequences onprices. She stated that the uncertainty about the level of slackwas high and that the relationship between slack and wageson the one hand, and wages and inflation on the other handmay have been deeply affected by the Great Contraction.What she seems confident about is that there remains slack inthe labour market even though fading rapidly as of recently.The previously incredibly large amount of slack had a greatimpact on the way wages are formed. What she cannot bedefinitive about is how long this will last and how this will

1 http://www.brookings.edu/research/interactives/2014/fiscal-barometer. SeeLouise Sheiner, The Hutchins Centers Fiscal Impact Measure, BrookingsPaper, Hutchins Center on Fiscal & Monetary Policy, October 1, 2014.

unfold. So Fed officials will keep on closely monitoring allavailable indicators to try and extract a signal. Admittedly,when interviewed by Time Magazine earlier this year, shesounded more dovish. However, our view is that she did notchange her mind about willing to witness real wageacceleration. She just keeps an open-mind when analysingdata: monetary policy ultimately must be conducted in apragmatic manner that relies not on any particular indicator ormodel, but instead reflects an ongoing assessment of a widerange of information in the context of our ever-evolvingunderstanding of the economy.

This uncertainty about what really is happening will have theFed weigh risks. When it comes to the balance of risks between tightening policy too soon or too late Miss Yellendid not answer the question for a while. In Jackson Hole she,however, describe how the materialisation of those risks couldhurt the economy. Tightening too late would necessitate anabrupt and potentially disruptive tightening of policy later on .Tightening too soon could prevent labor markets fromrecovering fully and so would not be consistent with the dualmandate. As stated several times in the past by Fed officials,the longest it will take for the labour market to fully recover,the greater are the chances that it will have negativeconsequences on the long-term potential rate of growth. If youadd to that the recent downward trend in energy prices, theappreciation of the US dollar and the global lack of inflationpressures, you understand why William C. Dudley, thePresident of the New York Federal Reserve and a permanentvoting-member of the FOMC sees greater risks in tighteningtoo soon than in tightening too late.

Alexandra [email protected]

4- A lighter brake, but still a brake

Contribution of Fiscal Policy to Real GDP Growth (pp)

Source : Hutchins Center on Fiscal & Monetary Policy.

Summary

e : BNP Paribas Estimates & Forecasts

-2

-1

0

1

2

3

4

2000 2002 2004 2006 2008 2010 2012 2014

Components of Growth

y/y , vol, % 2013 2014 e 2015 e

GDP 2.2 2.1 2.8

Priv ate Consumption 2.4 2.2 2.4

Public Spending -2.0 -0.5 0.5

Fix ed Inv estment 4.7 6.3 10.4

Net ex ports (contribution) 0.0 -0.2 -0.2

Inflation & Labour

y /y , % 2013 2014 e 2015 e

Consumer Prices 1.5 1.8 1.6

Consumer Prices (ex . F & E) 1.8 1.8 2.1

Unemploy ment Rate, % 7.4 6.5 6.2

External & public accounts

% GDP 2013 2014 e 2015 e

Current account -2.4 -2.5 -2.3General Government Budget -4.9 -4.0 -3.5

Debt ratio 107 108 108
http://www.brookings.edu/research/interactives/2014/fiscal-barometerhttp://www.brookings.edu/research/interactives/2014/fiscal-barometerhttp://www.brookings.edu/research/interactives/2014/fiscal-barometermailto:[email protected]://www.brookings.edu/research/interactives/2014/fiscal-barometermailto:[email protected]://www.brookings.edu/research/interactives/2014/fiscal-barometer


6/39

Japan 4thquarter 2014


Japan

Hard to kick the QQE habitThe sharp GDP contraction in Q2 was followed by a modest rebound. In the next two years, monetary policy should remainvery accommodative to support growth, while fiscal policy will be close to neutral. The two forces driving GDP growth willbe investment and exports. Consumption will continue to decline due to losses in purchasing power. Even though inflationcould reach the BoJs 2% target in 2016, the central bank will continue to buy JGBs in order to keep interest rates low.

A limited reboundIn the second quarter, GDP contracted sharply by 1.8% afterfront-loaded demand ahead of the consumption tax on 1 April

had boosted activity in early 2014. In Q3, the economy hasstrengthened again, albeit in a rather moderate way. Forexample, the headline index of the Economy Watchers Surveyrebounded strongly but fell sharply back in August. Moreover,the overall business index of the Tankan survey weakened inSeptember. It seems that the economy has shifted to a lowergear.

The main reason for the growth deceleration is the substantialloss in purchasing power. The depreciation of the yencombined with the consumption tax hike has pushed upconsumer price inflation to around 3.3%. Since the springwage round, earnings for regular workers have been rising

again, although in a limited way. In July, total earnings were1% higher from a year ago. As a result, disposable income ofworkers families (of which the head is a wage earner) fell by1.4% in August from a year earlier according the FamilyIncome and Expenditure Survey.

In addition, exports have been stagnating. In the three monthsto August, they were almost at the same level as in the periodMarch-May. This is largely related to sluggish world trade.Moreover, structural factors, such as the relocation ofproduction overseas and the decline in competitiveness in theIT sector, have played a role. Lastly, firms have not used thedepreciation to lower their prices in overseas markets but

rather increased their profit margins.

The latter explains the strong growth in profits. The Tankanreports that in FY 2013 (April 2013-March 2014), profits were28.4% higher from a year earlier. In the manufacturing sector,profits almost doubled. In combination with fiscal stimulusmeasures and easy lending conditions, this has alsostimulated investment. In the first half of 2014, non-residentialinvestment was more than 7% higher from a year earlier.

A very accommodative monetary policy stanceThe Bank of Japan (BoJ) will continue its asset purchaseprogramme, the so-called Quantitative and Qualitative Easing,

which started in April 2013, under which it has beenpurchasing assets - mainly JGBs and treasury bills - at anannual pace of about JPY 60-70 trillion or 14% of GDP. As

JGBs at all maturities, including 40-year bonds, are eligible,the remaining maturity of the banks JGBs holdings hasdoubled to around 7 years. In this way, the bank has beenable to influence directly interest rates over the whole maturityspectrum. The yield on the 10-year benchmark is currentlyonly just above 0.5%.

The exit of the programme is conditional on inflation reachingthe BoJs price stability target of 2% in a durable way.Proposals to put a two year time limit on the programme aresystemically voted down by all but one of the Policy Board

members.

However, it will be very hard for the BoJ to quit the QQE policywithout substantial progress in bringing the public sector debtdown. Otherwise, if interest rates were to normalise to higherlevels, the increase in the debt service burden would not bemanageable. Moreover, JGB holders would suffer substantiallosses. To reduce the interest rate risk, the banks havealready reduced substantially the share of JGBs in theirportfolios.

Fiscal policy is expected to be close to neutral in the comingyears. The governments objective is to reduce the primarydeficit, i.e. that is deficit excluding interest payments, to zeroby 2020. However, not much progress has been made inreaching this objective. The budget for the next fiscal year

1- Exports have been stagnating%, y/y

world imports (volume);

Japanese exports

-30

-25

-20

-15

-10

-5

0

5

10

15

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source:CPB World Trade Monitor.


7/39

Japan 4thquarter 2014


could be the biggest to date if the Ministry of Finance isgranting all the initial requests amounting to JPY101.7 trillioncompared with JPY 95.9 trillion for the current years budget.

We assume that the government will go ahead with the 2 pointVAT hike in October 2015. In that case, it is likely that thegovernment will launch an additional stimulus package tosoften the impact.

A moderate recoveryThe Tankan indicates that, on balance, business conditionsshould remain virtually unchanged in the coming three months.However, there are some remarkable variations. Whereas, thecar makers expect a sharp worsening, the big departmentstores anticipate a substantial improvement. Moreover,

construction activity may cool down.

As a trend, growth is projected to be around 0.5% per annum,which is substantially slower than in 2012-2014, but still abovepotential, estimated at 0.2%. It will be mainly driven by twoforces. First, enterprises might step up further their capitalspending. According to the latest Tankan, capital spendingcould increase by 4.2% in the current fiscal year, supported bygood profits and favourable financing conditions.

Second, exports could strengthen in line with world tradegrowth. They will also be supported by the further depreciationof the yen, which is related to the widening spread of interest

rates between Japan and the US.

By contrast, private consumption will continue to be a drag ongrowth due to continuing, although diminishing, losses inpurchasing power. Household expenditure could betemporarily boosted in the middle of 2015 by frontloadeddemand before the second VAT hike in October.

Inflation, excluding the direct effect of the VAT hike, isexpected to gradually increase and could even reach theBoJs 2% target in the course of 2016. This will boost the

credibility of the target, which may serve increasingly asbenchmark in wage negotiations. Moreover, the tightening ofthe labour market will further push up earnings. In 2016,wages could rise by 2.8%.

The reaching of the inflation target in 2016 does not imply thatthe BoJ is soon to exit QQE. To prevent government spendingspiralling out of control, the Bank will continue to buy treasurybills and JGBs even in 2016 in order to keep interest rates low.Investors might reduce their JGB holdings in favour of higheryielding assets. Nevertheless, Japanese pension funds andlife insurance companies are likely to remain interested inbuying JGB to match the duration of their liabilities with theirassets. Moreover, the government could tighten macroprudential rules to force domestic investors into buying JGBs.

Raymond Van Der [email protected]

2- Investment rebound supported by increased profits

Investment (%, y/y.); Profits to sales ratio(%, RHS)

0

1

2

3

4

5

6

-25

-20

-15

-10

-5

0

5

10

15

20

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: Ministry of Finance.

Summary


y /y , % 2013 2014 e 2015 e

GDP 1.5 0.8 0.5

Priv ate Consumption 2.0 -0.5 -0.2

Public Spending 3.5 1.3 1.2Fix ed Inv estment 0.1 4.1 0.4

Net ex ports (contribution) -0.2 0.1 0.1

Inflation & Labour

y /y , % 2013 2014 e 2015 e


Consumer Prices (ex. F & E) -0.2 1.9 2.0



% GDP 2013 2014 e 2015 e

Current ac count 0.7 0.1 -0.1

General Government Budget -9.0 -8.0 -6.4

Debt ratio 225 229 232 e : BNP Paribas Estimates & Forecasts


8/39

United Kingdom 4thquarter 2014


United Kingdom

Strong economic performanceGeopolitical tensions and the weakness of the eurozone recovery are holding back growth in the United Kingdom. The Bankof England is watchful, and is unlikely to tighten monetary policy until early 2015. However, sentiment amongst the British,both households and businesses, remains robust. The reduction of over-capacities and easy financing conditions aretherefore likely to boost investment spending over the coming months. In addition, the strength of the labour market islikely to boost consumer confidence and spending.

Positive growth prospectsThe situation seems set fair. The United Kingdoms economicposition is better than initially thought. According to the latest

estimates from the ONS, second quarter GDP was 2.7%higher than its previous peak in the first quarter of 2008.According to previous estimates, GDP had at this point onlyjust returned to the previous peak level. The interveningeconomic contraction was in fact smaller than initiallyestimated over the course of 2009 (-4.3% instead of -5.2%).The United Kingdom has enjoyed particularly strong growthsince the first quarter of 2013 (0.7% q/q on average). Thuseconomic activity returned to pre-crisis peak levels in the thirdquarter of 2013.

The rate of GDP growth is likely to ease slightly over the nextfew months due to weak global economic conditions. That

said, the UK still enjoys positive growth prospects. Surveydata from the PMI and CBI also indicate continued positivegrowth trends. The composite economic indicator for allsectors showed an average for the third quarter of 58.4 (from58.6 in Q2 2014). Household spending, supported by thestrength of the labour market, coupled with businessinvestment will enable the United Kingdom to register growthof close to 3% in 2014 (from 1.7% in 2013) and 2.8% nextyear.

The global climate is not helpingHowever British businesses need to rise to the twinchallenges of a sluggish global economy and a rise in the

value of sterling. Growth in China is likely to slow down, whilstthe recovery will remain slow in the eurozone, the UKs maintrading partner (nearly 45% of its exports of goods). Againstthis background, the rise since March 2013 of more than 10%in the trade-weighted exchange rate for the pound, aconsequence of the UKs recent strong economicperformance, has been a burden to exporting companies.Manufacturing industry (10% of total added value) will havebeen particularly hard hit. According to the Markit survey, therate of growth in foreign orders received by manufacturingsector companies slowed sharply in the third quarter (to 52.1,from 54.7 in Q2 2014). We would therefore expect growth inexports to be slower than that in imports, which will be

bolstered by the strength of domestic demand this year.

Domestic demand comes to the rescueBusiness investment and consumer spending, which bothcontributed 0.3 of a point of GDP growth in the second quarter,will remain as the main engines of growth over the next fewquarters. The absorption of excess production capacity andfavourable growth prospects are likely to encouragecompanies to continue to invest. Favourable financing termsare also helping. Meanwhile, lending to business has seen avery slight improvement this summer. All sectors are likely tocontribute to this trend, particularly construction, thanks to

strong growth in real estate prices (9.4% y/y in Septemberaccording to Nationwide).

Growth in payrollsPrivate sector consumption, which is now close to its previouspeak in the fourth quarter of 2007, will continue to support theeconomy over the coming months. Continued growth at afairly fast pace will be accompanied by further increases inemployment. In addition, consumers will continue to spend,despite the deterioration of purchasing power.

Wage moderation is likely to continue until the end of the year(3-month moving average of 0.6% y/y (including bonuses) in

July). Tension in the labour market remains contained. Therelatively high proportion of part-time workers wishing to workfull time (16.5% of part-time workers at the end of July)

1- Domestic support for growth

Contribution to growth (points of GDP)

Inventory change Net exports Final domestic demandGDP

-3

-2

-1

0

1

2

3

4

2008 2009 2010 2011 2012 2013 2014 Source: Office for National Statistics.


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United Kingdom 4thquarter 2014


suggests continued overcapacity. The fall in theunemployment rate to its lowest level since the end ofNovember 2008 (6.2% at end-July from 6.4% a month earlier),coupled with modest wage growth and the increase in thestate pension age for women, have probably combined todrive up the labour force activity rate (to 76.9% 1 in Q1 2014,compared to 72.3% in the eurozone according to the OECD).In addition, the concentration of job creation in service sectors(government services, health and social care), wherecompensation is low, is likely to help contain upward pressureon wages.

Wage growth will not be enough to boost householdpurchasing power before the end of this year. Inflation is likelyto remain below the Bank of Englands 2% target over thenext few months, thanks to this modest wage growth and thestrength of sterling. It will however remain too high (1.5% y/yby the year end according to our estimates) to enablehouseholds to maintain their purchasing power.

Even so, given the confidence of consumers, the savings ratewill remain low (6.2% of gross disposable income on averageover H1 2014). Consumers are enjoying the combination offavourable economic conditions and accommodating lendingterms, which offers them the possibility of having easy accessto credit.

Meanwhile the government is seeking little in the way ofadditional effort, with the next general election only monthsaway (May 2015). It is counting on the fiscal tighteningmeasures adopted over the past few years and robusteconomic growth to bring the government deficit (5.7% ofGDP in 2013-14) down below 3% of GDP in 2016-17, andthen to reduce the debt burden from its current level of 87.2%of GDP.

1Population aged 15 to 64 years.

The Bank of England remains cautiousThe victory for the unionist cause in the Scottish

Independence Referendum on 18 September brought a periodof uncertainty to an end. New estimates of national economicactivity have indicated a stronger picture than initially thought,and growth prospects remain favourable. However, the BoE isunlikely to tighten monetary policy until early 2015. It fears thata premature increase in its policy rate from the current level of0.5% would hit businesses and households, which arecarrying high levels of debt (137.8% of disposable income inQ2 2014). The eurozone recovery is taking longer thanexpected and geopolitical tensions have been ratcheted up anotch. Moreover, inflationary pressure remains under control,and there is still uncertainty over trends in productivity andwages. However, we expect that the gradual absorption of

excess capacity in the labour market will be accompanied, atthe beginning of next year, by greater productivity gains andwage increases. Even so, the monetary tightening, which weexpect to come in February 2015, will be very gradual in ordernot to kill off the recovery. Monetary policy is therefore likely toremain accommodating for a considerable time to come.

Catherine [email protected]

2 - Declining saving ratio

Gross disposable income (y/y, %)Household saving ratio (% of disposable income, rhs)

4

5

6

7

8

9

10

11

12

-3

-2

-1

0

1

2

3

4

2007 2008 2009 2010 2011 2012 2013 2014

Source: Office for National Statistics

Summary


y /y , % 2013 2014 e 2015 e

GDP 1.7 3.0 2.8


Public Spending 0.7 1.3 2.3Fix ed Inv estment 3.2 8.6 6.3

Net ex ports (contribution) -0.0 -0.1 -0.2

Inflation & Labour

y /y , % 2013 2014 e 2015 e





% GDP 2013 2014 e 2015 e

Current account -4.5 -5.1 -4.7


Debt ratio 87 90 91 e: Estimates and forecasts: BNP Paribas


10/39

Eurozone 4thquarter 2014


Eurozone

Relying on the ECBAfter positive readings for four quarters in a row, GDP growth came to a halt in Q2 2014. While one-off factors were partiallybehind this poor performance, survey data had already began to signal that activity was losing momentum. Inflation is stillalarmingly close to zero and inflation expectations are trending downwards. Against this backdrop, the ECB cut interestrates, provided cheap liquidity to banks and started buying private sector debt securities. A more accommodative monetarypolicy stance, the depreciation of the euro combined with a lighter fiscal drag should support activity going forwards. WhileGDP growth should remain modest in the second half of the year, it should gain some momentum thereafter.

Losing momentumAfter modest positive readings for four consecutive quarters,GDP growth came to a halt in the second quarter of 2014.

Some temporary factors weighed on activity, like calendareffects or the mild weather, which reduced the consumption ofenergy. Yet, survey data had already begun to signal thatactivity was losing some momentum. Q2 2014 GDPbreakdown shows that domestic demand was almost flat.Growth in private consumption more than offsets the fall ininvestment, while the positive contribution of net exportshelped to compensate the negative one of inventories.

Investment the weakest component of GDPAvailable data for Q3 are not very encouraging. Both theComposite PMI for activity and the Economic SentimentIndicator declined further during the quarter. Geopolitical

tensions weighted significantly on confidence, particularly inGermany, highly exposed to the Eastern-Europe. The highlycyclical investment is probably the GDP component that is themost vulnerable to the decline in confidence and the rise inuncertainty. According to survey data, capacity utilizationremains well below its long-term average and lack ofequipment seems to be less an issue for companies that itused to be on average over previous quarters. All thissuggests that firms are less in a hurry to increase theirinvestments. Against this backdrop, investment probablycontracted again in Q3. Thereafter it is expected to graduallyrecover as headwinds (geopolitical tensions, deleveragingprocess, uncertainty regarding future output etc) progressively

fade. In particular, domestic demand might benefit from amore accommodative monetary policy stance (see below) andfrom a lesser fiscal drag. The ongoing discussion on how touse all flexible clauses of the Stability and Growth Pact andthe Junkers plan (EUR 300bn of public and privateinvestment over three years) are likely to support demand aswell. The slower fiscal tightening should bring some relief tohouseholds disposable income and so on privateconsumption. Notice, however, that we are far fromforecasting a significant pick up in private consumption. Thehousehold sector is still deleveraging and wage growth willremain moderate on the back of still high unemployment ratesin several countries. Last but not least, households saving

has been eroded during the crisis and households mightprefer restoring their buffers rather than increase significantlytheir purchases.

The external sector should continue to sustain growth,moderately in the short term and more vigorously in thesecond half of next year, benefiting from the stronger recoveryin the main trading partners of the eurozone, (the UK and theUS) and from the ongoing depreciation of the euro. Since thebeginning of June the euro depreciated by almost 7% againstthe US dollar by almost 4% in nominal effective terms.Divergent monetary policies followed by the Fed and the BoEfrom one side and the ECB from the other side, suggest thatthe euro will continue to depreciate going forwards. Standardeconometric models suggest that a 10% depreciation of theeuro in nominal effective terms would produce an increase ofoutput of around 0.4pp after one year. Taking all theseelements together, we expect GDP growth to remainlacklustre in Q3, to improve somewhat in Q4, beforeaccelerating more markedly in the second half of 2015, as theeffects of an easier monetary policy stance, of a weakercurrency and of less fiscal drag will pass on to the economywith some lags. On average, GDP growth is foreseen at 0.7%this year and slightly below 1% next year.

Inflation, low for a while

Inflation continues to remain alarmingly close to zero. A lowlevel of inflation is a risk per-se. First of all, as there are nobuffers against a negative shock, the risks of falling intodeflation increase. In addition, debt ratios hardly decline in an

1- Running out of steam?

Balance of opinions; %

GDP growth (q/q, right) ;

Composite PMI (activity)

-1.4

-0.7

0.0

0.7

36

43

50

57

2000 2002 2004 2006 2008 2010 2012 2014

Sources : Eurostat, Markit Economics.


11/39



environment characterized by low inflation and low real growthrates, and the eurozone is particularly sensitive to this threat.

Admittedly, energy and food prices contributed the most to thedecline of inflation over recent months Yet, at 0.8% in Q32014, the level of the less volatile core inflation (excludingfood and energy) is everything but comfortable. Services andNon-Energy industrial goods are the main components of coreinflation. The former (40% of the HICP index) is mainlydependent on domestic factors such as wages and the outputgap. The amount of slack in the economy is still large.International organizations currently estimate the output gapat around 3%. Given the poor state of the economy, it isprojected to narrow at a very gradual pace over the forecasthorizon. On the same line, the unemployment rate will declinemoderately

. Against this backdrop, wage and firms pricepressures are very limited if not totally absent. Taking all theseelements together we expect services inflation (1.2% in Q3) toease or to remain broadly stable in the short run, beforegradually recovering in 2015.

The other main component of core inflation, non-energyindustrial goods (or core goods, around 30% of HICPinflation), is particularly sensitive to import prices andexchange rate movements. The past appreciation of thecurrency and the decline in import prices were the mainfactors dragging down core goods inflation since mid-2012. Asthe euro is on a depreciation trend, this trend seems to havecome to an end. Consequently, core goods inflation is likely toincrease, although gradually, over the forecast horizon.

Against this backdrop, we expect core inflation to be around0.8% (or slightly below) it in Q3 and Q4 2014 before gentlyaccelerating thereafter. It should average 0.7-0.8% in 2014and 2015. The profile of headline inflation is more volatile dueto projections for energy and food components. The former ishighly related to oil prices developments. While the oil profilehas been revised slightly downwards, due mainly to lowerdemand from oil-intensive countries, China in primis, the euro

depreciation should more than offset this factor, addingupward pressures on energy inflation. After, falling over theprevious three quarters, energy inflation is expected toaccelerate in Q4, a development likely to gain momentum in2015. The escalation of geopolitical tensions added furtherdownward pressures on food inflation, which is likely to remainsubdued in the near-term, before accelerating next year.Against this backdrop, headline inflation should remain closeto its cyclical low of 0.3-0.4%% in the short-run, and smoothlyincrease going forwards. It should, however, remain below 1%for a large part of 2015. On average we expect inflation to bearound 0.5% this year and to remain below 1% next year.

ECBscredibility at risk?Credibility is the essence for central banks. The less a central

bank is believed credible, the greater the efforts it has toundertake to meet its targets. The success of the OMT is acase-study. The sole announcement of the program (it hasnever been activated) ended the speculation on thereversibility of the euro, reducing significantly tensions in debtmarkets. Recently, however, markets have been questioningthe ECBs credibility and ability to meet its main goal that isprice stability in the medium term, consistent with an inflationrate close but below 2%. Medium-to-longer term measuresof inflation expectations detect how markets assess thecredibility of a central bank. The 5-year forward five-yearahead inflation swap rate derived from financial markets, quiteoften cited by the ECB as a measure of inflation expectations,

has been on a downward trend since the beginning of lastyear. Recently, the pace of the slowdown has accelerated,with the index falling below 2%. Fearing that its credibility wasat risk, the ECB embarked on further actions this summer,cutting key policy rates to new historical lows (the refi rate isnow at 0.05% and the interest rate on the deposit facility is at-0.20%), announcing new refinancing operations aiming atincreasing lending to the private sector (Targeted LongerTerm Refinancing Operations or TLTROs) and launching aprivate sector debt security purchase program, which includesABS and Covered Bonds.

2- Eurozone, core inflation dynamics still subdued

Yearon-year, %Core inflation and confidence intervals

0.0

0.4

0.8

1.2

1.6

2.0

2010 2011 2012 2013 2014 2015

Sources : Eurostat, BNP Paribas.

3- Testing the ECB credibility

Inflation expectations derived from financial markets, y/y, %

5-year forward five-year ahead (2 weeks average)

1.9

2.0

2.1

2.2

2.3

2.4

2.5

2.6

2.7

2.8

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Sources : Bloomberg, BNP Paribas.


12/39



Effects on interest rates and liquidityAlthough several of these measures have just been

announced (and not yet implemented), they already havestarted to produce positive effects: thanks to the features ofthe TLTROs (interest rate fixed in advanced, equal to the refirate plus a spread of 10bp i.e. 0.15% and maturity up to 4years), interest rates have declined significantly and the eurois on a downward path.

At its first TLTRO conducted in September, liquidity demandwas below expectations, totaling just EUR 82.6 bn; a cost-opportunity analysis might have led banks to wait untilDecember for asking liquidity at longer maturity, taking theopportunity of getting liquidity at lower rates through thestandard weekly Main Refinancing Operations (MROs) and

3-month LTROs where interest rates are set equal to the refirate or 0.05%. The cumulative demand at the first twooperations, will probably net out the withdrawn liquidity effectof early next year, when the two 3y-LTROs mature. Bycontrast, through the other TLTROs and the private sectordebt security purchase programs, liquidity in the market islikely to increase. Greater amount of liquidity might adddownward pressures on money market rates. The Eonia,currently traded close to zero or below, might be traded atlower rates. The reduction of short term interest rates is likelyto pass on to the longer part of the curve, reducing interestrates at all maturities.

What might go wrong?The ECB is doing a significant effort to stimulate activity andinflation. Through all these measures the ECB is addingliquidity to the system, providing cheap funds for the bankingsector, which accounts for around 80% of the external sourceof funding for the non-financial sector in the eurozone. Thanksto these measures, credit supply conditions have improvedeven though the new regulatory and prudentially rules mightrepresent a constraint, at least to some extent, for lending Yet,demand for credit might remain lacklustre. A significantlylower demand than expected at incoming TLTROs would

signal that despite cheap liquidity banks face a very weakdemand for credit. In addition, when the economy isdeleveraging, the effects of a cheaper cost of credit might notstimulate credit demand as largely as usual, making theactions of the ECB less effective. A lower demand at thefollowing TLTROs would make it quite difficult for the Bank toexpand significantly its balance sheet. According to the ECBthe ongoing programs (ABS, Covered Bonds and TLTROs)might bring its balance sheet back to early 2012 levels(around EUR 3000bn). As the other options for stimulating theeconomy and increasing its balance sheet have beenexhausted, the ECB would be forced to embark on a morebroad based asset purchase scheme, including governmentbonds.

The Governing Council seems divided between those whowould have preferred to adopt bolder actions and those forwhom the ECB has already gone too far. Therefore, it is wiseto assume that further actions, if any, will be data dependent.Inflation, inflation expectations, liquidity demand and creditgrowth will be the variables to monitor very closely as if theywere to disappoint, they could trigger further actions from thecentral bank.

Clemente De [email protected]

4- ECB actions: some positive effects are already evident

%, EUR/USD

3 month Euribor, 3-monht Libor EUR/USD exchange rate (rhs)

1.28

1.3

1.32

1.34

1.36

1.38

1.4

0.05

0.10

0.15

0.20

0.25

0.30

0.35

Jan-13 Jul-13 Jan-14 Jul-14

ECB's decisions

June 2014

Draghi spokeat Jackson Hole

August 2014

Sources : ECB, Datastream.

Summary


y /y , % 2013 2014 e 2015 e

GDP -0.4 0.7 0.9

Priv ate Consumption -0.6 0.7 0.8

Public Spending 0.2 0.8 0.1Fixed Investment -2.8 0.8 0.8

Net ex ports (contribution) 0.5 0.0 0.3

Inflation & Labour

y /y , % 2013 2014 e 2015 e





% GDP 2013 2014 e 2015 e

Current account 2.4 2.5 2.7


Debt ratio 95 97 97 e : BNP Paribas Estimates & Forecasts


13/39

Germany 4thquarter 2014


Germany

The slowdown that came in from the coldAfter a brilliant start up earlier this year, German growth suddenly stalled in Q2, and leading indicators do not point to astrong recovery in the second half of the year. The absence of an economic rebound can be attributed to the combination ofgeopolitical factors and weak global demand for German goods. Under these conditions, Berlin might miss its 2015balanced budget targets, especially since the growth assumptions used in the budget now seem to be overly optimistic.This could be an opportunity for the eurozone

A mid-year air pocketThe year 2014 got off to a very promising start. GDP growthaccelerated strongly to 0.7% q/q in Q1, from 0.4% in Q4 2013,

and survey results surged to a 2-year high. Even so, thesefigures had to be interpreted cautiously, since particularly mildwinter weather had bolstered activity in industry andconstruction.

Consequently, a downward correction was expected in Q2,especially since the late Easter holiday this year and bankholidays in May (long weekends for 1 May and AscensionDay) automatically reduced the number of working days inApril and May. GDP contracted 0.2% q/q in Q2 whileeurozone growth was stagnant. Private consumer spendingand public expenditure were the only components thatincreased (+0.1% q/q each), with the first making a positive

contribution to Q2 growth (+0.1 percentage points). In contrast,corporate investment in machinery and capital goods declinedslightly (-0.4% after +3.2% in Q1). In the construction sector,investment plunged, down 4.2% q/q (compared to +3.6% inQ1), reducing GDP growth by 0.4pp. This was the sharpestdecline since Q2 2008. Foreign trade made a negativecontribution to growth (0.4pp), despite a mild increase inexports (+0.9%), which was more than offset by import growth(+1.6%).

An early summer improvementThe first statistics for July were somewhat more encouragingfor the third quarter. Manufacturing orders rebounded

buoyantly (+4.6%) after contracting in the two previousquarters (-1.7% in May and -2.7% in June). Internationalorders increased strongly (+6.9%) thanks to dynamic demandoutside of the eurozone (9.8%), particularly in the capitalgoods sector (+14.6%). Even so, total orders held to a slowingtrend (-0.9% after -0.4% in June). Industrial production pickedup strongly in July (1.9%, after +0.4% in June and -1.6% inMay). Production of capital goods also rose 5%. Nonetheless,industrial activity continued to trend downwards (-1% in July).

Downbeat survey resultsSeptember survey results (IFO, ZEW and PMI) do not raisehopes for a marked recovery in Q3. The IFO declined for the

fifth consecutive month, dropping to 104.7 from 106.3 inAugust, the lowest level since April 2013, but still higher thanthe long-term average. The expectations index slipped below

100 to 99.3, which is below the long-term average and thelowest level reported since December 2012. Confidenceeroded in all sectors without exception. The decline in thewholesale and retail sectors is also alarming (below zero forthe second consecutive month, the index is at the lowest levelsince May 2012). The GfK household survey is not verypromising either. Household confidence declined in Octoberfor the second consecutive month. Their outlook for theGerman economy continued to erode in October afterplunging in September, undermined by rising geopolitical

pressures and the sluggish eurozone recovery. Yet theconditions have come together to boost household confidenceand disposable income. The job market is near fullemployment. The unemployment rate has held stable for sixstraight months, at 6.7% in September, and wages are risingat a rapid pace (3.4% on average since the beginning of theyear, compared to 2.5% in 2013), thanks to low inflation.Inflation held steady at 0.8% y/y in September. Theintroduction of a minimum wage should benefit nearly 4 millionGermans. Lastly, monetary and financial conditions havebecome even more favourable since the ECBs latest meeting(see Eurozone: Relying on the ECB). As to retail sectorstatistics (which admittedly are extremely volatile), it is worth

noting that retail sales picked up in September (+2.5%),erasing the previous months decline (-1.5%).

1- Growth and confidence

IFO headline index IFO expectations IFO current conditions

GDP (q/q, rhs)

Sources: IFO, Destatis.

-5

-4

-3

-2

-1

0

1

2

3

70

80

90

100

110

120

130

2008 2009 2010 2011 2012 2013 2014


14/39

Germany 4thquarter 2014


The Ukrainian crisis: a major source of concernBoth companies and households alike point out that the main

factor behind the erosion of confidence is the risinggeopolitical tensions between Russia and the European Union.With its special relationship with Moscow, Germany triedthroughout the summer to use diplomatic channels to resolvethe conflict. Alas, Angela Merkels efforts proved vain and theEuropean Council announced new sanctions against Russia,on top of those already in place since July: a transactions banpertaining to new financial instruments with a maturity of morethan 30 days issued by the big state-owned Russian banksand by big companies in the defence and energy sectors; aban on loans to these same banks and companies; and anexport ban on dual-purpose goods and technology that canalso be used for military purposes, including a list of mixed

companies in the defence sector.

A prolonged contraction in Russian activity (in H2 2014 and in2015) and the implementation of any retaliatory measures bythe Russian authorities (such as cutting off gas and oilsupplies to the European Union during the winter) willprobably have a much higher impact on Germanys economythan is suggested by Russias rather limited share of Germanforeign trade (3% of German exports are sent to Russia, while4.5% of German imports come from Russia). Moreover, thenew sanctions occur at a time when trade with Russia hasbeen declining since H2 2013. In H1 2014, exports to theRussian confederation plunged by more than 15%: the

hardest hit sectors were agricultural goods (-30%),automobiles (-24%) and machinery (-19%). Moreover, 6000German companies are located in Russia in diverse sectorsranging from chemicals to transport and machine tools. Theyemploy nearly 300,000 people, and nearly EUR35bn wereinvested in them in 2013. Consequently, the Russian embargocould have a lasting impact on these companies.

All in all, given the negative acquired effect arising from thecontraction in Q2 GDP and the Russian crisis, we havelowered our growth forecasts for Germany to 1.4% in both2014 and 2015. Under these conditions, Berlin could miss its

fiscal targets for 2015 (balanced budgets for publicadministrations, i.e. the federal government, social securityand the Lnder), since the growth assumptions used in thebudget adopted last July now seem to be extremely optimistic(2% in 2015). According to Ministry of Finance calculationsused in the 2014 stability programme, a half-point shortfall ingrowth compared to the central scenario would result in anextra 0.5pp increase in the public deficit ratio.

Caroline [email protected]

2- Exports: Russian fallEURmn

Total exports Exports to Russia (rhs)

Sources: Destatis.

Summary

e : Estimations, prvisions : BNP Paribas

1 000

1 500

2 000

2 500

3 000

3 500

4 000

40 000

50 000

60 000

70 000

80 000

90 000

100 000

110 000

2008 2009 2010 2011 2012 2013 2014


y /y , % 2013 2014 e 2015 e

GDP 0.2 1.4 1.4


Public Spending 0.7 0.9 0.8Fixed Investment -0.6 3.2 2.3

Net ex ports (contribution) -0.5 -0.1 0.0

Inflation & Labour

y /y , % 2013 2014 e 2015 e





% GDP 2013 2014 e 2015 e


General Gov ernment Budget 0.0 0.2 0.3

Debt ratio 78 77 74


15/39

France 4thquarter 2014


France

Growth comes to a standstillThe French economy stalled in the first half of 2014 and is likely to remain in a standstill in the second half. Althoughhousehold consumption has shown some resilience, this is not the case for investment, and exports are struggling to pickup. After marginal growth in 2014 (estimated at +0.3%), growth prospects will improve only modestly in 2015 (+0.7%).Domestic demand is expected to remain fairly tepid and the external environment mildly supportive. However, the eurodepreciation and the governments efforts in favour of the corporate sector, particularly the employment andcompetitiveness tax credit (CICE), should help initiate a recovery in profit margins and investment.

The pick-up that did not happenGDP growth was again flat in Q2, dashing hopes of a slightrebound after an already stagnant Q1. The disappointment

can be attributed to the decline in investment (which wassharper than expected for residential investment andunexpected for non-residential investment) and the virtualstagnation of exports (vs. an expected rebound). Householdconsumption picked up as expected (+0.4% q/q after -0.5%q/q) and the increase in public consumption did not falter(+0.4% q/q). As a result, final domestic demand made a smallbut positive contribution to growth (+0.1 percentage points).Yet this support was cancelled out by the negativecontribution of net exports, since the increase in consumptionwas coupled with an increase of similar magnitude in imports.After contributing 0.5 points to Q1 growth, the correction inchange in business inventories proved to be limited, with a nil

contribution to growth.

In Q3, we expect consumption to slow somewhat whileinvestment declines less quickly. Yet the resulting smallpositive contribution of final domestic demand will be offset bythe negative contribution of change in inventories. Thecontribution of net exports is expected to be nil since importswill grow as little as exports.

Based on this breakdown, Q3 growth should therefore be nilagain, for the third quarter in a row. Yet available monthlyeconomic data point towards positive growth. Industrialproduction and retail sales both benefit from a positive carry-

over of +0.5% q/q in Q3 (in July and August, respectively),which should translate into a 0.2-0.3% q/q GDP rise accordingto our forecast model. Yet business confidence surveysavailable through September send much more mixed signalsconcerning growth prospects, which range betweendeterioration and the status quo. Taken together, thesestatistics paint a picture of an economy at a standstill, with nomomentum as it enters into Q4.

Growth under pressureDespite the absence of quarterly growth, full-year 2014 GDPgrowth should prove to be slightly positive (+0.3% accordingto our estimates), thanks to the positive carry-over inherited

from Q4 2013 GDP rise. Growth is expected to remainsluggish in 2015 (+0.7% according to our forecasts) and couldbe even weaker, since the impulse from the various support

factors remains limited, while those curbing growth hardlydissipate.

The distinction between cyclical and structural hindrances isas important as it is hard to differentiate. French growthshould recover all the more quickly from the current standstillsince it is cyclical by nature. Yet this purely cyclicalcomponent now seems to be quite small, which means therecovery promises to be anything but quick.

On the one hand, the old structural weaknesses of theFrench economy are at work, namely mass unemploymentand deteriorated competitiveness. On the other, thedepressed level of business and consumer confidence, fiscalconsolidation, the slump in the construction sector and thestrong euro are hindrances that are half cyclical and halfstructural. Even the Russian-Ukrainian crisis can be enteredinto this hybrid category in so far as it is a temporary shockwhich is lasting. The outcome of the crisis, which broke out inNovember 2013, is still uncertain, and in the meantime it isweighing on business confidence and trade of France and itsEuropean partners, especially Germany. This is one reasonwhy the disappointing cyclical performance of recent monthshas not been limited to France, but concerns the Eurozone asa whole.

1- Growth assumptions

Annual and quarterly growth

QoQ annualised yoy Forecasts

-8%

-6%

-4%

-2%

0%

2%

4%

6%

2009 2010 2011 2012 2013 2014 2015

Sources: INSEE, BNP Paribas.


16/39

France 4thquarter 2014


French growth is not lacking support factors either, eventhough their effectiveness is limited. Along with persistentlyaccommodative monetary and financial conditions, lowinflation and abundant household savings, there is also therecent depreciation of the euro, the ECBs extra monetarystimulus, the US economys improving health, and, on thedomestic front, the governments various reflation efforts. Thehousing support plan, reduced employers charges, and taxcuts favouring low income households should begin to bearfruit as of 2015. They will not radically change the situation athand, but they will undoubtedly operate in a positive manner.The employment and competitiveness tax credit (CICE) is agood example. Although it has gotten off to a laborious start,companies queried on the subject by the INSEE said theyplan to use these contracts, while two thirds intend to investand/or to hire.

Consolidation vs. reflationSluggish growth has spilled over to public finances. Thegovernment took note and sharply revised downwards itsforecasts for growth (0.4% in 2014, 1% in 2015) and inflation(0.6% in 2014, 0.9% in 2015) while raising its fiscal deficitforecasts (-4.4% of GDP in 2014, -4.3% in 2015). The returnto the 3% deficit target has been postponed until 2017.Although the governments 2014 forecasts look more realistic,they still seem overly optimistic for 2015 and, in any case,they raise several concerns.

The fiscal consolidation process has clearly come to halt. In2014, for the first time since 2010, the fiscal deficit will notnarrow from one year to the next (in 2013 it was 4.1% of GDP),and it will barely shrink in 2015. The public debt ratiocontinues to increase, and a reversal of this trend has still notbeen achieved. The big question is no longer if, but when thepublic debt ratio will cross the 100% threshold.

Compared to previous targets, this is a considerable slippage,which raises the question of whether it will be accepted by theEuropean Commission. Granted, sticking to a deficit reductiontarget of 3% of GDP in 2015, whatever the cost, would

probably mean relapsing into recession. It is understandablethat the French government refuses to take this path and isgiving priority to growth (what little there is) over sticking to itscommitments. Moreover, this slippage is not due to adeliberate lack of fiscal discipline. The government highlightsthe exceptional set of circumstances: sluggish growth and lowinflation in France, as in the rest of the Eurozone, on the onehand, and the countrys ongoing efforts in terms of spendingsavings and reforms, in particular to restore competitivenesson the other. Indeed, France has made notable efforts, withroughly EUR20bn in tax cuts injected into 2015 to boostgrowth (around EUR17bn for companies and EUR3.5bn forlow-income households) on one side, and EUR21bn inspending savings a true show of fiscal austerity on theother.

Consequently, the structural deficit does not narrow much.Estimated at 2.5% of GDP in 2013, it will be cut to 2.4% in2014 and 2.2% in 2015. Measured in this way, fiscal policy isnow only very mildly restrictive. A priori, it should positive forgrowth, at least less negative. Yet the High Council on PublicFinances clearly contests Frances deviation from its trajectoryof rebalancing public finances, and its recommendations forthe 2015 budget are much more circumspect than theprevious ones. We can also expect the European Commissionto issue a severe warning to the government for fiscallyslacking off, even though it will probably go ahead with thegovernments arguments and grant the extra time requestedto bring its deficit back to 3% of GDP.

Hlne [email protected]

2- Fiscal consolidationFiscal imbalances, % of GDP

headline fiscal deficit structural deficit

-8

-7

-6

-5

-4

-3

-2

-1

0

-8

-7

-6

-5

-4

-3

-2

-1

0

1978 1982 1986 1990 1994 1998 2002 2006 2010 2014 2018 Sources: INSEE, French Government, BNP Paribas.

Summary


y /y , % 2013 2014 e 2015 e

GDP 0.4 0.3 0.7


Public Spending 2.0 1.8 1.1Fixed Investment -0.8 -2.5 -0.6

Net ex ports (contribution) 0.1 -0.0 -0.1

Inflation & Labour

y /y , % 2013 2014 e 2015 e





% GDP 2013 2014 e 2015 e

Current account -1.3 -1.8 -1.5

General Government Budget, %GDP -4.1 -4.4 -4.4

Debt ratio, % 92 95 98 e : BNP Paribas Estimates & Forecasts


17/39

Italy 4thquarter 2014


Italy

Time for reformsItaly was not different from other eurozone countries in Q2, with well below expectations GDP growth. Still, thedevelopment is worse, as it pushed back the Italian economy into recession, for the third time in just seven years.Investment proved the weakest link, contracting by almost one full percentage point. Since the beginning of the currentcrisis, i.e. early 2008, investment has been cut by a third. Such a prolonged and substantial under-par investment raises thethreat that the long-term potential rate of growth has been lowered for good. Structural reforms are more needed than everto avoid Italy slipping into secular stagnation. The labour market is on top of the list.

Suffering from the European slowdownItaly was not immune from the general weakness experiencedby the Eurozone in Q2, with a GDP contraction of 0.2%. But

contrary to others, this resulted in Italy slipping back inrecession, the third such episode over the last seven years.While the Q2 underperformance left both French and Germanactivities above the Q1 2008 previous peak, this drove itfurther down in Italy. In Q2 2014, GDP was 10% lower than 6years ago.

In Q2, final domestic demand was particularly weak, shaving0.1 percentage point off the Ital ian GDP. As the inventorychange accelerated (adding 0.2 pp to growth), this liftedimports. As exports suffered from the weakness in the rest ofthe Eurozone, international trade was a drag on growth(-0.2 pp). Looking forward, prospects are not that encouraging,

and the chances that Italy will have experienced another GDPcontraction in 2014 as a whole are great. Even if the economywere to manage not to contract further in H2, this would leaveGDP growth at -0.2%. We thus expect that the Italianeconomy will record in 2014 a third consecutive decline(-0.3%, after -2.4% in 2012 and -1.8% in 2013).

A widespread contractionIn Q2, the contraction of activity was widespread. Themanufacturing sector, which had shown signs of a moderaterecovery, with production increasing both in Q4 2013 and inQ1 2014, recorded a significant contraction. This negativetrend is expected to continue in the coming quarters.

Production fell by almost 2% year-on-year in July, with all sub-components going down. In Q2, the decline in the valueadded of the construction sector was also particularlypronounced (-0.8%, after -0.9% in Q1), while activity in theservices sector virtually unchanged.

Towards a new low level of consumptionDespite benefiting from the recently introduced tax reliefs forlabour income, Italian households have continued to rebuildtheir savings. At the beginning of 2014, the personal savingratio remained unchanged at 10%, well above the 7.8%minimum reached in the middle of 2012. As a consequence,private consumption grew very moderately over the first half of

2014 (+0.1% both in Q1 and in Q2). It was boosted, mainly, bythe falling prices for durable goods, allowing households toincrease those expenditures.

Still, as the conditions on the labour market are still terrible,households disposable income does not allow to expect amarked rebound in consumer spending. The unemploymentrate stabilised, but at a high level (12.6% in July). To thisreading, one has to add 2 percentage points, as workersbenefiting from the wage supplementation scheme arecounted as employed even though they do not work, whichcan be considered as hidden unemployment. Hence,households purchasing power is stagnant, actually 10%below pre-crisis levels.

Still declining investmentAfter having rebounded in Q4 2013, partly owing to taxincentives and to spending in anticipation of newenvironmental regulations for road transport, investment fellby about 1% in Q2, i.e. the same rate of decline as in Q1.Expenditures in machinery and equipment renewed withcontraction (-1.5%), more than offsetting the limited recoveryexperienced over the previous quarter. Since the beginning ofthe crisis in 2008, fixed investment has been cut by a third,both the private and government sectors slashing theirspending.

Business investment continued to be held back by persistently

uncertain prospects for demand, large over-capacities andtight financial conditions for firms, while the government sector

1- Non-encouraging components of demandContributions to Q2 quarterly GDP growth, %

Investment ; GDP ; Private consumption ; Exports ; Imports

Source : Istat

-1.0

-0.5

0.0

0.5

1.0

1.5


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Italy 4thquarter 2014


has had and still has to maintain a primary budget surplus tolower the public debt ratio

Resilient exports, so farThe relative resilience of exports has marked a distinctivefeature of the economic performance of Italy throughout thepast years. Compared with Q1 2008, exports of goods andservices are down by only five percentage points. As acomparison, the decline in GDP is twice as large and the cutin fixed investment six times as large. However, the slowdownin international trade, the deceleration of growth in theEurozone and a fiercer competition from non-EUmanufacturers proved powerful headwinds. A substantialrecovery in the Italian competitiveness probably is thenecessary condition for avoiding a further slippage of the

share of Italy in international trade. More crucially, the fight isagainst a prolonged stagnation that would dampen the long-term growth potential, as ageing capital would result in slowerproductivity potential while the longer the spells ofunemployment are, the greater is the potential loss of workersskills.

Time for reforms: labourAs for the desperately needed structural reforms, the ones onthe labour market rank first. Specifically, the duality that doesexist on the Italian labour market has to be lifted. Dualitybetween over-protected elder insiders and highly precariousjobs for the youth has severely deepened in Italy through the

past seven years. While total employment declined by 5%,since Q2 2008, employment of those aged 15 to 34 year-old isdown 30%. With 70 percent of new hires being temporarycontracts, the unwillingness to invest in young workersrepresents a major threat against both economiccompetitiveness and social cohesion.

The Jobs Act proposed by the Prime Minister, Matteo Renzi,focuses on the introduction of a single labour contract withgradually increasing protection. The new contract would setthe right balance between flexibility and durability thusstimulating new investment. This would be particularly true for

large and medium-size companies, which are now deterred bythe rigidities of a workers statute , a statute dating back to the1970s. Further chapters of the reform will design andimplement a national agency responsible for coordinatingactive labour market policies. The new agency would play apivotal role in spreading wider information on job openingsand improve the monitoring and evaluation of job seekers.

The political debate around the labour reform is going to befierce as oppositions to change are multiple. Approval of the

Jobs Act will be necessary to revert long-run investment

depletion and to consolidate confidence both inside andoutside Italy.

Giovanni Ajassa Paolo [email protected] [email protected]

2- Diverging trends

Q1 2008 = 100

Investment ; Exports

Source : Istat

Summary

e : BNP Paribas Estimates & Forecasts

3- Employment: heart-breaking trendsQ2 2008 = 100

Total persons at work ; Permanent employees aged 15-34

Source : BNL calculations on Istat data

70

75

80

85

90

95

100

2008 2010 2012 2014


y /y , % 2013 2014 e 2015 e

GDP -1.8 -0.3 0.3

Priv ate Consumption -2.6 0.1 0.4

Public Spending -0.8 0.1 -0.6

Fixed Investment -4.6 -2.0 -0.5

Net ex ports (contribution) 0.8 0.2 0.3

Inflation & Labour

y /y , % 2013 2014 e 2015 e





% GDP 2013 2014 e 2015 e



Debt ratio 128 132 135

60

65

70

75

80

85

90

95

100

2008 2010 2012 2014
mailto:[email protected]:[email protected]:[email protected]


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Spain 4thquarter 2014


Spain

Negative externalitiesSpains economic situation continues to improve, but in a deteriorating external environment. This could put somewhat of astrain on growth, although it does not substantially change our scenario. We expect to see a lasting but relatively slowrecovery. Under this environment, inflation will remain near zero, which complicates the debt reduction process and thusthe clean-up of banksbalance sheets. As for public finances, fiscal consolidation continues, but will probably be harder toimplement with the approach of next years elections and increasing tensions between the central government andCatalonia.

Growth to dip slightlyAfter starting off the year at a buoyant pace (GDP growthreached 2.3% q/q saar in Q2), GDP growth could ease slightly

in H2. First, sluggish Eurozone growth coupled with aslowdown in Latin America risks straining growth in exportsectors. Therefore the pattern of the recovery (i.e. dynamicexport sectors create jobs, which in turn boost domesticdemand and fuel growth), although not called into question, islikely to unfold at a more gradual pace. Second, thehouseholds savings rate is back to historically low levels, andwill probably need to be lifted in order to pursue debt reduction.While consumption has been growing at a very dynamic pacesince Q3 2013 (0.6% q/q on average), a higher savings ratecoupled with a slowdown in job creations should result in aless rapid increase in household spending. All in all, ourscenario calls for an ongoing economic rebound, at a relative

sustained pace (0.4% q/q on average), which is nonethelessslower than previously expected. We are maintaining our 2014GDP growth forecast at 1.2%, but lowering our 2015 forecastto 1.6% from 2.1%.

Inflation or the lack of itUnder this environment, we are also lowering our inflationoutlook to roughly 0% for both this year and next. Severalfactors are exerting downward pressures on prices. Internaldevaluation enabled companies to boost their competitivenessby squeezing labour costs. Energy costs have also fallen.Lastly, the persistent sluggishness of domestic demand limitsthe pricing power of firms.

Of these three factors, the first is probably not playinganymore. After declining 6.5% between early 2011 and year-end 2012, real unit labour costs (i.e. real labour costs per unitproduced) levelled off before picking up slightly. Yet rising unitlabour costs are unlikely to carry over to prices, since they areessentially due to a shift in the sharing of value added infavour of employees after several years of increasing in profitmargins. The second factor, lower energy costs, could alsostop contributing to deflationary pressures. A weaker eurocoupled with relatively stable energy prices forecast for thequarters ahead should swing energys contribution to inflationinto slightly positive territory. This leaves us with the third

factor: the very low level of demand, and in particular, thepersistently big output gap.

It would take several quarters of dynamic growth, well aboveSpains potential, to absorb excess production capacity andgenerate pricing pressures again.

Low inflation will make debt reduction harder, and will thusmaintain credit risk at a fairly high level. The debt of non-financial private agents (households and non-financialcompanies) still represents 200% of GDP 1 . Although non-performing loans have eased slightly, they still account for13% of total loans. Under this environment, despite the

beginnings of an easing trend, credit conditions are likely toremain tight for quite some time, another factor that isstraining price momentum.

Fiscal consolidation is still neededThe public deficit target for the general government this yearis 5.5% of GDP, which corresponds to a primary budget deficitof 2% of GDP. The government seems to be in a position touphold its commitments, even though nominal growth willprobably be lower than in budget projections (1.7%).

Even so, public deficit will remain too high to prevent the debtto GDP ratio from rising. It is likely to come close to 100% of

1In Q1 2014, household debt amounted to 76% of GDP and corporate debtto 126%.

1- Inflation

y/y change, %

Headline inflation

Core inflation

Source : INE

-2

-1

0

1

2

3

4

5

6

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014


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Spain 4thquarter 2014


GDP this year. Low inflation makes it even harder to stabilisethe public debt ratio. The differential between the implicitinterest rate on debt (3.6% in 2014) and nominal growth mustbe offset by a primary budget surplus proportional to the levelof debt to be stabilised. Assuming that nominal growth is 1%this year, a primary surplus of 2.4% would be necessary tomaintain the public debt ratio at last years level (94% of GDP).

In other words, sizeable fiscal efforts still need to be made tostabilise and then lower the public debt ratio. Yet with nextyears electoral calendar (local elections in May followed bygeneral elections in November), the government might lackthe necessary willpower to undertake greater austerity. The2015 budget seems to be based on overly optimisticassumptions, while the promised adjustment is ambitious(public deficit target of 4.2% of GDP). Consequently, weforesee an ongoing rise in the public debt to GDP ratio at leastuntil 2016, when the strengthening of nominal growth andfiscal advances should offset the increase in the debt derivedfrom interest expenses.

Regional tensionsThe regional Catalan Parliament recently passed a lawallowing the organisation of a referendum on the regionsindependence in early November. The Spanish governmentfirmly opposes this project and filed suit with the ConstitutionalCourt, which in keeping with expectations, suspended theregional law based on its unilateral nature.

It remains to be seen whether the referendum will bemaintained. The head of Catalonias ruling coalition, Mr.Arturo Mas, faces a serious dilemma. Maintaining thereferendum would be illegal and risks accentuating tensionswith the central government. Moreover, the European Unionmight not recognise the referendums results, which isnonetheless vital for the viability of the independence project.Inversely, following the moderate nationalist CiUs traditionalline, and giving up the referendum would risk losing thesupport of the ERCs radical separatists.

In this case, new regional elections would have to be held,which would probably give more power to ERC, an outcomethat would surely displease the central government.

Faced with this impasse, it remains the path of negotiations,which has been explicitly left open by Mr.

bnp paribas - eco perspective_4tr_en 9.10.2014

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